Rates Spark: Easing into tightening

At today’s FOMC, the Fed is expected by our economics team to bide its time but (slowly) crank up the communication ahead of a tapering of QE, to be announced in December. If the policy statement to be published this evening is unlikely to rock the boat, chair Jerome Powell’s subsequent press conference will be the centre of attention.

The definition of "transitory" looks like it will be stretched from a few months to over a year

Based on his July testimony to congress , we fully expect him to stick to his transitory inflation mantra. No matter that the definition of "transitory" looks like it will be stretched from a few months to over a year based on our economics’ team forecast of core inflation remaining above 3% until this time next year. In time, this should push the Fed into an aggressive policy of tightening, doing away with QE in H1 2022, while hiking twice in H2.

It will also be interesting if his tone remains as upbeat as at the June meeting. Any departure would be seen as a sign that the rate hikes forecast in the June projection material (which will only be updated again in September) may have overshot. This is definitely the line along which the rates market is currently thinking but it will be hard for Powell’s tone to be so downbeat that it justifies the decline in forward Fed Fund rates compared to what prevailed in March.

As the Fed’s next policy step is widely expected to be a tapering of its asset purchases, it makes sense that long-dated yields take for a while the role of most volatile section of the curve. It would make sense at least if hike expectations had remained roughly constant throughout the phase of aggressive curve flattening seen in June and July. The problem is that the curve has priced out hikes over the same period, a lot of them, so it is hard to conclude that tapering expectations is actually an important driver of USD rates.

One reason could be that tapering, discussed since at least the start of this year by FOMC members, and creeping up progressively in official communication, is widely expected. We have argued before that its main relevance for markets was a signal on the timing of the Fed Fund rate hiking cycle. This is of course a simplistic reasoning but it offers some insight as to how markets would react to any more aggressive messaging on tapering at today’s meeting.

Unless the Fed goes out of its way to separate the messaging on tapering and on hikes, for instance by signalling a longer lapse of time between the two, we think any more hawkish messaging today should result in more hikes being priced back into the curve. The sector most likely to be impacted would be a rise in rates in the 3-5Y maturities. This would go some way towards offsetting the steepening impetus that one would expect from tapering getting closer.

US rates have reacted to the hawkish shift at the June meeting with scepticism

One last consideration is that US rates have reacted to the hawkish shift at the June meeting with scepticism. Another step in the same direction would run counter to the dominant (bearish) economic narrative in rates markets and could eventually push rates lower if they expect Fed tightening to unnecessarily slow the economy down. This outcome would add to flattening pressure on the curve in our view, and lead 10Y treasuries closer to 1%.