Rates Spark: Playing chicken

This week will likely see the FOMC persisting in its game of macroeconomic chicken with inflation. Our economics team reckons that all this meeting will deliver is a further preparation for a tapering of asset purchases that will eventually be announced this December. Between here and then, the thinking goes, a very gradual shift in communication will prime markets for the end of QE, and allow the economy to clock more job market gains.

Policy tightening will prove a lot trickier to pull off

This is a laudable objective but the subsequent policy tightening will prove a lot trickier to pull off. Our core view is that the $120bn/month bond purchases is to be reduced down to zero by the time of the first rate hike in September 2022, which will be followed by a second in December. To us, the Fed’s persistent dovishness in the face of persistent inflation is akin to a driver keeping their foot on the accelerator to only slam the break at the last minute.

These consideration are far from the rate market’s thinking. In recent months, yield curves have shaved nearly 100bp to the expected terminal Fed Fund rate, and also delayed the date at which they expect the first hike to occur. The temptation is great to take these at face value and conclude that investors anticipate a sharp slowdown in economic activity.

QE is as much part of the solution as it is part of the problem

While there may some legitimate concerns about the spread of the Covid-19 Delta variant, these feel to us like an attempt to fit a story to the move. The drop in interest rates has at least as much to do with heavy-handed Fed purchases, constrained supply, and illiquid summer markets. If we’re right, then QE is as much part of the solution as it is part of the problem.

In the near term, only a change in the Fed’s communication surrounding QE could affect this state of play and, as we wrote above, we doubt the Fed will send a strong signal this week. Granted, there is broad agreement that current yield levels do not reflect economic fundamentals but, as we are still in the ascending phase of the current Covid-19 wave, we fear that appetite to fade the move on that basis will remain limited.

Yet the case for holding treasuries at this yield level is weakening fast. Not only is the carry benefit proportionally diminished, the jump in volatility means investors should demand a greater compensation for taking the risk of owning them. There could, of course, be a period of stabilisation at current levels. This, in our view, would require at least a month of anaemic price action. By this time next month, we expect market liquidity to have recovered, and for the September supply surge to come firmly into view, hardly a recipe for stable rates.