Rates Spark: Super Thursday

A 75bp hike from the Federal Reserve was as expected, but the median dot of 4.6% for 2023 and the 4.4% median dot for 2022 were higher than expected. These dots are above the pre-FOMC market discount, and mean that the rates market needs to re-calibrate. The dots are nothing more than a guesstimate, but they are from those that ultimately set the rates. In that sense, the entire curve needs to react to this.

Note also that the hike in the dots is in excess of the 75bp hike delivered up front. The 2022 hike in the dots is 100bp and the 2023 hike is 80bp, which helps explain the big move higher in the 2yr yield.

The big impact move was in the 2yr, which shot up to 4.1% post the hike, a full 10bp move. The elevated median dots for 2022 and 2023 were the dominant driver here, and especially the 2023 median dot which is now closer to 5% than to 4%. There is also a messaging there for the market that the Fed intends to maintain a tightening trajectory beyond the end of 2022 and into 2023, as least as telegraphed from the dots themselves.

The 10yr yield now needs to consider a path towards 4%

The 10yr yield now needs to consider a path towards 4% in the coming couple of months. History shows that the 10yr rarely trades more than 50bp through the funds rate before the Fed has peaked. And note that 50bp through is the exception. A more normal discount would be to see the 10yr 25bp through the funds rate ahead of a confirmed peak from the Fed.

Real rates have come under rising pressure as inflation expectations managed to ease lower post the hike. This is good from the Fed's perspective. Higher real rates are required in order to tighten financial conditions, while an easing in inflation expectations tells us that the market ultimately expects the Fed to see inflation fall. The thing is, the case for big falls in inflation has yet to be proven.

The dot profile points to rising official rates in 2023, and muddies the waters for the prognosis of falling market rates into the turn of the year. But if we are right and the Fed does in fact peak by year end, then that fall in market rates anticipated through December/January is very much back on.

Consensus seems to have shifted from a 75bp to a 50bp hike at this Bank of England (BoE) meeting on the back of an already visible economic slowdown, and despite a very generous energy support package aimed at shielding consumers from higher prices. At first glance greater, probably debt-financed, government support should push the Bank into more aggressive tightening by shielding the economy from a more serious recession. This is a simplistic view however, given that the plan also entails a much lower inflation peak, and given that the UK economy looks set to enter a difficult phase economically regardless. This is without even considering the optics of working at cross purposes with fiscal policy.

The BoE also has to contend with markets quickly losing confidence in the UK’s economic management

If the economic dilemma it faces wasn’t daunting enough, the BoE also has to contend with markets quickly losing confidence in the UK’s economic management. The promise of effectively open-ended fiscal support, a current account deficit, and a fast-approaching recession have foreign investors question their exposure to sterling-denominated assets. In theory, the BoE could help stem outflows by raising interest rates but it would do so at the risk of worsening two of the three problems mentioned above. Keep also in mind that the Bank is currently actively reducing its balance sheet size (aka Quantitative Tightening) and could start active gilt selling as early as this month, and you have a credible rationale for not raising the hike increment from 50bp to 75bp.

If it finds the time, the BoE may also discuss remuneration of the bank reserves, running at £945bn, created in large part to finance QE. As the Bank Rate (BR) rises, markets are now pricing a terminal rate not far from 5%, the cost of remunerating these reserves will quickly climb, resulting in a loss for the BoE and a cost for the Treasury. One of the ideas floated repeatedly in the press would be for a fixed portion of Bank Reserves to earn 0%, and the rest to earn the BR. We have covered the mechanism for the ECB in a recent article. The BoE doesn’t have to worry about cross-border effects but the basic dilemma remains: the more it wants to save in interest bill to banks, the more it risks losing control of money market rates.