2023-03-07 21:01:22 ET
Summary
- Jay Powell stunned markets on Tuesday, indicating the pace of rate hikes could increase.
- Additionally, he noted that would need to go higher than previously thought.
- This led to a massive re-pricing of interest rates.
The market experienced significant turmoil after Jay Powell's testimony on the Senate floor. Bond yields skyrocketed as Fed Funds Futures priced in even higher rates for far longer than markets expected. This caused the dollar to soar and equity prices to tumble.
Powell's concern over the hot data from January and early February led him to warn that the Fed may increase rates faster if the data support such a move. He also suggested that rates will likely be higher than noted at the December Fed Funds meeting.
While it's no surprise that the terminal rate will have to move higher given the hot PCE, it was unexpected to see Powell consider raising rates by 50 bps at this stage. This suggests that he may be seeing something in the data that has worried him enough to consider moving faster. We may find out more when the February Job and CPI reports are released on Friday and next week. Additionally, the Fed will soon be entering a blackout period, and this was his last chance to warn the market a rate hike greater than 50 bps is still possible if the data warrants it.
A Massive Repricing of Rates
The entire Fed Funds Futures curve rose sharply, with the peak terminal rate now at 5.64% by October 2023, while the December contract is pricing at 5.45%. It's almost laughable to think that just on Feb. 2, the market priced at a peak rate of 4.875% by July, and rates falling to 4.47% by December.
As a result, the two-year rate rose by 12 bps, moving over 5% for the first time since 2007, and it is likely to continue rising. This is because it's following the December Fed Funds Futures contract higher.
Rising Real Yields
With the expectation of more rate hikes and a higher terminal rate, the market began to reprice inflation expectations. As a result, real yields rose sharply, while nominal yields on the long end of the curve barely moved. Today, the 5-Year TIP rate rose by 20 bps, and the 10-year TIP rate increased by ten bps. However, the 5-year and 10-year nominal rates only rose by six bps and one bps, respectively. This caused the 5-year and 10-year breakeven rates to plummet—higher rates in the short-term mean slower growth in the long term.
Inversion Grows Deeper
Rising rates on the short end of the curve lead to the spread between the 2-year and 10-year yields falling to -1.05, indicating that the Fed's rate-hiking cycle is far from over. The steep inversion of the yield curve suggests that the Fed must continue its efforts to cool the economy and slow inflation. The spread has not shown any signs of bottoming out yet, so until it does and begins to price in a Fed pause, the inversion suggests the Fed will likely have a lot of work ahead of them. This also suggests that a recession may still be far off in the distant future.
The 2/10 spread typically rises before the unemployment rate, just before a recession. However, the bond market currently suggests that the job market is still relatively healthy, and as a result, the Fed will need to continue tightening rates.
One has to wonder what the market has been thinking beyond recognizing the Fed's serious intentions. The Fed has been clear about its plans to raise rates above 5% for several months and warned that inflation would likely be persistent.
Inflation Still A Problem
Moreover, there are a few indications that suggest inflation isn't cooling. For example, Manheim reported today that used auto prices rose 4.3% in February, the highest reading since October 2021. This was higher than the preliminary reading from mid-February.
Additionally, preliminary data suggests that the CPI for February may be running hotter than analysts' expectations of 6%. The Cleveland Fed forecasts a year-over-year increase of 6.2% in February, while inflation swaps are pricing in a CPI rate of 6.1%. This news is unwelcome for both the markets and the Fed since it wasn't long ago that swaps were pricing in an inflation rate of 5.2% for February.
It's becoming increasingly clear that a CPI print that comes in higher than expected, particularly if it shows little improvement in core-services ex-shelter, coupled with a low unemployment rate and strong wage growth, will likely force the Fed to raise rates by another 50 bps. This news will not bode well for equity prices, and once again, equity investors will be left holding the bag.
For further details see:
Powell's Hawkish Speech Sparks Massive Market Repricing