The Market Today
Inflation Forces Forecast Revision
by Craig Dismuke, Dudley Carter
EVOLVING PARADIGM FOR MONETARY POLICY PATH
Inflation Forces Forecast Revision: Because of how broad inflation pressure has become and the growing risk of rising core services inflation, we are now raising our rate forecast for 2022 to include 6 rate hikes (we see risks to both sides of this revised outlook). While we continue to expect the tightening to negatively affect financial conditions, and even more so given the faster liftoff, we now believe the Fed will be more tolerant of this given how pervasive the inflation problem has become. As we have frequently stated, the faster the Fed is forced to liftoff, the closer on the horizon an economic downturn appears to be.
Ratcheting Higher of Policy Expectations: Questions already on the table about the path of monetary policy in 2022 were 1) how many hikes would there be in 2022 and 2) how large would the first hike in March be (25 or 50 bps). After yesterday’s report, markets are now pricing in 6-7 hikes in 2022 (more below) and a 70% chance that the hike in March will be 50 bps. From the head of Vining Sparks’ trading desk, Mark Evans, “A 50bp tightening would be the Fed’s first increase of that size since May 15, 2000. The Fed has not started a tightening cycle with a move of more than 25bp since the 1980s.”
Emergency Hikes: The heat and breadth of the inflation numbers have now raised a third question for the path of monetary policy. Now in question is if there will be an intra-meeting (“emergency”) hike, either before the March 16 meeting or at any point in the next several months. This is certainly plausible given the Fed’s desire to retain market confidence in their ability to fight and contain inflation.
Emergency Policy Actions and Investor Confidence in the Fed: However, 5y5y forward TIPs breakeven inflation rates (Chart of the Day) show that investors remain confident in the longer-run inflation outlook despite the recent Fed criticism and surprisingly hot inflation data. If cracks emerge in longer-term inflation expectations, emergency policy decisions would be more likely. Keeping longer term inflation expectations anchored is of highest priority for Fed officials given the potential impact an unanchoring would likely have on longer term interest rates, and the resulting economic damage.
Bloomberg Survey and Consumer Confidence: The Bloomberg Survey of Economists, compiled before the January inflation data were released, will be released at 8:00 a.m. CT. February’s preliminary report on consumer confidence from the University of Michigan is expected to inch lower (9:00 a.m.).
OTHER ECONOMIC NEWS
Fed’s Bullard Wants 100bps of Tightening Over Next Three Meetings: St. Louis Fed President Bullard fanned the flames of a pre-existing sell-off in Treasurys with remarks he made in the aftermath of January’s hotter-than-anticipated CPI report. Bullard said, “I was already more hawkish but I have pulled up dramatically what I think the committee should do.” “I’d like to see 100 basis points in the bag by July 1,” Bullard said, adding that he would also like to begin the process of running off the investment portfolio in the second quarter. “You have got the highest inflation in 40 years,” Bullard noted, recalling that “There was a time when the committee would have reacted to something like this to having a meeting right now and doing 25 basis points right now. I think we should be nimble and considering that kind of thing.”
Shorter Yields Surged after Hot CPI Report and Hawkish Response from Fed’s Bullard: January’s hotter-than-expected CPI report reversed an overnight decline for Treasury yields and ruffled the feathers of one of the Fed’s biggest hawks. The 0.6% monthly gains for headline and core inflation were supported by broad strength across categories and boosted the respective annual rates a half percent each to 7.5% and 6.0%, the fastest increases since 1982. Shorter yields led the post-CPI jump, with the 2-year Treasury yield rising around 14 bps from pre-release levels as the 10-year yield jumped roughly 9 bps. The action on the front end of the curve intensified just before noon CT after St. Louis Fed President Bullard, a current-year voter, said in an interview (more above) he wants the fed’s target rate to be 1.00% higher by July 1; the Fed has three meetings scheduled between now and then. Markets adjusted from pricing in a roughly 30% chance of a 50-bp hike in March to a nearly 80% chance by Thursday’s close. The 2-year yield closed 21.4 bps higher at 1.58%, its sharpest increase since June 2009 and highest close since January 2020. The 5-year yield jumped 13.4 bps to 1.95%, its highest level since May 2019, and the 10-year yield climbed 9.4 bps to 2.03%, its highest mark since July 2019. The spread between the 5-year and 10-year notes flattened to below 8 bps, the second flattest level since 2007. The 2-year, 10-year spread fell below 45 bps, its lowest level since August 2020. Stocks had recovered from initial post-CPI weakness but fell anew after Bullard’s remarks. Closing near session lows, the Nasdaq ended down 2.1%, the S&P 500 fell 1.8%, and the Dow shed 1.5%.
Stocks Remain Weaker As Treasury Yields Give Back Only Small Portion of Thursday’s Surge: Global stocks traded lower Friday in response to Thursday’s sell-off on Wall Street and Treasury rates relinquished only a small portion of their sharp increases from the prior session. Europe’s Stoxx 600 slipped 0.7% following a slightly larger 0.9% decline for the MSCI Asia Pacific Index. U.S. index futures were down 0.1% at 7:15 a.m. CT after climbing from session lows. Considering the severity of yesterday’s surge, Treasury yields dipping Friday is not a surprise. The recovery, however, is comparatively minor and markets continue to price for a more aggressive path of tightening from the Fed after yesterday’s CPI report. Fed funds futures are currently priced for around 1.65% of tightening by the end of the year, equating to six quarter-point increases with a better than 50% chance of a seventh. Late Thursday Goldman Sachs changed its Fed call for five increases this year, joining Bank of America in forecasting seven quarter-point hikes in 2022. At 7:30 a.m. CT, the 2-year yield was down 3.6 bps to 1.55%, the 5-year yield was 4.5 bps lower at 1.91%, and the 10-year yield had declined 3.0 bps to 2.00%.