USD Swaps: Creeping steepening before the FOMC

Fed seen raising rates and dots, trimming forecasts

The Fed funds strip is 0-5bps stronger in pre-Fed trading with the peak now at 4.82% (implied) for May23 falling to 4.40% for Dec23. Treasuries are steeper on the back of modest gains for 2y to 5y while the 30y yield is +3bps 3.56%, 5s/30s 4bps steeper. In risk assets, S&P futures are -0.1% and TIPS breakevens are edging 1-3bps into the red, led by the 2y despite an 80 cent rise in WTI. Finally swap spreads are marked tighter at 1.75bps (-1.25) for 2y, -22.50bps (-0.25) for 5y, -29.75bps (+0.25) for 10y and -65.75bps (-0.50) for 30y.  

Ahead, banks preview the FOMC meeting. JP Morgan expects  that, alongside a (consensus) 50bps hike, the median dot for ’23 likely will be revised “higher by 25bps to 4.875%”, though JPM sees “an appreciable risk of a 50bp increase to 5.125%.” It expects similar upward revisions to the ’24 and ’25 dots.

The phrase “ongoing increases” in the interest rate guidance may need to be adjusted, reckons the bank, but it expects this will be done with “offsetting hawkish revisions”.

JPM adds that Powell’s remarks about keeping rates restrictive for some time may indicate “a bias for less easing”, though it thinks that bias will be “counter-balanced” by revisions to the economic forecasts, which will likely look for “weaker economic activity”.

Elsewhere, BNP Paribas expects the Fed’s communications to stress the likelihood of “holding rates at restrictive levels over a longer time horizon—possibly even challenging current market pricing,” as well as pointing to a higher terminal rate.

It sees the dots on track for shifting higher in the December SEP – “thereby implying a more restrictive stance of policy in 2023, most importantly, but possibly in 2024 as well.” BNPP looks for the 2023 median dot to rise to an upper bound of 5.25% (50bp higher than September) and the 2024 median to rise to 4.25% (25bp higher than September).

The bank also expects Chair Powell's message to sound “incrementally more hawkish relative to November—drawing attention to a higher terminal rate and emphasizing the amount of time the Fed expects it to stay there.”

BNPP notes that the markets are pricing a 50bps hike but also “the higher chance of a 25bp downshift in February than another 50bp hike.” The bank continues:

“Although our forecast is for fed funds to reach 5.25% by Q1 2023, the possibility of ending at 4.75% cannot be fully discarded which could put the 2y UST yield at 4% (if 200bp of rate cuts are assumed for 2024). This could reduce the odds of a deeper curve inversion or at least suggest it may come from bull flattening more than bear flattening should economic data deteriorate rapidly.”