USDi: Bullard boost BEs but better sellers and FOMC minutes help sink them

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Bullard boost BEs but better sellers and FOMC minutes help

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Comforting words from St. Louis Fed President Bullard - along with better early buying - helped put a little skip in the steps of the U.S. inflation market this morning with TIPS breakeven and inflation swaps flying higher right out of the gates this morning – extending yesterday’s uber-bullish run. 

To be sure, in an early CNBC interview, Bullard actually rubbed against the Fed’s more aggressive grain by implying that the Fed’s work may almost be done as his projection is for the fed funds rate to reach 5.375% - or a mere 75bps more in hikes.  And coming from an uber-hawk like Bullard, markets like what the heard with nominals, breakevens and the major domestic equity indices embarking on a rally in the early trade today.

However, the wheels started coming off the rally in inflation when buying waned and sellers quickly seized on this early strength with this afternoon’s FOMC minutes serving as the final blow for the market.  Indeed, while market participants didn’t really glean any new major insight when it came to rate hikes after sifting through the tea leaves,  the minutes confirmed the Fed’s resolve to bringing inflation down to 2% while also stating that “almost all” officials favored a 25bps rate hike while “a few” could have backed a 50bps hike instead.  And post-minutes, breakevens continued to slide – barring a late bounce off the lows – with the inflation curve marked roughly 2-4bps lower across the board today.

“We started the day with the same craziness tone as yesterday, with breaks jumping and pretty much impervious to anything - even energy down 3%,” one trader explained.  “Then exhausted by this run, the market started to go down slowly with still some buying presence from foreign real money and finally the market collapse aggressively during the afternoon,” he continued. 

Flow-wise, in derivatives-space, inflation swap trades on the SDR today included 1y ZC swaps at 308.5bps, 305bps, 303.5bps and 299bps, 2y ZC swaps at 280.5bps and 280.25bps, 5y ZC swaps at 270.75bps and 270.5bps, and 10y ZC swaps at 266.125bps (for all of today’s trades, see Total Derivatives SDR, which now also includes information on broker/platform).

Heading into the late close, the 2y breakeven is going out at 296.75bps (-2.375bps), 5y at 259.875bps (-4bps), 10y at 240.625bps (-2.125bps) and 30y at 235bps (-3bps).

Deutsche Bank: Inverse correlation between real rates and equities

Rates are up for the month - both real and nominal - while TIPS breakevens are wider.  Against this backdrop, strategists at Deutsche Bank find that “a rethinking of the rates path is taking the center stage as risk scenarios are beginning to compete with the base case.”  Consequently, the bank notes that “volatility has increased across the board with 1Y1Y back above 135bp and 3M10Y, after touching 100bp earlier in the month, is trading again around 115bp. The market is pricing in a highly restrictive Fed, and the Fed seems to be not only in agreement with that pricing, but promises to push even deeper into restrictive territory if necessary.

Moreover, Deutsche Bank notes that “real curve inversion is back to last year’s levels with the spread between 2Y1Y and 5Y5Y forwards at -25bp. This is, however, less aberrant than when it first appeared in mid-2022 as inversion usually occurs by the end of the tightening cycle.”  All in all, the bank finds that “aggressive rate hikes and the rise of real rates have overpowered all other considerations in the current cycle and have been the dominant driver of the markets in 2022.”  Below the bank expounds on the correlation between YTD performance of S&P and 5Y5Y real rates:

”… The inverse correlation between real rates and equities has two aspects. On the one hand, negative reaction to high rates is a legacy issue reflecting markets’ addiction to stimulus after more than a decade of administered markets and Fed transparency. In its extreme form, it shows up as the willingness to embrace bad news as long as they imply continuation of stimulus. On the other hand, it is an implicit reflection of the belief that, in order to curb inflation, Fed would have to cause a recession, and the deeper the rate hikes go into restrictive territory, the deeper the subsequent recession is likely to be.

 

“…The last installment of data has created an additional ambiguity. Growth and activity numbers have come above expectations and, while this is good news, it emphasized the need for higher levels of hawkishness with deeper penetration into restrictive territory. In its response to these numbers, risk has temporarily drifted away from the 2022 mode – while real rates continued to rise, stocks have staged a rebound with signs of stability above 4000.

 

“…In that context, the first two weeks of the month indicate a behavioral shift away from addictive mode of the markets. This was an encouraging turnaround where good news are no longer rejected, but taken for what they are. However, based on the price action of the last three days, it looks like that was not meant to be. We are seeing a relapse indicative of the narrative of more aggressive hikes and potentially deeper recession. If we are on the way back to the last year’s regime of interaction between real rates and risk, S&P is likely to undergo another 5% downward correction towards the 3800 handle.”