USDi: Tide continues to turn bearish for BEs during Powell Part II

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Tide continues to turn bearish for BEs during Powell Part II

Fed Chair Powell rehashed the same song list on his second day of testimony in the D.C. Beltway, today before the House Services Committee.  And while many market participants have ramped up their expectation to a 50bps hike in March in the wake of yesterday’s testimony, Powell did say today that the Fed has “not made any decision about the March meeting” which would make sense since it hasn’t occurred yet – but I digress. 

In any case, with the same generally hawkish tone reverberating from Powell today, risk assets treaded water (Dow -0.18%, S&P +0.14%, Nasdaq +0.4%), the energy complex failed to find footing (gasoline -0.61%, Brent -0.96%, WTI -1.39%) and nominals bear flattened (~1-6bps).  So once again, the U.S. inflation asset class had very little to hang its hat on this session, thus breakevens and inflation swaps fell again for the third consecutive day as the tide continued to turn bearish this week after the recent bullish run for the inflation curves.

“The repercussions from yesterday's surprisingly hawkish Powell testimony continued to wreak havoc on the breakeven complex, though in comparatively less fashion than yesterday's bloodletting,” one dealer explained.   “The most acute point of pain was again the 5y but the whole curve moved swiftly lower once some early niceties were out of the way,” he continued.

Flow-wise, in derivatives-space, inflation swap on the SDR today included 5y ZC swaps at 262bps, and 260bps, 10y ZC swaps at 256.125bps, and 254.75bps, and 30y ZC swaps at 239.75bps, and 238.625bp (for all of today’s trades, see Total Derivatives SDR, which now also includes information on broker/platform).

Heading into the final hour of trade, the 2y breakeven in the screens is trading at 321.25bps (-6.875bps), 5y at 254bps (-7.875bps), 10y at 232.75bps (-6bps) and 30y at 226.625bps (-4.875bps).

NatWest: The upward shift in inflation expectations – time to fade?

Following the strong January data, markets not only repriced the Fed’s expected rate path higher, but also the expected path for inflation.  And while we are not near early-2022 highs, the recent rebound in inflation expectations as measured by inflation swaps has reversed most of the pull-back in inflation expectations over the second half of last year.

However, strategists at NatWest note that “what we have observed YTD, however, differs from the recent experience. Despite the Fed’s rate path being priced higher, breakevens did not fall but…under a credible Fed, the inverse relationship should hold.”  Indeed, more recently, inflation expectations have jumped alongside a higher terminal rate and an un-inversion of the Fed funds curve (i.e. higherfor-longer),” which NatWest thinks is problematic for the Fed for the following reasons:

”… First, we believe the Fed’s credibility remains high given their significant tightening actions last year, which should cap any substantial upside in market-based inflation expectations - particularly in comparison to early 2022 when the Fed risked being seen as behind the curve.

 

“…Second, we do not think inflation will settle in a level that is structurally significantly higher than the pre-pandemic world. We see inflation coming back to target, albeit at a gradual pace (i.e. 2024), but we do not subscribe to the views that inflation will get to 3-4% and fail to break below. As far as market pricing goes, our view is that to get inflation markets to fundamentally reprice inflation above 2% would require a concession by the Fed, where they accept a higher inflation target, or a break in the Fed’s credibility. We do not think that is a possibility under Chair Powell’s term.

 

“…Third, breakeven inflation expectations often trade similar to risk assets and react to growth data as much as they do to inflation data. Therefore, we think breakevens got an oversized boost following the strength in January data, strength which we still aren’t convinced will hold over the coming months. Therefore, if January turns out to be a blip rather than a trend-starting data point, breakevens should suffer alongside.”

Adding all those points up, NatWest thinks that:

“…Breakevens are now too high compared to where they should be. However, before going forward and adding shorts in 5y breakevens- the part of the curve, which we think is most susceptible to a correction based on our views above, we should note the negative carry that could impact ill-timed trades… Particularly…our economics team forecasts 0.68% m/m for the February CPI print (NSA), which is roughly 13bps above the market fixing. Therefore, while we think the medium-term inflation pricing is too high, we would like to avoid a short exposure into the February CPI number – if breakevens remain high afterwards, at that point we would be more open to outright shorts even though we agree with the directionality today.”