USD Swaps: Hawkish Fed-speak muffles UofM inflation; Underpricing Fed cuts?

Big hawk 1 Jun 2021
Hawkish Fed-speak has muffled a big drop in UofM 1y inflation expectations, with USTs bear flattening further. DB sees rate cuts underpriced.

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  • Hawkish Fed-speak muffles UofM inflation; Underpricing Fed cuts?

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    Hawkish Fed-speak muffles UofM inflation; Underpricing Fed cuts?

    The University of Michigan sentiment index edged up to a better-than-expected 63.9 (versus Bloomberg consensus of 60) but even more startling was a big drop in 1y inflation expectations to 3.3% (versus Bloomberg consensus of 4.1%, prior 4.2%) – marking the lowest print in inflation expectations since March 2021


    However, Fed officials were quick to push back on any improvement in the inflation outlook today.  To be sure, Fed Governor Waller said that “we’re seeing policy rates having some effect on parts of the economy.  The labor market is still strong, but core inflation is just not moving, and that’s going to require probably some more tightening to try to get that going down.”


    Similarly, Richmond Fed President Barkin stated that “2% inflation is our target, and that I am still looking to be convinced of the plausible story that slowing demand returns inflation relatively quickly to that target.  If coming data doesn’t support that story, I’m comfortable doing more.”


    And lastly, just to drive the point home even further, Fed officials stated in their latest monetary policy report to Congress released today (see here for full report) ahead of Chair Powell’s stints in the hot seat next week that inflation “remains elevated and has not shown signs of easing.” 


    Hence, with all this hawkish Fed-speak flying around today - as well as the rather hawkish rate pause by the Fed this week - the Treasury market seems right to have taken no notice of today’s Michigan inflation data.  Indeed, in the afternoon trade, the bear-flattening has grown some legs with the benchmark 2y note yield now 8.1bps higher at 4.723% while the 2s10s spread is 3bps narrower at -96.4bps.


    Meanwhile, SOFR futures are 8 to 12 ticks softer in the reds while SOFR swap spreads are mostly lightly offered amid paltry activity as IG issuance takes a pause ahead of the long holiday weekend with the major domestic equity indices narrowly mixed (Dow +0.05%, S&P +0.19%, Nasdaq -0.11%) in the backdrop. 


    Separately, while some dealers look to fade the amount of Fed cuts prices in for next year (see Total Derivatives), strategists at Deutsche Bank are ready to take the other side of that bet based on historical patterns.  To be sure, by looking at the history of the fed funds rate along with the ED/SOFR futures curve (extending 2y out) at each point in time back to 1990, the bank makes the following key observations:


      “…First, futures this year have been implying more Fed rate cuts than they ever have historically. At around 3.4%, June 2025 SOFR futures are currently pricing in close to 200bp of easing over the next couple years.


      “…Second, the market never prices cuts in the midst of a Fed hiking cycle, a fact that amplifies the unusual nature of pricing this cycle. The cuts priced today reflect the strong market consensus around recession, which is also highly unusual by historical standards. (In the NY Fed’s latest survey, economists assigned an average probability of 72% to recession coming by H1’24.)


      “…Third, in easing cycles, the fed funds rate typically realizes below futures-implied rates – that is, the market under-prices the extent of Fed easing. (The reverse is true in tightening cycles, where the market under-prices hikes.) In our view, this reflects a combination of forecast errors and risk premia.


      “…If a similar pattern of realized vs. implied holds today, the Fed would wind up cutting substantially more than currently priced. This would be broadly consistent with our forecast. Our economists have the funds rate dropping to 2.6% by the end of next year and our probably-weighted projection has it moving even lower.”


    Currently, SOFR swaps – 2s -9.625ps (-1.125bps), 3s -12.375bps (-0.125bps), 5s -21.375bps (unch), 7s -27.625bps (+0.125bps), 10s -26.25bps (-0.125bps), 20s -63.5bps (-0.5bps), 30s -66.125bps (-0.125bps).


    New issues

    • South Korea’s NongHyup Bank plans a 5y USD Social bond after investor meetings on June 19th. Via BNPP, BofA, Credit Agricole, MUFG, SocGen and UBS.


    • Hyundai Capital America is meeting investors on June 15th. Leads are Citi, CA, HSBC, Mizuho, SocGen and SMBC Nikko. 


    • Univar (Windsor Holdings) plans a $1.8bn 7y NC3 secured bond at around 8.5%. Leads are Apollo, BMO, BNPP, CS, FTG, HSBC, JPM, Mizuho, RBC, TD and WFS.