The latest data on U.S. consumer prices for January showed an above-consensus surge in both headline and core inflation at 7.5% and 6% respectively. These were the highest numbers since 1982.
Not only is inflation running at four-decade highs, but it has also proven to be broad-based, which makes the task of taming it all the more imperative. Price pressures are being witnessed across the goods and services sectors of the economy. Consumer demand remains high while supply chain bottlenecks persist. Meanwhile, the tight labor market is fueling wage increases and rising commodity prices are raising input costs. There are mounting concerns that price increases, that were once deemed by the Fed to be “transitory” in nature, are now exhibiting sufficient breadth and magnitude that they may become entrenched unless there is a rapid and long overdue policy response.
Against this backdrop, the market has had to rapidly reprice expectations of rate increases by a central bank that appears to be increasingly behind the curve. Amid the vacillations of Fed fund futures contracts with the ebb and flow of data and investor sentiment, as many as seven rate hikes have been priced in for 2022 in recent days – this essentially means a rate increase in each of the seven FOMC meetings between March and December.
How might these rate hikes play out? Even as each Fed meeting from March 16th onward can be considered to be “live” in that it might lead to a rate hike, we believe it is highly likely that the policy response will need to be frontloaded. Indeed, last Thursday’s comments by St. Louis Fed President James Bullard in support of raising rates by a full percentage point by July 1 illustrates the urgency with which policy makers are recalibrating their assessment in light of stronger inflation data. In comments he made just this morning, Mr. Bullard reiterated his support for frontloading the Fed response.
The price action last week has already shown how relatively sanguine expectations can be jolted by an above-consensus data release on inflation, in a repeat of what was witnessed following strong labor market data the prior week. The U.S. two-year Treasury yield spiked by 26 bps in the aftermath of the January CPI data last Thursday in one of the fastest moves since 2009. The 10-year Treasury yield breached 2% for the first time since mid-2019 as rate hike bets were repriced in the wake of the inflation surprise.
We expect volatility to intensify, particularly as there may yet be further measures required to rein in inflationary expectations. For example, quantitative tapering (QT), which is expected to commence soon after rate liftoff, may need to be sped up. The Fed has expressed a preference to retain Treasuries as it shrinks its balance sheet, which implies agency debt and mortgage-backed securities may be offloaded quicker, thus fueling volatility in the mortgage market. If the Fed also pares its Treasury holdings, there is the question of how it might manage offloading different maturities in attempts to ensure the yield curve remains positively sloped, lending more uncertainty.
The picture gets murkier still. Despite a heightened sense of urgency to tighten policy, the market is still pricing in a terminal rate lower than 2% which appears to be insufficient as it reflects an overly shallow path of rate hikes. Even if inflation subsides during the second half of 2022, it is highly unlikely it will fall below 3-4% by year-end. In fact, price pressures may remain worryingly and stubbornly elevated, thus keeping real short-rates negative unless there is a sharper and steeper trajectory of rate hikes. In sum, there may yet be further repricing of the terminal rate that is required, which will also fuel volatility.
Adding further complexity is that the current inflationary phenomenon must be considered in the global context. A growing number of developed and emerging markets are experiencing price pressures. What’s more, it was especially notable to hear ECB President Christine Lagarde strike a hawkish tone at her press conference two weeks ago. The so-called “Lagarde pivot” led to a rapid repricing of Eurozone yields and a sharp sell-off in peripheral debt markets such as in Italy and Greece.
In sum, we expect numerous more bouts of volatility that investors will have to weather in the coming weeks and months. The evolution of Fed policy responses will be center-stage in an investment environment that offers an expanded opportunity set for seasoned fixed income relative value managers across rates, credit and mortgage strategies.
 As measured by the Consumer Price Index and the core index, respectively.
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