Friday, May 14, 2021

"Mind the (rate expectation) gap"

Unless the Fed engages in some form of financial repression long rates will continue to rise, followed by short rates as the Fed sloooowly steps on the brakes.

From Blackrock, May 10:

A disconnect
Markets are still grappling with the Federal Reserve’s new framework, leading to a disconnect between market pricing and the Fed’s projections for rates.
Forward looking estimates may not come to pass. Sources: BlackRock Investment Institute, Federal Reserve and Federal Reserve Bank of New York, with data from Refinitiv Datastream, May 2021. Notes: The chart shows expectations for the federal funds rate, the Fed’s policy target. Market pricing is based on futures on the U.S. dollar Secured Overnight Financing Rate. We use the median forecast in the March 2021 Survey of Market Participants by the New York Fed. The BII assumption is part of our economic projections in our capital market assumptions. The Fed median dot plot comes from the January 2021 Summary of Economic Projections.
Markets are pricing in a liftoff from near-zero policy rates as early as next year, even though the Fed through its new framework has committed to stay behind the curve on inflation. We caution against extrapolating too much from strong near-term activity data amid a powerful restart. We see a high bar for the Fed to change its policy stance and believe this may be underappreciated by markets.

The Fed has reiterated its intention to stay behind the curve on inflation under its new framework that implies inflation overshoots to make up for past misses. Yet this has been met with some skepticism in markets, against the backdrop of a powerful economic restart. Current market pricing and consensus expectations suggest the federal funds rate, the Fed’s policy rate, would start rising much sooner than Fed officials’ own projections would indicate. See the chart above. We see two reasons for this disconnect. First, investors may be over-extrapolating from near-term growth data amid the powerful economic restart. We view the Covid shock as more akin to a natural disaster followed by a rapid “restart” – instead of a traditional business cycle recession followed by a “recovery.” That implies the huge near-term growth spurt will be transitory. And second, we believe many are still wedded to the central bank’s old policy framework, and may underestimate the central bank’s commitment to push inflation above target.

Market chatter about a potential tapering of the Fed’s asset purchases has gotten louder, yet we don’t see the Fed discussing this imminently. Tapering is the first step towards normalization of Fed policy, but even a discussion later this year does not mean the liftoff is close. There is a risk the discussion could trigger market volatility or be miscommunicated by the Fed. We believe investors should look through any such bouts of volatility, as our new nominal theme implies that the Fed will likely be much slower than in the past to raise rates in the face of rising inflation.

Inflation – not the near-term growth outlook – is key to the Fed’s rate outlook under the new framework, in our view. We believe two important developments would need to take place before the Fed considers a liftoff. First, the realized core personal consumption expenditures (PCE) price index, the Fed’s preferred inflation gauge, should stay at or around the Fed’s 2% target for a sustained period of time. The current inflation overshoot doesn’t meet the bar as the Fed views it as driven by transient factors. We also see uncertainties around the near-term persistence of the overshoot as the restart has led to unusual supply and demand dynamics. This is why we have recently closed our overweight in inflation-linked bonds over the tactical horizon. Second, the Fed’s inflation forecast would need to rise from current levels and point to a prolonged period of moderately above-target inflation. What could potentially pull forward the Fed’s timetable for a liftoff? An upward spiral in prices and wages set in motion by behavior of individuals and firms could be one driver, in our view....