September 29, 2023
This morning’s release of US core PCE and Eurozone CPI fail to shift an emerging stagflation theme. The stagflation theme first emerged this week after downbeat consumer confidence was met with higher bond yields. Catalyst vacuums have a tendency to lead to trend continuation. In this case, trend continuation means higher bond yields and lower stock prices. The September Jobs Report on 10/6 and September CPI print on 10/12 are the next two pieces of economic data with the necessary density to shift the narrative away from the stagflation theme. A government shutdown that delays the release of key economic data could keep the catalyst vacuum in effect a bit longer. Fortunately, Q3 earnings season that starts on Friday 10/13 won’t be impacted.
The higher yield environment has largely been driven by increased Treasury issuance, short-term technical factors and the rally extension in crude oil prices. The one ‘technical factor’ with potential staying power is the assumed convergence of 10-year bond yields with Fed terminal rates. This usually happens toward the end of a hiking cycle. The backup in yields started in late July when terminal rate expectations in the OIS market stopped rising. An unchanged terminal rate of ~5.45% following the September Fed meeting accelerated the yield back up. The terminal Fed rate could decline a little, but it’s far more likely that the two rates converge closer to 5.45%.
The good news is that a further backup in yields could be the beginning of the end to the Fed’s tightening cycle. We suspect the Fed has already completed its hiking cycle, but monetary tightening continues if the committee keeps real rates in positive territory. A current 1-year inflation breakeven yield of 1.73% and a 1-year nominal yield of 5.45% gives you a real rate of ~372bp, which is significant tightening. Several Fed officials have said they need to see three consecutive months of lower YoY CPI prints before they can feel comfortable that inflation is under control. Base effects suggest the soonest that can happen is Q1’24, which also seems like the earliest window to consider a change in policy. May ’24 is the earliest rate cut currently priced into OIS markets with a probability of 32%. Unfortunately, lower asset prices and a more significant stepdown in global growth are the two conditions that could increase the probability of a policy pivot. Our early indicator of an imminent Fed pivot is found in the shape of the 5/10 yield curve. The 5/10 yield spread currently sits at -5bp and our trigger is closer to +19bp with a lead time of 1-2 months.