BMO Weigh In On Post-FOMC Price Action

BMO write “while we’re certainly sympathetic to investors’ eagerness to move beyond run-away inflation risk dominating the actions of the Fed, it’s still a bit too soon for policymakers. We anticipate that the Fed will respond by pushing back against the magnitude of rate-cuts currently priced into 2023; after all, once inflation begins to react to prior policy tightening, the real growth picture will improve during the second half of 2022. The one (and most meaningful) caveat is that the Fed will be willing to dismiss the slowdown as an inflation-driven anomaly only up until the point when the labor market begins to show convincing evidence of a negative turn in momentum. For the time being, Powell has the cover of a strong jobs market on which to base future rate hikes – until it doesn’t. If nothing else, this builds the case for hikes at each meeting until the mid-term elections – leaving the only open questions of cadence, terminal, and whether the market will ultimately see another Santa Pause come December.”

• “We’re looking for the official rhetoric to quickly shift in favor of higher front-end yields as the Fed attempts to dissuade investors from pricing in aggressive cuts for 2023. It’s safe to assume that this dynamic resolves in the further inversion of the 2s/10s curve; although we’re open to a near-term period of consolidation following the -32 bp print achieved yesterday. That said, even in the event the Fed is able to get 2-year yields closer to the terminal policy rate assumption, our key takeaway from the recent price action is that effective fed funds and the terminal estimate won’t function as a floor for nominal coupon yields. It strikes us that the greater the disconnect between 2s and funds, the more challenging the Fed’s job becomes. Recall that Greenspan’s conundrum occurred when the Fed lost control of the long-end of the curve; Powell’s conundrum might ultimately be a loss of control of the front-end of the curve in the event 2-year rates continue to trade so far below markets’ pricing of terminal (i.e. 3.25% according to fed funds futures).”