Discussion
Nothing will get the Fed to move faster than a rise in inflation expectations (as measured by TIPS break-evens). 1- and 2-year BEs are still low at circa 146 and 202 bps, but the 5y5y and 10y tenors are on the move.
The 10y BE is particularly important and is currently over 240 bps, up from a local low of 223 on July 19. May not sound all that high, but in conjunction with the rise in 5y5 and a nascent rise in the 5y, the direction will be of concern for the Fed, and we’re already seeing movement out of the Fed Funds futures contracts reflecting this concern.
In the wake of the July 12 CPI report the July 2024 FFR contract fell to 429 bps, implying roughly 100 bps of rate cuts between July 2023 and 2024. Currently 471 bps, that contract has taken out almost two full cuts in two weeks. Likewise, the March 2024 contract has taken out almost one cut, up to 521 from a nadir of 498 in the wake of CPI.
Economic and equity market bulls cannot have their cake and eat it too when the Fed is at war with sticky above-2% inflation. Either the Fed has done enough to engineer the recession necessary to bring it back to 2%, or economic strength is such that the Fed needs to continue hiking to tip the economy into recession. Right here and now, the bond market is saying the Fed has not yet done enough.
Now, there is an alternative scenario here: pure, unadulterated stagflation. Leading economic indicators suggest the Fed has done enough to take the economy into recession, but the bond market is saying inflation remains a problem, which means the Fed needs to engineer an even deeper recession to bring inflation back to 2%. On this point, FED Chair Powell’s exchange with Senator Kennedy back in March comes to mind: