17/02/2023 Traders have drastically shifted their expectations for
where they believe the Fed will be with interest rates by the end of the year. Naturally
hotter inflation is to blame: Thursday’s PPI came in hot at +0.7% vs the +0.4% expected,
after the CPI earlier in the week hit +0.5% vs the +0.4% anticipated. As can be seen below,
markets had been pricing a better than evens chance the Fed would be below 4.5% by the end
of the year. A month on, this has been all but entirely priced out of the market and traders
are betting on rates to be north of 5% by the end of the year, implying more hikes and no
cuts. 
The shift in rates has been significant – the 2yr US Treasury yield
has risen from 4.1% to above 4.7% in barely two weeks. The 10yr is now above 3.9%, its
highest since November, from below 3.4% at the start of February. December 2023 Fed Funds
implied rate has risen to 5.10% from 4.35%. What’s this telling us as investors?
Fundamentally, the market and perhaps the Fed were declaring victory on inflation too soon.
It’s the old pivot narrative from last year but remember the Fed was never going to pivot
and now can’t because it’s become data dependent; and the data won’t allow it. The main
takeaway from the Fed’s last meeting was that it was now, after catching up with the
inflation dynamic following a breakneck pace of tightening last year, back to data
dependency. The problem is the data, not the Fed. As our Chief Markets Analyst, Neil Wilson
said on Feb 2nd: “I think bulls were too keen to read what they wanted from the comments
around disinflation and tighter financial conditions and chose to ignore the fact that the
Fed signalled it’s keeping going for now. What matters now is the data – I think we switch
now to a more data-dependent Fed henceforth, which is why I think it will keep tightening.
The Fed may have declared victory too early and will see wages and inflation accelerate
again.” Fed hawks have been out and about on the wires, too, to underline the central bank’s
position as the inflation data burst. St Louis Fed’s Bullard won’t not rule out supporting a
50bps hike at the next meeting, adding that “it will be a long battle against inflation”.
Cleveland Fed’s Mester said: “We will need to bring Fed Funds rate above 5% and hold it
there for some time”. In contrast, Bank of England chief economist Huw Pill hinted
policymakers are ready to slow the pace of rate hikes at the next meeting as they await the
passthrough of past hikes. “Continuing to raise rates at the pace and magnitude seen over
the past year would eventually – and perhaps soon – imply that monetary policy had
cumulatively been tightened too much,” Pill said in a speech Thursday. The hawkishness
around the Fed is driving the dollar bid this month. The market should act to price in a tad
more Fed hawkishness, but we are getting closer to the point at which the market will have
fully priced in the appropriate number of rate hikes – there will be uncertainty over
duration for a while longer. Given the UK housing market dynamics there is a real chance it
cuts later this year even if inflation remains too high – the BoE will point to easing wage
pressures in the medium term as a reason but it won’t be correct. This will fuel divergence
in the UK and US rates outlook and could see cable retest 1.15 soon.
Group