USD Rates: Scorching October inflation

Inflation and plausible Fed reaction
Eugene Leow11 Nov 2021
    Photo credit: Unsplash Photo

    US Treasuries spiked overnight as market participants re-evaluate how dovish central banks can be in the face of scorching inflation. Sequential inflation in October managed to beat already lofty expectations (actual: 0.9% MoM sa, consensus: 0.6%). Even after food and energy prices got stripped out, core inflation still hit 0.6% MoM sa, with indications that price pressures are broadening out. With this print, YoY CPI has been at 5% or higher over the past six months. Inflation is clearly looking a lot more persistent than transitory. The UST curve bear flattened with 3Y yields closing above 0.85% (first time since the pandemic hit) as rate hike expectations got frontloaded. The back of the curve was not spared as 10Y and 30Y closed about 10bps higher for the day. 

    There are some nuances in the breakdown of USD rates. Inflation breakevens did climb in the shorter tenors in the face of the shock. However, longer-term expectations (5Y5Y inflation swap) did not budge (although they are still trading at elevated levels). One way to interpret this could be that the Fed would be forced to tighten earlier and faster, hence curtailing inflation worries further out. Another could be that market participants do not foresee this kind of price pressures beyond the immediate few years. If actual inflation hovers clearly above the Fed’s 2% symmetrical target for an extended period, risks towards unanchored inflation in the longer-term could build. We do not think that longer-term USD rates are sufficiently pricing in this uncertainty.

    Note that the market is having a perverse reaction to Fed normalisation. Real rates are a measure of how tight policy settings are going to be relative to inflation. However, since the Fed announced taper, real yields (2Y, 5Y, 10Y, 5Y5Y) have fallen significantly. In other words, monetary policy settings just got looser. We are not convinced that growth would be so slow as to prevent the Fed from hiking (stagflation scenario) to curb inflation if needed. We still see real yields rising over the medium term, driven by a combination of falling breakevens and rising nominal rates. December’s FOMC will be critical. Fed Chair Powell deliberately committed to only two months (November and December) taper at a USD 15bn/mth pace to provide policy flexibility. The taper pace could be accelerated, setting up room for a hike as early as mid-2022. The Fed may be comfortable enough to put in 2022 rate hikes in the next dot plot.


    Eugene Leow

    Senior Rates Strategist - G3 & Asia
    [email protected]

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