US markets playing along to Fed tune…for now

Treasury Secretary Yellen’s comments ten days ago were merely a temporary distraction. Perhaps more surprisingly, at first glance, the release on Wednesday of a much larger-than-expected increase in US CPI-inflation in April has not had much “sticking power”.

Core CPI-inflation almost doubled to 3.0% yoy (the high since December 1995) and as a result the Federal Reserve’s “real core” policy rate fell to a multi-decade low of -2.8%.

The range-bound 10-year Treasury yield subsequently closed 7bp higher at a 5-week high of 1.69%. The S&P 500 sell-off (-2.1%) and Dollar NEER rally (+0.6%) recorded on 12th May were both the largest since 25th February.

However this spike in volatility was modest in the greater scheme of things. More poignantly, these far from dramatic moves have been largely reversed in the past 48 hours.

The Dollar NEER is back to within striking distance of the 3-year low recorded on 10th May, in line with our bearish Dollar view. Markets are still only pricing in 15bp of rate hikes by end-2022, versus pricing of 12bp of hikes pre Wednesday’s release of US CPI-inflation data.

Markets, rightly in our view, are still not fully convinced that the Federal Reserve will signal, let alone deliver, a tightening of US monetary policy in coming months.

The Federal Reserve after all has form, having kept its “real core” policy rate firmly in the red in 2012–2015 (it averaged -1.7%) despite annualised GDP growth averaging a decent 2.2% qoq. By comparison the Federal Reserve’s “real core” policy rate averaged -1.4% between Q2 2020 and Q1 2021 despite GDP growth having averaged only 1.1% qoq.

At the very least markets still seemingly have appetite to be long US equities and short Dollars. While not insensitive to valuations and the risk posed by further upside inflation surprises we remain bearish the Dollar near-term.

Finally, while much of the debate about Covid-19, vaccination, the re-opening of economies and the bogeyman of inflation has centred on what will happen in 2021, more attention needs to be paid to 2022, in our view.

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