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Volatility Melts as Fed Doubles Down Inflation Gamble: Can It End Well?

Published 03/21/2024, 03:49 AM

At this point, one must wonder what the Fed is trying to pull off, and it isn’t entirely clear to me. It seems like the Fed is taking a big gamble here on inflation hotter than not.

That isn’t my opinion; that’s the bond market’s opinion based on things like inflation swaps and breakevens.

The Fed upgraded its GDP forecast, raised its core inflation estimates, and left the median dot at 4.6%. But in the meantime, it took rate cuts away from 2025 and raised its long-term run rate to 2.6% from 2.5%. It’s just odd once again.

It will be interesting to see how the market responds to all of this today once we get past all the changes in positioning. The implied volatility crush that I noted was likely to happen yesterday pretty much happened on schedule, with the big move happening around 2:35 PM ET.

This has been a predictable thing for years now, and when it is predictable for this long, it tells you that is all the market is responding to and nothing more. Yesterday, the options market was pricing about 75 to 80 bps moved up or down yesterday, so we finished higher by 89 bps.

CBOE Volatility Index

When you look at the dot plot, you wonder why the yield curve is still inverted at this point. The economy looks pretty healthy.

At some point, shouldn’t the yield curve steepen? Shouldn’t the 2-year rate fall or the 10-year rate rise? It is something to watch because, at least right now, the curve steepened by seven bps and seemed to break a downtrend.US10Y-US02Y-Daily Chart

Meanwhile, 5-year inflation expectations crept higher yesterday and are sitting below resistance with the potential to break out. This is just a spread that measures the difference between the real rate and the nominal rate, and inflation expectations rise as the spread widens.

US Breakeven 5-Yrs-Daily Chart

It would seem that if the market believes that the Fed has lost control of inflation, it would be noted by the 5-year breakeven rate breaking out.

A breakout, I would think, comes in the form of the 5-year rate rising and the 5-year real yield rising more slowly.

I don’t see why nominal rates would go down from here if the Fed is taking away rate cuts from 2025 and 2026 while suggesting higher core inflation and stronger growth.

US Breakeven 5-Yrs Chart

It will be interesting to see how Japan and the Yen trade after they reopen from a holiday session yesterday. At 2:33, it was leaked that the BOJ may consider raising rates again in July or October, and that news sent a very sharp reversal in the yen.

Of course, this leak from Nikkei Asia came perfectly time to coincide with the start of the press conference, and the Yen was tempting fate to break out and rise above the highs seen in the fall.USD/JPY Chart

Overall, the Fed dot plot suggests to me that inflation expectations and the nominal rate should be higher, while stocks were just doing what they always do in that 2:30 to 2:45 PM time slot. More today.

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