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Fed: Swap traders are back

by indirimbulindirim

Fed pricing… As a result of the recent movements in the bond markets, it is understood that the perception was formed by the activation of the expectations for the Fed’s tightening cycle against inflation rather than the risks of Russia. As of today, we observe that 10-year yields continue to move closer to long-term interest rates, with 2.12% and 2-year yield at 1.84%. The inflation phenomenon, which continues its steep level, including the last consumer price index indicator going to 7.9%, and generally surprises upwards in the past months, increases the belief in the Fed’s rate hike despite all the economic risks. Markets increased their sensitivity to the challenging dynamics of the Fed’s decision.

 

Swap traders… While sanctions were being imposed on Russia, which launched a military operation against Ukraine, swap traders had withdrawn the interest pricing for the whole year and had been keeping a distance from 7 rate hikes for a while. This situation seems to have changed a bit on the final straight. Although the traditional band of 25 basis points rather than 50 basis points continues, current inflation and rising inflation expectations fuel the expectations that the Fed will continue the transition to the terminal rate. Of course, if the Fed does this in a period when recession risks are cumulative, it will make it difficult to balance growth and inflation. The revitalization of the economy and workforce with the expansion implemented after the Covid-19 pandemic and the power to maintain the momentum from there are among the trusted facts at this stage in the transition to tightening.

 

Inflation and spread… What we understand from the available data and pricing trends is as follows; In US bonds, pricing that the Fed will increase interest rates and inflation will remain high in the short term stands out rather than the safe-haven phenomenon. For this reason, sales are weighted and interest rates are rising. Short-term interest rates gained momentum faster, long-term interest rates are also rising, but slower, and the resulting narrowing of the spread signals the danger of recession after a period of 1 year or a little longer. The Fed’s signal in the projections for the transition to the terminal rate is important. In the long term, inflation is expected at 2% and the funding rate is 2.5%. The issue of whether these rates will be raised is important in terms of the target and the interest rate to be applied to achieve it. That is, the signs of what the Fed will do in the future will be as important as what it will do this year, if not more so, in managing the yield curve.

 

Pricing Fed futures funds… Source: Bloomberg, CME Fedwatch

 

Conclusion? The expansion period will be over with March 2022. Continuing to keep the economy strong and balancing inflation take place in the Fed’s data-based action base. It will be difficult to make this adjustment in an environment where geopolitical risks will rapidly increase inflation and slow down the economy. Therefore, the most logical scenario seems to be a cautious path of progress that will not harm economic prospects. Of course, there is a strong possibility that the Fed will balance its moves based on explanations and reservations. As a matter of fact, in his last speeches, Powell still supported the rate hike phenomenon, while he was careful to observe these balances. Narrowing the $8.9 trillion balance sheet and bringing the interest rate curve closer to inflation are the most challenging elements of this transition. Therefore, it is necessary to take into account the risks of dragging the economy into recession when the equilibrium point is exceeded a little too quickly.

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