Hawks Gather in February

Much has changed in rates markets over the course of February. Almost immediately following the “dovish” central bank meetings at the start of the month, economic data suggested it was far too early for pivot talk.

In the US, we have had three main data points which have spooked those who were expecting a Fed pivot. First, we had a blockbuster employment print – the economy added an additional 517k jobs versus 189k expected. Then, we had retail sales also outstrip expectations, coming in at 3% - both data prints suggesting the economy is faring well enough to take further hikes if required. And finally, we had a hot CPI print suggesting further hikes may indeed be required – both core and headline inflation came in higher than market expectations and were indicative of an economy not yet in deflation mode.

The Fed minutes released later in the month were also less dovish than the meeting itself was interpreted. The release warned of the risks of inflation becoming unanchored and spoke of how many Fed members saw financial conditions easing, meaning further hikes were required. This rhetoric has been reiterated in recent days by Fed speakers – Bullard calling for terminal rates at 5.375% and Williams expecting it to take a “few years” for inflation to come back to 2%. All things pointing toward higher rates for longer.

And indeed, the market began to take heed. The opportunities we mentioned in last month’s newsletter have been priced out. Markets are now pricing in line with Fed expectations – terminal rates are at 5.35% and less than one cut is priced in for the back end of 2023. The way the economy is looking at this point, even one cut seems quite ambitious. The moves have seen rates on 2y swaps climb over 60bps in the month of February, and signs of stickier inflation are also evident in the market. As recently as mid-January, 2y breakevens (market expectations for inflation over the next 2 years) were trading at 2%. Today, they are back over 3% in a rapid move, the majority of which has come in February with further evidence that rates may not be coming lower any time soon.

In Europe we have seen much the same trend. Despite progress on the headline inflation numbers, helped by falling energy prices, core inflation has actually ticked higher. This has been exacerbated by an historically tight labour market. The ECB expect wage inflation to run at double their inflation target through 2025, not traditional conditions for lower rates as some more dovish nations are calling for. ECB Board member Schnabel drove the point home in a recent interview, stating that a 50bps hike in March is “necessary under virtually all plausible scenarios,” and that the market may be too optimistic about inflation coming back to 2%.

These developments have pushed fixed rates higher, but as we discussed this week in Risk Insight – calming peripheral spreads have helped vols lower, allowing hedgers to buy caps at levels significantly lower than 6 months ago. Efficient hedging strategies may be harder to come by but if February is anything to go by, they are as essential as they have been at any point over the last year.