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Rates spark: The Fed holds and the long end gets nervous

The Fed held rates steady, and whilst 2Y rates gapped lower, the long end popped higher. Longer UST yields will remain vulnerable and the 10Y could move toward 5% again. Next in line is the Bank of England, and while we disagree with the hawkish positioning of markets, taking the opposite position remains difficult given the tight correlation with oil.

Chair Warsh does little, but actually with big effect

The gap lower in the 2yr yield following the unchanged decision was quite striking, illustrating that a decent rump of the market had indeed positioned for a possible hike. And even though the statement added very little, some of the steam has been taken out of the rate hike risk talk. That said, we’ll likely do it all again in September. The path of least resistance for the rate discount remains a build towards a hike. That’s the trade. But ultimately we don’t think the Fed will hike, barring a significant escalation in the Iran war.

Longer dates have not taken the unchanged outcome well, with the long bond yield up and touching 5.2% at one point. Interesting that Chair Warsh noted this and the rise in real yields as the market is doing some tightening for the Fed. There is an implied acknowledgement here that if the Fed were to move right now, it would more likely be a hike than a cut. Minimal talk for now is the preferred strategy, helped by the five task forces out doing their due diligence on how the Fed operates. Unless something big gives, waiting for the completion of this process is the baseline preference.

We view long yields as remaining vulnerable to the upside ahead, with real yields being a driver. We doubt the 10yr yield tops 5%. That’s a red line for the Treasury. One that would likely be resisted. But an edge in that direction is entirely conceivable in the coming weeks (and perhaps months). We still think the front end is the safer place to be, on a short duration preference.

Hard to push against hawkish Bank of England pricing

The Bank of England is next in line, but similar to market pricing, we don’t anticipate any change to the policy rate at today's meeting. Markets continue to be relatively hawkish when it comes to the UK, much more than we think is justified based on macro dynamics. But even if you disagree with current pricing, taking a bullish position will quickly burn you on the back of oil volatility. Compared to USD and EUR rates, sterling rates are particularly sensitive to oil price swings. For every $10 move higher in oil, markets add some 20bp of expected BoE tightening.

Interestingly, the correlation between 2Y sterling swap rates and oil actually seems to have increased over the past month. One could point out the non-linearities inherent in inflation expectations. The Bank of England identifies 4% inflation as particularly worrisome when it comes to second-round inflation risks. The 2Y inflation swap is close, at around 3.9%. Having said that, GBP inflation swaps are not a perfect measure of inflation expectations, but in this case still illustrate why UK rates might be more nervous than peers.

Looking ahead, we don’t expect the Bank of England to hike at all, and even though we might see more votes for hikes, the doves will likely keep a majority. With markets already positioned for significant tightening, we doubt a hawkish tilt in voting behaviour will be able to push markets much. Markets already see close to 70bp of hikes over the next 12 months, which looks stretched considering the policy rate is already well above neutral at 3.75%.

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ING Global Economics Team

ING Global Economics Team

ING Economic and Financial Analysis

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