Persistent Inflation; Another Fed Hike?
As we turn to June, the market has refocused on persistent inflation pressures and the possibility the Fed might raise rates one more time. Globally, there have been some glimmers of hope in the fight against inflation.
The debt ceiling drama is at last behind us. Our base case, no default, played out as expected. The politicians came to their senses, knowing there was little to gain in this game of chicken. Over the last two weeks of the month, T-Bill volatility in late May and early June T-Bill maturities increased and we saw ~200bps of yield swing in some issues. Fortunately, there continued to be buyers of these bills up to the deal date and the selling pressures did not break the market. As we turn to June, the market has refocused on persistent inflation pressures and the possibility the Fed might raise rates one more time.
Survey data was expecting non-farm payrolls to post 195k gains and the actual number came in at 339k. This should give the Fed more room to raise rates one more time.
Additionally we get May CPI data on the 13th of June, the first day of the Fed’s two day FOMC meeting. The market will be watching this closely and it could prove to be the catalyst for a hike or pause. The Fed’s preferred measure of prices, Personal Consumptions Expenditures (“PCE”) has been trending mid 4% (deflator 4.4%YOY, core deflator 4.7%YOY). The Fed’s economic projections have PCE data ending the year at 3.3% and 3.6% respectively, so we still have a ways to go.
Globally, there have been some glimmers of hope in the fight against inflation. In addition to the slow decline in US inflation measures, we see disinflationary trends in the Euro-area economies of both Italy and Germany. However, the UK economy continues to struggle to tamp down inflation pressures. UK government bonds have been experiencing a prolonged sell-off with yields on the 10yr GILT 68bps higher and the 2yr GILT 90bps higher over the past two months. The BOE’s QT, increased GILT supply and reduced demand from pension accounts have contributed to the back-up in yields, not to mention persistent inflation pressures: UK Core CPI ticked up to 6.8%YOY for the month of April. The futures market is pricing in a peak policy rate of 5.35% at the time of this writing (see Figure 2) from the current policy rate of 4.5%.
Figure 2: Bank of England Policy Rate Expectation (SONIA1)
Treasury yields in the US have also moved higher over the past two months, with 2yr yields ~60bps higher at the time of this writing. There could be further pressure on those yields as the US Treasury begins to rebuild their checking account balance.
The Treasury’s General Account was drawn down to ~$50bln dollars during the period of extraordinary measures and that balance is expected to rebuild to $600-$800bln. This will be a drain on liquidity as cash will leave the money markets and sit in the Treasury’s account at the Fed. Additionally, the Treasury could issue as much as $1.4trln in new T-Bill supply. The Treasury Borrowing Advisory Committee (TBAC) meeting minutes of May 3rd (link here ) indicated dealer surveys showed estimates between $600bln to over $1.0trln of new T-Bill supply could come without significant deviations from fair value pricing. Issuance is expected to be concentrated in the front end of the bill market (1month to 4months). Now with the Fed potentially on hold, money market funds could substitute their holdings in the Fed’s RRP with T-Bills if they are cheap enough and concentrated in the very short end.
Could there be a synthetic rate hike? If there is a $600-$800bln cash drain due to rebuilding the TGA and the US Treasury issues as much as $1.4trln in new T-Bill issuance that should put significant upward pressure on money market yields. Could that upward pressure be as much as 25bps? Time will tell.