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The Fed Will Pause Rate Hikes In September: Here’s How To Trade It

The Fed Will Pause Rate Hikes In September: Here’s How To Trade It

Earlier this week, after months of predicting that it is only a matter…

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This article was originally published by Zero Hedge

The Fed Will Pause Rate Hikes In September: Here’s How To Trade It

Earlier this week, after months of predicting that it is only a matter of time before Powell pulls off another “December 2018” and capitulates on plans to keep hiking until the fed funds rate is “well above neutral”, we finally got the first tentative confirmation of this when Atlanta Fed president Bostic said that “it may make sense to pause in September”, to which we countered that this is only “the first “pause” hint – Expect many more, and then a hard stop.”

Just one day later, a second, far more material confirmation came in the form of the Fed Minutes themselves, which revealed that the Fed’s updated PCE forecast shrank notably, with the year-end 2022 print of 4.3% dropping to 2.5% in 2023 and then again 2.1% in 2024, which “would imply the next expected three half-point rate hikes would be the end of the current tightening cycle and set the stage for a major risk rally into second half of 2022.”

And just like that – in the blink of an eye – a September “Fed pause”, our long-running thesis, has become consensus.

For the best example of this, look no further than the latest note from BofA’s rates strategist Ralph Axel (available to ZH professional subscribers), in which he writes that “while the market is still pricing the Fed to reach a terminal at or above 3% by mid-’23, we have recently seen a tenuous but remarkable change in Fed communications, where some Fed officials suggest the option of downshifting or pausing later in the year as they reach 2% given the challenging macro backdrop, tightening of financial conditions, and potentially softening inflation.”

Some more details from the BofA note:

We saw a notable change in communication from the Fed in recent weeks as financial conditions have tightened sharply, the economic outlook has deteriorated moderately (see more “stag”, more “flation”) and the threat of runaway inflation appears to have subsided (for now) with a potential peak in YOY CPI back in March.

In a 13 May speech, Cleveland Fed President Mester argued that “If by the September FOMC meeting, the monthly readings on inflation provide compelling evidence that inflation is moving down, then the pace of rate increases could slow, but if inflation has failed to moderate, then a faster pace of rate increases may be necessary.” Earlier this week, Atlanta Fed President Bostic said a pause in September might make sense.

The Fed has essentially opened the door to a pause in September, or a downshift to 25bp hikes per meeting (our Econ team’s house call) or possibly 25bp per quarter. All options are on the table, but we expect that a pause will gain increasing sponsorship from Fed members if financial conditions remain tight or worsen, and incoming economic data continues to disappoint.

The Fed’s risk-management approach to current policy requires normalizing overnight rates as quickly as possible, but also seeks to avoid hurting the economy with an overshoot in case the neutral rate curve has shifted lower since the last hiking cycle. A September pause at normal policy levels would allow time to assess the impact of their rapid pivot without sacrificing too much in the fight against inflation.

The Fed paused for a year after their first hike in Dec ‘15 as equity markets corrected in Jan ‘16. The Fed paused again after the Dec ‘18 hike in the midst of an equity market downturn, and then cut 3 times in ‘19. This time around, however, the Fed needs to more fully normalize policy before pausing because of the high level of inflation. In their view, normalizing policy probably means reaching 1.75%-2%, combined with their balance sheet normalization which starts in June.

As long as inflation continues to slowly decline, a pause in September we think would result from a combination of slowing jobs growth amidst tightening financial conditions. While it is impossible to know at this time whether these conditions will prevail strongly enough in their September FOMC meeting to trigger a pause, we think the rates market will begin to price higher probabilities of a September pause if the incoming data – both hard data and sentiment data – remain weak and inflation continues to moderate. This should mean lower rates across the curve.

And while September is now at “risk”, inflation remains too high for the Fed to do anything before then, and indeed, Axel writes that “the next 2 meetings in June and July will almost surely produce two 50bp hikes, which was reiterated in this week’s FOMC minutes. The fed funds range will then be 1.75-2% going into the Sep meeting. The Fed will be able to argue that 1.75%-2% is the bottom of the “neutral range” indicated by the median of the long-term dots in their summary of economy projections.”

Of course, the actual neutral rate is not visible and is likely a moving target; the market is currently pricing neutral in the range of 2.5- 2.75%, slightly above the current Fed median (2.4%) but below steady state over ‘16-’19 which was 2.75-3%

BofA thinks that the Fed can easily make the case that reaching 1.75%-2% provides a normalization of policy, but not necessarily a final resting place for policy: “This would offer an opportunity to assess the impact on jobs and inflation, both of which would need to be softening through the summer for this scenario to arise. While tightening may of course resume later as conditions change, a September pause would likely lead to a large re-pricing of interest rates given that current year-end pricing for the Fed is 2.60% and the peak reached in May ‘23 is 2.87%.” Incidentally, if the Fed paused in Sept, the policy rate at that time would likely be 1.83%.

Implications for rates and markets

The Fed’s acknowledgement that the neutral level has dropped again – something we have discussed ever since 2015 

… would not only decrease the probability of higher terminal rate scenarios, but also push back against a view that had been gaining traction in the market for the need to target positive real policy rates near term (which in turn would send growth stocks and cryptos soaring).

At the moment, the fed funds OIS curve levels off at around 2.5% after peaking at 2.9% in mid-‘23 and the market prices 6.1 hikes in ‘22 and 0.2 hikes in ‘23. In the context above for a pause in the tightening cycle around 2%, BofA breaks out scenarios based on the level of the mid-’23 terminal rate.

According to Axel, the table above changes the forward path of fed funds to generate hypothetical outcomes for term rates shown (assuming Treasury spreads to OIS do not change). A key part of each of the 3 scenarios is the terminal rate – which is the main determinant of 10y and 30y rates. (see Exhibit 5).

In the table it is defined as the 1y rate 7 years forward. It is likely that terminal would be priced considerably lower if the Fed guides the market to a September pause, sparking a massive risk rally. But the extent of decline in the terminal rate would drive the curve movement. We can see a steeper or flatter 2y-10y curve depending on how terminal reprices, but in all cases we see significantly lower rates across the curve. The implication is that a long duration view in 5y rates would likely be the safest play to take advantage of a pause scenario. to which we would add however, that a rate hike capitulation event would send virtually all risk assets sharply higher.

How to position for a Sep pause: Receive Sept FOMC OIS, and long 5s

While the peak yields in the belly of the curve may be behind us, especially if the Fed increasingly believes a pause in September appropriate, it is likely that we have also seen the highs in the 10Y, something we pinged followers a few weeks ago when the rate differential between the US and China brought the sharp selloff in the yuan to its breaking point.

Here, BofA says that it continues to like trading the market from the long side, buying on selloff in yields instead of selling on rallies. This stance is likely to benefit in the type of scenario where optionality around the policy path increases as the Fed reaches 2% in a context where inflation continues to drift lower.The bearish impulse that the Fed provides to the rates market as it turns hawkish and guides towards rate hikes supports the shift to lower maturities for long-only portfolios. Axel believe it is time for portfolios to start extending out the curve towards the 5-10y sector.

Which brings us to the bank’s two trade recommendations:

  • Trade recommendation 1: BofA like receiving September FOMC OIS currently at 2.13%. Assuming the Fed hikes 50bp in both June and July, the bank expects Sept FOMC OIS to settle at 1.83% in case the Fed does not hike at all in September. If the Fed hikes 25bp, which is the base case view of the bank’s Economics team, Sept OIS should settle at 2.08%. And if the Fed hikes 50bp in Sept we would expect it to settle at 2.33%. Axel puts his target at 1.96% which is midway between the pause scenario and the 25bp hike scenario, essentially a 50% probability of a pause (he also puts his stop at 2.23% which is about a 60% chance of a 50bp hike in September. The main risk is strong CPI and wage prints in the next 2 months of data, which however as we discussed earlier here and here are increasingly unlikely).
  • Trade recommendation 2: BofA is also buying conditional 9m5y receivers spreads atm/atm-50bp financed by selling 9m5y out of the money payers (atm+50bp indicative). The max upside on the position is 50bp for 5y SOFR rates in the 2.0% context (c.2.4% for 5yT at constant spreads). Carry is positive by c.4bp/3m. The main risk on the position is a selloff beyond the payer strike (c.3.05% for 5y SOFR), with potentially unlimited downside. The bank has a lower degree of conviction on the slope in a pause scenario, curve versus our duration view. But we think the entire curve will rally if a pause comes into focus

To this we would add one final point: if these trades seem a little contrived and complex for most, don’t despair: in this world where conventional wisdom is still the erroneous “Fed will hike 8-9 times”, if Powell is indeed going to end hiking after just another 100bps (2x50bps) and pause in September with the implicit suggestion that he will cut in early 2023, then any risk asset and any crypto is a solid buy here.

There is more in the full report available to professional subs.

Tyler Durden
Fri, 05/27/2022 – 14:48




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