June FOMC Preview

Inflation narratives, Risk outlook, and other thoughts

Tomorrow, we expect the Fed to leave interest rates unchanged but to communicate that the “job isn’t over” and that interest rates may need to rise again to bring inflation down to the Feds target of 2%. We’ll discuss what this means for cross-asset strategy and the existing inflation narratives driving markets.

But first, a brief recap on CPI which printed in-line this morning:

Despite the progress, Core CPI remains elevated:

In all — a mixed report. On one hand, slowing YoY CPI will make the Feds job easier. On the other hand, Core CPI is still elevated, and easy comparisons will flip by the end of summer. This means the risk of inflation rising YoY again is high.

Inflation Narratives

There are three primary inflation narratives in the market today:

• (1) inflation is cooling, the Fed doesn’t need to raise interest rates further, the economy is fine at this level of rates

• (2) inflation is cooling, the Fed will need to cut rates later this year as the level of rates is too high for the broader economy

• (3) inflation is sticky, the Fed may need to raise rates at least one more time

All narratives have major implications for the level of rates, the impact to duration, and the yield curve. In (1) we should see steepening led by the belly selling off, for (2) further inversion will be driven by the long end being bid, and for (3) we would get a much deeper inversion. It’s important to note here that narrative (3) can morph into (1) or (2), which suggests higher interest rate volatility.

Our base case, given this dynamic, is that yields should move higher as data is in-line with (1), though (3) is at-risk given the stubborn nature of core CPI. Indeed, we saw this today in rates markets after a strong 30y auction, with the belly of the curve leading a sell off that pushed yields higher across the board:

Pricing Scenarios

The market has completely priced out cuts it was expecting during the SVB turmoil:

vs. 3/15/2023:

• In Scenario (1) the Fed will communicate it is data driven, will “skip” to maintain an option to hike again should inflation come back, and will suggest that the economy is resilient and can withstand rates at current levels. We believe this is the likely scenario.

• Scenario (2) would require material increases in the unemployment rate, and we think it is off the table for the June meeting.

• Scenario (3) would require the Fed to communicate a much more hawkish tilt — a willingness to go higher in rates to get inflation down faster. There is a risk of this occurring, and we would place it at 40% odds.

From a pricing standpoint, the market is pricing in scenario (1). A hawkish tilt would increase the odds of scenario (3), which would result in higher implied rates for July and September meetings. We believe this risk is underpriced and could be a unique short-term trade.

Risk Implications

In our outlook published in April, we laid out our expectations for the year and highlighted some key risks.

• Consumer spending and new order growth remains muted:

  

• EM resilience is real, with improving PMIs led by India:

  

• China’s recovery story is stalling and PBoC has begun to cut reserve ratio requirements as it plans for broader stimulus, a key risk we highlighted

• Debt ceiling came and went, with nothing breaking (luckily!)

• Data has continued to show resilience, and we do not expect data to come in weaker than trend until 2H of 2023 — so our view of the Fed is that they will push inflation scenario (1) by changing their Summary of Economic Projections to show rates higher for longer

Cross-Asset Strategy

• We believe that equities can still move higher through the rest of year, driven by Nasdaq and technology stocks — we do not think cyclical shares (materials, energy, industrials, and financials) will perform well until the Federal Reserve begins to cut interest rates.

• Commodity prices, led by oil, will continue to move lower as industrial demand in the United States, Eurozone, and developed Asia continues to struggle. We would need to see new orders pick up for the oil demand outlook to improve.

• Bond yields will initially move higher as the Federal Reserve will paint a too-rosy picture of economic resilience in the face of these levels of interest rates — however, we see rates dropping quickly once real yields get closer to ~2%

We’ll be publishing an FOMC Recap tomorrow after the press conference. Stay tuned. If you have any questions or comments, please feel free to reach me directly by email or on the terminal.

Muhammad Wahdy
Portfolio Manager
Wahdy Capital