Hawkish repricing in US yields underway

The dust is settling after a big week in global macro. Powell ruled out a rate cut in March as “not his base case”, and reiterated the stance in his Sunday interview on CBS’s 60 Minutes. The market was focused on regional banking worries on the day of the FOMC, but a monster employment number on Friday changed the narrative and triggered a sharp selloff in US Treasuries and SOFR futures. The market went from pricing in 150 bp of cuts in 2024 to 118 bp today. ISM manufacturing and non-manufacturing surprised to the upside, with large increases in sub-categories like new orders, prices paid, and employment.

The events of the past week diminish the risk of a US recession and reduces the number of insurance cuts that need to be priced into the curve. Fed board member Kashkari also commented yesterday that the neutral rate might be higher and that policy is not too tight. If the neutral rate is now structurally higher, then the Fed’s rate cut cycle will be shallower than expected.

I previously believed that the Fed would find every excuse to cut as quickly and deep as possible to support the economy in an election year. Fortunately I abandoned this view, pressed the reset button on my portfolio, and alerted readers before the rates selloff happened on Friday. I also previously held the view that growth, employment, and inflation were all trending lower, but the data is now confusingly mixed and I am open-minded to where the economy goes from here.

What the charts are telling me is that we are undergoing a narrative and positioning shift where the market weighs more heavily the probability of a reacceleration of the economy rather than a sustained slowdown. If this is the case, then the Fed funds curve must move closer to the Fed’s dot plot projections of three cuts in 2024 and the Treasury curve must steepen to price in the prospect of another hiking cycle 2-3 years from now. 5 yr yields are breaking resistance at 4.10% after last week’s failed breakdown.

5 yr Treasury yields

Dec 24 SOFR futures have broken down from the range they have held since December’s FOMC meeting.

SOFR Dec 24 futures

Despite all the calls by Fed board members and Fintwit analysts pushing back on the 150 bp of cuts that were priced into the curve, the market is poorly positioned for a move like this. Brent Donnelly, in his am/FX blog, observed on his trip meeting clients around the US and Brazil:

We did not meet a single trader net paid rates. A few were paid US vs. received Europe and trades like that, but literally not one out of 100 people we talked to said they were positioned for higher global yields. Make of that what you will!

A reasonable target for the short end of the curve would be to price in 3-4 cuts in 2024, which would be 18-43 bp lower from the current market in SOFR Dec 24. The move in 10 yr yields would be even more pronounced, as the market would need to bear steepen to price in a higher neutral rate and a reacceleration of the economy in 2025. This should also send USD higher against most currencies.

DXY USD Index

What does this mean for risk assets, and how am I expressing the current narrative shift in my portfolio? Paid subscribers can read on…