Baker Market Update – wk220218

The recent surge in bond yields took a breather this week as the risk of the largest military conflict in Europe since World War II overshowed soaring inflation and the potential for a more aggressive Federal Reserve tightening cycle in 2022. The 2-year Treasury yield peaked at 1.58% on Tuesday, up 137bp since Sep 2021, as the BLS reported producer prices spiked 1% in January alone and are up 9.7% over the last year. That combined with last week’s hotter than expected CPI report that showed consumer prices rising at a 40yr high of 7.5% had traders anticipating the Fed may have to raise rates at every single FOMC meeting this year, including the possibility of a 50bp hike in March. But the threat of a Russian invasion of Ukraine and the potential havoc that could unleash on energies markets and the world economy were enough to remind markets that the Fed may not be able to raise rates as much of they may want. By the end of the week, 2-30yr yields had fallen 10bp or more from Tuesday’s high.

Despite the late week rally in Treasuries, it is clear investors need to prepare for an aggressive Federal Reserve tightening cycle in 2022. It is almost a certainty the Fed will raise rates in March, but the markets are split on whether it will be a 25bp or 50bp. St. Louis Fed President James Bullard made headlines this week when he said he wanted the Fed to raise rates 100bp at the next three meetings between now and July 1, which would imply at least one of the hikes was 50bp. But Bullard remains the most hawkish Fed president and most other FOMC members have expressed a desire for a more measured approach that would imply 25 rate hikes at each meeting. The pace of rate hikes will almost certainly depend on whether and to what extent inflation falls and/or growth slows. In my opinion, there are 3 possible paths for rate hikes depending on the path of inflation/growth:

  1. Inflation continues at its current elevated pace: Fed raises rates 25bp at each meeting until inflation falls
  2. Inflation accelerates higher: Fed raises rates at every meeting with some hikes 50bp
  3. Inflation falls and/or growth slows sharply: Fed raises rates at next 3-4 meeting and then pauses to reassess

This is only my expectation for possible paths the Fed may follow, but I think it’s clear the Fed will be “data dependent” and they will we focused on tightening monetary policy until inflation falls. February CPI will be reported the week before the FOMC’s next meeting (Mar 15-16) and I believe that report could very well determine whether that first rates hike is 25bp or 50bp.

Treasury Yields & Fed Funds Rate Since 2002

Source: Bloomberg, L.P.

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