After today’s University of Michigan reading of one-year inflation at 4.2%—alongside the BLS annual update of seasonal factors, which suggested that core inflation was running hotter in the second half of last year than previously indicated—and the WTI oil price touching USD 80/bbl, the 1-year and 2-year breakeven inflation expectations are 70 basis points higher since mid-January.
As market expectations appear to be leaning more toward the Federal Reserve’s guidance, the terminal rate now sits at 5.2% in July, with 25bps of rate hikes priced in for March and May alongside a potential hike in June. The market has eliminated the prospect of Fed easing in 2H23, which today sits at a mere 7bps, but holds firmer on the view of slowing growth in 2H23, leading to about 145bps of easing in 2024.
Ten-year Treasury yields are trending toward the upper band of our 3.4–3.9%range, reaching 3.75% on Friday, 13bps lower than where we started 2023 (the year-to-date low is 3.31%). As we expected, rising interest rates have also pushed volatility higher, and as we discussed in our latest Fixed Income Strategist report, “Pulling forward to push back,” the tightening in risk assets in January was well overdone, and in the short term pockets of vulnerability are to be expected in widening spreads and rising interest rates.
Our fixed income portfolio entered 2023 with slightly longer interest rate risk and a bias for higher-quality sectors such as investment grade (IG), munis, or agency MBS. We began trimming our long exposure as the market trended toward the lower end of the 3.4–3.9% range. While we continue to view a lower 10-year yield in 2H23—trending toward 3%—we wait to add again to our long interest rate exposure close to the upper range (3.9%) and wider spreads.
The shifts in sentiment we have witnessed over the past two weeks have heightened the volatility in the short end, particularly the 2-year Treasury which moved about 40bps in a two-day period. This volatility pushed the 2-year/10-year curve inversion to a new cycle low of –88bps. We do not see a meaningful reversal in the inversion trend until 2H23, and project the 2y/10y moving from –87bps now to –25bps by end-2023, assuming the Fed’s 25bps rate hikes end in 1H23.
Main contributors - Leslie Falconio
Content is a product of the Chief Investment Office (CIO).
Original report - Fixed income: Disinflation vs. reacceleration, 13 February 2023.
