The Federal Reserve held a meeting last week to discuss the state of the economy and update their policy stance. At the conclusion of the meeting, they determined that inflation rates could remain above their target level, and they will start to become less accommodative in the coming months. Part of this change in policy stance included their view on short-term interest rates. They are now considering at least three rate increases in 2022. At the same time, market signals continue to suggest that inflation will likely not be an ongoing concern and that three rate hikes will not be necessary.
The fixed income market continued to signal that inflation rates are likely done increasing and that multiple rate increases in 2022 will risk inverting the yield curve and causing economic activity to decline. The yield on the ten-year U.S. Treasury declined on the days following the Federal Reserve announcement and remains below the level reached on the latest Consumer Price Index report.
The yield on the two-year U.S. Treasury also declined following the Federal Reserve announcement and ended the week below the level short-term interest rates would reach if the Federal Reserve actually increases rates three times in 2022 (assuming 25bps increases each time).
The 10 year-two-year yield curve continued to flatten last week and has now reversed all of the steepening that took place in 2022.
These movements in interest rates suggest that investors are not concerned that inflation rates will continue to increase in 2022 and that continued interest rates increases are not necessary.
The market signals tied to expectations for future short-term interest rates are suggesting that it is unlikely the Federal Reserve will increase rates at the pace they announced last week. The Eurodollar futures market continued to flatten following the Federal Reserve announcement and has developed multiple inversions.
The forward market for one-month overnight index swaps (OIS) declined for the 1-3 year tenors and the three-year level remains below the two-year level.
The directional changes and absolute levels of these future short-term interest rate markets suggest that investors expect short-term interest rates to increase by a small amount and for a short period of time. These moves also suggest that investors are not concerned about inflation levels in 2022.
The market signals for inflation expectations also suggests that investors are not concerned about rates of change continuing to accelerate. The five- and ten-year breakeven inflation rates continued to decline last week, and the spread between them is moving back to more normal levels.
Five- and ten-year inflation swap spreads also continued to decline last week, and their spread continued to narrow.
The five year-five-year inflation swap rate increased modestly last week but remains well below 2009-2013 periods.
On the commodity side, oil prices (WTI) declined on the week and remain 15% below the recent high. Oil volatility also declined on the week but remains above the trending levels from prior months.
Natural gas prices also declined on the week and are over 40% below the recent high.
The agriculture index declined on the week, as the weakness in commodities has spread into other areas.
As a result, the broad commodity index declined last week and is 8% below the recent high.
A lagging commodity market is another sign that inflation pressures have likely peaked and the rate of change for inflation will likely start to slow in 2022.
If inflation pressures have peaked and continue to slow, a move to tighten policy by the Federal Reserve will be counterproductive and will likely have a negative impact on economic activity at some point in 2022.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.