Fed's Hawkish Pause: Impact on Market Rates and Investor Sentiment

Rates Spark: Raising the hawkishness bar

A hawkish pause from the Fed, but the higher dots add to its degree. Market rates have reason to rise more. The bar for the ECB to surprise to the hawkish side today and move longer rates sits high, with the market apparently well-priced already.

 

Market rates have enough here to push higher, and the front end will feel tighter even without a hike

The Fed has latched on to the theme that has dominated the market mindset in the past number of weeks, namely that the US economy continues to refuse to lie down. This has helped risk assets, as by implication default risks that would typically evolve from a recession have been kept at bay, helping credit spreads to tighten and equity markets to perform. There has also been an easing in measures of system risk, especially as immediate banking sector angst has been downsized. This overall combination has allowed market rates to ease higher, driven by higher real rates, which in turn are a sign of strength.

 

Initial comments from the Fed do not negate these themes, and in fact push for more of the same. While this is more reflective of the new “dots” than anything else, it in any case pushes in the direction for higher market rates ahead. We continue to position for the 10yr to head to the 4% area, and it would not look wrong if it were to drift above for a period, at least until the illusive macro slowdown is a tad more clear-cut than now. We still expect the 10yr to be much closer to 3% by the end of the year but for now we see yields rising higher first.

 

There was no particular mention of the changing liquidity circumstances. Currently there is amble liquidity, with bank reserves on the rise (up from US$3trn to US$3.4trn), and still over US$2trn going back to the Fed on the reverse repo facility. The US Treasury has only slowly rebuilt its cash balance at the Fed since the debt ceiling was suspended, so the impact of less prior bills issuance and more bank support has dominated the ongoing quantitative tightening programme. Ahead, some US$500bn off liquidity will get drained out of the system as the Treasury rebuilds its balance through net bills issuance. We expect from that a combination of lower bank reserves and lower cash on the reverse repo facility.

 

This will make it feel like there has been some tightening in conditions, even if not in levels (as the Fed has not hiked).

 

Still hawkish, but harder to regain traction further out

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