That swing is now well underway, having gained additional fuel from tariff headlines and the broader policy uncertainty that has gripped recent survey data. From the mid- February highs, 10y yields are lower by ~30bp, the S&P 500 is down by ~6%, and 2025 Fed pricing is back to 3 cuts (from ~1.5).
So far, the data downshift has generally been contained to the “soft” survey data (aside from some likely noise around tariff front-running, bad weather, and the California fires in the hard data). Also, the first read of 2025 inflation data wasn’t exactly comforting. While the Fed’s preferred Core PCE was benign in January, y/y Core CPI ticked up despite consensus expecting a decline. Looking beyond January, we remain wary of a return of strong Q1 data seasonality and potential inflationary tailwinds emanating from both trade and immigration policies as the year progresses. And while inflation breakevens still look well-anchored, invocations of “stagflation” have skyrocketed over the last few weeks.
The path to the more optimistic economic outcome we envisioned in our 2025 Year Ahead is rapidly narrowing. We haven’t (yet) turned into full-on economic bears or put any cuts back into our 2025 Fed call, but the skew of risks has decisively shifted from the upside to the downside over the last month. Our conviction remains low, but the next month or two should hopefully provide some clarity around key questions: Will the dizzying pace of whipsaw policy announcement slow and allow policy expectations to stabilize? Even if the administration’s headlines do calm (limited reasons to expect they will), can the uncertainty toothpaste really be put back in the tube? To what degree will that uncertainty drag on capex, hiring, investment, consumption, etc.?
The recent rate rally has generally been consistent with the rapid evaporation of the positive post-election “vibes” (as also evidenced by the equity moves). But the unwind of short-vol/carry-focused trades likely added to the voracity of the shift. Up until the last few weeks, putting on these positions has been very popular, given expectations for the Fed to remain on hold into H2 and very low conviction around longer-term, directional, thematic trades. We think some meaningful shifts in supply/term premium risks also played a role (more on that below).
The narrative pendulum is still swinging in the negative direction. The last few sessions have shown some uneasy signs of stabilization, but with the help of some tariff policy walk back and German fiscal largesse. We think markets are still skewed to glom on to any data weakness or negative policy headlines, while largely dismissing positive developments. This skew also applies to Friday’s NFP print, and we would expect to see more buying on weakness than selling on strength – especially given that the February data is likely too early to see any discernible impact from the recent policy uncertainty. So those risks will remain regardless of last month’s print. Any meaningful crossover into hard data is likely more of an April/May story. Still, this week’s NFP print is likely pivotal in setting the narrative and market direction into the March FOMC.
We have been a bit surprised at the degree of the steepening over the last week. To be fair, some of this may have been positioning pain (pressure on carry-driven flatteners and fast money fading the rally in the front-end) and the moves in European rates after the German fiscal announcement propping up the back-end. But the repricing of the Fed looks to have gone a bit too far at this point (~3 cuts currently priced for 2025, vs. the December SEP median at 2). Even though we see downside risks growing, we don’t think the Fed is going to be particularly pre-emptive in reacting to policy uncertainty and the recent downshift in soft data. After several years of divergence between soft/hard data, they will likely want to see the former bleeding into the latter before shifting to a more dovish stance. Uncertainty was certainly a major theme of the most recent Beige Book release, but it didn’t seem to be bleeding over into an actual drag on activity at the current stage. The Fed may also be somewhat handcuffed by the recent inflation data, especially if we continue to see a repeat of Q1 seasonal strength. If the March SEP maintains a 2-cut median for 2025, it’s hard to see front-end pricing diverging further than it already has. (We will discuss this more in our FOMC preview). In our view, this should mean further growth concerns, or any risk-off sentiment, should eventually start to hit further out the curve – looking more like a policy “error” forced by stagflation (bull flattening) than a hard-landing pull forward of cuts (bull steepening).
