Rate Spark: Navigating Tightening Conditions and Market Expectations

Rates Spark: Is it a pause, or is it a skip?

A hawkish hold need not be market moving for dollar rates, and a lot of financial tightening is still in the pipeline. Hot UK labour data adds to sterling curve flattening pressure - we think this will continue, especially when compared to dollar and euro rates.

 

The Fed will hold at this meeting, but expect some tightening from other sources ahead

Directionally, a decision to hold rates steady at this meeting should not have a material effect on the level of market rates. What’s more important is the tone and language used by Chair Powell, where a hawkish tilt should prevent yields from seeing this event as a rationale to move lower. A surprise hike would deepen the inversion and likely shift the curve materially higher (by some 10bp in the 10yr, and by 20bp in the 2yr). That said, a hike is highly unlikely given that the market attaches a 90% probability to a hold at this meeting.

 

We will also get the Fed’s updated forecasts and dot plot chart for individual forecasts for the path of the Fed funds rate. In March, the Fed signalled rates would be left in a 5-5.25% range through to year-end, with rate cuts in 2024. We suspect there will be only minor tweaks in their forecasts – our predictions for what they will say are in the table below. Nonetheless, the big risk is that even if the Fed do hold rates steady it inserts a further hike into their central forecast. This would likely see markets firmly swing in favour of a 25bp move in July.

 

Even as the Fed holds, there is set to be a material tightening in conditions in the weeks and months ahead. Bills and other bond issues that had been held back are now being accelerated as the US Treasury looks to rebuild its cash balance. To the extent that money market funds buy extra bills, this likely means less use of the Fed’s reverse repo facility. At the same time, as the Treasury’s cash balance is increased there should be an associated fall in bank reserves held at the Fed. This will make things feel that bit tighter.

 

 

A combination of extra floating collateral and less liquidity should place some upward pressure on repo rates, adding to the tightening being felt generally. Also, there is an underlying tightening coming from the rises in market rates seen in the past few weeks. This is largely a part reversal of the falls in market rates seen in the wake of the Silicon Valley Bank collapse. But still, this is helping the Fed to do the tightening job that it believes needs doing.

 

 

Pitted against that, however, has been a tendency for credit spreads to tighten, volatility to fall and Libor OIS to re-tighten. These act to loosen conditions, but are also a consequence of the reduction in system stress as the debt ceiling was suspended and banking fears have receded, both of which the Fed welcomes.

 

ING's expectations for what the Federal Reserve will forecast today

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