It's Fed day, finally.
There is only one game in town today and that is the FOMC meeting decision. The Fed may technically have two choices that it can make. But in market terms, it is getting increasingly difficult to see how standing pat is going to be a viable choice at this juncture.
Markets are now pricing in more than a 90% chance of a 25 bps rate hike, with 10-year Treasury yields threatening a breakout through 5% for the first time since 2007. That combination tells you where the pressure point is heading into the decision.
It is a case that investors are not just worried about higher inflation on its own. They are starting to ask how seriously the Fed intends to respond to it.
The inflation data in August reaffirmed that price pressures remained persistent. And now we're seeing oil prices race well above $100 and long-end Treasury yields spiking to levels not seen in nearly two decades.
If the Fed ignores those signals now, the risk here is that investors interpret the decision not as patience, but as reluctance to confront inflation.
And that really matters when you look at the long-end of the curve.
A Fed hold could pull 2-year yields lower initially, but the 10-year and 30-year will very well be a different story.
The issue here is that the market reaction will likely lean towards investors demanding more compensation for inflation uncertainty and policy credibility. As such, the term premium can and will rise.
When that happens, we might end up with a rather uncomfortable outcome where there is no rate hike but long-term borrowing costs move higher anyway.
And in this stance, Treasury buybacks are unlikely to solve that problem either. After the August CPI report, markets pushed the probability of a September rate hike sharply higher. In other words, the bond market has effectively moved towards demanding the more monetary orthodox response: If inflation is proving persistent, do your job and tighten policy.
So, I would argue that the Fed has backed itself into a difficult corner here.
A rate hike carries obvious risks to growth and financial markets. But with the current macro backdrop and rate expectations being this overwhelmingly priced, not hiking rates will risk sending an even worse message.
And this is not just one that will see yields at the long-end move just a bit higher or rather gradually. I would wager that the moves are going to be sharp and can even come off as disorderly.
The danger here might not even be just a 5 or 10 bps move in long-end yields. BofA is warning that 30-year yields could even jump to as high at 5.75% in a jiffy if the Fed decides to stand pat today.
That paints a bit more colour to the gravity of the situation that the Fed is facing ahead of their decision later today.
This article was written by Justin Low at investinglive.com.
Source: Investing Live - Central Bank
