Market pricing 1% rate hike – has it gone too far?
03 March 2021
Market indicators show a too far, too fast behavior that is likely to be corrected.
Bottom line
Recent turbulence in equities was likely related to strong moves in the bond markets. The latter are pricing a strong economic recovery and a 1% hike in FED rates, which in our opinion is a case of markets moving too far, too fast, and expect the subsequent adjustment to provide a tailwind for equities.
What happened
The combination of a catastrophic 7y auction on the 25th of February (the worst in years in terms of bid-to-cover ratio), rising real rates, and talks about inflation, was a potent mix that impacted the shape of the U.S. yield curve significantly. Butterflies such as 2s5s10s, which represents the shape and curvature of the yield curve, had the largest daily move of the past 10+ years, exceeding even the spikes of the ‘08-‘09 financial crisis. This may have led to a risk reduction in various cross-asset books, exacerbating the sell-off in equities.
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What is the market currently pricing?
Looking at the underlying factors of the move in the yield curve, the 60 bp rise in 10y yields in 2021 seems mostly due to the increase in real rates (45 bp) and, to a lesser extent, to increased inflation expectations (15 bp). Indeed, the 5y-5y TIPS spread, indicating breakeven inflation rates, went down last week. Thus, real rates are also pricing better growth with larger stimulus and quick re-opening of the economy. Copper, which also correlates to global growth expectations, doubled over the last year and is close to its all-time high.
Concerning monetary policy, it is useful to observe the changes in the 3m Libor future curve (Eurodollar). These futures are mainly used because of their high liquidity and because it is a good indicator of expected short-term rates, i.e., FED policy.
The Eurodollar future for December 2024 currently trades at 98.5, implying a future 3m Libor rate of 1.5%, compared to the current month's future settling at 0.18425%, in line with current FED rates. The difference between the current month's future and the December 2024 future is >1%, implying a hike in FED interest rates of a similar amount by 2024.
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Our takeaway
While the signals of economic recovery being priced by the market appear consistent with what were our expectations, we think that the re-pricing of the front end of the yield curve (implying a full 1% rate hike by the FED) has gone too far, too fast. An adjustment in rate expectations would represent renewed tail-winds for equities.
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