By Tiffany Wilding, North American Economist at PIMCO
Last Thursday felt like a rollercoaster ride in the bond market, after the US CPI report kicked off a 25bp intra-day selloff in the 2-year Treasury note, the Fed Funds Future market priced a 20% probability of a rate hike before the March meeting, and a 70% probability of an additional 50bp hike at the March meeting.
Thursday’s inflation report was firmer than our consensus expectations. And this coupled with the January employment situation report, which showed broadening wage pressures despite greater labor supply improvements, confirmed the case for the Fed to kick off the rate hiking cycle in March and to hike at consecutive meetings thereafter until inflation shows signs of moderating, which we still expect will be in the latter half of the year. In other words, the risk case that we highlighted a few weeks ago appears to have rapidly come to fruition, and more concretely; we now expect 5 rate hikes this year (March, May, June, Sept and December) with the risk of more.
We see the chance of the Fed announcing a hike before the March meeting as virtually zero, and believe most Fed officials would prefer not to hike 50bps at the March meeting. The balance of evidence still suggests to us that a wage/price spiral is not imminent. Nevertheless, with Powell and Brainard still awaiting Senate confirmation, it may be more difficult for the senior leaders to communicate to markets ahead of the March meeting (and remember the February CPI report will be released during the blackout period). Therefore, we admit that market pricing may become a self-fulfilling prophecy, if Fed officials see broader risks in surprising markets.
In other words, while the market’s reaction was directionally right, the magnitude of the move was extreme relative to our read of the recent macro data, and Friday’s retracement seemed reasonable.