Peeking past the peak
What 5y5y swaps tell us about the terminal rate
Yield not thy neck To fortunes yoke, but let thy dauntless mind Still ride in triumph over all mischance. - Shakespeare, King Henry VI
The question that’s been going around is whether the Fed is behind the curve. I can’t answer that conclusively, but I can expand a tiny bit more of what we can look at to understand the answer to this question better, which is, what are the medium-term inflation expectations as priced by the markets.
The 10-year US Treasury yield curve estimates expected economic growth and inflation expectations, among other things. This curve can also be divided into two different time horizons. The short term can be derived at the 5 year yield and the longer term from the 5-year-5-year-forward which covers the second half of the bond’s 10-year maturity. The second half of the curve is useful because it can isolate transitory fluctuations in inflation, such as those driven by volatile food and energy prices. Hence, it is a good gauge of whether the markets’ longer-term inflation expectations are anchored.
One measure we can use is the 5y5y Overnight Index Swaps (OIS). It serves as a proxy for the terminal rate, and with a flattened curve it can also reflect the peak Fed rate. The 5y5y OIS also contains information about the inflation risk premium, which is the compensation investors require for the risks surrounding their central estimates of inflation over the forecast horizon. The uncertainty about inflation lately, has seen multiple repricing episodes by the markets.
If the markets believe that the Fed is behind the curve, the medium-term inflation expectations would be expected to rise, i.e. the 5y5y OIS would rise. For the past few years however, the 5y5y OIS average has been sticky despite the repricing that has been happening at the shorter-term maturity. In fact, post 2019 average has been lower than that for the period of 2015-2019.
Why have these rates remained low? It could be that investors thought the higher inflation is only temporary and would revert to its previous level. Then again, maybe they are expecting that a recession would follow soon after, or that the state of the economy might suddenly deteriorate, all of which then necessitate a Fed pivot. All of these scenarios would mean that the Fed would not tighten financial conditions overly much.
Be that as it may, the story does not end there. Around the beginning of this year, 5y5y OIS curve began climbing sharply upwards, to reach 2.6% as of 22nd April 2022. What could prompt this change after much stickiness before? Perhaps it’s because of the Ukraine-Russia war, or the Fed firming up its hiking intentions, or maybe investors are questioning whether some of the price changes from supply shocks have become embedded. Whatever conceivable reasons we could think of for this change, the fact remains the same - markets are revising their medium-term inflation expectations upwards.
Investors would demand more compensation for taking increased risk if they rethink the assumption that this inflation regime self-corrects to a lower level and anticipate the Fed having to tighten beyond what is projected. Consequently, the terminal, terminal rate could very well be higher than the current market pricing. This requires more repricing, but which might be realised gradually as the Fed hikes.
The adjustments in the markets will not be smooth considering the many factors that affect inflation, plus, who knows what further curveballs may come our way. Investors however will gain increasing confidence and lower their demand for holding inflation risk if, as the policy rate approaches the terminal rate, the economy remains healthy and inflationary pressures subside. That is, investors no longer feel the need to protect themselves against so many inflationary scenarios.
The Fed has navigated through a once-in-a-century pandemic, crazy supply chain shocks, enthusiastic demand stemming from generous fiscal support, strong wages, and the tragic Ukraine-Russia war (did I miss anything?).
The medium-term inflation expectations receding steadily from their peak - whichever rate that ends up to be - means that the markets will ultimately be convinced that the Fed has safely anchored inflation expectations and at long, long last, is no longer behind the curve.
Many people think that quantitative tightening (QT) is the opposite of quantitative easing (QE). In fact, QT doesn’t accurately describe what the Fed is currently doing. When the Fed is doing QE, it can choose which part of the yield curve to target, and that will determine whether the curve steepens or flattens.
However, in this case, it’s the US Treasury that is going to decide once the Fed stops reinvesting. The Treasury will decide how to respond whether it will increase the supply at the front end or the back end. That determines whether the curve steepens or flattens, which is quite the opposite of when the decision is held by the Fed. Hence, from the perspective of the Fed itself, asset sales should be considered the opposite of QE.
Would the Fed start selling, for example, MBS to tighten financial conditions? The Fed prefers utilising the policy rates first before resorting to asset sales, but nowadays, anything is possible.
The terminal neutral rate is the estimated Fed Funds rate that would help the economy maintain full employment and capacity utilisation and yet retain stable inflation. It is the rate when the Fed will stop tightening.