Hawks Take Flight, But U.S. Yields Fall

Global central banks have evaluated inflation as their top priority, outweighing Omicron uncertainty. And the "Super Central Bank" week delivered some relatively surprising outcomes: the Fed front-loading by doubling their taper pace from January with three rate hikes expected by the end of 2022; the ECB will taper PEPP purchases, with net assets to terminate at the end of March (could be resumed if "if needed"); and the BoE hiked rates by 15bp to 0.25%, with more likely coming in 2022. Other central banks such as the BoC (January 26) should follow the same pattern given the recent comments from Governor Macklem.

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The ECB left a more hawkish impression than markets had expected on QE. However, Lagarde is still telling a shrinking year-end crowd that Rate liftoff in 2022 is very unlikely, but we know it's possible after the Fed let the multiple rate hike genie out of the bottle.

Meanwhile, covid headlines are likely to worsen in the near term before getting better in the Spring. And with Biden's economic syllabus deferred to next year or longer, the market is looking for the next catalyst to boost risk sentiment into the year-end.

Does the market care? The US rates market does not! 

The US 10-year yield is down to 1.41%, from 1.45% heading into the FOMC. It has been down 21bp in the past month. All the post-FOMC decline comes from real rates, now down to -1.03% from -0.96% pre-FOMC.

Oddly, since December 8, the market has removed a quarter-point hike from Fed pricing despite the Fed indicating its pedal to the medal for rate hikes next year. The 2-year has also reversed course and dropped back from its immediate jump on Wednesday. The rates market does not believe the Fed will tighten far – certainly nowhere near the last cycle's peak of 2.50%.

The risk markets and US dollar looked through a hawkish Powell. Still, for the FOMC members, this could be a positive message and might encourage further hawkishness and an early start to the tightening cycle. For macro investors, this might mean:

• Dollar bullishness.
• Rates bearishness and curve steepening.

The market terminal rate is so low that it should not have been difficult for the Fed's long-term rate expectations to look hawkish relative to the market, but bond traders shrugged.

As for currencies, none of this is academic. On the contrary, the USD is likely to remain closely tied to the hip with the expected fed funds terminal rate. The USD will follow if the nominal terminal rate goes up solidly into the twos, with EURUSD sliding solidly below 1.10. If the last three months' betas are maintained, 50bps addition to the US terminal rate would be worth at least five prominent figures on EUR/USD.