Rates playbook: look to add duration risk

We did not learn anything new about the Fed’s strategy, forecasts, or balance of risks from the June FOMC. Inflation continues to track around 2.5-3%. I think the constellation of growth/labor/inflation data over the past 12 months should allow us to incrementally build more confidence that the Q1 spike in inflation was a statistical anomaly and the disinflation process remains largely intact; and above-trend domestic demand growth and robust employment are not translating into upside risks to inflation and wage growth.The bulk of excess inflation today remains a function of legacy shocks and shifts (see below). This supports the Fed’s core view that the stance of monetary policy is sufficiently restrictive to generate a sustainable decline in underlying inflation to 2%. To get a sense of where inflation is going, we (and the Fed) must work with contemporaneous and forward-looking data. Roughly, this will be some combination of inflation expectations (stable around 2%), economic growth (stable around 2.5%), labor market dynamism (slowing rapidly), and wage growth (slowing but around 1%pt above where the Fed wants to see it relative to productivity growth). I think this mix gives us most of the ingredients to start normalizing rates this year, perhaps as early as September. At this stage, our focus should shift to the trajectory for front end rates in 2025. We’re priced for around 75bp of cuts next year, with a terminal rate of 4% in this easing cycle. My base case is that this is too high, even with the Fed’s estimates of long-term neutral rates drifting higher towards 3-3.5% from 2.5% in 2018/19. Powell sketched out three scenarios under consideration at the FOMC this year: stay on hold to build more confidence in inflation trending lower; cut because inflation is sustainably approaching 2%; and cut because unemployment is rising quickly. I see Q2 inflation data supporting a small shift in probabilities from option 1 to 2. More importantly, odds of the Fed resuming hikes to offset rising inflation expectations or an acceleration in wage growth continue to recede, despite a significant easing in financial conditions since last October. This should give us more confidence of a durable ceiling on longer end Treasury yields around 4.5-5%, with the upper end of that range likely to require a deterioration in the fiscal outlook/higher term premium