• February 8, 2023

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Rising inflation and worries of an economic slowdown caused a severe flattening of the yield curve and propelled the U.S. dollar to new highs against several major currencies.

The move was triggered by the latest CPI release that showed consumer prices rose to an annual rate of 9.1%, the highest level since 1981. Excluding food and energy, the core rate came in at 5.9%. Both headline and core figures were higher-than-expected.

After the announcement, traders quickly priced in a higher possibility that the Fed may be forced to respond to the inflation pressure by raising rates by 100 bps at its next meeting at the end of the month. Before the inflation report, most market participants expected a 75 bps move when the Fed meets on July 26 and July 27.

FOMC official, Atlanta Fed President Bostic, called the CPI news “a source of concern” and added that when it comes to the July meeting, “everything is in play.” Cleveland Fed President Mester , a voting member of the FOMC, said the Fed needed to be “very deliberate and intentional about continuing on this path of raising our interest rate until we get and see convincing evidence that inflation has turned the corner.” The odds of a 100 bps hike in the overnight rates climbed as high as 70% following the comments from the central bank officials. A surprise 100 bps hike in the overnight rate from the Bank of Canada added to the negative sentiment.

Two-year yields rose and 10-year rates fell, flattening the 2y/10 yield curve by 14 bps to -22 bps, the most inverted level since 2000. Just one year ago, the spread was 120 bps. Yield curve inversions typically precede recessions; this time may be no different. The more the Fed hikes rates, the greater likelihood the economy will contract.

Weak survey data in the Fed’s Beige Book report, a collection of views across its 12 districts, confirmed growing recession concerns. The report highlighted sluggish auto sales and weakening housing demand across the country. While the labor market remained strong overall, nearly all districts cited modest improvements in labor availability stemming from weaker demand for workers, particularly in the manufacturing and construction industries.

Foreign exchange markets also responded to the possibility of more aggressive Fed action. The Deutsche Bank’s trade-weighted U.S. dollar index hit a new high, taking its year-to-date gains near 14%. EUR/USD fell below parity for the first time since 2002, to 0.9998, and GBP/USD dropped to 1.1860.

A strengthening dollar is good news for the Fed because it tightens financial conditions in the U.S., helping the central bank fight inflation. For U.S. companies that get revenue from overseas, however, it is a headwind to corporate earnings. Several large companies, such as Microsoft
MSFT
, have already pre-announced hits to profits and sales from the strong dollar.

The shape of the yield curve, the pace of Fed tightening and the strength of the dollar (and the speed at which they are changing) are all very important macro variables. These variables are in a strong trend and hitting multi-year extremes. Historically, it is at these extremes that something cracks. Investor angst at this stage is understandable. Grab your tickets — it’s going to be an exciting show.

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