Auction Concessions and Pre-CPI Positioning

Last week offered up decent bookends for a narrow, short-term range.  A series of downbeat economic reports set the low yields last Monday.  Then Fed speakers and strong data pushed back in the other direction.  The breadth of the range was finally realized on Friday after the jobs report.  Since then, not only would it be within the bond market's playbook to consolidate ahead of a key data report (Wednesday's CPI), that's exactly what's happening.  Monday was surprisingly resilient, but Tuesday is off to a more logical start, nearer that upper yield "bookend."  Said logic is fueled by a concession for the supply environment (Treasury auctions and corporate issuance).

All of the above assumes an upper bookend around the 2.85 technical level, but that could prove to be an intermediate stop in the event CPI comes in hot tomorrow.

But even if CPI comes in hot, June's precedent suggests it's more of a temporary headwind.  This is really a story of Fed credibility.  The market now believes that the Fed will be increasingly aggressive with policy tightening if data forces its hand.  The following chart shows 10yr yields and the market-based inflation metric derived from the spread between yields and TIPS (the inflation-adjusted 10yr yield, also known as inflation "breakevens").   Notice that breakevens didn't react too much to June's CPI--a phenomenon most easily explained by the market's belief that the Fed will pound the economy into submission if that's what it takes.  This gave way to a delayed recovery in yields themselves and it's not unreasonable to expect a repeat performance in the event tomorrow's CPI causes a temporary spike in yields.

The following chart confirms the market's read on June's Fed meeting.  After CPI and up until Fed day, traders saw the Fed Funds Rate moving another 50bps higher between the end of 2022 and the middle of 2023.  After Fed day, mid-2023 rate expectations plummeted in relative terms, adjusting by almost 90bps at the most extreme levels.    

The lowest point in the chart above was driven by a big spike in rate expectations for 2022 combined with a much smaller spike for rate expectations in 2023.  In other words, markets saw inflation data prompting bigger hikes from the Fed in the short term and concluded those hikes would do the trick.  In subsequent weeks as econ data proved to be resilient, traders have been ramping up mid-2023 rate expectations to be more closely aligned with late 2022. 

The paradoxical takeaway is that strong economic data is a bigger risk for longer-term bonds right now compared to hotter inflation data.  That doesn't mean there are no risks heading into tomorrow, but it does suggest an initial sell-off could be fairly temporary if econ data softens in the coming weeks.  Conversely, it could serve to limit the positive impact of friendly shift in inflation (here too, it would take several days or more than a week for that paradoxical scenario to play out).