We continue to see two rate hikes this year. We retain the baseline of those hikes likely coming at the September and December meetings, but think that the market is underpricing the probability of a July hike. Investors still appear anchored to an inertial framework, in which the Fed is assumed to move gradually and only once the data have fully forced its hand. We think the pivot from inertial to adaptive policy-making is likely real and underappreciated. In an adaptive policy-making framework, the optimal strategy for a central bank would be to respond quickly to deviations from the dual mandate before that deviation becomes entrenched, thereby signaling to economic agents such deviations will not be tolerated. This means that wage and price-setting behavior is more likely to embed a 2% inflation expectation, which in turn would make realizing that target more likely, and ultimately would require less forceful action than tightening later, as would be implied by an inertial policy framework. We think the market reaction to the June FOMC meeting, which saw breakeven inflation decline (albeit alongside oil), the curve flatten, the dollar strengthen, and the dip in risky assets quickly unwound, represents an A+ grade for Chair Warsh’s first meeting from a markets perspective. It should embolden the shift from inertial to adaptive policy-making by demonstrating that delivering a short, sharp succession of credibility hikes is digestible for markets, even if they are not fully priced ahead of time. Passing up the first opportunity to “do as you say you will” risks making Chair Warsh’s June presser look performative, and could see the market unwind some of the new found credibility-premium.
UST Flow Analysis Implies Net Selling and Upside Risks to Yields
20d Average Buy/Sell ratio Z score and CT10 20d Avg Change in Yield (Inverted)
Source: Citadel Securities, Jun-26. Figures are for illustrative purposes only. Past performance figures do not guarantee future results.
We see upside risks to the June employment report. This reflects both a perceived upside skew in our framework for the payrolls print, which has a 71.4% out-of-sample directional hit rate (flattered by short sample lookback), and the relatively low bar for the unemployment rate to round down to 4.2% from 4.296%, given the strong run of US labor market data over the past three months, and the lagging nature of the unemployment rate. Relatedly, we think consensus assumes that part of the strong May jobs number reflected one-off World Cup-related hiring, and hence will not be repeated in June. However, looking at the leisure and hospitality sector data on a non-seasonally adjusted basis suggests the strength hiring in May appears to have been driven by calendar factors, as it was broadly in line with an average May print in recent years and implies limited excess hiring from the World Cup. As a result, we expect the World Cup boost to show up in the June print, which aligns more closely with the start of the tournament.
We See Upside Risks to June Employment Report
Directional Lean of Our NFP Framework, Historical Performance vs Realised Outcome
Source: Citadel Securities, Jun-26. Figures are for illustrative purposes only. Past performance figures do not guarantee future results.
Labor Market Tracking Points Shows Rebound in Hiring
3mma of NFP, ADP, Revelio Payrolls
Source: Citadel Securities, Jun-26. Figures are for illustrative purposes only. Past performance figures do not guarantee future results.
On 19th May, we wrote that there were risks of a snap richer in global duration because of the confluence of two factors in our macro framework. First, our cross-asset decomposition had flagged an apparent unstable equilibrium between equities and rates, based on the valuation of its PC1 growth factor, which had reached the >+2 sigma reversal threshold, implying downside risk to yields. Second, our UST cash flow data showed a material increase in net buying intensity in fixed income. The 19th May marks the year to date peak in yields, however both bullish duration factors have now fully reversed (see charts above and below). The PC1 in our macro framework has moved over 3 sigma in recent weeks to its current -1.17 sigma reading, while our UST cash flow data now points to a step-up in net selling intensity, as demonstrated in the first chart. Together, these signals may imply upside risk to yields from here.
The Growth Factor in our Macro Framework Has Normalized as Yields Have Rallied
First Principal Component of our Cross Asset Macro Framework
Source: Bloomberg, Citadel Securities, Jun-26. Figures are for illustrative purposes only. Past performance figures do not guarantee future results. *Note we have tweaked the specification of our cross-asset framework to include inflation products since our latest update, the above charts reflect that improved specification.
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