This year has been nothing if not volatile and confusing even for the most seasoned of traders. We started the year with the market starting to think the Fed may be finishing the rate hike cycle, at the same time CPI was calming down. This “Twin Peaks” of Fed hawkishness and inflation led to a risky asset rally at the start of the year. The FOMC responded by upping the ante on hawkishness in February, leading the market to price rate cuts out of the curve and to extend the pause date. Risky assets responded in kind, struggling all through February. We moved into March and hit a low with the problems at banks. As a result, the FOMC was seen as more dovish in March, leading to the same risk asset rally into the end of March that we saw at the start of the year. We had come full circle. As we look at the market expectations going forward, we can see there is roughly a 50% chance of a hike in May but then expectations of cuts starting in July and growing the rest of the year.

Image 1: Probability of a rate move at FOMC meetings

Image 1:	Probability of a rate move at FOMC meetings
Source: Bloomberg

If we compare the Fed Funds futures to the FOMC dot plots, we can see that the market is much more dovish than the FOMC itself. Of course, some would argue that the FOMC cannot be as dovish vocally as it may be behind the scenes, given it must remain vigilant on the inflation front. However, while the majority sees a pause, the granularity of the dots for this year suggests that if there is a dissension at all it is for higher and not lower rates. Only one member sees lower rates in 2023. Does this suggest that the FOMC just needs any small excuse to continue on the path to higher rates? It was only a month ago when some expected the terminal Fed Funds rate to have a six handle.

Image 2: Fed dot plots vs. Fed Funds futures

Image 2:	Fed dot plots vs. Fed Funds futures
Source: Bloomberg

The lingering question has been, “where are we on the inflation front?” This has been the market concern for two years as we can tell from the positive correlation between stock and bond prices. If the market were concerned about growth, these assets would revert to the negative correlation exhibited in the entire post-GFC through 2021 period.

Where do we stand on inflation? In the latest ISM prices paid, we see the measure continue to fall. It has had a good lead over the headline CPI and PPI data, suggesting we could continue to see a disinflationary impulse in the months ahead.

Image 3: ISM prices paid vs. PPI and CPI

Image 3:	ISM prices paid vs. PPI and CPI
Source: Bloomberg

Image 4: Food inflation

Image 5: Energy inflation

Image 6: Housing inflation

Image 7: Finished Goods price inflation vs. SRAA (TS2)

Image 8: Inflation expectations vs. SRAA (TS2)

Image 9: Employment Cost Index and Atlanta Fed sticky inflation vs. SRAA

Image 10: Employment Cost Index and JOLT Survey

Image 11: SRAA futures curve

Image 12: Implied volatility term structure for SOFR options

Image 13: Vol skew for SOFR options

Image 14: Expected return for a TS2M3 95-95.5 ratio risk reversal

Image 15: Option Greeks for the ratio risk reversal trade