How Bad Could It Get?

With rates seemingly no longer to the YTD high yield of 1.625%, and with everyone – hedge funds, CTAs, retail and now, even primary dealers dumping Treasurys…

… Mizuho’s head rates trader Peter Chatwell asked “how bad can the selloff get.” To answer this question, he rhetorically asked another: what would the market normally expect from the Fed here? Here is how take:

Looking at how hot the US data are, and taking into account what we expect in the coming months, I asked myself the question of “what would the market normally price from the Fed, on its previous reaction function?”.

Right now, 1y forward 5Y UST is around 1.30%. Our fair value for 5Y UST 1y-forward *on a normal Fed reaction function* is 1.82%. So if the Fed puts some 2023 hikes onto the dot plots on next week’s SEP, then the market will probably bring hikes forward into H1-22 and the 1y-forward 5Y could spike another 50bp.

While Chatwell notes that “this is not our central scenario” this is an indication of how far things could go… Worse, liquidity conditions remain terrible and while risk assets have been trading very well, that inflection point on higher UST yields is still all that matters…