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digital daily: Predictable Policy

Predictable Policy. Inflation and policy surprises have been dominant drivers of risk. This is elegantly captured in the life cycle of the June 2023 Eurodollar futures contract. It is the highest yield on the curve, capturing the estimated peak of the Fed tightening cycle. Coming out of the pandemic, June 2023 rates were priced at 21 basis points at the lows. Expectations were deeply entrenched that policy would go nowhere for a very long time. Fast forward two years to the beginning of May, June 2023, rates jumped to 3.81%, with 68% of the move occurring this year. But this is yesterday’s story. The market is searching for a new narrative. It will center on the pause in policy surprises. Quantitative tightening will start this week with the Fed balance sheet contraction. The pathway is known. The pathway of rates is also known. There is almost a uniform agreement that 50 basis point hikes will follow expectations in bond markets. The next policy pivot will be attentive to inflation expectations over longer horizons. Even hawkish members of the Committee are encouraged by the recent data. Longer-term inflation expectations were on the verge of becoming unhinged. In April, the 5-year forward of 5-year inflation jumped 170 basis points to multi-year highs. But they have since settled, falling to 2.31% on par with the 2.25% average since the start of 2003. It is at these points where leadership matters, and Powell’s guidance is clear. Powell documented his philosophy, admiring the Greenspan era in his 2018 Jackson Hole address. “Meeting after meeting [from 1996 to 1998], the Committee held off on rate increases while believing that signs of rising inflation would soon appear. And meeting after meeting, inflation gradually declined. Conventional wisdom at the time, however, still urged policymakers to respond preemptively to inflation risk – even when that risk was gleaned mainly from hazy, real-time assessments of the stars.” Inflation is past its peak. Inflation expectations have moderated. Powell will steer away from estimates of ‘equilibrium’ stars. Powell wants a 1996-98 styled soft landing. A pause with a wait-and-see approach is coming. But this isn’t the mid-1990s. Oil prices fell to all-time lows with the deflationary impulse from the Asia crisis. Today, oil markets are flashing bright red. The wait-and-see may not last long, demanding nimble active management. Of course, digital assets are linked to all these themes – rates, the US dollar, and energy markets. Will differentiation emerge? Will the net rise in digital assets positively reward those most closely benefiting from commodity markets? That’s the controlled experiment we are entering. The market wants a new narrative. Policy is predictable again, at least until the next wave of inflation.

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