Fed Chair Powell announced the Fed’s new inflation policy regime – average inflation targeting, where inflation can now overshoot 2%. This was very big news and the market took note. The 10y breakeven inflation rate appeared to begin a new phase higher, rising 13bps WOW. This was the third largest weekly gain of the year, exceeded only by the 25 bps gain the week of March 23, when the Fed first rolled out COVID policy response, and the week of April 6, when the Fed followed with announcement to buy corporate bonds. Given the new Fed policy, we will not be surprised to see the 10y breakeven rate move another 50-75 bps higher, to the 2.25%-2.50% area. This is very bullish for risk assets: higher yielding credit spreads have room to move substantially tighter as this breakeven story unfolds.

Once again, corporates led the way in responding to the new policy regime, although there was a twist this time. HY CDX narrowed by 20 bps, from 388 bps to 368 bps, while IG CDX was only 1 bp tighter. Excess return for the HY bond index was a whopping 97 bps, versus -1 bp for the IG corporate bond index. Reach for yield most certainly remains a dominant theme as the reflation trade powers on. But the new inflation policy regime now mandates an asterisk to the theme – reaching for yield in high quality long duration assets now is a much riskier proposition. The chances that the 40-year secular low in interest rates is behind us rose materially this week as a result of the policy shift. The additional increase in the MOVE index this week may be signaling this. The BofA house view remains that IG spreads can narrow further, but this week’s relative weakness may be the first sign of investors balking at the sector’s long duration.

Source: Bank of America