How Will Higher-than-Expected Inflation Data Impact the Fed's Next Rate Decisions?

Chris Hussey: This is The Markets. I'm Chris Hussey, and today is Thursday, November 12th, and we're here on the Goldman Sachs trading floor with Muhammad Qubbaj, who is co-head of North American Interest Rate Sales and Trading within FICC and Equities. And today, we're going to talk about how a hot CPI print this week is impacting rates and bonds markets, and how that has a carryover effect to other markets around the world.

Q, thanks so much for joining us.

Muhammad Qubbaj: Thanks for having me.

Chris Hussey: Okay, Q, let's start with the CPI print. It came in hot this week. What did you make of the market's reaction? How do you think the Fed is going to respond?

Muhammad Qubbaj: Well, there's no rest for the wicked when you look at the sources of volatility in the market, whether it's geopolitics, whether it's the Fed, whether it's AI.

We felt we almost had a little bit of a respite, maybe for five minutes, and all of a sudden CPI comes to the forefront and changes the board a little bit, too, and the Fed walks right back into the building. CPI affected us in three ways. First, I would say that it was unacceptable number, .3, third time in a row.

Strong across all categories. The Fed has to reckon with that number, and the market priced that accordingly. Two, it wasn't just about the CPI level, it was about the Fed reaction function. We woke up that morning, Waller had made a speech and put 50s back on the table. He basically asked a question, and CPI answered.

He said, "Contingent on .3, 50s could be on the table." And-

Chris Hussey: And by 50s on the table, what you mean is that we could do a hike of 50 basis points, not 25.

Muhammad Qubbaj: Exactly. So it just, again, underscored a hawkishness to the Fed and opened up the distribution to 50s, which was definitely a surprise that morning, before we even walked in and got the CPI number.

The third thing was we spent almost a month executing a hike compression. We took out almost 50 basis points of hikes in the next one year, and some of this is a give back. So in terms of the market reaction, unwind of positioning and the high compression, a reaction to the strength of the CPI, the third one in a row and a re-understanding of the Fed's reaction function and opening up the distribution for 50s.

Chris Hussey: All right, so it wasn't trivial. That's interesting. But you also talk about a Fed reaction function, and one of the things they have to react to is oil, I would imagine, because, this was an October report, but for the month of November, oil prices are now down 15%. How does oil factor into the rates market?

Muhammad Qubbaj: We can't basically say that the causality between oil and rates is a one-for-one thing. They're definitely a participant. They definitely have a feed through to CPI, and they definitely show up into, basically, core CPI and how the Fed takes that number so that they can adjust policy.

But, the sell-off wasn't just about oil when we had the big sell-off in the year. At one point it was about corporate earnings and growth. At another point it was a debate on the Fed reaction function uncertainty because they removed forward guidance term premium on the back of bond supply and CapEx supply, convexity hedging or the convexity profile of the market where we saw a lot of selling and positioning.

Oil coming off in the last couple of weeks is definitely affects the level of rates, but you can't expect a full refund just based on the oil movement.

Chris Hussey: Okay. Another thing that's changed since that October CPI print was the midterms. We got the midterms in early November. How does a change in Congress, if at all, have any impact on the rates market?

Muhammad Qubbaj: I think a couple of things. One is the Fed's not a political body. It should not affect the Fed path, first order. It affects oil, obviously, based on the vote on the geopolitical outlook of the Iran war. Midterms affect oil, CPI affects the Fed. We've had almost triple the move based on the CPI morning print that we did in rates for the entire of midterms week. So I think that's where the focus is.

Chris Hussey: Okay, Q, let's expand the conversation to 10-year bond yields. They have such an impact across markets. We were up at 5.3% not too long ago. They've come back to 5%. Are the conditions still in place, though, for us to eclipse the recent highs?

Muhammad Qubbaj: You have to look at basically what took us to the peak in rates. There were several different factors. One, we had this new reaction function from the Fed, no forward guidance, the debate on how the Fed's reaction function will evolve under a Warsh leadership.

You had the debate on term premium. You had the debate on Government issuance compounded by AI CapEx-related supply. You had a positioning situation in the market. You also had convexity selling in the market. All of those things contributed to the sell-off. So, I don't think that you're going to have that same set of circumstances reassert itself on the market again and push yields to the high, high level that we saw in October.

Furthermore, you have two new breaks in the system: a Fed that is actively hiking, a hike lands in the front end but flattens the curve. Two, we had some sort of reflexivity that's been put onto the market in Warsh's last speech. He specifically tied the level of rates to the level of AI CapEx financing.

So what happens when you do that is basically saying that you have a self-balancing system. If rates go up too much, then it can slow down the AI CapEx build-out, and it will almost have a self-balancing system from that perspective. But let us remember that if -- Do I think it's going to be a rate sell-off can happen again driven by positioning or term premium or supply worries or convexity selling?

No. If we have a reassertion of strong earnings and I think that can give us some room.

Chris Hussey: Yeah, a little bit of a growth-driven thing. Can I ask you to define one thing? Convexity selling, what is that?

Muhammad Qubbaj: Convexity selling is a situation where, as the market sells off, people have more to sell.

At its core, it means as things are getting worse, your flows are going to make it even worse.

Chris Hussey: Right. It's a little technical factor. All right, let's talk about the competition between stocks, bonds, and credit.

Cause that's always part of the equation here, I would imagine. How do you see that shaping up here? You talked about the growth equation being such a big one for where yields go from here.

Muhammad Qubbaj: When we look at yields as it pertains to credit and as it pertains to equities, we have to look at it from a couple of lenses.

What drives higher yields? Is it growth? Is it earnings? Then that should be good for the credit complex, and should be good for the equity complex. Is it driven by term premium worries and a supply absorption worries? Then you have a capital markets problem, and that's where they could be negative for equities, and it could be negative for credit.

That's one factor. The other factor is the amount of leverage that we're talking about. When you're looking at a bond that is a corporation that is on the lower side of the spectrum of leverage, then higher rates affects the discount factor. When you look at a bond that's on the other side of the leverage spectrum, higher rates is a funding bill.

It's a funding problem. So you can't... You have to be a little bit more nuanced when you say how do higher rates affect the equity market or credit market. It's a function of how did we get there, and how levered are the companies that we're talking about?  And that's basically where you get your answer.

Chris Hussey: All right, lot to digest. Let's put a bow on it. What's the trade?

Muhammad Qubbaj: I like to think of it from a serenity prayer perspective.

Chris Hussey: Ah, the serenity prayer.

Muhammad Qubbaj: Accept the things you cannot change. It is a one-factor market.

It's all about mega-cap tech. Once you accept that, you realize that's the bet you're going to be making. Now, where do you have control? Where can you make some changes on the edges? One is how much of a size of a position you're going to take. It depends on how you hedge your portfolio. Two, the amount of leverage and what's the expression you take on mega cap to see basically how much exposure you have and how much factor risk you have.

So we have discussed the risk. Now let's discuss the hedges. When you look at the hedges, you basically have out-of-the-money dollar puts. You have out-of-the-money equity puts. Delta one is favorable in the level of rates. A combination of those, you can build a carry neutral or positive carry hedge portfolio, and you can size it up and down depending on the amount of risk and leverage you're taking on the mega-cap tech.

Now, you wanna own the factor, and you wanna rent the insurance.

Chris Hussey: And by owning the factor, you want to own stocks.

Muhammad Qubbaj: Yes.

Chris Hussey: And by renting the insurance, you wanna maybe own some puts as well.

Muhammad Qubbaj: Exactly.

Chris Hussey: All right, what are you looking for in the weeks ahead?

Muhammad Qubbaj: Three sources of volatility we mentioned in the market. Oil, let's continue to see how the geopolitical, situation unfolds. The Fed, we are going to look at Fed speak and the Fed minutes and basically try to read the tea leaves and to see how hawkish the Fed is right now so we can get a feeling for the size.

While, we're confident on the direction of which way the Fed is going. It's about size and timing right now. And the third factor is the AI economy. Anything, whether it's a capital market situation or an earning situation, anything that can continue to give us confidence or allow us to re-rate the level of risk in the market as it pertains to the AI economy.

Chris Hussey: That's terrific. Q, you're always just a fountain of knowledge for us. Really appreciate you joining us.

Muhammad Qubbaj: Thank you for having me.

Chris Hussey: That does it for this week's episode of The Markets. I'm Chris Hussey. Thanks for listening.