Well, damn.

If you’re in the camp that thinks maybe rising inflation pressures are going to put the Fed in a rather precarious situation characterized by having to choose between leaning aggressively hawkish (i.e. withdrawing transparency from the market by effectively revoking market participants’ license to co-author the policy script) at the risk of flattening the curve/hiking us into a recession or chancing falling behind by remaining gradualistic at the risk of the curve aggressively bear steepening, you’re probably feeling like this week afforded plenty of evidence to support your case.

The situation described above is only a “question” (so to speak) if you believe the Fed would actually risk surprising the market – in other words, if you think there’s a chance they panic-hike or otherwise start to sound noticeably concerned about inflation pressures in the forward guidance. If you don’t think it’s likely they’re going to truly cut the market out of the loop in terms of allowing market conditions and market reactions to forward guidance to effectively help dictate the evolution of policy in a continuation of the reflexive relationship we’ve been in for years, well then you already know which way they’re going to lean.

They’re going to try and stick to a gradualistic pace and if the curve bear steepens on them, hope it doesn’t accelerate quickly enough to cause any problems as the “playground” expands and (possibly) opens the door to a widening out of risk premia, a rise in cross-asset vol., and the slow abandonment of a scenario where everything has morphed into an expression of the carry trade.

Ok, so as far as this goes, this week’s action both in markets and on the fiscal policy front have interesting ramifications.

For one thing, the equity selloff might have obviated the need for pension investors to rebalance by selling stocks and reallocating to fixed income. Remember how everyone was talking about that rebalance flow a couple of weeks ago and how it could result in a bid for bonds that, theoretically anyway, could keep yields from rising further in the near-term? Yeah, well that dynamic may have changed virtually overnight. Here’s Deutsche Bank from a really great fixed income piece out Friday:

Until just over a week ago, equities were outperforming fixed income by nearly 8%, and we estimated that in order to maintain static portfolio weights defined benefit pension investors would need to sell nearly $100 billion of equity holdings, and re-allocate those holdings into fixed income. From a risk perspective, the total DV01 was over $130 million.

Following the sharp decline in equities last week, this seemingly enormous source of demand is substantially gone. At the time of writing equity declines had accelerated enough to imply that the re-balancing “bid” for fixed income from pension investors had now become a re-balancing “offer”. That is, equities outperformed fixed income to the downside, and – as of Thursday’s close – to maintain static weights, pension investors would likely have needed to sell between $10-15 billion of fixed income to buy equities, rather than vice versa. This was the world turned upside down.

So there’s that. And then there’s the budget agreement. Remember how 10Y yields rose on Wednesday as rumors of a pending bipartisan agreement conspired with a weak auction to pressure Treasurys?

Well there’s another element to it outside of the straightforward conclusion that expansionary fiscal policy will equal more marketable supply. Consider this from the same DB note:

With the debt ceiling suspended through March 2019, the Treasury could immediately ramp up its bill issuance. Recent market dynamics point to an interaction between Treasury supply and demand from international investors. Specifically, increases in bill supply can absorb liquidity which might otherwise be lent to non-US investors to finance Treasury purchases. If dollar liquidity is absorbed by bills, it is no longer available to be lent via cross currency basis swaps. The scarcity of dollar liquidity makes dollars trade more special; that is, it makes the basis swap more negative, which reduces the net yield of Treasuries swapped into the foreign currency of the basis swap pair. Note that greater bill supply also absorbs liquidity that might otherwise be invested in repo, increasing repo rates and pushing Treasury yields higher.

Boom. Throw in the possibility that the repatriation of cash held abroad (as encouraged by Trump’s tax plan) decreases available liquidity overseas and you’ve got another reason to believe that X-ccy basis swaps will widen thus making Treasurys even less attractive.

Now think about what the equity turmoil likely means for the Fed’s (non)propensity to lean aggressively hawkish. Sure, it’s unlikely that a possibly fleeting correction is going to deter them for the time being, especially considering they can lean on the excuse that while the first week of turmoil might have been tied to the bond rout, the acceleration of the declines this week was down to a one-off unwind in esoteric short vol. ETPs (of course there’s more than a little irony in Fed brushing that off considering it’s the two-way communication loop with markets that made the short vol. trade work in the first place). But what it probably will do is remind them that they need to remain gradualistic in the pace, which underscores the argument that what they’re likely to do is risk the curve steepening if it means avoiding a scenario where the withdrawal of transparency (i.e. faster hikes, aggressively hawkish forward guidance to curb inflation pressure) is expected to create bigger problems than they expect might be created by a bear steepening episode. Here’s DB one more time:

Our colleagues in economics argue that an additional 16-17% decline in equities would be required to reduce the prescribed level of an FCI-augmented policy rule by 25 bp. Note that we recently raised our expected end-2019 “terminal” short rate by 30 bp, from 2.45% to 2.75%, and raised our yield forecasts consistent with that Fed “baseline”, with our year end 10y Treasury forecast rising from 2.95% to 3.25%. While the tightening of financial conditions last week was acute, it must become chronic to materially change the Fed’s intentions. If anything, we think that more fragile risk assets will force the Fed to remain gradualist. This implies that if the terminal policy rate has risen consistent with our estimates, the Fed will have to add hikes sequentially in 2019 and potentially even into subsequent years. The risk then is that the Fed might fall modestly behind the curve temporarily. Note that when this means that “r” will be rising more slowly than “r*”, which is also a prescription for a steeper curve.

DB goes on to contend that this won’t get out of control, noting that they “do not think the current market is likely to return to the dynamics observed during 2013’s Taper Tantrum, when Fed-speak surprised the market and led to sharp bearish curve steepening.”

But coming full circle, the possibility exists that this thing accelerates on them and in the event of aggressive bear steepening, the prevailing dynamics that have served to compress risk premia could change leading to an uptick in vol. and whatever comes with it.