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: