Month: December 2021

Inflation Outlook 2022

In this week, the Treasury market got a fair amount of new information, both in the form of economic data, as well as a better sense of investors response function to recent developments.

As mentioned in the last blog, Friday’s CPI print was the most attention-gasping fundamental event of the week. We saw a slightly above expectations headline print, but the core number came in as expected, increasing five tenths of a percent month over month. This pace of inflation, while certainly above trend, wasn’t enough to get the market truly concerned about inflation getting out of the Feds control. So one should see a fairly impressive flattening into the release but the generally as expected print actually gave way to a little bit of a steepening. My interpretation would be that besides the biggest fundamental event of the week i.e. the CPI release, the fact that the 30 year auction tailed more than three basis points actually led to the most dramatic price action. So the long end of the curve cheapened up into the auction, which contributed meaningfully to the fives thirties re-steepening.

Future Path of Inflation

While Powell has retired the transitory characterization of inflation, as we think about the path of inflation throughout 2022, it is worth mentioning that the factors that originally led to transitory are still going to be in place. The supply chain issues and pandemic specific increases in prices are still going to work themselves out. As the Fed has said, it’s just taken longer than was initially presumed. Taking this fact, combined with the Fed that’s leaning hawkishly and prepared to offset inflation from the demand side, it’s going to be difficult to see an acceleration in realized prices and also inflation expectations as we start to get through the first half of next year.

As Biden’s recent comments right before the release, the decline in energy prices associated with the release of oil from the strategic petroleum reserves, wouldn’t be reflected in November CPI, and that’s precisely what we saw. A slightly higher than expected headline figure that was driven by elevated energy costs. Biden also noted that the expected moderation in the pace of car prices wouldn’t show up in the data, and again, he was correct. Easy to forecast when you have the numbers ahead of time. What we saw in practical terms was a slowing, but a still meaningful contribution from new and used auto prices to the core CPI print. But to his point, there is downward pressure on energy prices that will eventually work its way through to the inflation data.

And let us not forget the importance of the base effects that come into play in 2022. Effectively a reversal of Q2 2021 i.e. the bar is now much higher for the year over year pace of inflation to continue to accelerate during the months of April, May and June of next year. This is something that the Fed has referenced directly in the past and I suspect that even though the transitory language has been retired, the reality is that the Fed would like to see those numbers before they make any decision related to rate hikes. The nuance of this timing implies that it will be very difficult to justify pricing in a March rate hike.

These bring us back to one of the primary debates in the market at this moment and that is the flattener versus the steepener. I would lean to the flattening side, working under the assumption that anything that brings forward rate hikes or implies a higher terminal rate will ultimately hurt twos, threes, and fives more than tens and thirties. But the most important is not to rule out other possibilities. For now the only way to envision a sustainable steepener is if one of two things occurs. First, the Fed signals an unwillingness to address higher than expected consumer prices and the second being that the market loses faith in the Fed’s ability rather than willingness to combat accelerating inflation. At the end of the day, again, either of those would be my base case scenario, but I won’t be surprised to see episodes of re-steepening if the realized inflation data continues to outperform expectations as it did in the second quarter of 2021.

Hawkish Pivot

In the week just past, the Treasury market had a lot of new information to digest, and the resulting price action, frankly, triggered more questions than it answered. Initially, we came into the week with a solid bid as a result of the most recent Omicron variant of the coronavirus. 10-year yields dip back to the 141 level, and the curve continued the flattening trend that has been in place throughout the fourth quarter, which is consistent with the recent hawkish pivot of the Fed.

Monetary policy implications of the retired transitory characterization

Powell’s congressional testimony effectively retired the word transitory, which because it was accompanied by an expressed openness to consider accelerating the pace of tapering, has near-term monetary policy implications that the Fed is expected to accelerate the pace of tapering in December. Logically, from the Fed’s position at least, there are really only two meetings that matter in terms of an acceleration of the pace of tapering — the December meeting and the January meeting. If the Fed were to wait until March or beyond, it’s largely a moot point, simply because the window of remaining purchases would be so small at that point that a tapering wouldn’t provide the Fed with any increased flexibility. So all else being equal, I would agree that the Fed will be eager to take this opportunity to wind down QE sooner rather than later, providing an incremental amount of flexibility, if and when the economic data dictate that a rate hike is warranted.

Now, the Fed Funds futures market has been very aggressive in their pricing in terms of two-and-a-half plus rate hikes now priced in for 2021, although historically the market does tend to price in more rate hikes at the beginning of the cycle than are ultimately realized. That said, the balance of risks at this moment are tilted toward the upside in terms of inflation. This reality will complicate the Fed’s communication strategy. It’s one thing to accelerate the end of tapering. It’s another to pre-commit to a rate hike as soon as the March meeting. Certainly this is not the Fed’s best-case scenario. Nonetheless, the combination of an accelerated tapering and an increase in the beloved dot plot will lead to fully pricing in a June, September and December rate hike and get the market excited about the prospects for a March move. Given the Fed’s operating assumption that inflation pressures will ease in the second quarter of next year, I struggle to see the needed degree of urgency for a March move at this point and therefore would consider that pricing to be a fade.

Focus shifting From Employment to Inflation

Another important release for the macro narrative this week was the headline job report. And yes, the NFP figure was below consensus, but when drilling down into some of the details, we saw a declining unemployment rate, an increase in the labor market participation rate, which is in fact very important given the Fed’s emphasis on labor market participation at this point in the cycle. What we heard from Powell at his congressional testimony this week was that the Fed seems to, at this point, be moving toward a bias where they’re content to call the improvement in the labor market good enough, and what is most consequential at this point is the direction of inflation. Given this policy focus shifting, my takeaway is that there was nothing contained within the release that would keep the Fed from accelerating the pace of tapering when they meet on the 15th of December, barring a material deceleration of inflation, which we will get the CPI series related to on Friday.

Peak of the Breakevens

Besides the inflation, another development we observed was the peak of the breakevens, the out-performance of which has been the defining feature of the Treasury market throughout 2021. It was encouraging to see the response in the tips market following Powell’s remarks, just given the fact that the chair’s more hawkish inclinations translated through two declining inflation expectations and higher real yields. Now that we have seen 10-year breakevens move decidedly off the peaks they set not that long ago, at this point it’s reasonable to assume that the breakeven peaks for this cycle are in, unless we find ourselves in a situation that, for some pandemic-specific reason in terms of curtailing aggregate demand, the Fed needs to pivot back to a more dovish stance. Again, by no means is the best-case scenario, but the only way that we can envision forward inflation expectations drifting higher than the levels that we saw in 2021 would be that the market loses faith in the Fed’s ability or willingness to address inflation.