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.
All About Macros 