Author: Yumeng Li

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.

In the week just passed, the Treasury market started with a decidedly bearish tone. This was due in large part to hedging associated with series of large corporate bond offerings. Once those deals flowed through the market, we saw a stabilizing bid occur even before Friday’s flight to quality that was driven by an increase in COVID cases in Europe and the announcement of an Austrian lockdown.

The Long-End Outperform

Lately, even in an environment where inflation is running high, forward inflation expectations are elevated, and the market continues to bring forward Fed rate hikes we have been seeing a contained sell off in tens and thirties, in a different way, the outperformance of the long end of the treasury market.

To some extent, it is the notion that the Fed will bring forward rate hikes contained the sell off in the long end of the curve end since the more aggressive the Fed is compelled to be in tightening monetary policies to offset inflation, the lower one would expect inflation and real economic growth to be going forward. So the disconnect in fact has to do with the divergence of the outright levels of CPI and real GDP versus what we’re seeing in terms of nominal rates in tens and thirties. The logic being that traditional models would suggest that given the amount of inflation that’s going through the system, 10 and 30 year rates should be substantially higher. But we have seen over the course of the last 20 years is an ongoing compression in term premium, and even an environment where inflation is running higher than anticipated, the amount of inflation premium required to go further out in the curve, while higher than it might otherwise have been, still remains contained in historic context. And this does bring into the question below why are ten year yields still below 160 and 30 year yields not even at 2%.

Greenspan’s Conundrum

In the fourth quarter, October’s retail sales data came in well above expectations, both on a headline and control group basis. So once again, this begs the question that if in fact growth is doing okay in an environment when we’re getting such high inflation prints, why are tens and thirties still trading below 160 and 2% respectively?

This could be simply a reflection of not only forward expectations for US growth and inflation to eventually mean revert, but also the idea that treasuries, particularly the 10 and 30 year sector, are a function of global macro influences. Whereas twos, threes, and fives are simply wedded to monetary expectations. The reality is that Greenspan’s conundrum never truly went away. Since the financial crisis of 2008–09, the U.S. Treasury yield curve is as flat as it has been. When asked for the likely cause, I would lean towards that the negative interest rate policy that the ECB and Bank of Japan adopt promotes the need of overseas investors for higher-yielding long-term bonds in the U.S. The strong need has been compressing the term premium, inflation premium and growth premium of the U.S. treasuries, which is in fact a reflection of the slowing down of global economic growth. It could also explain why some are perplexed that such a flattening has historically been a late cycle development, not what one would expect when the Fed has yet to follow through with the first rate hike. I mean it is a late cycle development, just not for the U.S., but globally.

Fed’s New Framework

This trend is also consistent with the increase in central banking transparency that has occurred and as we have learned over the course of 2021, the Fed has been and will continue to be unwilling to risk decades of hard credibility as an inflation fighter during one cycle. Now, this does bring into question how committed the Fed is to their new framework, recall that in 2020, the Fed introduced this average inflation targeting notion as well as maximum versus full employment. All of which implied, that the Fed wouldn’t respond to inflation in the same way that they had in the past. What we have seen in 2021, is that investors to a large extent have lost faith in the Fed’s commitment to the new framework. Now I’ll argue that’s not necessarily fair, simply because the magnitude of the upside surprises on the inflation front had put Powell in a very difficult situation. Even if the Fed did want to allow inflation to run hotter than it has in prior cycles, the US economy is simply faced with too much inflation at the moment for the Fed to stand idly by.

The Nod for the Big Job

And another defining feature of the market narrative this week was uncertainty about who it ultimately will be that president Biden nominates for the Fed chair seat. The baseline assumption remains that there’s a higher probability that Powell gets the official nod since this is the path with the least resistance. The second most likely candidate will be Brainard. Some of the recent price action confirms the notion that Brainard would be interpreted as a more dovish outcome for the FOMC. But regardless of whether or not Powell or Brainard ultimately get the nod for the big job on the FOMC, it’s certainly likely that whoever is nominated will lean more dovishly. After all, let’s not forget, the midterms are going to be quickly approaching and for any presidential administration that would like to perform well at the polls, having an easier monetary policy bias and a title labor market would obviously be a benefit.

In the week just past, the choppy price action in the treasury market has contributed further to the evolving macro narrative.

The Thematic Flattening

Over the last week, one important macro narrative was the stronger than expected headline and core CPI print. In fact, inflation is now running at the highest levels that it has both on the headline and the core series since the early 1990s, which intuitively brings into question the Fed’s expectations for prices to eventually moderate and also leaves the market focused on the pace of tapering. Will the Fed accelerate the pace of bond buying, which will create the needed flexibility to bring forward the liftoff rate hike into the middle of 2022 compared to the previously assumed Q4? So does the October inflation print warrant recalibrating Fed expectations for the year ahead? The higher-than-expected CPI certainly puts Q4 2021 on a reflationary trajectory causing the market to reinforce its notion that the flattening of the curve will keep being thematic in 2022. However, my take is that still, there will be plenty of data between now and the point where the Fed actually needs to make the decision on liftoff.

A Breakdown of The October Inflation

As part of this discussion, there’s also the critical component of the details within the CPI release. When looking at the breakdown of the inflation, what we see is that there is arguably a broadening of the categories of upward pressure on consumer prices. The surprise was not solely a function of some pandemic-specific increases in prices, i.e., airfares, lodging away from home, subcategories simply related to the lifting of restrictions and reengaging in some version of a normal economy. Rather, we saw that energy was intuitively up sharply, and even within the core series, the new and used auto prices continue to support inflation expectations and probably most noteworthy, a sharp 0.44% month over month increase in OER or owner’s equivalent rent.

Now this is not necessarily a surprise, given what we’ve seen in the real estate market over the last 12/18 months (history suggests there’s a lag between housing prices and rent increases by roughly five quarters i.e., rents are “sticky”). But the fact that it’s now flowing through with a meaningful effect on the core CPI series, has to raise some questions on the FOMC. The interesting part is that Powell has come out in the past and said that the Fed is not worried about the run up that we have seen in home price appreciation. Now, that isn’t to suggest that there’s no chance that the Fed would ultimately feel compelled to respond to inflation, even if it was driven in part by the recent acceleration in home prices, as evidenced by OER, but here’s a very compelling argument that what drove the increase in home prices was 100% the pandemic and the Fed’s response. Not very obviously that this can be the natural result of reopenings and the new normal coming back online. It’s effectively saying that the Fed’s policy response, i.e., much lower rates combined with the exodus from densely populated urban centers to first and second ring suburbs is what’s truly driven home prices higher. Perhaps there’s an argument to be made that that’s a temporary impact or transitory.

Signs to Pay Attention

In the upcoming week’s heavy slate of Fed speak, it’s going to be very interesting to see the degree to which other monetary policy makers stick to that transitory characterization. As we get closer to that point in the cycle, any earlier tone shift from either Powell or frankly anyone else on the committee could potentially be a signal that monetary policy makers are thinking about either accelerating the pace of tapering or pondering maybe bringing the lift off rate hike forward, or making the first rate hike by more than 25 basis points.

In the week just past, there were several meaningful developments that helped to contribute to the markets’ broader understanding of the macro landscape.

A Dovish Taper

Most notably was the FOMCs decision to follow through with a tapering announcement. The announcement delivered was extremely well-telegraphed, widely anticipated and precisely what the market was looking for, which was 15 billion a month of tapering, 10 billion in Treasuries, and 5 billion in mortgages. This puts the presumed end of QE in the middle of 2022. That’s been a very well-telegraphed timeline. And as a result, the price action which ultimately occurred was relatively limited. And by characterizing it as a dovish taper, I simply mean that the Fed chose to emphasize that, while the threshold for winding down QE has been achieved on the employment front, the same cannot be said about the threshold for rate hikes.

At this point in the cycle, while market participants might think that policy makers are behind the curve, but unlike forcing a central bank to ease, it is very difficult to force a central bank to tighten monetary policy. In fact, it may look like that the market was pricing in a significantly higher probability of rate hikes in the near to medium term, but in practical terms, effectively what has occurred is that the market is tightening for the Fed, which is entirely different than the market prompting the Fed to tighten. In fact, as front-end yields increased, we saw equities begin to wobble and financial conditions tighten, which is the opposite of the type of environment in which one would expect hawkish action from the Fed.

Supply-driven Inflation？

We also heard from Powell at the press conference that at this point the acceleration in consumer prices is probably still more a function of issues on the supply side. There will eventually come a time when the logistical headaches and supply chain bottlenecks work themselves out. And until then the Fed will have greater clarity on this topic that the committee will start contemplating raising rates.

So the question becomes, how high is the risk that the Fed is either in the midst of committing a policy error, or will eventually commit a policy error in 2022 by tightening monetary policy more quickly? If in fact the Fed has the transitory characterization of inflation wrong and we see self-perpetuating upward pressure on consumer prices throughout the course of the next two or three quarters, then the Fed would arguably be a bit behind the curve. The flip side is, if in fact the FOMCs assumptions regarding the nature of inflation pan out and we see a steady drift back to pre-pandemic style inflationary pressures, then if the Fed chooses to accelerate tapering and/or bring forward a rate hike, then the risk quickly becomes that the Fed is effectively putting the brakes on the real economy too quickly.

Demand-driven Inflation?

A question would be that given we’re seeing what is ostensibly a tight labor market and upward pressure on wages, doesn’t that risk the self-perpetuating nature of inflation driven by higher wages, more capacity to consume and higher propensity to consume that would trigger a runaway acceleration in consumer prices? Unlike the supply-driven inflation, the demand side inflation that higher interest rates would be very effective at combating. And what we heard from Powell is, that’s not at all what the Fed is thinking. At this point, the low participation rate, distorting the traditional Phillips curve narrative, and this latest increase in wages is a function of temporary or transitory distortions on the supply side of the labor market.

As what we see in today’s job report, the participation rate remains unchanged at 61.6%. And this is, again, what Powell focused on in his press conference, that the reluctance of workers to reenter the labor force has been much more pronounced than what the Fed was anticipating. At 61.6%, the current participation rate is hardly in a zone that would be encouraging for the FOMC.

Beyond that, there’s some nuance within the unchanged labor market participation rate that’s worth highlighting. Specifically, we did see a decrease in labor market participation for the 55 and older cohort, and a slight increase for the balance of the labor force. So, this is very consistent with the idea that expiring extended unemployment benefits have prompted some workers to reenter the market, while elevated asset prices have brought forward the retirement plans of many in the labor force. All of this does risk a sustainably higher trend in wages. However, when we look at the year-over-year pace of average hourly earnings at 4.9% versus what we have seen in terms of headline CPI gains, what it suggests is that wages are still struggling to keep up with prices. So, on real terms, consumption might continue to face headwinds into the end of the year. This is particularly troubling not only to retailers, but also to the overall pace of the recovery.