Something going wrong around here
April 10, 2022 – Weekly comment
‘Cause if my eyes don’t deceive me
There’s something going wrong around here
-Joe Jackson
Fed officials, especially Powell, used to loosely equate “inflation” with higher wages when the goal was to get to 2%. On August 27, 2020, the Fed adopted FAIT, Flexible Average Inflation Targeting. Just twenty months ago. Here’s an excerpt of Powell’s speech:
The persistent undershoot of inflation from our 2 percent longer-run objective is a cause for concern. Many find it counterintuitive that the Fed would want to push up inflation. After all, low and stable inflation is essential for a well-functioning economy. And we are certainly mindful that higher prices for essential items, such as food, gasoline, and shelter, add to the burdens faced by many families, especially those struggling with lost jobs and incomes.
The inflation on essential items for less well-off households was a topic of Brainard’s speech last week. After years of creating financial asset inflation which increased economic inequality, the Fed is now in a full fledged-fight against inflation, and by unstated implication, against asset values. Here’s the key comment by Brainard:
…the Committee will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace as soon as our May meeting.
It’s worth mention that many other central banks are also raising base rates: Romania on April 5, from 2.5 to 3%. Poland on April 6, from 3.5 to 4%. Pakistan on April 7, 250 bps from 9.75 to 12.25% as inflation and political instability weigh on the rupee. (Pakistan’s leader Imran Khan was ousted this weekend). High inflation is a source of societal instability.
Below is a chart of the Fed’s balance sheet and SPX. You can see that the initial balance sheet reduction of 2018 went fairly smoothly. In continuation of a hiking cycle that essentially started in December of 2016, the Fed hiked rates four times in 2018, by 25 bps each time: March 22, June 14, Sept 27 and Dec 20, culminating with a target of 2.25 to 2.5%. Q4 of 2018 was a tough one for markets and liquidity, prompting Mnuchin to call an emergency meeting on Dec 23 of the heads of major banks, and forcing the Fed into an abrupt shift of policy.
The great repo scare of September 17, 2019 also occurred while the Fed was trimming the balance sheet. Probably just a coincidence (right?) but after that event the balance sheet started to grow again.
They say, don’t fight the Fed, and indeed, Brainard’s speech last week coincided with a jump in the ten year yield of nearly 35 bps, as the balance sheet comments caused an immediate re-evaluation of curve flattening trades. On Friday 1-April, 2/30 had gone slightly inverted; by Friday 2s ended just over 2.52% and 30s at 2.75%, a swing of over ¼% in a week. With QT, the Fed’s goal was to push investors into riskier assets, i.e. stocks. Now the Fed is telling you it is engaging in QT. Your eyes are NOT deceiving you. The Fed has shifted its focus to benefit savers rather than borrowers and is, by extension, discouraging capital flows into riskier assets. The saying I always keep in the forefront of my mind is this: When a bullish news item or event occurs, and the market does NOT GO UP, that’s bearish. I’m not sure this is a good analogy, but Miami just hosted a huge bitcoin conference. Peter Thiel and others received all sorts of press for the bitcoin hype and “the man is keeping me down” rhetoric [but Peter, you ARE the man]. Here’s a headline from Sunday’s WSJ: ‘Crypto Boosters Toast Bitcoin, Jeer Wall Street over Cigars in Miami’. Bitcoin did not go up. THAT’S bearish. BTC was 46k Sunday April 3 and is 42.5k as of Sunday morning April 10.
One other point. Growth in M2 exploded during COVID. It has now decelerated massively. Velocity of course, declined with the huge injection of Fed largesse. Now velocity is going to increase. There’s NO WAY we could have seen that coming, right? In the week prior to the March FOMC, the 10y inflation-indexed note yield hit MINUS 107 bps. On Friday it ended at -19, a move of 88 bps in a month. Real rates are going up.
This should be an interesting (holiday shortened) week. On Tuesday and Wednesday we get inflation data with yoy CPI expected 8.4% and yoy PPI 10.6%. Thursday we have Retail Sales (+0.6% month/month) and Michigan Sentiment which has collapsed to test GFC lows! Auctions of $46b in 3s on Monday, $34b 10s on Tuesday and $20b 30s Wednesday will raise $35b in new cash. Supply and inflation. How will the curve handle it?
I’ll note a couple of clues from the ED curve. Last week EDM2/EDM3 was up 4.5 bps to 179, but EDM4/EDM5 jumped 12 from -38.5 to -24.5. The front-loaded rate hikes are still being priced, but the new dynamic is a steeper back end due to uncertainty about balance sheet reduction. This feature is also apparent in the level of US vol, at its highest since the onset of covid. EDM3 has been the lowest point on the ED curve and settled at a new low 9654 on Friday. However, EDU3 actually settled slightly lower at 9653, a subtle shift further back. My guess is that the market will trade heavy in the early part of the week, but rally out of the completion of the re-opened 30y auction, and I believe the curve will be slightly steeper at the end of next week.
One more bonus chart:
OTHER MARKET THOUGHTS
Since 2000, peak one-year spreads occurred at the end of 2001, start of 2002, as the Fed was easing with the pop of the dotcom bubble and 9/11. Highs in ED calendars at that time: 1st to 5th 252.5, 2nd to 6th 263.5, 3rd to 7th 264, 4th to 8th 243. These spreads made the historic highs with EASING, not tightening. The most recent highs were in 2009 associated with the GFC: 1st to 5th 166, 2nd to 6th 179, 3rd to 7th 173, 4th to 8th 163. The high for any one-year calendar this cycle was put in last week at 181, and it was EDM2/EDM3 or 1st to 5th. That level is higher than anything seen in 2009 and is based on tightening rather than easing. Quite a stark change.
| 4/1/2022 | 4/8/2022 | chg | ||
| UST 2Y | 242.8 | 252.2 | 9.4 | |
| UST 5Y | 254.5 | 276.4 | 21.9 | |
| UST 10Y | 237.3 | 272.1 | 34.8 | WI 272.7 |
| UST 30Y | 242.1 | 275.0 | 32.9 | WI 275.2 |
| GERM 2Y | -6.8 | 5.0 | 11.8 | |
| GERM 10Y | 55.5 | 70.7 | 15.2 | |
| JPN 30Y | 94.8 | 97.2 | 2.4 | |
| CHINA 10Y | 277.7 | 275.9 | -1.8 | |
| EURO$ M2/M3 | 174.5 | 179.0 | 4.5 | |
| EURO$ M3/M4 | -30.5 | -32.0 | -1.5 | |
| EURO$ M4/M5 | -36.5 | -24.5 | 12.0 | |
| EUR | 110.46 | 108.76 | -1.70 | |
| CRUDE (active) | 99.27 | 98.26 | -1.01 | |
| SPX | 4545.86 | 4488.28 | -57.58 | -1.3% |
| VIX | 19.63 | 21.16 | 1.53 | |
https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm
