Tim Duy’s Fed Watch, 11/1/21

Published on November 1, 2021
SGH Insight
Finally, an even trickier issue. Will the recent trends in fixed income markets continue this week? Recent moves – pulling forward rate hikes, higher short rates, bear flattening – have been sharp and swift. I have been happy to ride that train, but I am getting to the place where I am concerned that these moves are now vulnerable to near-term repositioning. I think part of these moves are attributable to investors caught on the wrong side of the flattening and unwinding positions ahead of month-end. That said, I don’t want to get in front of this train. Powell could do everything I said above and still inadvertently say something market participants perceive as hawkish that won’t be cleaned up for another day or two. Getting off the train but not in front of the train seems like a more comfortable place for me going into this week.
Market Validation
Bloomberg 11/2/21

Fed Rate-Hike Premium Eases Following Front-End Treasuries Rally

Interest rate swaps market are cutting the amount of Fed hike premium around 2022 and 2023 area of the curve, following Tuesday’s front-end rally in Treasuries.
First rate hike has been pushed out to July from June, while 50bp or two hikes remain priced by the end of 2022; pricing of a 25bp June hike have dropped to around 60% from 80% at the end of last week
On the day, U.S. 2-year yields are lower by 4bp and heading for the largest daily drop since February (closing 4.5bp lower Feb. 26), following a wider rally across global bonds after RBA’s policy shift -- large block buyer in 2-year note futures added to front-end gains in late U.S. morning session
The front-end rally has seen U.S. rates volatility crushed, led by upper-left underperformance as rate hike premium erodes; drop in vol was aided by a large $35 million straddle strip package sold over U.S. morning session

Monday Morning Notes, 11/1/21

If You Don’t Have Time This Morning

Despite pressure from markets looking for a hawkish pivot, the Fed will likely stay the course this week and not signal an imminent acceleration in the tapering process. It was a big lift to build the consensus that brought the Fed to this point. The Fed will need to address mounting inflationary pressures, but it would be hard to shift that taper consensus in a hawkish direction on short notice. I don’t think the Fed can do that without tossing out the new framework, which would throw markets into disarray.

Recent Data and Events

The economy grew just 2% in the fourth quarter as supply constraints took their toll. Nominal growth, however, came in at a strong 7.8%. This is what happens during an inflationary boom – if the real economy can’t support the nominal spending, that spending shows up in prices rather than quantities. Consumer spending, which contributed 7.92 percentage points to growth in the second quarter, contributed just 1.09 in the third, with most of the decline attributable to the beleaguered auto sector.

On the investment side, the numbers got a boost from a slower pace of inventory reduction, which means that inventories are still falling despite stepped-up efforts to fill supply chains. Intellectual property investment continues to make strong gains, which should be supportive of future productivity growth. Housing was a drag again:

Housing should become supportive again now that activity has retrenched to pre-recession trends. See, for example, the rebound in new home sales:

Builders couldn’t match the pace of demand earlier this year and throttled back sales. Higher pricing will eventually hinder demand growth as well:

That said, if we are entering an inflationary environment, we should expect income growth to support price increases in general, including housing prices. Watch too for upward pressure on rents to sustain the relative attractiveness of owning.

Household spending continues to rebound although inflation is biting into real growth:

Wages and salaries grew at an annualized pace of 9.7% in September; the average annualized monthly rate since March is 9.6%. This tracks what we are seeing in aggregate weekly payrolls and ultimately spending:

In my opinion, this is the space to watch. If nominal spending power keeps growing near 10%, and if you want 2% inflation, you need 8% real growth. That’s not happening. The labor market needs to cool down to keep spending power from climbing at these rates. And I don’t think increasing labor supply helps as much as you might think at this point; we have already returned to pre-pandemic wage and salary trends with millions of missing workers. Add those workers back in and nominal spending power explodes higher. Indeed, looking forward into October, the Chicago Fed estimates that retail sales excluding autos grew a solid 2.3%. I don’t think we should get caught up in the effect of waning fiscal support on topline income growth. It’s all about the handoff to private income growth, and there is no question what is going on there.

That said, core inflation did moderate in September:

Be wary though that this is the calm before the storm. First, note that the CEA measure that excludes pandemic- and vehicle-related impacts remains elevated:

This indicates that the inflation shock created a persistent uptick in the underlying inflation dynamic. Second, inflation is broadening out. The Dallas Fed Trimmed PCE number exploded higher in September:

It’s not just about used cars anymore. Third, the employment cost index surged:

This opens the door to a more extensive wage/inflation interaction than the Fed has anticipated.

This latest round of data presents a distinct problem for Federal Reserve Chair Jerome Powell. It directly contradicts the tame inflation outlook he championed in his Jackson Hole speech. I know from talking with many of you that this speech has always presented something of a mystery as to why Powell staked out such a one-sided position on inflation: it’s transitory, and here are all the reasons it will be transitory. The mystery is why there was so little apparent caution about upside risks and why so much emphasis was placed on metrics that were obviously vulnerable at that time. I have kind of wondered if this was written by staff insistently defending an internal forecast. It has that “I’m right, I know I’m right, and there is no chance that I am wrong” kind of feeling.

In any event, one by one the metrics Powell cited in that speech are signaling more intense inflation pressures. Atlanta Fed wage growth, ECI, used car prices, and Dallas trimmed PCE have all gone against the Fed. I would even call into question the assuredness over global disinflationary pressures. I think Fed doves will respond that higher wages alone do not signal an inflationary issue, that the higher wages are concentrated at the lower end of the wage spectrum and thus are good and do not represent broad-based wage pressures, and that car prices are just part of the “this is taking longer than expected” story. Basically, I think Powell has a response if he wants to many of these points if questioned on the Jackson Hole speech, but it will be kind of forced. I don’t know what he does with trimmed PCE; he can rely on the year-over-year numbers, but we know where that is going.

Upcoming Data and Events

Busy week ahead! We get manufacturing and service sectors survey reports from IHS and ISM; the general story expected is that these measures reveal still solid growth with substantial supply chain and labor constraints. Wednesday brings the ADP report, which often provides some additional guidance for the upcoming employment report. Thursday, we get what is expected to be a weak productivity report with surging unit labor costs, not great for the Fed’s dovish story but I don’t read much into these numbers on a quarterly basis. Too much noise.

Friday brings the employment report, expected to show an acceleration in job growth. Wall Street is looking for nonfarm payrolls gains of 400k. The solid read on employment from the IHS flash reports suggests some upside risk to this number. There will be a lot of attention to the labor supply metrics. The Fed will read improvement in these numbers as a sign that labor market conditions will ease as they anticipate. I think this could be a misleading take on the data. As I noted earlier, I am focused on the aggregated weekly payrolls number. Also, contrary to the Fed’s assumption, increasing labor supply measures do not mean inflation will necessarily be held at bay. Labor force participation steadily increased throughout the 1970s.

The FOMC meeting concludes on Wednesday with the statement followed by the press conference. Currently, there are no additional speakers on the schedule. I suspect though that there are potential speakers waiting in the wings to do press interviews if the Fed needs to clean up any press conference mishaps.

Day Release Wall Street Previous
Monday Markit US Manufacturing PMI, Oct. 59.2 59.2
Monday ISM Manufacturing, Oct. 60.3 61.1
Wednesday ADP Employment, Jan. 400k 568k
Wednesday Markit US Composite PMI, Jan. 57.5
Wednesday Markit US Services PMI, Jan. 57.5 57.5
Wednesday ISM Services, Jan. 56.7 57.2
Thursday Nonfarm Productivity, 3Q21 -1.3% 2.1%
Thursday Unit Labor Costs, 3Q21 5.4% 1.3%
Friday Unemployment Rate, Oct. 4.7% 4.8%
Friday Nonfarm Payrolls, Oct. 400k 317k
Friday Average Weekly Earnings, MoM, Oct. 0.4% 0.6%

Fed Speak and Discussion

This week’s meeting was supposed to be straightforward. The messaging immediately ahead of the blackout period from three governors and the Chair uniformly directed us to expect a tapering announcement this week with a projected end to the asset purchase program in the middle of next year. There was to be no surprise, no market reaction, but instead a perfect execution of Federal Reserve Chair Jerome Powell’s choreographed plan to make the actual tapering announcement as dull as dirt and avoid another taper tantrum.

Instead, as it stands Sunday night, this week presents a challenge for the Fed. While the Fed has been focused on creating the perfect taper, the overall dovish narrative supporting the delayed taper and rate hikes has been collapsing under the weight of relentless inflationary pressures. Hawkish moves by global central banks, notably last week’s surprise by the Bank of Canada, have further heightened concerns that the Fed is falling dangerously behind the curve and will soon need to abruptly pivot policy. The Fed bought a position that is increasingly underwater, and it doesn’t know how to unwind that position. Or even if it wants to unwind that position. The Fed is still waiting for that position to pay off next year when it believes inflationary pressures will ease.

Meanwhile, market participants have priced in rate hikes beginning next June, well ahead of where FOMC participants were just six weeks ago when the Fed released the September SEP. This brings rate hikes right up to the expected end of asset purchases. The Fed may have been able to delink rate hikes from tapering had it begun the latter much earlier, but that opportunity is long gone. As of now, that midyear line in the sand is the only thing holding back market participants from pricing in rate hikes in the first half of 2022. Any hint that the end date for asset purchases is vulnerable to being pulled forward will spark a massive selloff at the front end of the curve. If the Fed decides to abruptly turn more hawkish this week, things might break.

So what’s the Fed going to do? The Fed doesn’t like to break things. The whole tapering process was designed to avoid that exact outcome. As always, back to the baseline. Based on the messaging prior to this meeting, the Fed intended for us to expect:

  1. A tapering announcement, with tapering beginning in November and ending in the middle of next year, a pace of $15 billion per month, proportionately distributed between treasuries and MBS. This is operationally the same as $20 billion per meeting.
  2. A reiteration of the basic “inflation is transitory” story with the acknowledgement that the process is taking longer than expected. I think the Fed needs to modify the language in the statement accordingly, but at the same time can’t drop the word “transitory.” If “transitory” is not in the statement, markets are going to overrun the Fed.
  3. Powell will highlight the upside risks for inflation but will add that the Fed won’t know the true inflation story until at least the beginning of next year, more likely the end of the first quarter. The message is that the Fed intends to let the inflation story play out for some time yet.
  4. Powell will continue to lean heavily on the inflation expectations story to justify the Fed’s faith in the “transitory inflation” forecast but at the same time will likely acknowledge the data implies greater inflation risks. The Fed likely thinks it already has room to maneuver because there is space between the end of the taper and the SEP-implied forecasts to pull rate hikes forward.
  5. Powell will caution that structural changes to the labor market mean that labor force participation may not entirely return to pre-pandemic levels but add that the economy is still a long way from full employment. He will likely repeat his pre-blackout statement that reaching full employment by the latter half of next year is very possible. This is code for “it’s OK to price in rate hikes for the latter half of next year because we may hike rates if the data confirms full employment.”
  6. Watch for Powell to say that “policy is in a good place.” Similarly, this is a signal that Powell isn’t ready to fight the markets, a sort of “we think our policy stance is correct and aren’t changing it for you.” Instead, Powell can see the risk relative to the September dots and doesn’t want to prevent markets from preparing for those dots to rise in the December and March SEPs. This would help avoid a surprise like that which occurred when the June SEPs were released.

These above points were captured in the messaging of Waller, Quarles, Bowman, and Powell in the week before the blackout period and Clarida on October 12. It would be very unusual for the Fed to pivot within a week of the Board establishing such a clear position. Typically, if the Fed pivots quickly, it’s during a crisis that requires a dovish response. Otherwise, the Fed moves more slowly than the markets. If we think of similar times, December 2015 and December 2018 come to mind. In both instances, the Fed struggled and ultimately failed to make a pivot from hawkish to dovish; that shift came after the meetings. I think it would be even more difficult to quickly pivot the opposite way, dovish to hawkish.

Now for the tricky part. Powell can’t reasonably say that the tapering timeline is set in stone under any circumstances. He must retain the flexibility for the Fed to adjust asset purchases as needed, either pull forward or push back the end date. Powell in fact said exactly this at the last press conference:

HEATHER SCOTT. Hi. Sorry, you caught me off guard. Thank you, Chair Powell, for taking my question. I really appreciate it. Again, on the taper timing. You say it’s going to last to the middle of next year. But with your concerns about the potential for upside risks to inflation, would you think you might need to have liftoff happen before you finish the tapering?

CHAIR POWELL. That’s not my expectation. Of course, we can always—we haven’t decided to taper yet, and we haven’t decided the pace yet. So, you know, it’s not my expectation that we would have to. We can certainly speed up or slow down the taper if we—if it becomes appropriate, though. Absolutely. In fact, back in ’13, when we tapered, we always said we weren’t on a preset course. I think this will be a shorter period. The economy’s much farther along than it was when we tapered in 2013. So it makes sense to allow the runoff to happen. It’s a very gradual taper. It will be when we agree on it. And, but we certainly have the freedom to either speed it up or slow it down if that becomes appropriate.

We all know how this works. Just because Powell has said this in the past and it didn’t have any market impact does not mean it won’t have a market impact if he says the same thing this week. It opens the door to an early end to the taper. And, again, you can’t separate that move from rate hikes. Indeed, Powell already connected the two in the follow-up question:

HEATHER SCOTT. But you wouldn’t expect rate liftoff to happen until you’re finished with that process?

CHAIR POWELL. You wouldn’t, no, because, you know, when you’re—as long as you’re buying assets, you’re adding accommodation, and it wouldn’t make any sense to, you know, then lift off. I mean, what you would do is, you’d speed up the taper, I think, if that were the situation you’re in. Not—we don’t expect to be in that situation, but I do think it would be wiser at that point to go ahead and speed up the taper, just because the two are then working in the same direction.

If Powell wants to draw a hard line at next June while retaining flexibility, I think he needs to firm up that “we don’t expect to be in that situation” line. I think how you do that is to emphasize that even if inflation risks are heightened, the Fed thinks it will be several months before the inflation story plays out which means by the time they have clarity on the situation, the end of asset purchases is already in sight. In other words, the inflation situation will need to go very sideways to make a BoC-like pivot.

To be sure, the risk is that the tone of this meeting is more hawkish than I anticipate. I suspect that the latest round of data has only increased the hawkishness of the Fed presidents and they will make that known at the meeting. Moreover, as I noted in the data review above, Powell’s dovish Jackson Hole inflation outlook is not aging well. I suspect he is privately more concerned about the inflation outlook than he lets on publicly. He almost has to be; no one wants to be the Fed chair that let inflation loose.

That said, the new policy framework should keep the Fed on the course the Board signaled ahead of this meeting. The Fed had provided a three-part test for raising interest rates – inflation at 2%, inflation projected to be moderately above 2% for a period of time, and full employment. The Fed may be wary that the economy can’t make it all the way back to pre-pandemic labor force participation, but it still believes that the economy won’t return to full employment before the middle of next year. That means the earliest the Fed can raise rates is sometime around the middle of next year, which means there is no need to pull tapering forward.

The Fed doesn’t want to drop the new framework at the first sign of trouble. The issue of full employment still obstructs the path to rate hikes. If the Fed were to pull tapering forward, the implication would be either the Fed is abandoning its shiny new framework or that it has redefined full employment. I don’t think the Fed is ready to choose either of those alternatives. Remember, there is institutional inertia at play here. In a sense, the choice of ending asset purchases in the middle of next year basically commits the Fed to not abandoning the new framework with an early rate hike. Moreover, it has the added benefit of locking in policy ahead of next year’s rotation of more hawkish Fed presidents onto the FOMC. The new framework also sets the Fed apart from its central banking peers that are quickly pivoting in a hawkish direction. Indeed, the new framework is intended to prevent just such a pivot, which means that if the Fed were to move in the BoC/BoE/RBA/RBNZ direction, it would amount to abandoning the new framework.

The Fed does retain the option to hike rates if inflation expectations were to rise substantially but believes expectations while firmer are still consistent with its inflation mandate. The Fed has placed a heavy emphasis on its Index of Common Inflation Expectations:

It seems unwise to base a critical, in fact key, element of your policy stance on a measure which only extends back to 1999 and thus covers a period of remarkable inflation stability, and assume the underlying metrics contain substantial insight into inflation dynamics in the presence of a massive shock of a magnitude never present in the chosen data set. I find this no less fuzzy than estimates of the natural rate of unemployment, and arguably fuzzier. That said, it’s what the Fed picked and thus we follow.

Finally, an even trickier issue. Will the recent trends in fixed income markets continue this week? Recent moves – pulling forward rate hikes, higher short rates, bear flattening – have been sharp and swift. I have been happy to ride that train, but I am getting to the place where I am concerned that these moves are now vulnerable to near-term repositioning. I think part of these moves are attributable to investors caught on the wrong side of the flattening and unwinding positions ahead of month-end. That said, I don’t want to get in front of this train. Powell could do everything I said above and still inadvertently say something market participants perceive as hawkish that won’t be cleaned up for another day or two. Getting off the train but not in front of the train seems like a more comfortable place for me going into this week.

Bottom Line

We think the Fed will try to stay the course signaled before the blackout period. While the risk is to the hawkish side of that course, it took a lot of consensus-building to get the Fed to this place. It would be unusual to shift such an established position quickly. It is typically a struggle to quickly pivot from hawkish to dovish. We think it is even more of a struggle to pivot in the other direction. It is even more of a struggle in the context of the new framework; the Fed would need to abandon what I would call “central truths” to make a BoC-style pivot this week.

Good luck and stay safe this week!

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