Tim Duy’s Fed Watch, 4/4/22

Published on April 4, 2022
SGH Insight
Fed highlights this week will be the minutes and an appearance by Federal Reserve Vice Chair Lael Brainard. I discuss the minutes below. Brainard’s speech (Tuesday), Variation in the Inflation Experience of U.S. Households, will be an opportunity for her first extensive commentary on the economy since last September. This is an obvious platform to highlight the disproportional impact of inflation on lower income households and further build the narrative that restoring price stability is critical for both minimizing the costs of inflation and preventing the need for the Fed to hard stop the economy (which would also disproportionately damage low-income groups through higher unemployment). There is potential for Brainard to reveal growing concern that trend inflation now exceeds the Fed’s 2% target (see below), which would foreshadow what we expect to be hawkish minutes. It would be notable if Brainard downplayed the inflation situation, but we think that is unlikely.
Market Validation
Bloomberg 4/5/22

Brainard’s Hawkish Comments May Lessen FOMC Minutes Surprises

Treasury yields rose after comments from Federal Reserve Governor Lael Brainard signaled she is on board for faster tightening. These comments may signal a continued shift of the Fed’s most dovish members. Her comments were not a total surprise but traders noted her comments were viewed as much more hawkish than her most recent comments in mid-February. Brainard’s comments may spoil any surprise from Wednesday’s FOMC minutes from the March 16 Fed meeting.

Treasuries Drop to Lows, Curve Extends Steepening After Brainard

Treasury 10-year note futures drop to fresh session lows while 2s10s curve extends to steepest levels of the session after Federal Reserve Governor Lael Brainard says central bank will shrink its balance sheet rapidly and as soon as May.
Around 24k 10-year note futures trade over 3-minute period in move to 121-15 session lows, highest volumes on the session so far; into the move 10-year yields peak at 2.486% session highs
U.S. 2s10s curve extends steepening as intermediates lead Treasuries lower in the aftermath of Brainard comments; 2s10s peaks at 1.2bp and steeper by 4.3bp on the day

Monday Morning Notes, 4/4/22

If You Don’t Have Time This Morning

Everything is shaping up for the Fed to initiate the first of at least two consecutive 50bp rate hikes at the May meeting, in addition to announcing balance sheet plans. The Fed has simply fallen too far behind the curve to continue to slow-walk the path to neutral, something recognized now by even some of the most dovish FOMC participants. Watch also for heightened concerns at the Fed that trend inflation already exceeds the Fed’s target and is poised to move toward 3% if inflation pressures do not soon ease.

Recent Data and Events

The employment report came in strong with job growth of 431k for March plus another 95k in revisions to January and February combined. The pace of employment gains has been remarkably consistent over the past year:

Labor force participation climbed a bit higher from 62.3 to 62.4, propelled by a solid gain in prime-age participation:

Still, employment growth continues to outpace gains in labor supply, resulting in the unemployment rate falling to 3.6%, just a hair away from the Fed’s March SEP median forecast of 3.5% for year-end 2022. St. Louis Federal Reserve President Jim Bullard’s prediction of a sub-3% unemployment looks good after this report. Wage growth picked up from February:

We will be getting a better sense of wage growth with the Atlanta Fed numbers, which compensate for composition effects. The latest from the Atlanta Fed was 5.8%, likely consistent with inflation around 4%. I expected something similar in the March number.

Aggregate weekly payroll growth slowed in March:

Regular readers know I am watching this metric carefully as it speaks to nominal spending capacity of households. Something close to a 5% pace was consistent with 2% inflation prior to the pandemic; currently it is running at 10% year-over-year. Slowing aggregate payroll growth would be consistent with easing inflationary pressures, so the easing to a three-month annualized rate of 7.7% is potentially notable. That said, the hours component was flat, largely attributable to what is likely an anomalous decline in construction hours worked. In addition, further declines in the unemployment rate will put additional upward pressure on wages which will translate into faster growth of aggregate weekly payrolls. Overall, it would be premature to conclude a change in the trend just yet. There may be implications, however, for spending in March, which I will discuss later.

Household incomes grew 0.5% in February, supported by a solid gain in wages and salaries:

Still, spending rose just 0.2% in nominal terms and fell after accounting for inflation:

Core inflation moderated to an annualized monthly rate of 4.3%:

In some good news for the Fed, services inflation also moderated for the month although it is still accelerating on a year-over-year basis:

I suspect, however, that spending going forward will continue to tilt toward services as that category makes up for lost ground:

This will place upward pressure on services inflation as the year progresses (after all, the unemployment rate is 3.6% and services are labor intensive).

Separately, manufacturing surveys were mixed. The ISM measure for March was softer than expectations, falling from 58.6 to a still expansionary 57.1. Underneath the surface, however, there was a sharp drop in the new orders and production components while the prices paid component rose to 87.1. Still, the numbers can be volatile, and the anecdotal evidence was a familiar mix of strong demand and ongoing supply chain challenges. On the other hand, the S&P Global US Manufacturing PMI (the PMI previously known as the Markit PMI) rose to 58.8, a notch higher than the flash estimate of 58.5:

Contributing to the overall upturn was a sharper expansion in production at the end of the first quarter. The pace of growth continued to gain momentum and was the quickest since last August. Crucial to the increase were reports of improved availability of raw materials and inputs as supply chain disruption eased slightly. Companies also noted that higher output was supported by stronger client demand and a rise in new orders.

Despite the differences, both measures suggest that the U.S. manufacturing sector continued to grow in March.

There may be increasing cross currents in the data as the month progresses. As noted earlier, the employment report suggests the pace of household income growth eased in March. Given the underlying momentum in the labor market, which doesn’t seem likely to stop anytime soon with job openings still hovering at record levels, this slowing feels to me like noise. That said, even if the (still strong!) pace of income growth was more resilient than it appears in March, households were still likely overwhelmed by higher prices. While over time households have other sources of income to support spending (savings and debt), we should recognize that in the near term, real spending likely took another hit. The Cleveland Fed currently estimates March CPI inflation of 1.11% (!) and PCE inflation of 0.75%. Those are big numbers that will erode real spending power. In addition, I expect that households shifted spending toward services in March as they took advantage of the lull in the pandemic. While I have argued that over time income growth at the current pace is sufficient to allow for continued goods spending while services spending gains, I also recognize that high inflation in March may have left consumers forced to choose between goods and services spending, and they picked the latter.

Note that I am not changing my basic outlook – I think we need to see sharply less pressure in the labor market to ease concerns that underlying inflation remains elevated at something closer to 4% than 2%. Fundamentally, I believe inflation is a macro issue (economy/labor market overheating and triggering a shift in underlying inflation) and not a micro issue (supply chains). Moreover, the March inflation spike should be a peak after which nominal income growth will be again sufficient to expand real spending capacity. Still, in the near term we will likely see cross currents in the data – such as weaker real goods spending, declines in closely watched prices like lumber, higher mortgage rates shaking out marginal buyers or second home purchases, etc. – that will feed into the narrative that the Fed is hiking into a slowdown, a recession is imminent, etc. I will be paying close attention to these cross currents.

Upcoming Data and Events

This is a lighter week for data. The highlight will likely be services sector surveys, which Wall Street expects firmed in March as the pandemic eased and households rushed into leisure and hospitality spending. We are also watching mortgage applications, in particular purchase applications, for indications of the impact of higher mortgage rates on the housing sector.

Fed highlights this week will be the minutes and an appearance by Federal Reserve Vice Chair Lael Brainard. I discuss the minutes below. Brainard’s speech (Tuesday), Variation in the Inflation Experience of U.S. Households, will be an opportunity for her first extensive commentary on the economy since last September. This is an obvious platform to highlight the disproportional impact of inflation on lower income households and further build the narrative that restoring price stability is critical for both minimizing the costs of inflation and preventing the need for the Fed to hard stop the economy (which would also disproportionately damage low-income groups through higher unemployment). There is potential for Brainard to reveal growing concern that trend inflation now exceeds the Fed’s 2% target (see below), which would foreshadow what we expect to be hawkish minutes. It would be notable if Brainard downplayed the inflation situation, but we think that is unlikely.

 

Other Fed speakers this week include Williams (New York, Tuesday, and Thursday), Harker (Philadelphia, Wednesday), Bullard (St. Louis, Thursday) and Bostic (Atlanta, Thursday).

Day Release Wall Street Previous
Tuesday S&P Global US Services PMI, Mar. F 58.9 58.9
Tuesday ISM Services PMI, Mar. 58.5 56.5
Wednesday MBA Mortgage Applications   -6.8%
Wednesday FOMC minutes
Thursday Initial Jobless Claims 200k 202k

Fed Speak and Discussion

The employment report supports the case for aggressive action at upcoming FOMC meetings. Although the Fed will look favorably on the improvement in the labor supply, its focus will fall on the still declining unemployment rate. While there is considerable uncertainty of the natural rate of unemployment, the current central tendency of SEP estimates is 3.5-4.2% with a median 4.0%, which means unemployment will soon be at or below even the most optimistic estimates – and this is the longer-run estimate! Recall that Powell suggested that the short-run natural rate is higher, which means an even greater degree of overheating now. Ongoing declines in the unemployment rate create a serious challenge for policy. The further unemployment falls below the natural rate, the higher it needs to subsequently rise to quell inflationary pressures. But the Fed can’t easily fine tune the unemployment rate – if it moves up a few tenths of a percentage point, it’s likely to keep moving up. From a risk management perspective, the Fed needs to be doing more now to prevent unemployment from falling further.

Incoming data clears the way for a 50bp rate hike at the May meeting. The March employment numbers argue for 50bp, the March CPI report will argue for 50bp, and markets have cleared the way with an 80% chance of a 50bp rate hike. Moreover, the market pricing naturally followed Federal Reserve Chair Jerome Powell’s most recent speech. We believe the Fed thought market participants did not properly appreciate the hawkish message of the March FOMC meeting and Powell sought to rectify that situation. Our understanding is that Fed officials liked the market reaction to Powell. Powell knows that the Fed will need to follow through on his messaging otherwise financial conditions will loosen and undo some of the Fed’s work.

Odds favor that the Fed follows 50bp in May with another 50bp at the June FOMC meeting. Although headline inflation will fall in April on the back of stabilizing gas prices, core inflation will hold strong (the Cleveland Fed currently estimates 0.26 and 0.54 for April headline and core CPI, respectively). And labor market momentum likely will not stop abruptly in the next few months. Remember, job openings are still off the charts even if they are being filled a bit more quickly. Also, two 50bp rate hikes looks to be shaping into a part of a deliberate strategy to get halfway towards neutral by midyear. A solo 50bp in May would read random. Get halfway to neutral by June as a risk management exercise, and then have the option to slip back to 25bp hikes. This is how the Fed gets to an equivalent of nine 25bp rate hikes projected for 2022 in the June SEP. Markets are getting there too, with 8.6 hikes priced in as of last Friday. Finally, Fed hawks will want to push for more than one 50bp hike before any crosscurrents in the data weaken the argument for aggressive action.

While not all FOMC participants are on board with a series of 50bp rate hikes, the consensus is moving rapidly in that direction. While some like Chicago Federal Reserve President Charles Evans are still hoping to continue with 25bp hikes, the change in tone from San Francisco Federal Reserve President Mary Daly illustrates just how dramatically the center of gravity has shifted in a far more hawkish direction. After spending most of 2021 as a reliable arch-dove, Daly offered her support for an aggressive series of moves in a FT interview reported over the weekend:

“The case for 50, barring any negative surprise between now and the next meeting, has grown,” Daly told the Financial Times in an interview conducted on Friday. “I’m more confident that taking these early adjustments would be appropriate.”

Estimating the neutral policy rate to be between 2.3 per cent and 2.5 per cent, and advocating for getting to that level “efficiently” this year, Daly acknowledged that that translates to “multiple” half-point adjustments given the target range of between 0.25 per cent and 0.50 per cent.

The Fed is quickly realizing it needs to get to neutral by the end of the this year, which means both that it needs to step up the pace of tightening and also that the March SEP is already out of date.

We expect the minutes of the March FOMC meeting to lean hawkish. Importantly, watch for indications that the Fed staff have rising concerns over whether inflation expectations will remain anchored near 2%. In this FEDS note released last week Fed staff estimate that trend inflation has risen above target with further upside risks:

They then perform an analysis of what would happen if inflation expectations deteriorated in the months ahead. The implications would be sobering for FOMC participants:

This research now percolating among the staff suggests not only has the Fed fallen behind the curve, but the risk is that the Fed will fall further behind the curve and helps explain the shift in Powell’s rhetoric from maintaining to restoring price stability. The further trend inflation moves away from target, the more likely that the Fed can’t restore price stability without a recession. This only enhances the case for front loading rate hikes.

The Fed minutes will also likely shed further light on the Fed plans for the balance sheet. Powell said that FOMC participants made good progress on QT plans at the March meeting, and this should be reflected in the minutes. Powell has also provided substantial insight into the Fed’s plans in public remarks, saying that he expects it to take three years to return the balance sheet to its pre-pandemic level of roughly 20% of GDP. We interpret this to mean the Fed will fairly quickly (over 3 to 4 months) ramp up the caps to $100 billion a month split 60/40 across Treasuries and MBS. The Fed hopes to put the program on the back burner and adjust policy rates as necessary to guide the economy and financial market conditions. This may be aspirational; it is too early to conclude that financial markets can function smoothly at the pre-pandemic balance sheet levels, but there should be enough room to let the balance sheet unwind continue for some time without adjusting. Ultimately, the Fed will hope for the best with the standing repo facility providing at least some guardrails not available in the last cycle.

In his most recent press conference, Powell suggested that QT was equivalent to a 25bp rate hike. We think he meant just for this year, implying that reduction of the balance sheet would be equivalent to three 25bp hikes across three years. Powell said:

…there’s also the shrinkage of the balance sheet which you people do the math different ways, but that might be the equivalent of another rate increase just from the runoff of the balance sheet.

Still, internally Fed leaders and staff have a wide range of estimates of the impact of QT as measured in rates policy, so it’s hard, as Powell suggests, to have a high degree of confidence about any one number. We expect the Fed will say it does not anticipate outright sales of assets. Interest in asset sales to manage the yield curve (see Kansas City Fed President Esther George) is a minority position. The Fed’s likely approach will be to bring the balance sheet back to a “normal” level and then, if possible, adjust the composition by selling MBS and buying Treasuries. If QT is interrupted by a recession, the Fed will need to think long and hard about buying MBS in the future as doing so would only dig itself deeper into that hole.

Bottom Line

Barring some unexpected geopolitical event, the consensus at the Fed is gravitating toward pulling forward rates hikes with 50bp rate hikes in May and June. Until we see a change in the inflation outlook, we need to assume the Fed will continue to ratchet up the hawkish rhetoric, and market pricing will adjust accordingly.

Good luck and stay safe this week!

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