Fed Does The Talking, Markets Do The Walking
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Last Week: Short rates rose and long-term interest rates rocketed higher, as inflation fears undermined equity and bond markets, sending the yield on the benchmark US 10-year Treasury note briefly as high as 1.61% on Thursday – its highest level in a year – before easing to 1.40% by week’s end. Elsewhere, 1-month LIBOR was finally dragged higher to .1185%, after weeks of hovering near all-time lows. The price of a barrel of West Texas Intermediate crude oil firmed over $2 a barrel to $62.50, and the US Dollar strengthened, and Gold weakened. Treasury yield volatility, a key driver of the cost of rate caps and swaptions, rose to levels not seen since the start of the pandemic last April.
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What’s driving the huge moves in interest rates? While pretty much everyone expected rates to rise over the course of this year, the speed and breadth of the moves seen recently have taken many by surprise, including us. Usually there are several reasons for large moves in rates, and this time is no different. Here’s the three main catalysts for the large moves we’re all witnessing now: 1) Overall, higher yields were expected given the continued easy monetary policy from the Fed, and on improving economic optimism as lockdowns ease and vaccination distribution slowly broadens. This increasing optimism is spurring many investors out of the safety of US Treasury bonds and into more risky investments, like stocks and real estate. 2) Fears that eased regulations aimed at improving the functioning of bond markets may come to an end are causing banks to sell Treasuries (more sellers = prices fall = yields rise). 3) Regarding this week’s moves in particular, hedging by mortgage-backed security investors at month end helped speed the 10-year Treasury yield’s move back off its highs.
What does it mean for the Fed, and prospects for future rate hikes? There is a growing disconnect between monetary policy and the US Treasury market. Fed Chair Powell delivered the central bank’s semiannual monetary policy report to Congress last week, where he maintained the Fed’s current stance: keeping its foot firmly on the gas pedal, via near-zero short-term interest rates and large-scale asset purchases. The Fed Chair embraced the recent rise in rates as a sign of market confidence that a robust recovery is on its way. Markets essentially disagree on timing, with Fed funds futures markets – a gauge of the bond markets expectation of future Fed rate hikes – pricing in the first Fed rate hike by the end of 2022, a year sooner than what the Fed forecasts.
Our take: Given that the Fed remains totally focused on its dual mandate of price stability and robust employment, Fed Chair Powell reiterated that it would take more time for the economy to reach those goals. Taking them individually, inflation, if it ever shows up, will likely take a while, and the Fed is expecting a long haul on this one. A robust job market, however, is the Fed’s primary goal right now. With nearly 10 million still unemployed when compared to pre-pandemic levels, we don’t see the Fed pulling away the punch bowl until the jobs picture improves dramatically, plain and simple. This all translates into a potential Fed hike in early to mid-2022 at soonest.
The bottom line? The Fed is resolved to avoid easing off the accommodation throttle prematurely, even in the face of an improving economic outlook and rising Treasury yields. Ultimately, a controlled, passive unwind of the Fed’s balance sheet and interest rate hikes will begin returning monetary policy toward a more neutral setting, but this will be a multi-year process.
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Solid economic data support rate rise. Despite numerous COVID-19 restrictions being in place last month, economic data for January are looking solid. Durable goods orders rose much more than expected on the month, up 3.4%, an improvement from an upwardly revised 1.2% advance in December. New home sales rose 4.3% last month, and the Case-Schiller home price index rose 10.1% year over year. Personal income surged 10%, and spending rose 2.4% as additional stimulus payments made their way into consumers’ hands. The core personal consumption expenditures price index, the Fed’s preferred inflation measure, rose to 1.5%, slightly ahead of expectations but well below the Fed’s 2% target.
What to Watch This Week: After a recent couple of weeks containing a dizzying list of superlatives, including the steepest weekly jump in five-year Treasury yields in months and the biggest convulsions in the yield curve since the early days of the pandemic, this week’s listing of tier -1 economic data releases and events provide more fodder for drama.
On the data front, Friday’s February jobs report tops the list in importance. Historically the most influential piece of economic data on interest rates, the report should feature only a modest pickup in hiring last month of around 175K in new jobs. For some perspective, broad-based weakness in the January jobs report appeared to be setting the tone for a gloomy start to the year. Weakness in previously vigorous job categories like construction and manufacturing sounded alarms that a broader malaise was setting in.
We don’t expect the gloom on the jobs front to continue this time around, given that a majority of data releases in February topped consensus expectations, specifically retail sales, industrial production, durable goods orders, building permits, home sales and consumer confidence. The strength in these gauges suggests that the weakness on the jobs front in January may have been a one-off event, possibly a lingering remnant of COVID-19-related lockdowns around the holidays. All-told, we’re getting the sense that fiscal stimulus measures are rapidly impacting economic activity, and likely jump-starting the spring reopening hiring surge a bit sooner than expected. We’ll see if this week’s jobs data confirm that.
Thursday’s scheduled remarks from Fed Chair Powell – who will be speaking at an event hosted by the Wall Street Journal – will loom especially large for all markets, not just bond traders betting on higher yields. While some would hope for more, we expect Powell to extend his message of unwavering policy support even considering improvement in economic data and the backup in Treasury yields.
Regarding rates moves this week, we suspect we’ll see long-term yields stay below their current highs in the days ahead, consolidating into a range. However, over the coming weeks, strong growth and inflation momentum will likely push yields to new highs. As bond markets bet on the timing of a Fed stimulus pullback, its stocks that will likely suffer first, given that so much of their gains are predicted on lower-for-longer borrowing costs.
Big Picture: The latest communications from the Fed confirm that Chair Powell & Co. are willing to play a more passive role in the early stages of the post-pandemic economic recovery. In doing so, the Fed is allowing market-determined interest rates – a confluence of expectations for growth, inflation and credit – to move to less accommodative levels, which in turn will eventually rein in economic activity.
An example of this is the housing sector, where record low mortgage rates and a change in housing preferences drove demand to red-hot levels. The rise in rates is now tapering demand via higher mortgage rates, low inventory, and less affordable prices. In this case, the housing sector serves as a microcosm for the broader economy, as other interest rate-sensitive sectors will witness similar fates. The Fed knows this and will remain patient while the feedback loop from higher interest rates asserts itself. As fiscal stimulus-juiced economic growth surges to multi-decade highs in the coming months, fears that the economy will overheat will grow with it, but the resulting tightening of financial conditions – via higher rates and higher prices – will insure against such an outcome. It’s all part of the Fed’s master plan of doing all the talking while markets do their work for them. Thus far, that plan is manifesting perfectly.
Current Select Interest Rates:
Rate Cap & Swap Pricing:
LIBOR Futures:
Source: Bloomberg Professional
10-year Treasury:
Source: Bloomberg Professional
