Long-term Rates Higher as the Fed Sits on Its Hands

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Last Week: Long term interest rates traded higher, as global equities largely treaded water near all-time highs, consolidating recent gains. The yield on the benchmark US 10-year note rose 3 basis points to 1.21%, touching its highest level since the start of the pandemic chaos last March. 30-year yields traded just above 2% – their highest since February 2020. The back end of the Treasury yield curve, in particular the difference between 5-year and 30-year Treasury yields – was about 152 basis points, its steepest level in over five years. Conversely, 1-month LIBOR and SOFR drifted near all-time lows. The price of a barrel of West Texas Intermediate crude oil rose 1.25% to $58.05, while the US Dollar and Gold both weakened. Treasury yield volatility, a key driver of the cost of rate caps and swaptions, drifted lower throughout the week.

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Powell suggested the Fed is sidelined for a long while. In an address to the Economic Club of New York, Fed Chair Jerome Powell underlined what the central bank’s new approach to setting monetary policy will be. Powell said the Fed will not consider raising rates until both “broad and inclusive” full employment and core inflation rates sustainably rise above the central bank’s 2% target. Markets anticipate that the Fed will allow the economy to “run hot” for a time, traditionally a supportive backdrop for many risky assets, this has been our view for the past couple of years.  Easier to tame inflation by raising rates than combating deflation.  Powell noted that the official US employment rate, 6.3%, understates the true level of unemployment, which he estimates to be closer to 10% because of millions of citizens not actively looking for work during the pandemic.

Our take: In one of the most coherent and forceful speeches from the Fed Chair we have seen in years; Powell’s words reinforced our belief that the Fed won’t pull back on stimulus – let alone hike interest rates – until it’s clear that the job market has become robust and inclusive. Given last month’s weak jobs report, where the US economy produced a paltry 49k new jobs, it’s going to be a long while before we see the Fed change tact toward easing off the accelerator.

What’s that mean for borrowers? Short term rates will remain anchored near zero for several quarters ahead at a minimum. But long-term interest rates, like the 10-year Treasury yield, could continue to drift higher as the economy slowly but surely recovers and investors further venture out toward riskier investments. What about the risk of inflation spiking due to all this easy money sloshing around the economy and the Fed eventually having to hike rates to combat it? Forget about it for now. The Fed is 100% focused on jobs, plain and simple. As such, keep an eye on weekly jobless claims data, and of course, the monthly jobs report. Buckle up folks, despite some decent jobs gains late last year, there are still nearly 10 million extra unemployed workers. It’s going to be a long struggle to get back to normal.

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Fears of inflation prove misplaced – for now. Fears of a resurgence in US inflation cooled somewhat after the Consumer Price Index rose 0.3% in January from December, in line with expectations, and held steady when stripping out food and energy costs.  What about the US debt versus GDP?  Consider the cost of funds at the moment.  The current 5-year US treasury is at 0.524% and 3-years ago the yield was 2.60%.

Our take: The recent evaporation of inflation in the service sector of the economy over the past several months is particularly pronounced – and noteworthy – as it now stands at the slowest pace in over a decade. It’s a telling signal that the current state of economic slack, as embodied in things like high unemployment and low utilization of America’s industrial capacity, are poised to exert even more downward pressure on inflation for the foreseeable future. Read on for a deeper explanation.

What to Watch This Week: The holiday-shortened week ahead will shed important insight on the degree to which America’s economic momentum at the start of the year is coalescing or collapsing. While we’re confident that there will be green shoots of solid growth in the spring and summer, the first few months of the year look to show signs of economic struggle.

The January retail sales report (Wednesday) will be the most important data release of the week. If consumers – who are responsible for 70% of US economic activity – were bogged down early in the year by falling confidence in the future, a sputtering labor market and sharply rising gas prices, any resurgence in their spending habits may be too little, too late for an economic turnaround in Q1.

Regional purchasing manager surveys – gauges of the prevailing direction of economic trends in the manufacturing and service sectors – out of New York (Tuesday) and Philadelphia (Thursday) will show the health of factory activity this quarter, while January industrial production (Wednesday) will give a sense of whether supply chain disruptions in general and chip shortages in particular are curtailing production in certain sectors, such as automobiles.

In summation, the tone of this week’s economic data will help frame the sense of urgency for additional fiscal support.

Outside of data, the minutes of the Fed’s most recent policy meeting will be released on Wednesday. The minutes will confirm that the Fed sees little reason to reevaluate the course they have chosen for 2021, as the slack in the labor market – far more than what a low 6% unemployment rate would otherwise imply – and zero evidence that monetary policy is fanning the flames of inflation give the Fed comfort to keep their foot on the gas pedal. Over the course of 2021, the Fed will begin to develop a clearer framework for dialing back its current stimulative stance, but we won’t see it until midyear at soonest.

Big Picture: But wait, there’s more, what about a third round of massive fiscal stimulus that’s about to be dumped onto the economy – won’t that eventually spike inflation? Probably not. Over the last 50 years of economic cycles, recessions have consistently proven to be disinflationary; there is little reason to expect a different outcome this time around.

The Biden stimulus plan will likely concentrate aid into this year and tilt it toward direct aid in things like enhanced unemployment benefits and stimulus checks, at the expense of investment intended to spur longer-run economic growth, like infrastructure projects. As such, the Biden stimulus will mainly serve to keep the economy on an even keel, blunting pressures driving inflation even lower than it already is – like elevated unemployment – in the near term.

Further, the Biden stimulus will allow the Fed to look past any temporary distortions – such as laid off workers earning more via unemployment benefits than they did when working – and get comfortable in allowing the economy to “run hot” as it gradually returns to its pre-pandemic status over future quarters.  The bottom line is that until full employment is restored – a task requiring the creation of nearly 11 million jobs – the Fed will sit on its hands.

All told, the state of the world is spurring investors to view additional fiscal stimulus as a sure thing and they are banking on the vaccine rollout gaining momentum, placing increasing bets – via the sale of Treasuries and purchase of riskier assets, like stocks – on solid economic recovery in the months ahead.

Current Select Interest Rates:

Rate Cap & Swap Pricing:

LIBOR Futures:

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Source: Bloomberg Professional

10-year Treasury:

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Source: Bloomberg Professional