Markets Chase Their Tails as Fed Remains Resolute
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What You Missed: Long-term interest rates rose, while equities wrapped the week near record territory as senior leaders of the Fed affirmed the view that they are in no hurry to tighten monetary policy and that the recent surge in inflation, resulting from pandemic-induced bottlenecks, is transitory. The rate on the benchmark US 10-year Treasury rose to 1.54%, while short-term rates, like 1-month LIBOR and SOFR, held onto their upward momentum. The price of a barrel of West Texas Intermediate crude oil rose $2 to $73.10, as the US Dollar and Gold both weakened. Treasury yield volatility, a key driver of the cost of rate caps and swaptions, fell steadily throughout the week.
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Fed reiterated patient approach to removing stimulus. Amid a parade of Fed officials all spouting their own personal and often contradictory views of inflation and how and when then Fed should act to combat it, Fed Chair Powell – the only Fed official that really matters – testified on Capitol Hill that the Fed sees no risk of runaway inflation and expects it to drop back toward the Fed’s longer run goal. The comments helped soothe fears sparked a week ago when Fed forecasts, via the Fed’s over-analyzed dot plot, showed that members of the rate-setting Federal Open Market Committee expected to hike rates twice in 2023, months earlier than they had previously predicted.
Our take: While we won’t bore you again with our views on inflation, know that Chair Powell is correct. Consumers, eager to get back to pre-pandemic habits, are set to rotate spending toward services in the remainder of the year (keep reading for more detail on this), helping supply-constrained goods suppliers to catch up, therefore easing price pressures and making room for inflation to mellow into next year. The expiration of enhanced unemployment benefits in late summer and schools reopening in the fall will only add to the inflation-easing momentum. As inflation decelerates rapidly next year, we expect the Fed to keep rates on hold well into 2023. A taper of asset purchases will begin early next year following big improvements in the jobs market.
In the meantime, the large moves in LIBOR and Treasury yield curves over the past week has driven rate cap costs through the roof, especially for 3-year terms and beyond. As an example, the cost of a $10MM, 3-year LIBOR rate cap struck at 1.50% is nearly THREE TIMES the cost of its 2-year counterpart. Do you find yourself in this situation? Negotiate a 2-year term with your lender to save money.
Economic data disappointed but showed a set up for future growth. Personal spending, a key gauge of consumer’s spending behaviors, was flat in May following a modest 0.9% gain in April. The decline was largely due to a pullback in spending on goods, versus an increase in spending on services, against the backdrop of accelerating vaccinations. Within services, increases were widespread, led by spending for recreation services, food services and accommodations, and housing and utilities.
On the other side of the coin, personal income, a key gauge of the advances and declines in consumer’s wages and ability to spend, fell 2.0% in May, a second consecutive drop (-13.1% in April) after a 20.9% spike in March. With augmented unemployment benefits now beginning to taper off, consumer’s total incomes are feeling it. However, core wages and salaries rose 0.8%, slowing only slightly from 1.0% in both March and April. A good sign indeed.
Our Take: The spending data suggests that consumers – who’s spending is single handedly responsible for roughly 70% of America’s economic activity – will continue to rotate their spending from goods toward spending on services over the summer months, supporting calls for accelerating economic growth as the fall approaches.
On the income front, even though the jobs shortfall remains significant and waning government support has dented consumer’s total incomes, a solid recovery in wages – now above the pre- pandemic trend – means a more durable foundation for even greater consumer spending is emerging. One caveat though: The bulk of returning workers are concentrated in lower-wage service industries, and that’s where we’re really seeing the gains in wages thus far. Before we’ll see rising wages across the economic strata of workers, the return-to-work frictions including childcare, augmented unemployment benefits and health concerns must continue their easing trend.
Inflation signals flashing red. Inflation, as measured by the headline (0.4%) and core PCE deflator (0.5%), posted another strong reading in May. The core surged to 3.4% on a year-over-year basis (vs. 3.1% prior and the highest in 30 years), while the headline moved to 3.9% (vs. 3.6% prior). The headline and core were both 0.1% below expectations.
Our Take: The highest core PCE reading since 1992 in May is indeed scary but isn’t enough to break the disinflationary trends in place prior to the pandemic, nor equate to the inflation we (or our parents) suffered during the 1970s. We expect that suppliers of in-demand goods will catch-up due to consumer spending shifting away from goods and toward services, which means that price increases will have a harder time persisting (can you say “transitory”?).
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Sales slip amid stratospheric US house prices. The median price of an existing home in the US soared 24% from a year ago in May, helping cool demand for homes, despite ultra-low interest rates, since more buyers are priced out of the market. Sales of both new and existing homes declined last month as inventories of unsold properties fell to astonishingly low levels. Houses remained on the market for only 17 days, on average, before selling, according to data from the National Association of Realtors. The median price of an existing home in the US reached $356,600 last month.
What to Watch This Week: It’s a key data week. On the data calendar, important gauges of the economy’s supply fundamentals – and inflation and the timing of Fed rate hikes, by extension – lie in wait. First and most importantly, the June jobs report (Friday) will likely show its best gain since August 2020 due to accelerating hiring growth and an expanding supply of available workers. We suspect around 750K in new jobs were created, with the unemployment rate slipping lower slightly to 5.7%. The ISM manufacturing survey (Thursday) will show another month of factories’ optimism outstripping their ability to supply product, though input prices will be shown to be off their near-record highs.
Big Picture: The consumer was the main driver of economic growth prior to the pandemic and this time around, it won’t be any different. Experience-starved and cabin-fever inflicted consumers, flush with savings and emboldened by increases in home equity and stock prices, will propel growth through the summer and fall. As the year progresses though, higher inflation – a direct consequence of over-the-top reopening demand – will start to drag on consumer’s spending power, softening demand and their spending appetite.
Businesses, which play an important but smaller role in the recovery, will seek to tackle investment projects deferred by the pandemic by launching a surge in capex spending. Despite their enthusiasm, rising labor costs and lingering supply constraints will limit the extent of further re-investment plans through the fall however.
This consumer and business dynamic of increased appetite for spending, but one ultimately restrained by higher costs will allow the Fed to take its time in developing a plan to taper asset purchases; and, when combined with improving job creation over the summer, will reassure the Fed that it’s meeting its “substantial further progress” goal.
In the meantime, the 10-year Treasury yield’s tight, 1.40-1.70% range will likely hold as markets come to grips with a resolute Fed and an increasingly bumpy road toward post-pandemic America.
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Source: Bloomberg Professional
Source: Bloomberg Professional