Implied interest rate volatility for USTs peaked early last week at the highest levels seen since Covid hit.  Volatility did moderate somewhat as the days wore on to end Friday nearly unchanged on the week.  Rate volatility, a key component to the cost of interest rate caps, is being kicked around by some of the manic features of the current rate environment.  In recent weeks, sentiment has vacillated between identifying whether recession or inflation is the greater threat for the rate outlook.  By the end of last week, inflation worries again took the lead which was the opposite of where the focus stood at the end of June. The jumpy rate environment, and its residual impact on rate volatility, is at the epicenter of absorbing the market’s shifting conviction over which threat will dominate.  For the foreseeable future, we expect the unacceptable inflation backdrop to overshadow economic growth concerns as the July Fed rate decision is still over 2 weeks away.

Last Thursday, 2 voting members of the Fed’s FOMC indicated that they would support raising the Fed funds target by 75 bps at the upcoming July 26-27 FOMC policy meeting.  Fed governor Christopher Waller reiterated that inflation was “just too high” while St. Louis Fed President James Bullard said he remains focused on getting the Fed’s target rate to 3.5% by the end of the year.  And on Friday Atlanta Fed’s Raphael Bostic, currently a non-voting FOMC member, said he fully supported a 75 bps rate hike later this month.  By the end of last week, the implied yield on the Dec 2022 Fed funds futures contract had risen to 3.40%, up 14 bps for the week.  As of last Friday’s market close, the highest implied yield for Fed funds futures was 3.60%, seen for the April 2023 contract.  Those expectations had exceeded 4.00% back in mid-June before recession concerns intensified.

The Fed minutes from the June 14-15 FOMC meeting, released last Wednesday, showed a relatively strong amount of agreement among Committee members supporting June’s 75 bps rate hike.   There’s little doubt that as economic growth concerns build, a fierce debate over the magnitude of subsequent rate hikes will be ongoing within the FOMC.  All said, the public “Fed speak” gathered since the mid-June Fed rate hike suggests the Committee is prepared to risk a recession as a tradeoff to bring down inflation.  For the foreseeable future, the rate environment will continue to confront these conflicting forces.

Some key sentiment drivers were looking up last week.  As rates climbed higher through last Friday, the U.S. equity market managed to eke out a gain.  The S&P 500 added 1.9% for the week, not a trivial outcome given the broader sentiment shift that took place as markets refocused again on the possibility of another 75 bps U.S. rate hike on July 27.  More broadly, the market capitalization of the public U.S. equity market ended last week approaching $39 Tn, a gain of approximately $0.9 Tn on the week.  With this measure of accumulated wealth having fallen from $48.5 Tn at y/e 2021, any uptick in stocks is likely to be favorable for overall consumer sentiment which has been beaten up this year badly amid falling stocks, higher inflation, and particularly gas and food prices.

The U.S. dollar (USD) continued to strengthen last week.  The DXY currency index reached 107.13 last Thursday, its highest closing level October 2002.  The key contributors to this development, which gives U.S. consumers more purchasing power for imports, are the increased pace of U.S. interest rate hikes and the continued decline of the euro currency and the Japanese yen.  Last Thursday the euro fell to $1.016, its lowest closing level against the U.S. dollar since December 2002 amid a widening interest rate gap between the U.S. and the Euro area.  With a 1 to 1 exchange rate parity in sight, the focus on a 50-bps rate hike by the European Central Bank (ECB) to confront inflation later this month (July 21 ECB meeting) has intensified.  While a more hawkish ECB could soon cap the USD’s strength, a shift in monetary policy by Japan’s central bank could notably reverse the dollar’s fortunes.  The Japanese yen closed Friday at JPY 136.1, a near 24-year low against the USD.  The Bank of Japan (BoJ), with its ultra-low interest rate policy, has become increasingly out of sync with global central banks.  Despite the reality that the BoJ is deeply dug into its ultra-easy monetary policy stance, the yen’s deep decline since March, combined with an increased pace of global rate tightening, should at a minimum continue to lift speculation over the possibility an eventual policy shift by the BoJ.  Over time, this likely leaves the USD more vulnerable to weaken (than strengthen) which could add further to market volatility.

Crude oil prices fell about $3 last week, with WTI briefly below $100/bbl Tuesday and Wednesday, before closing out the week just shy of $105/bbl.  Arguably more significant, U.S. retail gasoline prices (national average regular prices tallied by AAA) continued their descent last week dropping roughly 12 cents/gal.  Since reaching a record high price of $5.02 on June 13^th, prices have fallen 32 cents/gal to $4.70 last Friday.  Although prices are only back down to about where they began June, the reversal is providing some unexpected economic relief.  Since the level and direction of gasoline prices are a major contributor to headline CPI, impact consumer sentiment, and have political consequences, the latest price drop is significant.  If price declines are sustained or drop further, this should certainly help in the Fed’s efforts to turn back the growing inflation mindset hanging over the economy.  Unfortunately supply conditions are not abundant and geopolitical risks are significant, and potentially unstable, suggesting energy prices remain quite vulnerable to greater volatility.

Elsewhere, while grain commodity prices climbed last week, prices remain at levels that are unlikely to add to additional inflation pressures and perhaps even bring about some price relief if sustained. Although corn prices rose for a second consecutive week, prices ended last week about flat to the 3-month average.  Although wheat prices climbed last week, they ended Friday 38% below the surge price that unfolded after the war on Ukraine began in February.  Friday’s closing price of $879 on the CBT Wheat futures front contract was nearly 17% below its 3-month average price.  While copper prices ended Friday 28% below their early March 2022 peak, they rose modestly last week.  Why you should care about commodity prices: The industrial metal’s relative weakness should help alleviate some inflation pressures but is more frequently aligned with anticipating economic sluggishness than as an inflation/deflation signal.

The cushion that may likely absorb some economic pain

Friday’s release of June’s US employment situation beat consensus expectations and reinforced the need for the Fed to worry less about its maximum employment policy mandate right now and more about seeking price stability, its other key mandate.  June’s 372k nonfarm payroll gain combined with previous revisions, beat expectations by approximately 100k.  For H1 ‘22, monthly NF payroll gains have averaged 457k and for Q2 ‘22, 375k suggesting the U.S. Labor market is holding up quite well so far amid the Fed’s rate hikes.  The unemployment rate held at its recent low of 3.6% for a 4^th consecutive month while the YoY change in average hourly earnings held above 5% for a sixth straight month.  The monthly change in average hourly earnings, however, was a 0.3% gain reflecting some slippage compared to late last year/early this year.  Key issue here is that inflation is clearly outpacing wage gains … a reality that should incentivize the Fed to stay the course on continuing to hike rates and fulfill its price stability mandate.

The other key data on the U.S. job market last week was the Labor Department’s May job openings report released last Wednesday.  Although U.S. job openings fell by 427k to 11.25 mn, the outcome exceeded consensus expectations and remained near March’s record 11.86 mn.  Despite May’s decline, the latest level of job openings is still extremely high.  Consider that the number of May job openings was also higher than any level seen prior to last December.  According to the June employment report released last Friday, there were 5.91 mn unemployed, essentially unchanged since March.  Before covid hit in Feb 2020, there were 5.72 mn unemployed workers in the U.S.

While the job market has largely recovered its covid-effect amid dislocations and reshuffling, the latest figures between these 2 job market reports (by the Labor Department) suggest there are approximately 1.9 jobs available in this country for every unemployed person.  Not too shabby in theory and very suggestive of a deep (theoretical) cushion in place for U.S. employment conditions to hold up overall in the event the Fed’s policy tightening triggers a recession.