The Fed: Putting the K in ReKovery.

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Last Week: Long term interest rates edged higher and equities moved lower amid a rise in volatility, spurred by growing belief that economic stimulus may take longer than expected. The yield on the US 10-year note traded four basis points higher to 1.07% on the week, after having dipped to 1% mid-week. Short term rates continued to drift lower, specifically 1-month LIBOR, which touched a record low of 0.1195% as financial markets struggle with a glut of cash in search of a short-term home. The price of a barrel of West Texas Intermediate crude oil rose $0.50 to $52.95 while the US Dollar strengthened, and Gold weakened. Treasury yield volatility, a key driver of the cost of rate caps and swaptions, rose steadily throughout the week.

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The GameStop retail army spurred a price spike – in rate caps. If you were hiding under a rock last week, a handful of heavily shorted stocks went on wild rides as retail speculators banded together in Internet chat rooms to unleash a historic squeeze. Several hedge funds were substantially impacted, prompting a wide array of investors to reduce market exposure, both long and short. As a direct result, equity market volatility and trading volumes on the New York Stock Exchange reached record levels. The turmoil spilled over into other asset classes – like the fixed income markets – after the rally in some stocks caused the rates markets – like the 3-year Treasury yield – to sell off (prices lower, rates higher). As a direct result, several rate cap banks put us on notice that rate cap pricing had become elevated due to the higher rate volatility. Short term yields have since fallen back from their highs, but volatility – a silent, opaque driver of rate cap costs – remains elevated.

Our take: The GameStop episode is what happens at the intersection of overabundant liquidity, perceived financial repression for some, and the madness of crowds. More importantly, the rise in short-term rates tells us that equity-rate correlations, where any rise in equity markets is met with a rise in yields (or vice versa) appears to be re-emerging, albeit very gradually, in markets where yields have moved away from the lower bound, like US Treasuries. While fun to think about, we expect Treasury yields will likely be driven by developments on the fiscal and public health fronts, and not the direction of stock markets, over the near term.

Fed meeting proves a non-event (mostly). In its scheduled policy meeting last Wednesday, Fed Chair Powell & Co. broadly met expectations of no change in policy and only nuanced changes to the Fed’s official assessment of the outlook for growth and inflation. The post-meeting communiqué nodded to a moderating pace of recovery in the economic data since the Fed’s December meeting, but also stressed that weakness was concentrated in specific sectors which are particularly vulnerable to the pandemic.

Our Take: The Fed’s modest adjustments are slightly positive on net, as its concerns about pockets of weakness in the economy are less alarming than if the Fed implied that the slowdown was more broad-based. Barring a deterioration in the public health situation or a botched vaccination rollout, the Fed continues to see decent economic prospects – and possibly a pull back on the stimulus throttle – later this year.

As for the Fed acknowledging that superabundant liquidity and financial repression could pose financial stability risks, like that seen in the GameStop YOLO army at present, the Fed has batted away those suggestions for years, and will not fess up anytime soon, if ever. Fed Chair Powell knows that the Fed maintains a suite of available, yet unused macro-prudential tools – like raising equity trading margin requirements – to lean against any market disrupting leverage.

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Economic data showed America’s economic momentum is on the cusp of a pause. Recent economic gauges are showing that job creation is backsliding, consumers are tightening their purse strings and households’ belief of brighter futures appear to be plateauing. However, while the more high-frequency measures of economic health, like monthly measures of goods purchases, imply that a malaise of sorts is settling in, other, more broad-based measures, like lower frequency, quarterly gauges, tell a very different story. Specifically, last week’s initial reading on fourth-quarter GDP showed robust business investment trends, which, along with data on durable goods orders, suggest that it will carry on into this quarter. For some perspective, the US economy expanded at a 4% annualized rate in the final quarter of 2020 and contracted 3.5% for the full year, its worst performance since 1946.

What to Watch This Week: The term “K-shaped recovery” that has been bounced around is truly coming into its own now. It illustrates the diverging tracks of the wellbeing of those negatively impacted by the pandemic and those who were able to adapt with little-to-no economic consequence. The question now? Just how much longer and to what degree will the K-shaped economic divergence continue.

It’s jobs week, historically the single most impactful piece of economic data for interest rates. Friday’s nonfarm payrolls data will clearly feature the divergent “K” track, as sectors such as leisure, hospitality, restaurants and bars are due to post ongoing, significant job losses. While the economic plight of those dislocated workers must certainly not be left unaddressed, a crucial silver lining of the jobs report will be to decipher the extent to which some portions of the economy continue to recover.

We expect the state of the job market in January to be less weak than December’s, when renewed lockdown initiatives in November and December extracted a steep employment toll on the service sectors of the economy.

A critical silver lining of the report may depend on whether industries which previously exhibited resilience to renewed lockdown measures, such as finance, construction, and manufacturing, continue to show job gains.

We’re expecting that the economy added a modest 30k jobs in January, and that the unemployment rate held steady at 6.7%. We don’t expect any real uplift in America’s job situation until the health crisis begins to abate, specifically via mass vaccinations, a squashing of virus variants and expanded jobless benefits via fiscal stimulus.

Curious on where rates are headed through all of 2021 and why? Check out our 2021 Interest Rate Outlook.

Big Picture: We suppose that concentrated weakness in certain parts of the economy is certainly preferable to a broad-based malaise – as it implies that the Fed’s and Congress’s policy choices are indeed effective, but uneven in the assistance they provide. For this reason, the “K-shaped recovery” provides a cold comfort of sorts, at least until a broader recovery begins. The week ahead should help clarify just how long it may take to show up for everyone.

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