Fed Releases Paper Dismissing Curve Inversion, Hawkish Rhetoric Continues Building as 50 bps Hike Gets Priced In
The yield curve inversion has spooked investors this week. However, Fed economists Eric Engstrom and Steven Sharpe took the position that investors should not spook so easily because of the yield curve alone. In their paper “Don’t Fear The Yield Curve, Reprise,” the two economists argued that the correlation between the 2s10s spread inverting and recessions were likely spurious. Rather than having predictive value, they argue that the spread closely reflects market participant expectations. The authors argued that for now at least, the shorter end of the curve isn’t sending the same ominous signals as the closely watched 2s10s spread. Prior work on the same issue from the San Francisco Fed suggested the three-month to 10-yr spread has a better track record than the 2s10s. More cowbell, please.
The Fed hasn’t conducted more aggressive 50 bps hikes in some time, but that is exactly what the banks are beginning to price in now. Our Head of Global Portfolio Strategy, Brian Rauscher, has heard rumblings from trusted sources that Fed leadership has made a hawkish pivot and what some market participants consider mere jawboning is reflecting the intended course of Fed policy.
The jobs report today likely makes the hawkish activity more comprehensible for even some doves. While the headline expectation was missed, the revisions for February were high and the unemployment rate declined to 3.6%, which means the jobless rate in the United States is approaching pre-pandemic levels when inflation data is still coming in at multi-decade highs. Monthly job increases have been above 400,000 for 11 consecutive readings. Let’s remember that the pre-pandemic unemployment rate of 3.5% was a 50-year low.
The Federal Reserve Bank of Chicago President, Charles Evans, repeated that his baseline expectations were for 7 quarter-point increases. However, he mentioned that he believed larger increases remain a distinct possibility if the data suggests they are needed. While Evans had a somewhat more dovish tone his colleagues, even he says 50 bps may be needed.
Philadelphia Fed President Patrick Harker advocated aggressive rate hikes saying, “Inflation is running far too high, and I’m acutely concerned about this.” Esther George of the Kansas City Fed took a much more hawkish argument earlier this week. She favors bringing monetary policy to “neutral” faster like Bullard. Fed economists think the neutral rate is somewhere around 2.5%, so to get there quickly requires 50 bps hikes. She argues that the rationale for removing accommodation should not be difficult with high inflation, strong demand, and a very tight labor market. John Williams of the New York Fed and Loretta Mester of Cleveland also opened the door to supporting 50 bps hikes as well. So the messaging campaign to prepare folks for a 50 bps hike may have begun. Of course, Fed officials may be reflecting their genuine fears as well.
Fixed income markets appear to be anticipating that the hawks have the upper hand. Wall Street banks that anticipate 50 bps hikes are becoming more plentiful. JP Morgan has recently shifted their expectations to a 50-bps hike in May and June. Bank of America expects another 25 bps in May, but the June hike is to be 50 bps in their opinion. Goldman Sachs expects back-to-back 50 bps hikes in May and June as well.
While we always urge you to take Fed Fund futures with a grain of salt, the odds for a 50 bps as of Friday, April 1st were approaching 75%. It’s always unclear to what extent the equity markets have priced this possibility in, but at least some of our team feels that an aggressive Fed solely acting to suppress multi-decade highs in inflationary pressure has not been fully considered by many equity investors. A more “Old Testament” Fed, if you will, could be one of the major headwinds for equities going forward whether the Ukraine-Russia conflict resolves in the short-term, or not.
A big deal in the coming May meeting will also be how the Fed approached quantitative tightening. Rhetoric about large cuts in the Fed balance sheet has been coming out of the hawks as well. The language and developments in the FOMC approach to tightening the balance sheet will be a key piece of information for markets trying to digest how the Fed’s inflation-fighting will play out. Details will be provided on Quantitative Tightening at the May meeting. The benchmark yield on the 10-Year Yield was 2.386%
