The Rising Influence of Rising Affluence

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The Yield-Curve Strawman and the Week Ahead

http://www.marctomarket.com/2022/04/the-yield-curve-strawman-and-week-ahead.html

Consider Bill Dudley's latest criticism of the Federal Reserve, published a few hours before the 2-10 curve inverted in the middle of last week. The title says it all: "The Fed has made a US recession inevitable," and he does not cite the yield curve once. Instead, his focus is on the impact of the necessary tightening on unemployment. It draws on the "Sahm Rule" that holds that if the three-month average of unemployment rises by more than 0.5%, a recession is inevitable.

The reason our outlook has darkened also had little directly to do with the yield curve. We saw monetary and fiscal policy tightening in a pro-cyclical fashion as the economy pumped-up by massive stimulus, and the easing of the pandemic was already slowing. Say what you want about Powell, but the market has historically aggressive tightening priced in for the rest of the year. The market is not waiting for the Fed to move. Rates have jumped a multiple of the Fed's 25 bp hike. From the March 1 low to the April 1 high, the two-year note rose 120 bp.

Many critics under-appreciate the power of the central bank's communication channel, which also speaks to the Fed's credibility. Some critics assert that the Fed's credibility has been undermined by being so far behind the curve but are hard-pressed to provide compelling evidence. Also, it seems that the role of the market as a discounting mechanism is not sufficiently recognized. Powell & Co have signaled their intention to hike rates, and the market believes them. That is why 216 bp of tightening has been priced into the Fed funds futures market. Of the remaining six FOMC meetings this year, the pricing of the Fed funds futures strip is consistent with two 50 bp hikes and leaning (almost 70% chance) toward a third.

At the same time, fiscal policy is tightening dramatically, but it does not seem to get nearly the same attention as monetary policy. The median forecast in Bloomberg's survey sees the budget deficit going to be more than halved from 10.8% to 5.1%. To say this is the largest percentage point drop in the budget deficit may not capture the magnitude of the fiscal contraction that is underway. Consider that it took four years (2010-2013) to reduce the deficit was as much after the Great Financial Crisis. The smaller deficit in part reflects less spending. The fall in government spending is translated into less household income. Income helps drive consumption, which contributes something on the magnitude of 70% of the US economy.

In addition to the significant tightening of monetary and fiscal policy, another major headwind is the rise in food and energy prices. The reason that they are excluded from the common but not universal measure of core inflation is not that they are volatile, as some claim. They are excluded because the change in their prices is driven by supply, not demand. And, the headline rate, over time, converges to the core rate, not the other way around. The squeeze on the cost of living will likely adversely impact consumption. The last three recessions were preceded by a doubling of the price of oil. Consider that the 20-day moving average of WTI was near $47.50 at the end of 2020 and is now around $107.60.

Two tailwinds for growth in recent quarters cannot be counted going forward. First, the inventory cycle is mature after accounting for the lion's share of growth in the final three months of last year. Businesses are still accumulating inventories, but what counts is the change in the change, and this looks set to slow going forward. Also, the boost in savings spurred by the pullback in consumption and the transfer payments have been drawn down, especially for lower- and middle-income households.

In a relatively subdued week of US economic data, the minutes from the FOMC's recent meeting may be the most anticipated (April 6). Chair Powell said at his press conference that the minutes would provide more insight into its thinking about the coming balance sheet reduction. There are two issues, timing, and pace. Word cues from Fed officials suggest that unwinding can begin shortly after the May 4 FOMC meeting. Like the 2017-2019 experience, there may be a rolling start.

The balance sheet shrinks when the Federal Reserve does not reinvestment the full amount of the principle of its maturing assets. In 2017-2019, the Federal Reserve allowed a maximum of $30 bln of Treasuries and $20 bln of mortgage-backed securities a month not to be reinvested. A consensus appears to favor a faster pace, and some suspect it can be a combined total of $100 bln. This time, the Fed's balance sheet includes around $325 bln in T-bills; last time, none. This could add another wrinkle, but we suspect the bill sector will not be included in the caps. The maturing of Treasuries will extinguish reserves, and allowing the T-bills to roll off as they mature, the use of the Fed's reverse repo facility will likely decline.