Baker Market Update – wk220318

This week March Madness arrived in every sense of the word. The ongoing war in Ukraine continues to send shockwaves through the world, including profound effects on financial, foreign exchange and commodities markets. In the midst of that angst, the Fed began a tightening campaign that’s been well telegraphed to markets, and is expected to be the most aggressive in a decade and a half at least. On Wednesday the Fed lifted the Funds rate by 25bps in the first of what is currently expected to be six or seven hikes over the next year, accompanied by a steady reduction of the Feds balance sheet which may begin as soon as this spring. The bond market, always discounting future events, has very quickly priced-in the anticipated tightening. So much so that the yield curve has flattened dramatically to the point where much of the curve is already flat as a pancake at yield levels undulating in a range of 2 – 2.15% as we approach the weekend. The closely-watched yield spread between 2s and 10s is now inside of 18bps. It seems the move communicated by the Fed’s guidance is well baked into the cake already.

Market prices on any given day are a reflection of the discounting future events, but it’s notable how quickly the bond market has adjusted to Fed policy expectations. The math of current yields tells us what the market expects at different points in the future… the so called “forward yield curve.” It’s a moving target to be sure, but today it projects that one year from now the 2yr yield will be 10-20 basis points higher than the 10yr… the sort of inversion that almost always precedes recession.

So, it seems that the market has already made a 1994-type of move… a massive jump in yields in anticipation of a process that the Fed has just barely begun. It leads some to question whether the Fed will actually be able to achieve what they propose. It may well be the case that they will get halfway through the process and find that economic weakness is coming on faster and more intensely than they had expected. Remember too that the gigantic multi-tiered fiscal stimulus that was pumped into household and corporate balance sheets for two-year has also ended. The one-two punch of aggressive and simultaneous monetary and fiscal policy tightening could choke the growth out of the economy and send it into recession, putting an end to rate hikes earlier than expected. All of this is worth considering, but markets cannot and will not ignore the ongoing threat of sustained inflation, particularly concern about the psychology of inflation becoming embedded into economic decision-making. This is why the Fed’s aggressive stance remains the right message and the right plan of action. From that standpoint Paul Volker would be proud. Still, if the inflationary psychology can be kept at bay, and the supply-side bottlenecks and transport issues resolved, the Fed may find that the demand destruction of six or seven rate hikes is more than the economy can stomach. Time will tell.

The economic data released this week was nothing so exciting as to sway the Fed from their task. Jobless claims continued to show improvement in the labor market, core producer prices were lower than expected on a year-over-year basis, the key measure of retail sales was unexpectedly weak, and existing home sales faded more than estimates. But all-told, no great shakes from the data. Next week we’ll see how new home sales, durable goods and capital expenditures are trending, along with news on consumer sentiment.

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