Baker Market Update – wk220422

Bond yields continued to march higher this week as Fed Chairman Jerome Powell reinforced expectations of aggressive tightening policy including a likely 50bps hike at the next FOMC meeting. Futures markets now project a fed funds rate of nearly 3.00% one year from now. Speaking on a panel with other central bankers, Powell said he sees it as appropriate to move more quickly and suggested that “front-end loading” the pace of rate hikes was a good idea. This follows earlier comments along the same lines from his colleagues on the FOMC. Treasury yields across the maturity spectrum drifted higher on the week as maturities from five years out traded above 3% at times during the week. As we approach the weekend, 10-year is trading around 2.90%, and the spread between 2-year and 10-year T-Notes hovered around 16bps.

The other component of the Fed’s tightening campaign is their intention to reduce the size of their balance sheet beginning next month. Formally announced plans call for a reduction of $95 billion a month in MBS and Treasury holdings. The effect on MBS is expected to be ambiguous depending on coupon and structure. The specific MBS-types held by the Fed will, of course, be affected, but others may perform quite well as the net supply of securities this year will be far less than originally forecast. In any case, much of what the Fed has telegraphed has already been priced-into markets.

Another point of focus for the Fed right now is the very tight US labor market. At 3.6%, the unemployment rate is near a 50-year low, and worker shortages in key sectors are putting upward pressure on wage inflation. Average hourly earnings YOY through March are clipping along at a pace of 6.7%, feeding concerns about a wage-price spiral and the risk that expectations of high and rising inflation could become embedded into decision-making of businesses and households. In his remarks, Powell referenced Paul Volker, his predecessor who squashed the double-digit inflation of the late-1970s with aggressive rate hikes and clarity in communication to the market, saying that Volker understood the critical importance of “dismantling the public’s belief that elevated inflation was an unfortunate, but immutable, fact of life.” The risk, as is well-known, is that this cure for the inflation problem involves some painful economic weakness. It’s a difficult balancing act indeed, but the Fed has no choice. The massive and unprecedented fiscal and monetary stimulus that was injected into the economy over the last two years, coupled with continuing supply chain sclerosis, has now caused a massive imbalance between aggregate supply and demand. And the Fed runs the greater risk of moving to slowly and allowing inflation to continue erosion of real wages, earnings, and returns on investment.

The economic data released this week included monthly numbers on housing starts and building permits, as well as existing home sales. All of these numbers came in stronger than expected (or less-weak than expected in the case of existing home sales). The “Philly Fed” manufacturing index was reported to be a touch lower than estimated, and Leading Economic Indicators was right on the screws at +0.3%, or 6.9% YOY, continuing a year-long downtrend. Next week we can look for fresh data on capital expenditures, consumer sentiment, and new home sales among other things.

US Federal Funds Futures Projections

Source: Bloomberg Finance, L.P.

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