2023: Windows of Time

Good morning, everyone. We've been adamant not to extrapolate this period of time, but we need to respect what's going on. And this is a window which has sentiment and the narrative wrong-footed. Yesterday, in speaking with a big recreation center (services ex-housing), a dramatic rate increase across the board just to "maintain services", keep current employees and recruit new ones. Businesses "react" to inflation. They don't raise prices because they anticipate increases a year from now. And although inflation has peaked, prices are simply still adjusting and that was clear from Friday's PCE report. In the end, when you look at the components across the board comprising the Fed's favored measure, PCE, the conclusion reached is the Fed's ultimate ability to control many of its components. For years, decades, no one cared. It was a foregone conclusion with secular stagnation. And central banks spent their time buying bonds, manipulating interest rates, and telling the story of missing their golden 2% inflation target. Keep in mind, Jay Powell's Fed changed their monetary policy framework into the inflation pandemic, abyss trap in August of 2020. We've never looked back.??

Rate markets have been repricing and rightly so. Below we re-share our thoughts from Friday afternoon (The Fed, markets, key data points going forward before the March 22nd meeting) and our weekly summary. The charts for US Treasuries remain bearish across the board with the 2-year UST leading the way (Updated chart below). Consolidating on a likely move through 5%. There is still a contingent of market participants that shun the higher rate story.

Is there reason for caution? 100 percent. In the FOMC Minutes, the commercial real estate market was mentioned more than disinflation (lots of stress). And the outright residential housing numbers are at levels not seen since the global financial crisis. The consumer presents strong, but the fiscal sugar high will wane as the year progresses. And the animal spirits of the post-pandemic period which we believe are still alive, will begin to reflect a bit more of reality later this year into 2024.?

But these points are not today's trade and pocket of time. And the reason we prefer respecting this window of time without extrapolating. For the Fed, they are forced to deal with the issues and data in front of them while also be mindful of the work done and the lags that are likely. And there are lags. It's the timing of these lags and the changed economy post pandemic on the supply side which is creating policy challenges.?

Have a great week ahead!

Let's Take a Look:?

The Fed's favored inflation measure, the Personal Consumption Expenditure Index (PCE) measured higher than market expectations. In our notes this morning this was clearly our lean. As were continued higher rates. In a nutshell, although not a welcomed sign for the Fed and Cleveland Fed President Mester taking a bit of a victory lap this morning in favoring 50 v 25-basis points earlier this month, there are no blinders on from this Fed. They have been consistently hawkish, on their game, and telling markets what they intend to do. Markets have every right not to listen and for the most part up until recently have been tuned out. Mistake.

The services sector, ex-housing in the PCE comprises 54.6% of the index: Healthcare, recreation, transportation (on fire), food, beverage, hospitality, financial services and insurance, travel abroad. One of the main differences between PCE ad CPI is the weighting on services, housing with the PCE's weighting 15-16% lower than the CPI. And the spread over time between the two indices is known but very volatile through the pandemic. What's not as known to mom and pop is the PCE Deflator versus CPI because most people's lives relate more closely to CPI. And in this environment why the Fed and markets have been watching both very closely.?

For those that have been around inflation before it's known that once the genie is out of the bottle it's hard to put back in. Anecdotally, every structural bill that's hit my desk at home of late, prices are higher by 5-10% still. It's insidious, like grabbing your Starbucks one day and a month later the price is up 5% and you may or may not notice it. Bottom line, it doesn't disappear overnight. And when looking at that 54.6% of services, ex housing, higher rates will NOT exactly resolve the issue at hand. Most of us are working harder and paying more for everything. Nominal GDP is still running very high although slowing. And an unemployment rate of 3.5% is not helping the Fed's cause.?

Markets and the Fed: we know the Fed's work is not done. They have TOLD us this repeatedly. And have written 5-10 speeches over the past few months discussing the services side of the inflation equation. The "super core" and very much with an understanding this will take TIME. New York Fed President Williams said recently he expects the Fed to get back to 2% in 2025! Look, we all hope it's sooner. For those that follow and read our work (and TY!), we have long stressed for the Fed to play "long ball". My view is with Mohamed El Erian: the Fed has no credibility to officially change their inflation target but if they go "all out" gunning for 2% they will do significant damage to the economy, jobs, and families. No, the Fed didn't massage the FOMC Minutes, but they will need to massage the message along the way if they get a better trajectory toward 2%. Was the super shock of last year necessary: the Fed was way behind the curve. And for Jay Powell, so long as markets (financial conditions) are reflecting policy (of late yes with the move in real rates, the DXY, and equities awakening), he can likely take a more measured approach signaling a higher terminal if necessary. And longer. The Fed is no longer behind the curve.?

Ultimately, we are still in uncertain times. Consumer behavior is still evolving coming out of the pandemic. Markets are hearing what they want at times, rates included. But very seldom in time will I find myself fading the US Treasury market. Slow to adjust but very quick to catch up. And risk assets very hesitant to follow. The Fed's work is clear: get to a significant enough positive real funds rate. Powell had refenced in the range of 1%. For the Fed now: balancing how high and how long. What's emerged of late is how high is well, higher. We are now pricing terminal closer to 5.50%. If this data persists in the near term the Fed will certainly revise their DOTs higher. And the only thing inappropriate with US Treasury rates of late was a 4%, 3.33%, 2/10-year note. This repricing is completely rational and warranted. And unfortunately, Chair Powell fueled the fire that was in motion on February 1st, to only get hit with a double whammy of stronger employment and higher inflation readings within this pocket of time. Don't extrapolate.??

On 25 v 50-basis points, our feeling remains the same: the Fed made a conscience decision to downsize. The FOMC Minutes highlights the consensus, and we understand who the outliers are. Quite honestly, Bullard has been right. And it very well may be that the Fed was early with the downsizing, but we agree with it and understand the thought behind it. In terms of pricing, we remain skewed toward 25-basis points for next month but there is plenty of data ahead. Certainly, if the data continues this way, a 50-basis point move shouldn't be ruled out although we feel the Fed's preference would be to stick with this pathway and emphasize 1) the endgame (even Mester today highlighted) 2) how committed they are to holding it there depending on economic conditions and the pathway of inflation.?

Key data points ahead:?

3/3: ISM Services

3/10: Employment Friday (late)

3/14: CPI

3/22: Fed Day. New Summary of Economic Projections

On the ground

The US Treasury market continues to trade heavy and rightly so. Offsides and flat-footed with a pocket of declining month over month inflation readings (seen that before and the Fed is aware), disinflation, rate cut euphoria, and looming recession. With that, we respect the long year ahead and one in which will likely bring change and challenges along the way.?

Updated chart: UST 2-year.?

Have a great week!?