Is This the Big One?

Good morning, everyone. Today's employment report changes little in our view. A long week it was! we are far more interested in the dynamics of the US long end going forward than tweaks in probabilities for another 25-basis points. Of course, that changes if dynamics appear to suggest the Fed needs to move another 50-100 basis points higher. Not today's business.?

Let's Take a Look:??

For the people that want to work this is a good economy. Sure, since 2021 we have marked prices to a new normal. Remember, just because the change in the rate of inflation cools doesn't mean prices are coming down. For example, the rent in a major city for a one-bedroom apartment may not be going up as fast, yet the 30-40% increase from before the pandemic is not going away and still stings. Most Americans are not economists. They live their lives and are feeling the pinch regardless of markets cheering the 2023 trajectory.?

In general, there have been few periods in time whereas, we had an unemployment rate like now and the economy sustained a "soft landing" as the current narrative goes. By the way, what is a soft landing? This economy continues to chug along. We have deficit spending that is inconsistent with the economic cycle by a mile. Like Fitch's move or not, it was warranted when you look at US debt levels coming out of the GFC, current rate levels, and political and thus governmental discourse. Passing extreme legislation without partisan spirit is dangerous regardless of the controlling party. And spending trillions with an economy which is growing well above trend is reckless and purely political. At a minimal it leaves no room for fiscal stimulation when you need it. And at some point we will (see 9/11, 2008 housing, 2020 pandemic).?

For now, we remain in this somewhat awkward period. The recession narrative has been annihilated. Not forgotten. Imminent rate cuts pushed out. Today's number by no means pushes the Fed to do anything next month. And the yield curve as a predictor will ultimately be right but with nominal dollars flowing like NY Met players from the roster the timing is extra suspect. But after all, the yield curve inversion in 2019 actually predicted the pandemic recession of 2020! We digress.?

Ultimately, what we learn about the United States economy is resiliency. In some ways today's number does feel a bit like 2019 before the pandemic. Apart from the inflation of course. But when looking at the past recessions over the last 25 years it generally incorporates shocks to the system. Otherwise, pockets of ups and downs but for the most part moving forward.?

This past March was one of those shocks. And as we've learned as recently as last month, the ebbs and flows of the banking sector is ongoing. Although the Federal Reserve came in to lend to banks when depositors were saying no more, the implications and exposures of the current setup, makeup, balance sheet implications of regulatory induced changes since the GFC, and important technological change will force..... well, more change. Simply put, in the coming years we will have less banks. To Powell's point it will still include tiering but the numbers smaller. Our view.?

The bigger point here is the Fed. The interest rate shock to the system. The implications and fallout. And the willingness to utilize programs and vehicles that were once considered taboo. It's even gone so far as to garner attention in the upcoming presidential election as Vivek Ramaswamy called for cutting 90% of the Fed staff. Smart guy but in the world designed over the past 15 years BY the Fed, this pocket of time in March exploited understaffing and lack of initiative not the need for less! Look, we don't agree with it all but we're forced to play by, opine, and hopefully influence the outcomes for the better of the American people and economy.?

We've written at length the competing forces within this period. On the fiscal side, no comment from the Fed, now downgrades, financing at higher rates, and the use of 13(3) programs which have loosened financial conditions. This week, a bat to the long end of the US Treasury market with 10-year real yields threatening a major breakout. And met today with positioning and oversold conditions. But for the Federal Reserve to succeed, and at a minimal higher for longer, financial conditions will need to remain on the tighter side, real yields restrictive more so out the curve, and inflation expectations contained. Lately, energy on the move higher and so too the Fed's 5-year forward, 5-year inflation break even rates.?

Higher for longer is no easy task. This is what it comes down to. And help from the fast money, "this is the big one Elizabeth", lean into the narrative trade helps. Short-term. Long end real yields rising and doing some of the Fed's work. But let's be real (pun intended), the 10-year part of the financing curve matters. And it matters a lot in the grand scheme of things. 5+ percent T-bills? That's happy days as seen from $5.5 trillion in money market funds. Yes, $5.5 trillion. Think about that as a percentage of US GDP. Honestly, it's brutally refreshing, needed, and healthy for capital markets!!!

This is going to take time to play out. To be clear we are not suggesting this time will "end" differently. But this is a very different economic cycle and the timing of which is very tricky. And we are living and learning that since the pandemic hit. On the housing side, lower not higher rates likely brings more inventory online. See the Fed's balance sheet. And with labor, productivity IS normalizing (see this week's release and decade long chart), and the hoarding of labor may ultimately lead to more and quicker layoffs down the road as technology and demographics regain their footing. Again, time and timing.?

So, over 500-basis points of very aggressive and quick tightening. Impacting the financial "system" more relative to markets and the real economy. We've seen this before. But we live in different times. We expect the road ahead to be bumpy. On the inflation side too. It will certainly keep the Fed on their toes. Yet, it doesn't mean they need to go higher and higher. But one must be open to the idea that more work higher could lie ahead. And if that more work is needed, IF, it will likely be painful on many fronts.?

In the end, things?feel?okay for now. The ability for private capital to fill some needed voids is timely. The freeing of assets and balance sheets. The evolution on the flip side (good) of the regulatory changes emanating from the GFC and away from banking. Rate reset risk is all over; sovereign, corporate, CRE, residential, and more. May not be today's business but it's coming and thus the lower rate structure from the Fed (Summary of Economic Projections) and market. Delayed. And more capital requirements coming for the big banks. Clear coming out of March: a strong US banking system highlights the biggest and best. Sure, love tiering (JP) but...It's just a fact and reality of the 2023 world we live in. As one prominent bank CEO put it: it's likely not in the best interests of the American people. Enough said.??

On the ground:?

A beast of a week.?Narratives are powerful. This week was part narrative, part reality. Some of our recaps and highlights:?

1)?10-year UST real yields. Holding now at the upper end (1.80% we've highlighted) following today's NFP and a brutal week for the US long end. This report does little our view. More about positions, market level, and location ahead of corporate issuance, the Treasury's quarterly refunding, and CPI/PPI next week. Totality of data. TGIF! Long end yield moves (term premium) far more relevant right now than tiny moves here and there for another 25-basis points.

2)?Nominals grab the media headlines, but real yields matter most. In 2021 through October 2022 mainly a Fed driven rate hiking story. In the latest episode to cycle yield highs again a different story. Central bank policy is generally the overriding factor with rate and curve shape. But what happens when you combine extreme fiscal and monetary policy with a pandemic and inflation unseen in decades? And it shifts global rate policy in a manner not seen in years. The bear steepening is alive. It's a bit of a head scratcher in the sense that many of the variables have been staring at us now for quite some time. And March a stark reminder, Fed induced long duration portfolio risk in the market. As was the case in 2006-2008 when the Fed peaked, these swings back and forth since October of 2022 typically signal a topping pattern and creating good opportunity. But should we break the cycle yield coupon highs (2022) we are in a territory not seen in a very long time.

3)?10-year UST.?The ascent from ZIRP, 2020. 2021: The Georgia runoff. Transitory inflation. The December 2022 ECI moment. Bullard 1994 (credit yours truly 1st), Brainard (October 2022, long and variable policy lags), March 2023 minefields US rate hiking aggression, Q2 Fed Put 13(3) rate alleviation. On the rise again, higher, and steeper. Of late:

1) Japan shifting, higher and steeper.

2) Solid jobs. Soft landing narrative. Offsides rate cuts.

3) Deficits. TGA replenishing. Increased auction current and forward.

4) Unexpected (expected) downgrade. Symbolic but not to be ignored.

5) Watching paint dry balance sheet runoff. Price sensitive buyers for UST.

6) CRB rising since the May bottom.

7) Two and three handle PPI/CPI. The bottom in headline?

The rounding and chart points are well-defined. The upper end of a year-long range in UST 10-year real yields known: 1-1.80%. The party line from every Fed chair over the last two decades has been the same: The fiscal trajectory is not sustainable but okay for now. We don't comment on fiscal policy.

When you keep rates at ZIRP or close to for 15 years AND money is easy which it is for the US gov't, guess what? There was no belief in a catalyst to move to a scenario we face now: at a minimum cyclical inflation and the need for a much higher rate structure. Higher for longer is not the US gov't's friend.

We've written and highlighted key levels in the UST market. Opportunities into this August refunding depending on one's view. Many accounts looking to add duration with good location above 4% in UST 10-year and getting it. We do believe, a continued move higher in real UST 10-year yields will bite, both economically and with risk assets. But given the move looser in financial conditions since March, a correction in risk may be a welcomed event for this Fed.?

The week ahead: More corporate issuance. Expectations are roughly $35 billion, and markets have been open. The Treasury's quarterly refunding with $7 billion of additional note and bond issuance. And yes, inflation. CPI/PPI, the totality of the data.?

Have a great and safe weekend!?