There is no ceiling on this debt

Tis the season. Covid-19 is not going away. How different governments cope through time will be paramount to their economy. The latest focus is now on Germany and lockdowns in Austria. Vaccines are now readily available and therapeutics are close behind. For markets, feelings of flight to quality in the air. Although impacted by Delta, the US economy emerged well. Certainly, a rise in "cases" should be anticipated here in the US too. The bigger theme is onward and upward in our view.

For the US, vaccinations have peaked. And the economic data has rebounded nicely coming out of Delta. The Philly manufacturing index yesterday, other regional surveys recently and the NAHB point to strong growth. Labor gains of late.

Citi Economic Surprise Index

The cycle continues. Let's look to Europe and Germany. Clearly inflationary pressures. Now, Covid-19 front and center in their biggest economy. So, will the ECB begin to raise rates in a quest to thwart inflation? Christine LaGarde has already said no. But the point here is: it will be hard for central banks to diverge all that much. Just look at global rate direction of late. And with certain other economies reacting stringently to continued variables around the virus, central banks in many cases will proceed with caution.

2-year Interest Rate Swap Levels: Europe versus the United States

Fed Chair Waiting Game

For the Fed, still waiting on the President's choice for Fed chair. In the interim, yesterday we had Atlanta Fed President Bostic 'marking to market' his rate increase projections to summer 2022. And even New York Fed President Williams, a known inner-circle dove, expressing as well concerns about the move with inflation expectations and broadening inflation. Focus is still on longer run inflation expectations.

"We definitely have seen a pickup in underlying inflation in the U.S. that we'll be studying carefully"

5y, 5y Forward Breakeven levels still hoovering slightly above the Fed's 2% target

Inflation Politics is complicated: hard to have one's expensive cake and eat it too right now

What's the biggest priority right now politically? Appears very much that higher inflation is the narrative hurting the incumbent party the most at the polls. Very tough play. Someone is the fall guy for "not so transient" inflation. Yet, at the same time, the President's top advisor for economics asking for the Fed to let the economy run hot focused on employment. Suits the market's perception of Fed Governor Brainard and "lower for longer". But inflationary pressures are challenging the notion of holding rates at emergency levels with labor force participation still lagging.

Diverging Opinions on Liftoff and Path: DOT Plot, market pricing and taper speed

We've been discussing with clients the divergence in opinion right now around rate increases and the liftoff. And to a great extent, it all comes down to the taper and timeline. Perhaps too soon at next month's meeting, but a slow move in the labor force participation rate, declining unemployment rate, coupled with sustained higher inflation readings and expectations, could speed the Fed's taper entering early 2022. We favor a continued balanced approach from the Fed with risks skewed toward a faster taper all things known.

Fed Governor Christopher Waller on Monetary Policy today

https://www.federalreserve.gov/newsevents/speech/waller20211119a.htm

"The timing of any policy action is a decision for the FOMC, but for me rapid improvement in the labor market and the deteriorating inflation data have pushed me towards favoring a faster pace of tapering and a more rapid removal of accommodation in 2022.

Chart below: Fed's DOT, FF probabilities and OIS curve. Very flat forward curve.

Fed's DOT plot toward neutral and very flat FF forward curves. Has been a theme of ours for the past few months. Gaining traction with others now. Markets and the economy will not be able to sustain projections this week from former New York Fed Governor Dudley of a peak cycle Fed Funds rate of 3-4%. Emphasizes the importance, therefore, for the Fed to continue reigning in liquidity now. And ideally faster.

Conversely, pricing the end of a tightening cycle between 1.5-1.75% may prove misguided. A steepening of the forward curve would certainly catch the attention of risk assets too. The amount of liquidity to unwind is enormous. Despite hawkish markets, financial conditions although slightly tighter as of late, remain near all-time lows. The Fed has challenges that do need managing.

St. Louis Fed President Bullard has been delivering the news. Votes next year. This week:

1) "think the Fed should move more hawkish over next several meeting to properly manage inflation". We agree, but how hawkish is the question.

And when asked about a faster taper (optionality retained in Bullard's words) and the potential for a taper tantrum, Bullard's response:

"I think we've gotten past the taper-tantrum because we have tapered". True, but...

Broader markets are not priced for a faster taper. Market price action is hungry, illiquid and volatile (rates). A timeline of a faster taper would almost certainly lend to more creeping for rate increases shortly thereafter. Slow, telegraphed, methodical and slow moving tapers have clear advantages and disadvantages. We appear well past the advantages. The Fed's job with a faster taper, if needed, just as important as the taper itself.

MMT Gone Bad

House passes another $1.6 trillion "on the surface". The chart below: the Fed's balance sheet, Effective Funds Rate highlighted since 2008 and CPI. MMT gone bad. We are now roughly $6 trillion deep since the pandemic began. And complaining about inflation and the need to spend more in the same breath. All of this, amidst one of the most divided government in our country's history. In our first White Paper of 2021 in January, we wrote about the need for a gatekeeper: the Fed. That has hardly emerged. As Vice Chair Clarida said throughout 2021: there is no lower bound on fiscal spending. Inflation: spending/quantity of goods and services.

US Rates and market direction: Whipsaw continues

We write a lot about financial conditions. Over the past few days, financial conditions have finally begun to tighten. But let's keep it in perspective, still near all-time lows. The USD has been quietly strengthening since the FOMC pivot this past June. And with inflation in the US a standout based on extremes in monetary and fiscal policy, the market's pricing of more aggressive action on the interest rate side.

The USD- since the June FOMC. Flatter curves, higher USD. More hawkish Fed.

In general, the US longer end is reflecting a few realities and perceptions: 1) continued lack of yield globally in fixed income 2) a general lower rate environment since 2008 globally 3) a shallow tightening cycle with growth and inflation slowing in tow. Sure, the narrative says "potential for policy error". Of the three right now, continued lack of global yield continues to lead as evidenced by strong support in 5 and 10-year UST around the most recent yield highs of 1.25% and 1.70% respectively.

Despite frustrations with outright levels in a world of negative to zero interest rates, we are focused more on the "direction" of moves. Throwing out the extremes in 2021, we are in a 1.25-1.75% range in UST 10-year. And spending time now, all things considered, within the upper quadrant of that range makes sense to us. In 5-year UST, a range of 1-1.25%.

Updated Chart 10-year UST w Moving Averages. Covid-19 fears out of Europe and long end supply behind us. The week's 20-year auction tailed, but far less than 30-years!

Updated Chart 5-year UST w Moving Averages. Covid-19 fears lends to some rate liftoff premium coming off the forward curves. Continued good end-user support in and around the 1.25% level.

Have a safe and healthy Thanksgiving!