Go Quick, Shallow and Home

Small uptick in the labor force participation rate, Employment to population ratio showing gains along "broad-based and inclusive".

We don't believe the headline miss in the payroll survey changes much regarding short-term Fed trajectory. We do expect revisions to the payroll survey (been uneven throughout 2021, trajectory good) and when looking at the household survey, we are seeing big gains. We are still a believer in a very hot, tight and improving job market heading into 2022. In all of our recent client conversations, the challenges remain the same: demand to hire, trouble finding workers. Big companies, big numbers.

In general, the Fed has shifted gears. And if anything, post-nomination, Powell has joined the party. This committee in general has skewed hawkish and we are hearing this in a very explicit ways by the outgoing, yet still voting members. Vice Chair Clarida: "I along with the other FOMC members see upside risks to inflation".

Outgoing Vice Chairman Quarles this week:

"Our framework indicated we'd wait until we see the "whites in the eyes" when fighting the inflationary pressures". We never said we'd like the army roll over us. "The army is upon us and so now we'll begin to fire".

The Yield Curve

Been involved with yield curves for many years. It is dominating conversations. And clearly impacting allocations in other asset classes. The bigger curves are often distorted with flows and positions. Structurally, the globe still needs yield. And it has simply been difficult for the 30-year Treasury to trade above 2% for long. Conversely, levered money has been finding it very difficult to hold onto bearish rate bets, both curve and outright. The narratives this year. In the end, if we throw out some extreme and disorderly moves, 10-year UST has traded in a 50-basis point range (1.25-1.75%). 5-year forward, 5-year OIS is now close to the lows seen in 2019 (curve inversion) and the summer of 2021.

Ultimately, it's been the legitimate repricing of Fed expectations impacting the 5-year and under maturities which has garnered the most attention over the past 3 months. Even Chair Powell capitulated on transitory this week. These rate moves have been no picnic for many.

And the chart below, the 5 versus 10-year UST curve. A pure one. We overlay the Effective Funds Rate.

These are markets unlike any other. The 5/10 UST curve for some perspective back to 2000 below. The dance, spot and forward curves. Look at this 5/10 UST curve at 23-basis points. Look at where the 5/10 curve was in 2018 when the FF rate was "actually" at neutral. These are conundrum times again and the yield curve is on a crash diet. Yesterday, San Francisco Fed President Daly indicating she doesn't anticipate the Fed needing to tighten beyond 2.50. Sounds great, but the market doesn't think the Fed will tighten beyond 1.50%!

The markets are saying: The Fed will go quick, shallow and go home!!

A few thoughts on the yield curve:

1)?Powell "admitted"?the Fed has been wrong on inflation this week. That's big. When he was asked twice explicitly, the answer was the same: we underestimated the longevity of supply chain issues. This includes labor. The Fed's is using "fighting" words. Unequivocally and across the board. There has been no gray in the communication to "grab optionality in 2022" to raise rates. Flatter curve, short-term.?

?a) VC Clarida did tell us months ago when he thought the Fed would be wrong on inflation. The answer: the end of 2021. We're here.

?b)?Outgoing VC Quarles yesterday: in favor of a quicker taper.?"The Fed will need to tighten rates to bring supply and demand more in line. And although we said we'd like to see the "whites in the eyes" of inflation, we didn't say we'd like the army run us over. The army is upon us and it's time?to fire".?

2)?We live in a lower rate global environment. Stinks, but it's real. Hard to control the posture of other central banks with regards to negative rate policy. Europe matters for the US rate backdrop. But the lack of global yield (structurally) is a continued driver when yields backup. Credit too. We have seen nothing but real money interest to add duration anytime 10-year yields have reached 1.70% or long bonds a little north of 2%. Flatter bias.?

3)?What does the yield curve signal anymore? Perhaps not what we'd like to think. In 2019, the US curve inverted (2/10). Chart below (5/10) held positive. But, we had a very strong economy and job market. Back then, the narrative clear as day "are we heading into recession?". And our answer was clear: no. Obviously, we didn't know the pandemic was coming. The US yield curve in today's day and age is much more reflective of issues outside the domestic economy. I'll never forget sitting as a young trader listening to the seasoned professionals talk about the long bonds they own at 15% and all the reinvestment risk. Little did I know that 3% would be a bargain back then. Hard to steepen meaningfully in that environment.??

4)?The steepening (and we advocated) earlier this year with very?asymmetric dynamics: tons of Treasuries responding to the fiscal spending AND the Fed selling a new framework and transitory. The Fed narrative: we want hot inflation. Transitory was doubted by some, but the market was willing to purchase. Now the house is on fire. Powell threw transitory out the door this week, but the beginning cracks emanated (and we've written) following the June FOMC presser. The charts don't lie. We started with a large bull, position induced flattening in June (5/30 UST). The curve is approaching levels seen in 2018 when the Funds rae was "actually" AT neutral. Bull, bear, bull, bear moves. All within a 50-basis point range in UST 10-year.

5)?Global central banks?have become coordinated "in spirit". Some are hiking, and at a minimal, others pointing in that direction. Some are dropping unconventional monetary policies in a flash. The inflationary dynamics have been far more powerful and lasting. And the risk of embeddedness and expectations. Core CPI and the Fed's PCE have been running "double" the Fed's 2% target.?

6)?Short-term. A quicker taper, which is warranted, construes to quicker rate hikes (market pricing). Insurance and optionality seem rational. If the Fed is right on inflation, rate hikes get pushed back. And if wrong, flexibility to hike a few times. That dynamic is one of "here and now" for markets. No question, this can and likely will change and evolve, but it's not today's trade. Today's trade= quicker taper, quicker hikes, flatter curve.

7)?Positions. Challenged all year: curve and outright. These flows distorting markets and changing the narrative. In the end, on the flip side, higher yields and wider spreads have created opportunities. And this will continue to play out into 2022. There are plenty of portfolios that would welcome wider spreads, higher yields and a Fed which is leaning more hawkish, but still likely to remain accommodative. We are still shifting through that transition. And with that, a flatter bias.?

8)?The Fed's #1?priority right now is fighting inflation and thwarting the potential for unanchored expectations. Given the Fed speak of late, barring surprises on the data side, the biggest surprise would be the Fed not speeding up the taper at this point. And if they wrap up purchases in March, the ensuing meetings are in play and pricing accordingly. We will likely see an obvious shift this month with the Fed's updated DOT lot and Summary of Economic Projections. The Fed will need to sacrifice the desire for more entry back into the workforce to thwart inflation. As Powell said this week: we will not have maximum employment without stable prices".?

Markets

The S/P. Amazing chart. We've had these blips into the 50 and 100-day moving averages. Never meaningfully through since the Fed driven, March 2020 bottom. This pocket of time thus far proving the same. Think a change in Fed posture matters? Sure.

The day traders, a Fed pivot? What's that?

Cash is still plentiful. Fiscal contribution in the US has been the clear inflation differentiator. And it is interesting: Atlanta Fed President Bostic, who's been more hawkish (in general) on rate increases: Slow and steady. Sounds great, but that was the same and succinct message on the taper: boring and slow. And here we are now and shifting toward a March end date. The Fed doesn't know. They are in risk management mode and in search of optionality and insurance. No doubt.?

These types of moves and volatility are significant. Rate markets have been flashing now for months.?The easy money in markets, like fiscal and monetary policy, in the books. 2022 will be a much different and challenging year. Transitory inflation is no longer for sale.

Have a great weekend!