Powell: Risk Management Mode

Chairman Powell weighs in before the Fed's blackout period. The table is set for November. All eyes should be on inflation expectations. And they come in different forms: consumer an business, economic models, market-based and surveys. Short, medium and longer term. Fed Governor Waller indicating this week: be careful in "cherry picking". Global short-end yield curves continue to reprice. And in the United States, perhaps no surprise the speed in which markets shift from the taper to liftoff. In linear fashion, and Powell's words today regarding the expected path of the economy, taper ends the middle of 2022. Immediate rate increases thereafter? Seems aggressive. Yet, despite the consistent message from the Fed of taper then liftoff and rate increases being a ways off, concerns over rising consumer, business inflation expectations and clear signs worker behavior appears to be shifting toward higher wages, is enough for markets to challenge the Fed's narrative. We expect more curve volatility ahead. Despite the Fed's expedient response to the recent ethics investigation, political dynamics in Washington remain extremely complex, and a Fed Chair Brainard would equate to a steeper, not flatter curve in our view. In general, the evolution of the FOMC into 2022 and in front of the 2022 midterm and 2024 general election, leans dovish. Clearly, not today's trade.

This Past Week:

Fed Governor Waller:" This is why I have always preferred market-based measures because they are formed by investors who are betting with real money about future inflation: skin in the game" It is important to account for all measures of inflation expectations: not to "cherry pick" the measure that one finds most comforting".

Fair to say: the Fed has skin in the game with the TIPs market too.

Vice Chair Quarles: "I would also be quite wary of further increases in inflation expectations in this environment".

5-year TIPS/Treasury break-even rates: moved toward 3% this morning before reversing

Chair Powell from this morning:

The themes remain the same: supply chain, inflation, worker dynamics and central bank expectations. We know central banks don't control supply chains. The fear is broadening dynamics, wages, spillover to the mainstream dialogue and inflation expectations.

Expectations for Fed Rate Hikes Being Pulled Forward: Probabilities June 2022 FOMC

Back in June of 2021, transitory was alive and well with the curve ratcheting flatter in a bull fashion. And now, transitory turned on its head, we have bear curve dynamics. The curve has been very tricky of late. Still, the move recently is explicitly moving liftoff forward. And the curve further out, 5-year forward, 5-year OIS implies higher rates, but shallow cycle and low rate environment looking further out.

Globally, yields have been on the move. And now 10-year nominal Euro yields one of the last standing in negative territory. Chart below pool of negative yielding assets. Declining.

In the US market, we've maintained a bearish stance as we continue to backfill large gaps in the charts from pre-pandemic levels. In 5-year UST: 1.35%. And the 10-year UST equivalent comes in at 1.50% with the market spending time within its pre-pandemic range of 1.50-2%.

Fed Governor Waller

A speech by Fed Governor Waller is being credited as the catalyst for some of the repricing this week. It is interesting throughout this period of extreme uncertainty, how certain FOMC members have presented very open-minded and rational, others stubborn and convicted.

Agree with it or not, there is nothing inappropriate with markets pricing in rate increases for 2022. June does seem tight. With taper baked in, and inflation running hotter and longer than the Fed expected, pricing in potential rate increases in 2022 is rational. The separation of the taper from liftoff, though, is easier said than done. From Waller's speech this week:

CW: "should inflation not subside into 2022, more aggressive action may be needed beyond tapering". Sounds right, markets agree and pricing.

Waller's speech: worth a read our view.?

?https://www.federalreserve.gov/newsevents/speech/waller20211019a.htm

A few relevant excerpts within this period of time:

"I would like to follow up on this last point as it pertains to thinking about inflation. As I mentioned earlier, a lot of commentators, including me, have deflected concerns about high inflation readings being the result of "outliers" or "idiosyncratic". Result: recent high inflation readings are transitory and not broad based. There is a fallacy in doing so that one should avoid in judging whether higher inflation is transitory"

"A similar logic applies to trimmed mean measures of inflation: the Cleveland Fed trimmed mean consumer price index and Dallas Fed trimmed mean PCE. These are measures that censor the tails of the price change distribution avoid having average inflation distorted by extreme price movements.?However, inflation is distilled from many prices, and those prices do not move uniformly. As a result, we may be led to "falsely" dismiss certain price movements and risk being misled as to the true inflation rate"

The Week Ahead

The Fed speak concludes with comments from Powell. The notion of inflation preceding the Fed's desired employment gains was not on the radar. Powell: frustrated and yes, challenging the patient framework. For quite some time in 2021, we have explicitly used the words "risk management" around the collision of the Fed's new framework and pandemic dynamics with inflation. It's taken Powell time, but he's come around. The question now: will he be around?

The shift in the transitory narrative is reflected in the curve. In UST 10-year, creeping of late toward the yield highs of 2021, testing 1.70% overnight. The difference in the 2/10 curve for context between March yield levels and now: 50-basis points. A lot can change between now and the middle of 2022. As we indicated earlier, whether one agrees with the current market pricing or not, there is nothing inappropriate with two rate increases in 2022.

10-year UST. Highlights late 2019/2020 1.50-2% range. And the quarter by quarter story of the US long end: uneven. Georgia runoff, higher inflation expectations, abundant Treasuries, vaccinations to rollout of the TGA, less supply, declining vaccination, Delta variant back to Fed taper, more aggressive liftoff, stickier inflation and expectations. Technical factors and positions in both directions. We have favored higher rates heading into the fall. Tempering around the 1.7-1.75% makes sense short-term with Powell speaking tougher on inflation.

Have a great weekend! Go Army, beat Wake Forest!