To Be Thankful

As we look toward the Thanksgiving week and last month of 2022. Liquidity?issues are still prevalent across the board. And when looking at the US Treasury market, this week Beth Hammack of Goldman Sachs who also chairs the Treasury Borrowing Advisory Committee, speaking about the number of outsized moves in UST 10-year from this year. There are several issues coming into play with regards to not just US markets but globally. The least of which is the collision of excessively high inflation with its counterpart on the multi-year central bank liquidity regimes.?

It is astounding at this point in the year the lack of conviction heading into 2023. What's being discussed on so many fronts rather, is "scenario analysis". Always a part of any research effort but far more pronounced this year as the uncertainty around the economy, global geo-political risks, and central bank policy looms. A global economy that is witnessing the first stagflation environment in decades, coupled with strong talk of recession. For sure, the yield curve narrative is alive, robust, and well. Its history is very steadfast suffice it to say. Timing debatable.?

We opened this morning with what we believe is the game plan for the Fed right now. Bullard yesterday pulling the Taylor Rule out of thin air. We were under the impression the Taylor Rule resided with the Phillips Curve: dead. And throwing a range out there you can drive a truck through, 5-7%. I guess we can call this the Fed's forward guidance if you will. Although in the words of Chair Powell from the November meeting, essentially, "guys, we don't know we just keep revising the SEP each quarter". Thus, part of the uncertainty as we head into next year. Let the jawboning begin as the Fed manages market expectations, potentially further declines in inflation, and overall financial conditions "ripe" to loosen.?

Ultimately, this is a dangerous game for the Fed. The amount of wealth destruction to date has been enormous. And engaging on a warpath to destroy the economy and people's assets is not a good look. And part of the reason we feel Jay Powell's easy work is done. Our contention and focus remain on the cost of funding and a regime shift with Federal reserve policy moving forward. Inflation, liquidity, zero interest rates, QE, you name it. This period has left a very deep dent on prior Fed policy and framework changes. There's still a way to go as we dig out of this hole.?

We are not discounting St. Louis Fed President Bullard's presentation. He's been a leader in the pathway away from QE and zero interest rates. People were laughing when he intimated many months ago how he'd like to see the Fed Funds rate at 3.75% by year end. We are here and with another meeting to go. For markets, and liquidity, 2-year UST yields had moved close to 50-basis points following one constructive CPI print. And we've written from earlier on, and New York Fed Williams stressed this week, the Fed will have challenges with the proper implementation of monetary policy without a US Treasury market that functions properly.?

As we evaluate 2022, and look toward 2023, what matters for markets and the central banks? This week Fed Governor Waller speaking about the Fed's reaction function and pointing to the terminal rate, speed, lags in policy, and the cumulative impact of rate increases to date. So, what's the reaction function for financial markets as we wind down 2022 and look ahead? It would appear we experienced it following this month's CPI reading; the trajectory of inflation (for now). So, after the extreme year we've had in 2022 with the re-pricing and in some cases destruction of financial assets around global interest rates and volatility, can financial assets do better even if the economy decelerates? The answer is likely yes. And yes, it's counterintuitive.?

Markets are very savvy. Even when looking at Bullard's comments yesterday, 2-year UST yields are still 30-basis points off their highs. Telling, at least for now. And risk assets holding in well all things considered. It tells us we're in a much different place than the beginning of 2022. But we've seen these pockets before throughout 2022 (euphoria). And each and every move higher in risk assets this year off the back of a Fed pivot has been met with a steadfast and hawkish hand from the Fed. For markets to truly call the Fed's bluff on reality versus jawboning we will need further confirmation on the inflation front. It hasn't paid to challenge this Fed's resolve.?

Are we declaring victory with regards to risk assets??Not at all, and if anything, when looking at the chart on the S&P as it flirts with the 200-day moving average, the downward channel from the peak still appears intact.?Please see (Chart #1)?below. Similarly,?when looking at (Chart #2)?(Investment Grade OAS), a strong directional re-pricing (2022), room for widening, and like the chart on the S&P (downward), and argument could be made with and upward bias.?

S&P and IG OAS, respectively

On the ground:?

TWO'S?(Chart #3). A 50-basis point rally since the high yield around 4.80%. Now, Bullard: 5-5.25% "minimal" amount Fed should raise to. The Fed is not backing away and setting the stage for the December SEP and a higher terminal rate. As they downshift, the Fed will continue to jawbone markets as the economy economy and inflation evolves. The script has been handed out with Bullard at the hawkish peak.

The chart below showing the clear 2022 direction of UST 2-year yields and consolidation points in a long journey.?Markets shouldn't discount the Bullard presentation or scenario in our view.?

We continue to field questions on the yield curve.

The Fed has broken the yield curve. Pick your poison: 3m/10-year, 3m/3m-18m forward, FF-10-year, UST 2/10.

One part of the curve we watch very closely is UST 2/5- almost now as inverted at UST 2/10. Impressive. Chart below in freefall. Keep an eye on this part of the curve as a sign of something breaking, could very well be abroad.

Bullard floating 5-7% FF. 5-5.25% a floor. The Fed knows what the rolling yield curve inversion means. This is all be design as the Fed speaks of the "pain".

So much for the balance sheet runoff steepening the curve as some suggested, LOL. All about financial conditions, we've written. And we have a Fed hawking them, like a hawk.

If the Fed wants to bend this curve steeper all they need to do is to start selling some MBS. Of course they won't, nor are they concerned about a curve that continues to invert. Recession is a part of the way out, so indicators that suggest as much become less relevant.

Look at it this way, when in history have you seen the Federal Reserve "tighten" policy into a suspected recession??Chart #4?below, UST 2/10 takes us back to the eighties.

The Fed has, is, making it blatantly clear: growth, employment, and financial conditions need to suffer to bring inflation down. There is no gray. The expression of the "suffering, pain" that Powell refers to in the economy needs to manifest itself somewhere. And that somewhere is in the UST 10-year. Conversely, we have Feed speak of a terminal rate at a minimal of 5-5.25% percent and a continued hawkish tone.?

Have a great weekend and Thanksgiving!