The Yield-Curve Strawman and the Week Ahead

The US 2-10-year yield curve inverted last week, unleashing an avalanche of commentary about the significance. Simply put, market participants do not believe that the inversion is necessarily a harbinger of a recession, outside of perhaps a few headline writers. Some observers set up a simple strawman and proceeded to knock it down. They do not really argue that the Fed will achieve the proverbial soft-landing by pushing price pressures down without unemployment rising, as the median forecast of Fed officials showed a couple of weeks ago.  

Consider Bill Dudley's latest criticism of the Federal Reserve, published a few hours before the 2-10 curve inverted in the middle of last week. The title says it all:  "The Fed has made a US recession inevitable," and he does not cite the yield curve once. Instead, his focus is on the impact of the necessary tightening on unemployment. It draws on the "Sahm Rule" that holds that if the three-month average of unemployment rises by more than 0.5%, a recession is inevitable. 

The reason our outlook has darkened also had little directly to do with the yield curve. We saw monetary and fiscal policy tightening in a pro-cyclical fashion as the economy pumped-up by massive stimulus, and the easing of the pandemic was already slowing. Say what you want about Powell, but the market has historically aggressive tightening priced in for the rest of the year. The market is not waiting for the Fed to move. Rates have jumped a multiple of the Fed's 25 bp hike. From the March 1 low to the April 1 high, the two-year note rose 120 bp. 

Many critics under-appreciate the power of the central bank's communication channel, which also speaks to the Fed's credibility. Some critics assert that the Fed's credibility has been undermined by being so far behind the curve but are hard-pressed to provide compelling evidence. Also, it seems that the role of the market as a discounting mechanism is not sufficiently recognized. Powell & Co have signaled their intention to hike rates, and the market believes them. That is why 216 bp of tightening has been priced into the Fed funds futures market.   Of the remaining six FOMC meetings this year, the pricing of the Fed funds futures strip is consistent with two 50 bp hikes and leaning (almost 70% chance) toward a third.  

At the same time, fiscal policy is tightening dramatically, but it does not seem to get nearly the same attention as monetary policy. The median forecast in Bloomberg's survey sees the budget deficit going to be more than halved from 10.8% to 5.1%. To say this is the largest percentage point drop in the budget deficit may not capture the magnitude of the fiscal contraction that is underway. Consider that it took four years (2010-2013) to reduce the deficit was as much after the Great Financial Crisis. The smaller deficit in part reflects less spending. The fall in government spending is translated into less household income. Income helps drive consumption, which contributes something on the magnitude of 70% of the US economy.  

In addition to the significant tightening of monetary and fiscal policy, another major headwind is the rise in food and energy prices. The reason that they are excluded from the common but not universal measure of core inflation is not that they are volatile, as some claim. They are excluded because the change in their prices is driven by supply, not demand. And, the headline rate, over time, converges to the core rate, not the other way around. The squeeze on the cost of living will likely adversely impact consumption. The last three recessions were preceded by a doubling of the price of oil. Consider that the 20-day moving average of WTI was near $47.50 at the end of 2020 and is now around $107.60.  

Two tailwinds for growth in recent quarters cannot be counted going forward. First, the inventory cycle is mature after accounting for the lion's share of growth in the final three months of last year. Businesses are still accumulating inventories, but what counts is the change in the change, and this looks set to slow going forward. Also, the boost in savings spurred by the pullback in consumption and the transfer payments have been drawn down, especially for lower- and middle-income households.  

In a relatively subdued week of US economic data, the minutes from the FOMC's recent meeting may be the most anticipated (April 6). Chair Powell said at his press conference that the minutes would provide more insight into its thinking about the coming balance sheet reduction. There are two issues, timing, and pace. Word cues from Fed officials suggest that unwinding can begin shortly after the May 4 FOMC meeting. Like the 2017-2019 experience, there may be a rolling start.  

The balance sheet shrinks when the Federal Reserve does not reinvestment the full amount of the principle of its maturing assets. In 2017-2019, the Federal Reserve allowed a maximum of $30 bln of Treasuries and $20 bln of mortgage-backed securities a month not to be reinvested. A consensus appears to favor a faster pace, and some suspect it can be a combined total of $100 bln. This time, the Fed's balance sheet includes around $325 bln in T-bills; last time, none. This could add another wrinkle, but we suspect the bill sector will not be included in the caps. The maturing of Treasuries will extinguish reserves, and allowing the T-bills to roll off as they mature, the use of the Fed's reverse repo facility will likely decline.  

The next round of major central bank meetings is kicked off by the Reserve Bank of Australia (early on April 6 in Sydney). No one expects it to do anything. Officials have only recently begun allowing for a rate hike this year. The economy is strong, with growth in Q1 expected to be around 1% quarter-over-quarter. The 4% unemployment rate in February matches what appears to be a record low. Wage growth has been modest (2.3% year-over-year in Q4 21). Some see the minimum wage setting in June as a potential inflection point.  

Consumer inflation expectations (Melbourne Institute survey) rose to 4.9% last month, the highest since 2012.   Economists (median in Bloomberg's survey) see Australia's CPI reaching 4.3% this year after 2.9% in 2021. Like other countries, Australia's cut (50%) in the fuel tax will help reduce measured price pressures. On the other hand, the pre-election budget will offer more fiscal stimulus than expected. Australia is also experiencing a positive terms-of-trade shock. The price of its exports is jumping, while import prices are less so. The new free-trade pact with India will not be implemented in a timeframe that would impact monetary policy. Still, it offers an important counter to the deterioration of relations with China.  

The cash rate futures have almost 25 bp fully priced for the June central bank meeting. If this is truly going to materialize, it is reasonable to expect officials to begin laying the groundwork. As a first step, Governor Lowe would recognize the strength of the economy and the easing of Covid.   It seems clear that the monetary accommodation provided during the pandemic is no longer needed. The RBA brought the cash target rate from 0.75% in February 2020 to 0.10% by the end of the year. It seems prudent set a course to get it back to pre-Covid levels. The policy would still be very accommodative, and the cash rate would still be well below inflation and inflation expectations. The swaps market has about 110 bp of tightening discounted over the next six months. This seems too aggressive.  

Two other high-frequency data points are notable in the week ahead. The first is Japan's February current account. Without fail, the February balance always improves from January. This January was in deficit (~-JPY1.19 trillion or ~$9.7 bln), and February is expected to swing back into surplus (~JPY1.45 trillion).   Japan ran an average current account surplus of nearly JPY1.3 trillion. The average in 2019 was JPY1.6 trillion. However, many observers will be surprised that Japan's current account surplus is not driven by trade. On a balance-of-payment accounting, Japan averaged a monthly trade surplus of JPY146 mln last year and JPY12.5 mln in 2019.  

The most important impact of the yen's depreciation may not be to boost exports but to boost the value of its Japanese businesses' overseas earnings. This comes in the form of dividends and coupon payments for portfolio investors. The yen value of foreign-earned profits, royalties, licensing fees, and the like will increase for businesses.  

The second high-frequency data point next week of note is Canada's jobs report. Recall that Canada reported an over-the-top 336.6k jobs were filled in February, of which 121.5k were full-time positions. Given that the Canadian economy is about 1/11 the size of the US, it would be as if the US reported a 3.7 mln jump in nonfarm payrolls. After the revisions announced before the weekend, the US nonfarm payrolls rose by 750k in February. The unemployment rate fell to 5.5% from 6.5%. It is the lowest rate since May 2019. The participation rate is almost as high as before the pandemic (65.4% vs. 65.5%).  

It is unreasonable to expect another report as strong. The median forecast in Bloomberg's survey looks for another 79k jobs to have been filled with over half (almost 42k) full-time posts. This is the last important data point before the Bank of Canada's April 13 meeting. The swaps market has about a 2/3 chance of a 50 bp move then and 170 bp over the next six months (five meetings).  

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