Friday 9 July 2021

How far behind the curve is the Fed?

Over the last few months Treasury yields have dropped and retraced a large amount of the Q1 sell off.

Commodity prices have peaked, in my view, stimulus has or is peaking, and the usual suspect deflationists are calling for lower bond yields. 

Set against this is the ongoing economic recovery and, in my experience, without a massive unexpected shock and with the ongoing fiscal and monetary stimulus, its hard to see why the US economy would relapse into a recession and deflation. 

The fact that the US Current Account has widened suggests that there is ongoing excess demand in the economy.

Instead, the drop in US 10yr yields since March is probably more down to the combination of a normal consolidation phase following a large move and then some short term supply/ demand technicals, concentrated positioning, stop losses and regulated buyers vs the fact that the 10yr-plus part of the Treasury market is a relatively small amount of the outstanding, with 10-30 year bonds being about 20% of new Treasury issuance.

Instead we are likely to see a normal reflationary cycle of unemployment falling, capex rising/ service industry job creation, wages rising and ultimately a hiking cycle followed by a recession. 

So where are we in this cycle? 

The Fed today published its monetary policy report. Their ongoing conviction is that yes the economy needs more support in the form of ZIRP and continuing QE and that they are not ready to commit to tapering, but might be later in the year. In fact, over half of the FOMC participants expect Fed funds to have zero to two hikes by the end of 2023 with 5 of those expecting zero hikes! 

Unfortunately for them, the strong recovery in the US economy has now led the number of job openings to be larger than the number of U3 unemployed.

The last and only time this has happened before was in early 2018 when Trump was stimulating the late cycle economy and the Fed was half way through their hiking cycle. US 10yr Treasuries were yielding around 2.4-2.5% and fed funds were at 1.4%. 

So even by the Fed's own track record in the most recent cycle, they are far behind the curve, their projections are absurd and the excess stimulus and Fed balance sheet growth is causing many asset bubbles to extend. 

The excess balance sheet growth in the last cycle never really led to a wage-price inflation spiral. So the Fed never got trapped with a large balance sheet leading to excess reserves in the system that then lead to credit growth and rising monetary velocity. 

When asked about when the Fed would unwind its balance sheet, Bill Gross famously quipped 'never'. And for the most part he was right. 

In this cycle however the starting point is with over 3% wage growth whereas in 2009 it was well under 2%. In the last cycle job switcher wage growth almost hit 5% before the recession. 

In this cycle, given we already have more job ads than employable unemployed, most probably wage growth will exceed 5%.

If that combines with credit growth and a weak Dollar then the Fed will be forced to act much earlier than expected. 

Dec 2022 and Dec 2023 Eurodollar futures have diverged this year but Dec 2023 is only pricing in 3-4 hikes and Dec 22 only 2.


As mentioend above the last time the employment market was this strong the Fed was already at 1.40% in early 2018 and by year end had hiked to 2.4%. That sent the 10yr from 2.4% in early 2018 to 3.2% by year end, the cycle high, as in 2019 the economy slowed and manufacturing went into recession.

Fed funds rate:

So if wage inflation starts to rise and point towards higher inflation going into 2022 the Fed will be under immense pressure to speed up policy normalization and hike rates.

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