January’s commentary is exceptionally late but not without good reason. I had written no less than three drafts that had to be completely scrapped due to data coming in that deviated from consensus (payrolls, CPI) as well as a bevy of Fed speak, both of which moved markets and added more color to the developing story of this year’s markets. In retrospect, I should have just gone with the original and added an “at the time of this writing” disclaimer. So at the risk of a fifth rewrite, all commentary below are my views as of the time of this writing, February 18th, 2023.
We came into the new year with softer inflation data, stronger payroll data and stronger growth data. It appeared as though we were headed towards economic nirvana: a soft economic landing, or perhaps no landing and a pause in Fed rate hikes. Chair Powell at his February 2nd FOMC press conference sounded slightly more dovish than his post-meeting statement, but altogether hinted that the committee felt their 5-5.25% policy target might be appropriate. Initially, the markets weren’t convinced that a 5+% terminal rate and “higher for longer” policy were appropriate. Two year US Treasury yields had been moving lower from their high in Nov ’22 (4.72%) to a low of 4.08% on Jan 18, 2023. Fed Funds Futures was pricing a peak policy rate of 4.86% and a cut to 4.34% by year-end. Currently we see 2 year yields at 4.61% and peak policy rate at 5.28% - quite a move! In my view, this change of heart is a result of a few things:
First: The US consumer’s balance sheet is strong, US households are now as de-levered as the German household. And we know how the Germans love their austerity.
Second: US household FICO credit scores have improved dramatically since the great financial crisis.
Third: We have not seen these levels of unemployment since the 1960s.
So the consumer is de-levered, has good credit and is employed. All of these enable spending, so we have not seen the decline we had hoped for in CPI. Let’s hope that as ’23 unfolds, the consumer is a bit more discerning in their spending otherwise, we could see policy rates headed towards 6% or higher.
Should the market keep playing their game of chicken with the Fed? In a typical business cycle this is all pretty normal. Market participants will try to guess when the Fed is done with their rate hikes and/or when the Fed begins to ease their policy rate. Those that get it right tend to make a lot of money. But is this time different? In my opinion, no. It just feels different because the rate of change has been so dramatic and volatility is elevated. We have not seen these levels of inflation since the 1970s and have not seen a labor market this constrained since a decade before that. The Fed is very wary of another wave of pricing pressures so they tell us they will keep their policy rate elevated for some time. The market thinks otherwise and is fighting the Fed. US Treasury rates volatility as measured by the MOVE Index (1month Treasury Options Implied Volatility) is elevated. From 1990 to 2000 the index average was 101, from 2000 to 2010: 105, and from 2010 to 2020: 71. The index average for the past year was 123 and it now stands at 110. This rate of change is much higher than what we have been accustomed to over the previous decade, during a time of very low growth and inflation. The increase in volatility might take some getting used to as we all continue to guess the future path of interest rates.