Felt Like 1994

Markets love clarity. In 2020, a combination of monetary and fiscal liquidity were able to steady very rocky waters. In 2021, we kept our foot on the gas on both fronts driving US financial conditions to all-time lows. The end result=2022. Geopolitical dynamics have changed too. As we fret over mask or no mask in the United States, global leaders around us are moving pieces.

The global pandemic has changed more than we know and understand. With certain things in life we have time. But markets don't wait. The emergency measures from 2020 were very necessary on both the fiscal and monetary side. Much of the spending was bipartisan and on emergency measures from Federal Reserve, needed at that time. Ultimately, and we learned from the quickness of recession to recovery, the underlying economy was strong heading in. And it was strong because private capital was functioning, our regulatory environment was friendly, small business was thriving and our labor market was broad-based and inclusive. It was being done with interest rates very similar to what we see today in terms of what's now priced into the spot Treasury curve. Inflationary dynamics; worlds apart. Crystal balls don't exist but the ability to adapt to changing dynamics does. There have been many unintended consequences emanating from this pandemic. And in reality, we don't have all the answers even today.

Chair Powell, January 26th: "So, and I'll say also that we are going to be guided by the data. In fact, what I'll say is we're going to be led by the incoming data and evolving outlook. We will try to communicate as clearly as possible, moving steadily in transparency"

What an epic 48 hours. We realize what markets are saying about seven rate hikes this year. But Michigan Sentiment is flashing something different. Consistently heading lower and the main reason is inflation. The bad news for the consumer; the Fed is likely to make it worse but they have little choice now. 2021 is going to go down as a year of very poor judgement on both the fiscal and monetary side. And it is coming home to roost in 2022. There haven't been too many times in history whereas consumer confidence was down at these levels yet central banks were raising rates. Much higher inflation is changing consumer behavior and this will play out in 2022 in or view on the demand side.

Michigan Expectations versus Headline Consumer Prices

Although not with the committee anymore, it stuck with us the comment from former Vice Chair Clarida last year when he was asked the right question early on; when he thought the Fed would be wrong on inflation: 'by the end of 2021'. And here we are.

Many often refer to 2018 for reference. We have too. Any form of context is valuable within this pocket of time. The chart below highlights a policy mistake then. The Fed ultimately needed to recalibrate both the funds rate and bank reserves. The dynamics we face now are a much different. Subtract those differences. Add them up. The answer: global pandemic.

In 2018: Bank Reserves: 1.8T Balance Sheet: 4T Core PCE: 2% EFFR: 2.5%

In 2022: Bank Reserves: 3.8T Balance Sheet: 9T Core PCE: 5% EFFR: 0%

Even the Fed's Trimmed Mean Measures Offer a Clear Picture: Dallas and Cleveland

2-year Repricing, Bullard and Terminal Funds

This past week, St. Louis Fed President Bullard weighed in. But even with 100-basis points through July, the Fed is a long way from tightening. Ultimately, we are still just removing emergency rate levels. Higher, flatter and quicker has been our theme. The short-end of the US curve is now closer to where it should be for the removal of some emergency rate cuts. We are not priced, however, for a Fed that needs to truly tighten with rate increases closer to or even above the Fed's neutral rate. We've been bearish with an initial target of 1.50% UST 2-year yields. And this past week we reached a cycle high of 1.60%, only to retrace with the news from Washington on Friday warning of a potential imminent attack on Ukraine.

The chart below offers perspective back to 2018 when the Fed was moving closer to neutral before being forced to stop. Back then, inflation was a full 3% lower and long end real rates were 150-basis points higher in UST 10-year. Core PCE in 2018 was 2%.

So, there is still considerable discussion on the balance sheet and terminal funds rate. With all the discussion on emergency rate meetings, we sense the Fed is working feverishly on a gearing of balance sheet runoff. In the end, when looking at the three policy measures back in 2020:

1) 13(3) programs- Pulled back in a timely fashion. Credit SOT Mnuchin.

2) Asset purchases- Too long. RRP. Circa 2021.

3) Rates- See #2. Sequencing. ECB sighting "sequencing" too.

There are some easy wins on the balance sheet this time around given the composition and duration of the portfolio. A good chuck of the buying through the pandemic has been along shorter maturities. Ultimately, if the Fed wants to succeed in moving toward "mainly" UST, they will need to sell agency mortgages. And we have heard this now from several members of the Fed of late. It's not going to happen at the outset but certainly being acknowledged. It is not clear the impact of balance sheet runoff on fighting inflation. Draining excess liquidity yes. One would expect that to flow through to financial conditions, but as we highlighted in charts above, this is a different liquidity scenario than 2018.

Where does the terminal rate belong? The pathway of inflation will determine. Could it mean breaking something along the way? That's been the history.

In many ways, the repricing of the short-end is the easy part. Perhaps not so easy liquidity wise this week, but this is what happens when markets lead the Fed and the discussion on inflation becomes unhinged. Liquidity will play a critical role as we end asset purchases & begin to raise rates. It's being talked about but perhaps not enough.

The US long bond became unhinged before the pandemic. But its rate direction was very much signaling what was coming to the United States. Since 2019, we have been unable to trade higher in yield than the Fed's neutral rate of 2.5%. The absolute rate bands over time moving lower.

The Yield curve.. the Fed hasn't done a thing with rates or balance sheet

The risk over time will be inversion. Although inverted curves generally precede recessions if you look at the charts, the timing is suspect. In other words, in 2019 the yield curve from twos to tens inverted, and the economy wasn't in a recession. Yet, then in 2020 a pandemic related recession. Did the yield curve see the pandemic coming? Of course not. The Fed will have no choice but to accept the flatter or perhaps inverted curve. The optics don't play well but those around inflation are far worse.

7/10 UST

5/10 UST

2/10 UST

Go Bengals!