Is the Fed Chasing Rainbows and Unicorns?

  • As yields moved over 4% on the 10yr yesterday, buying interest returned overseas and that has buoyed market sentiment across the curve as the weekend awaits. A hot ISM Services print, however,  has dampened a bit of the early enthusiasm. Currently, the 10yr is yielding 4.00%, up 14/32nds in price, and the 2yr is at 4.89%, unchanged on the day.


  • The ISM Services Index came in stronger-than=expected this morning adding more inflationary fears to a market hypersensitive to that right now. The overall index printed at 55.1 vs. 54.5 expected and 55.2 in January. The prices paid sub-index was strong at 65.6 but that was slightly better than January’s 67.8. The employment sub-index improved to 54.0 vs. 50.0 in January and the new orders sub-index improved to 62.6 vs. 60.4 Overall, another strong read on the services side of the economy and one that will certainly encourage the Fed to continue with the hawkish rhetoric.


  • The reason for today’s title is a tongue-in-cheek reference to the Fed’s insistence on the 2% inflation benchmark in a post-pandemic world. Is it realistic? We get the point of not wanting to move the goal posts for fear of damaging credibility, but we worry too about that last mile of inflation reduction (say 3% to 2%) and at what cost will it come to the economy to get there.


  • Recall that pre-pandemic, we enjoyed a confluence of factors that all contributed to generationally low inflation. The move to offshore manufacturing to the lowest cost producer was exploited over the last decade. The standardization of shipping containers enabled movement of massive amounts of goods globally. The offshoring of manufacturing jobs also contributed to modest domestic labor growth and limited wage-pricing power. Finally, the demographics of slowing population growth in major developed markets contributed to slow growth and demand for fixed income investments and aided in capping prices and yields. Yes, we spent a decade trying to get inflation up to 2% but is that still a reasonable goal in today’s post-pandemic world?


  • The Fed has been unified in voicing their commitment in returning inflation to the 2% benchmark and doing “whatever it takes” to get us there. Just this week, Atlanta Fed President Raphael Bostic who is a moderate, middle-of-the road member not prone to hyperbole, emphasized the need to return inflation to the 2% target. We have no reason to question their sincerity, but we wonder if the messaging might become a little more nuanced as we get closer to 3% on core PCE.


  • With highly publicized supply chain snarls, some of the shortcomings of offshoring, especially in critical areas, became apparent as the recovery progressed and some onshoring from low-cost providers is happening. Also,  with the various stimulus measures put in place early in the pandemic, and more long-term programs like the Infrastructure Bill and CHIPs Act set to inject more stimulus into the economy on a long-term basis, the labor market seems unlikely to cool considerably anytime soon. Also, the pandemic sent many of the 55 and older cohort to early retirement which has crimped the labor force and increased the tightness in the labor market. Also, these departures have negatively impacted productivity. Just yesterday, the latest release showed that 2022 productivity was the lowest since 1974. That’s another negative for pricing pressures as unit labor costs increase as older more experienced workers are replaced with less experienced less productive workers.


  • Thus, getting wage gains and other prices back down to pre-pandemic levels will be challenging at best, and perhaps even unrealistic. Certainly 6% or 8% inflation is unacceptable, but will the consumer really discern the difference between say 2% and 3% inflation?


  • The Fed projects core PCE to dip to 3.5% by year-end and 2.5% by year-end 2024. Will they continue to hold rates at whatever the terminal rate is to get core back to 2% in 2025? And at what cost will that entail to the economy and the labor market? Perhaps the efficiencies that we enjoyed pre-pandemic are just not coming back anytime soon to allow for a return to 2% without significant demand destruction. We think the Fed knows this, and once inflation returns to 3%, or high 2%, that the rhetoric will change, and thus rate cuts may come before a return to 2% is achieved given the economic damage it might entail.




Agency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 5.70 5.50 5.43 5.40 5.40 5.86
0.50 5.69 5.47 5.37 5.29 5.26 5.75
1.00 5.68 5.44 5.33 5.25 5.17 5.62
2.00 5.43 5.28 5.17 5.05 NA
3.00 5.12 4.99 NA
4.00 4.94 NA
5.00 4.91 NA
10.00 NA

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Published: 03/03/23 Author: Thomas R. Fitzgerald