Fed Minutes Might Overshadow December Jobs Report

The December jobs report is due out this morning (8:30 ET), but the most consequential market moving event has already occurred and that was the release of the FOMC December minutes on Wednesday. We discuss in more detail below our thoughts on the minutes and what the market got right and wrong in its initial interpretation, but for now, let’s return to the December jobs report which should see a return to near 500 thousand new jobs that were the order of the day until the November miss.

Recall that report had only 210 thousand new jobs, but the Household Survey, which is used to generate the unemployment rate and other labor force measures, posted a near 1 million gain in jobs. That led to a significant move lower in the unemployment rate while the headline jobs number from the Establishment Survey was much more mundane. As it stands now, Bloomberg median expectations are for 433 thousand new jobs with the unemployment rate dipping a tenth to 4.1%. If expectations are met or exceeded we should likely see continued upward pressure on yields as the Fed moves a step closer to fulfilling its full employment mandate, allowing a clearer focus on inflation pressures.


FOMC Minutes Stoke Outsized Market Reaction

FOMC minutes don’t often get the reaction they did from Wednesday’s release of the December meeting, so let’s look at what the market interpreted, rightly or wrongly, from those minutes. The biggest reaction came from the mention of perhaps faster and larger rate hikes than was anticipated at the prior meeting. Recall that at the September meeting the committee was split on whether there would one rate increase in 2022.

Step forward to December and the revised dot plots showed three rate hikes as the median call. The minutes didn’t offer any real new news there but equity traders, who admittedly aren’t ever accused of being astute Fed Watchers, sold fast and furious on the rate-hiking revelation. Remember too that Fed Chair Powell’s congressional testimony two weeks before the FOMC meeting signaled the coming pivot to combat inflation. The December meeting made good on that pivot.

Source: Bloomberg

The other bit of legitimate new news was the discussion around not only ending tapering in March but beginning the process of shrinking the $8.8 trillion balance sheet soon after rate hikes begin. Recall that in the last tightening cycle it took 22 months to begin shrinking the balance sheet after the first rate hike in December 2015. That time frame will surely be shortened this time around, but many thought it would happen only after rate hikes were nearly finished. If inflation and job growth continue strong into March, it wouldn’t be a stretch to see a hike at that meeting, and then setting up shrinking of the balance sheet beginning in June.

One caveat to all this hawkishness from the December meeting is that it occurred prior to the explosion in Omicron variant cases. Will that alter the recent inflation-fighting pivot? We are skeptical of that, if for no other reason than the Fed didn’t give much credence to the Delta variant having a material economic impact. Looking back that was the right play. And with the latest variant having much less severe outcomes, despite soaring case numbers, the Fed is not likely to alter its playbook of expecting little economic impact from the latest virus, other than continued price pressures. All that seems to point to further pressure on long-end yields if tapering is followed quickly by balance sheet run-off.

Real Yields Finally Start to Move Higher. What Does it Mean?

One of the interesting aspects of the fixed income market coming into and through the pandemic had been the reluctance of real yields to move higher. Recall, that real yields are nominal yields minus inflation expectations. Even with pre-pandemic inflation running under 2%, with longer-term yields often sporting 1-handles, real yields rarely moved much above zero. As inflation expectations started to rise coming out of lockdowns last spring, real yields fell deeply into negative territory as nominal yields fell from April through August on economic growth concerns.

Source: Bloomberg

Nominal yields finally began to lift in the fall of 2021 (orange line) but inflation expectations (blue line) also rose. That kept real yields mired deeply in negative territory. 2022, however, has sprung something different. With the Fed’s recent hawkish pivot, inflation expectations are starting to ebb just as nominal yields move higher on the back of new year optimism for growth, a typical January phenomenon.

It seems, for now, investors believe the Fed will move forcefully to contain inflationary forces while at the same time not kill the goose that laid the golden economic egg. History has not been too kind on the Fed piloting such soft landings.  For now, however, the market is giving them the benefit of the doubt. Keep in mind too, this move higher in real yields is in its infancy, but if inflation expectations continue to leak lower and economic growth expectations avoid damage, this early stage increase in real yields could have some legs.

Agency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 0.92 1.25 1.50 1.80 2.30 2.76
0.50 0.91 1.22 1.44 1.69 2.16 2.65
1.00 0.90 1.19 1.40 1.65 2.07 2.52
2.00 1.18 1.35 1.57 1.95 NA
3.00 1.52 1.89 NA
4.00 1.84 NA
5.00 1.80 NA
10.00 NA

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Published: 01/06/22 Author: Thomas R. Fitzgerald