Hot Retails Sales Turns Up the Heat on the Fed

The heat on the Fed is only being turned up lately. First, it was last week’s October CPI numbers that had inflation on the tips of everyone’s tongues. Now it’s a hotter-than-expected retail sales report for October that seems to indicate that while consumers may profess to feeling lousy, they are still spending like drunken sailors on shore leave.  Some of the usual Fed voices, like James Bullard, are beating the drum on finishing the taper in spring so as to get to rate hikes sooner. Even retired New York Fed President Bill Dudley, normally pretty level-headed, expected that rates would have to eventually move over 3% to 4% to douse the inflationary embers.

We have mentioned before that with the inflation story jumping from the business pages to the front pages that the Fed will have to do more than preach patience. As mentioned, some of the more hair-triggered Fed officials are already clamoring for action but so far it has been rather quiet from the likes of Powell and the other governors.

The December 15 FOMC meeting looks to be pivotal as it will include updated rate and economic forecasts, along with a possible speeding up of the tapering program. In any event, some cards will be laid on the table at that meeting and we expect some messaging to come from the Fed between now and then.

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Hotter-Than-Expected Retail Sales Adds to Rate-Hiking Expectations

The hotter-than-expected retails sales numbers for October continued to feed rate-hiking expectations for the market. While the retail sales numbers are not inflation-adjusted some of the beat comes from higher prices, but even the sales ex-auto and gas were impressive (1.4% MoM vs. 0.7% expected and 0.5% in September). The results were the third month in a row of impressive sales and argue against the recent sentiment measures that had most recently printed at decade lows in the case of the University of Michigan sentiment survey.

Source: Bloomberg

Those surveys are taking on more of a political bent which obviously colors the results and makes them of limited usefulness. Take the latest University of Michigan survey where self-identified Republicans considered the current environment more depressing than the period during the Great Financial Crisis. Be that as it may, it pays right now to look more at what the consumer is doing and not so much what they are saying.

As shown in the graph above, rate-hiking expectations continue to move up. More than two hikes are priced in by December 2022 and nearly three by December 2023. Right on cue yesterday, St. Louis Fed President James Bullard was making headlines the Fed needed to finish tapering by spring in order to move more quickly to rate hikes. Bullard said he had two hikes penciled in for 2022 but didn’t see the need to go above the terminal rate of 2.5% that stood pre-pandemic. Retired New York Fed President Bill Dudley had opined on Monday that the terminal fed funds rate might need to move to 3% – 4% to quell the recent bout of inflation.

Needless to say, this will be the overriding issue for the Fed for the remainder of 2021 and into 2022. Over the last several years it has been the market pulling the Fed in its direction and right now the market is pulling the Fed’s rate expectations higher.

TIPS Inflation Breakeven Rates Move to New Highs

We wrote a few weeks ago that TIPS inflation breakeven rates had just recently started to roll over a bit indicating some softening in the implied inflation forecast from TIPS investors. That is clearly not the case today after a red-hot CPI report and retail sales for October. The graph below tracks the 5-year and 10-year TIPS Inflation breakeven rate and as you  see there was a brief dip a couple weeks ago that we highlighted but the hotter reports of late have reignited the upward move in both breakeven rates with each moving to all-time highs.

Source: Bloomberg

The breakeven rate is the implied CPI rate that would result in an equivalent yield for the TIPS investor as is received by a traditional 10-year Treasury investor. The breakeven rate increases when the TIPS price increases as less yield is generated from the coupon piece; thus, more is needed from the CPI piece to generate an equivalent yield to the nominal Treasury security.

Another peculiar aspect to this is that as nominal Treasury yields have lagged the move higher by breakeven rates the so-called real yield (nominal yield minus inflation rate) gets more negative which implies an even looser monetary policy position. That’s exactly the opposite of what the Fed is wanting right now. They want to remove some accommodation out of the market not add more to it. That’s just another reason to expect the patient approach at the Fed is probably running out of time.

Agency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 0.49 0.89 1.17 1.51 2.13 2.59
0.50 0.48 0.87 1.11 1.40 1.99 2.48
1.00 0.47 0.83 1.08 1.36 1.90 2.35
2.00 0.82 1.02 1.28 1.78 NA
3.00 1.23 1.72 NA
4.00 1.67 NA
5.00 1.63 NA
10.00 NA

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Published: 11/16/21 Author: Thomas R. Fitzgerald