June retail sales numbers will be released later this morning, and expectations are that sales will rebound after the May pause which came after strong March and April numbers. The report, however, like most of the recent economic releases is likely to be given short attention by the market. They are more focused on Fed policy and pricing in how quickly the Fed will be moving forward rate hikes due to hotter-than-expected inflation numbers. This week, investors did hear from Fed Chair Powell in two days of  Capitol Hill testimony in which he remained adamant that the pricing spikes we are currently experiencing are transitory and will abate after several months or quarters. We explore the  recent pricing action in both Treasuries and fed funds futures and find the market seems convinced the Fed will move sooner than they forecast and that could lead to a policy error. Does the market have it right?  Read on for our answer.

Fed Error or Market Error?

One of the things we wanted to learn this week was whether Fed Chair Powell was still a strong proponent of leading with the maximum employment mandate over price stability as it pertains to the Fed’s policy reaction function. After two days of Capitol Hill testimony the answer is clearly yes. While many legislators expressed concern over the recent jump in inflation numbers, Powell remained adamant that while the spikes are more than he anticipated and may take longer to recede, he still sees them as stemming from transitory factors, supply-constraints meeting surging demand in certain obvious categories.

Source: Bloomberg

Powell’s focus remains on repairing more fully the labor market while watching inflation, but not letting it dictate policy at this time. We had mentioned before that in the latest dot plot five members felt no rate hikes would be necessary through 2023, and while we surmised that Powell and many of the other Fed governors were in that group, we’re almost certain of it now. No doubt we will hear soon from the inflation hawks on the Fed, with most of those coming from the ranks of the regional Fed presidents, as the latest CPI data surprised to the upside. But as we’ve mentioned before, many of the regional presidents don’t have a vote on policy so their pontifications have to be taken with a grain of salt. Powell seems resolved as ever to continue and push to get the jobs numbers as close to pre-pandemic levels as possible.

One metric that was mentioned multiple times was the Labor Force Participation Rate which is simply those in the labor force (both employed and those unemployed but looking) divided by the population. Because of the unique impact of the pandemic many people left the labor force to care for elderly or children while schools and other facilities faced lockdowns. Getting those people back into the labor force and then finding jobs is a goal that Powell has mentioned repeatedly. Thus, we still see the Fed maintaining a very accommodative posture, and while rate hikes were brought forward in the latest dot plot with the market embracing that message, it will be wise to also listen carefully to those in leadership at the Fed for the message they tell in regards to future policy.

Fed Funds Futures Calling for Three Hikes by December 2023

Despite Fed Chair Powell’s continuing reference to transitory inflation, the market still believes the Fed will be hiking long before 2024 which is where five Fed members had it in the June update to the dot plots.  We’ve surmised that Powell is one of those five dots but the market continues to believe he’ll come around to hiking sooner rather than later like some of his colleagues have already decided in the June update.

Source: Bloomberg

As the graph of Fed Funds Futures for December 2023 shows, investors in those futures see the Fed hiking three times (25bps each) by December 2023 which is a bit more aggressive than the two hikes by December 2023 projected in the latest dot plots. The curious reaction that has many scratching their heads is the rally in the long-end of the Treasury curve in the face of the same updates. That tends to imply a Fed error in hiking either too quickly, or too much, or both. The unique feature of this current pricing is that Fed Chair Powell has specifically mentioned recent instances (like in 2015) when the Fed may have moved too soon, choking off a more robust economic recovery. Powell has also been consistent in calling the latest inflation moves as transitory, even after the hotter-than-expected June numbers. The market, however, seems to see only the median dots rather than consider who owns the individual dots. So while every voting member gets a vote on policy, the Chairman does have considerable sway in framing the debate leading up to the vote. We think Powell is more apt to be patient with existing policy than the median dot implies. That’s something the market should probably consider a bit more in its current pricing calculus.

Agency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 0.12 0.39 0.65 0.96 1.73 2.19
0.50 0.11 0.36 0.59 0.84 1.59 2.08
1.00 0.10 0.33 0.55 0.80 1.49 1.95
2.00 0.32 0.50 0.72 1.38 NA
3.00 0.67 1.31 NA
4.00 1.27 NA
5.00 1.23 NA
10.00 NA

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Published: 07/15/21 Author: Thomas R. Fitzgerald