April 2022
Last week investors were delighted that the Fed only raised interest rates 50 basis points and Fed Chairman Powell drove home the point that a 75 basis point hike was not forthcoming. However, by the next morning, the relief had been replaced by anxiety that stagflation is on its way, stock prices are too high and the yield curve too flat. Since the announcement, the S&P 500 has tumbled sharply, joining bonds in the year-to-date bear market. The current long bond (2 ¼ % 2/15/2052) is trading at a price of about 82, down from its issue price of 100 in February. At a dollar price of 82, the yield-to-maturity calculates to 3.20%, offering a real interest rate (Treasury rate – inflation rate) of about -5.00%. Moreover, with the latest selloff, the 2-year/30-year yield curve has steepened approximately 45 basis points since April 1st. Typically, the yield curve steepens when market participants believe the Fed is losing the inflation battle.
Despite the rate hike and the Fed’s plan to sell portfolio holdings into the open market (quantitative tightening), the front-end of the Treasury market is still flashing signs of a policy out of balance. Following Wednesday’s hike, the Fed funds target range is 0.75% to 1.00%, but 5/31/22 T-bills are offered at 0.51%, and the Fed’s reverse repo book, the operation designed to soak up excess liquidity, continues to total more than $1.8 trillion. If there wasn’t the massive amount of excess liquidity in the market, the Treasury bill rate would be somewhere between the Fed Funds target range and reverse repo amount would be at or close to $0. In other words, we expect it’s going to take a very long time to withdraw that excess liquidity.
The April employment report came in above expectations, with the U.S. generating 428,000 new jobs in the month, besting the consensus expectation of 380,000. To put that into perspective, 200,000 new jobs per month is the trend growth rate. The U.S. has now recorded 16 consecutive months above the 200,000 new job trend.
The April Consumer Price Index also came in above expectation, climbing 8.3% over last year’s measure. Economists were forecasting an 8.0% year-over-year change, as the prior year comparisons continue to rise, but to no avail. In fact, a deconstruction of the report failed to reveal any instances of weakness. The coming May CPI will have an even higher comparison so, mathematically, we should see a decline in the year-over-year rate, but with the release a month away a consensus forecast has yet to develop.
With inflation remaining begrudgingly high, policy makers and Central Bankers have been saber-rattling. President Biden said that the number one threat to the economy is inflation and that he is “confident the Fed will do its job with that in mind.” We have to scratch our heads a bit with that statement. Arguably the one-two punch that caused the current bout of inflation was the Fed’s quantitative easing program and the Biden sponsored spending bill. Billions of dollars of the spending bill remain unspent and sit on the balance sheet of the states to spend as they see fit. Thankfully, “Build back Better’ was killed by West Virginia Senator Manchin or an additional $2.2 trillion of “made up” money would be adding to the liquidity problems. As Milton Freidman said, “Inflation is always and everywhere a monetary phenomenon.”
For their part, since their 180-degree U-turn on inflation back in December, the various members of the Open Market Committee continue to espouse their commitment to getting inflation under control, while achieving a smooth deceleration of economic growth. We hate to break it to the committee, but it doesn’t happen that way. To reduce inflation, the excess liquidity will need to be withdrawn from the system, borrowing will slow and growth will contract. The trend growth rate of the U.S. economy is 2% and it’s been well above that rate since the second quarter of 2020. Getting back to trend is likely to be painful and leave the current members of the FOMC and the President with a dubious legacy.
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