It was fleeting, but for a few hours on Thursday the 30-year bond traded above 4.0% as bond investors debated whether the Fed has again fallen behind in battling inflation. The bout of selling reversed itself on Friday, with the long bond closing out the week unchanged. Fed Fund futures, on the other hand, continue their upward march and are now forecasting a peak rate of 5.45% in September of this year.
This holiday shortened week was free from the wild, unexpected economic data we’ve been seeing since the start of the year. Activity continues to surprise to the upside as has the inflation backdrop. Existing home sales fell -0.7% from last month’s measure, while the second look at Q4 GDP was revised lower to 2.7% from 2.9%. The most eye-popping of the week’s data, the Personal Consumption Expenditure price deflator, the Fed’s preferred measure of inflation, rose 5.4% year-over-year. That measure, when paired with the above expectation CPI released mid-month has taken the steam out of the nascent bond rally that started the year.
With the events of the last few days, February seems like a distant memory. More importantly, it was yet another test of the integrity of the Reserve Cash Management strategy, and it performed as designed. As we have espoused, the emphasis of the RCM is broad diversification and an emphasis on liquidity, and that has served our investors well during the crisis. We’ve emphasized that to keep any more than $250,000 in a bank account is to make an unsecured loan to that institution. The RCM is a strategy that holds the securities in the name of the client, in a separately managed account, at a qualified custodian, thereby eliminating counterparty risk.
This week’s economic data was far worse than we had feared! We had hoped that 400 basis points of rate hikes would have slowed the economy and eased the rate of inflation, but to no avail. The January consumer price index, month-over-month, registered 0.5%, and 6.4% on a year-over-year basis, outpacing consensus expectations.
As we wrote last week, the tone of Chairman Powell’s comments during the post-FOMC press conference left observers with the sense that the Fed was close to a peak in the overnight rate. That view was immediately undone on Friday when the BLS reported that 517,000 jobs were added to the economy in January. Certainly not the outcome expected of an economy teetering on the brink of recession. To counter Powell’s comments, Fed speakers this week resounded their hawkishness. The “jawboning” worked with the 2-year note rising 40 basis points from last week’s low yield. The 30-year yield also rose, but by about half of the 2-year move. The overnight/30-year spread remains inverted and is closing the week at about -80 basis points. As we’ve mentioned before, an inverted yield curve has a negative cost of carry for levered investors. The risk is that those investors tire of the expense and exit the trade causing long rates to rise. Effectively, it’s the inverse of a short squeeze. That realization may have played a role in the disastrous 30-year auction on Thursday. Treasury notes and bonds trade on a when-issued basis for a number of days prior to being auctioned. The practice is useful in that it gives investors a strong idea of the yield level at which the new issue will clear. Yesterday’s 30-year auction had a 3.2 basis point tail. That was a disastrous outcome and equated to about a half point repricing on the bonds bought just before auction.
January was a peculiar month in that the New Year kicked off with a general feeling of malaise in terms of market sentiment stemming from what proved to be a disappointing holiday selling season. The stock market commenced the year trading at the December low as economic data continued to disappoint. The Fed, reacting to the string of weak Q4 economic reports and continued stubborn inflation readings, communicated that they would reduce the magnitude of rate hikes again from 50- to 25-basis points. In holding to their word, they did so at their February 1st meeting. Moreover, the committee members loosely suggested that the peak of the rate would reach 5% and not the 5.25% to 5.50% they communicated just 3 months earlier. That change in messaging succeeded in boosting investor concerns as witnessed in both stock prices and bond yields. The 30-year kicked off 2023 yielding 3.96%, only to close the month at 3.63%, as investors fretted that the economy was on the verge of recession and the Fed would be forced to cut rates later this year. Paradoxically, equity indices rallied for the same reason. The S&P 500 gained more than 6% for the month. While still more than 15% below the all-time high touched in December 2021, the index has rallied nearly 20% off of the 2022 low touched last October.
We thought the lead story for this week was going to be the less hawkish, post-FOMC press conference, but in fact it’s the January employment report. Economists had been forecasting that the economy would add 188,000 jobs in January and the unemployment rate would tick up to 3.6%. Given the increasing number of layoff announcements since December, we thought the actual release would have been about half of the expectation. Instead, the economy generated a staggering 517,000 new jobs during the month and the unemployment rate ticked down to 3.4%. There was no weakness in any of the subcomponents and, to be honest, the report was bewildering.
Fourth quarter GDP registered 2.9% annualized growth, beating the 2.6% expectation, but as is often the case with economic data, the devil is in the details. The growth was driven by rising inventories, government spending, and softening imports. The weakness in imports is mostly due to the Chinese covid quarantine and the resultant slowdown in production. With the Chinese factories humming again, we expect that net imports will revert to being a drain on GDP in the first quarter. Similarly, inventories added nicely to the headline number but that is also likely to flatten this winter. The biggest disappointment in the release was private final domestic demand. The measure of how much Americans wanted to consume fell from 1.1% in Q3 to 0.3% in Q4. That’s a significant slippage in demand, which jibes with the disappointing retail sales registered in the last two months of 2022.
Though it was a holiday shortened week in the U.S., there was plenty of action in the markets. The most significant market-moving news was the Retail Sales report for December. Recall that November retail sales were disappointing, worrying analysts that the holiday selling season was going to be a bust. That worry proved prescient! Retail sales for November were revised down from -0.6% to -1.0% from the October level. On Wednesday the government reported that December retail sales fell -1.1% from the revised November figure. Parsing through the details, the weakness was broad-based, with sales at department stores falling a shocking 6.6% from November’s level.
The December CPI report released on Thursday was a pleasant surprise for investors. The headline CPI fell -0.1% month-over-month, and the year-over-year measure fell to 6.5% from 7.1% the previous month. Core CPI, the measure that excludes food and energy, rose 0.3% over the previous month, a slight uptick from the 0.2% previously reported. Core CPI has fallen to 5.7% year-over-year from the peak of 6.6% reported last September. The market breathed a sigh of relief as witnessed by the massive rally in the long bond on the day of the release, closing nearly two points above the previous day’s close. We suspect that much of the rally was driven by short covering, driving the yield-to-maturity down below 3.6%. At that yield level it’s hard to justify buying from a fundamental perspective.