Market turmoil has reached a fevered pitch as investors continue to digest the May inflation reports. Headline year-over-year CPI for May came in at 8.6% versus the consensus estimate of 8.3%, and the ex-food and energy tally came in at 6.0%, a touch above the survey estimate of 5.9%. Contributing to the unease was the University of Michigan survey, a popular coincident indicator of consumer sentiment. The overall sentiment tally plunged to 50 versus 58 last month, and the inflation expectation component for the coming year ticked up to 5.4%. That’s a clear message to Messer’s Biden and Powell of no confidence in their inflation fighting prowess. The market rection to the news has been brutal, with the 2-year Treasury note trading as high as high as 3.43%. Similarly, the S&P 500 is now 22% off the January high.
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 However, by the next morning, the relief had been replaced by anxiety that stagflation is on its way, stock prices are too high and the yield curve too flat.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.
The Halyard Reserve Cash Management (RCM) strategy has encountered an unprecedented sixth consecutive monthly loss. While we are not happy with the string of losses, our conservative positioning has mitigated the downside relative to many of our peers. Since October 1, 2021, the RCM composite has generated a -0.42% loss. Comparatively, PIMCO’s MINT has lost -1.51% and Blackrock’s NEAR has lost 0.82% since October 1st. The loss for the Bloomberg Aggregate Bond Index, the flagship benchmark for the broad fixed income market is down 5.93% for Q1 2022. The loss has accelerated into the second quarter with the Aggregate now down 8.04% YTD thru April 12th.
Losses are unusual for short maturity fixed income portfolios and have been directly influenced by the sharp and steady selloff in the 2-year Treasury note. Since October 1st, the yield-to-maturity of the 2-year note has risen from approximately 0.30% to as high 2.50% earlier this month. The Federal Reserve has been the driver of the sharp rise in short maturity rates. As recently as November, the Fed had assured market participants that the uptick in inflation would prove transitory. Then the Central bank abruptly changed the narrative and communicated that interest rates would need to rise to battle inflation. Since then, the “drumbeat” of forecasted rate rises has gotten louder, and the committee has strongly suggested that there would be a 50 basis point hike at the May 4th FOMC meeting and, likely another 50 basis point at the June 15th meeting, with more to come this year.
The February 24 invasion of Ukraine by Russia has resulted in heightened volatility as bid/ask spreads have widened and liquidity has dried up. President Biden’s decision to punish Russia’s aggression by halting purchases of Russian fossil fuel has caused the price of a barrel of crude oil sky-rocket. West Texas Intermediate briefly touched $130 a barrel on March 7th before settling in around $106 a barrel at the time of this writing. The rise in oil is having a direct impact, as one would expect, on gas prices. While the general population is aware of the dislocations in the capital markets, the rise in the price of gasoline is a direct hit to their wallet and one that has the average citizen worried. Economic forecasters are attempting to back into the price of a gallon of gasoline should the Russian oil ban become a sustained policy, and their forecasts are frightening. Estimates are as high as $150 to $200 per barrel of oil with gasoline topping out at $8 to $10 per gallon. Should the price of a gallon of gas rise to that level, we’re fairly confident that the U.S. economy will be in a recession. As it is, the Atlanta Federal Reserve’s GDP calculator is forecasting 0.041% economic growth in Q1 2022. We wonder how the investing public is going to react to 0% economic growth after enjoying 6 quarters of “eye-popping” economic growth fueled by emergency COVID stimulus. The first estimate of that growth comes at the end of April so we have plenty to worry about between now and then.
Without a doubt, the Federal Reserve should have raised the overnight interest rate interest rate today, February 10th. The Bureau of Labor Statistics (BLS) released the January inflation report and, again, it shocked to the upside. Consensus expectation was that prices would have risen 7.3% year-over-year. Instead, prices rose 7.5% over last year’s basket. The Fed has 2% as their stated target for inflation and when inflation began to exceed that target last year they revised the mandate somewhat to say 2%, on average, given the vagaries of the economic cycle.
Parsing the individual components of the inflation report, the only category that did not exceed 2% was education, rising 1.7% for the year. At the opposite side of the spectrum, energy was up 27%, and the gasoline subcomponent was up 40% compared to last year. For the same period, new car prices rose 12.2% and used car prices rose a whopping 40.5%.
For the second month in a row the non-farm payroll and the household employment reports have diverged. The establishment survey came in at less than half of consensus expectation at 199,000 new jobs, while the household measure registered 651,000 new jobs for the month. That measure was enough to push the unemployment rate down to 3.9%, and just above the post-financial crisis low of 3.5%. That comes on the back of the surprisingly hawkish minutes of the December 15th FOMC meeting. Not only did the minutes solidly indicate a March rise in Fed Funds, the committee apparently had a meaningful discussion on the appropriate size of the Fed balance sheet under normal circumstances. That discussion included how fast they would allow a runoff of maturing securities. The minutes failed to detail a targeted amount, but it’s certainly well below the current balance of $8.2 trillion. They did indicate that a “substantial buffer” is the likely target. Also, some participants favor a complete runoff of the Fed’s mortgage-backed holdings in favor of Treasury debt. That last point could become problematic in a rising rate environment. Mortgage-backed securities are negatively convex, which is to say that as interest rates rise the duration extends. In a rising interest rate environment home owners are less likely to refinance and the pace of maturing MBS would slow, perhaps materially.
Undoubtedly, the most important economic release of the month is the jobs report on the first Friday of the month. Jobs drive the economy! The November report was a bit of a “headscratcher” though. The general public and media look to the nonfarm payrolls as the lead indicator of job gains and in November that number came in well below expectation, registering 210,000 new jobs versus an expectation of 531,000. That statistic is based on a survey of businesses.
Wednesday November 10th provided a proverbial “gut punch” to the capital markets. The day started with the inflation report for October that was way above expectations and was capped with a 30-year bond auction that was an absolute disaster. Year-over-year CPI came in at 6.2% versus the 5.4% registered last month. Fed Chairman Powell continues to believe that the uptick in inflation is going to pass but it’s not happening, and people are not happy about it.
At the September FOMC meeting Chairman Powell and the Open Market Committee failed to signal a concrete start to tapering open market purchases, but they did inch closer. Powel described current economic condition as having mostly met the committee’s standard to begin to taper and suggested that an announcement would be made at the November meeting. It was also announced that the Reverse Repo (RRP) operation designed to sop up excess front end liquidity will be doubled from $80 billion per counterparty to $160 billion. That totals over $12 trillion dollars if every counterparty maxed out the operation! The size of outstanding RRP ballooned at quarter end, totaling over $1.6 trillion, a record for the program.
August proved to be the quietest month of an unusually quiet summer. The 10-year Treasury Note had a 13 basis point range for the period. The supposed highlight of the month was to be Chairman Powell’s comments to the virtual Jackson Hole Central Bank meeting on the last Friday of the month. Despite a cadre of Central Bankers calling for an immediate halt to the open market purchases, the Chairman fell short of that mandate, saying the Open Market Committee is likely to commence tapering before the end of 2021.