December 2021
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.
The tone of the minutes changed so dramatically that we see it as an admission that the members had completely misread economic indicators for the last year. So much so that had the Fed not committed to a disciplined communication policy, they would probably raise rates at the meeting later this month. But that would be too drastic a move and has not been communicated, so we’ll look to March 16th for the first rate hike of this cycle.
At least the committee has moved past the transitory inflation discussion that was the basis for flooding the economy with emergency liquidity. Economist are now expecting the central bank to raise rates four times this year and another four times next year. We don’t think that’s likely. The Powell-led Fed has not shown any signs of the boldness a 200 basis point hike would require, especially since such a move is likely to have an adverse effect on what is arguably an overvalued equity market. The logical question is what level of correction would the Fed tolerate. A ten percent correction is unlikely to impact their decision-making, but a twenty percent correction could force them to pause the rate rise, and may even cause them to reverse course and cut interest rates. The point is that the committee members seem to be collectively coming to the realization that they’ve “painted themselves into a corner.”
While the Fed has been slow to come to that realization, bond investors are not waiting until March to adjust rates higher. The price of the 30-year bond is down over ten points since this time last month, trading an astonishing 46 basis point higher in yield. However, the damage hasn’t been limited to the long end. The two-year note is roughly 35 basis points higher for the same period, closing the week at 0.87%. From our perspective this is unmitigated good news, as we’re able to invest at higher and higher yield levels. We expect to continue to keep our portfolios populated with short maturity notes with the strategy of reinvesting maturing notes into higher yielding paper. Our forecast is that one year from now the 10-year note will be roughly 75 basis points higher, starting next year at 2.50%. That’s assuming the Fed is able to convince investors that higher interest rates won’t sink the economy, which is a big assumption. At any rate, 2021 is likely to be a volatile one for the capital markets.
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