Judging by the November Consumer Price Index, the Fed’s harsh medicine of higher interest rates is starting to work. While year-over-year CPI still rose 7.1% last month, that’s down from 7.7% in October, and the 0.1% month-over-month increase is exactly what the Fed has been expecting. While the November Producer Price index came in higher than expected, that measure of inflation takes a back seat to CPI in that some of those price pressures can be absorbed by margin compression at the corporate level. The CPI, on the other hand, directly impacts consumers and risks the spiral effect in which consumers expect prices to continue to rise into the foreseeable future.
The reaction has been a swift and steady drop in interest rates across the curve, with the 2-year note dropping from the November high of 4.72% to 4.17% on the day of the CPI release. Similarly, the Fed Funds future contact is now speculating that the overnight rate will peak at 4.82% next May.
For their part, the Fed raised the overnight interest rate 50 basis points at the December meeting, inching the overnight rate closer to that Fed Fund futures target. While the tone of Powell’s post-meeting conference continued to be hawkish, as it should, he tempered that hawkishness saying that rate-hike speed is no longer the most important question. To be sure, the year-over-year comparisons will become easier going forward as the pandemic and supply chain issues wash out and we get a purer look at changes in prices on an ongoing basis. With inflation falling, we expect that the FOMC members will soften their tone and the yield curve will normalize.
The question yet to be answered is how deep the damage the aggressive rate hikes have caused and will it tip the U.S. into recession in the new year. The housing and auto sectors have already rolled over and anecdotally layoffs have been announced but those announcements haven’t yet shown up in the monthly jobs report which continues to register above trend growth. However, if those job cuts begin in earnest, that could translate into an economic downturn.
December is a tricky time for the capital markets as banks, brokers, and investors all endeavor to close the year with their respective portfolios 100% invested. Carrying cash over “the turn”, as year-end is colloquially referred to, is not acceptable in the capital markets. As a result, markets can become volatile to the point of seeming irrational. This year that irrationality is most evident in the Treasury Bill market. We refer to the soon to mature January 5, 2023 Treasury Bill, although the entire nearby Bill market has also been volatile. The Jan 5th Bill yielded 3.60% as of December 15th. Logically, that makes no sense. The overnight Fed Funds rate corridor is 4.25% to 4.50%, and the Fed Reserve Repo program offers a set 4.30% rate for the institutions that qualify for the program, and yet the near-term Bill curve continues to be in disarray as we approach the end of the year. One needs to look no farther than the “Calculated New Cash/Pay Down” section of the Treasury Direct website to understand why. Between December 6th and December 13th, the Treasury paid down $76 billion in Bills; that’s to say that they sold $76 billion Fewer Bills than the amount maturing. In effect, the Treasury tipped the supply/demand of Treasury Bills out of balance which has resulted in wild gyrations in the Bill market. As a result, we expect Treasury Bills to continue to trade rich to the Fed Funds target and the Reverse Repo program into year end.
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