Monetary Policy & Inflation | US
Entering Friday’s payrolls number, EDZ2 traded higher than before the June FOMC meeting and the now infamous dots. Since the Fed told the market that recent CPI prints have made them uncomfortable and added two hikes from none to their 2023 forecast, red Eurodollars trade richer than they did beforehand.
There is no shortage of reasons why the front-end trades bid. One, the bond market overall has been extremely strong. Over the last month, the 10y Treasury yield has fallen another 20bps, the 5y 16bps, and the 30y 14bps. So, part of the rally in the very front end of the curve concerns the bond market in general.
This article is only available to Macro Hive subscribers. Sign-up to receive world-class macro analysis with a daily curated newsletter, podcast, original content from award-winning researchers, cross market strategy, equity insights, trade ideas, crypto flow frameworks, academic paper summaries, explanation and analysis of market-moving events, community investor chat room, and more.
Entering Friday’s payrolls number, EDZ2 traded higher than before the June FOMC meeting and the now infamous dots. Since the Fed told the market that recent CPI prints have made them uncomfortable and added two hikes from none to their 2023 forecast, red Eurodollars trade richer than they did beforehand.
There is no shortage of reasons why the front-end trades bid. One, the bond market overall has been extremely strong. Over the last month, the 10y Treasury yield has fallen another 20bps, the 5y 16bps, and the 30y 14bps. So, part of the rally in the very front end of the curve concerns the bond market in general.
The bond market strength has obviously surprised people, but good reasons exist for this rally. First, near-term growth has been revised lower on the back of supply-side pressures and the Delta variant. In terms of real money demand, it has been extremely robust. From bank buying, foreign demand, pensions (STRIPS data shows this) and EM recycling surpluses, there has been no shortage of a real money bid for US fixed income. Adding to this, demand for TIPS as an inflation hedge continues to pressure real yields lower. So, there are both fundamental and technical reasons why fixed income has traded very strongly.
However, the bond market’s technical side should not theoretically be having such an outsized effect on the very front end of the Eurodollar strip. And while growth concerns are real, especially as they relate to Asia, looking at the very front end to the back end of US fixed income, it is over 10bps off its tights (30y vs 1y1y).
The question is, is there a third, stealth factor weighing on US fixed income right now? It may be Governor Lael Brainard.
The choice of Fed chair is seemingly down to Brainard and current Chair Jerome Powell. And while both would be great choices, the market is starting to notice differences between them that are much more apparent now than nine months ago.
Brainard’s Speech in Aspen Was a Clear Push for Fed Chair
The speech was dovish to arguably very dovish. Politics aside, especially on financial stability, Brainard was much more dovish than Powell. One, she essentially took out the September taper announcement by saying she needs to see the September payrolls first. So the earliest announcement is November, which aligns with ‘advance notice’ and plural ‘meetings.’ But Powell was far less committal. On inflation, Brainard quoted the 24-month PCE to show inflation is still close to target at 2.3 and will likely return down next year as base effects/supply chain bottlenecks calm down and fiscal/pent-up consumption turn to headwinds.
From the market perspective, if Brainard’s Fed chair chances are rising, the chances of a hike next year must fall. And I think that is part of the bull steepening we saw at least before Vice Chair Richard Clarida’s speech last week. If Brainard is Fed chair, the ‘overreaction’ premia to inflation must come out. I am unsure the Brainard trade has legs, but it is noteworthy that 10s30s keep steepening and 5s30s are more than 10bps off their lows. The market is trading that Brainard as chair equals a reduced chance of a 2022 hike; that makes sense.
Brainard v Powell
Delta:
- Powell: ‘What we’ve seen though is with successive waves of Covid over the past year and some months now, there has tended to be less in the way of economic implications from each wave.’
- Brainard: ‘Fears related to the Delta variant may damp the rebound in services and complicate the return to in-person school and work in some areas and slow the rotation from goods to services that account for three-fourths of the shortfall in jobs.’
Jobs:
- Powell: ‘This is a very strong labor market. If you look at the number of job openings compared to the number of unemployed, we’re clearly on a path to a very strong labor market with high participation, low unemployment, high employment, wages moving up across the spectrum. That’s the path that we’re on and it shouldn’t take that long in macroeconomic time to get there.’
- Brainard: ‘Thus, as of June, we had closed between one-fourth and one-third of the employment shortfall relative to last December according to a variety of measures.’
Clarida’s Pushback
Clarida’s speech last week clearly showed the big division over Flexible Average Inflation Targeting (FAIT) intra-Board right now: FAIT the concept, or FAIT the rule. We have discussed this in prior posts. One camp is that FAIT is a forward guidance tool that allows the Fed to fight the asymmetry of the zero lower bound (ZLB) via a pro-cyclical expansion of its policy posture. In a sense, to Brainard, FAIT is very much a concept – one purposefully loosely defined, or in Bernanke terms, ‘constructively ambiguous.’
For Clarida, it is much more technical. He sees FAIT as a rule. And given the inflation overshoots so far this year, the price side of FAIT guidance for liftoff will be hit by the end of next year. Clarida noted that employment lags GDP, and many reasons exist to think much of the post-Covid employment shortfall will be made up by the end of next year. So, the three elements of liftoff will all likely be hit by the end of 2022, which Clarida noted today.
For Clarida, showing two hikes in 2023 is consistent with FAIT. For Brainard, there is an innate contradiction with the dots and the Fed’s goals of being purely outcome based.
The Overall Picture
Between Clarida and Brainard, Powell is somewhere in the middle. But Brainard has made it clear where she stands. She is deliberately creating dovish space between her and the rest of the Board of Governors, and the market has taken note. In terms of Clarida vs Brainard, the market has transitioned to the former’s side. The problem is, one is leaving and one might be the next Fed chair. With that said, Clarida follow-through is the hawkish risk of Jackson Hole. In other words, which speech does Powell sound more like, Clarida at Peterson or Brainard in Aspen?