Inflation raises risk for the Fed and the markets

Steven Abrahams | February 11, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The January inflation print has raised the ante for the Fed and for debt markets.

It looks increasingly likely the Fed will need to push fed funds toward neutral quickly to cool inflation. But the market is not priced for that or for the risks that come with it. Higher rates and a smaller Fed balance sheet should work eventually, but both are blunt instruments. The case for an inverted yield curve, higher volatility and wider spreads keeps getting stronger.

An uneven grip on inflation

January’s inflation results underscore the uneven grip that the Fed’s theory of inflation—and the market’s theory, as well—has on the phenomenon. When inflation showed up last spring mainly in parts of the economy rebounding from pandemic, it seemed reasonable that supply bottlenecks would resolve, and inflation dissipate. Instead, by the fall, inflation broadened to other sectors. When the labor market seemed tight last summer with labor force participation down, it seemed reasonable that an end to supplemental employment benefits and the beginning of the school year would bring people off the sidelines and wage pressures down. As Stephen Stanley points out, the labor market remains hot and should stay that way through this year. Rising home prices also stand to add momentum to inflation as well. As the Fed acknowledged in November and December, inflation has not proven transitory.

The market still expects inflation to fall back to target

Despite the latest inflation surprise, the market still expects inflation will drop eventually. Since the February 10 report, the average inflation implied by the TIPS market over the next two years has jumped 30 bp (Exhibit 1). Implied 5-year inflation, however, has moved up 7 bp. Implied 10-year inflation, up less than 2 bp. And 5-year forward 5-year inflation—the market benchmark watched most closely by the Fed—has come down by 7 bp. Inflation expectations in the long run sit at 210 bp, just about right where the Fed might hope.

Exhibit 1: Only implied 2-year inflation jumped lately with 5Y5Y down

Source: Bloomberg, Amherst Pierpont Securities

Back to target the easy way or the hard way

The bigger issue for the markets is exactly how inflation will eventually come down. The relatively easy way—resolution of bottlenecks, increased production of vehicles, computer chips and other scarce goods, construction of homes, increased labor force participation—looks unlikely over anything but a long horizon. The Fed may get some help from fiscal drag since the Congressional Budget Office projects federal spending in fiscal 2022 will drop by $1.15 trillion or 16.3%. But it looks like inflation will come down the hard way, with the Fed raising rates and reversing QE in order to reduce demand. There is always risk in that process, but particular risk when inflation is running at its current, disruptive pace.

The case for inversion

One clear disconnect between the market and the Fed is in the path of policy rates. The overnight index swap market, where investors pay a fixed rate and receive the floating overnight fed funds rate, implies fed funds will peak in the second half of 2023 around 2% (Exhibit 2). That is not the way the Fed sees it. The Fed dots have long planted the flag at 2.5% as the neutral fed funds rate—the rate where the economy is not too hot and not too cool. It is not a visible rate or a traded rate, so the Fed’s economists have to estimate it. But to bring inflation down, policy rates have to get above neutral. That happens only two ways:

• Either the Fed pushed funds well above current market pricing and pushes up rates all along the front of the yield curve in the process, or
• The Fed revises the estimated neutral rate down, likely bringing rates in the long end of the curve along for the ride

Either way, it is a recipe for further flattening and inversion of the yield curve.

Exhibit 2: Markets imply fed funds will peak well below the Fed’s neutral rate

Note: data shows forward rates implied by the OIS curve.
Source: Bloomberg, Amherst Pierpont Securities

The case for higher volatility

Remember, too, that central bankers routinely remind their audiences that monetary policy works with long and variable lags. In any cycle, that means the central banks do not know the precise number of steps or their magnitude when policy turns. That uncertainty is heightened today and is likely the reason the FOMC refuses to get pinned down on pacing or terminal rate. The range of possible Fed paths looks likely to get wider before it gets narrower, and that is the case for higher volatility.

The case for wider spreads

It is also worth thinking about exactly what it means to reduce demand. In the abstract, it sounds clinical. In practice, it means raising the cost of funds enough to reduce the ability of business and households to buy stuff. That means less spending, less growth, fewer businesses, less employment. That should raise the premium for taking credit risk.

Managing a bearish market

Investors working for total return have good reason to position for a bearish market. Positioning for a flatter yield curve still makes sense. Moving into stronger credits and reducing spread duraiton in corporate debt and structured products still makes sense. Reducing spread duration by moving into MBS pass-throughs with higher coupons still makes sense, or into ARMs or 20-year pools.

Investors managing assets against liabilities have a different set of opportunities. Almost all assets now trade at much higher yields and wider spreads even to wholesale funding. Longer agency CMBS looks attractive, selected longer private conduit CMBS classes and SASB deals look attractive. For banks largely limited to agency MBS, it is an opportunity to use CMO floaters to make the balance sheet more asset sensitive or to use other CMO structures to make the balance sheet more liability sensitive.

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The view in rates

The FOMC on January 26 left open the door to a 50 bp hike at some point, but the market does not see that yet for March. Fed funds futures price an average rate of 0.47% for April, the first full month after the March 16 FOMC. By the end of 2022, fed funds futures price a rate of $1.64%, equivalent to slightly more than six 25 bp hikes.

The Fed’s RRP facility is closing Friday with balances near $1.635 trillion, only down slightly from last week. Treasury repo remains very soft, so with the RRP facility paying 5 bp, it is getting heavy action.

Settings on 3-month LIBOR have closed Friday at 39.486 bp, up more than 8 bp on the week. Setting on 3-month SOFR have drifted up to 34 bp. At one point on February 10, 3-month LIBOR rates traded slightly below 3-month SOFR.

The 10-year note has finished the most recent session at 1.94%, up 3 bp on the week. The 10-year real rate finished the week at negative 54 bp, down 3 bp on the week. A more aggressive Fed would start balance sheet normalization earlier, with portfolio runoff taking cash out of the market. That should lift real rates.

The Treasury yield curve has finished its most recent session with 2s10s at 44 bp, flatter by only 16 bp on the week, and 5s30s at 38 bp, flatter by 6 bp on the week. The curve should continue to flatten.

The view in spreads

Spreads generally look vulnerable while the Fed is calibrating policy to inflation, and the past week has provided good illustration. Of the major spread markets, corporate and structured credit is likely to outperform, as it has since March 2020. Corporates benefit from strong corporate fundamentals and from buyers not tied to Fed policy. The biggest buyers of credit include money managers, international investors and insurers while the only net buyers of MBS during pandemic have been the Fed and banks. Credit buyers continue to have investment demand.

MBS faces pressure as the Fed considers a quick start to runoff. My colleague Brian Landy projects that new supply of MBS will run at $60 billion a month. He also estimates the Fed will need to allow runoff in MBS of more than $30 billion a month. Without the Fed or banks to take up an average of $90 billion in incremental supply, the burden would likely fall on mutual funds. Mutual funds do not have the capital to fully take up the slack.

MBS also faces pressure from new, higher loan limits on Fannie Mae and Freddie Mac MBS. Higher balances bring more negative convexity. Fed taper also reduces the amount of negatively convex loans filtered out of the TBA floating supply. The quality of TBA should erode this year, and spreads widen with it.

The view in credit

Credit fundamentals continue to look strong but could start to soften later this year if the Fed aggressively dampens demand. Corporations have record earnings, good margins, low multiples of debt to gross profits, low debt service and good liquidity. It will be important to watch inflation and see if costs begin to catch up with revenues. A higher real cost of funds would start to eat away at highly leveraged balance sheets with weak or volatile revenues. Consumers last year put on $1 trillion of new debt, starting to releverage the household balance sheet. Rising home prices and rising stock prices have both added to consumer net worth, also now at a record although not equally distributed across households.