Take a hike?
Rates continued to grind higher in April as the market prepares for an aggressive tightening cycle by the Fed, with the 2T up 26bps and 10T up 56bps. The 2T/10T spread inverted at the beginning of the month but has since turned back positive, ending the month at ~22bps
The market is pricing in 50bp rate hikes in each of the Fed’s next four meetings, followed by 25bp hikes in each of the last two meetings of the year, for a total of ten 25bp hikes in the remaining six meetings and putting fed funds around 2.85% in December.
Loretta Mester, Cleveland Fed President and 2022 voting member of the FOMC, has said quantitative tightening (QT), or the unwinding of its balance sheet, could begin “as soon as our May meeting.” And the pace of the unwinding is expected to be “considerably more rapidly” than the last time the Fed embarked on QT from 2017 to 2019. We discussed the potential impact of QT in March’s market update, which is likely to be more significant than the market is anticipating.
The accelerated pace of the upcoming rate hikes combined with rapidly unwinding the balance sheet will arguably create the most aggressive tightening cycle since the Volker era in the early 1980s, assuming the Fed follows through.
We have our doubts.
If the Fed does follow through, investing will prove to be more challenging now and into the foreseeable future. Investors and the entire economy have enjoyed a low cost of capital for decades, but the world has changed.
As we mentioned last month, over the previous 40 years, the Fed has ended each tightening cycle with fed funds below the peak reached in the prior one. During the last rate hiking cycle, the Fed stopped hiking rates when fed funds got to 2.25%-2.50%. Based on fed fund futures, the market expects the rate to peak in mid-2023 at roughly 3.25%, about 1% higher than the peak in the previous cycle.
The aggressive stance taken by the Fed would present economic challenges in the best of times, but the Fed has some additional headwinds this time around. We received the first estimate for Q1 GDP, and the print was surprising…showing the economy contracted by 1.4% as the market expected Q1 to be up 1.0%. We will talk more about it below, but the Fed is also dealing with a demographic change that will likely weigh on the jobs market for the foreseeable future.
And while some market participants believe we have reached, or are approaching, peak inflation, the Fed’s preferred inflation gauge jumped to a 40-year high in April of 6.6% (year-over-year). The Fed has inflation squarely in its crosshairs. To reign it in, the Fed wants to tighten financial conditions, but hiking into an already slowing economy will take some serious grit.
The Fed’s tightening also assumes the rate hikes have the desired effect on inflation. If the increased cost of goods is largely attributable to supply chain issues, how much will raising the fed funds rate help fix the problem?
Read between the lines.
There is a long-term demographic shift affecting the jobs market that likely started in 2010. The blue line below represents the number of available workers, and the red line represents the number of open jobs. From 2000 to 2018, the number of workers exceeded the number of open jobs, but the relationship has since turned. There are now more job openings than workers available to fill them. Note that the flip occurred in 2018, before COVID.
Another way to look at the data is the number of available workers per job opening. When the blue line below is above 1, there are more available workers than open jobs. But when the blue line drops below 1, the number of open jobs exceeds the supply of available workers.
Looking at the data over the past 20 years, you can see the trend lower in workers per open job started as the US began recovering from the financial crisis in 2010. This is expected, as unemployment peaked at nearly 10% in Q4 2009 before dropping as monetary stimulus helped spur the economy and tighten the jobs market.
But it is also interesting that 2010 was the year the baby boomer generation was just reaching retirement age. Born between 1946-1964, the group was the largest generation in US history until the millennial generation and represented a highly influential subset of the working population.
If we zoom in on the last five years, we see that the number of open jobs started to exceed the number of available workers in 2018, well before the pandemic hit.
The working-age population in the US appears to have also peaked.
According to the US Chamber of Commerce, “There are 4.75 million more open jobs today than there are people looking for work. One reason for the shortfall is decreased legal immigration. It is past time for Congress to act to modernize our broken immigration system.”
The birth rate in the US has also dropped 20% over the past 15 years…while the people born since 2007 are not old enough to be counted as available workers, it points to further supply disruptions in the labor force going forward.
Cap pricing continues to be pushed higher due to volatility, aka “uncertainty.”
According to the ICE BofA Move Index, a measure of volatility, the current level of volatility is about twice as high as its average over the past five years.
The other variable affecting cap cost is the market’s expectations of rate levels in the future. We can see the increase in expected rates by overlaying a chart of 3-year Treasury yields, which is essentially what the market expects fed funds to average over the next three years.
To help illustrate the effect volatility has on option pricing, let’s look at another time when rate expectations for the following three years (white line) were about the same today. In November 2018, markets expected short-term rates to average 2.94% over the following three years, comparable to the current expectations. But volatility levels (blue line) were less than half as high as they are today. A 3-year cap at 3% on $10MM cost about $115k in Nov 2018. Today’s current cost for that cap is about $235k, with neither cap expected to pay out significantly over the term. The high degree of uncertainty in the market drives this, causing traders to price in a larger “cushion,” or volatility premium, in the event rates move much higher than expected.