Mr. Justified

MON 06 JUN 2022

From our perch, Friday’s US employment report didn’t really change perceptions on the state of the US economy. While there was some evidence that labor supply shortfalls might be easing a little, current conditions suggest that the labor market is still rather tight. As a result, there was no real change in consensus beliefs on the expected trajectory of the Federal Reserve’s policy cycle and the move to neutrality and beyond. The 16th Eurodollar contract implied yield continues to trade around 3% albeit marginally below the early May high. That is probably a decent approximation of the terminal rate. However, we will only know that after macro conditions deteriorate or something breaks.

As we noted last week, the monthly US employment report has always been key to the Fed’s reaction function and the short term interest rate outlook. The time series below highlights the year-on-year change in non-farm payrolls against the annual change in the Fed funds rate (chart 1).

Of course, the interest rate markets have already priced most of the probable tightening cycle back to around 3%. While no one really knows where the neutral or terminal level is, what we do know is that the Fed is committed to keep hiking rates until “inflation comes down in a convincing way.” Put another way, do not anticipate a market friendly Fed pivot anytime soon even if some of the leading indicators of the cycle deteriorate.

As we have observed over the past few weeks, there has been a notable shift in the prevailing bias from inflation to growth fear. The shift in consensus beliefs is likely a function of consumer, business confidence and the tightening in financial conditions (fall in equity prices). There has also been some tentative evidence that labor supply shortfalls might be easing a little. Job openings have eased from a record high, labor force participation has picked up and wage growth was a little more muted than expected. However, one month of data does not make a trend.

The key conclusion for risk assets (equities and credit) is that the Fed is unlikely to pivot until there is a meaningful or convincing moderation in consumer price inflation. In turn, that suggests ongoing cross asset volatility is likely to continue as rates rise and liquidity is withdrawn (chart 2). The good news is that above average phases of volatility are not always synonymous with a crisis.

In a typical cycle, growth momentum does not deteriorate until rates move above neutral. Of course, that could be achieved by the end of this year and many elements of this episode are anything but typical. Of sense is that volatility is likely to remain elevated, with any near term phases of vol compression opportunities to buy some protection, particularly in credit where the cost of protection remains inexpensive relative to the potential payoff.