Daily Comment (December 16, 2021)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EST] | PDF

Note to readers: The Daily Comment will go on holiday after Friday’s comment and return on January 3, 2022. From all of us at Confluence Investment Management, have a Merry Christmas and Happy New Year!

Good morning!  So far this morning, financial markets are in risk-on mode.  However, we warn there is a torrent of news this morning that could change sentiment.  We start with a quick run of headlines before we dive into the FOMC’s decision yesterday.

Our coverage begins with a recap of the FOMC decision.  Our regular reporting starts with China news.  The update on economics and policy comes next; it looks like Build Back Better won’t be passed this year.  The international roundup follows, and we close with pandemic news.

The FOMC:  The Fed issued a hawkish statement yesterday, doubling the pace of its taper and signaling, through the dots plot, rate hikes next year.  Here is a snapshot of the dots.

First, yesterday’s meeting:

(Source:  Bloomberg)

And, the September meeting.

(Source:  Bloomberg)

The difference is that at the September meeting, there was one rate hike projected by a small majority.  Most of the tightening was projected for 2023.  That has clearly changed.  The majority is projecting a 0.875% fed funds target by year’s end, which is three rate hikes.  Fifteen of 18 members project two to three rate hikes, and no member signaled no change in rates.  Even the most dovish (Kashkari, Minneapolis FRB most likely) has moved to one rate hike.  The expansion of the balance sheet is set to end by March.

In the economic projections, members are expecting inflation to fall; the core PCE forecast is for 2.7%, up from 2.3% in September.  GDP is also expected to rise to 4.0% from 3.8% in September.  In Powell’s comments, he suggests we are near full employment.  There is evidence that confirms that position, although other evidence suggests otherwise.  In a sense, the decision suggests the Fed has concluded that the pandemic has changed the labor markets, and using the pre-pandemic levels as a benchmark is no longer appropriate.  This means the Fed can declare victory on the labor front and move to confront inflation directly.

Here are our thoughts:

  • Every Fed chair puts his stamp on the FOMC. Some dominate, like Volcker or Greenspan.  Others sway by the strength of the intellect, like Bernanke or Yellen.  Powell is probably best characterized by the term “pivot.”  He is not an economist and seems to bear no allegiance to a particular school of thought within economics.  Because he lacks a core position, he tends to sway with the situation.  Thus, in 2018, he seemed on a path to tightening regardless of the outcome…until, of course, equities cratered, and he rapidly reversed course.  He aggressively moved to support the economy as the pandemic hit, engaging in novel measures to directly backstop various markets usually not supported by the Fed.  Now, after assuring markets that tightening is far off, he suggests it’s coming soon.  To some extent, Chair Powell seems to adhere to the ideas of one of the 21st century’s great thinkers, Groucho Marx, who famously noted, “I have my principals…if you don’t like them, I have others.”
  • Financial markets are used to Fed chairs with ideological leanings. When a course of policy is decided upon, there is a tendency for that policy to be held until some goal is met.  That isn’t the case with Powell.  A course of action decided today may not last if conditions change.  In some respects, this stance isn’t necessarily a problem.  It can allow a chair to move quickly and boldly without the restraints of ideology.  For market participants, it’s a bit like batting against Ebby LaLoosh.  At any point, the bull could be hit.  The financial markets have already built in expectations of rate hikes.  The Fed essentially confirmed that today.  Just be careful “digging in.”  If inflation falls by midyear and there is any cooling of the economy, these expectations could vaporize rapidly.
  • The other thing to remember is that two voters will be gone by the end of January. The president could select doves for three open governor positions and change the stance of the FOMC.  On the other hand, the roster of regional bank presidents voting next year is hawkish.  For now, the path of tightening will be generally supported by the committee.  However, by midyear, it could become less clear.  Of course, as we have noted, the White House has become increasingly deliberative over time, so it may be a while before governor replacements are nominated.
  • Clearly, so far, financial markets are pleased with the tightening decision. There were growing worries that the Fed would ignore signs of inflation.  In the end, the Fed has pivoted yet again to now fight inflation.  It’s only bullish for risk assets if the Fed engineers a soft landing.  Although such outcomes are rare, if any chair can pull one-off, it’s probably this one because he is so flexible.

China news:  The U.S. continues to restrict trade with China.

Economics and policy:  Build Back Better won’t get passed this year, and new money market regulations may be coming.

  • The Build Back Better program is in trouble, as the White House and Congressional leadership can’t seem to sway Senator Manchin (D-WV) to support the measure. It now looks like the bill will not be passed this year, and while we expect something to pass, it will be smaller than the current proposal.
  • Flexport has developed a set of shipping indicators that measures the average time for cargo to move from the exporter shipping dock to when it is ready to go on the water to its destination. Two key areas, the Far East Westbound and the Transpacific Eastbound, show this process takes over 100 days; pre-pandemic, this trip averaged between 50 to 60 days.  These indicators suggest there has been little improvement in supply chains.
  • The SEC is proposing new rules for money market funds (MMK) that are designed to reduce the likelihood of runs. The proposals have not been taken well by the industry.  One proposal would allow for “swing pricing,” which would give MMK the ability to price their NAV by a calculation of the value of the entire portfolio.  Under current rules, MMK will meet redemptions by selling the most liquid elements of their portfolios first; it tends to give an advantage to customers who liquidate the quickest.  The swing price is designed to take away this advantage.  Another proposal would require that at least 25% of the portfolio be either cash or assets that are one day from maturity.  The current rule allowing MMK to suspend redemptions would be rescinded.  We would not expect MMK firms to support these measures, but MMK remains a worry because they typically become unstable during periods of financial stress.
  • Natural gas prices continue to soar in Europe. The weather is turning colder, and tensions with Ukraine are the culprits.  One fallout from the rise in natural gas prices is soaring fertilizer prices, which some farms use as a feedstock.  We will be watching to see if higher fertilizer costs reduce planting or skew the crop away from corn (which needs fertilizer) to soybeans.
  • California is seeing a net migration out of the state; high living costs and taxes are likely leading people to leave.
  • Thinking about being a trucker? The White House wants to help.
  • The EU has been taking the lead on tech policy. Europe’s tech industry is smaller than in the U.S., so the industry has been less effective in lobbying in Brussels.  The rules in Europe are guiding U.S. policy.

International roundup:  Iran installs cameras and Germany expels Russian diplomats.

COVID-19:  The number of reported cases is 272,336,362, with 5,332,813 fatalities.  In the U.S., there are 50,374,554 confirmed cases with 802,511 deaths.  Data show that infection rates are rising rapidly, but so far, fatalities have not, raising hope that the highly infectious Omicron variant may not be as deadly as the earlier version.  For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics.  The FT has also issued an economic tracker that looks across countries with high-frequency data on various factors.  The CDC reports that 599,876,215 doses of the vaccine have been distributed with 488,296,089 doses injected.  The number receiving at least one dose is 239,975,167, while the number receiving second doses, which would grant the highest level of immunity, is 202,845,886.  For the population older than 18, 72.2% of the population has been fully vaccinated, with 61.1% of the entire population fully vaccinated.  The FT has a page on global vaccine distribution.  The Axios map shows increasing cases across most of the East and Midwest.  The mountain states and high plains are seeing falling cases.

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[1] Small wars or operations to stabilize areas, such as Vietnam, Iraq, Afghanistan, or the heavy commitment to NATO.