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Job Market, Credit Spreads and Inflation Expectations

"The 800 pound guerilla in the room are the central banks. The traditional laws of physics have changed." - Kyle Bass
 

Moment of Clarity II

Last week, I called Wednesday's Fed policy decision a "Moment of Clarity" and a moment of clarity it was indeed. The Fed raised the Fed Funds Rate by 50bps to 0.75-1% and announced the balance sheet runoff to start at $47.5bn/month before increasing to $95bn after 3 months. 

Fed Rate Announcement and Balance Sheet Runoff:

1. Federal Reserve issues FOMC statement
2. Plan for Reducing the Size of the Federal Reserve's Balance Sheet

After a neutral response initially, risk assets rallied hard when Fed Chair Powell took 75bps hikes off the table. Interestingly enough, 75bps hikes were floated around in the run-up to the meeting, which made for an extremely hawkish set-up. Combined with dealer positioning on the options side, a relief rally kicked in and flows drove positive price action into the rest of the day. A day later, the economic current took over again and there we were back in fears around recession or potential stagflation. 

Looking forward and away from micro events, however, let's turn to what remains the global economic backdrop.

The Fed's two mandates are 1.) maximum employment and 2.) stable prices (as defined by 2% average inflation.) The inability to maintain either one of the two requires action via contractionary or expansionary policy. For a long time, maximum employment was at the forefront of the Fed's policy as no amount of money seemed to set off an inflationary cycle -- in fact, central bankers were struggling to ignite sustained inflation. What a luxury problem to have viewed within the current context.

When low inflation is no longer the issue and the pendulum swings in the opposite direction, there are no more good answers and we are only talking about hard trade-offs. Employment still being fairly stable, the Fed will have to scramble to get the Fed Funds Rate up as fast as possible before business sentiment spills over into employment data. At the point at which employment data worsens, demand destruction becomes a very tough tool to use -- further entrenching inflationary fears in the population at large. 

Looking back in time, we can clearly observe that employment - especially on the jobless claims front, - has been a late cycle indicator during prior crises (as a business owner, you won't lay off your employees if you only expect a blip.)

US Employment Data | S&P 500 | 10yr - 2yr Yield Curve

Source: Bloomberg

If a blip suddenly turns into an intermediate to longer-term problem, businesses around the country are going to act accordingly.

On the way from place A to B, we will watch 1.) corporate credit spreads 2.) high yield and 3.) emerging markets. Emerging markets are particularly interesting as the current environment of shifting power structures globally may favor commodity exporting nations insofar as internal stability can be kept in check. Food shortages may put a lid on those nations prospering until we are in the clear on that front, however.

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Charts to Watch | U.S. and Global Economies

US Corporate High Yield | US Corporate Total Return Fixed Income | EM Fixed Income

Source: Bloomberg

Emerging market debt has felt the pain of a rising Dollar combined with concerns around political instability that stems from the current context of global commodity shortages. If and when global famine becomes a real issue, another test of internal stability will face the nations that are already under stress.

We have to balance that fact with the important factor of nations that can export commodities and are able to trade hard assets.

CDX High Yield Spread

Source: Bloomberg

If employment stays at somewhat stable levels and inflation remains elevated, there's a good argument to be made that the Fed won't put on the breaks insofar as credit spreads stay somewhat contained. Are there signs of stress surfacing? Yes. Are we at extremes just yet? No.

5yr 5yr Forward Breakeven

Source: Bloomberg

Long-term inflation expectations have been the last bullet left in the Fed's revolver and it remains so. I like to think of commodities and the degree to which they will entrench inflation expectations as the factor central banks will have to front-run if reigning in demand is the goal. This will be accompanied by a tightening in financial conditions and a constant back and forth that will come in waves -- financial markets rarely move in a straight line.

 

U.S. Inflation SWAPS | GS Financial Conditions, Fed Funds Rate, Money Market Funds Assets

Source: Bloomberg

Be sure to check out prior writings of Top Things to Watch:

• Bank of Japan, European Economic Cycle and the Fed - April 30, 2022
• Commodities and Commodity Cycles - April 17, 2022

 

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Economic Calendar

U.S.

Data Release Times (E.T.)

 

China

Data Release Times (E.T.)

Eurozone (decreasing importance of events from top - bottom)

Data Release Times (E.T.)

 

Food for Thought

Japan Accumulated Government General Bonds Outstanding

Source: Ministry of Finance, Japan (April 2021)

 

Global Demographics

Source: Ministry of Finance, Japan (April 2021)

 

Crude Oil & Natural Gas | Net Managed Money Positioning, Open Interest, Price

Source: Bloomberg

 

Earnings

Tyson Foods (TSN) reporting before the open on Monday:

• Consensus: EPS est. $1.83; Revenue est. $12.84bn

Commentary on the following will be monitored:

• Pricing power and the degree to which costs are getting passed on to the consumer
  • Pricing power
• Wage pressures

• Margins as input costs rise (including energy prices)

 

Suncor Energy (SU) reporting after the close on Monday:

• Consensus: EPS est. $1.31; Revenue est. $9.67bn

 Commentary on the following will be monitored:

• Activist involvement from Elliott Management
• Oil sand and potential efficiencies to be had as oil prices rise
• Any commentary on export agreements with the U.S. as heavy oil from Canada plays an essential role in the refinery process

 

Occidental Petroleum (OXY) reporting after the close on Tuesday:

• Consensus: EPS est. $1.97; Revenue est. $7.96bn

 Commentary on the following will be monitored:

• Berkshire Hathaway investment
• Oil inventory and decline rates

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Fed Bank of Japan Credit Spreads Job Market

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