“Chill Out… Things Gonna Change”

November 5, 2021

Weekly Summary: November 1 – 5, 2021


Key Observations:

  1. The Federal Reserve (Fed) Chair Powell appeared to convince successfully many investors to “Chill Out,” that the Fed was not behind the curve and that the Fed was ready with the correct policy tools to deal with unexpected contingencies.
  2. The Fed continued to step back from its characterization that inflation was due to “transitory” factors.
  3. We believe that the approach emanating from the Federal Open Market Committee (FOMC) November 2-3 meeting was “hawkish” – quicker-than-anticipated tapering and possible faster interest rate hikes than generally expected. Powell’s use of “patience” language when discussing interest rate hikes led some investors to characterize the FOMC meeting results as “dovish.”
  4. Economic indicators, including October’s U.S. nonfarm payrolls, suggest a continuing expansionary economy, accompanied by inflationary pressures.

The Upshot: Like many other central banks, the Fed appears to be indicating that a “forward guidance” policy approach, often used by central bankers over the past few years, will be increasingly replaced by “data dependency.” The latest U.S. economic data appears to be very strong. To paraphrase Powell, policy will have to adapt to “reality.” The Fed accepts that “things gonna change.” The Fed is just uncertain with respect to identifying the upcoming changes, as well as their timing. By his own admission, Powell acknowledged that it was “very difficult to do economic forecasting now.”


FOMC Meets – Taper Begins

The FOMC decides how to manage U.S. monetary policy. Both the FOMC statement from the end of the committee’s November 2-3 meeting and Fed Chair Jerome Powell in his press conference appeared to take John Lee Hooker’s advice and tried to convince investors to “Chill Out” even though “things gonna change.” It appears that the Fed successfully calmed the financial markets. As expected, the Fed announced that the tapering of its asset purchase program, which is currently $120 billion per month, would begin in mid-November at the rate of a total $15 billion reduction in its monthly purchases for each of November and December. The rate of subsequent tapering was not specified and has been left more flexible.

“The Committee judges that similar reductions in the pace of net asset purchases will likely be appropriate each month, but it is prepared to adjust the pace of purchases if warranted by changes in the economic outlook,” stated the FOMC report. Powell indicated that these adjustments could be up or down. However, we strongly believe that any adjustment would be in the direction of increasing the amount of tapering, which would mean reducing the amount purchased each month. Powell indicated that he expected to see strong inflation numbers into the second or third quarters next year. Many economists expect supply issues to finally ease around that time. Moreover, Powell indicated that he viewed bottlenecks accompanied by strong demand, and not wage increases, which were most responsible for higher and more persistent inflation than the Fed had expected. Given Powell’s expectations, it would stretch credulity that he was contemplating any possible decrease in amounts of tapering.


Powell’s Term Expiring

It should be noted that Powell’s term as Fed Chair expires in February 2022 and President Biden indicated on November 2, that he planned to announce his nominee for this position “fairly quickly.” We believe that Powell was trying to appear as “dovish” as possible in an attempt to secure his nomination, even though we interpret the Fed’s pronouncements as decidedly “hawkish.”


Hawkish Fed?

Let’s examine how Powell managed to convince certain investors and analysts that the Fed was relatively “dovish.” One of Powell’s key comments that appeared very dovish was in reference to the timing when the Fed might begin hiking interest rates: “We think we can be patient. If a response is called for, we will not hesitate.” He also stated that “[w]e don’t think it is a good time to raise interest rates because we want to see the labor market heal further.” And finally, Powell stated, “I don’t think we’re behind the curve. I feel policy is well positioned to address plausible outcomes.” Judging by their November 3 assessment of the Fed’s meeting, Powell was able to at least convince Goldman Sachs that the Fed’s stance was rather balanced – some hawkish elements and some more dovish elements. We remain unconvinced. Our view is much more closely aligned with the November 3 view of Citi Research, which mostly viewed the Fed’s stance as hawkish. Citi’s base case now is that the Fed will increases its taper as early as January and that it will expand its purchase reductions per month from $15 billion to $20-$30 billion, given continued high levels of inflation.


Indications are that Fed is Behind the Curve

In spite of Powell’s words to the contrary, we believe that the Fed’s actions and statements are more indicative of a Fed that believes to be “behind the curve” (not reining in easy monetary policy quickly enough). We believe, as we indicated in previous commentary, that the Fed switched from its focus on headline employment to a focus on various measures of labor market tightness – which Powell specifically enumerated in his press conference – to ensure that their tapering policy would begin as soon as possible. In other words, the Fed did not want to risk a disappointing headline employment number, which would delay the onset of tapering.


Fed Continues to Step Back from Characterizing Inflation as Transitory

The FOMC statement took another “step back” from characterizing inflation as “transitory.” The prior FOMC statement from its September 22 meeting declared, “Inflation is elevated, largely reflecting transitory factors.” In contrast, the comparable November 3 statement claims, “Inflation is elevated, largely reflecting factors that are expected to be transitory.” Looks like the Fed is now only “expecting” certain factors to be transitory that would lead to higher and more persistent inflation. The Fed’s uncertainty is beginning to show.


Is Central Bank Forward Guidance Still a Viable Policy?

In general, many central banks have increasingly relied on “forward guidance” as a primary policy tool over the past several years. It was through these policies that central banks were able to manipulate markets by guiding expectations of market participants. Central banks were able largely to convince market participants to look through certain variables and to focus on what such banks considered to be the underlying trends. Central bankers would then telegraph their intended policies with the implicit promise that any change in policies would be indicated well in advance of their implementation. This approach seemed to work as long as facts and reality could be reconciled with guidance. The recent experiences of the Reserve Bank of Australia (RBA), Bank of Canada (BOC) and the Bank of England (BOE) have shown how banks can lose their narrative when reality overwhelms guidance. The RBA experience was perhaps the most dramatic example of this. The BOE, however, managed to delay this week the onset of interest rate hikes against market expectations to the contrary.


RBA Experience as an Example – Losing Control of its Narrative

The RBA had a target band of inflation in the range of 2% to 3% before it said that it would consider raising its cash interest rate of 0.1%. The cash rate is the interest rate on unsecured overnight loans between banks. The RBA was adamant that this rate would not be raised before 2024. In conjunction with this, the RBA implemented a “yield curve control” (YCC) policy in March 2020, whereby it pegged the yield on the April 2024 bond to the same 0.1% interest rate. When the underlying rate of inflation crossed the threshold of 2.0% to reach 2.1% recently, the Australian bond market overwhelmed the RBA’s pegged rate of the April 2024 bond and pushed up the yield to about the 1.0% level as the RBA refused to defend the 0.1% level. At its November 2 meeting, the RBA officially abandoned its YCC policy. According to a November 2 Reuters story, it also dropped its projection for no cash interest rate rise until 2024. Like the Fed, it also promised to be “patient” on the timing of interest rate hikes as it now pointed to 2023 as a possible time to start interest rate hikes.

The RBA basically admitted that it was “behind the curve.” It also was admitting implicitly that it was now “data dependent.” Forward guidance was beginning to lose its relevance. When the reality of higher inflation superseded the RBA’s projected rates of inflation, the markets essentially took over. Although the details are very different from the RBA saga, both the BOE and BOC were also exposed as being behind the curve and would be “forced” to hike rates earlier than they had anticipated. It is usually very difficult to predict when a central bank can lose its narrative and succumb to market forces.


Fed Still Appears to be “In Control”

So far, the Fed has done a masterful job of appearing to be in control of its narrative. In case anyone was wondering, the Fed even told us that it was not behind the curve. And, by the way, even if it is behind, the Fed is “prepared for different eventual outcomes … policy will adapt as appropriate.” In other words – “Chill Out.” At the same time, while indicating during Wednesday’s press conference that it is “very difficult to do economic forecasting now,” Powell also stated that the Fed is positioning to address a range of outcomes and “will let data lead us.” The Fed is assuming that “things gonna change” – it’s just not sure exactly what will change nor when such changes will occur.


Erratic Fixed Income Responses to FOMC Meeting

On the day of the FOMC announcement interest rates traded higher and the yield curve either steepened or remained stable. The following day, day two, Treasury yields dropped dramatically, but generally steepened. It appears to us that the bond market was focused on Powell’s aforementioned “can be patient” language in regard to when the Fed will start raising interest rates. On day two, the 2-year Treasury yield traded lower as if expecting the Fed to begin raising rates later than it anticipated just the day before. We still believe that these actions indicate the Fed’s belief that it is most likely behind the curve and that is will taper at a more rapid rate than the market anticipates so that it can be ready to start hiking rates if need be. As we illustrated above, at least three major central banks are being prompted by market forces to hike rates more quickly than they had anticipated. Does it make any sense that the Fed will be alone in postponing interest rate hikes? We don’t think so. In fact, Powell acknowledged in his press conference that the Fed’s taper is earlier and faster than the Fed anticipated six months ago, “because policy was adapting to reality.” The Fed has clearly shown by its actions that it will react as the inflation and economic data warrant.

At least two other plausible explanations are possible for the drop in Treasury yields on day two, especially in regard to the 2-year Treasury yield. One possible explanation is extreme positioning betting on higher interest rates and a steepening yield curve, and the other possible explanation is the BOE failing to raise rates that day. The bond markets are now all global. We don’t believe that the U.S. bond market can be viewed in isolation.


Market Reaction to October Employment Data Even More Surprising

Needless to say, the bond market reaction to the very positive October nonfarm payroll data was not what we expected. The 10-year Treasury yield traded as low as 1.457% and the U.S. Treasury yield curve mostly flattened. We believe that this market reaction was mostly due to extreme one-sided positioning anticipating higher yields along with a steepening yield curve. Initially, the financials sector of the S&P 500 was the second-best performing sector that day before retreating. We were encouraged by that initial reaction. We remain very encouraged by the very positive out-performance of the Russell 2000 Index relative to the other major U.S. stock market indexes on that day. We remain steadfast in our expectation of higher interest rates.


Volatility Divergences – Equities vs. Fixed Income

We continue to monitor closely and compare the extremely low equity volatility versus the volatility of many other asset classes. Our focus remains on the relatively high volatility of fixed income relative to equities. As indicated in last week’s commentary, this divergence of volatility measures was recently at a four year high. The VIX (Cboe Volatility Index), which is derived from S&P 500 index options with near term expiration dates, is the most familiar measure of equity volatility. The MOVE Index is a well-recognized measure of U.S. interest rate volatility that tracks the movement in U.S. Treasury volatility implied by current prices of one-month over-the-counter options on 2, 5, 10 and 30-year Treasuries. We find this continued divergence in these two volatility measures somewhat disconcerting with regard to equity valuations. So far, however, the equity markets remain unconcerned about higher volatility measures elsewhere.

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Data Confirms a Strong Economy and High Inflation

Before further deciphering our interpretation of the Fed’s policy stance, at least a brief mention is necessary of our thoughts on economic growth and inflation. The latest economic data for U.S. manufacturing continue to exemplify an expansionary economy whose output production and growth is hampered by continuing bottlenecks and supply constraints, lengthy delivery times, and higher prices. A recent example of this was the October manufacturing survey of the Institute for Supply Management (ISM) announced early this week. The survey results were based on data compiled from purchasing and supply executives nationwide. The data is weighted based on each industry’s contribution to GDP. The latest data on U.S. services seem to indicate that Covid-19 concerns could be mostly behind us. The ISM Services sector survey index for October, which was announced mid-week, hit a record high and greatly exceeded expectations. According to a Reuters November 3 report, the U.S. services sector accounts for more than two-thirds of U.S. economic activity. Like its manufacturing counterpart, supply chain disruptions and shortages of materials and labor constrained the sector’s output capacity. Near record long delivery times and high prices were typical.

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Source: Citi, US Economics: ISM Services hits a new high but supply chains are still broken (11/03/2021)

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Source: Citi, US Economics: Supply issues increasingly evident in ISM manufacturing (11/01/2021)


Q3 U.S. Company Results

Q3 results also indicated a strong U.S. economy. Based on 69% of S&P 500 companies reporting, J.P. Morgan (JPM) disclosed on November 3, that 78% of these companies beat earnings expectations and 72% beat on revenues. On average, revenue growth was about +19% year-over-year while net income growth was approximately +41.1% for the same time frame. Goldman Sachs indicated on November 1, that managements of many companies highlighted pressures from inflation and stretched supply chains. Most companies were able to pass on input costs to maintain their margins. Many managements characterized consumer demand as “healthy.”

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Source: J.P. Morgan, Equity Strategy: Q3 Earnings Season Tracker (11/05/2021)


U.S. October Nonfarm Payroll Employment

The U.S October employment data exceeded expectations and each of September’s and August’s employment gains were revised higher by over 100,000. Slightly more than 30% of the October job gains were attributable to the leisure and hospitality sector. Private payrolls increased by even more than the headline employment gains due to declines in government education jobs. The unemployment rate declined to 4.6% from 4.8% in September. Employment gains were broad-based. Average hourly earnings continued to increase at a healthy pace — +0.36% month-over-month and +4.9% year-over-year. The only disappointment in the October data was that the labor force participation rate was unchanged at 61.6%, remaining in a very narrow range since June 2020. It is about 1.7% lower than in February 2020.


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Source: Citi, US Economics: NFP Preview – Wages, participation becoming more important than job growth (11/02/2021)


Bottom Line

We maintain our belief that interest rates should generally trend higher in the short-to-intermediate term, but in a very unpredictable pattern. The strong economic data and higher inflation data discussed in this commentary increase our assessment of the favorable risk/reward characteristics of purchasing Value and Cyclical types of stocks. This was further confirmed by the recent breakout of the Russell 2000 Index above its February 2021 high. This index measures the performance of the 2,000 smaller companies in the Russell 3000 Index. The Russell 2000 Index is widely regarded as a bellwether of the U.S. economy because of its emphasis on smaller companies that focus on the U.S. market.

We would become increasingly concerned regarding equities if interest rates moved very dramatically in either direction. If dramatically lower, yields would bring into question the attractiveness of Value and Cyclical types of stocks. Alternatively, dramatically higher interest rates would push Growth and Defensive types of stocks to become more problematic. The “sweet” spot of the 10-year Treasury yield, which is most beneficial for the overall U.S. equity markets, appears to be around the 1.60% level.

Given the strong indications of economic growth and higher inflation continuing, we maintain that the Fed really believes that it is behind the curve and is very likely to complete its tapering program earlier than expected so that it is in a better position to start hiking interest rates if warranted. We believe that the economic data will justify the beginning of Fed rate hikes earlier than many investors expect.

November 5, 2021 ICE Formulas
November 5, 2021 Weekly Economic Calendar


KBW Nasdaq Bank Index (BKX): The KBW Bank Index is designed to track the performance of the leading banks and thrifts that are publicly-traded in the U.S. The Index includes 24 banking stocks representing the large U.S. national money centers, regional banks and thrift institutions.

MSCI EM Value Index: The MSCI Emerging Markets Value Index captures large and mid cap securities exhibiting overall value style characteristics across 27 Emerging Markets (EM) countries.

MSCI EM Index: The MSCI Emerging Markets Index captures large and mid cap representation across 27 Emerging Markets (EM) countries.

NASDAQ: The Nasdaq Composite Index is the market capitalization-weighted index of over 2,500 common equities listed on the Nasdaq stock exchange.

PCE: Personal Consumption Expenditures (PCEs) refers to a measure of imputed household expenditures defined for a period of time.

Russell 1000 Growth: The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher forecasted and historical growth values.

Russell 1000 Value: The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected and historical growth rates.

S&P 500: The S&P 500 Index, or the Standard & Poor’s 500 Index, is a market-capitalization-weighted index of the 500 largest publicly-traded companies in the U.S.

VIX: The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX℠) call and put options.

Z-Score: A Z-score (also called a standard score) gives an idea of how far from the mean a data point is. It is a measure of how many standard deviations below or above the population mean a raw score is.



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