Written by: Steve Majoris | Advisor Asset Management
The January jobs report — headlined by the Change in Nonfarm Payrolls number of 467,000, which was significantly higher than expectations (125,000) — was nothing short of spectacular. In addition to the strong number of jobs added in January, the December number was revised up from 199,000 to 510,000 and revisions from October to December totaled 700,000, which further illustrates the strength of the current labor market recovery. Although the unemployment rate ticked higher, from 3.9% to 4.0%, this can be attributed to the increase in labor force participation and people coming back into the workforce, ultimately a good sign for the labor market. Last but not least, average hourly earnings continued their upside momentum with both month-over-month and year-over-year gains coming in above market expectations which reinforces the robust demand for workers in the current environment.
The strongest jobs report in months was probably welcomed by the Fed, which can now focus more on addressing inflation — which has proven to be anything but transitory. The most recent CPI (Consumer Price Index) reading from the month of January further boosts the argument to hike interest rates as the year-over-year number came in at 7.5%, slightly above expectations of 7.3%. This is officially the hottest inflation number in 40 years as the last reading above 7.5% was in February of 1982. A year ago, Fed Chair Jerome Powell speculated that most of the inflation we’ve been seeing was due to supply chain issues and broad numbers were being pushed higher by products like used vehicles and lumber. The story now is that two of the stickier components in wages and rent are the main culprits for the overall inflationary environment we’re in currently. Rent accounts for approximately one-third of CPI, while goods/commodities are about 22% and was one of the big surprises from the January number with a 11.7% year-over-year increase for commodities excluding food and energy. Supply chain issues don’t appear to be improving and Powell even mentioned that relief in bottlenecks most likely won’t come until the second half of 2022. All of these factors are putting more and more pressure on the Fed to begin the path toward normalization of monetary policy. One Bloomberg analyst perhaps said it best, “This trend is no friend for the Fed.”
One thing that can’t be ignored is the change in market expectations over the past month. The key question that the markets are grappling with isn’t whether or not the Fed will hike, but how much and at what pace. When looking at Fed Funds Futures, it appears the January Jobs report and CPI has tilted outlooks to be more hawkish. As of this writing, the market is pricing in a higher probability of a 50-basis-point rate hike at the March meeting, a move that hasn’t been done by the Fed since May 2000. On February 10, data from Refinitiv showed a 30% probability of a 50-basis-point move in March pre-release but shot to 54% after the new inflation data came out. However, the Treasury forwards market is still indicating 25 basis points, with the same outcome at the May and June meetings. The bond market — which has traditionally been an accurate predictor of Fed policy — has responded as expected to recent data. The 2-year Treasury note, which is somewhat correlated to the Fed Funds rate, has been volatile to say the least. After the January CPI release the 2-year Treasury yield spiked almost 30 basis points and touched 1.63%, a level not seen since late 2019.
While the market is pricing in what seems to be a forgone conclusion of a 25-basis-point hike in March, investors likely won’t get further clarity on the pace of hikes until the next FOMC (Federal Open Market Committee) meeting. It would be hard to argue that there isn’t potential for different scenarios and that any new data that comes in between now and the mid-March meeting will have a significant effect on policy. In an interview with CNBC last week, Atlanta Federal Reserve President Raphael Bostic continued to reiterate that “every option is on the table,” while commenting that he sees three to four rate hikes in 2022. We believe it is worth mentioning that the Fed went from dovish (“inflation is transitory and we will gradually reduce our asset purchases”) to hawkish (“we need to hike interest rates because of the risks of inflation and also halt our asset purchases”) in a matter of months and the result has been one of the worst starts to the year for fixed income markets on record.
Oh…and then there’s the unprecedented $8 trillion balance sheet that will have to be addressed at some point. The outlook on interest rates for 2022 remains uncertain but given the drastic dovish-to-hawkish shift from the Fed, we would tread carefully and expect continued interest rate volatility moving forward.