By Benjamin Picton, senior macro strategist at Rabobank
For Lease Navidad
Following a softish ADP jobs figure last week, the market was poised for a similarly weak print in the much more consequential non-farm payrolls report. Alas, the recent form of virtually no correlation between the two numbers held, and non-farm employment growth in November handily beat the 185,000 consensus estimate to print at 199,000.
The bond market reacted in orthodox fashion. 2-year yields jumped 12.5bps and 10-year yields pumped higher by 7.6bps. Fed Funds futures show the centre of gravity for market-implied probability of rate cuts have been pushed a little further out the yield curve into 2024, but there are still 4.5 cuts priced in before Christmas.
So, the huge disparity between market pricing and the Fed dot plot continues. The dot plot median for 2024 is 5.125%, and the lowest value is 4.375%, while the futures market is suggesting that Fed Funds will finish the year just a touch above 4%. This suggests that every member of the FOMC would have to be wrong (or fibbing) about the likely future path of their policy rate decisions for the market to have it right.
Jerome Powell and other Fed speakers who have been warning traders not to get too carried away with bets on looser policy will be pleased to see some tentative crabwalking back towards the higher for longer meme. You can only huff and puff about hawkish policy stances for so long before you have to actually deliver, or risk losing your credibility. Equity markets were sufficiently unfazed by a firmer than expected labor market to see the Dow Jones rise by 0.36% and the more duration sensitive NASDAQ up by 0.45%. Mr Market says “I do not believe you!” to the Fed.
This week brings the December FOMC meeting (previewed here by Philip Marey), so we will get an updated picture of how determined the Fed is to stick to the higher for longer meme. No-one will be sweating on this meeting more than the commercial real estate sector and the regional banks who loaded up their balance sheets with CRE risk in the go-go years of ever lower policy rates (and money printing). Unrealized losses on held to maturity bond portfolios might be looking a little better since 10-year yields encountered resistance at 5% and subsequently fell by ~80bps, but this might be splitting hairs between disaster and calamity.
The soft-landing becomes important in this context as office fund managers sweat on the double-whammy of refinancing risk and vacancy rates driven higher by the work from home trend that just won’t die. Assets bought off funny-money cap rates don’t make much sense in a normalized free market where supply and demand of credit is determined by free exchange between willing borrowers and lenders. Mispricing is just one negative legacy of interventionist easy money policies. As Walter Bagehot famously put it: “John Bull (or Uncle Sam) can stand many things, but he cannot stand 2% (or 0.25%)”.
Obviously, there are financial stability risks here, and the Fed already demonstrated a willingness to ride to the rescue with new liquidity when similar risks were exposed earlier in 2023. This is the underlying tension between r* (the neutral rate of interest) and r** (the financial stability rate of interest). The Fed is talking about the former, the market is pricing for the latter. Who can blame them if CRE managers are heading towards the holidays saying “for lease Navidad” as all of the white-collar workers telecommute from their living room.
Major Bank CEOs in the USA seem to be well aware of the financial stability risks inherent in such a system. CEOs appearing before a Senate Hearing on December 6th pushed back against the proposed implementation of the Basel III capital framework, which would require banks to hold more capital against the assets on their balance sheets. Critics will say that the resistance is pure self-interest, because lower capital requirements means more leverage and therefore higher potential profits. Another interpretation might be that senior bankers don’t want to be forced to hold a greater volume of debt securities whose value is routinely manipulated by the central bank.
The case could be made that, beyond a certain point, capital requirements that force banks to buy government debt at what can be effectively off-market rates (during periods of yield-curve control, for example) is not only a form of financial repression, but a source of systemic risk in the future. Unfortunately, that future appears to be arriving quickly as interest rates normalize, debts fall due for refinance and bond portfolio’s nurse whopping losses.
The more arcane points of monetary frameworks and financial stability will get a good airing this week because the Fed won’t be the only central bank in action. We also have rates decisions due from the BOE, ECB, SNB, BCB and the Norges Bank. Almost all of these are expected to remain on hold, with the exception of the BCB who are in the midst of a cutting cycle. On Friday our rates team put out a detailed summary of the Bloomberg survey ahead of the ECB meeting this week. The key takeaways were that:
- Economists’ expectation for the volume of rate cuts in 2024 has remained at 75bp (albeit that the first cut is now expected in June rather than September) but this is of course now hugely less than market pricing.
- A majority now expect that the ECB will bring forward its current commitment to invest bonds maturing under the PEPP until the end of 2024, with the favoured timing being Q2 2024.
- -The expectations regarding the ECB’s forecast for 2025 headline and core inflation are almost evenly split between those that expect them to be left unchanged and those that expect downward revisions.
This week will also bring the release of CPI figures for the United States on Tuesday. As always, headline inflation is expected to decline further while core inflation remains resilient. It will be very interesting to see which direction any surprises come, especially after last week’s inflation numbers our of China that showed accelerating deflation for both consumer and producer prices. Hopefully the soft landing survives the week!