The Market Today

Fed Talks Quantitative Tightening While Still Easing

by Craig Dismuke, Dudley Carter


Jobless Claims Hit by Seasonality or Omicron at Year-End: Initial jobless claims for the week ending January 1 rose 7k to 207k versus expectations they would decline to 195k.  Initial claims typically increase in the final week of the year, as they did this year.  On a non-seasonally adjusted basis, claims rose to 316k, their highest level since August.  Interestingly, the seasonal pattern for claims had diverged somewhat prior to this report.  As such, the next few reports will be key to determine if the non-seasonally adjusted increase was the result of normal, year-end patterns or the rampant spike in Omicron cases.  Continuing jobless claims for the week ending December 25 increased 36k to 1.75 million.  While the result disappointed expectations for a decline to 1.68 million, the result still marked the second-lowest level of the pandemic.

Trade Deficit Jumps to Record: The November trade balance showed the deficit increased from $67.2b to $80.2b, as was expected after the surprising goods trade data released last week.  The increase in the deficit came from a 4.6% jump in U.S. imports and only a 0.2% increase in exports.  The monthly result brought the trailing 12-month deficit to $851b, the largest on record.  Trade is currently on pace to be slightly accretive to 4Q GDP although that December data will determine that.  Going forward, global demand is expected to recover more fully while U.S. demand is expected to slow which will be a tailwind for the U.S. economy.

ISM Services, Factory Orders, Fedspeak: At 9:00 a.m. CT, the December ISM Services index is expected to decline from 69.1 to 67.0.  November’s factory orders report is expected to show continued strength in demand for durable goods.  Speaking from the Fed today are San Francisco Bank President Daly and St. Louis President Bullard.  Bullard is a voting participant this year and has recently been one of the more hawkish voices.


Fed Talks Quantitative Tightening: The Fed’s December meeting minutes revealed in-depth discussions about the future path of policy, including the Fed’s plans for its balance sheet.  The minutes showed general agreement on certain high-level aspects of the eventual normalization process but unsettled opinions about key details. There was widespread agreement that balance sheet runoff would occur closer to lift-off of the Fed funds rate relative to the last cycle.  In the aftermath of the Financial Crisis, portfolio holdings were first reduced 22 months after the first rate hike and four hikes into the tightening cycle.  Many also expect the pace of run-off to “likely be faster than it was during the previous normalization episode.”  In justifying a faster normalization process, participants identified several differences between today’s environment and that of the last cycle: a “much stronger” economic outlook, “higher inflation”, “a tighter labor market”, and a “much larger” balance sheet.  Officials appeared less settled on the ultimate size of the balance sheet and the composition of holdings, although a portfolio of primarily Treasurys is considered to be the consensus favorite.

The Numbers for the Narrative: The Fed’s balance sheet has more-than doubled since February 2020, up $4.6 trillion to $8.76 trillion.  They are still adding new holdings at a rate of $90 billion per month ($60b Treasury and $30b MBS), down from a rate of $120 billion per month in November.  They are expected to continue tapering the rate of monthly purchases through March when new purchases are expected to be completed.  Procedurally, this timeline would open the door to a rate hike beginning in March.  Fed Funds Futures are currently pricing in a 100% chance of a hike by the Fed’s May 4 meeting and an 80% chance that hike will occur by their March 16 meeting. Given the expectations for a faster pace of normalization, the door would then open for quantitative tightening shortly thereafter. For context, the Fed reduced its portfolio holdings from September 2017 to July 2019 by $689 billion to $3.76 trillion. This quantitative tightening process was discontinued in July 2019, six weeks before the first of two back-to-back rate cuts.

The Economy and Inflation: Officials described activity in the fourth quarter as strong and expected “robust growth to continue into 2022.” Omicron increased uncertainty, officials said, but several noted it hadn’t “fundamentally alter[ed]” the outlook. Strong demand and constrained supply were keeping inflation at undesirably high levels. Officials were less than optimistic about near-term improvement in participation that could alleviate a worker shortage, furthering the belief the labor market was “very tight.” As expected, officials saw inflation remaining higher for longer. Against that backdrop and consistent with revisions to the dot plot, “Participants generally noted that, given their individual outlooks for the economy, the labor market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.”

Markit’s Services PMI Declined in December As Strong Demand Continued to Face Supply Headwinds: Markit’s Services PMI for December was revised up 0.1 from the initial estimate to 57.6, a solid level that nonetheless marked a decline from November and the third lowest reading of the year. Output eased to a three-month low while new orders hit a five-month high. Hiring was “marginal” at a three-month low, held back by a worker shortage that led to “soaring wage bills.” Higher employee costs combined with rising vendor pricing to drive “the steepest increase in cost burdens on record.” Nonetheless, the 12-month outlook was the strongest since November 2020 on easing supply-side issues. Markit added a note of caution that, “The swift spread of the Omicron variant does lace new downside risks into the economic outlook heading into 2022.” The underlying data were collected from December 6 to December 22.

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Fed Minutes Flustered Markets: Treasury yields added to earlier gains and a modest decline for equities deepened after the minutes from the Fed’s December meeting confirmed the hawkish shift in officials policy paradigm evident in the statement and updated projections and Fed Chair Powell’s post-meeting press conference. Officials discussed how they may normalize, or shrink, the balance sheet once they begin to raise rates, both steps aimed at reining in historically fast inflation that has emerged since the pandemic disrupted the balance between economic supply and demand (more above). While the broader themes were previously telegraphed, confirmation of the more rapid move away from accommodation flustered investors. The S&P 500, down just 0.3% just before the minutes were released, closed 1.9% lower. The Nasdaq suffered more severely, ending the day 3.3% lower in its sharpest drop since February 2021. The 2-year Treasury yield had risen 4.4 bps ahead of the minutes but closed 6.6 bps higher at 0.83%. The 5-year yield, 4.6 bps higher before the release, ended 7.2 bps higher at 1.43%. The 10-year yield added to a 3.9-bps increase to end 5.8 bps higher at 1.71%. Fed funds futures adjusted for a higher rate path, pricing in three rate hikes this year with a roughly 20 percent chance of a fourth.

Treasury yields rose further overnight but trailed increases across Europe that pushed Germany’s 10-year yield up to -0.05%, the closest it’s traded to positive territory since May 2019. Most global stock indices pulled back, tracking the sell-off in U.S. equities that unfolded after the Fed’s December minutes were released. Stocks dropped more than 1% in both Asia and Europe and U.S. futures were mostly lower. While Dow contracts regained some lost ground, the S&P 500 was flat and the Nasdaq continued to underperform, sliding another 0.4% around 7:30 a.m. CT. Treasury yields continued to press higher ahead of this morning’s jobless claims report, finally pushing the 10-year yield above its previous cycle-high close of 1.74% from March 31, 2021. The key benchmark yield briefly broke above 1.75% before paring its gain to 1.73%. The Treasury curve was between 2 and 3 bps higher before and after the latest unemployment claims report, with yields seven years and in at cycle-highs.

ICYMI – 2021 Year-In-Charts – A Year To Rival 2020: 2021 was another eventful year including three COVID-19 waves, a third wave of direct stimulus payments, expansion of the economy but imbalances throughout, a lagging labor recovery, the hottest inflation since the early 1980s, and a substantial pivot from the Fed. We recap the highlights of the year in our 2021 Year-in-Charts. (links: video, chartbook)

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