The Weekly Beat: 29 March 2022

·  Last week’s meeting provided the FOMC the opportunity to communicate clearly and definitively that it has no idea what is happening or how to handle it.  The committee did not disappoint and made the most of the opportunity.  The yield curve has effectively been broken into two halves by the Fed’s difficult position.  From the policy rate to the two-year maturity is very steep while the rest of the curve is nearly flat and even inverted in some places (Charts 1 & 2). 

·  This has happened because the Fed has failed to provide a framework for how to manage the hand-off from asset purchases to “normal” monetary policy operations.  Movements on either end of the yield curve have been measured, but the five-year maturity has had an outright tantrum.  The three-month yield can be programmed with monetary policy and the buyers pool for thirty-year bonds is shallow enough to communicate intentions, but the five year is a hodge-podge that includes asset-liability matchers (i.e. pensions).  They are managing duration risk and have no specific attachment to the middle of the curve.  When it threatened to turn on them, they headed for the hills (Charts 3 & 4).

·  The result is that the slopes of the two halves of the yield curve are now moving in opposite directions, producing monetary strain and uncertainty (Chart 5).  Financial conditions are tightening rapidly, and corporate bond yields have been rising (Charts 6 & 7).  Until recently, falling corporate bond spreads have compensated for rising policy rates and preventing tightening from hitting the corporate sector (Chart 8).  Russia’s invasion of Ukraine kicked off a sharp reversal of that process resulting in spreads widening and risk-free rates rising.

·  The more distorted the shape of the yield curve, the more likely the Fed is to come out of the closet and implement yield curve control using its repo and reverse repo facilities.  We caution against holding into flattener positions for anyone expecting an outright inversion of the yield curve.  The Fed cannot allow the yield curve to invert and a recession to strike while the committee’s proverbial fly is unzipped.

·  The Fed needs to tighten financial conditions, but not too much, and they will eventually grow tired with the market’s perturbations.  The U.S. government as a whole is concerned about maintaining credibility, and the Fed is no exception.  Instead of showing some humility and admitting the limits of their vast powers to distort but not change economic realities, the FOMC will likely double-down and intervene in more markets when it should be doing less. 

·  Once upon a time, Bernard Connolly wrote a series of notes titled “After the Fed” that addressed such an eventuality.  Former Connolly Insight subscribers with photographic memories, hoards of old papers, or illicit electronic copies should take the time to review the series. 

·  Stocks to Watch: X, SBLK, WLK, PBR, GGB, GPE, AXS, DOX ,TSN, MKSI, QDEL

Stocks to Watch

·        U.S. equity markets have defied expectations of an implosion due to rising rates, warfare, and rising energy prices.  In our opinion, the best indicator that the sell-off that began in January was an orderly repricing was how neat all the technical lined up.  The key reversal point lined up with the existing downtrend and a trading channel that stretched back to May (Chart 9).