Top Line

  • FOMC members openly debated likely path for rate hikes, with market predictions set at 25 basis points on February 1
  • Various disinflationary indicators are further signaling that the peak is in, but possible cracks in consumer health may be showing

Inflation Weakens, Expectations Remain

Personal Consumption Expenditures (PCE) and the University of Michigan Inflation Expectations survey data were released on Friday and showed that, while pricing pressures have subsided, expectations of longer-term inflation have remained stubbornly above the Federal Reserve’s two percent target.

  • Headline PCE: The high-level look at prices paid by everyday consumers in December rose 5.0 percent on a year-over-year (YoY) basis. This was in line with the economist estimates of 5.0 percent and below November’s 5.5 percent pace.
  • Core-PCE: After removing the more volatile and energy price series, December’s Core-PCE showed a 4.4 percent increase over the 12-month trailing period. While still higher than central bank officials would like to see, this index has now fallen roughly 100 basis points (bps) from the peak in February 2022.
  • University of Michigan Five- to 10-year Inflation: Federal Reserve Chair Jerome Powell explicitly called out an upward shift in this indicator as a key argument for the first of four 75 bps interest rate hikes last June. Friday’s 2.9 percent figure, while above the two percent inflation target, shows cooling that will be welcomed by policymakers.

As the inflationary picture becomes increasingly clearer, markets have begun to sniff out when and how aggressively the Fed is likely to cut rates. Fed fund futures markets imply the U.S. central bank will continue to hike rates through mid-year before cutting around 50 bps by the conclusion of its December meeting. The Fed easing rates would likely lead to a tightening impulse for Agency CMBS spreads, especially if accompanied by a slowdown in the central bank’s quantitative tightening program. Globally, it seems that central bankers are viewing the risks to recession as having increased enough to begin to pause interest rate hikes. The Bank of Canada is the most salient example due to explicitly declaring a pause in its hiking cycle last week after raising benchmark rates 25 bps. The Reserve Bank of Australia also hinted at an upcoming pause in its tightening program.

Macro Themes: Fourth Quarter GDP Flash Report Strengthens Dovish Case

As we have grown increasingly accustomed, the big data releases hold something to support and undermine any of the economic narratives tossed about by market participants. The advanced estimate of 4Q22 Gross Domestic Product on Thursday was no exception.

The headline came in above expectations at 2.9 percent, between the 2.6 percent consensus estimate and 3.2 percent from 3Q22. This unquestionably robust figure can be viewed as comforting reassurance that the U.S. economy is cruising on a glide path toward a soft landing or as evidence that the Fed has ample runway to hike further if recent declines in inflationary pressures turn out to be short lived.

Repeating the December PCE experience, the data components lean toward the optimistic side of the argument. Foremost in the fine print are the accounts that drove the headline. Major contributors to growth included inventory investment (1.46 percent), consumer consumption of services (1.01 percent), government consumption (0.64 percent), and net exports (0.56 percent). Bulging investments in inventory can, in large part, be attributed to weak holiday season sales rather than rising retailer and manufacturer enthusiasm for business in 2023. The pop in net exports was fueled by a decline in import consumption rather than export growth, and the gain in government consumption was an extension of 3Q22 federal and state non-defense consumption trends that aren’t sustainable in the current fiscal environment.

Consumer service demand was the bullish case anomaly. But service consumption’s contribution to GDP growth was down meaningfully from 3Q22 (1.63 percent) and 2Q22 (1.82 percent), and perhaps is running out of gas. Conversely, the principal economic growth engines—fixed investment and goods consumption—were soft at -1.20 percent and 0.26 percent, respectively, and the growth of final sales to private domestic purchasers (demand with global noise stripped out) collapsed to 0.2 percent. Translation: the domestic economy is growing, but certainly not overheating.

The price indexes were also mostly favorable to the soft-landing argument. GDP deflator increased at a 3.5 percent annual rate, down from 4.4 percent and 9.0 percent in 3Q22 and 2Q22, respectively. The prices of goods, exports, and imports fell. Services again were the sore thumb, accelerating from 5.2 percent in 3Q22 to 5.6 percent in 4Q22.

When the FOMC members meet next week, the services price issue will gather plenty of attention. Still, the GDP report provides much for them to be pleased with. The committee will reiterate that much work needs to be done, but the “tighter longer” camp is losing ammunition. We expect the FOMC will raise rates 25 bps and signal data dependency thereafter, only to raise rates an equal amount in March before signaling a pause.

From Our Desk

Fannie Mae The DUS market was pretty constructive this past week. The bulk of our trading occurred in the seven- to 10-year part of the curve. The story really hasn’t changed much week over week though. 10/9.5s are still sought after by all with heavier interest in full interest only. Small loans have continued to be punished although callable structures have become more interesting to buyers and the bleeding in wider spreads seems to have stopped.

Ginnie Mae – MBS remains well bid on low volume, but the market has stratified somewhat in that small loans are now attaining more aggressive bids than otherwise similar but larger loans. The impetus for this strength is a handful of smaller investors trying to get loan counts up for their REMIC deals. Larger PLs can trade two to three bps back on a relative basis. The same applies to CLs. In general, the temperature is somewhat sanguine as most REMIC sponsors have been able to sell their deals.

Municipals AAA tax-exempt yields were relatively flat this past week while the tax-exempt to taxable interest rate ratios were lower throughout the yield curve compared to last week (five-year ratio was 57 percent, 10-year ratio was 63  percent, and the 30-year ratio was 88 percent). Whereas a major theme of 2022 was continuous mutual fund outflows to the tune of $79 billion pulled out of the market (outflows for high yield funds were $19 billion), we start the first month of 2023 with inflows in three of the first four weeks (inflows of $2.3 billion for all mutual funds and $1.6 billion for high yield funds). However, as we near the end of January, municipal bond issuance is down over 19 percent compared to last year as higher borrower costs and fewer refunding opportunities still persist.

The Week Ahead

A highly-anticipated Wednesday FOMC meeting highlights a packed week of economic events. Tomorrow’s FHFA and Case-Shiller Housing Price Index (HPI) releases will add color to last week’s strong New and Pending Home Sales data. Wednesday will see manufacturing data from both S&P Global and the ISM as well as labor market data in the form of ADP Employment Change figures and JOLTS. As mentioned above, the Federal Reserve will conclude their first meeting of 2023 after these releases. Thursday will bring Challenger Job Cuts, Jobless Claims, Factory Goods, Durable Goods, and Capital Goods Orders. Finally, on Friday we will close out the week with Non-Farm Payrolls estimated to show 175,000 jobs were added to the U.S. economy in January, with a forecasted 3.6 percent Unemployment Rate. Friday will be rounded out with S&P and ISM Services indices.

Economic Calendar

Case-Shiller Housing Price Index 1/31 Nov 6.80% 8.64%
S&P Global US Manufacturing PMI 2/1 Jan N/A 46.8
Job Openings and Labor Turnover Survey (JOLTS) 2/1 Dec N/A 10458k
FOMC Meeting Conclusion 2/1 Feb4.50% – 4.75% 4.25% – 4.50%
Non-Farm Payroll Jobs 2/2 Jan185k 223k
Unemployment Rate 2/2 Jan3.60% 3.50%
S&P Global US Services PMI 2/2 Jan N/A 46.6
*Source: Bloomberg

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