While the PMs put on brave faces amid the recent surge in the U. S. 10-year Treasury yield, their fundamental outlooks continue to deteriorate.
To explain, while the Delta variant increased investors’ economic anxiety in August and September, I warned on Sept. 24 that the path to higher interest rates was still intact.
I wrote:
"To explain, the red line above tracks the U.S. 10-Year Treasury yield’s rally off of the bottom in 2009-2010, while the green line above tracks the U.S. 10-Year Treasury yield’s current move. If you analyze the fits and starts, you can see that excessive optimism often gives way to excessive pessimism. However, after the dust settled in 2009, the U.S. 10-Year Treasury yield continued its uptrend and ultimately made a new high.
"For context, the yield fell off a cliff in April 2010 before another sharp rally ensued in October 2010 (which recouped most of the losses). However, the important point is that the second cliff arrived roughly four months after the U.S. 10-Year Treasury yield recorded its second bottom. As a result, with the pace of the current economic recovery tracking well ahead of 2009, it will likely take a Black Swan event to keep the U.S. 10-Year Treasury yield from following a similar script."
To that point, while the Omicron variant helped delay the fireworks, the U.S. 10-year Treasury yield is poised to complete its mission. With the Treasury benchmark ending the Jan. 4 session at 1.66%, more upside will likely materialize over the medium term.
Furthermore, while I warned throughout 2021 that higher U.S. Treasury yields would stifle the PMs' upward momentum, their 'flash crashes' often occur with a delay.
For example, the PMs can ignore rising interest rates for a few days or a week. However, once fundamental pressure becomes too much to bear, the PMs often suffer sharp daily sell-offs that wipe out days or weeks of gains. As a result, don't be surprised if another one materializes once Omicron fears fade.
Furthermore, while the PMs have enjoyed Fed speakers' holiday quiet period, the fundamentals remain unchanged: the Fed is hawked up, and simmering inflation should result in higher interest rates in the coming months.
As evidence, Paychex (NASDAQ:PAYX) and IHS Markit released their Small Business Employment Watch report on Jan. 4. After analyzing 350,000 small businesses with less than 50 employees, they revealed that "the December data shows hourly earnings growth improved to 4.27 percent, the highest level since reporting began ten years ago."
In addition, the Small Business Jobs Index increased to 100.94 in December, its highest level since August 2014. As a result, the U.S. labor market continues to strengthen, and the Fed is unlikely to reverse its hawkish policy plans anytime soon.
To that point, Minneapolis Fed President Neel Kashkari—who is by far the most dovish Fed member of them all—wrote on Jan. 4:
“while my baseline forecast remains that the high inflation consumers and businesses are currently experiencing will likely be transitory, I am putting more weight on the possibility that such transitory high inflation could nonetheless lead to an increase in long-term inflation expectations above our 2 percent target.”
As a result:
Source: Minneapolis Fed
Thus, while the PMs didn’t notice, the man who preached the most monetary patience in 2021 now expects two rate hikes in 2022. As such, Kashkari’s material about-face highlights the inflationary anxiety within the Fed.
Continuing the theme, IHS Markit released its U.S. composite PMI on Jan. 3. While the headline index declined from 57.2 in November to 56.9 in December, U.S. economic output ended 2021 on a relatively high note. The report revealed:
“Supporting the upturn in activity was a quicker increase in new orders during December. The pace of expansion was the sharpest for five months, and largely driven by a faster rise in service sector new business. New order inflows to the manufacturing sector eased to the slowest since October 2020, however. Meanwhile, new export orders increased at the strongest pace since September.”
More importantly, though, inflationary pressures still remain:
Source: IHS Markit
Likewise, the Institute for Supply Management (ISM) released its U.S. Manufacturing PMI on Jan. 4. While its Prices Index decreased from 82.4 in November to 68.2 in December, the report revealed that “raw materials prices increased for the 19th consecutive month, at a slower rate in December. This is the 16th month in a row that the index has been above 60.”
In addition, the ISM’s Employment Index “reported a fourth consecutive month of expansion” and that “an overwhelming majority of panelists indicate their companies are hiring or attempting to hire, as 85 percent of Employment Index comments were hiring focused.”
As a result, while it may seem like the PMs have a bullish bid under them, their fundamental prospects are fading. With the stars aligning for aggressive Fed policy in 2022, ignoring these realities will likely upend overzealous investors over the medium term.
For example, with inflation still rising—at a slower pace, though—it’s drifting further away from the Fed’s 2% annual target. Second, with the U.S. labor market, the main deterrent to an earlier tightening cycle, near-record job openings and strong hiring sentiment eliminate that concern.
As evidence, the U.S. Bureau of Labor Statistics (BLS) released its Job Openings and Labor Turnover Survey (JOLTS) on Jan. 4. With more than 4.5 million Americans quitting their jobs in November—an all-time high—does it seem like they’re worried about their employment prospects?
Finally, while the U.S. 10-year Treasury yield hovers roughly 10 basis points from its 2021 high (~1.75%), pandemic progress should elicit a move back toward 2%. Likewise, with higher long-term yields as the key to calming inflation, we’ll likely witness more upward pressure in the coming months.
“You only reduce inflationary pressure by slowing aggregate demand and that requires higher long-term rates,” David Kelly, chief global strategist at JPMorgan Asset Management, told Bloomberg on Jan. 4. “There will be no impact on curbing inflation if long-term rates are not pushed up. The Fed is quite capable of pushing up long-term rates if it decides to reduce the size of its balance sheet along with higher overnight rates.”
The bottom line? Investors have gotten so used to a dovish Fed that they assume Chairman Jerome Powell won’t follow through and raise interest rates. However, with rampant inflation, a hot labor market, and a resilient U.S. economy still in play, the PMs may find out the hard way that the Fed isn’t bluffing. As a result, their superficial strength will likely fade, and their price action on Jan. 4 mirrors the tepid confidence they displayed throughout 2021.
In conclusion, the PMs rallied on Jan. 4, though, nothing fundamental supported the moves. While 2021 was filled with defiant rallies that ultimately ended in disappointment, 2022 is shaping up like more of the same.
Moreover, with the USD Index and the U.S. 10-year Treasury yield rising in unison on Jan. 4, the two-headed monster is extremely bearish for the PMs. As a result, more downside will likely materialize over the medium term.