December 4, 2021


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Bottom Line:


The November jobs report posted a US unemployment rate of 4.2%, well below the Fed’s expectations. With even more stimulus on the way, the Fed seems right to fear an overheated job market. By previously establishing a taper schedule terminating in June, the Fed limited its ability to hike rates for another seven months. By accelerating the taper termination timetable to March, as Chairman Powell signaled on Tuesday, the Fed will have more policy flexibility with rates. Given that their Quantitative Easing program appears to be just filling bank reserves parked at the Fed (like overfilling a water tank), fewer asset purchases shouldn’t impact economic growth. However, a fearful Fed rightly triggers fearful investors, who now must revise rate timetables and termination points. Unfortunately, until we get more from the Fed on December 15th, we may not get more from these markets.     


The Full Story:


Markets reacted violently after Fed Chair Jerome Powell signaled an accelerating pace of tapering on Tuesday. A more aggressive Fed, warranted or not, causes multiple concerns. Faster tapering implies faster rate hikes, and not only do higher rates slow economic growth but the Fed also tends to over-tighten once they begin. While Omicron took the blame for this week’s sell off, it’s the reappraisal of the Fed policy path that rightly deserves the blame.


What the Fed Fears


Friday morning, the Bureau of Labor Statistics reported a 4.2% unemployment rate for the US economy. In September, the Fed forecasted a 4.8% unemployment rate by year-end. The Fed therefore under projected significantly… with one more month to go! This rapid decline toward “full employment” has the Fed on edge. For perspective on the 4.2% rate, the US economy reached an unemployment rate low of 4.4% in 2007, prior to the Great Recession. Prior to the Great Lockdown in 2020, the US economy reached an unemployment rate low of 3.5%. In other words, we typically see unemployment rates this low at the END of an economic cycle, not at the beginning. Furthermore, we have NEVER seen rates anywhere near zero with an unemployment rate at this level:




This makes things tricky for the Fed. At previous 4.2% unemployment rates (20 occurrences), the Fed Funds rate averaged 3.5%. Also in September, the Fed projected a bottom in the unemployment rate near 3.5% for this economic cycle. At previous 3.5% unemployment rates (11 occurrences), the Fed Funds rate averaged 6.2%. In modern central banking, gradually lower unemployment levels meant gradually higher interest rate policy levels. In the heavily distorted stimulus-fueled post-COVID economy of today, unemployment levels have fallen too fast for the Fed to adapt.


What the Market Fears


While rate hikes seem warranted at such low unemployment levels, a debate will soon rage around the “neutral” level. Rates at the neutral level support economic growth without inciting above-target inflation… i.e., monetary nirvana. Unfortunately, arriving at monetary nirvana often requires trial and error. Most recently, the Fed removed three excessive rate hikes in 2019 to forestall recession. In retrospect, a Fed Funds rate of 2.25% seemed too tight, while a Fed Funds rate of 1.5% seemed just right, or “neutral.” Should 1.5% remain the “neutral” rate for this cycle, the Fed only has five .25% rate hikes in its quiver. Deploying any more than that might reprise the over-tightening, yield-curve inverting, recessionary invitation they issued in 2019. Concerningly, the Fed has forecasted a 2.5% “neutral” rate for this cycle, a full 1% above the market’s estimate. This has left investors rightly unnerved as the pace of job gains has spooked the Fed and risks rushing its decision-making. With even more fiscal stimulus on the way to add further distortion, the risk of a monetary policy mistake impairing growth has grown.


The Good News


Fortunately, longer-term inflation expectations gauges express confidence that the Fed will figure this out. Let’s first examine the 10-year breakeven inflation rate. The chart below chronicles inflation expectations over the next 10 years by deducting the 10-year Treasury Inflation-Protected Security yield from the 10-year Treasury Bond yield. Currently, the yield spread suggests 2.47% inflation over the next 10 years, a bit higher than the Fed’s long term 2% projection but well within historical bounds over the last twenty years:




We can filter this 10-year view down further to adjust for stimulus-induced, near-term inflation distortions. The 5-Year, 5-Year Forward Inflation Expectations Rate measures 5-year inflation expectations beginning 5 years from now. Based upon this measure, 5-year inflation expectations 5 years from now fall to 2.2%, even more within historic bounds:




Lastly, since interest rates price off inflation expectations, if market participants truly believed we had years of inflation ahead, long-term interest rates would be rising. Instead, they are falling. Currently, the 30-year Treasury yields 1.77%:




Based upon these market-based gauges, inflation is not a longer-term concern. So, while the Fed’s near-term policy mix has fallen into question, the markets’ assessments of the Fed’s longer-term policy effectiveness have not.


Have a great Sunday!



David S. Waddell 
CEO, Chief Investment Strategist



Sources: FRED




David Waddell
Author: CEO Chief Investment StrategistAfter graduating from the University of the South with a BA in Economics, David began his career with Charles Schwab & Co., Inc. in Phoenix, AZ. Having been recognized for his outstanding business development record, David was promoted to the San Francisco- based Institutional Strategic Accounts Team, which interfaced with the Big 5 accounting firms and Schwab’s largest customers. David left Schwab to continue his education at the graduate level in Boston. While earning his MBA degree with a concentration in finance and investments at the F.W. Olin School at Babson College, he was appointed by the college Trustees to manage a team of seven portfolio managers overseeing the student-managed portion of Babson’s endowment fund. David also founded the Babson Investment Management Association to assist undergraduate and graduate students with training and career path planning in the investment management field. As the firm’s Chief Investment Officer, David chairs the W&A investment committee and combines macro economic forecasting, macro market analysis and macro risk assessments to design portfolio strategies utilizing public market securities worldwide. A civic leader in Memphis, David currently acts as Chairman of Epicenter Memphis, and Co-Chair of the Memphis Chamber Chairman’s Circle while also serving as a board member for LaunchTN and the New Memphis Institute. David previously served as chairman for The Leadership Academy, the RISE Foundation, and the Economic Club of Memphis. He also chaired the capital campaign to build the “Live” stage at the Memphis Botanic Garden. David was a member of the 2004 Leadership Memphis class and has been recognized as one of Memphis’ “Top 40 under 40” by the Memphis Business Journal, and as a finalist for “Executive of the Year” in 2007. In addition to weekly columns in the Memphis Daily News and the Nashville Ledger, David has appeared in the Wall Street Journal, USA Today, Forbes, Business Week, Investment News, Institutional Investor News, The Tennessean and Memphis Business Journal. He has also made appearances on Fox Business News, Yahoo Finance, Bloomberg TV, CNBC, and CBS News and ABC News Channels. Read some of David's articles on his author page in Inside Memphis Business. David has two wonderful children, Easton and Saylor, an obedient Labradoodle named NASDAQ, and a devoted Goldendoodle named Ripley.


David S. Waddell


Chief Investment Strategist

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