Employment Preview & Minutes Review
Very little slack and increasing dynamism imply faster wage growth
Before we get to a December employment report preview, here are our takeaways from the minutes of the December FOMC meeting. Our FOMC meeting preview note was titled The Case for Ending Reinvestment, needless to say the release of the minutes confirmed our view that balance sheet contraction is likely to occur soon than the prior cycle. The took notice markets with 10-Year TIPS 24bp above their December 31 close, Nasdaq down 3% and ARKK down 7% on Wednesday.
FOMC Minutes takeaways:
1) Sequencing will remain the same but is likely to be condensed (rate hike first, then balance sheet contraction but not a two-year lag, likely 1-2 meetings).
2) Balance sheet contraction will start sooner and be faster due to the shorter average duration of the Fed’s Treasury portfolio.
3) The longer-run goal is to not hold MBS; this implies they may allow faster runoff of MBS that gets reinvested into Treasuries.
4) They will use caps as they did from October 2017 to December 2018 to achieve a 'measured' balance sheet contraction.
5) The terminal value of the balance sheet is under debate, the development of the RRP (Reverse Repo, lower bound) and the SRF (standing repo facility, upper bound) has increased the staff’s confidence then can run down the balance sheet quickly without another repo rate spike like in Sep '19.
The Bottom line: balance sheet contraction and mortgages in particular are catalysts for higher rates volatility. Keep in mind, the Fed does not hedge mortgage prepayment risk. Before the taper they were buying $40bn/month and reinvesting $50-$60bn/month. The reinvestment is even more important to the mortgage market than the new purchases because it ebbs and flows with prepayment trends. As the Fed ends these purchases, the street will have to warehouse this volatility risk and they will hedge convexity risk (prepayments). This will move interest rate implied volatility sharply higher. Real rates and fixed income implied volatility heading higher are key elements of a risk-off episode.