Higher and Steeper
No Quadrilemma resolution, Inflation Week, Earnings Preview and Asset Allocation
Fiscal Dominance
The week began and ended with the same theme, the most accommodative fiscal policy outside of a war, including the war-like pandemic policies, is pushing the US to its fiscal limit. While the Fed has a bias to ease, strong labor market data lowered the probability of a benign yield curve disinversion (bull steepening). Only communication services and energy managed price gains this week, small caps and regional banks got smoked as you would expect amidst a real rate driven bear steepening of the Treasury curve. Friday’s March employment situation report was cheered by equity investors, like the initial reaction to stronger data in 3Q23, however, the risk of another cross-asset risk off episode is rising. Stocks closed at their highs for the day Friday, but so did Treasury yields.
The March employment report smelled of fiscal dominance. Government employment growth continued its strong trend, wage growth in sectors benefiting from debt financed record levels of government spending during an economic expansion was hot, and the thesis we detailed in our preview note — that immigration policy is both increasing employment and pressuring wage growth in low skill sectors — was strengthened by the March report. The report drove a stake in our Quadrilemma thesis: the FOMC may be in a position for some modest rate policy normalization if services inflation cools, but three strong months of labor market data has left the FOMC in no position to cut the policy rate to 4%, the level that would trigger a benign 3m10y yield curve disinversion. Next week brings the March CPI report, followed by a 10-year auction, the minutes of the March FOMC meeting, and the March Budget Statement from Treasury. Although the time it takes to cut to 4% is more important for the banking system and Treasury market than the timing of the first cut, unless next Wednesday’s core CPI is 0.2% or less (and consensus is for a 0.3% increase), a June start to the rate normalization process will be off the table.