AI: Acute Irrationality

Waller: Markets Are Undervaluing the Risks

Soundbite: Fed Governor Christopher Waller’s Friday afternoon remarks were the last words from an FOMC member before the April 28-29 meeting. His comments resonate with our long-held view that if Core PCE were to rise above 5%, as it did only four years ago, consumers are likely to raise long-term inflation expectations. This time, they are likely to stick, unlike in 2022, when long-term inflation expectations moved up but reversed because consumers hadn’t experienced such high inflation in forty years.

Importantly, Governor Waller is focused less on the most recent oil spike (which raised energy CPI by 11% in March) and more on the cumulative nature of transitory shocks that have repeatedly hit the economy. He noted that standard monetary policy involves looking past supply-side shocks. Unfortunately, the inflationary combination of COVID’s supply chain disruptions, followed by commodity-related dislocations after Russia invaded Ukraine, last year’s tariffs, and now the Strait of Hormuz, has kept inflation above the Fed’s target for five years. His latest message is that this “series of price shocks may lead to a more lasting increase in inflation that can move up inflation expectations.” That is a big departure from the FOMC’s consensus view of transitory inflation back in 2022.

Waller is not fully embracing the current investor view that the rise in energy prices that boosted headline inflation will fade as energy prices recede. Under this view, investors believe that any pass-through of higher energy prices to other goods and services will be limited, and expectations will turn to the positive prospects of “ongoing growth in spending, production, and hiring.” In contrast, Governor Waller thinks crude markets are undervaluing “the risk that the conflict continues…[and] the longer energy prices remain elevated…the greater the chances that higher inflation gets embedded in goods and services.” He further stated, “oil prices at the end of this year are skewed toward the higher prices that I see as more likely than what markets are pricing in.”

We believe investors are also ignoring the secondary effects of energy shortages, which could cause production shortages in certain countries, further pressuring global supply chains. Additionally, consumers may reduce spending as higher inflation weighs on confidence. If households worry that a threshold has been violated, less spending could be the spark that ends the labor market support that has kept businesses retaining workers.

The monetary policy implications point to staying on hold, and Waller ended his speech saying he is not turning hawkish but may need to strike a more balanced approach between the Fed’s dual mandate. We have been expecting the Fed’s tone to shift toward acknowledging the possibility of rate hikes. Waller’s comments on Friday only strengthen our expectations.

Hank Paulson: Doom Loop

Soundbite: We have been writing for quite some time that the risk parity world that benefited from a passive 60/40 stock/bond mix is history. While we enjoyed secular disinflation for decades, the flood of pandemic-related stimulus has moved us into a structurally different inflationary universe. Dire warnings about catastrophic budget deficit scenarios date back to the late 1980s, so we understand why the latest alarms are met with some skepticism, but we believe the Treasury market will reflect these rising concerns. Last week, former Goldman Sachs CEO and Treasury Secretary Henry Paulson joined other serious players, such as Jeff Gundlach, who question the age-old belief that Treasury bonds are the most stable element in portfolio construction. If they are correct, investors will require a far more thoughtful, opportunistic fixed income strategy, as we may be on the threshold of a sustained period of higher interest rate volatility.

Escalating interest payments against a backdrop of mounting budget deficits have increased the possibility of a “doom loop,” where investors demand higher Treasury yields, widening the budget deficit, which calls for even greater Treasury issuance and pushes rates even higher. Paulson has advocated for concrete steps to boost confidence in Federal fiscal management, including raising taxes and reining in entitlements such as Social Security and Medicare, to get in front of this problem. Otherwise, he warns of an outright collapse in Treasury demand. He worries that Congress may not act “until there is an immediate crisis,” a crisis we fear will only materialize if rates rise to painful levels.

We prefer to steer away from nightmare scenarios, but investors need to prepare for the likelihood of bond markets demanding higher compensation as refinancing supply threatens to outstrip demand. We do expect a period of significantly higher interest rate volatility, and those with fixed income exposure will need to adopt a far more active trading strategy.

Complacency abounds, thanks to the generous long-term deflationary growth cycle that has supported fixed income markets. But positioning for a riskless horizon is coming to an end because short maturities now represent a significant portion of outstanding Treasury debt. Bond investors will likely need to brace for a surge in government bond auctions to refinance this growing supply in these short duration instruments that mature quickly. The structural problems hanging over the fixed income markets have the potential to coalesce into an inflection point that ushers in, as Paulson and Gundlach describe, an extended period of capital losses for bondholders.

Thankfully solutions exist, but they will weigh on growth as the only way out is by raising taxes and cutting government services in an effort to shift the burden on the private sector. The Congressional Budget Office forecasts budget deficits of six percent of GDP for several years, unless action is taken. If our expectation of a rising interest rate regime takes hold, overall liquidity will tighten, creating the need for more active equity management to best serve clients.

If the Labor Force Was a Shark, It Would Be Dead

Soundbite: The New York Federal Reserve Bank published a piece about how labor force growth will be completely stagnant due to near-zero immigration and aging demographics. Not only is labor supply at historically low levels, but this dynamic can also cause investors to misread negative employment readings. Secondly, it implies that GDP growth will be fully reliant on labor productivity growth, not headcount expansion. Their conclusion: “These features would represent a significant shift in U.S. labor market dynamics and the composition of economic growth.”

Severely dampened employment growth means that payrolls are just as likely to come in negative as positive for any given month. This dynamic of low breakeven payrolls will be a long-term feature, so get used to this new normal. The heightened risk of misreading the labor market could make the FOMC reluctant to change the fed funds rate for fear of making a policy error. Furthermore, because employment growth will hover around zero, average worker productivity will be the sole determinant of potential GDP growth. If AI productivity gains are not felt this year, even a modest economic downturn could tip the economy into a recession or stagflation.

Investors must adapt to yet another supply shock, but this one is unfolding in the labor market. Potential labor supply is forecast to be flat this year, and the dramatic drop in immigration flows will force population growth to its weakest in 75 years. Breakeven employment growth, or the pace necessary to keep the unemployment rate steady, calls for an unprecedentedly low 10,000 jobs monthly. This means that even with a string of negative payroll numbers, the economy may still be healthy. New York Fed economists estimate that a two-standard deviation variation, meaning an unusually large swing from the average, “implies that it would not be unusual for there to be one or more months in 2026 with declines in total payroll employment as large as -100,000 jobs” without it signaling a recession warning.

This theory has already played out in the payroll volatility we have seen this year, snapping from large negative readings, such as February’s -133,000 drop, to surges, such as March’s +178,000 reading. This volatility makes it very difficult to gauge where the economy stands relative to the FOMC’s maximum employment mandate, so this is not a friendly environment into which Kevin Warsh is entering.

What to Look for This Week

(All times E.S.T.)

1. Friday, April 24 at 10:00 a.m. University of Michigan Survey of Consumers final results for April. The Preliminary report released on April 10 was before the ceasefire, but long-term five-year inflation expectations surprisingly moved up by 0.2% to 3.4%. If long-term expectations do not reverse with two more weeks of polling in April, it will become a centerpiece for discussion at the April 28-29 FOMC meeting.
2. Thursday, April 23 at 11:00 a.m. Kansas City Fed Composite Index for April. March came in at 11, the highest level in almost four years. The Kansas City Manufacturing Index released simultaneously saw increases for durable and non-durable production. The New Export Orders index was one of the few categories that declined, while the Employees index rebounded to 7 from -6.
3. Tuesday, April 21 at 8:15 a.m. ADP Employment Change Weekly for the week ending April 7. This is in our top three economic indicators for the second consecutive week: US private employers added an average of 39,250 jobs per week over the four weeks ending March 28, 2026, a big jump from 26,000 weekly jobs created in the prior period. It is the fourth consecutive improvement in hiring reaching its highest level since weekly tracking began seven months ago. Thursday, April 23 at 8:30 a.m. Four-week average of Initial Claims is out and has just started to rise.

FOMC Voters Speaking: Already in the FOMC blackout period the week before the meeting. Tuesday, April 21 at 2:30 p.m., Governor Christopher Waller speaks but on Banking Modernization, not monetary policy.

Earnings: Tuesday, April 21 before market, D.R. Horton, Inc. (DHI) reports. The Mortgage Bankers Association has reported softness in purchases (and refinancings) with the recent uptick in mortgage rates, and we will see if that has impacted the homebuilder. After market on Tuesday, April 21, United Airlines Holdings, Inc. (UAL) reports and we will be keen to hear their outlook on future oil prices. Interactive Brokers Group, Inc. (IBKR) also after market, and we are curious if we will learn anything about retail participation during this chaotic period. Wednesday, April 22 is a bigger event, with Tesla Inc. (TSLA) reporting after market, along with Lam Research Corporation (LRCX), International Business Machines Corporation (IBM), and Texas Instruments Incorporated (TXN). LRCX has been by far the best performer of these four tech companies relative to the broad indices. Before market on Thursday, April 23, American Express Company (AXP) and Union Pacific Corporation (UNP) report to lend insight into crude oil’s potential overhang on consumer spending, and rail traffic. Intel Corporation (INTC) will be an investor focus on Thursday after market as well.

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By Peter Corey

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