The Fed tightened its administered federal funds rate (the rate banks pay to borrow reserves) by 75 basis points (bps) (0.75 percentage points) to 1.50%-1.75%, a unprecedented rate hike since 1994. The problem here is that, for the first time in 109 years of history, the Fed is approaching a recession. In 1994, when they tightened 75 basis points, the economy was growing and they managed to pull off one of those rare “soft landings”. That won’t happen this time around because by all indications it looks like the recession has already started. The only questions that remain are “how deep” and “how long!” And that will depend on how long the Fed continues to apply the financial brakes. Hopefully the monthly inflation data will start to soften soon (perhaps in July), giving the Fed policy cover to ease its tightening program.
We say the recession may have already started. The definition of the rule of thumb is two negative GDP quarters in a row. First-quarter GDP was -1.5%, and the Fed’s own Reserve Bank of Atlanta is currently posting its second-quarter GDP forecast at 0%. With the way the incoming data has headed, it will soon turn negative.
Stock market woes
Investors appear to have dismissed Wall Street’s “mild recession” narrative (which was due to begin in 2023) and, as the chart below shows, have reacted quite negatively in the week just ended (June 17) with weekly losses for the major indices ranging between 8% and 9.4%. Note that all major indexes except the DJIA are now in “bear market” territory, with the Nasdaq and Russell 2000 down more than 30% from their highs.
We expect the DJIA to hoist the “Bear Market” banner soon. Speculative assets, like crypto, have been hammered. Bitcoin
Meanwhile, bonds, after being trashed for most of the year, have finally found a bid as investors now realize that the impending recession will prevent the Fed from implementing its entire recovery plan. forward guidance”. This plan calls for the federal funds rate to increase to 3.375% by the end of this year (2022), increase further to 3.75% by the end of 2023, and then drop back to 3.375% in 2024 (it is believed that 2 .5% is neutral, where the Fed is neither tightening nor loosening). The Fed, of course, has a built-in excuse to deviate from its “forward guidance,” as that guidance is derived from the median score of the “Summary of Economic Projects” (SEP), otherwise known as the “dot-plot.” “. .” Jay Powell has said at every recent press conference that the “dot chart” is individual FOMC member forecasts and not official Fed policy. Thus, the Fed remains free to deviate. However, until this week, the bond market had taken the dot-plot as gospel. On Wednesday, June 14, the yield on the 10-year T-Note reached 3.50%. On Friday, it was down to 3.23%, the bond market’s way of saying it doesn’t believe the Fed will meet point-plot projections.
The chart above shows that at the Fed’s June meeting, it cut its GDP forecast (but not to recessionary levels), raised its unemployment rate forecast, and increased its view of inflation and core inflation only for 2022.
We know that for political reasons the Fed cannot publicly admit that its policies will cause a recession. After every meeting since Bernanke started the practice, the Fed chairman answers questions at a press conference. At the Wednesday, June 15 press conference, Powell’s rationale for the sharp (75 basis point) hike in the fed funds rate was laughable. The University of Michigan (U of M) conducts a monthly consumer phone survey, and the latest survey showed inflation expectations had risen from 3.0% to 3.3%. Powell pointed to this as vindication. The thing is, it’s a lagging indicator because consumers are getting their point of view from the media that hammered the inflation narrative (using back data – March, April, May CPI). The real “leading” indicator of inflation expectations is found in Treasury Inflation-Protected Securities (TIPs
And why does Powell only select certain data from the U of M survey? This survey now shows that general consumer sentiment is at an all-time high for the index’s history (see chart) which has been around since the mid-1970s. interest at 20%! Or during the Great Recession!
Additionally, the U of M survey showed that the sample’s revenue growth expectation for next year now stands at +0.5%; this, in the face of an inflation of 8%+. Obviously income is not keeping up and that means real consumption will languish.
Moreover, companies do not expect things to improve. The chart at the top of this blog shows the worst business prospects in the history of the National Federation of Independent Businesses (NFIB) survey, and by a significant margin!
· Industrial production: it increased by 0.2% in May, only because the production of utilities increased by +1.0% due to abnormally hot weather. The weakness was concentrated in the manufacturing sector, where production fell -0.1% M/M despite an increase in automotive production (+0.7% M/M) which continues to catch up with to the shortage of chips caused by the pandemic. Declines occurred in the production of machinery, aircraft, computers and other electronic devices, as well as in metal fabrication.
· Housing: The construction of new homes is an important sector when it comes to measuring GDP. New home sales were -16.6% year-on-year in April (March was down -10.5%). New home inventories are now 8.3 months down, nearly double what they were a year earlier. In May, housing starts fell -14.4% M/M and building permits fell -7.0%. The National Association of Homebuilders (NAHB) confidence index fell again in June for the sixth consecutive month. The last time we saw that was in 2007! June’s Potential Buyer Traffic Index now stands at 48; it was 71 in January. The six-month sales forecast is 61 (June) versus 82 (January). The chart shows the impact of the recent mortgage rate hike from 3.0% to 6.0% on a 30-year fixed rate mortgage payment for a $250,000, $500,000, and $750,000 home. The California Association of Realtors reports May home sales were -9.8% lower than April and pending sales were -30.6% lower on a Y/Y basis.
The Canadian housing market appears to be a quarter or two ahead of that of the United States. In Canada, house prices have fallen -13% since mid-February. You think it can’t happen in the United States? Think again !
As we’ve reported in previous blogs, mortgage purchase requests are down -21% from a year ago. With the drop in new home sales and building permits, it’s no wonder that lumber and metal prices are also falling.
Retail sales: They were down in May -0.3% on a nominal basis. When inflation is taken into account, real retail sales (ie volume) fell -1.2%. It is enormous! Auto sales fell -3.5% M/M and -3.7% Y/Y. Maybe the all-time low in the U of M consumer purchase intentions measure is a good leading indicator after all!
The fact that the Fed is looking at the U of M consumer confidence indices gives us great confidence that their economists (400 of them) consider these indices to be leading indicators, just like we do. If these clues are any indication of what’s to come, buckle up!
Finally, the Conference Board’s Leading Economic Indicators (LEI) have been negative for three months in a row and for four of the last five.
· Inflation: Just a few thoughts on inflation. Our view is that inflation is “passing”. The problem with this word is that it was never defined as to duration, so the media attributed it to a short period, like a few months. The term actually means “not permanent”. We believe that inflation is, indeed, transitory, but long-lasting. Of course, Russian aggression made things worse (but that’s not the main cause of the inflation we have). At this point, we are quite confident that May or June will be the peak for the following briefly stated reasons:
- Fiscal policy has tightened compared to last year;
- The money supply is contracting now;
- The Fed not only pushed interest rates higher, but has now launched quantitative tightening (liquidity will dry up);
- The supply chain is decongested;
- Rents will moderate as record multi-family units come online;
- The US dollar is strong, reducing the cost of imported goods;
- Commodity prices appear to have peaked;
- Large retailers are stuck with unwanted inventory levels; “for sale” is imminent;
- Wage growth has slowed to about half its 2021 rate;
- Gasoline and food prices are causing major problems in the retail sector, with May posting -61,000 layoffs there.
The stock market was hammered last week as investors realized how dire the economic situation had become with a seemingly tone-deaf Fed. The bond market, however, seems to have come around to our view that the recession will come sooner and be deeper than the Wall Street narrative would suggest. And, although the current “dot plot” is more hawkish than the previous one, Treasury yields are now down.
So, Mr. Powell, you can fool some people all the time, and everyone sometimes, but you can’t fool the bond market, and you can’t fool us!
(Joshua Barone contributed to this blog)