The Economist is becoming known as a source of the contrarian magazine cover indicator. As the world holds its collective breath for the FOMC decision next week, the recent cover of the magazine begs a number of important questions for investors.
- How far beyond the inflation-fighting curve is the Fed?
- What are the likely policy implications?
- Is this a case of peak hawkish expectations for the market and what does that mean for asset prices?
A “whatever it takes” moment
Let’s begin with the Fed’s policy path. Not only has the Fed taken a hawkish pivot, but also so have most central bankers around the world. John Authers
reported that Deutsche Bank currency strategist George Saravelos summarized the recent IMF/World Bank meetings as a “whatever it takes” moment on inflation for global central bankers.
The IMF/World Bank meetings are rarely market-moving events. But this year they were: It was the “whatever it takes” moment for global central bankers on inflation. As the week progressed, the messaging got progressively more hawkish. Take President Lagarde [of the European Central Bank] who said little at the start of the week, only to conclude by Friday that an early end to QE was likely. Take Governor Ingves of Sweden – an outspoken dove until a few weeks ago — who threw “low for long” out of the window. Governor Macklem of Canada probably summarized the outcome of the mingling best: “There is a growing sense… central bankers need to ensure that control (on) inflation is realized.”
In a CNBC panel discussion
that featured Fed Chair Jerome Powell, IMF Managing Director Kristalina Georgieva, ECB President Christine Lagarde, G20 host Indonesia Finance Minister Sri Mulyani Indrawati, and Barbados Prime Minister Mia Mottley, Powell reiterated his mantra that the Fed is focused mainly on price stability. Fed officials had expected inflation would peak in the wake of the pandemic, but they are now waiting for real evidence of deceleration before acting and the Fed is no longer waiting for help from the supply side to bring down inflation. In the face of supply shocks from the pandemic and the war, Powell acknowledged that monetary policy can do little to affect supply, but the Fed is raising rates to reduce demand through two policy levers. The jobs market is too hot, and the Fed would like to see the unemployment rise. Powell also gave an indirect nod to Bill Dudley’s thesis in his Bloomberg Op-Ed
that monetary policy affects financial conditions whose effects are transmitted to the actual economy. Translation: the Fed would like the stock and bond markets to fall. As a reminder, here is what Dudley wrote:
Financial conditions need to tighten. If this doesn’t happen on its own (which seems unlikely), the Fed will have to shock markets to achieve the desired response. This would mean hiking the federal funds rate considerably higher than currently anticipated. One way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower.
From a monetary policy perspective, here is how the Fed is thinking about inflation. Researchers at the San Francisco Fed
decomposed the components of core PCE that are COVID-sensitive and insensitive. As the analysis shows, inflation pressures would be under control without the pandemic. Most of the inflation pressures stem from COVID-sensitive elements of core PCE.
In light of this analysis, Fed officials had hoped that once the pandemic-related supply chain disruptions begin the fade, the inflation surge would be transitory and decelerate back to the Fed’s 2% target again. A recent New York Fed study
on the breadth and persistence of inflation has thrown many of those assumptions out the window. Here are the key conclusions:
We find that the large ups and downs in inflation over the course of 2020 were largely the result of transitory shocks, often sector-specific. In contrast, sometime in the fall of 2021, inflation dynamics became dominated by the trend component, which is persistent and largely common across sectors.
To make a long story short, Fed researchers found that inflation pressures rose strongly at a sector level in the fall of 2021, which was much sooner than many analysts had expected. Moreover, the statistical isolation of common components shows that inflation broadened much earlier than consensus.
In other words, don’t expect inflation to ease in a transitory fashion when momentum is so strong. That’s why Fed officials have taken a decidedly hawkish pivot.
In response to the Fed’s hawkish path, recession warnings have begun to come out of the woodwork. Wall Street forecasts vary greatly. The most bearish is the call for a hard landing by the team at Deutsche Bank. Fannie Mae
issued a forecast for a mild recession in the second half of 2023, which is an important marker as the organization is intensely focused on the highly sensitive housing sector.
Our updated forecast includes an expectation of a modest recession in the latter half of 2023 as we see a contraction in economic activity as the most likely path to meet the Federal Reserve’s inflation objective given the current rate of wage growth and inflation. Since our last forecast, monetary policy guidance has shifted in a hawkish direction, and markets have responded with rapid increases in interest rates, signaling a belief that brisker tightening is likely to occur. While a “soft landing” for the economy is possible, which is where inflation subsides without economic contraction, historically such an outcome is an exception, not the norm. With the most recent inflation readings at levels not seen since the early 1980s and wage growth exceeding that which is consistent with a 2-percent inflation objective, we believe the odds of a soft landing are even lower. Returning to the Fed’s policy target, therefore, likely necessitates economic growth slowing sufficiently to lead to a rise in the unemployment rate, which would cool wage and price pressures.
Other housing focused forecasters, such as Logan Mohtashami, have been more on the fence. Mohtashami outlined his concerns in a recent podcast
. Housing starts numbers have been distorted by supply chain problems and he is monitoring new home sales instead. Mortgage rates have been rising, which has put pressure on new home buyers because some can’t qualify for purchases at the higher rate. This has left builders scrambling to replace the buyers who have abandoned purchases. If new home sales fall, a decline in housing construction will follow, which leads to a cyclical downturn.
The latest release of the March new home sales was weak and missed expectations. This may be the start of a stall, which could be dire for the economy. However, this data series is volatile and prone to revisions. Therefore I would like to wait at least a month for confirmation of weakness.
Another disconcerting data point can be found in the spread between the forecasted new orders and current new orders components of the Philly Fed manufacturing survey. While readings may not necessarily be recessionary, they do warn of a slowdown ahead.
For the last word, I turn to New Deal democrat
, who maintains a set of coincident, short-leading, and long-leading indicators. He recently wrote about the parallels between the situation in 1948 and today. The economy went into a recession without a yield curve inversion, though it did follow a familiar boom-bust cycle.
Our current situation shows many similarities: the Fed has been on the sidelines, while both wages and prices have increased sharply. While there has been no yield curve inversion, the increase in real consumer spending has stopped. And this may be taking a toll on corporate profits, although we won’t know – at least in terms of the official GDP report – for another month.
But there are several differences as well. Most importantly, the important leading sector of the housing market has not yet turned down, and there is no sign of cooling demand showing up in commodity or producer prices. Additionally, much of the inflation is from outright supply chain disruptions (viz., at the moment the COVID-caused bottleneck in the port of Shanghai), rather than just increased demand.
Of course, the Fed could yet step in and raise interest rates enough to persistently invert the yield curve. Failing that, the housing market and a sharp pullback in commodity prices are the surest signs of the “bust” part of the old-fashioned Boom and Bust cycle, a la 1948.
We’ve had some additional data since the publication of that note. Real M2 growth has slowed sufficiently to signal a recession, though real M1 growth remains neutral. More importantly, Q1 proprietors’ income, which is an early look at corporate profits, held up reasonably well. NDD
concluded that “the picture continues to deteriorate”. I interpret this to mean that the economy is wobbly, but it would be too early to call a recession based on NDD’s set of long-leading indicators that look ahead 12 months.
Rising systemic risk
One of the risks of Fed hiking cycles is the systemic risk of a disorderly deleveraging event or financial crisis. Financial stability risk within the US should be relatively low. In the wake of the COVID Crash, household and corporate balance sheets improved because of the massive fiscal and monetary stimulus. Leverage ratios fell and the risk of a financial crisis should be low because the economy has already deleveraged.
That said, the risk is outside the US. The Fed has embarked on a more aggressive tightening program than other major central banks. The eurozone economy is extremely weak in the face of the war. Despite the threat of rising inflation, the ECB is expected to take an easier monetary policy in its tightening cycle. Over in Asia, the BoJ is stubbornly clinging to its yield curve control regime and the PBoC is eyeing an easing cycle. Consequently, the USD is appreciating against all major currencies. This has led to the unusual condition where inflation is rising alongside the USD, which is creating risk for fragile emerging markets.
In other words, when the Fed raises rates, it’s raising them for the rest of the world. IMF head Kristalina Georgieva warned in the CNBC panel discussion
that a 50 basis point hike by the Fed doesn’t just mean that fragile EM economies have to take on the burden of a similar hike, but the prospect of hot money fund flows out to dollar assets as a safe haven. This exacerbates the risk of sovereign debt defaults. Moreover, the stampede into King Dollar raises the risk of a dollar shortage in the offshore USD markets, which also raises the risk of a discontinuous deleveraging event.
Ahead of the May FOMC meeting, hawkish expectations are high. Even though the Fed Funds rate has barely budged, the 2-year Treasury yield, which is a proxy for the market expectations of the neutral Fed Funds rate, has soared.
What’s the neutral rate? Currently, the market is discounting a half-point hike in May, a three-quarter point rate hike at the June meeting, followed by another half-point hike in July. The December projection of a Fed Funds rate of 275-300 bps is past the Fed’s published median neutral rate of 2.4%, as outlined by the Summary of Economic Projections.
Consider Friday’s report of March core PCE, which came in at 0.3%, which was equal to market expectations. In the next three months, high core PCE rates will roll off and the annual rate will decline. Based on current figures, core PCE is running at around 4% per annum, which is roughly equal to the Fed’s projected core PCE rate of 4.1% at year-end, according to its Summary of Economic Projections. This reduces pressure on the Fed to be aggressive in its tightening policy.
This is sounding like the market has overshot the Fed’s policy path. The Economist cover may prove to be another classic contrarian magazine indicator for a bond market rally, with the FOMC meeting as a possible trigger for a reset of expectations. Arguably, USD strength will weaken inflation and growth and contribute to a gentler rate hike cycle.
For much of 2022, stock and bond prices have fallen in an unusual synchronized manner. A more dovish Fed rate hike policy could send both stocks and bonds up together.
Stay tuned. Tomorrow, I will write about how to tactically position for the potential rally ahead.