Why It’s The Fed’s Fault
Equity markets ended Q1/22 (Thursday, March 31) with the first quarterly loss in two years (since Q1/2020, i.e., when the pandemic began). Of interest was the rush to sell in the last hour of trading, as if mutual funds and equity ETFs did not want to show too many equity holdings for the March 31 reporting period. Unfortunately, volatility looks to be the order of the day, at least for the next few months, as markets must deal with both the possibility of a recession and the Fed’s soon to be announced Quantitative Tightening (QT) program (more on this below).
While the media concentrates on equities, the chart above shows that the rapid rise in interest rates over the past couple of months and the concomitant plunge in bond prices has been at least a three standard deviation event, the worst downdraft in at least 50 years. In addition, there is now a growing controversy between those economists that work for the sell side and those that rely more heavily on history as to whether or not the flat/inverted yield curve (2 Yr. T-Note yield (2.46%)>10 Yr. T-Note yield (2.39%)) continues to be the reliable recession indicator that it has been in the post-WWII era.
The Tightening Narrative
Whenever the Fed begins a tightening cycle, its prognosis for the economy must show up as bullish so that it can forecast a “soft landing.” Imagine if the Fed started a tightening cycle and told the media that the economy was weakening and its actions could spell recession! (This, however, does appear to be reality!) As a result of such need, the accuracy of the Fed’s GDP forecasts (as calculated by Rosenberg Research) is a lowly 17%! In the current set of circumstances, with a significant portion of the current inflation caused by commodity issues impacted by the pandemic, war, and drought, it is quite possible that the Fed’s actions will hurt the underlying economy without quickly reducing inflation.
In last week’s blog we showed that, for the past 50 years, inflationary spikes were tied to spikes in the price of oil, and inflation recedes when oil prices fall. There is no doubt that today’s inflation is tied to the prices of oil, certain agricultural commodities, and specific commodities tied to battery technologies but needed in other industrial products. A significant portion of these price spikes are due to war, sanctions, and geopolitical tensions over which the Fed and other central banks have literally zero control/influence.
The 10-Yr 2-Yr Controversy
In post-WWII 20th century tightening cycles, the Fed gave no “forward guidance.” The only information the market knew was what actions the Fed had taken in the marketplace., i.e., the level of the Federal Funds (FF) rate. If that were the case, today, all the market would “know” was that the Fed had just raised the FF rate by 25 basis points (bps). During that era, the best recession indicator was an inversion of long-term bond yields (i.e., the 10-Yr.) with the FF rate. Today, with the 10-Yr. at 2.39% and FF at 25-50 bps, there is still more than 200 basis points of positive slope. At his last press conference, Fed Chair Powell noted this positive slope as an indicator that the probability of a recession was remote.
What’s different today is “forward guidance” as displayed in the quarterly “dot-plot.” (The “dot-plot” is the forecast by the FOMC members of the FF rate for the next two years.) With such “forward guidance,” markets have already incorporated the expected trajectory of Fed policy, in effect implementing in a couple of months what the dots suggested would take one to two years. Take, for example, mortgage rates. Last October, these were under 3%, and they were just over 3% at the turn of the year. On March 31, they stood at 4.67%. While the FF rate tells us where the Fed is in this expected cycle (at the beginning), the markets have moved the 2-Yr. through 10-Yr yields to the expected end state of this tightening cycle. Because the entire tightening regime has already occurred except in the very short end, the 10-2 yield spread is a much better predictor than the 10-FF spread.
It is our view that the current forward guidance, via the dot-plots, introduces unnecessary volatility into the fixed-income markets. Assume, as Chairman Powell has stated several times, that Fed policy and actions are “data dependent.” Assume that the economy is weakening, as we have continued to show in these blogs (see more such data below). If incoming data proves to be weaker than expected and the dot plots shift lower, then the Fed has unnecessarily introduced market volatility (as per the three standard deviations shown in the earlier chart). We believe that “forward guidance” shouldn’t extend beyond one quarter. Volatility would be significantly lower.
Quantitative Tightening (QT)
As if the current volatility weren’t bad enough, markets must also deal with the Fed’s upcoming QT regime. For background, this will be the Fed’s second attempt to reduce its balance sheet. The first was the abortive attempt in 2018. Back then, the withdrawal of a modest amount of liquidity exposed the fragility of the overleveraged financial system, with overnight rates in the interbank reserve lending market spiking to double-digit levels in a matter of just a couple days. Today’s financial system is significantly more leveraged. Michael Lebowitz (“Will Quantitative Tightening Overwhelm the Markets?”) recently calculated the following:
- During the Financial Crisis, QE1 injected $300 billion in liquidity. That took more than a year. During Covid, that amount was injected in three days;
- QE2 injected $600 billion in eight months; during Covid, that took six days;
- QE3 injected $1.5 trillion over 22 months; that took just over one month during Covid!
According to Lebowitz, taking various Powell pronouncements into account, the Fed plans three years of $1 trillion balance sheet reductions per year. This rate is twice as fast as the QT that caused the liquidity issues in 2018, and into a system that is significantly more leveraged. The implication here is for significantly more market volatility in both the equity and fixed-income markets, and, in all liklihood, the Fed will have to abandon that QT program..
Meanwhile, the incoming data continues to show weakness despite Powell’s pronouncements to the contrary.
- The Manheim Used Car Price Index fell in both February and March. While still high, this is an indicator of cooling demand.
- Mortgage applications fell -6.8% for the week ended March 25 after falling -8.1% the prior week. They are down in seven of the past eight weeks and down -42% Y/Y. Refinances, a significant source of liquidity for U.S. households, fell -15% the week of March 25, -14% the prior week, and -60% Y/Y. No doubt this is a function of rising mortgage rates which wouldn’t be at this level if not for the flawed “forward guidance dot-plots.” This is a great example of why we think the recession will occur more quickly than in past tightening cycles, because, with no “forward guidance” like it was back then, today’s mortgage rates would just be moving above 3% (the rate at the turn of the year), not anywhere near today’s 4.67%!
- The latest apartment national vacancy rate was 4.6%, up from 3.8% last summer (new supply(!) as this blog suggested would be the case). This will have an impact on inflation going forward (i.e., lower), and will also negatively impact future multi-family starts.
- Friday’s payroll report looked strongish on the surface (+431K), but the strength was not broad based, mainly concentrated in leisure/hospitality and professional and business services. Average weekly hours worked fell from 34.7 to 34.6. According to Rosenberg Research, each tenth of an hour represents about 370K jobs. Thus, on net, the economy was only ahead by the equivalent of about +60K jobs, still positive, but more in line with minimal GDP growth.
- Real Disposable Personal Income fell -0.2% in February and is down seven months in a row. In addition, average hourly earnings were up +5.6% Y/Y, but with inflation at or above 8%, real average weekly earnings are down (see chart). That means take home pay isn’t going as far as it was last year and that is one reason that the Atlanta Fed’s GDPNow forecast for Q1 is a lowly 1.5%.
- China’s economy is slowing significantly (partly due to lockdowns). Its March manufacturing PMI index fell into contraction (<50) at 49.5, and its service sector Index fell hard to 48.4 from 50.3. Another manufacturing measure, the Caixin Manufacturing Index also fell into contraction at 48.1.
- By now, everyone with a traditional gasoline powered car has experienced price shock at the pump. (While the price of oil is now back below $100/bbl., we haven’t seen any relief there!) In this inflation, too, food prices have skyrocketed (chart), so that is a double-whammy for consumers and will surely impact negatively on economic growth.
- Consumer sentiment has always been a leading indicator. Like we’ve seen consistently from the University of Michigan (chart), the Conference Board’s Consumer Confidence Index is also signaling recession.
- Challenger data for March show a +40% increase in layoff announcements and a fall in hiring intentions.
- In the equity markets, home builder stocks, autos and parts manufacturers, media and advertising companies, and retailers are all either in steep corrections (between -10% and -20%) or in “bear” markets (price declines of more than -20%). Some markets are already prepared for recession!
We see financial market volatility and confusion ahead, especially if the Fed continues its hawkish guidance as the economy weakens. Worse, with the economy now more overleveraged than it was pre-pandemic; the impact of QT (withdrawal of liquidity) will likely be quite disruptive to the equity markets.
Robert Barone, Ph.D.
(Joshua Barone contributed to this blog.)