A Powell Failure
The Fed tightened its administered Federal Funds Rate (the rate banks pay to borrow reserves) by 75 basis points (bps) (0.75 pct. points) to 1.50%-1.75%, a rate hike not seen since 1994. The issue here is that, for the first time in its 109 year history, the Fed is tightening into the teeth of a Recession. Back in 1994 when they tightened 75 bps, the economy was growing and they did manage to pull off one of those rare “soft landings.” That won’t occur this time because, by all indications, it appears that the Recession may have already begun. The only questions remain are “how deep” and “how long!” And that will be a function of how long the Fed keeps stomping on the financial brakes. Hopefully, the monthly inflation data will soon start to mellow (perhaps in July) which will give the Fed political cover to ease up on its tightening agenda.
We say that the Recession may have already begun. The rule of thumb definition is two negative GDP quarters in a row. Q1’s GDP was -1.5%, and the Fed’s own Atlanta Reserve Bank currently sports its Q2 GDP forecast at 0%. With the way the incoming data have been headed, that will soon turn negative.
Stock Market Woes
Investors appear to have cast off the Wall Street “Mild Recession” narrative (which was to begin sometime in 2023), and, as shown in the table below, reacted quite negatively the week just ended (June 17) with weekly losses for the major indexes in the 8%-9.4% range. Note that all the major indexes except the DJIA are now in “Bear Market” territory, with both the Nasdaq and Russell 2000 down more than 30% from their highs.
|Peak Value||Value 4/30/22||4/30 Chg fr Peak||Value 5/31||5/31 Chg fr Peak||Value 6/17||6/17 Chg fr Peak|
We expect the DJIA will soon hoist the “Bear Market” banner. Speculative assets, like crypto, have been hammered. Bitcoin is down more than -70% from its 52-week high.
Meanwhile, bonds, after being trashed for most of the year, finally found a bid as investors now realize that the impending Recession will prevent the Fed from enacting its entire “forward guidance” plan. That plan has the Fed Funds Rate rising to 3.375% by the end of this year (2022), rising further to 3.75% at the end of 2023, and then back down to 3.375% in 2024 (2.5% is thought to be 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 Projections” (SEP), otherwise known as the “dot-plot.” Jay Powell has said at every recent press conference that the “dot-plot” is the individual FOMC member forecasts and not official Fed policy. So, 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 10-Year T-Note yield reached 3.50%. By Friday, it was down to 3.23%, the bond market’s way of saying it doesn’t believe the Fed will reach the “dot-plot’s” projections.
The chart above shows that at the June Fed meeting, it reduced 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, for political reasons, the Fed can’t publicly admit that its policies will cause a Recession. After every meeting since Bernanke began the practice, the Fed Chair answers questions at a press conference. At the presser on Wednesday (June 15), Powell’s justification for the large (75 bps) rise in the Fed Funds rate was laughable. The University of Michigan (U of M) does a monthly telephone survey of consumers, and the latest survey showed inflation expectations had risen from 3.0% to 3.3%. Powell pointed to this as justification. The fact is, this is a lagging indicator because consumers get their point of view from the media which has been hammering the inflation narrative (using backward looking data – March, April, May CPI). The real “leading” inflation expectations indicator is found in the Treasury Inflation Protected Securities (TIPS) market. For several weeks that inflation expectations there have been falling. The five year futures are at 2.85%, a level not seen since prior to Russia’s aggression. So, no, inflation expectations aren’t rising; they’re falling!
And why is Powell cherry picking only certain data from the U of M survey? That survey now shows that overall consumer sentiment is at a record low for the history of the index (see chart) which has been around since the mid-70s. Sentiment wasn’t this low when Volker had interest rates at 20%! Or during the Great Recession!
In addition, U of M’s survey showed that the sample’s income growth expectation for the next year now stands at +0.5%; this, in the face of 8%+ inflation. Clearly, incomes aren’t keeping up and that means real consumption will languish.
Furthermore, businesses don’t expect things to get better. The chart at the top of this blog shows the worst corporate outlook in the history of the National Federation of Independent Businesses (NFIB) survey, and by a significant margin!
- Industrial Production: It rose 0.2% in May, only because utility output rose +1.0% on the back of unseasonably warm weather. The weakness was concentrated in manufacturing where output slipped -0.1% M/M despite a rise in auto production (+0.7% M/M) which is still playing catch-up from the pandemic induced shortage of chips. Declines occurred in the production of machinery, aircraft, computers and other electronics, and in fabricated metals.
- Housing: New home construction is a significant sector when it comes to measuring GDP. New home sales were -16.6% Y/Y in April (March was down -10.5%). New home inventories are now 8.3 months nearly double what they were a year earlier. In May, housing starts fell -14.4% M/M and Building Permits were down -7.0%. The National Association of Homebuilders’ (NAHB) sentiment index fell again in June for the sixth month in a row. The last time we saw that was in 2007! The June Prospective Buyer Traffic Index now stands at 48; it was 71 in January. Six month sales expectations are 61 (June) down from 82 (January). The chart shows the impact of the recent rise in mortgage rates from 3.0% to 6.0% on a 30-year fixed rate mortgage payment for a $250k, $500k, and $750k home. The California Association of Realtors reports that home sales in May were -9.8% lower than in April and pending sales were -30.6% lower on a Y/Y basis.
Canada’s housing market appears to be a quarter or two ahead of that in the U.S. In Canada, home prices have fallen -13% since mid-February. Think that can’t happen in the U.S.? Think Again!!!
As we’ve reported in prior blogs, mortgage purchase applications are down -21% from a year ago. With new home sales and building permits falling, it isn’t any wonder that lumber and metals prices and 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 (i.e. volume) fell -1.2%. That’s huge! Auto sales fell -3.5% M/M and -3.7% Y/Y. Perhaps the historic low in U of M’s measure of consumer buying intentions is a good leading indicator after all!
The fact that the Fed looks at the U of M Consumer Sentiment Indexes gives us a lot of confidence that their economists (400 of them) view those indexes as leading indicators, as we do. If these indexes are any indication of what lies ahead, buckle up!
Finally, the Conference Board’s Leading Economic Indicators (LEI) have been negative three months in a row and in four of the last five.
- Inflation: Just a few thoughts on inflation. Our view is that inflation is “transient.” The problem with that word is that it was never defined as to time frame, so the media imputed to it a short period, like a few months. The term actually means “not permanent.” We believe that the inflation is, indeed, transient, but with a long time frame. Of course, the Russian aggression has made things worse (but it isn’t the main cause of the inflation that we have). At this stage, we are fairly confident that May or June will be the peak for the following briefly stated reasons:
- Fiscal policy has tightened up vs. last year;
- The money supply is now contracting;
- The Fed has not only caused interest rates to rise, but has now embarked on Quantitative Tightening (liquidity will dry up);
- The supply chain is unclogging;
- Rents will moderate as record multi-family units come on-line;
- The U.S. dollar is strong which reduces the cost of imported goods;
- Commodity prices appear to have peaked;
- Major retailers are stuck with undesirable levels of inventory; “on sale” is imminent;
- Wage growth has slowed to about half of its 2021 rate;
- The prices of gasoline and food are causing major issues in the retail sector with May showing -61k layoffs there.
The stock market got hammered last week as investors realized how serious the economic situation has become with a Fed seemingly tone deaf. The Bond market, however, appears to have come around to our view that the Recession will come sooner and be deeper than the Wall Street narrative would have one believe. And, despite the current “dot-plot” being more hawkish than the last one, yields on Treasury Notes are now falling.
So, Mr. Powell, you can fool some of the people all of the time, and all of the people some of the time, but you can’t fool the bond market, and you can’t fool us!
Robert Barone, Ph.D.
(Joshua Barone contributed to this blog)