The Stage is Set for the Fed
Despite our expectation that markets would become erratic, the volatility displayed on Thursday and Friday (February 24-25), especially in equities, was shocking, even to us! The Nasdaq had a huge 7% swing from the intraday low to the close on Thursday, then proceeded up another 1.6% on Friday for a total up-move of 8.7% from the low. That number for the DJIA was 5.3%, and 6.6% for the S&P 500.
It was a similar story for bonds. As Russia’s invasion of Ukraine occurred pre-market on Thursday, there was a flight to quality (i.e., to Treasury bonds) early in the market day. 10-Year Treasury yields, which had closed on Wednesday at 1.98% fell to 1.86% early in Thursday’s trading, but swiftly returned to Wednesday’s levels when they were surprised by the mildness of the Biden Administration’s sanctions. Not only are oil and natural gas sanctions excluded, apparently the list of exemptions is as long as a roll of butcher paper. In addition, Russian financial institutions were not excluded from the SWIFT banking protocols (a worldwide system connecting financial institutions to one another), a significant sanction that was widely expected.
When the sanctions (or lack thereof) were announced, the financial markets quickly decided that the Russian invasion would have only minor economic consequences; thus the 10-Yr Treasury closed the day (1.97%) not far from its Wednesday close (1.98%), and of course, the equity market completely recovered and then some. Clearly it only took markets moments to decide that the invasion of Ukraine would not carry major economic consequences.
As a general rule, major market sell-offs caused by geopolitical events are short-lived. The chart from Vanguard shows market reactions to major geopolitical events since the 1962 Cuban Missile Crisis. Note that the chart deals in terms of months. This market event is the shortest-lived sell-off in modern financial history, lasting 1.5 hours (on Thursday, the Nasdaq opened at its low at 9:30 am EST, and had recovered to its Wednesday close by 11 am).
To be sure, there is going to be some economic fallout from Russia’s actions, mainly in the commodity space as Russia/Ukraine are major players in that space (mainly in oil, coal, fertilizers, grains, copper, nickel, and aluminum). So, indeed, if this invasion marks the beginning of a new “cold war,” commodity prices will end up higher than they otherwise would have.
That, along with the already weakening economy (see below), has shifted all analysis (speculation) to the Fed. Short-term rates continue to ratchet up with inflation, but the slowing economy keeps long-term rates from rising as fast. A rate hike (highly likely to be 25 basis points (bps) (0.25 pct. points)) is baked into the March Fed meeting along with the final cessation of QE (Quantitative Easing – additions of Treasury paper to the Fed’s balance sheet resulting in increases to already bloated bank reserves).
The Fed’s Dilemma
The real issue here is that the Fed’s tools impact demand, but the inflation is, and has been, a supply side phenomenon. Any price increases on the commodities mentioned above will be due to supply reductions. (The Fed can’t grow wheat, mine copper, or drill for oil!) The Fed certainly can stop inflation, but only by using its tools to reduce demand. For example, rising interest rates impact the demand for houses (see below).
In an economy already slowing, a too aggressive Fed risks recession. That is why we see only two or three rate hikes (of 25 bps), why equities tank when Fed FOMC members (i.e., Bullard) make uber hawkish statements, and why long-term rates aren’t rising as fast as short-term ones. The last point is the bond market’s signal to the Fed that they see a slowing economy ahead. Remember that historically, yield curve inversion has been followed by recession 100% of the time. Hence, the Fed is walking on egg shells.
Weaker Emerging Data
- Fed Surveys:
- The Kansas City Fed’s Monthly Survey is the latest Fed survey to document bottleneck easing in the supply chain. Order backlogs, inventories, hiring plans and supplier delivery delays were all lower in February, with the latter (delivery delays) at 36 vs. 55 in November.
- The chart shows the downturn in all the Regional Fed Manufacturing Surveys.
- New Home Sales fell -4.5% M/M in January and are down -19.3% Y/Y.
- With the rise in interest rates caused by market anticipation of the upcoming Fed tightening cycle, mortgage applications have fallen. The February 18 week showed a fall of -13.2% W/W, and they are now down -41% Y/Y.
- Not only is falling demand due to rising mortgage rates (4.06% for a 30-year fixed rate), but because home prices have skyrocketed (+18% Y/Y). It now takes eight years of personal income to buy a median priced home (50% higher than the historical mean).
- As seen on the chart, the home price issue is worse today than it was in ‘05-’06. What happened next is clear from the chart; a significant descent of home prices. Already the mild rise in interest rates has impacted demand. Think of what happens to the psyche and spending patterns of homeowners if we have a similar downcycle in prices, an event to which we assign a significant probability.
- Other Concerning Indicators
- This chart shows the downturn in the Conference Board’s Leading Economic Indicators (LEI). The -0.3 for January was the first negative reading since a slight stumble last February (2021) and before that since the early days of the pandemic. Note the weakness pre-pandemic when the economy was growing at stall speed. We don’t see any reason why the pandemic has changed the potential growth path of the economy and expect the pre-pandemic pattern to re-emerge.
- During the just concluded earnings season, the share of companies issuing weaker-than-expected full-year sales guidance was double those that came in stronger relative to expectations.
- Wage growth has fallen far behind inflation (see chart) and Russian aggression in the Ukraine is only going to put more upward pressure on gasoline and food prices as discussed above. And with the savings rate (6.4% as of January) now below its pre-pandemic level, households have little cushion. Rising prices of oil and commodities act as a deflationary tax. Consumption will suffer. It isn’t any wonder that credit card borrowing is through the roof!
The geopolitical events of the past week have now been sloughed-off by the financial markets because weak sanctions won’t have significant economic impacts. Markets are now waiting on the Fed. In truth, the bond market has already done much of the Fed’s work.
Unlike past tightening cycles, this one begins with an already weakening consumer, a flat yield curve, undesired inventory levels, and a weakening corporate outlook. The real danger resides with the next Fed signal, one that will come with the Fed’s meetings, its March 16 press release, and the follow-on press conference. If the signal is too hawkish a la Bullard (e.g., a 50 bps rate hike and aggressive dot plots), the yield curve is sure to invert and a recession becomes highly probable.
The Fed knows all this as they have more economists on staff than any other institution in the world. As we have written in these blogs, for political reasons, they have to appear tough on inflation. We think their best play is:
- To end QE as scheduled;
- To show moderation in their dot-plots;
- To raise the Fed Funds Rate by 25 bps;
- And, most important, to emphasize that policy, going forward, is data dependent.
That will stop the yield curve from inverting and reduce volatility in the financial markets.
Robert Barone, Ph.D.
(Joshua Barone contributed to this blog.)