Financial markets became temporarily unglued with the release of the Fed’s post-meeting statement on June 16 and the publication of its “dot-plot” table. The dot-plot, originated in the Bernanke Fed in 2012, represents the 18 individual policy committee member views as to what the Fed Funds Rate level will be on December 31 of the next three years and then a longer-run view. Despite Chair Powell’s reiteration at the post-meeting press conference that the dot-plot represents individual member views, not the Fed’s view, and that the Fed still views the current uptick in inflation metrics as “transitory,” nervous markets took back most of the 12 basis points (bps)(0.12%) rate decrease in the 10-Year Treasury from the prior week. (The market has a nasty habit of shooting first and asking questions later.) The 10-Year closed on Wednesday, June 16, at 1.58%, up +8 bps (from 1.50%) on the day. After ruminating on all the issues for a day, the market retraced nearly all that upsurge on Thursday, June 17, closing the day at a 1.51% yield and falling even further on Friday. Fed committee members thinking about the Fed doing something about inflation is apparently enough to quell the inflation-phobes.
Dot-Plots: Quite Useless
Data provided by Rosenberg Research show that the dot-plots are useless as a predictive tool. Rosenberg provided a table in a recent blog showing the dot-plots at every meeting since 2012 and how far off from the actual they have been. In the two typical examples below, the median dot-plot for the Fed Funds Rate for the end of the year is shown alongside the actual result.
Reality is what Chair Powell said at the press conference regarding the make-up of the spike in May’s inflation indexes. He said that May’s inflation was skewed to those sectors that were most heavily impacted by the pandemic and its aftermath (leisure/hospitality, travel, car rental, used cars…), and that the categories of prices that have historically been highly correlated with underlying inflation were much more subdued. (20% of the CPI represented a +2.5% surge M/M in May; 80% showed up as +0.15% according to Rosenberg Research.). Powell even made the point that used vehicle prices were skewed upward by the chip shortage impact on new vehicle production and by the huge demand for used vehicles from auto rental companies, caught with low levels of vehicles as they had reduced their fleets due to low demand during the lockdowns. All the Federal Reserve Regional Bank inflation models back up Powell’s “transitory” inflation view, the most recent being the Cleveland Fed’s Weighted Median Index which showed up at +0.26% M/M in May, up ever so slightly from its +0.24% April reading.
A Slow Second Half
With much of the stimulus from the December and March money drops now behind us, recent data are now giving us a glimpse of what the second half of 2021 may hold as far as economic activity is concerned – that is, without a fourth round of free money.
Retail sales fell -1.3% in May (M/M). April was revised up, but it is the direction of change that is important. If one factors in the price increases, retail sales in physical terms fell closer to -2.0%. Looking back to the first and second rounds of helicopter money, we saw retail sales turn negative when the stimulus wore off – negative in November and December when the first round of stimulus wore off and again last February when the second round had run its course. Without another round of such funding, and with the federal $300/week supplemental unemployment benefits winding down between June 12 and September 6, retail will likely be flat/down over the year’s second half.
Rising Wage Fixation
There has been a plethora of news reports on rising wages, much of which appears to be due to the apparent unwillingness of many of the unemployed to take one of the record number of unfilled job openings. Recall that our position has been, and continues to be, that the federal $300/week unemployment supplement is the dis-incenting reason. And aggregated data do not point to any sort of runaway growth in wages. The Atlanta Fed has a very sophisticated “Wage Tracker” (available to the public via their website) which breaks wage growth down in just about every imaginable way. The chart below shows the overall aggregate.
Note that wages were growing faster in 2019 when the Fed was struggling with deflation than they have since last fall. The chart shows that the rate of wage growth has actually fallen from the high to the low 3% range. With productivity growth above 4% in Q1, and likely to continue at that level or higher, there is no real case for “systemic” inflation.
Furthermore, as we have previously penned, pent-up demand for many of the service sectors most impacted by the pandemic (restaurants, airlines, hotels…) will be met by (we think steeper) pent-down demand for physical goods which showed outsized growth in 2020 (mainly because the service sector was closed and people spent on goods like appliances, carpet, couches, home improvement, autos,…). Such spending is unlikely to be repeated (you aren’t going to buy another couch, or re-remodel your kitchen)!
To conclude this section, it appears to us that the Street is still too bullish on the rest of the economy. Recent employment data haven’t been that hot (see below), retail sales are tailing off, and the housing data is rapidly softening; surveys say that intent to buy a home (and auto) is at a 39-year low! Hence, our view that GDP will be weaker than anticipated in 2021’s second half coincides with our view that interest rates will be lower at year’s end than they are today.
The Labor Market
The news this week (ending June 19) on the labor front was mixed. Initial Unemployment Claims (ICs), both state and PUA (Pandemic Unemployment Assistance program) reversed their recent downtrends, rising to +520K (Not Seasonally Adjusted) from +438K the prior week. ICs are a proxy for new layoffs. So, this is not a good sign for a supposed “hot” economy; perhaps it isn’t as “hot” as the financial media would have one believe. The chart below shows the IC data for the last week of each month since February 2020 and includes, as the last data point, the last week of published data; in this case June 12. Note the slight uptick on the right-hand side. Still a decent downtrend, however.
There was somewhat better news in the Continuing Unemployment Claims (CCs) filings, i.e., those receiving benefits for more than one week. These fell by -560K the last week of May (May 29, the latest available data) to 14.8 million (see right had side of the chart below).
During the last week of April, CCs were 16.8 million. At the current pace, then, “normal” (2 million) will return in about 6 months. As has been communicated in this blog over the past months, we think returning to “normal” will be faster with the rolling off of the federal $300/week dis-incenting unemployment supplement between now and September 6.
We have now entered the period where some states are no longer paying the enhanced federal benefit. Next week’s Department of Labor data by state will indicate whether the removed supplement had any initial impact in the four states where it was eliminated. Stay-tuned!
On the technical side, unnoticed (or, at least, ignored) and unquestioned by the financial media, the Fed raised the rate it pays on its overnight reverse repurchase (“reverse repo”) facility from 0.00% to 0.05%. This is where the banks can park their cash overnight taking Treasury paper as collateral, and now receive a modicum of interest.
Back in September 2018, there was a shortage of liquidity in the banking system, and overnight cash fetched in excess of a 10% annual rate. It was that lack of liquidity that turned the Fed from its rate hiking cycle, as it opened the liquidity spigots (which have yet to be turned off) and undertook its latest Quantitative Easing (QE) program, which includes purchases of $120 billion/month of Treasury and Mortgage-Backed Securities. As is clear from the blue line on the chart below (right hand scale), starting in April, there has been more than ample liquidity in the banking system. The day after the Fed’s announcement (June 17), demand for reverse repo spiked, rising by 50% in a single day (last data point, blue line). The real purpose here is to throw a lifeline to money market funds, as the Fed was worried that they would stop accepting new cash.
Based on similar work done by Danielle DiMartino Booth of Quill Intelligence, we have overlaid the rate on the 10-Year Treasury (gold-line, left scale), and it looks like interest rates are quite sensitive to this rising level of liquidity.
Note the general downtrend in yield as liquidity has risen. Ok– not unexpected once discovered! The Fed has just started talking about tapering its QE program. Be mindful, “tapering” is not a balance sheet reduction and doesn’t remove liquidity. In fact, it continues to add it. It just doesn’t add it as fast! So, even during the tapering period, interest rates may still be anchored to the floor, depending on what banks do with their cash. In general, they have three choices: a) keep the cash (use the Fed’s reverse repo facility); b) buy Treasury securities; or c) lend to the private sector. So far, the first two have been predominant, as bank lending to the private sector is flat to down since spring 2020. Hence, another reason why we don’t see upward pressure on interest rates at least through the end of this year, and probably for several months thereafter.
Rates spiked on Wednesday on the initial release of the “dot-plot” (shoot-first!). By Friday, all the initial angst had passed with the realization that the dot-plot is a horrible forecasting tool, and that, perhaps, the Fed is actually concerned about inflation. The short end of the yield curve is higher than pre-Fed levels, but the intermediate (10-Year) is back to or below Wednesday levels, and the long-end is slightly lower. Perhaps the “transitory” narrative is still emerging!
Incoming data show reopening, but consumption doesn’t appear to be “hot” except for a few specific services. Like the stimulus checks of 2020, the impact on consumption of March’s free money looks to have run its course. The result is that economic growth in 2021’s second half may disappoint current expectations. And, while the media continues to hype rising wages, the overall evidence doesn’t point to any kind of a wage-price spiral like the one rampant in the 1970s. We believe that the wage narrative will dissipate when the $300/week federal supplement ends. Some states are already ahead of that game.
Finally, banks are awash with cash. “Tapering,” itself, won’t reverse this; just slow the increase. Data analysis shows there to be a fairly strong inverse relationship between such liquidity and bond yields; yet another reason to believe that the pressure on interest rates is downward.
(Joshua Barone contributed to this blog)
Robert Barone, Ph.D. is a Georgetown educated economist. He is the co-portfolio manager of the UVA Unconstrained Medium-Term Fixed Income ETF (NYSE Symbol: FFIU). Robert is also a financial advisor at Four Star Wealth Advisors. He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO, a Director and Chairman of the Federal Home Loan Bank of San Francisco, and. similarly, a Director and Chairman of the CSAA Insurance Company (the AAA brand). Robert currently is a Director of the AAA Auto Club of Northern California, Nevada, and Utah, and a Director of Allied Mineral Products (Columbus, OH), America’s leading refractory company.