Markets to Fed: We’re Easing Whether You Like It or Not

The financial markets now recognize that the Recession has arrived, and given those markets, it’s time for the Fed to stop tightening, if not beginning to lower rates. And because the Fed isn’t doing that, the markets are doing it for them. Not that the Fed will like it. The Fed, of course, does care; otherwise, why would they send out FOMC members with hawkish comments?

The chart above shows that the 10-Year Treasury Note peaked at 4.24% on October 24^th, then again at 4.21% on November 7^th, and at a lower level (3.88%) on December 28^th. (It is a similar story for the 2-Year Note (4.72% on November 7^th, 4.55% on November 21^st, and 4.46% on January 5^th.) Note the downward trend and the lower peaks. As we write, those yields stand even lower (3.48% for the 10-Year; 4.18% for the 2-Year), well below the recent peaks.

This has occurred despite the Fed’s FOMC members attempt to jawbone rates higher and in the face of the nearly 100% chance of a 25-basis point rate hike at the February 1^st Fed meeting (raising the Fed Funds Rate to the 4.50%-4.75% range), and the promise to raise further to the 5% level.

The “Transparency” Dilemma

Several months ago, in this blog, we postulated that, in this new era of Fed “transparency,” the financial markets would reinforce the Fed’s tightening moves by rapidly moving market rates to the Fed’s indicated terminal rate (as markets gleaned from the dot-plots). However, we said when it comes time to “pause” (stop hiking) or “pivot” (cut rates), like in the tightening phase, markets would move rates down, but at a much faster pace than the Fed desired. And that’s the case today. To combat such market moves, Fed rhetoric has been extremely hawkish. And it worked for a while (the November 7^th and December 28^th intermediate peaks). But no longer, especially given the meltdown in the inflation data and almost daily new evidence of a faltering economy. It appears that the “bond vigilantes” have re-emerged and have wrested control of much of the yield curve from the Fed.

The Labor Market

The evidence that a Recession has begun is evident except in the traditional measures of the labor market. We suspect the unemployment rate has been sticky due to labor hoarding after a couple of years of insufficient labor supply. Instead of shedding employees, firms are adjusting to the Recessionary climate by aggressively slashing the workweek and overtime (see charts).

In addition, the headlining Payroll Survey doesn’t distinguish between full- and part-time jobs. That data is found in the Household Survey, and December’s report confirmed a 670K+ move to part-time work.

An almost daily occurrence of late is a headline about layoffs, especially in the tech world (i.e., America’s growth industry). Some examples:

• Amazon: -18,000
• Alphabet (Google): -12,000
• Meta (Facebook): -11,000
• Microsoft: -10,000
• Salesforce: -7,000

The list goes on.

Ultimately, a total and comprehensive view of the labor markets leads to a much different conclusion about its strength than one would glean from the traditional unemployment rate alone (clearly, the Fed does not have this view).

Other Recessionary Data

• The Leading Economic Indicators have fallen for eight months in a row and in nine of the last 10. This has never happened outside of a Recession.

• The monetary aggregates say Recession. M1 has turned negative, and M2’s growth is 0%, the lowest growth rate in the history of this series.

• The banks that have reported this earnings season have all significantly increased their loan loss reserves, so we know what they expect. We have commented in past blogs about the rapid runup in credit card balances as consumers attempted to maintain their living standards. Discover, Inc. now expects its charge-off rate to rise to 3.9% in 2023, up from 1.8% last year.

• S&P 500 companies that have already reported earnings for Q4 are showing up at -10.5% on a Y/Y basis.

• Retail Sales, which have been hugging the flatline all year long, turned negative in November (-1.0% M/M) and worse (-1.1% M/M) in December. After adjusting for inflation, Real Retail Sales fell at a -2.5% annual rate in Q3 and Q4.

• Industrial Production fell -0.8% in December on top of November’s -0.6% data point. This index has been negative or flat in four of the last five months and six of the last eight. The ISM Manufacturing PMI, which measures expansion (>50) or contraction (<50), fell below 50 in both November and December.

• Worse, Manufacturing Production fell -1.3% M/M in December (-1.1% in November), and Capacity Utilization fell to 77.5% (December)(79.5% in October).

Inflation

We noted falling interest rates at the top of this blog, and the reason was that the financial markets saw inflation’s meltdown. The data is there for everyone to see.

• Let’s start with shipping costs. Remember the port back-ups in mid-2021? Remember how the cost to ship skyrocketed? Not so today (see chart). The Baltic Dry Index shows that shipping costs on the high seas have melted, down -76% from the peak, clearly the result of a fall-off in demand.

• The ISM Survey of Manufacturers shows that supplier delivery delays are below pre-Covid levels, as are order backlogs, both indicators of normalization of supply chains and a cooling of inflation.

• The Prices Paid Index shows a significant decline in inflationary pressures to the point where price increases are lower than pre-Covid 2018 and 2019. In the latest survey, for every manufacturer raising prices, 2.5 were lowering them!

• CPI (Consumer Price Index) and PPI (Producer Price Index) are the popular inflation indexes – one would say the “go-to” indicators. Last week in this blog, we discussed the melting of inflation in the CPI over the past six months (+1.9% Annual Rate over that time frame). PPI for December fell -0.5%, the largest fall in that index since the lockdowns (April 2020). The Wall Street consensus estimate was -0.1%, so this was a big surprise. On a Y/Y basis, PPI was +6.2% in December vs. +7.3% in November, and a consensus estimate for December of +6.8%. Core PPI (ex-food and energy), watched closely by the Fed, was +4.6% Y/Y. We expect this to be 2% or lower by mid-year!

• Then there are rents. As we have indicated in past blogs, the BLS’s rent calculation lags reality by 6-9 months. The left-hand side of the chart shows the Zillow Rent Index. Note its rapid fall over the past few months. The right-hand side shows the volume of multi-family units under construction. This assures us that rents will continue to fall as this inventory enters the market in 2023, another reason why inflation will continue to melt over the foreseeable future.

Final Thoughts

Incoming economic data says the Recession has started. Incoming price data says inflation is melting. Since each of these alone presages lower interest rates, together, they leave no doubt even despite a reluctant Fed.

Last year was the only year in modern history where both equity and fixed-income returns were negative.

While this year has just begun, we know that, at year’s end, 2023 will not appear in the lower left-hand quadrant because the fixed-income market will show positive returns. YTD, they already have!

Last Thought: “BAAA:”  (Bonds Are An Alternative).

Robert Barone, Ph.D.

(Joshua Barone contributed to this blog)