A Hawkish Fed

The main emotional market news this week was the Fed’s unexpectedly hawkish stance. As expected, the Fed raised the federal funds rate (the overnight bank lending rate) by 25 basis points (from 0%-0.25% to 0.25%-0.50%). What was unexpected was the number of rate increases implied by the median “dot chart”, i.e. six more (one at each Fed meeting) in 2022, forecasting a rate federal funds from 1.75% to 2.00% by the end of the year. Additionally, 2023 showed more rate hikes with the 2023 terminal rate at 2.75%-3.00%. With the Fed setting its “neutral” rate at 2.4%, this implies that the Fed’s policy will be quite unaccommodating! (The “dot chart” represents the individual forecasts of each member of the Federal Open Market Committee (FOMC).) Two things are important to note:

  • As Powell pointed out in his post-meeting press conference, the dot plot is a forecast of individual FOMC members, not Fed policy. The policy is determined by the data available at the FOMC meeting. For example, the last time the FOMC met, the dot chart predicted only four quarter-point rate hikes in 2022; the current is seven including the one that just happened.
  • Dot-plots originated in 2012. Rosenberg Research performed correlation analysis of what the dots predict and what actually happened. It turns out that the midpoint accuracy for the fed funds rate is 37%.

Our view is that this particular set of points was not intended to make predictions, but to convey a message to the markets and the public, that message being: “we are very serious about fighting this inflation”. One would normally think that, given this new information, the entire yield curve would rise. But that didn’t happen. At the end of the day on Wednesday March 16, short-term interest rates were higher (e.g. the 2-year Treasury was up 10 basis points (0.10 percentage points)), but long-term yield curve, the 30-year fell -3 basis points. It was the market’s way of saying, “If you do this, it will be a political mistake!

Also of note at this Fed meeting is their revised forecast for “core” inflation (i.e. the level of inflation for everything except food and energy). In their forecasts, in the fourth quarter, underlying inflation fell to 4.1% from its current level of 5.2%, and it falls further in 2023 (2.3%) and 2024 (2. 1%). Just for comparison, the “base” number in the last PPI (Producer Price Index) was 0.2% M/M in February (2.4% Y/Y). The PPI is the most widely distributed leading CPI indicator. Thus, this “basic” figure of 4.1% seems somewhat high to us. It should also be noted that at the time of writing these lines (March 18), the price of oil (West Texas Intermediate – WTI) has fallen back to $105/bbl. starting at nearly $130/bbl. a few days ago (March 7). This should reduce perceived future inflation, but we wonder how fast the price at the pump will drop!

“A strong economy;” “Tight labor market”

The reasons Powell used to justify the Fed’s warmongering were a “strong economy” and “tight labor markets.” In our last blog, we highlighted the rise in the labor force participation rate as service workers returned to the workforce in droves in February, and we looked at the increase in layoffs and the decline in job offers from the last JOLTS. We’re sure Powell must be aware of this; they just don’t fit the narrative he needs.

Despite the aggressiveness on rates and the narrative of a “strong” economy, the Fed drastically lowered its GDP growth projections for 2022 from 4.0% (extremely disconnected) to 2.8%. (Incredibly, while growth has been reduced, the unemployment rate (U3) forecast for the fourth quarter has remained at 3.5%!) Given that the latest forecasts from the Atlanta Fed’s own GDPNow model predict real GDP growth of 1.2% in the first quarter, then, to reach 2.8%, the economy would have to grow at a pace of 3.3% for the last three quarters, which will be difficult to achieve with inflation, rising interest rates and the onset of QT (Quantitative Tightening – a reduction in the size of the Fed’s spreadsheet balance – something that will put upward pressure on interest rates and likely downward pressure on stock prices). Looking back to the pre-pandemic period, GDP growth averaged 2.3% from 2012 to 2019. Facing headwinds from fiscal policy, rising food and energy prices ( a regressive tax on low and middle incomes), sluggish real retail sales growth, and negative real wage growth, such a growth forecast seems unrealistic. (Note: Rosenberg Research pegs the accuracy of the Fed’s GDP forecast at 17%.) We’ve asked this question before, but it keeps coming up: what has the pandemic done to increase the rate of growth? post-pandemic economy, especially in the face of inflation? Answer: Nothing we can even imagine!

But, as we’ve written about in the past, the Fed is under enormous political pressure. If Powell could tell the truth, it would look like this: “Well, the economy really isn’t that strong, and we’re risking a recession if we end up doing all these rate hikes, but the poll numbers Uncle Joe are in the tank and Congress is holding our appointments hostage, so we have to come across as inflation fighters.By the way, that’s why I praised Paul Volcker in my testimony to Congress earlier this month- this !” (Note: Last Wednesday (March 16), the Senate Banking Committee, just after the Fed meeting, finally advanced the nomination of Powell and two others to serve on the Board of Governors of the Federal Reserve. Coincident with the your warmonger from the Fed meeting? We don’t think so!)

Emerging economic data

The chart at the top of this blog shows what the markets think of the strength of Retailers (bearish market), Homebuilders (bearish market) and Consumer Services (approaching a bearish market) (price as of March 14).

  • Real retail sales (adjusted for inflation) only grew at an annual rate of +1% for the five months ending in February (ie October to February). The chart shows that before the Russian invasion, food and energy accounted for 50% of CPI growth in February. Post-invasion numbers for food/energy will be higher.
  • Moreover, as the graph below shows, soaring energy prices are almost always associated with recessions. It should be noted that before the invasion, energy prices were already rising (from $66/bbl at the end of November to $92/bbl the day before the Russian attack).
  • The tax stimulus is in the rearview mirror (the restraint is in the headlights)! This will act as a real drag on GDP in 2022.
  • Sales of existing homes fell -7.2% in February and -2.4% year-on-year. These are closings, so the sales took place during the December/January period when mortgage interest rates hovered around 3.5%. Today, they are 4.5%. While the drop in sales appears to be a surprise to the markets, it was not for us, as we have documented on several blogs, that the University of Michigan Consumer Sentiment Survey telegraphed a weaker housing market as purchase intentions fell to record lows. since the early 1980s (see graph). This is also reflected in the latest NAHB (National Association of Home Builders) index which indicates a -10% decline in new home sales over the next six months. As noted above, mortgage rates are now significantly higher which, combined with limited supply (1.7 months of inventory at current sale levels, -15.5% less than there a year old) and exorbitant prices (+15% YoY) put real downward pressure on home sales going forward. This is just another hurdle for the Fed’s upbeat economic outlook to overcome. Markets, of course, are well ahead of the Fed, as seen in the chart at the top of this blog showing homebuilder stock prices (2n/a sign).
  • The good news is that industrial production increased by +0.5% in February and is now above its pre-pandemic peak. Despite a drop in automobile production, manufacturing grew by 1.2% on the back of soaring defense spending (+2.7%) and oil and gas drilling (+3.4% and +47% year-on-year). So, yes, soaring gasoline prices caused a supply response, proving once again that “high prices are a cure for high prices!”
  • Credit markets mid-week (week of March 13) were stressed by the threat of a Russian default on their dollar-denominated sovereign debt coupon payment ($117 million due March 16). This interest payment took place on Thursday, March 17. S&P further downgraded Russia’s credit rating from CCC to CC. The next point of tension here will be April 4 with the maturity of a $2 billion Russian government bond. (Stay tuned!)

Final Thoughts

By the end of the week, markets appeared to have shaken off the Fed’s unexpectedly hawkish stance, and stocks rallied significantly from oversold positions. In the fixed income space, however, yields on long-term securities fell while yields on short-term securities rose in line with perceived Fed rate hikes. The yield spread between 10-year T-Notes and 2-year T-Notes (the 10-2 spread) closed Friday, March 18 at 21 basis points (0.21 percentage point) and the spread between the 5-year T-Notes and the 10-year T-Notes was 0 (zero) (ie the yield on both was 2.15%). Yield curve inversion (short-term rates higher than long-term rates) is a reliable leading indicator of an impending recession, so these yield spreads are worth monitoring. The refusal of long-term rates to go up (and the audacity to go down) is the markets’ way of telling the Fed that they are making a policy faux pas and that their economic forecasts are something of a fairy tale.

Indeed, the markets seem to be as confident as we are that when the economic weakness we see in emerging data manifests itself in the well-known and well-watched economic indicators, the Fed will become less hawkish, even dovish (i.e. say another “Pivot Powell”). Stay tuned!

(Joshua Barone contributed to this blog)