Monday Morning Notes, 5/23/22
If You Don’t Have Time This Morning
The Fed remains on track to hike rates 50bp at each of the next two FOMC meetings. What happens afterwards is data dependent, but some speakers are already lining up to support a 25bp hike in September. Still, nothing has yet been determined; we are waiting for more data to help establish the Fed’s next move. Financial markets have tightened quickly on the back of effective forward guidance, leading to the possibility that we at or near something of a pause in the effective tightening portion of the cycle while policy rates catch up with what’s already been priced into the markets.
Recent Data and Events
April retail sales came in over expectations with a 1% gain excluding autos and gas while March sales were revised higher. In nominal terms, consumers continue to do what they do best, spend:
To be sure, households remain pressured by inflation, which has particularly impacted some goods spending, leading to challenges for retailers especially given that households are trying to boost their spending on services at the same time. I think this is more of micro than macro story. Overall spending has held up quite well despite the inflation shock as households continue to benefit from strong job and wage gains and can leverage healthy balance sheets. If the labor market comes off the boil as expected later this year, spending growth will slow; sustained outright declines in spending typically require job losses like experienced in a recession.
Initial jobless claims are off their lows:
I don’t think this is worrisome; claims had fallen to record low levels that weren’t likely sustainable. It does suggest, however, that the economy is past peak labor market tightness. Of course, it is still extraordinarily tight, but should loosen as the year progresses. That said, I remain skeptical that without at least a mild recession it will loosen enough to put the downward pressure on wage growth needed to restrain inflation.
I see much discussion of recession, and even some random claims that the economy is already in a recession, but common indicators tell us that the economy remains on an uptrend:
Granted, recessions are difficult to predict, but I don’t think a recession is imminent. In my opinion, that’s still more of a 2023-2024 story, assuming the Fed can’t execute the soft landing. For now, the story remains one of deceleration from a very rapid pace:
Adjusting to that deceleration, however, can be painful for markets to absorb, something very evident in recent weeks.
With the rise in mortgage rates clearing out marginal homebuyers, builder confidence has fallen to pre-pandemic levels:
I think it has further to fall; note the decline in 20181/9 after mortgage rates climbed higher. Similarly, we can expect further weakness in single family construction activity. Starts edged down in April and I anticipate they will fall below trend, again like in 2018/19:
The housing market needs time to adjust to the rapid increase in mortgage rates, but I think the sector remains fundamentally sound, bolstered by strong demographic factors. Building activity will not fall off a cliff. Multi-family starts have been strong in recent months:
And there is a large gap between starts and completions:
That gap represents a steady flow of work to still be completed and speaks to the extent by which housing demand still outstrips capacity.
Upcoming Data and Events
Inflation data on tap for this week. At the front end of the week, we get new home sales for April, which will be carefully watched given anecdotal reports from builders that the housing market is softening as expected with higher mortgage rates. Also early in the week are the preliminary S&P Global manufacturing and service sector PMIs. More manufacturing numbers are released on Wednesday; core capital goods orders have been rising at a solid clip this cycle, but this partly reflects inflation. Jobless claims, Thursday, might get more interesting. As noted above, they bounced off historic lows, good news for the Fed given its efforts to cool the job market. Personal income and outlays data will be released on Friday. Of particular interest will be core-PCE inflation, expected to be 0.3% for the month; higher numbers will make it harder for the Fed to meet its 2022 inflation forecast. I am looking to see if a wedge is growing between the CPI and PCE inflation data. Also on Friday are the final Michigan consumer sentiment numbers for May.
Limited Fedspeak this week. Bostic (Atlanta) and George (Kansas City) both speak on Monday. Powell releases pre-recorded remarks on Tuesday and Brainard gives a commencement address on Wednesday. The Fed will release the minutes of the May FOMC meeting on Wednesday. Watch for how the Fed views the transition back to 25bp rate hikes; see more on this below. Some Fed speakers expect that the Fed will be done with 50bp hikes after the July meeting. The outcome of that meeting is obviously data dependent, but it will be important to see if there was a broad expectation that three 50bp hikes would be sufficient front-loading of policy.
|Tuesday||New Home Sales, Apr.||750k||763k|
|Tuesday||S&P Global US Manufacturing PMI, May P||—||59.2|
|Tuesday||S&P Global US Services PMI, May P||—||55.6|
|Wednesday||MBA Mortgage Applications, May 20||—||-11%|
|Wednesday||Capital Goods Nondefex Air, Apr. P, MoM||0.5%||1.3%|
|Thursday||Initial Jobless Claims||213k||218k|
|Friday||Personal Income, Apr., MoM||0.5%||0.5%|
|Friday||Personal Spending, Apr., MoM||0.6%||1.1%|
|Friday||PCE Prices, Apr., MoM||0.2%||0.9%|
|Friday||Core PCE Prices, Apr., MoM||0.3%||0.3%|
|Friday||Univ. Of Mich. Sentiment, May F.||—||70.4|
|Friday||Univ. Of Mich. 5-10Y Inflation Exp., May F.||—||3.0%|
Fed Speak and Discussion
The near-term path for rates remains unchanged. Fed speakers consistently endorse the consensus view of 50bp rate hikes at the June and July FOMC meetings. The September meeting is a potential opportunity to transition back to 25bp rate hikes if the data allows. If the Fed can’t find sufficient cover in the data to see a path back to 2% inflation within the forecast horizon, it will press forward with another 50bp. Ultimately, the decision may hinge on the September SEP inflation forecast. I think that if FOMC participants see they can hold steady or even lower the 2022 and 2023 inflation forecast, they will be inclined to transition to 25bp. However, I have been skeptical that the data will break in that direction, leaving me leaning toward another 50bp hike in September. The Fed will try to form a consensus around the September outcome at the July meeting but may not have sufficient data to establish a consensus either way. That of course would put the August Jackson Hole conference in the spotlight, although arguably it’s always in the spotlight.
There is a high bar for the Fed to abandon plans for 50bp hikes at the next two meetings. As we have written before, the steady escalation of hawkishness in recent months has left some market participants distrustful of Fed guidance. The near-bear market in stocks, however, has shifted concerns about from a surprise 75bp to the thought circulating in some corners that the Fed will need to transition back to 25bp sooner than expected. This isn’t something on the Fed’s radar. The Fed is committed to restoring price stability through a tightening of financial conditions and expects falling asset prices with increased market volatility as part of the process. The Fed believes its forward guidance has been effective because market participants expect the Fed to follow through, and the Fed does not intend to disappoint. To be sure, existing plans are not set in stone, but forcing the Fed off the current path would require signs of market dysfunction, not orderly declines. A persistent down trend in asset prices, however, would add to the case to transition to 25bp in September.
Fed speakers are already drawing a focus on September, with some openly anticipating a 25bp hike at that meeting. As we reported last week, Chicago Federal Reserve President Charles Evans and Philadelphia Federal Reserve President Patrick Harker set a transition to 25bp in September as their baseline expectation. They included the caveat that all outcomes are data dependent, but it reveals that the nature of the discussion is about when to step down the pace of rate hikes. While 75bp hikes can’t be ruled out, they really, really aren’t under consideration.
Meanwhile, St. Louis Federal Reserve President James Bullard repeated his call to push rates to 3.5% this year. That translates to 50bp hikes for the rest of the year, which stands in contrast to the baseline thinking of Harker and Evans. Bullard has a 1994-95 cycle in mind with aggressive rate hikes at the front end but a quick reversal down the road:
“The more we can front-load and the more we can get inflation and inflation expectations under control, the better off we will be. In out years — ‘23 and ‘24 — we could be lowering the policy rate because we got inflation under control.”
Such a “shock therapy” policy approach is not the current consensus at the Fed. It would be viewed as an unnecessarily risky strategy given the Fed does not want to break markets or the economy if it can be avoided and conditions have already tightened as expected. I think the consensus will fall in line with the strategy outlined by Chicago Federal Reserve President Charles Evans last week. In a nutshell, he suggests pushing rates modestly to moderately above neutral and then holding at that level for an extended period rather than deliberately putting the Fed into the position where it may need to cut rates soon after the peak policy rate for the cycle. To be sure, if inflation doesn’t show signs of moderation, then the Fed may have no choice but to move deeper into restrictive territory, but the Fed would obviously prefer to glide path the economy into a new equilibrium if possible.
Although the Fed will keep raising policy rates, we may already be at what is at least an effective pause in the tightening cycle. Fed speakers point to the two-year Treasury rate as the correct measure of the Fed’s policy stance, and that rate has plateaued in the last few weeks:
This is another way to say that forward guidance has already effectively pulled forward much of the policy tightening this cycle. Another illustration of this dynamic is the sharp divergence in the steepening between three month and ten-year rates versus the flattening of the 2s10s spread:
Certainly, more tightening might eventually be needed, but the pricing of the big move may be complete, and the economy needs to digest that move before longer rates can rise further in this cycle.
The Fed’s plan is in motion, and now we are waiting for clear and compelling evidence in the data that the economy will be on a trajectory toward restoring price stability over the forecast horizon.
Good luck and stay safe this week!