Tim Duy’s Fed Watch, 6/21/22

Published on June 21, 2022
SGH Insight
The Fed intensified its commitment to its inflation target last week, accelerating the pace of rate hikes to 75bp increments and raising the expected terminal rate to 3.8%. In the statement that followed the FOMC meeting, the Fed emphasized its commitment to price stability but offered no such commitment to the employment side of the mandate. While the Fed isn’t trying to induce a recession, and while no Fed speaker will predict a recession, the Fed has already made clear that if the choice is between recession and inflation, it now chooses recession. The Fed has committed to maintaining rate hikes until inflation is clearly on a path to 2%, something that will likely not be evident in the data for several months. If inflation prevents the Fed from pivoting to rate cuts when the economy turns, a recession feels all but guaranteed under the current guidance...

...The next several months will become very uncomfortable. We have become accustomed to the Fed responding quickly to signs of economic weakness, but in recent history those have always occurred in a period of low inflation. Now the Fed will hold rates higher for longer by design, which will appear as if it is ignoring the real side of the economy. Assuming the Fed does not change its guidance, it needs to see clear and compelling evidence of slowing inflation before it can pause rate hikes. Considering that inflation lags the cycle, we aren’t likely to see significant slowing in the near-term. For example, the Cleveland Fed predicts core-CPI will be 0.49% in June, the only release before the July FOMC meeting (which helps guarantee a 75bp hike).
Moreover, one or two soft inflation prints will not likely suffice to convince the Fed that it will restore price stability given that the Fed tried that strategy last year and was badly burned when inflation rebounded in the fall after an apparent improvement over the summer. That error will create a bias in the opposite direction, and could set up a dichotomy with markets, where the Fed will tend to dismiss any good news on inflation (from, for example, any discounting that occurs when retailers try to shed excess inventories) as insufficient to justify a policy shift. At the same time, we can expect slowing in the interest rate sectors of the economy and eventually a weaker job market...
Market Validation
Bloomberg 6/23/22

Traders Hedge Fed Cuts in 2023 as Recession Risk Hits Yields

A newfound uneasiness on where US interest rates will be a year from now has started to fester throughout the bond market, as traders seek hedges to cover against an abrupt dovish shift in the Federal Reserve’s policy plans.
With fears of a recession evolving, rates extended their plunge Thursday, taking the three-year Treasury rate down more than 20 basis points to less than 3%. Ominously, traders are also piling into hedges that protect against Fed policy rates not only topping out, but actually being cut back down toward zero as soon as next year.
The moves follow comments from Fed Chairman Jerome Powell on Wednesday which appeared to accept that steep rate increases could trigger a US recession.

Bloomberg 6/24/22

Inflation could remain high until the second half of next year, despite the Federal Reserve’s rate hikes and the after-effects of higher oil prices, according to a blog post published Friday by the New York Fed.
Inflation is accelerating both in the US and the euro area, and the expected path for policy rates has risen sharply in both economies, the researchers say.
Those factors, when combined with the potential for a slowdown in economic growth, add more uncertainty to the outlook for inflation, they say.
“Based on our analysis, we anticipate that inflation will likely remain elevated through the second quarter of 2023, despite payback for the inflationary impact of current negative oil supply shocks during the second half of 2022 and the disinflationary effects of tighter monetary policy,” researchers wrote in the blog post.
Tighter monetary policy alone is not enough to explain the deceleration projected for U.S. inflation over the next year.
“There is an important role for disinflationary payback in the latter part of 2022 for the current inflationary consequences of recent adverse oil supply shocks, driving the downside risk to the forecast,” the post says.
Inflation is projected to ease somewhat in both the US and the euro area, “but will remain elevated by May 2023.” There is a “higher likelihood of a larger-than-expected easing of inflation in the United States compared to the euro area.”

Monday Morning Notes, 6/21/22

If You Don’t Have Time This Morning

The Fed intensified its commitment to its inflation target last week, accelerating the pace of rate hikes to 75bp increments and raising the expected terminal rate to 3.8%. In the statement that followed the FOMC meeting, the Fed emphasized its commitment to price stability but offered no such commitment to the employment side of the mandate. While the Fed isn’t trying to induce a recession, and while no Fed speaker will predict a recession, the Fed has already made clear that if the choice is between recession and inflation, it now chooses recession. The Fed has committed to maintaining rate hikes until inflation is clearly on a path to 2%, something that will likely not be evident in the data for several months. If inflation prevents the Fed from pivoting to rate cuts when the economy turns, a recession feels all but guaranteed under the current guidance. 

Recent Data and Events

Excluding autos, retail sales rose 0.5% in May compared to expectations for a 0.7% gain. The control group was basically flat while food services and drinking places edged higher:

Retail sales are not adjusted for inflation, so while nominal spending is holding up, real retail sales are falling. Not only is inflation eroding real retail sales but spending patterns have shifted towards services spending as travel strongly rebounds this summer. That shift will aggravate the inventory problem facing retailers, which will likely lead to increased discounting later this summer.

Housing starts tumbled in May:

We should expect further slowing in the housing market. The leap to 6% mortgage rates occurred too quickly to be easily absorbed, especially considering the substantial price appreciation in recent years. Not only will higher rates shake out the marginal buyers, but even buyers still able to afford housing have a rational incentive to wait for lower rates. This pause in demand will help builders clear the backlog of construction and increase inventory. That said, inventory gains for existing housing might be somewhat limited if sellers balk at putting homes on the market in a weaker environment.

Auto production accelerated in May:

At the same time, auto sales fell:

It would be ironic if supply rebounded just as high gas prices and higher interest rates trimmed demand. Even before the Fed’s latest rate hike, the typical monthly car payment reached a record high in May of $712; like with housing, a rational buyer might delay purchasing until rates fell.

Initial unemployment claims continue to rise:

While this bears watching, note it is bouncing off a record low and that continuing claims remain flat at low levels. In total, there is not much evidence yet of a meaningful slowing of the labor market, but of course it is still early in the cycle. Even if the Fed’s pivot to 75bp hikes reveals the kind of resolve that raises recession odds to effectively 100%, it is far too early to expect that to be revealed in the current data.

I am intrigued by the possibility of a stop/start kind of cycle much like the 1970s. Structurally, I believe there is an excess in demand for both housing and autos. Housing benefits from strong demographics (the aging of the Millennials into their peak homebuyer years and, later peak earning years) and there is pent-up demand for autos due to the extended period of supply challenges. These are both interest rate sensitive sectors of the economy, and if the Fed can’t see inflation falling, there is a high likelihood the Fed will hard stop both sectors (housing may already be there). As noted above, it is reasonable to delay purchases until interest rates fall. Moreover, it is also reasonable to assume that while high inflation may delay a monetary policy reversal (see below), the Fed will cut aggressively when the time comes. That will be the institutional reflex as explained by Federal Reserve Governor Christopher Waller last week:

Structural changes in the economy have tended to lower interest rates and limit the room that the Federal Reserve will have to cut rates during a slowdown. I hope we never have another two years like 2020 and 2021, but because of the low-interest-rate environment we now face, I believe that even in a typical recession there is a decent chance that we will be considering policy decisions in the future similar to those we made over the past two years.

If the underlying structural demand remains solid, as I expect, that demand should come roaring back as soon as interest rates fall, which means the economy could quickly run up against supply constraints again. A series of rapid cycles like this would make the next five to ten years a golden era for macro hedge funds.

Upcoming Data and Events

Some interesting data on the way this week. We get existing homes sales (Tuesday) and new home sales (Friday). Existing home sales are expected to fall from 5.61m in April to 5.40 million in May, while, interestingly, Wall Street expects new home sales will remain flat. Seems like there is room for a downside miss for new home sales, although the data can be volatile and maybe there was a rush to buy ahead of further increases in mortgage rates. The June preliminary S&P PMIs will be released on Thursday; we will be carefully watching for any early signs of wavering economic activity. Friday might be very interesting with the June final Michigan numbers. The jump in long term inflation expectations in the preliminary report was a key factor in the Fed’s decision to step up the pace of rate hikes to 75bp increments. The Fed will look like it overreacted if that number is revised back down to May’s 3%. Alternatively, if revised up, it will only further cement the case for 75bp in July and raise the prospect of 100bp. It could be ugly.

Fedspeak is basically nonstop this week; the key event is Federal Reserve Chair Jerome Powell’s delivery of the Semi-Annual Monetary Policy Report to the Senate (Wednesday) and House (Thursday).

DayReleaseWall StreetPrevious
TuesdayExisting Homes Sales, May5.40m5.61m
WednesdayMBA Mortgage Applications, June 176.6%
ThursdayS&P Global US Manufacturing PMI, June P56.057.0
ThursdayS&P Global US Services PMI, Jun P53.753.4
ThursdayInitial Jobless Claims225k229k
FridayNew Home Sales, May592k591k
FridayUniv. Of Mich. Sentiment, June F.50.250.2
FridayUniv. Of Mich. 5-10Y Inflation Exp., June F.3.3%

Fed Speak and Discussion

The Federal Reserve has fully committed to fighting inflation. Over the weekend, Federal Reserve Governor Christopher Waller said the “Fed is “all in” on re-establishing price stability.” In practice, that means another 75bp rate hike at the July meeting, an action Waller and Minneapolis Federal Reserve President Neel Kashkari already anticipate supporting, assuming the inflation data continues to disappoint. Beyond that, the path turns murky although Kashkari said in a blog post that the “prudent strategy” is 50bp moves until inflation is “well on its way” to target, which, assuming that is not likely to happen before the end of this year, suggests he currently anticipates rate hikes to total 375bp this year, making his dot the highest in the June SEP. Kashkari becoming the most hawkish FOMC participant was certainly not on my bingo card for this year.

The Fed is chasing a lagging indicator, raising the odds of a recession. The Fed arrived late to the game in the inflation fight and initially brought a “knife to a gun fight,” as the saying goes. Making a resolute public statement by surprising the market would have been more helpful in the spring, but the Fed can’t go back and change time. To its credit, the Fed recognizes its error. Here is Cleveland Federal Reserve President Loretta Mester, via Bloomberg:

While she reiterated that she is not predicting a recession, Mester said that the central bank’s lag in raising rates damaged the economy.

“The recession risks are going up partly because monetary policy could have pivoted a little bit earlier than it did,” Mester said on CBS’s “Face the Nation” on Sunday.

The Fed doesn’t want to induce a recession but has a clear preference for recession over runaway inflation. Consider this from Federal Reserve Chair Jerome Powell’s post-FOMC press conference:

VICTORIA GUIDA. My question is, is inflation data itself the best indicator for when you’re getting to where you need to go or might it lead you to go too far?

CHAIR POWELL. There’s always a risk of going too far or going not far enough, and it’s going to be a very difficult judgment to make, or maybe not, maybe it’ll be really clear, but we’re, and we’re quite mindful of the dangers. But I will say the worst mistake we could make would be to fail, which it’s not an option. We have to restore price stability, we really do, because everything, it’s the bedrock of the economy. If you don’t have price stability, the economy’s really not going to work the way it’s supposed to and it won’t work for people, their wages will be eaten up. So we want to get the job done. This inflation happened relatively recently, we don’t think that it’s affecting expectations in any kind of fundamental way. We don’t think that we’re seeing a wage price spiral. We think that the public generally sees us as very likely to be successful in getting inflation down to 2 percent and that’s critical. It’s absolutely key to the whole thing that we sustain that confidence. So that’s how we’re thinking about it.

If I am being completely honest with myself, the odds of recession within the next twelve months are quickly approaching 100%. To be sure, I want to tell a different story, and this is an unusual cycle so maybe it doesn’t play out as I expect, but typically avoiding a recession requires the Fed be willing and able to pivot quickly. By starting so late, and then leaning into a lagging indicator and setting a high standard (“clear and compelling”) for acknowledging when that indicator has turned, the Fed almost guarantees it won’t pivot quickly enough to avoid a recession. Indeed, the Fed knows that, historically, episodes of high inflation end with a recession. That said, while I can’t tell you the exact dimensions of the upcoming rough patch, I don’t think this will be a deep or extended cycle, as I explained above this feels like the set up for frequent cycles concentrated in interest rate sectors of the economy. Regardless of how it plays out, the path to a “softish landing” is very, very narrow and depends on inflation soon retreating. The best advice I can give is hope for the best but prepare for the worst.

The next several months will become very uncomfortable. We have become accustomed to the Fed responding quickly to signs of economic weakness, but in recent history those have always occurred in a period of low inflation. Now the Fed will hold rates higher for longer by design, which will appear as if it is ignoring the real side of the economy. Assuming the Fed does not change its guidance, it needs to see clear and compelling evidence of slowing inflation before it can pause rate hikes. Considering that inflation lags the cycle, we aren’t likely to see significant slowing in the near-term. For example, the Cleveland Fed predicts core-CPI will be 0.49% in June, the only release before the July FOMC meeting (which helps guarantee a 75bp hike).

Moreover, one or two soft inflation prints will not likely suffice to convince the Fed that it will restore price stability given that the Fed tried that strategy last year and was badly burned when inflation rebounded in the fall after an apparent improvement over the summer. That error will create a bias in the opposite direction, and could set up a dichotomy with markets, where the Fed will tend to dismiss any good news on inflation (from, for example, any discounting that occurs when retailers try to shed excess inventories) as insufficient to justify a policy shift. At the same time, we can expect slowing in the interest rate sectors of the economy and eventually a weaker job market.

Remember though that weaker data won’t show up instantly given the economy retains considerable momentum heading into the summer. We will be in this place where the financial sector (the yield curve is ready to invert again) and early data signal recession but the preponderance of data remains sufficiently strong to say a recession is not underway. The absence of clear recessionary data will help the Fed hold the line on its commitment to fighting inflation.

Bottom Line

Ongoing high inflation leaves the Fed with little choice but to continue to tighten the screws on the economy. A rough patch, likely rough enough to be called a recession, is ahead.

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