Tim Duy’s Fed Watch, 7/25/22

Published on July 25, 2022
SGH Insight
The last of the Fed’s 75bp rate hikes will be viewed by market participants as a “dovish” pivot. There will be a sense that the “worst of the cycle” has passed, and now we can look forward to the eventual rate cuts while downplaying the additional rate hikes between now and then. I suspect that a sense of relief will even be true among many FOMC participants who will believe the Fed is no longer deeply behind the curve on inflation, but they will have to be careful about how they express this relief...

...The Fed will not see the transition away from 75bp as a dovish pivot. The Fed remains fully focused on the inflation fight. In fact, no pure “doves” currently remain at the Fed. The Fed intends to bring rates to a restrictive setting and hold them there until inflation is clearly no longer a problem. Moving to 50bp rate hikes does not mean the Fed is any less committed to restoring price stability. The plan has been to get rates to neutral quickly and then begin reducing the pace of rate hikes to glide to the terminal rate. This week’s meeting only concludes the first part of that plan...

Market Validation
Bloomberg 7/27/22

Stocks Surge, Bond Yields Sink on Powell’s Remarks: Markets Wrap
Powell says unusually large hike to be data-dependent
Fed to offer less ‘clear guidance’ on rate moves

Stocks rallied and bond yields tumbled after Jerome Powell said the Fed will offer less “clear guidance” on rate moves and that it will likely be appropriate to slow rate hikes at some point.
The Federal Reserve’s boss said the central bank is moving “expeditiously” when it comes to dealing with price pressures and reassured it has the tools to do the job. Powell also noted that another unusually large boost in rates would depend on data after officials raised rates by 75 basis points for the second straight month.
Expectations for the pace of Fed rate increases eased back -- with swap markets showing around 58 basis points of tightening priced in for the next meeting in September and the expected peak for the cycle dropping to around 3.3% -- with that kind of level seen toward the end of this year or early in 2023.

Chair Powell press conference

There's so much uncertainty. These aren't normal times. There's significantly more uncertainty about the path ahead and ordinarily it's quite high. The only data point I have for you is the June SEP, which, I think, is just the most-recent thing the economy's done. Since then, inflation is coming higher at economic activity, coming in weaker than expected, but at the same time, I'd say that's probably the best estimate of where the committee's thinking, which is still that we'd get to a moderately restrictive level by the end of this year. Somewhere between 3 and 3.5% and where the committee sees further rate increases in 2023. We'll update that at the September meeting, but that's really the best I can do on that.



Monday Morning Notes, 7/25/22

If You Don’t Have Time This Morning

This week the Fed will lift policy rates 75bp and signal that although this is most likely the last super-sized rate hike, inflation concerns will drive the Fed to hike to a higher level and hold rates there longer compared to pre-pandemic cycles. Still, market participants will be relieved by the end of the biggest rate hikes and may see this inflection point in policy as a “dovish” pivot and look forward to eventual rate cuts. A slowing economy will only reinforce this view as the Fed traditionally has quickly cut rates when faced with the prospect of higher unemployment. We don’t think the traditional behavior will hold true in a high inflation environment, but that will not become evident until the Fed faces the prospect of hiking into rising unemployment.

Recent Data and Events

Housing data last week revealed that tighter financial conditions were working as expected. Homebuilder confidence for July plunged to a two-year low:

Housing starts fell in June:

Single family starts are now below pre-pandemic trend but have fallen only to late 2019 levels:

In addition, existing home sales fell 5.4% in June, reaching a two-year low. These homes went under contract in April and May, before mortgage rates spiked to 6% in June, suggesting further declines in home sales are likely in the July data. Interestingly, median prices reached a record high of $416,000, indicating that the buyers still in the market have the means to keep bidding up prices. The marginal buyers forced out of the market are pushing up demand for rental properties. This has the perverse impact of raising rents, which commentators have noted means the Fed is putting upward pressure on inflation via the housing channel. What this tells me is that job growth needs to slow sharply, if not turn negative, to reduce the rate of household formation to put downward pressure on rents.

Jobless claims edged higher:

I see commentators pointing at the rise in claims over the past three months as being the relevant recession indicator. I think the plunge in claims earlier this year reflected distorted seasonal adjustment factors due to the pandemic. Compare this year’s non-seasonally adjusted numbers to the years just prior to the pandemic:

You can see that claims have been tracking 2018 and 2019 levels all year. It is only the latest data point that might be interesting in that claims typically peak the prior week. This might only be a calendar effect or timing of auto plant shutdowns for annual retooling. My main point is that I think we should dismiss the rise in claims so far this year as being an artifact of the seasonal adjustment process; the future path of claims likely has more information value.

The S&P Global composite U.S. number fell to 47.5 in the preliminary July report, entering contractionary territory for the first time since June 2020. The decline fed into the recession narrative and pulled market pricing for rate cuts forward, which is a completely reasonable expectation in terms of the Fed’s pre-pandemic reaction function. The Fed always cuts rates after weak PMI numbers. That said, I think a key issue is this from the report:

…US companies recorded a substantial hike in selling prices during July. Again, firms highlighted the pass-through of higher costs to their clients as a driving factor behind greater output charges. A number of firms stated that slower input cost inflation, greater competition and softer demand conditions led to some concessions being made to customers, however, helping to cool the pace of charge inflation to its slowest since March 2021.

This suggests inflation will fall in the months ahead, but how much and how long before it shows up in the official data? Core-CPI ran at a 7.9% annualized rate in the second quarter. It has a long way to fall before it is in a region that the Fed can comfortably pause rate hikes, and even longer before the Fed can cut. We need to be wary about assuming the Fed will behave in a pre-pandemic manner when it is now acutely attuned to inflation risk. That said, the Fed has yet to prove it will not react as it has in the past, and there will be a disconnect between market participants and the Fed until one side is forced to come to the other.

The yield curve has maintained a sustained 2s10s inversion:

Note also the spread between three-month and 10-year rates is collapsing. You know my story, if the Fed keeps hiking into a 2s10s inversion, history indicates there will be a recession in 12-24 months from the date of the first inversion. In this case, it is basically guaranteed that the Fed hikes rates through 2022 under the current guidance. I don’t see how a recession will be avoided at this point.

The Fed is nearly two months into QT, and clients comment that the balance sheet has barely declined:

Note that the Fed’s holdings of treasuries decline only every other week as the timing is determined by the mid-month and end-month auctions. On the MBS side, transactions can take as long as three months to settle, so the Fed has still been booking purchases made before QT began. Once those legacy purchases have been booked and the caps raised, the pace of QT will pick up noticeably.

Upcoming Data and Events

Busy data week ahead with some key data releases. Tuesday, we get new home sales for June, which should show the impact of sharply higher mortgage rates. On Wednesday we get to review the latest manufacturing orders data; Wall Street expects that core capital goods spending continued to climb in June but note that this number is not adjusted for inflation. Thursday brings the second quarter GDP numbers, which are expected to show weak growth after the decline the previous quarter. The current Atlanta Fed estimate is a deeply below consensus -1.6%; a second consecutive quarter of negative growth would be viewed by some as an indication that a recession began in the first quarter, but that will not be the Fed’s interpretation. The Fed will likely focus on private domestic demand, expected to be positive. Friday the June personal income and outlays report will be released although the prior day’s GDP release should provide substantial insight into the numbers. Core inflation will be most closely watched; Wall Street expects a 0.5% monthly gain, a dismal number for the Fed. Also Friday is the employment cost index number for the second quarter; the Fed would very much like to see employment costs growing more in line with the pre-pandemic pace. I will be paying attention to the measures that exclude incentive-based pay. The week will end with the final Michigan sentiment release for July.

Other than the FOMC meeting and presser on Wednesday, there is no Fedspeak on the calendar.

DayReleaseWall StreetPrevious
TuesdayNew Home Sales, Jun.670k696k
WednesdayCapital Goods Nondef ex Air, June P, MoM0.2%0.6%
WednesdayMBA Mortgage Applications, Jul. 22-6.3%
ThursdayInitial Jobless Claims200k229k
ThursdayGDP, 2Q A, QoQ0.4%-1.6%
FridayPersonal Income, Jun, MoM0.5%0.5%
FridayPersonal Consumption, Jun, MoM0.9%0.2%
FridayPCE Prices, Jun, MoM0.9%0.6%
FridayCore PCE Prices, Jun, MoM0.5%0.3%
FridayEmployment Cost Index, 2Q1.1%1.4%
FridayUniv. Of Mich. Sentiment, Jul. F51.151.1
FridayUniv. Of Mich. 5-10Y Inflation Exp., Jul. F 2.8%

Fed Speak and Discussion

The Fed will raise its policy rate 75bp at this week’s FOMC meeting. The idea of a 100bp move was short-lived in the face of Fedspeak that revealed a preference for the smaller move and non-supportive data such as the retreat in Michigan inflation expectations and the S&P Global PMI numbers. A 75bp hike will move the target rate up to a range of 2.25-2.5%, making good on the Fed’s intention to expeditiously raise rates to nearly neutral.

Most likely, this week’s action will bring an end to super-sized rate hikes. To be sure, we can tell a story of how the Fed can be pulled into another 75bp rate hike in September by bad inflation numbers, and it seems unlikely that Federal Reserve Chair Jerome Powell would take such a move off the table, but he also said that such moves would not be ordinary, and a third consecutive rate 75bp hike would make them ordinary. With rates near neutral, the Fed can begin looking for a path back to a “measured” pace of rate hikes as it feels its way to the terminal rate. We think the Fed will start that process by stepping down to a 50bp rate hike in September.

The last of the Fed’s 75bp rate hikes will be viewed by market participants as a “dovish” pivot. There will be a sense that the “worst of the cycle” has passed, and now we can look forward to the eventual rate cuts while downplaying the additional rate hikes between now and then. I suspect that a sense of relief will even be true among many FOMC participants who will believe the Fed is no longer deeply behind the curve on inflation, but they will have to be careful about how they express this relief.

The Fed will not see the transition away from 75bp as a dovish pivot. The Fed remains fully focused on the inflation fight. In fact, no pure “doves” currently remain at the Fed. The Fed intends to bring rates to a restrictive setting and hold them there until inflation is clearly no longer a problem. Moving to 50bp rate hikes does not mean the Fed is any less committed to restoring price stability. The plan has been to get rates to neutral quickly and then begin reducing the pace of rate hikes to glide to the terminal rate. This week’s meeting only concludes the first part of that plan.

The Fed intends to not repeat the mistakes of last year. Remember Powell’s tragically ill-timed 2021 Jackson Hole speech:

The rapid reopening of the economy has brought a sharp run-up in inflation. Over the 12 months through July, measures of headline and core personal consumption expenditures inflation have run at 4.2 percent and 3.6 percent, respectively—well above our 2 percent longer-run objective. Businesses and consumers widely report upward pressure on prices and wages. Inflation at these levels is, of course, a cause for concern. But that concern is tempered by a number of factors that suggest that these elevated readings are likely to prove temporary. This assessment is a critical and ongoing one, and we are carefully monitoring incoming data.

This assessment came at the end of string of declining monthly inflation core-PCE inflation numbers that provided the Fed with a false sense of security about the inflation outlook. Soon thereafter, inflation accelerated and broadened out to a wider range of goods and services. The Fed does not want to sound the “all clear” on inflation anytime soon only to see another re-acceleration. The only way to be safe is to err on the other side of the story, and that means keeping upward pressure on policy rates until inflation slows sustained and meaningfully, and delaying rate cuts until the Fed can see inflation returning to target, something that won’t be clear until core-PCE inflation is running at a sustained pace of annualized monthly rate of 2.5% or less.

The Fed’s current messaging suggests a string of rate hikes ahead. Fed speakers have said they will need to see “clear and convincing” evidence from a “series” of reports that reveal sustained deceleration of inflation before they can see the terminal rate in the cycle. This doesn’t mean rate hikes will continue at 50bp increments every meeting, or even 25bp every meeting. The Fed could switch to every other meeting at some point in the future. Once policy rates are at neutral, the Fed will balance inflation and growth when deciding on the pace of rate hikes. Still, the calendar here is important.

Given the current high pace of inflation, and the likely persistence of inflation, and the Fed’s need to see a series of improving inflation reports, my interpretation of the implied path for the next six meetings is 75-50-50-25-25-25, which would bring policy rates to the 4.0-4.25% range. This is well above the current market pricing which sees a terminal rate around 3.4%. Market pricing appears to reflect either an imminent and sustained sharp inflation decline or an expectation the Fed abandons inflation concerns in the face of weaker growth. I believe the rise in underlying inflation will be persistent, and that the calendar simply prevents a “series” of improving inflation numbers to appear before the December meeting to show a sufficient drop of inflation to justify stepping down to 25bp let alone pausing entirely. Still, I admit that I am only 85% confident the Fed will not take the first low inflation reading as an excuse to shift to a “measured” pace of hikes or even pause. We won’t know how the Fed will react until it faces such a number in the context of weaker growth.

Powell needs to explain why policy is at an inflection point and the rational for not maintaining 75bp rate hikes given the June CPI number. He needs to clear a path to stepping down to 50bp and smaller hikes at future meetings. I think Powell will lean into the “we must restore price stability” story but will also likely outline something like described above – the 75bp rate hikes were intended to bring rates to neutral and that the pace of hikes can ease. The Fed’s goal here will be to maintain the impression of a hawkish reaction function, what we call “higher for longer” rate policy when market participants are primed to interpret a step away from 75bp as a dovish pivot. As noted earlier, I don’t think Powell will rule out another 75bp hike, which might help to reinforce the Fed’s hawkish credentials.

Market participants will be watching carefully for Powell to say something that can be interpreted as validation of current market pricing. Watch for him to say the labor market is still strong but there are signs of slowing economic activity, pointing specifically to housing but it would be interesting if he also cites unemployment claims or recent survey numbers. My instinct is that market participants will latch onto any hints that the Fed sees slower growth ahead. That would feed into the current mood on Wall Street.On the inflation side, I don’t think the June numbers have any dovish interpretation, but Powell might identify falling gasoline prices as taking pressure off future inflation and inflation expectations. This I think would be dangerous ground for the Fed to tread because the Fed’s view on headline inflation is asymmetric; the focus will shift to core inflation when headline falls, but Powell left the impression at the last presser that the Fed focuses on headline now. Powell talking hopefully about falling gas prices will surely be taken as a dovish sign.

Bottom Line

The challenge for the Fed this week will be signaling a future step-down in the pace of rate hikes without appearing dovish. There are many ways, however, for the Fed to appear dovish, in which case the Fed might inadvertently trigger an unwanted easing of financial conditions. Powell will emphasize the Fed’s focus on inflation, the need to restore price stability even at the cost of recession, expected continued rate hikes, and a warning that no one should doubt the Fed’s resolve, but his hawkish positioning may fall on deaf ears if all the market cares about this week is that this is the last big hike.

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