Tim Duy’s Fed Watch, 7/5/22

Published on July 5, 2022
SGH Insight
The Fed remains committed to restoring price stability even at the expense of growth. I think recession fears are premature, but even if not, the Fed is not likely to break from current messaging, including consensus support for 75bp in July. I expect that outlook to be reinforced by hawkish minutes this week. Yes, the Fed seemingly made a last-minute shift to 75bp at the June meeting on relatively little new data, giving reason to worry that relatively little new data could trigger a reversal. Still, I think the bar to remaining hawkish is lower than to becoming more dovish.
Market Validation
Bloomberg 7/6/22

*FED OFFICIALS SAW 50 BPS OR 75 BPS HIKE AT JULY FOMC AS LIKELY
*FED MINUTES: `EVEN MORE RESTRICTIVE' POLICY POSSIBLE IN TIME
*FED OFFICIALS RECOGNIZED POLICY COULD SLOW GROWTH FOR A TIME
*MOST FED OFFICIALS SAW GROWTH RISKS SKEWED TO DOWNSIDE
*MANY ON FOMC SAW SIGNIFICANT RISK OF ENTRENCHED INFLATION
*FED: MANY CONCERNED LONG-RUN PRICE EXPECTATIONS COULD DRIFT UP
Treasury Yields Surge as Fed Minutes Underscore Inflation Fight
Yields at session highs after Fed minutes from June arrive
Minutes show inflation worries trump growth concerns

Treasuries extended their losses, driving yields to session highs, after the minutes of the most recent Federal Reserve meeting underscored policymakers’ commitment to tighten monetary policy aggressively to keep inflation from becoming entrenched in the economy.
Benchmark yields rose in mid-afternoon trading in New York, up more than 10 basis points across much of the curve, after the minutes from the June meeting showed officials saw a significant risk of entrenched inflation and that “even more restrictive” policy was possible.
The jumps capped another volatile day in the world’s largest bond market as traders try to navigate between the risks of persistent inflation and a potential recession set off by rising rates.
Yields on two-year Treasury notes -- among those that are more sensitive to central bank policy -- jumped 13 basis points to 2.95%, more than erasing a 6 basis point drop from earlier in the day. The swings mirrored the trading from Tuesday, when 2-year yields swung between a 13-basis-point advance and a 6-basis-point drop before ending the day little changed.
The 10-year higher by 12 basis points at 2.92%. The three-year note led the market selling, pushing the yield up 16 basis points to 2.98%.

Tuesday Morning Notes, 7/5/22

If You Don’t Have Time This Morning

The Fed remains committed to restoring price stability even at the expense of growth. I think recession fears are premature, but even if not, the Fed is not likely to break from current messaging, including consensus support for 75bp in July. I expect that outlook to be reinforced by hawkish minutes this week. Yes, the Fed seemingly made a last-minute shift to 75bp at the June meeting on relatively little new data, giving reason to worry that relatively little new data could trigger a reversal. Still, I think the bar to remaining hawkish is lower than to becoming more dovish.

Recent Data and Events

Recession fears ramped up last week after the personal income and outlays and ISM reports. To cut to the chase, while I believe that the Fed’s intention to restore price stability at all costs clearly raises the risk of recession to very, very high levels, that’s a story for some time in the future. I think it is unlikely that a recession is underway now.

Nominal spending edged higher in May while real spending fell. The latter has been challenged to maintain its pre-pandemic trend:

In nominal terms, goods spending remains well above pre-pandemic trend while services spending is now approaching its trend:

Interestingly, despite all the stories that consumers are rotating back into services, the percentage of nominal spending on goods hasn’t reverted to pre-pandemic levels:

This means that nominal income gains have been sufficient to maintain nominal spending on goods while expanding spending on services. In real terms, however, that is not the case. Inflation has eroded real spending on both goods and services:

Two interesting points follow. First, as we expected, real spending ran into a speed bump in the second quarter as households struggled to absorb the shock to headline inflation. This weighed on real goods consumption, which was already under pressure from an acceleration in services spending. We knew this was coming, and I remain surprised real spending held up as well as it did. Looking forward, wholesale gasoline prices are off their peak and U.S. natural gas prices are heading lower as well. This means that headline inflation will fall, which will mechanically translate into higher real spending going forward. The implication is that this is not a recessionary type of shift in consumer spending. Those are driven by job losses. What we are seeing primarily is the impact of inflation on consumption patterns. This will drive down real spending temporarily, but without job losses the impact is more likely than not – dare I say it – transitory.

To emphasize the point about this not being a recessionary shift in the second quarter, note that household spending on energy services has spiked but remains relatively low:

If energy prices stabilize and even fall in the U.S., while nominal income continues to grow, household spending can shift back toward other goods and services.

The second interesting point is the degree to which inflation has slowed the growth in real services spending. The hope that a transition from goods spending to services spending would diminish inflationary pressure rests on the hypothesis that there is plenty of excess capacity in services. That has not been the case, and services inflation has accelerated:

While there has been some optimism that goods inflation will ease as retailers reduce inventories, it is not evident this will translate into lower services inflation. Indeed, if services inflation accelerated before nominal spending even approached pre-pandemic trend, what’s going to happen when it exceeds pre-pandemic trend?

In short, the primary impediment to real spending growth is not the consumer’s willingness to spend. The impediment is inflation. Inflation erodes real purchasing power, contributing to the dark mood in consumer sentiment surveys.

The ISM number came in soft, falling to 53.0, below expectations for 54.5. New orders fell below 50, and employment fell to 47.3, the second month below 50. Interestingly, while the prices paid component fell, it remains very high at 78.2. I think the softer manufacturing number is related to the factors already discussed, primarily excess inventories as the composition of household spending change in response to inflation and a desire to increase spending on services. Note that ISM is not a reliable recession predictor; it frequently slides below 50 outside of a recession:

Also note that we are a long way into an ISM reversal, and if we don’t get a recession, it will bounce up from just under 50, and that could happen in the third quarter.

The ISM data drove a major downward revision in the Atlanta Federal Reserve GDP Now estimate to -2.1% for the second quarter, which if true, would mean the U.S. economy experienced two consecutive quarters of negative GDP growth. I would be very wary of interpreting that as a recession. First, there is no such thing as a “technical” definition of a recession as two consecutive quarters of negative GDP growth. The reality is far more complex. From the NBER Business Cycle Dating Committee:

Because a recession must influence the economy broadly and not be confined to one sector, the committee emphasizes economy-wide measures of economic activity. The determination of the months of peaks and troughs is based on a range of monthly measures of aggregate real economic activity published by the federal statistical agencies. These include real personal income less transfers, nonfarm payroll employment, employment as measured by the household survey, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, and industrial production. There is no fixed rule about what measures contribute information to the process or how they are weighted in our decisions. In recent decades, the two measures we have put the most weight on are real personal income less transfers and nonfarm payroll employment.

Consider some of these monthly indicators:

Nothing here to hang a recession on, with employment standing out as a particularly important data point. I see commentary over the weekend that not only is the NBER likely to declare a recession, but when it does, it will backdate the peak to November 2021. That’s clearly insane. The economy has added 3 million jobs since November! Job growth alone precludes the possibility of a recession beginning in November, with industrial production coming in a close second. And we certainly haven’t been in recession for seven months and still have rising earnings estimates.

Second, calling the first quarter decline in GDP growth the beginning of a recession is a stretch. Real final sales to domestic purchasers grew at a 3% rate in the first quarter. That’s the number we need to watch. Now, that number might come in negative in the second quarter, but as explained above, I believe that is more of a mechanical response to inflation than a recessionary shift in activity.

Third, there is a growing discrepancy between real gross domestic product and real gross domestic income:

In theory, these two measures should be the same with any difference being statistical noise, but the gap between the two suggests something besides statistical noise is at play. In my opinion, the strength of the rebound is more consistent with the GDI number, leaving me wary about reading too much recession signal in the GDP numbers.

Fourth, initial unemployment claims have leveled out at around 230k while continuing claims continue to bounce around at their lows:

And note that the claims are not rising for almost all states (the blue bars show the level of dispersion of rising claims):

Nothing in that data suggests a recession is underway. And fifth, the U.S. economy doesn’t have recessions when the front end of the curve is this steep:

I blame myself for feeding into the recession story. I have been writing for weeks about the increased probability of recession, and it is the right call. The economy is slowing, and anytime it slows, the odds of recession naturally increase. More importantly, however, the Fed clearly pivoted to focus on restoring price stability at all costs, and I think this is a big deal. FOMC participants penciled in something that looks about as much like a recession as they are going to forecast in the SEP, and Federal Reserve Chair Jerome Powell is adamant that the Fed must bring inflation under control.

I think the fact that the Fed has linked policy to a lagging indicator – inflation – almost guarantees it will be too late to pivot to avoid a recession, and the Fed is not shying away from that risk. Moreover, I don’t think a soft landing is likely given the Fed’s starting point of very low unemployment and high inflation. Had the Fed guided policy rates such that they would be near neutral as the labor market approached the Fed’s best estimate of the natural rate of unemployment, 4% (probably too low now), it wouldn’t be in this position, but that ship has sailed. The odds of achieving a soft-landing will increase in the unlikely event core inflation drops sharply soon, like next month, or the Fed reverts to more focus on inflation forecasts rather than the current focus on actual inflation.

None of us wants to miss a recession call, and that’s why there has been a profusion of such calls in the last two weeks. But timing here still matters. If everyone piles into the recession trade – and that’s rates, breakevens, commodities, etc. – and the recession doesn’t materialize this month, then everybody is going to jump back out of it. Moreover, the Fed isn’t seeing a recession in the data, isn’t going to buy this “two negative quarters” definition, is willing to endure low growth as a necessary condition to achieving price stability, and the Fed is still focused on inflation.

The Fed I believe will read the incoming data much as I did above. Maybe we are getting it wrong, but the Fed’s outlook leaves positioning vulnerable to Fed speakers who are not going to validate the recession call. That will be the overarching message. Although some Fed presidents may try to be “helpful” here in acknowledging the downside, I suspect the Fed isn’t looking for rates to reverse as they did last week. Mortgage rates dropped, providing potential buyers an opportunity to sneak back into the housing market, something the Fed likely didn’t want to start happening before it saw clear progress on inflation.

I have written before that I think we will go through a very difficult period where the Fed won’t validate slow growth concerns by signaling rate cuts. Funny thing is that I don’t think this is that time yet. When it comes, it will be much more painful. Note also there are very real recession risks still outside of Fed policy, largely stemming from energy issues, indirectly via what will be Europe’s energy challenge this winter and directly via higher oil prices if Russia retaliates against Western nations by cutting oil or gas output. The latter would be a nightmare for monetary policy, and this Fed would not be eager to ease into it.

Upcoming Data and Events

Busy, busy week ahead with some big data releases. JOLTS data for May is released on Wednesday. Wall Street anticipates a modest decline, which would be consistent with openings data from Indeed. While the Fed will be happy to see openings roll over, it will require a large decline to bring labor markets into better balance. Also on Wednesday are service sector PMI data. We get the usual initial claims report on Thursday; it will take on heightened interest given recession fears. On Friday the BLS releases the June employment report. Wall Street expects the unemployment rate to hold steady at 3.6% and payrolls to fall to 275k while earnings rise a modest 0.3%. Any softness in the employment rate will feed into recession fears and increase speculation that the Fed will soon change its tune. I remain of the view that the Fed will not shift gears easily.

Fairly light week for Fedspeak. New York Federal Reserve President John Williams will speak on Wednesday and Friday, and St. Louis Federal Reserve President James Bullard provides an economic outlook on Thursday. Federal Reserve Governor Christopher Waller will be interviewed in a virtual NABE event on Thursday. The Fed releases the minutes of the June FOMC meeting on Wednesday. I expect the minutes to be hawkish – really, we can’t expect anything else given the Fed stepped up to 75bp rate hikes at the meeting.

DayReleaseWall StreetPrevious
WednesdayS&P Global US Services PMI, Jun. F51.651.6
WednesdayISM Services, Jun.54.555.9
WednesdayJOLTS Job Openings, May11.0m11.4m
WednesdayMBA Mortgage Applications, Jul. 10.7%
WednesdayJune FOMC Meeting Minutes
ThursdayInitial Unemployment Claims230k231k
FridayUnemployment Rate, Jun.3.6%3.6%
FridayNonfarm Payrolls, Jun.275k390k
FridayAverage Hourly Earnings, MoM, Jun.0.3%0.3%

Fed Speak and Discussion

At this point, the Fed remains undeterred in its campaign to restore price stability. Federal Reserve Chair Jerome Powell last week expressed a sense of urgency with regards to inflation:

There’s a clock running here,” Mr. Powell said during a moderated discussion Wednesday at the European Central Bank’s annual economic policy conference in Portugal on Wednesday. “The risk is that because of the multiplicity of shocks, you start to transition into a higher-inflation regime. Our job is to prevent that from happening.

San Francisco Federal Reserve President Mary Daly delivered a clear message on what this implies for the path of policy, via Axios:

“I would say 75 [basis points] in July, and then you figure out what else needs to be done so that we can get to 3.1% by the end of the year. So that is likely to be some natural slowing of the pace of interest rate hikes in terms of the magnitude.”

“It’s more about getting to where we need to be, and how much do we do that? It could be the case that we’re very uncertain about how the economy will play out and we want to take 25 basis point increases at a time, but I don’t feel that uncertainty is the pervasive thing happening today. I think that really is about next year.

That second part very much speaks to the Fed’s current state of mind. The large 75bp moves aren’t likely to continue past July, but that will more likely than not be followed by 50bp rate hikes. Daly posits that 25bp rate hikes won’t even be a story until next year, setting up the 75-50-50-50 scenario. That’s slightly more aggressive than my baseline; I still lean toward 75-50-50-25. The Fed is not wavering from a 75bp rate hike in July; I still think the risk to that call is 100bp more so than 50bp.

It is too early to think the Fed’s inflation forecasts have changed, and the same is true for the policy rate forecasts. The Fed is not going to take comfort in the latest core-PCE inflation numbers.Yes, 0.3% in May was below expectations of 0.4%, but note that the unrounded number was 0.348%, a breath away from being rounded up to 0.4%. Over the past four months, core-PCE inflation has been ticking slightly higher and over the past three months averaged an annualized 4.1%:

This is not “clear and compelling” evidence that inflation is on the path to price stability. Also note that the Dallas Fed trimmed PCE number rebounded:

It appears that inflation pressures did not narrow as much as the last few readings would suggest. Also note that the Fed isn’t likely to see much relief on core inflation before the September meeting if the Cleveland Fed forecast is accurate:

Yes, inflation is a lagging indicator, and there exists a narrative that disinflationary pressures will intensify later this year, but the Fed has yet to return to weighing inflation forecasts heavily with respect to near term policy decisions. Fed signaling is telling us forecasts for falling inflation won’t change policy. Falling inflation for a couple of months won’t change policy. The inflation rebound last fall badly burned the Fed, and it is committed to not make the same mistake again. Inflation fell for five months after it peaked last April, and then rebounded. The Fed will be wary that the same could be repeated unless the labor market eases substantially.

Last week’s sharp interest rate decline suggests market participants believe the Fed will quickly abandon its rate hike plans in the face of weaker growth. I think the Fed has clearly stated otherwise, but I also understand why market participants might be skeptical of such claims:

  1. The Fed ALWAYS pivots to easier policy when markets struggle, or growth softens. That, at least, is the recent history, and by “recent” I mean going back to 1987. For most of that time, however, inflation has not been a pressing issue as is now the case, leaving the Fed with more room to pivot than in this cycle.
  1. Powell appeared to lean into headline inflation, leaving market participants thinking the Fed will turn dovish if commodity prices ease. Yes, the Fed would like headline inflation to ease, the Fed thinks it plays into expectations. But the Fed’s major challenge is underlying inflation, which means core inflation is critical, and commodity prices are not the driving factor in core inflation. Also, I suspect the Fed won’t take too much comfort from softening commodity prices. Remember last year when Powell used lumber as an example of upcoming disinflation? How well did that work out? Is Powell really going to go down that road again?
  1. The Fed’s last-minute shift to a 75bp hike ahead of the June FOMC meeting left the impression that Fed guidance is less than reliable. If the Fed can shift to 75bp on the back of what looked like a bad CPI number and a preliminary read on inflation expectations, why won’t it shift again on a better-than-expected PCE inflation number and a less alarming final read on inflation expectations? There is a fear that Fed policy is mercurial but notice that the Fed’s surprises have all been hawkish. Given the inflation numbers, I expect the Fed will continue to surprise on the hawkish side of expectations. The volatility in bond markets suggests that Fed is losing control of its story; a pivot back to 50bp rate hikes at the July meeting would indicate it really had no clue what was going on, and I don’t think that is a message it wants to send when it fundamentally believes rates need to be above 3%.

Bottom Line

Last week’s rates action, and the questions I am getting from clients, tell me that market participants are not in sync with the Fed. These situations resolve when either markets move toward the Fed, or vice versa. I don’t think the Fed will move toward markets in the near term. Or, more accurately given the possibility of a random Fed speaker going rogue, I don’t think Powell, or the Fed leadership, will move toward markets. The Fed’s position may change later this year, so we will see how the data evolves, but regardless of any recession concerns, near or far, I take Powell at face value. The Fed’s message will remain focused on restoring price stability until inflation is on a clear trend toward the Fed’s target. History tells us that the Fed will remain more optimistic about the economy long after we all turn pessimistic.

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