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Equity markets fell last week (April 8), but the biggest change was in fixed-income as the Fed’s minutes and continued hawkishness from Fed governors continued to put upward pressure on the yield curve. At the week’s start, interest rates had inverted (short-term rates higher than long-term rates). As shown in the table, both the 2 Yr. T-Note and 5 Yr. T-Note yields were higher than the 10 Yr. yield. Meanwhile, market commentators were debating as to whether-or-not such inversions, which have been a pre-cursor to recessions whenever they have appeared over the last half century, were prescient or whether “this time is different.”
The table shows, rates spiked during the week, much more so on the longer end. Note that on Monday (April 4), the 2 Yr. T-Note yield was higher than the 10 Yr. (yield curve inversion), but not so at week’s end (April 8). The 5 Yr. T-Note was also inverted early in the week, by 16 basis points (bps). By week’s end, that inversion was a much milder five bps.
Why Long-Term Rates Spiked
So, what happened last week to cause yields to spike, especially on the longer-end? The answer was the release of the Fed’s March meeting minutes on Wednesday. They were much more hawkish than markets had expected. And, to the markets’ surprise, there had been a detailed discussion of the upcoming reduction in the Fed’s bloated balance sheet (Quantitative Tightening (QT)) both as to levels and timing. Chair Powell, at the press conference after that March meeting, while not explicitly saying so, had led the markets to believe that such a discussion had yet to take place.
In last week’s blog, we discussed the implications of QT at a level of $1 trillion/year ($83 billion/month as estimated by Michael Lebowitz) that, we said, could easily result in liquidity issues for the financial markets. As it turns out, Lebowitz’s calculations were on the light side, as the Fed’s minutes revealed an FOMC consensus for QT at $95 billion/month ($1.14 trillion/year) for three years.
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Those minutes were released on Wednesday (April 6) about midway through the markets’ trading day, and, at that time, equity markets turned violently negative. That is also the moment that long-term rates spiked. Note in the table that the 10 Yr. yield bounced 31 bps while the 2 Yr. rose only nine. The chart (Lebowitz’s $1 trillion/year QT) shows that in nearly every 2022 month, the maturities in the Fed’s portfolio exceed that needed for its contemplated balance sheet run-off.
The Fed also had discussions regarding what the resulting composition of its balance sheet should be and there was agreement that it should consist exclusively of Treasury paper. The thinking for the $95 billion/month run-off was $60 billion in Treasuries and $35 billion in mortgage-backed securities (MBS). The Fed, then, could let its Treasuries mature (and reinvest any excess over $60 billion back into the Treasury market), but because MBS amortize over a long period of time (i.e., they are mortgages), the Fed would have to up to $35 billion/month of these in the open market. That led to the conclusion that such action would put upward pressure on longer-term and mortgage rates. And that appears to be why long-term rates rose so much faster than short-term ones.
The Fed “Put”
Equity markets have been hooked on the belief that the Fed “has their back” (i.e., the Fed “Put”), and the infamous “Powell Pivot” in 2018 (the Fed switched from tightening mode to easing mode when equity markets plunged) has reinforced that belief.
We noted in last week’s blog that this QT would be twice as fast as the QT attempt in 2018, that one aborted by liquidity events in an over-leveraged financial system. Not only is the recently released planned QT even faster than what we and markets had assumed, but the financial leverage in today’s markets is much greater than it was in 2018 (i.e., total debt/GDP today is 350% vs 305% in 2018). It looks to us that, as QT occurs, the equity markets will feel significant pain and will be screaming “uncle!” This time, however, because of inflation, it won’t be the equity markets that cause the Fed to alter its “forward guidance” (dot-plot). This time, we think, “it’s the economy (stupid)!”
Where We Are
Pre-pandemic, due to the Powell Pivot described above, monetary policy was in easy mode, and inflation was running at a rate that was less than 2% annually. In fact, the Fed was trying to push inflation higher.
Then we had the pandemic, shutdowns, supply shocks and several rounds of free money (which started the inflation). There are still lockdowns in China which continue to play havoc with supply chains. In addition, for the past month, we have had the supply issues from Russia’s invasion of Ukraine. Monetary policy can’t possibly solve those supply issues.
The free money has ended, and the pandemic appears to be waning. That should help on the inflation front. But supply chains are still a mess and now we have a war and ongoing political angst. The fact that markets have priced-in 100% of the Fed’s one-to-two-year rate view, and suddenly and violently raised interest rates, means an economic slowdown will occur. Unfortunately, this will be on top of the slowdown that has already begun, and this has heightened the risk of a recession, this time much earlier in the Fed’s rate hiking cycle than has occurred in the past when there was no “forward guidance.”
Let’s not forget that the Fed, itself, has just begun its tightening cycle (one 25 bps raise of the Fed Funds rate), and they can change their minds if incoming data weakens (which is our forecast). But as noted, markets have already tightened financial conditions to the Fed’s forward view, a view that, in our opinion, is not likely to play out.
The result is that today’s mortgage rates are at levels last seen in 2018 (just prior to the first Powell “pivot”). Consequently, home building and home furnishing stocks are in bear markets (down more than 20% from their nearby peaks). Mortgage applications are down -42% Y/Y, mainly refis (-62% Y/Y).
As we’ve noted in these blogs, the University of Michigan’s Consumer Sentiment Survey (reinforced by a similar survey done by the Conference Board) says home buying intentions, a leading indicator, are at or near historic lows. Same for intentions to purchase autos and major appliances.
More Incoming Data
- Energy is 8% of the CPI calculation. There is “backwardation” in the oil futures market, meaning that market participants believe that the future price of oil will be lower than today’s price (and, perhaps, this will translate into some relief at the pump). In addition, domestic drilling is up 50% Y/Y.
- Food is 13% of the CPI calculation. The U.S. is a net exporter of food and farm output is rising (3%) faster than domestic demand (1%). Drought and the availability and cost of fertilizer remain perplexing issues.
- Rent accounts for 30% of the CPI. As we have observed in several of our past blogs, multi-family starts have been at levels not seen since the 1970s, and finished units are just starting to hit the market. Already, apartment vacancy rates are up to 4.6% from 3.8% last summer.
- Together, rent, food and energy account for more than half of the CPI calculation. Of course, food and energy are impacted by the war in the Ukraine. Nevertheless, incoming data would seem to imply that there is some relief coming in these areas. Thus, if the Fed is really “data dependent,” they may not feel the need to fully execute their current dot-plot plan.
- The latest Atlanta Fed Q1/22 forecast for real GDP growth sits at 1.1%.
- The ISM Manufacturing March Index came in at 57.1 vs. February’s 58.6. The consensus was for a rise to 59.0.
- Quoting from the Fed’s minutes: “A couple participants commented that the increased uncertainty might lead businesses and consumers to reduce spending.” On Friday (April 8) CNBC featured a story entitled: As Inflation bites and American mood darkens, higher-income consumers are cutting back, too. The story said that American consumers have already cut back on spending. Those living paycheck to paycheck have little choice, the story noted, but the survey also said that higher income consumers are showing signs of financial stress and have been cutting back on dining out, travel and vacations, and have reduced plans to purchase cars. The chart at the top of this blog shows that planned cutbacks for higher income households are not much different from lower income groups.
- Real Disposable Personal Income (i.e., after accounting for inflation) has fallen in seven of the last eight months and is down at a -4.7% annual rate over that time period.
Monetary policy impacts demand. The only way for the Fed to cure an inflation caused by supply shocks is to reduce that demand. That means slowing an economy even faster than it is already slowing. Markets have priced-in an uber-aggressive Fed tightening cycle using the end state of interest rates and QT balance sheet reductions twice as fast as occurred in the Fed’s abortive 2018 QT effort. Q1’s real GDP growth, according to the Fed’s own Atlanta Regional Bank, will be around a lowly +1% (and two-thirds of Q1 was prior to the shocks coming from Russia’s invasion of the Ukraine). Mortgage rates have risen from 3% to 5% during Q1, and not only have consumer plans to buy homes, cars, and appliances tanked, but mortgage applications have succumbed too. Wages are growing, but not keeping up with inflation, and surveys show that consumers at every income level are switching to frugality mode.
If the Fed is truly “data dependent,” and if, as we suspect, the incoming data proves to disappoint, then the Fed will not fully execute either the interest rate guidance (dot-plot) or the recently released QT intentions.
We do expect market price volatility, especially early-on in the equity markets as QT begins. And we strongly suspect that the markets’ rapid pricing-in of the Fed’s forward guidance (i.e., the interest rate spikes) has already negatively impacted the economy’s growth path.
(Joshua Barone contributed to this blog.)