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June 6, 2022
We get the May inflation report on Friday.
Remember, the consensus view/hope is that inflation has peaked. Just as the "transitory" theory was spoken into the economic psyche by the Fed, and distributed by the media and politicians, so has the "inflation has peaked" theory.
To be sure, the former certainly influenced behaviors last year. In fact, the idea that inflation was transitory gave Congress the cover to nearly push through another $3 trillion in fiscal spending ("Build Back Better")! If not for the heroic steadfastness of Manchin, we might be looking at inflation in the mid-teens, if not 20%, by now.
So, what does the "inflation has peaked" messaging do to influence behaviors this go around? When people expect the price of everything to runaway, they chase prices (higher, and higher). "Inflation has peaked" can change that expectation, and therefore, soften inflation.
Remember, as the former Fed Chair, Ben Bernanke recently said: "Monetary policy is 98% talk and 2% action." They've tried to talk down inflation on the one hand, by saying it has peaked, and on the other hand by telling us they are going to bring down demand.
So, we'll see on Friday if indeed we are getting the signal that inflation has peaked (from the May report).
The April report (last month) presented some hope. The monthly change dropped from a very hot 1.2% (from Feb to March) to just 0.3% (from March to April). Despite a, still, hot 8.3% year-over-year inflation rate from the April report, the rate-of-change from month-to-month fell sharply. If we annualize that 0.3% number, we get inflation back in the high 3s.
The Fed would be very happy to see another monthly number projecting something in the 3%-4% annualized range.
All of that said, the "peak" inflation theory is unlikely. Just looking at the data coming in globally, the U.S. would be bucking the global trend with a softer May inflation report.
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June 3, 2022
The jobs report this morning wasn’t weak, but it wasn’t strong.
As we discussed yesterday, in this environment, bad news is good news. The Fed wants to bring demand down. Therefore, any data, to that end, is a “positive,” because it takes the pressure off of the Fed to carry out a draconian campaign of aggressive rate hikes.
So, it wasn’t good news today, but it wasn’t bad news (confused yet?).
The Fed has targeted employment, as a tool to influence demand lower, primarily through correcting the imbalance between job openings and job seekers. It’s this imbalance (two openings for every one job seeker) that has given job seekers the leverage to negotiate higher wages.
How are employers dealing with paying a higher wage? They are passing it along to consumers through higher prices (inflation).
On that note, if we look at the wage component of today’s report, it may be signaling some softness. The month-to-month change is just 0.3%. If we annualize that, it’s 3.7% wage growth. That’s well below the roughly 5.5% year-over-year wage growth numbers we’ve seen over the past eight months.
And while it’s not showing up in the employment data yet, we know that employers are pulling back on jobs.
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We looked at this chart above last week. With the telegraph of higher interest rates, and less liquidity in the system, the start up and early stage technology businesses had the biggest layoffs in May, since the depths of the lockdown-induced recession. Big tech is now announcing hiring freezes and head count reduction too.
So, again, the market is doing the Fed’s job for them.
Layoffs and softer wages sound like bad news. But it’s good news within the context of the probable outcomes that are on the table. A looser labor market, softer wage growth, lower stock valuations and higher gas prices are a formula for lower demand. That should keep the path of interest rates shallow and, therefore, lower the probability of an economic crash scenario.
That said, the Fed’s attack on demand will do little to contain the prices driven by structural supply deficits, namely oil. With that, a lower standard of living seems to be a common denominator in both the soft and hard landing scenarios for the economy.
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June 2, 2022
Last Wednesday, we talked about the setup for a break of the big trendline in this chart below (the yellow line). Moreover, we were looking for a close above the 4,000 level in the S&P 500, as a bullish signal for stocks.
We got it, and we've since had about a 5% rally in stocks.
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This, as we head into a big government jobs report tomorrow.
What should we expect?
We had some clues from the private jobs report this morning, published by ADP. The jobs added in May came in at 128k, versus the market consensus of 300k. It was a miss.
For tomorrow's report on non-farm payrolls, the expectation is for the weakest report in over a year, at 325k jobs added.
To be sure, this will be one of the more important jobs reports we've seen in a while.
Why? Because the Fed has explicitly targeted jobs, in the effort to bring down inflation. The Fed Chair, Jay Powell, told us explicitly that they intend to bring the ratio of job openings/job seekers down from two-to-one, to one-to-one.
Yes, we have a Fed that is trying to manipulate to the goal of higher unemployment.
In my 26-year career in markets, I've never witnessed a Fed that is explicitly attempting to destroy demand and jobs. But here we are.
With that, we are in a bad news is good news stock market.
As we've discussed here in my daily notes, the more verbal influence that the Fed can have on markets, and consumer and business psychology, the less work that the Fed has to do with interest rates.
The shallower the path of interest rate hikes, the higher the probability of a soft landing for the economy. That's a slowing growth scenario (the best case scenario in the this environment).
On that front, so far so good. The markets are doing the Fed's job for it. Lower equity valuations, higher gas prices and higher mortgage rates have quickly changed consumer and business psychology. Demand is coming down, which should translate into some loosening in the job market. We will see tomorrow.
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June 1, 2022
Today was the official start of the Fed’s quantitative tightening (QT) program. This is taking liquidity out of the system.
The Fed plans to allow the securities they bought at the depths of the pandemic (which injected liquidity into the financial system), to mature from this point forward, without reinvesting the proceeds. With this plan, they think they will extract $1 trillion from the financial system over the next year. And they estimate that a trillion dollars worth of QT will be the equivalent of about a half of a percentage point rate hike.
Remember, the Fed first disclosed that they had discussed plans for QT back on January 5th, when they published the minutes from their December meeting.
Here’s an update of what stocks have done since the minutes hit the wire (back in early January).
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So, the anticipation of reversing QE has already contributed to a steep decline in stocks. Now actual QT is officially upon us.
With that in mind, let’s take a look at how stocks behaved during the Fed’s first experiment in shrinking the balance sheet, following the Great Financial Crisis period (GFC).
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Stocks went up!
Over 535 days, stocks gains 22%. This measures the period of time from when the Fed signaled balance sheet normalization (June 2017), up until the day they ended it (July 2019).
On that note, as we’ve discussed over the past couple of months, the historical track record of QE exits is not good.
We know that in each case (globally and domestically), the “quantitative tightening” experiments ended with more QE.
From the chart above, clearly the Fed’s return to QE wasn’t because of a crashing stock market.
Why did they restart QE back in 2019?
Things started breaking in the financial system.
Remember, we discussed this back in my April 6 note. We had this 300 basis point spike in the overnight lending market.
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Here’s how the Fed explained what happened (my emphasis) …
“Strains in money market in September occurred against a backdrop of a declining level of reserves, due to the Fed’s balance sheet normalization and heavy issuance of Treasury securities.”
So, the Fed was forced to rescue the overnight lending market (between the biggest banks in the country) because of an unforeseen consequence of balance sheet normalization.
It’s important to understand that reversing the Fed balance sheet is an experiment, with outcomes unknown.
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May 31, 2022
We’ve talked over the past few weeks about the demand headwind that has come from: 1) the negative net worth effect from the decline in stocks, and 2) the tax effect from the rise in gas prices.
We’ve also talked about the other piece of the net worth effect: housing.
To this point, housing has had a positive net worth effect. And prices remain at record levels. But will it sustain through the demand headwinds and the record spike in mortgage rates?
Let’s take a closer look …
The Case Shiller housing price data for March was released this morning. This is now two months old, but the reports showed new record highs for house prices …
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That said, we’ve already seen evidence that this bull cycle for housing may be over.
Existing home sales topped in January. Housing inventory bottomed in February.
And while the Fed has moved only 75 basis points in this tightening cycle, and the effective Fed Funds rate has yet to rise above 1%, mortgage rates have exploded higher.
In just 17 months, the 30-year fixed mortgage rate has spiked from 2.68% to over 5.25%.
That’s a near doubling in mortgage rates. And as you can see in the chart below, it’s the fastest change on record.
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One might argue that this spike in rates is coming from a record low base. That's true. But this has translated into a spike in the cost of ownership as a percent of income, to levels of 2006 and 2007 (near 40% of median income, to cover housing).
So, is housing market set up for another bust? Unlikely.
More than half of mortgage holders have a fixed rate of 3.5% or less. And only 10% of mortgages have adjusted rate mortgages — and those ARMs have a fixed rate component, on average, for between 7 to 10 years. So this isn't the fragile mortgage market of the 2008 housing crash, where 40% of all mortgages were ARMs.
What the housing market IS set up for, is a moderation. And that's another headwind for demand. For the late cycle home buyers, the spike in the cost of ownership is destructive to discretionary spending (another tax effect). And a moderation in prices and turnover activity should be enough to knock down the animal spirits of existing home owners with significant home equity (i.e. the fearless consumption we've seen that has been underpinned by the net worth effect).
Add this, to the haircut in equity valuations and record high gas prices, and (again) the markets are doing the Fed's job for them: bringing down demand.
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May 27, 2022
As we head into Memorial Day weekend, let's talk about oil.
Two year's ago (this time of year), the national average price on gas was $1.87. Last year: $3.04. Today, it's $4.60.
Throughout much of the past two years, the "climate actioners" were convinced that oil demand was rapidly eroding, on the fantasy of a rapid change to a world of ubiquitous electric vehicles and wind farms. So, they underestimated demand, while simultaneously regulating away (oil) supply.
Throughout much of the past two years, the "climate actioners" were convinced that oil demand was rapidly eroding, on the fantasy of a rapid change to a world of ubiquitous electric vehicles and wind farms. So, they underestimated demand, while simultaneously regulating away (oil) supply.
The result has been ceding control on oil prices, completely, to OPEC. And that guarantees higher and higher prices (no limit).
With that, as we've discussed in recent weeks, the energy price input on the cost of living, has become a primary headwind for demand.
Add that to a reset in mortgage rates and a haircut in equity valuations, and we have an economic slowdown that will lower the standard of living, but may contribute to avoiding an economic crash (as the slowdown provides some relief against more aggressive Fed monetary policy action).
With that, as we discussed yesterday, the bounce in stocks looks early, and set to continue.
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May 26, 2022
Tightening financial conditions is not a typical brew for buying stocks.
We've had a tightening. And yet, we came into today talking about a bullish setup for stocks.
We were looking for a break of this big trendline (the yellow line) in the S&P 500, and a close above the key 4,000 level. We got it.
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This move today will likely end the streak of seven consecutive negative return weeks for the S&P 500.
And that's very important, as the S&P 500 is the proxy for global stability and risk appetite. With that, we had broadly positive risk appetite across global markets today (stocks, commodities, currencies).
Look for this to continue.
Why?
As we discussed yesterday, the haircut in equity valuations (i.e. the stock market) over the course of the past five months has taken considerable air out of the exuberance of economic activity. Add to that, soaring gas prices and a spike in mortgage rates have quickly swung the conversation from inflationary boom to recession.
It's the "negative net worth effect" of stocks, and the "cost of living tax" from gas and mortgage rates, that have resulted in a "tightening" effect on the economy.
Bottom line: Markets have seemingly done the Fed's job for them.
Without having to move past 1% on the effective Fed Funds rate (to this point) or sell a single bond from their balance sheet, they've gotten the desired result. Slowing demand.
Why is that positive?
As we also discussed yesterday, it reduces the probability of a 80s style inflation fight, and therefore, reduces the probability of a "hard landing" (i.e. a crash in the economy). That's good for stocks.
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May 25, 2022
The minutes from the May Fed meeting were released today.
It was three weeks ago that the Fed made it's second rate hike, and started what now projects to be a series of 50 bps rate hikes (probably three consecutive by July).
And from this meeting, they announced details on a quantitative tightening plan (i.e. reversing QE). That's due to begin June 1.
This was all within the context of what the Fed described as a "very strong economy," "extremely tight labor market," and "very high inflation."
Since then, stocks have made new lows. Gas prices have made new highs. Rents and the cost of home ownership have continued to rise.
Financial conditions have tightened.
And with that, consumer psychology is changing.
Take a look at these google search trends …
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When the Fed last met, inflation was top of mind.
Now it’s this …
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So, this brings us back to my prior notes, where we’ve discussed the power of the Fed’s tough talk.
Remember, back in March, Jay Powell explicitly said they were trying to better align demand with supply (i.e. bring demand down).
Within that strategy, they have explicitly said they want to narrow the job opening to job seeker gap (which has been 2 to 1).
As a proxy, this chart of layoffs in startups are happening (narrowing the gap) …
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So, just months after telling us they want to bring demand down, the switch seems to have been flipped (per the charts above).
And they haven't even gotten the effective Fed funds rate to 1% yet.
And they haven't even started their QT program.
But they have achieved the goal of knocking down animal spirits, curtailing inflation expectations, and extracting liquidity from the system (in the form of lower equity market valuation).
If we consider that, we have a Fed that should have the comfort to sit back and watch the inflation data come down.
This is a slow down scenario. And it has been quick. But this is not the Volker-like inflation-fighting scenario (and hard landing).
And it presents the very real possibility that the tightening effect from a stock market decline, high gas prices and an adjustment in mortgage rates, could be enough to bring inflation under control (without requiring sharply higher interest rates).
This should be seen as positive for stocks here.
With that, the S&P 500 sets up for a test of this big trendline tomorrow (in the chart below).
A break and close above 4,000 would be bullish, and give us a chance to see a break of the string of seven consecutive down weeks, each having had lower lows along the way.
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