This morning, Friday, February 11, I decided to write this blog about why the spike in interest rates on Thursday was way overdone, as the underlying economy was weakening, not strengthening. Before I finished writing, the fixed income markets had reversed most of Thursday’s long-term rate spike and some on the shorter end. Looks to us like this was due to short covering as a result of the White House’s announcement that a Russian invasion of the Ukraine was near. Markets, of course, react to much more than the underlying economics, as is the case here. Nevertheless, those economics remain the anchor. And, regardless of the market’s volatility, this blog explores why the anchor, the underlying economics, won’t support rising rates and why we think they will go lower once the scare about Fed hawkishness abates.
The Rate Spike
Inflation ran hotter in January than expected, up +0.6% M/M and now at 7.5% Y/Y. The consensus was +0.4%. Financial markets, especially in fixed income land, are no longer taking their cues from the state of, or prospects for, the economy. Rather, they are looking at what course the Fed might take regarding the magnitude of the pre-announced tightening cycle. So, the hotter than expected CPI numbers played to the markets’ fears. Making matters worse and amplifying market fears was a statement by St. Louis Fed President James Bullard, perhaps the Fed’s biggest hawk. He called for a rise in the Fed’s benchmark lending rate (Fed Funds), currently pegged at 0% – 0.25%, to jump to 1.00% by July, implying at least one 50 basis point (0.50 pct. points) increase at one of the two upcoming Fed meetings prior to July. Markets had penned in a much slower rise and also assumed that such rate increases would be data dependent as reiterated time and again by Fed Chair Powell.
Four positions on the Federal Open Market Committee (FOMC), the Fed’s policy and rate setting committee, rotate on an annual basis, and this year, Bullard is a voting member. The fixed-income markets, motivated by the fear that the Fed would be much more hawkish than markets had priced in, reacted violently, and interest rates spiked on Thursday. The 2-yr Treasury Note spiked 25 basis points (.25 pct. points), the largest one-day increase since the financial crisis in 2009. The 10-Yr Treasury Note, which is the benchmark for mortgage rates, spiked 10 basis points to 2.03%. That instrument began February at 1.77% and was 1.34% in early December.
[Note: The resulting rise in mortgage interest rates can’t be good for housing affordability and negatively impacts lower-and-middle income groups. In addition, if the Fed begins to shed the Mortgage-Backed Securities in its massive portfolio, as it has suggested it will do, mortgage rates will feel even more upward pressure.]
Markets occasionally react violently, especially when new information, not currently “priced-in” comes to the fore. Immediately after his statement, the markets priced in Bullard’s suggestion of a 50-basis point rate increase at an upcoming Fed meeting, likely the one in mid-March, causing the rate spike!
Was this rate spike an overreaction? While we won’t know for sure until the actual path of rate hikes occurs, we think there are several reasons it will prove to be so.
The first is the make-up of the 2022 FOMC. The Fed, under Powell, has articulated a sensitivity for how its policies impact various income groups. Esther George, the KC Fed President and 2022 voting FOMC member, has opined that a reduction in the Fed’s balance sheet would allow for a lower terminal Fed Funds rate. (That view plays to the income inequality theme, as lower rates benefit lower income households while balance sheet reduction is a big negative for Wall Street.) Other FOMC members (Barkin (Richmond) and Daly (SF)) also made it clear after Bullard’s statement that they were opposed to a 50 basis point rate hike in March. Still other Fed officials indicated that they were already looking for a heightened January inflation report, and that nothing in the report has changed their view. In addition, Powell has made it clear over the last few months that future policy initiatives will be data dependent. Thus, within the FOMC, itself, there appear to be different approaches to the inflation issue, and Bullard does not appear to be representative of the FOMC’s pulse.
Realities of the Pre-Pandemic Era
Prior to the pandemic, demographic factors and growing debt combined to limit real GDP growth to the 2% area (see chart). As the economy begins to return to some semblance of “normal,” we ask: What has changed that would raise real GDP growth?
- From a demographic point of view, the population continues to age, and population growth is nearly stagnant. These are negatives for GDP growth.
- Debt levels have risen. Just look at federal debt!
- As we chronicle below, economic growth in the near-term, will be anemic.
The next chart shows 10-Year Treasury yields since 2015. Note that in the pre-pandemic period, yields were as low as 1.5% with an eyeballed 2% average.
Rates rose to 3% in 2018 with the Fed’s aborted attempt to reduce its balance sheet, but quickly fell back to the 1.5%-2.0% range as economic growth weakened (and the equity markets threw a tantrum).
The recent rate history shown in those charts indicates that a 2% 10-Year Treasury yield is appropriate for a 2% growth economy. Unfortunately, it doesn’t appear that we have such an economy on our hands, at least in the near-term. Here’s why:
- Fiscal policy will be a headwind in 2022. Free money is in the rear-view mirror.
- The University of Michigan Consumer Sentiment Index (see top of blog) fell precipitously in early February from 67.2 to 61.7, now at levels last seen at the depth of the Great Recession. The Expectations sub-index, at 57.4 (down from 64.1) is now consistent with a contraction in real (inflation-adjusted) consumption. It is difficult to forecast real consumption growth in an environment where consumers are so downbeat.
- Inventory levels, which contributed more than 70% to Q4’s 6.9% real GDP growth now appear to be too high (see chart). It is evident that the “shortage” narrative caused stockpiling, some of which may now be unwanted, especially as supply chains ease. It is likely that inventories will fall in Q1 which will be a subtraction from GDP (remember, inventory accounted for more than 70% of Q4’s GDP growth!). The National Federation of Independent Business’ latest survey (January) shows the inventory sub-index at 7; less than half its November value (15).
- As of February 9, the Atlanta Fed’s GDPNow forecast is +0.7% for Q1’s real GDP growth, rising from +0.1% (February 2) due to the hyper-inflated jobs numbers (see our blog: Employment Data –Turning A Sow’s Ear Into A Silk Purse). Still, even +0.7% is too slow for a 2% 10-Year Treasury yield.
- Consumer credit expanded $18.9 billion in December, a record amount, while retail sales were falling (-1,9%). (Perhaps this borrowing was financing the “Great Resignation!”) Stimulus checks are in the rear-view mirror, and real incomes are falling. The chart shows weekly earnings rising 4% Y/Y. with inflation up 7.5%, this represents a significant loss of consumer purchasing power. No wonder consumer sentiment is at recessionary levels! The castle shaped portion of the Weekly Earnings chart was the Trump and two Biden stimulus checks to households, while the bumps in late 2021 were due to the extra funds for the one-time increase in the child care tax credit that were doled out in cash to parents of children under 18 years of age (ended December 2021).
- So far, during the current corporate reporting season, no company has issued stronger than expected sales guidance (while nearly one-third have issued weaker). So, while corporate profits, themselves, may be doing okay (we think much of it is price gouging – i.e., “everyone knows there is inflation, so no one will question our price increases”), the 80% of the income pie that is households looks to be rapidly falling behind.
If we look around the world, we find that, among the Developed Markets, inflation is most heated in the U.S. This is clearly the result of supply issues caused by the closing of the economy while demand was supported by several trillion dollars of federal government stimulus, which, with hindsight, the most generous description of those programs we can offer is “overdone!”
The hot January CPI data (aided by some price gouging) should begin to recede as the year progresses if the economy is on a path to “normalcy,” i.e., without another COVID variant. While wages in some sectors have risen, we don’t see a 70s style wage/price spiral resulting. And we don’t see such in other Developed Markets (likely because their fiscal responses to the pandemic were more “measured”). For example, Japan is still showing deflationary tendencies, while January’s Swiss CPI equivalent was +0.2% M/M (1.6% Y/Y) and Norway’s was -0.9% M/M (3.2% Y/Y). Once again, it appears to be government policies that have caused the inflation (look at the history and policies of several South American countries over the last 50 years for a comparable analogy).
Yield Curve Inversion
From an historical point of view, when the yield curve has “inverted” (short-term rates higher than long-term), 100% of the time a recession has followed. Because of the Fed’s hawkish stance (reinforced by Bullard’s statements), the 5-Year Treasury is now within nine basis points of the 10-Year (normal is 50), and the 2-Year Note is within 44 basis points of that 10-Year (normal is 120).
The short-end of the yield curve is normally a function of the markets’ view of Fed policy, shifting up or down when policy changes are imminent. Hence, when possible (probable), Fed policy shifts “surprise” markets, a rapid, and often volatile market move ensues.
On the other hand, the long-end of the yield curve is normally concerned with the underlying health of the economy. When the yield curve inverts, the short-end sees overly aggressive rates relative to the economy’s underlying health (i.e., policy mistakes).
It is unlike us to give any government entity the “benefit of the doubt,” but we are going to make an exception. The Fed knows the state of the economy; after all, they have more economists on staff than any other entity in the world. We believe they are sounding hawkish for political reasons, as the public views this institution as the government’s main inflation fighting entity. We believe that their actions over the next several months will be informed by their forward view of the economy’s health (as we have outlined above and as painted by new and emerging data). If they don’t, the policy mistake will lead to recession. In either case, interest rates will fade from current levels.
(Joshua Barone contributed to this blog.)