Why the next interest rate hike will be the Fed’s last hurrah
The stock market rally this week (which ended on July 22) appears to us to be a “bear market” rally supported by short hedging and the mistaken belief that a soft landing is possible and a recession is avoidable. The DJIA closed up +2.0%, the S&P 500 +2.6%, the Nasdaq +3.3% and the Russell 2000 +3.6%. Yet these indices are respectively -12.4%, -17.4%, -26.0% and -26.0% below their recent highs, with the Nasdaq and Russell 2000 still officially in “bear markets”. (see the right column of the table). .
As with all “bear market” rallies, the updrafts are much larger than when stock markets are in a “bull market” phase. The reason we believe this to be a “bear market” rally is that incoming data continues to slow and deteriorate, with most indicators falling faster than in previous months.
Enter the Fed. They meet on the 26the and 27e (Tuesday and Wednesday) with a post-meeting statement and press conference being key to the market’s reaction to what will no doubt be a 75 basis point (bp) rise. The incoming data has already convinced bond traders that, as we indicated in our last blog, this could be the Fed’s “last hurray” (last rate hike for this interest rate cycle), and bond yields plummeted. The 10 years old. The yield on Treasuries, for example, hit 3.04% on Wednesday July 20 and closed at 2.78% on Friday July 22, a whopping -26 basis point move in just two days! The good news is that at a fed funds rate of 2.25% to 2.50%, which will be the rate after the 75 basis point hike, the Fed can be content with having, at the very least , moved interest rates to where economists think is the “neutral” zone (where policy is neither easy nor strict).
Lately, cracks are starting to appear in housing, a sector that many believed (and still believe) is somehow recession proof.
Here are two well-known leading indicators of the new home market:
- Homebuilder Sentiment (National Association of Home Builders (NAHB)) – these are the voices of the builders themselves. The overall index fell to 55 in July from 67 in June, still positive (50 is the boundary between expansion and contraction) but down significantly. This index stood at 79 in March and, with the exception of April 2020 (the pandemic), July represents the largest one-month drop in the history of the survey. In the past month, 13% of homebuilders have reduced their prices.
- The potential sales sub-index fell to 50 from 61, and traffic from potential buyers dipped significantly into negative territory at a reading of 37 from an already negative reading of 48 in June.
According to Redfin
The good news is that multi-family dwellings increased by +10.3%, which should help to mitigate the rapid rise in rents over the past six months, as these, and the current large number of multi-family dwellings already in construction, should be put online. in the second half of this year.
Existing home sales fell -5.4% in June, are down -14.2% year on year, were at the slowest pace since May 2020 (again the pandemic) and, before that, January 2019 It’s important to understand that these are closings whose initial contracts were likely signed in April, before the big spike in mortgage rates (chart). We can expect worse numbers in the near future, and we can predict that as mortgage applications are now at a 22-year low, down -6.6% W/W for the week of July 15 and -60% Y/Y. The all-important refi sector is down -4.3% W/W and now -80% Y/Y. In addition, the surge in mortgage rates has caused a significant increase in contract cancellations, now at 15% in June (12.7% in May), the highest rate since April 2020 (i.e. the pandemic). Finally, it’s quite telling for the housing industry when major mortgage originators start laying off staff, as JP Morgan and Wells just announced.
Sentiment and LEI
The Conference Board’s leading economic indicators fell -0.8% in June after falling -0.4% in May, and are now down four months in a row and five of the last six (see chart at top of this blog). Since its inception in 1959, when the LEI fell for four consecutive months, a recession has ensued one hundred percent of the time.
We highlighted the University of Michigan Consumer Confidence Index over the past few months. It has been and remains an excellent leading indicator. The chart below, taken from the same survey, shows expected trading conditions six months from now. Note the current trend and note that a similar trend has appeared before every major recession since the late 1970s.
Fed Regional Indices
The Philadelphia Fed manufacturing index fell to -12.7 in June. The consensus estimate was +0.8! which goes to show how far off the soft landing tale is. In May, this index was also negative (-3.3). The new orders sub-index was -24.8 (vs. -12.4 in May). June’s expected trade conditions in six months at -18.6 was the lowest recorded number since 1979. May’s number was -6.8. Whenever this index has been -10 or lower, a recession has occurred.
It should be noted that the six-month outlook for the NY Fed Empire Manufacturing Index was -6.2 in July. In the history of the Empire Index, this component has only been negative three times: September ’01, and January and February ’09. You all know what happened next!
Back to the Philly index, the employment, workweek and inventory measures were all lower. Finally, and on a positive note, unfilled orders, supplier lead times and prices paid and received were all lower, indicating that supply bottlenecks have started to ease, a positive sign for inflation.
The evolution of the labor market
Initial claims (IC) for unemployment have been slowly rising since March, with their pace accelerating lately, reaching +251K in the week ended July 16th. They are now +85K above their March low. Historically, on average, +76K has signaled recession.
Those hoping for a soft landing point to the “strong” job market where “now the signs of hiring are everywhere.” However, indicators, including CIs, now point to a significant shift in this labor market narrative.
For starters, the horrendous Q1 productivity number (-7.3%) is destined to repeat itself in Q2 as companies over-hire and hoard labor, believing the market’s overly tight narrative. work (i.e. the narrative was self-fulfilling). The resizing is starting to happen, as evidenced by the reading of -350K in the June household survey (showing negative numbers now in two of the last three months). Incidentally, this household survey is used to calculate the unemployment rate and is much more sensitive to changes in working conditions than the wage survey.
The reason why the unemployment rate did not decline in June despite the decline in the number of jobs is that the labor force (the denominator) also fell. It is now clear that changes in the job market have already happened or are about to happen, as inflation, recession and falling stock prices push people back into the job market.
The Washington Post recently reported that 1.5 million of the 3.0 million workers who took early retirement during the pandemic are re-entering the labor market. The reasons cited were inflation (65%), falling stock prices (45%) and rising interest rates (30%). A Quicken survey found nearly half of those planning to retire in 2022 have put off that plan. It seems to us that a growing labor force will soon push up the official unemployment rate.
As we reported, when the July CPI is released (mid-August), we believe it will prove that inflation peaked in June. On Friday July 22, the price of a barrel of oil (WTI for September delivery) closed at just over $95, down -22% from the $122 level in mid-June.
Note on the right side of the chart the important role that energy has played in the current inflation saga. Given the much lower price per barrel, we expect the energy component to be down from July. Note that the prices of food and goods have already started to fall.
As further evidence, AAA reports that the national average for regular gasoline per gallon was $4.41 Friday, July 22, down -11% from $4.96 a month ago. In addition, the prices of agricultural and industrial commodities, as well as transport costs, have fallen rapidly. The price of wheat, for example, has fallen -41% since mid-May. And the price of copper (often referred to as Dr. Copper because the stock market often follows its price trajectory) fell about -8% from early March to early June, but then fell another -27% during the Last 5 weeks, and it won’t be long. appear in industrial prices.
The equity market has been sniffing recession for most of the year, and now the bond market is confident, as we’ve said here over the past few blogs, that the Fed will move away from its dot-plot of June (3.4% for Fed Funds at 12/31/22 and 3.8% at 12/31/23). That won’t happen at the Fed’s meetings this week (July 26-27), but come the time of their September meetings, the data coming in will be such that they will have little choice. The fading bond yields this week from 3.04% for the 10-year. The Treasury note Wednesday July 20 at 2.78% Friday (-26 basis points in two days) and 3.48% just a month ago (June 14; -70 basis points since) in says a lot. We said it in last week’s blog, and we’ll say it again now: the next 75 basis point rate hike at the end of this week’s Fed meetings will be the Fed’s “last hurray” for this rate cycle.
(Joshua Barone contributed to this blog)