Don’t Believe Soft Landing Hype
What You Missed
While Fed Chairman Jerome Powell’s public appearances – where he did his best to hammer home the Fed’s “higher for longer” mantra – may have been the talk of the town last week, it’s the economic data is what really caught our attention. It seems that the hinge connecting income growth to spending and inflation is loosening incrementally. Meanwhile, consumers, who alone are responsible for 70% of America’s economic activity, are clearly limiting their spending on goods, driving up retail inventories. Could it be the long-expected beginning of an economic slowdown?
Running the Numbers: Discouraging Data Translating to a Near-Term Peak in Rates
Interest rates across the maturity spectrum rose in the week. The crosscurrents of a persistently robust jobs market, stubbornly high inflation and a Fed that seems to be near the end of its tightening cycle, dominated the moves. For the week, the 2, 5, 10 and 30-year Treasury yields rose 19, 22, 16 and 7 basis points respectively, to 4.90%, 3.16%, 3.86% and 3.89%. Pressure persisted in the 2s-10s Treasury yield spread, a widely watched barometer of recession potential, to trade at -104 basis points, at the higher end of the recent range of -108 reached last Monday.
With the yield curve implying that a major recession is around the corner, coupled with diminished markets expectations of a recession, one must wonder: Is the yield curve signaling mechanism broken? That’s a topic of intense debate. It is certainly true that in the new world of over-the-top forward guidance from the Fed, one can assume that the curve’s signaling mechanism is more watered down than it has ever been. Should it be discarded? No, but the curve signaling is seemingly less reliable than in the past.
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, rose 5 basis points to 5.28%. The implied yield on the 3-month SOFR futures contract 1-year forward (June ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose a whopping 30 basis points point week over week, to 4.80%, reflecting the accumulation of less than encouraging economic data that implies short-term rates will go higher in the near-term, but that they’re near their peak.
The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR is already near its peak, and forecasts that it to peak in the fall, at 5.40%, then decline consistently over the next year as the Fed eventually eases. Swap markets still predict a rate cut by the end of this year, reflecting the seeming resilience of the US economy, but one that falls into a mild recession in Q4 2023. It’s all part of an emerging theme of deeply diminished expectations that the Fed’s 500 basis points of cumulative rate hikes are poised to set off a sharp recession, rather, expectations persist that we’ll eventually get a recession, but one that arrives later and ends up being shallower than previously thought.
Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, traded mostly flat through the week. Elsewhere, equities moved higher amid diminishing fears of a US economic slowdown. The price of a barrel of West Texas Intermediate crude oil rose $1.79 to $71.35, while the US Dollar and gold both strengthened slightly.
Just What the Fed Ordered: Emerging Signs of Slower Consumer Spending and Lower Inflation
Consumer spending slowed down significantly in May. Households are becoming more cautious about spending as excess cash built up over the pandemic dwindles. Alan Greenspan’s favorite economic indicators – railcar loadings and cardboard-box shipments – suggest that there is more cooling ahead.
The three-month moving average of railcar loadings shrank 16% on a year-over-year basis in May, the largest decline since August 2009. After plunging early in 2022, this indicator was broadly stable until January 2023, and helped predict the first wave of goods disinflation last year. Box shipments also show a large drop in recent months. It’s viewed that this indicator leads retail sales in major stores by three to six months.
The significant deterioration in the outlook for goods demand is consistent with the narrative in the Fed’s May Beige Book. Respondents in Richmond, Chicago, Atlanta, and Cleveland – all important freight nodes – recently noted a ‘freight recession’ caused by flagging demand. Last year, a similar freight recession jumpstarted an initial wave of goods disinflation. However, unlike last year, the current downturn’s driver isn’t simply a rotation in demand from goods to services – a benign reversal of the pandemic trend. Rather, there are signs that demand destruction is driving the current trend.
Why it matters: We’re betting that even a decline in goods demand isn’t enough to return core inflation to the Fed’s 2% target (it’s 4% now). A quicker cooling in wages and the jobs market will be required to finish the Fed’s job, or, as we’ve been saying for months now, it’s more likely that the Fed will strike a delicate balance of pausing rate hikes after this month, while tolerating inflation above its target as it waits for its hiking campaign to manifest in the economy.
In another sign that the Fed’s harsh medicine is working to slow things down, the “supercore” Personal Consumption Expenditures index, the Fed’s favorite inflation gauge, rose 0.2% in May, the slowest pace in 10 months. The change reflects increasing caution among consumers, a welcome development for the Fed, as Fed Chair Powell has stressed that job and wage growth create upside risks to core inflation. Last’s week’s supercore PCE data show the relationship between income growth and inflation loosening incrementally.
Our take: Softening inflation pressures – as expressed by the supercore PCE – tells us that the Fed won’t hike rate by the full 50 basis points as indicated in its latest Dot Plot. The Fed is more likely to hike just once more, by 25 basis points in July, then take a long pause as upcoming data show cracks emerging under the surface of the economy and growth momentum slowing.
Durable Goods and Manufacturing Data Add to the Slowing Theme
May saw a 1.7% increase in durable goods orders month over month (up from a previously reported 1.2% increase), driven by a spike in orders for non-defense aircraft and parts. That outperformed expectations of a monthly loss of 0.9%.
Although durable goods orders were higher in May, underlying weaknesses are beginning to appear. In contrast to forecasts for no growth, new orders increased only 0.6% when transportation equipment was excluded. Additionally, downward revisions to April’s data were responsible for approximately half of May’s upward surprise. Finally, after an upwardly revised 0.4% advance in April, shipments of non-defense related capital goods – which are directly factored into economic growth calculations – posted a much more moderate gain of 0.2% month over month. Since the start of the pandemic, the link between spending on commercial equipment to produce durable goods and orders for the durable goods themselves has become flimsy and warns us against interpreting the May data too broadly.
Why it matters: We expect an investment-led recession in late 2023/early 2024, as a softening trend in core capital-goods orders, lower revisions to previous orders, and a slowdown in the rate of shipments – all of which are direct inputs into GDP calculations – all come to fruition.
The Cherry on Top: Declining Manufacturing Activity
The headline purchasing managers’ index fell to 46.0 in June from 46.9 in May, its lowest level since May 2020, adversely affected by a drop in manufacturing employment. Any reading below 50 is a contraction of manufacturing activity.
Buried in the data are signs that everything on the demand side of the economy is contracting while factors on the supply side keep getting weaker. Supplier delivery times improved at a slower rate, and stock levels went down even more. However, manufacturers are trying to prevent stockpiling inventory as demand declines. The pricing component of the index has continued to decline, signaling that manufacturers are experiencing a more rapid decline in the prices they pay for components. It’s a good signal of falling inflation.
Our take: We are hesitant to draw conclusions from a single data point, but the data is encouraging for the Fed’s inflation fight.
What to Watch: Exaggerated Strength in the Jobs Market
Fed Chair Powell’s comments during a panel discussion on June 28 reflected the growing optimism among Wall Street economists and analysts that the US economy is headed for a soft-landing scenario. We’re not so sure about that. The economic buffer that previously existed in the form of households’ savings is rapidly dwindling. This is leading to a dramatic increase in both consumer delinquencies and small business bankruptcies.
Soft-landing speculation is likely to be fueled by job market data released this week (JOLTS, Thursday; nonfarm payrolls, Friday), but the underlying data – as we explained above – are less conclusive. Despite averaging over 200k in new jobs created in each of the last few months, the unemployment rate increased by 0.3 percentage points in May. How is that possible? It’s because the growth in unemployment among the self-employed isn’t captured by the payrolls survey. As such, to us, those aren’t signals of genuine strength in the jobs market.
For this week’s job report, we expect the economy to have added 225k new jobs in June, with the unemployment rate holding steady at 3.7% and wage growth of 0.3%. Despite the expected rise in wages, it won’t translate into higher inflation, as recent declines in hours worked have stunted growth in workers’ take-home pay, muddying what once was a direct link between wages and inflation.
Minutes of the June 13-14 Fed meeting (Wednesday) will shed light on the committee’s deliberations towards pausing rate hikes at the Fed’s last meeting on June 14th. Several Fed voting members, perhaps the majority, believed that core inflation had proven stickier than predicted, lending credence to the idea that more rate hikes are needed to take the sting out of inflation. However, this was likely countered by doubts about how soon the 500-basis point in cumulative Fed rate hikes would finally be felt in the economy. The compromise: Raise the peak Fed Funds rate in the dot plot but keep rates on hold in June.
After the Fed’s revision to the dot plot, it now implies that the Fed should hike rates by another 50 basis points before it’s done; we’re not certain they need to. With definite signals of a cooling jobs market in the second half of the year emerging, the Fed’s 25 basis-point hike on July 26th will be its last for several months.
Rex’s Story Time: The Ever-Shrinking Candy Bar
My first experience with inflation was when I was quite young. I didn’t know what it meant and can’t recall anyone ever mentioning it. I knew something was wrong because the candy bar size became smaller, but the cost was the same. It was shocking because the pittance of my allowance was devalued in my mind by 50%. When I asked my parents for a raise because I needed to buy two candy bars to compensate, they said you shouldn’t be eating so much candy. Did the candy companies care I paid the same for less?
When gasoline prices skyrocketed in 1980 to the equivalent of $3.00 in today’s dollars. I didn’t understand that there was a global recession happening because my father didn’t lose his job and I worked for minimum wage and lived rent free with my parents. Why didn’t I feel the pain? I had a motorcycle and didn’t have to wait in the long lines. An unused pump was free game.
I got lucky during the high inflation rates in the eighties. At the time I worked for a savings and loan. My job was to sell jumbo certificates of deposit. I earned a commission, and for my age I was well compensated. I made enough money to buy a house and finance it with a negative amortizing mortgage. How crazy is that? Fortunately, I was able to refinance at a more reasonable rate at 12% without a negative amortization schedule.
I’ve witnessed many economic cycles, but this time it feels different and nothing like I’ve experienced before. Our firm advises borrowers on how to best manage interest rate risk to fit their particular risk profile, which makes our job more complex in the current rate environment. It is challenging, but our capital market experience is advantageous to our customers and new clients looking for independent advice and in-depth knowledge of the markets.
One thing that is the same in this current rate environment is my childhood’s shrinking candy bar. I feel it now with smaller portions at restaurants and higher prices. Food and tip inflation. What is your first recollection of inflation? Anyone who started their career in 2000 has never experienced inflation until now. Anyone who has a pre-2000 inflation story, we’d love to hear your story.
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