BUYING INTO THE IMPOSSIBLE DREAM
For the past two months financial markets have been stuck in a trading range that runs the gambit between fear and greed – a classic tug of war buttressed by vague macro-economic scenarios that are, at best, subjective.
Efforts to pinpoint the terminal interest rate[1] vary depending on the latest iteration of ‘Fed speak’. Currently, market participants seem to have priced in an interest rate trajectory that will culminate somewhere between 3.75% to 4.25%. The overnight rate for the Bank of Canada now sits at 3.25%, while the U.S. rate is between 2.25% and 2.50% with an additional 0.75% hike expected at the U.S. Federal Reserve’s September 21st meeting. If our position is valid then the new rate hike cycle is closer to the end than it is to the beginning.
Our view hinges on current versus long-term inflation expectations, which requires analysis of consumer attitudes and spending trends. The objective is to weigh how monthly inflation statistics, versus long-term inflation expectations, influence consumer behaviour. The worry is that expectations turn into reality… If consumers believe inflation is a longer-term problem, it will become a longer-term problem.
The numbers for the August U.S. consumer price index (CPI) did not help. Inflation came in hotter than expected, rising 0.1% (expectations were for a decrease of -0.01%) for the month of August and 8.3% (expectation: 8.1%) on a year-over-year basis. Core CPI, which removes the volatile food and energy components, was up 0.6% in August and 6.3% year-over-year.
Energy prices fell 5% for the month, led by a 10.6% slide in the gasoline index. However, those declines were offset by month over month increases in shelter (0.7%), food (0.8%) and medical care (0.8%). New vehicle prices were higher (+0.8% month-over-month) though used vehicle prices fell 0.1%.
Not surprisingly, markets tanked on the news. Short term interest rates jumped as traders jettisoned any notion that the Fed would become more dovish and only raise rates by 0.5% next week. A 0.75% rate hike is now the baseline and, according to Fed funds futures, there is a 10% possibility that the U.S. Federal Reserve (Fed) will raise rates by a full percentage point. The reaction in the bond market was instantaneous, which spilled over into the equity markets.
Food and rental costs were the problem. Prices have continued to rise, which probably explains the shift in consumer behaviour. As prices for basic food rises, more consumers are looking for lower cost alternatives, which are delivered by Walmart and Costco. The rise in food costs, combined with labour shortages, is the main reason the cost of a meal at restaurants has surged.
That said, some analysts have opined that inflation could fall dramatically by yearend as rent increases have begun to stabilize. As more datapoints are added, rental costs should abate. Food, on the other hand, is more problematic and given its weight within the CPI, will continue to negatively impact the inflation data.
Most economists doubt that August inflation will alter the Fed’s stance, especially given Chairman Powell’s hawkish comments at his Jackson Hole speech. That said, the Fed has a history of changing direction as new datapoints emerge. You may recall that in June 2020 Fed Chair Powell was not even “thinking about thinking about raising rates” before 2023 at the earliest. When we fast forward to the second quarter of 2022, not only did the Fed begin thinking about rate hikes, but their tone also became more hawkish and the aggressive rate hiking campaign to quell inflation began in earnest.
The point is that a reversal of course would not be out of character for the Fed. Our position is the Fed will push rates up by another 175 bps before the end of 2022. They will likely do 75 bps in September and maybe two additional 50 bps before year end before hitting the pause button. Those hikes will hit their terminal rate and allow the Fed to stand aside until after the November mid-term elections. That would give the members of the Federal Open Market Committee time to assess the impact of their interest rate policy.
Finally, we turn to the ever-changing ‘soft landing’ versus recession debate. Soft landings are about as rare as Toronto winning the Stanley Cup. Historically, central banks have no better than a 1 in 10 chance of managing the interest rate sweet spot that tames inflation without causing a recession.
Could central banks pull off the impossible… orchestrating a soft landing without a pandemic playbook? We are seeing economic contraction based on data from the U.S. Commerce Department, but it doesn’t feel like a recession. The U.S. economy added just under 3 million jobs from January through the end of July. Earnings for consumer-facing companies such as Starbucks Corp. and Uber Technologies Inc. have pricing power, travel is booming as airlines experience unprecedented demand and hotels are operating at near capacity, with occupancy levels at or near pre-pandemic levels. Companies in the benchmark S&P 500 Index posted record profits for the second quarter.
While this recession is out of the ordinary it is not without precedence. The 1990-1991 recession was primarily confined to the commercial real estate and banking sectors, but it took another four years for unemployment rates to fall back to pre-1990 levels. The dot.com bust in 2001 could hardly be considered a recession but was extremely painful in terms of its impact on the stock market. Then there was the financial crisis of 2008 and 2009, which was referred to as the Great Recession because of its depth and duration, with the housing market collapsing, unemployment rising to 10% and personal bankruptcies surging. The COVID-19 recession of 2020 saw the economy contract by the most since the Great Depression and the unemployment rate shoot up to near 15%, but it quickly abated on the back of unprecedented fiscal and monetary stimulus.
Not surprisingly, economists have been adjusting their growth estimates considering the most recent data. It is possible that the current recession fear is grounded in recency bias. Which is to say, consumers are taking into account the damage caused by previous recessions and assume the next one will be of the same magnitude.
The labour market is the biggest source of angst. Based on the most recent data
(see “Non-Farms Payroll” section), the unemployment rate remains anchored at 3.6%, just slightly above the half-century low of 3.5% set in 2019. Although job openings have fallen to 10.7 million from the peak 11.9 million in March, they remain double the long-term average going back to 1999. Of note is the strength in the services sector, which rebounded to a three-month high in July on firmer business activity and orders.
We think the short-term gyrations in the financial markets – driven for the most part by algorithmic trading – is underpinning the notion that we may get the illusive soft landing. The S&P 500 bumped up against the 4200 level in August, fell back to support at 3900, rebounded, then fell off a cliff back towards the 3,900 support. Yields on U.S. Treasuries eased and then pushed higher, which highlights financial markets’ uncertainty. That said, we are comforted by the fact that the new issue corporate bond market is booming, and the U.S. dollar remains strong. The implication is that U.S. financial conditions are easing and, if that proves to be sustainable, the doom-and-gloom mantra will have less influence on the investor psyche.
Central banks have been criticized for not anticipating the sharp acceleration in inflation. If this group can tame inflation without causing too much economic pain, it would go a long way toward restoring credibility.
One thing is certain, the old economic playbooks are no help for what is happening now. There is no script that can decipher the aftermath of an economy that was hobbled by COVID-19, shedding 17 million workers over a two-week period and contracting 31% only to rebound just as quickly on the back of government stimulus and ultra-easy monetary policy. We cannot expect the economy to follow the usual boom-bust patterns. Faced with the notion that past economic playbooks are irrelevant, central banks had to navigate the uncertainty with something entirely new. What is interesting is that they may succeed.
NON-FARM PAYROLLS
Before the financial markets opened on Friday September 2nd, investors were greeted with what appeared to be a goldilocks non-farm payrolls report. The U.S. economy produced 315,000 new jobs in August, slightly below the 318,000 consensuses estimate among economists. This, by itself, is not so hot a number as to require the Fed to maintain its aggressive rate hiking stance. Nor too cold to suggest the U.S. economy is heading into a prolonged recession.
The markets’ reaction was swift, with pre-market activity lifting the major indices into positive territory. The upward spike was short lived, however! As analysts sifted through the minutia, the ‘just right’ analogy seemed less appropriate.
Demonstrating again that reading macro-economic tea leaves is more art than science, Wall Street investment houses released commentary that complicated the underlying thesis. As questions surfaced, the bears took center stage and stocks fell sharply. At the end of trading before the Labour Day long weekend, the Nasdaq 100 index closed lower for the sixth consecutive trading session.
Subsequently, the market regained some ground – before the September 13th sell-off – maybe as a simple reflection of investors inability to make a case for a sustained move either up or down. Our view is that the jobs report confirmed the ‘don’t-fight-the-Fed’ doctrine, in which good news is bad for financial markets. The worry is that the remarkable strength in the jobs market will increase competition for workers that accelerates wage demands, fueling higher inflation. We are already seeing evidence of that as average hourly earnings increased by 5.2% in the last 12 months.
These wage gains eclipsed the 3% annual pre-pandemic growth rate but remain far below the 8.3% annual rate of inflation recorded in August. The Fed’s concern is that competition for workers will amplify, which will propel wage inflation and keep driving prices higher. That concern has merit, but we would buttress the downside by pointing out that the unemployment rate increased from 3.5% to 3.7%.
How do we square these competing positions (strong jobs numbers with higher unemployment) and how does this complicate the inflation picture? One could argue that the stock market’s weak performance during 2022 has had a major bearing on the employment picture. For one thing we are witnessing a decline in the retirement surge, as boomers take a second look at whether they have sufficient capital to meet their post-work objectives. Another consideration is a surge in young mothers returning to the workforce as concerns about COVID wane.
Another factor that supports our slowing growth thesis (remember, this is subjective) is the average workweek fell by 0.1 hour to 34.5 hours in August of 2022, which was below market forecasts of 34.6 hours. In manufacturing, the average workweek for all employees was little changed at 40.3 hours and overtime held at 3.3 hours. The average workweek for production and nonsupervisory employees on private nonfarm payrolls declined by 0.1 hour to 33.9 hours.
Moreover, while average hourly earnings increased by 5.2% year-over-year the decline in the actual number of hours worked is telling because it is fundamental to net gains in a country’s gross domestic production. The implication, when viewed in combination, is that the U.S. economy is less productive implying slower growth, which is good for the inflation debate but raises concern about the recession outlook.
Another consideration is that fewer employees are quitting their jobs. That can be positive or negative for equity markets depending on which side of the fence you sit. If you are in the camp that is looking for a more dovish response from the Fed, fewer people leaving their jobs implies a slowing economy, which could dampen the Fed’s enthusiasm for aggressive rate hikes after yearend. If you are more concerned about the prospect of a lingering recession, fewer people leaving their jobs implies that a prolonged and deeper recession is more likely.
Our subjective view is that the August non-farms payroll was not enough to change the current rate-hiking trajectory of the Fed. When you look under the hood, there are simply too many contradictory factors. When one lacks clarity, as with most things in life, the best and easiest course of action is to maintain the status quo.
THE RISKS OF QUANTITATIVE TIGHTENING
The massive $25 trillion U.S. Treasury market is the foundation on which the global financial system rests. It supports the U.S. dollar as the world’s reserve currency, providing a standardized medium of exchange for most global transactions. Treasury yields underpin mortgages, personal lines of credit, corporate financing and high yield debt. The efficient functioning of this market is paramount.
The treasury market works because there is a deep liquidity pool allowing buyers and sellers to transact instantaneously. But what happens when liquidity is challenged because of friction in the system? We saw this play out in March 2020 as pandemic restrictions closed global economies and trading in U.S. treasuries stalled. Buyers were nowhere to be found, which caused volatility to spike, bid ask spreads to widen, and prices seesawed to the point of collapse.
The U.S. Federal Reserve came to the rescue as ‘the buyer of last resort,’ which stabilized the market. However, in the process the Fed’s balance sheet expanded to more than U.S. $4 trillion. Over the ensuing 18 months the Fed began a quantitative easing cycle that expanded their balance sheet by an additional U.S. $5 trillion.
We cite the events of March 2020 because we believe they provide a glimpse of what could happen as the Fed normalizes its balance sheet, which is now over-extended by U.S. $9 trillion. More worrisome is the fact that the Fed’s bloated balance sheet now accounts for nearly 40% of the entire U.S. treasury market.
Quantitative tightening to reduce this balance began in June as U.S. $60 billion in treasuries and another U.S. $35 billion in mortgage-backed securities were allowed to mature. As the pace accelerates so too does investor angst. The fear is that the process of normalization during a period of rising interest rates could undermine the safety and reliability of the Treasury market.
The Fed’s current program of quantitative tightening raises serious concerns for a market where small wobbles are troublesome. In a worst-case scenario, a liquidity crunch will cause the value of the dollar, stocks and other bonds to tumble. Economies that borrow a lot in dollars and hold U.S. treasuries in their reserves would teeter. Crucially, the U.S. Government could find it hard to finance itself, even up to defaulting on its debt, the financial equivalent of an earthquake. The sheer scale of U.S. Government debt, which now exceeds U.S. $25 trillion, plays a critical role. That debt needs to be bought by someone and not just the Fed.
“While this sounds like a bad science-fiction movie, it is unfortunately a real threat,” notes Ralph Axel, an interest rate strategist at Bank of America. He sees emerging strains in the treasury market as “the single greatest systemic financial risk today,” with the potential to do more damage than the housing turmoil that preceded the 2008 financial crisis.
The main concern is the impact quantitative tightening will have on liquidity. When markets are liquid, money flows freely, and transactions occur instantaneously with price stability. An illiquid market is like trying to push on a string. It may move, but the direction is unpredictable.
Quantitative tightening also draws into question the Fed’s role as the buyer of last resort. In that scenario, who will fill the void? Assuming new buyers can be found, they will not have access to the Feds’ unlimited resources, which will limit demand and exacerbate volatility.
Measures of price volatility are already elevated and liquidity is the worst it has been since the pandemic-induced sell-off in early 2020, notes Subadra Rajappa, an interest rate strategist at Société Générale: “The Fed doesn’t want to find itself in that situation again.” Last week, some traders pointed to the ramping up of quantitative tightening, combined with comments by Fed officials about rate increases, to explain large swings in treasury prices.
History has shown that normalizing the Fed’s balance sheet rarely goes smoothly. We note September 2019, when the Fed was about a year into the unwinding of its bond-buying program, which helped the U.S. economy recover from the 2008 financial crisis. At that point, the Fed was unwinding positions at roughly half the current forecast pace. That shook markets to the point the Fed had to step in and buy treasuries to ease the congestion.
On the positive side, that dislocation forced the Fed to introduce a permanent facility that could supply emergency cash to market participants in case of a liquidity crunch. In this round, we also have a number of U.S. regulators looking for out-of-the-box solutions to bolster liquidity.
It is also important to understand that the Fed is not actively selling its holdings – it is simply allowing them to mature and not reinvesting the proceeds. Some economists also believe that investors may not have to step in because the U.S. Treasury has significantly reduced its borrowing over the past year as the financing needs of the government during the pandemic have declined. In turn, this has reduced the number of Treasuries that need to be issued and ultimately purchased by investors.
Quantitative tightening is not the only reason liquidity is deteriorating. There is also an emotional quotient at play. In the treasury market, traders need to believe that when a trade is executed the price will not move significantly. That’s less likely due to elevated recession fears, the shifting course of the Russian-Ukrainian war and uncertainty about inflation’s trajectory.
If the demand for treasuries is unable to keep pace with supply, prices will decline. As we have stated in previous reports, bond prices and yields move in opposite directions. If yields rise, which is to be expected in a rate hiking environment, it pressures borrowers already grappling with the Fed’s hawkish campaign.
That takes us full circle back to the recession debate. Superimposing quantitative tightening on top of aggressive rate hikes could push global economies into a prolonged recession.
[1] The rate at which interest rates will quell inflation without triggering a prolonged recession
Richard Croft, Chairman & CIO