DID THE FED JUST BLINK? THE MARKETS THINK SO!

Equity markets closed the week higher, up nearly 5% with half the gain occurring on Friday (October 21). There was also big news in bond land. The 10-Year Treasury yield broke the 4% barrier and now stands above 4.2% (see table). Bond yields had been marching ever higher on continued hawkish comments from some Fed governors.

But, on Friday, after seeing a couple of weeks of carnage in the foreign exchange (FX) markets caused by those hawkish comments (the Japanese Yen near 150/dollar, a level last seen in 1990; the Yen was 131/dollar at the end of July and 115/dollar in March) and, of course, the unfolding drama in the U.K. over the liquidity crisis in their pension funds (not to mention their political turmoil), the Fed appears to have had a modest change of heart and looks to be signaling a lower terminal rate to the financial markets. That caused Friday’s equity market melt-up, and some significant reductions in short-term Treasury yields (see tables).

The?Wall Street Journal’s?Nick Timiraos, the Fed’s “go-to guy” when they want to “unofficially” send a signal to the markets, wrote in Friday’s?WSJ?edition that the Fed will be discussing “stepping down” the rate hikes after November’s 75 basis point (bps) raise. That is what set both the equity and fixed income markets on fire (DJIA +749; 2-Yr T-Note 4.48% on Friday vs. 4.61% on Thursday). In addition, during the market trading day, as if rehearsed (maybe it was!), Mary Daly (SF Fed) reinforced that notion by saying that the Fed should start planning for smaller rate hikes.

This appears to be in direct conflict with her uber-hawkish comments earlier in the week. This same May Daly said “4.5% to 5.0% is the most likely outcome” and that the Fed would “hold at that point for some period of time.” Indeed, earlier in the week, Bullard (St. Louis Fed) also said that two more 75 bps hikes were likely in 2022 (implying 75 bps at both the November and December Fed meetings). And Esther George (KC Fed) was also hawkish early in the week when she said “you may see a terminal funds rate higher (4.5% – 5.0%) and have to stay there for longer.”

The end result is that there is now hope that, because of the chaos in the FX markets and the resulting illiquidity in some markets at home (see more below), the uber-hawkish rhetoric has begun to change.

Note that this is not a “pivot,” or even a “pause,” but more of a “step-down” meant to temper the market’s view of the “terminal rate.” Remember, in this cycle, because of the Fed’s new found “transparency,” markets immediately reprice to where the Fed has hinted they are headed. Thus, because we expect less hawkish rhetoric in the days and weeks to come, both bonds and stocks are repriced higher.

The Dot-Plots

The track record of the Fed’s prognostications (i.e., the dot plots) is quite poor (37% accuracy according to Rosenberg Research). But, despite the poor track record, the bond market treats the dots as gospel. As we have written in past blogs, bond market volatility would be much lower if they returned to the days of no “transparency.” To show how unsettled the FOMC thinking is, and thus subject to significant alteration, look at the dispersion of the 2024 dots (the yellow dots for 2024 on the dot-plot chart).

Clearly there is no consensus among the voting Committee members as to where the economy will be in just 14 months. (Yet despite the lack of consensus, these guys are causing havoc worldwide!) As a result, we think that the probability of a major policy error is high and, in our view, the Fed has boxed itself into such a stance.

Nevertheless, on Friday, at least we had the first step away from ultra-hawkishness.

Incoming Data

Housing:?Starts fell-8.1% M/M in September with Single-Family starts down -4.7% (down six of the last seven months) and down at a -41% annual rate over that seven-month span. Multi-Family starts were also down (-13.2% M/M in September), but they are still up +17.6% Y/Y. The number of apartments under construction is up +27% Y/Y (the highest rate of increase since 1973). When these come online (the private sector data already sees impacts here) the rent inflation that is an issue in the CPI and PCE price indexes will turn to disinflation.

Indeed, the Fed and the media have ignored the rapid deterioration that is occurring in the housing market which is the most interest-sensitive sector of the economy. New and Existing Home Sales and Single-Family starts are in freefall. Existing Home Sales have now fallen for eight months in a row and Y/Y sales are down -23.8%. The last time that happened was March to October 2007. Remember what happened next?

Mortgage purchase applications are down -38% Y/Y. As interest rates have risen, home affordability has fallen due to the increase in monthly payments for a given level of borrowing. Home prices always adjust downward when rates rise. And, in this case, rates have more than doubled YTD. This is going to impact consumer confidence, at least for the 65% of the population that owns a home, and is not a good omen for future household wealth and spending.

The full impact of housing on the economy hasn’t shown up yet in the aggregate economic data, but it will be noticeable this quarter.

The Labor Market:?In past blogs, we discussed the discrepancy of more than a million jobs between the seasonally adjusted (SA) and not-seasonally adjusted (NSA) data. On Tuesday (October 18) an?Investors Business Daily?headline read:?The Federal Reserve Pivot Is Coming In December: Here’s Proof?(by Jed Graham). According to Graham, “this year’s seasonal adjustment [provided] an average boost of 539,000 jobs relative to the average seasonal adjustment from March through September over the prior nine years.” The article stated that the October seasonal factors for 2018, 2019, and 2021 reduced payrolls by -465K, -533K, and -709K respectively. Remember, the BLS makes changes to all the SA data all the way back to January each and every month, but only releases the prior month’s data to the public. The huge discrepancy between the SA and NSA data must disappear by year’s end (if it hasn’t already due to those hidden past adjustments). But, if the Graham article is accurate, the October Labor Market report may have a major impact on Fed policymaking. Unfortunately, that report is due out on Friday, November 4, two days after the Fed’s November meeting. It could be that the Fed is privy to the labor numbers prior to their public release, but, as a result of its hawkish rhetoric for the past months, it is a near certainty that we will see a 75 bps rate rise on November 2. However, according to Graham, if the October/November labor reports are weak enough, the Fed’s December 13-14 meeting set may not produce even the now lowered 50 bps expectation. Only time will tell!

Other incoming labor market data shows that the labor market is likely not as “strong” as the Fed believes:

• Challenger reported (October 6) that companies planned to hire 380K workers in September, down from 940K a year earlier and the weakest level since 2011. In addition, layoff announcements in September were up 68% Y/Y while hiring plans were down nearly -60%.
• Walmart, for example, plans to hire 40K workers for the holidays vs 150K last year; Macy’s numbers are 41K this year vs 76K last year. FedEx announced a large cost-cutting plan and is closing some sorting facilities. Last year the company hired 100K seasonal employees, but, as of this writing, hasn’t indicated its intentions for this holiday season.
• Microsoft, Meta (Facebook), Twitter, and Netflix have all announced job cuts. And full-time employees are being replaced with part-time (Note that part-time employment has risen 10% Y/Y).
• Note that while the current unemployment rate is at a low 3.5% (we will see if it stays there after the October labor report), workweek hours have fallen YTD, and there has been a boom in part-time jobs. (Because BLS counts part-time jobs the same as full-time, we don’t see the emerging weakness in the Payroll data.) The tight job market narrative also appears to be at play, as businesses are cutting back hours instead of letting employees go.
• Finally, let us remember that because the BLS doesn’t survey small businesses, they add a large number (from a time study) each month to the payroll data (called the Birth/Death model). So far in 2022, this number is +950K. In reality, the real trend in business formation is negative.
• From May to September, multiple job holders have risen by almost +450K while full-time positions have fallen -139K and part-time positions are up +464K. These are not indicators of labor market strength.

Inflation

A tighter Fed policy has little immediate influence on food prices, rents, education, or medical costs. And these were up +0.8% in the latest CPI report. But, what it does have immediate influence over (interest rate sensitive items) showed disinflation last month: In September furniture, appliances, and moving expense prices fell -0.1%, -0.3%, and -2.3% respectively (no doubt because fewer homes were sold). Used car prices were down -1.1% (down three months?in a row). Prescriptions fell -0.1%, IT services -0.1%, apparel -0.3%, theater tickets -0.6%, sports events -2.9% (and -2.8% in August), and hotels/motels -1.2% (now down or flat four months in a row).

Other Data

• In real (inflation-adjusted) terms, retail sales contracted at a -3% annual rate in Q3, are down in four of the last five months and are flat on a Y/Y basis.
• The majority of reporting banks so far in Q3 have raised their loan loss reserves as consumers have borrowed on their credit cards at a record rate.

• The NY Fed Empire Manufacturing Index fell to -9.1 in October from September’s -1.5. This was the third straight month the index has been negative. A similar story for the Philly Fed Manufacturing Index (-8.7 October vs -9.9 September). This index has been in negative terrain for four of the last five months and shows that tight Fed policy has begun to impact the manufacturing sector. On the positive side, both the NY and Philly surveys showed continued easing in both backlogs and vendor delivery delays (both good omens for the inflation outlook).
• Of great importance, we’ve lately seen illiquidity in the FX markets, and, at home, flagging liquidity in the mortgage-backed securities (MBS) markets. We’ve even seen offerings of Treasury securities having to be broken up into smaller batches for a lack of institutional demand. Let’s not forget, the Fed is selling nearly $100 billion of Treasuries and MBS into these markets each month. Such lack of liquidity in these important markets is troubling and may have been a catalyst for the “step-down” rumor.

Final Thoughts

An ultra-aggressive Fed has caused havoc in the FX markets and is impacting liquidity in the MBS and even in the Treasury markets. It appears that the Fed has realized that its uber-hawkishness has caused financial market turmoil worldwide. As a result, the Fed planted the Friday?WSJ?thought that it would soon begin (after the November meeting) to “step down” the rate hikes. This appears to be confirmed by the turnaround in Mary Daly’s rhetoric (SF Fed) this week.

Central Bankers elsewhere have to be fed up with an insensitive Fed causing worldwide financial chaos, including issues with the U.K’s pensions, its currency, and the currency of Japan. Perhaps, when things settle down, there will be a groundswell for a different reserve currency, one where no single central bank can be the dominant influence. This is an idea that comes and goes periodically, but, this time, there appears to be a good cause (a rogue Fed). Such an event would be a blow to the U.S. economy which benefits greatly from the dollar’s reserve status. But, given this set of Fed actors, and the intensifying east-west schism, the probability of such an outcome has certainly risen.

Robert Barone, Ph.D. & Joshua Barone - Universal Value Advisors

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