Stock markets ended Q1/22 (Thursday March 31) with the first quarterly loss in two years (since Q1/2020, i.e. the start of the pandemic). The rush to sell over the past hour of trading was interesting, as if mutual funds and equity ETFs didn’t want to show too many stocks for the March 31 benchmark. Unfortunately, volatility seems to be the order of the day, at least for the next few months, as markets grapple with both the possibility of a recession and the quantitative tightening (QT) program announced by the Fed soon (more on this below).
With the media focused on equities, the chart above shows that the rapid rise in interest rates over the past two months and the concomitant fall in bond prices accounted for at least one three standard deviation event. , the worst downtrend in at least 50 years. Additionally, there is now growing controversy between economists who work for the sell side and those who rely more on history as to whether the yield curve is flat/inverted (2-year T-Note yield (2.46%)> The yield on 10-year T-Notes (2.39%)) continues to be the reliable recession indicator that it was in the post-WWII era.
The story of the crunch
Whenever the Fed enters a tightening cycle, its prognosis for the economy must appear bullish so that it can forecast a “soft landing”. Imagine if the Fed started a tightening cycle and told the media that the economy was weakening and that its actions could mean a recession! (That, however, seems to be the reality!) Because of such need, the accuracy of the Fed’s GDP forecast (as calculated by Rosenberg Research) is a modest 17%! Under the current circumstances, with a significant portion of current inflation caused by commodity issues affected by the pandemic, war, and drought, it is entirely possible that the Fed’s actions will hurt the economy under underlying without rapidly reducing inflation.
In last week’s blog, we showed that over the past 50 years, inflation spikes have been linked to oil price spikes, and inflation falls when oil prices fall. There is no doubt that the current inflation is linked to the prices of oil, certain agricultural products and specific products related to battery technologies but necessary for other industrial products. A significant portion of these price spikes are due to war, sanctions, and geopolitical tensions over which the Fed and other central banks literally have no control/influence.
The controversy 10 years 2 years
In the post-war 20and tightening cycles of the century, the Fed gave no “forward guidance”. The only information the market had was the action taken by the Fed in the market, ie the level of the federal funds rate (FF). If that were the case today, all the market would “know” is that the Fed just raised the FF rate by 25 basis points (bps). At that time, the best indicator of recession was a reversal of long-term bond yields (ie the 10-year) with the FF rate. Today, with the 10 year old. at 2.39% and FF at 25-50 bps, there is still more than 200 basis points of positive slope. At his last press conference, Fed Chairman Powell noted this positive slope as an indicator that the likelihood of a recession was low.
What is different today is the forward guidance as displayed in the quarterly dot-plot. (The “dot-plot” is the forecast by FOMC members of the FF rate for the next two years.) With such “forward guidance”, the markets have already priced in the expected trajectory of Fed policy, in implementing months what the points suggested would take one to two years. Take, for example, mortgage rates. Last October, they were below 3%, and they were barely above 3% at the turn of the year. As of March 31, they amounted to 4.67%. While the FF rate tells us where the Fed is in this expected (early) cycle, markets have moved the 2yr. down to 10-year yields up to the expected end state of this tightening cycle. Since all of the tightening regime has already happened, except in the very short term, the 10-2 yield gap is a much better predictor than the 10-FF gap.
We believe that current forward guidance, via dot plots, introduces unnecessary volatility into fixed income markets. Assume, as Chairman Powell has repeatedly stated, that Fed policy and actions are data driven. Suppose the economy weakens, as we have continued to show in these blogs (see more such data below). If the incoming data turns out to be weaker than expected and the dot charts move down, the Fed has unnecessarily introduced market volatility (according to the three standard deviations shown in the previous chart). We believe that forward guidance should not extend beyond one quarter. Volatility would be significantly lower.
Quantitative Tightening (QT)
As if the current volatility wasn’t enough, markets also have to deal with the Fed’s upcoming QT regime. As a reminder, this will be the Fed’s second attempt to reduce its balance sheet. The first was the failed attempt in 2018. Bac-k then, the withdrawal of a modest amount of cash exposed the fragility of the overleveraged financial system, with overnight rates in the interbank reserve loan market reaching highs. double-digit levels in seconds. just a few days. Today’s financial system is much more leveraged. Michael Lebowitz (“Will quantitative tightening overwhelm markets?”) recently calculated the following:
- During the financial crisis, QE1 injected $300 billion in liquidity. It took over a year. During Covid, this amount was injected in three days;
- QE2 injected $600 billion in eight months; during Covid it took six days;
- QE3 injected $1.5 trillion over 22 months; it took a little over a month during the Covid!
According to Lebowitz, given Powell’s various statements, the Fed is planning three years of balance sheet reductions of $1 trillion a year. This rate is twice as fast as the QT which caused the liquidity problems in 2018, and in a system that is significantly more indebted. The implication here is significantly higher volatility in the equity and fixed income markets, and in all likelihood the Fed will have to abandon this QT program.
Meanwhile, incoming data continues to show weaknesses despite Powell’s statements to the contrary.
- Manheim’s used car price index fell in February and March. Although still high, it is an indicator of cooling demand.
- Mortgage applications fell -6.8% for the week ended March 25 after falling -8.1% the previous week. They are down in seven of the last eight weeks and down -42% year-on-year. Refinances, an important source of cash for US households, fell -15% the week of March 25, -14% the previous week and -60% year-on-year. There is no doubt that this is a function of rising mortgage rates, which would not be at this level without the faulty “forward guidance point plots”. It’s a great example of why we think the recession will come faster than in previous tightening cycles because, without “forward guidance” as was the case then, mortgage rates in today would just exceed 3% (the rate at the turn of the year), a far cry from today’s 4.67%!
- The latest national apartment vacancy rate was 4.6%, up from 3.8% last summer (new supply (!) as this blog suggested). This will impact inflation going forward (i.e. lower) and will also negatively impact future multi-family housing starts.
- Friday’s payrolls report looked strong on the surface (+431K), but the strength was not widespread, mostly concentrated in leisure/hospitality and professional and business services. The average number of weekly hours worked fell from 34.7 to 34.6. According to Rosenberg Research, every tenth of an hour represents approximately 370,000 jobs. So, on the net, the economy was only ahead by the equivalent of about +60,000 jobs, still positive, but more in line with minimal GDP growth.
- Real personal disposable income fell -0.2% in February and is down seven straight months. Additionally, the average hourly wage increased by +5.6% YoY, but with inflation at or above 8%, the real average weekly wage is down (see chart). That means take home pay isn’t going as far as it was last year and that’s one of the reasons the Atlanta Fed’s GDPNow forecast for Q1 is 1.5. %.
- China’s economy is slowing down significantly (partly due to lockdowns). Its March manufacturing PMI fell in contraction (
- Right now, everyone who owns a traditional gas-powered car has suffered a price shock at the pump. (While the price of oil is now back below $100/bbl., we haven’t seen any relief there!) Also in this inflation, food prices have soared (chart), which which represents a double whammy for consumers and certainly a negative impact on economic growth.
- Consumer sentiment has always been a leading indicator. As we have seen regularly at the University of Michigan (chart), the Conference Board’s consumer confidence index also signals a recession.
- Challenger data for March shows a +40% increase in layoff announcements and a drop in hiring intentions.
- On the stock markets, stocks of home builders, auto and parts manufacturers, media and advertising companies and retailers are all either in sharp correction (between -10% and -20%) or “bearish” market (fall in prices of more than – 20%). Some markets are already prepared for recession!
We expect volatility and confusion in financial markets, especially if the Fed continues its hawkish stance as the economy weakens. Worse still, with the economy now more overleveraged than it was before the pandemic; the impact of the QT (drainage of liquidity) will probably be quite disruptive for the equity markets.
(Joshua Barone contributed to this blog.)