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Bank failures, inflation progress, debt ceiling angst, and signs of labour market softening have markets begging the Fed to pause today. One more hike first...?
Because we like to do things differently around here, we'll start with a summary.
The Fed's won the battle against inflation, but it hasn't won the war.
And by the time the war is won, we'll be counting the bodies and wondering how things could've been done differently, asking questions like...
Were all those casualties really necessary?
First up, a simplistic analysis of why the Fed's probably hiking for the last time 👇
Rates have almost caught up to inflation. Back in June 2022, The Druck got a lot of attention for saying
"Once inflation gets above 5%, it's never come down unless fed funds have gotten above the CPI"
We're on the verge of that being the case...
And it should continue... 👇
Whether the Wells forecast of 3.2% by June is accurate or not, it's almost certain that the Fed Funds rate will be well above CPI by then...
The 'stickier' core CPI metric is expected to remain above the Fed Funds rate for a little longer... 👇
Goldman Sachs forecast core CPI down to 3.8% by the end of the year 👇
They also see the Fed's favoured core PCE at 3.4% by December 2023.
In all of these scenarios, inflation remains above the Fed's target beyond the end of 2023.
Absent a genuine economic slowdown and a surge in layoffs, rate cuts should be off the table.
However, with inflation falling and rates at 5%, the Fed will soon (finally) be in positive territory.
Interest rates above the inflation rate will eventually kill inflation (and economic momentum) according to the textbooks and Druck's/Deutsche's studies of history.
Their analysts took 318 global episodes of inflation spiking above 8% across 50 DM and EM economies right back to 1920 then looked at how long it usually takes for inflation to fall (and to what level). Here’s what they found:
“Looking at this full history, the evidence shows that once inflation spikes above 8%, median inflation takes around 2 years to even fall beneath 6%, before settling around that level out to 5 years after the initial 8% shock. This is around 2pp above the pre-shock median of c. 4%.
“However, the current consensus expects us to be back at or even below 3% just two years after we initially moved above 8%. This is far from impossible, but it would be around the 25th percentile of observations through history, and around 4pp beneath the median outcome,” the analysts say.
Little wonder that central bankers are worried and hiking aggressively, whatever it breaks.
And this is a big part of the problem facing policymakers now. Things are starting to break while inflation is settling above target. Bank failures have dominated the headlines, but the jobs market has also weakened too...
Which is of course what they need to happen...
Remember those labour shortages?
Companies have moved on...
And yesterday's solutions are becoming tomorrow's problems (again) 👇
We can fix the labour shortages by encouraging immigration!
So goes the theory. Expand the labour force and wages will fall due to increased competition. But first those immigrants need to find somewhere to live. Which according to RBA Deputy Governor Bullock is a problem in Australia...
'We've got strong immigration. So, yes, there is trouble brewing in rental accommodation, and that has implications for inflation because rental inflation is going to rise'
Oops. Anyway back to the US... 👇
SOFT LANDING HOPES LIVE ON
Nick Bunker at Indeed summarised yesterday's JOLTs report as follows... 👇
- There’s no argument that the labour market continues cooling down, as job openings and the rate of quitting declined and layoffs rose in March.
- The often-cited ratio of job openings to unemployed workers continued to fall, hitting 1.6 in March, its lowest rate since October 2021.
- The layoff rate picked up to 1.2%, its highest level since December 2020. The Construction sector saw a particularly large jump, which could be a sign that fallout from high mortgage interest rates is beginning to hit the labour market.
- The quits rate ticked down to 2.5% as workers are less willing to voluntarily leave their old jobs.
Construction layoffs in the final innings of the economic cycle? How strange...
I keep hearing that the property market's in great shape, the under-supply of homes will support prices, and homebuilders are poised to weather the storm which explains why very sensible people are buying homebuilder stocks at all-time-highs...
There's plenty of reason for the Fed to pause now. One more hike or not, it doesn't really matter (although markets may initially rally if they decide not to follow through).
For now, markets see the hike as likelier than not, then two rate cuts are 'priced' by the end of 2023, with a return to 4% rates by April 2024.
Whether it plays out like this is anyone's guess.
My guess is that it won't. I think we're heading towards a credit crunch later in the year, and Fed comments on lending standards and/or lower demand for loans is more important than anything the Fed says about pausing or pretending that they intend to keep hiking ('data dependency').
With a deeply inverted yield curve, banks find it harder to lend profitably, so tend to tighten lending standards, making credit harder to access.
In this environment, demand for credit is also starting to fall as uncertainty rises and business confidence dwindles.
This dynamic was evident in yesterday's ECB bank lending survey.
This process has started in the US, and we await the latest lending survey (Fed already has this, but full report is set for public release on May 8th) to see if tightening is continuing...
The risks hiding in private equity are not dissimilar to what's been happening with the failed banks.
Basically, if you mark to market, the picture's really not pretty. But private equity doesn't have to do boring stuff like that, at least until they need to raise more capital...
And if there's going to be a big 'shock' that freezes everything up (by making people question hopeful assumptions), private equity fraud/opacity is a prime candidate to provide it.
The extent of credit tightening matters most for where we're heading, but that doesn't mean stock markets will immediately collapse if the Fed pauses today.
If the markets' assumption about the economy & rate cuts in 2023 are wrong i.e. economy ticks along, inflation keeps falling, wage growth slows but no cliff edge, credit sequentially tightens but not dramatically, and earnings don't disappoint too much, stocks could still be supported for a while longer.
I'd guess we struggle to maintain SPX above 4200 for long, but markets, irrational, solvent etc. and I fully expect that everyone will get a chance to buy in at much better prices within the next 12 months anyway.
One big picture thing I keep coming back to. If the eventual economic damage is severe, as I fear it will be, will inflation targeting take the blame? Something like...
The 2% inflation target forced the Federal Reserve to be too hawkish for too long.
Studies found that the post-Covid fiscal stimulus was optimal, but the Federal Reserve's archaic inflation targeting policy caused excessive damage to a historically strong economy and labour market
And do we move on to nominal GDP targeting and economic growth instead...?
I just can't get on board with the idea that a swift and permanent return to zero rates and anaemic economic growth as policy is just around the corner... 👇