“Stocks crushed as jobs keep Fed on hiking path,” one Friday market wrap declared.
US shares were dramatically lower into afternoon trading on the heels of September payrolls. A fourth straight 75bps rate hike from Jerome Powell was priced as a near certainty for the November policy gathering (figure below). Terminal rate pricing showed traders see rates peaking at 4.65% early next year.
During a moderated panel discussion, John Williams emphasized data dependence, but nevertheless said rates need to get to 4.5% one way or another, sooner or later. 75bps is a lock for next month barring an anomalously cool CPI print next week or a total meltdown across markets. Fed speakers repeatedly emphasized their domestic mandate this week, which means even the threat of a financial crisis in a major developed market (i.e., the collapse of the LDI complex in the UK) wouldn’t necessarily be sufficient to sway the FOMC.
Wells Fargo’s econ team took note of softer average hourly earnings data, but was quick to state the obvious: Wage growth is still far too hot to be consistent with 2% inflation. “All told, none of this week’s incoming labor market data change our view that the Fed will continue to aggressively tighten monetary policy to tame inflation,” the bank wrote, reiterating their peak Fed funds target range forecast of 4.75%-5%.
A corollary of the almost universal conviction around aggressive Fed calls is the notion that a hard landing is now all but inevitable. What a difference three days makes. It was just Tuesday when JOLTS breathed new life into that left-for-dead narrative, which is nearly as taboo as the word “transitory.”
BofA’s Michael Hartnett made the hard landing case. “If the Fed is true to its 2% inflation target, the rates shock [will] continue,” he said, noting that over 60 years and 15 Fed rate-hiking cycles, the average unemployment rate at the time of the last rate hike was 5.7% (table and chart below).
September’s jobs report found the unemployment rate moving back to a half-century low at 3.5%. The Fed’s latest SEP suggested officials see the peak at 4.4%. Suffice to say a move from current levels to the historical average mentioned by Hartnett around “last hikes,” would be highly destabilizing both for the economy and markets.
It’s worth noting from the table (on the right, above) that inflation is nowhere near levels observed around previous last hikes with but a few dubious exceptions.
“Labor, housing and energy markets are too strong for a 3% Fed funds rate to kill inflation,” Hartnett went on to say, adding that during “proper recessions,” ISM troughs between 35 and 40. ISM manufacturing printed 50.9 for September. The “journey” to a recession-level ISM “involves significant cuts to EPS expectations,” Hartnett wrote, cautioning that the “risk of credit events remains extremely high.”
Friday’s painful equities rout made for a rather stark juxtaposition with the rally observed on Monday and Tuesday, when stocks mounted their largest two-day surge since the volatile days around the original pandemic lockdowns. The renewed selling was a reminder that this isn’t a friendly Fed. Far from it. This is a Fed which is averse to equity rallies. And fighting the Fed is historically a losing proposition.
Ironically in that context, the case for a soft landing goes through a reversion to the post-80s mean in terms of growth-conscious Fed policy, paired with fiscal panic. BofA’s Hartnett outlined that case too, despite not buying it, figuratively or literally. “Central banks are still in the business of bailing out Wall Street, and governments are now very much in the business of bailing out Main Street, so moral hazard once again rescues asset prices while the new bailout culture thanks to panicked government intervention leads to a ‘soft landing’,” he wrote.
The “ultimate destination” of such a policy conjuncture would be the institution of yield-curve control across the G7, BofA suggested. That’d be the only way to “safely” finance government social transfers.
For now, that’s merely a thought experiment. A daydream. Or a nightmare, depending on your views about the proper role of monetary policy in abetting fiscal spending.
In the here and now, policy is on the fast track to restrictive territory. Or it’s already there, depending on your preferred proxies. So, “tempting” as it is to be a contrarian bull, that’s a shaky limb to go out on with a locked-in Fed. Just ask Friday.
I kind of tuned out to the market most of today, but when I looked this afternoon something else struck me about the price action. Given the numbers, intermediate and long bond’s correlation to equities is starting to break down (good news in my view), and the last leg of the selloff late in the day, looked like it could be caused by margin calls. All in a very ugly day though. The next 3-6 months are likely to be a slog. Even with the lousy markets after Tuesday, the S&P was basically flat and bond yields were up about 4bps for the week. Time to go back into my cave.
As long as my income distributions hold up, I’ll join you in the cave.
Macro cycles (and the Fed response to them) are never different, but this time may be. The pandemic “everything” bubble was a once-in-a-hundred-year event — almost unprecedented. The unwind of that bubble will also look like nothing we’ve seen before. FWIW, I think it’ll go slowly and then all at once (with a whoosh). I predict that an additional 125bps in hikes and continued QT to the tune of $95b/month will get us there by 2Q23 — and before unemployment reaches 5%. In the meantime, I’m allocated 100% to cash.
The narrative flips and flops are tiring. Its time for earnings. My favorite time of the year (sung like Julie Andrews).
The FED’s restrictive policy will likely bring down inflation, if they stay the course. But history suggests a 5% terminal rate will not be enough to bring down inflation running at over 7-8%.
But can the FED stay the course and target 2% inflation? Is 2% a normal inflation rate? What happens if inflation persists in staying above 5% over the next few months?
First policy shift may be changing the target.
Can the terminal rate rise to say 6% or 7%. Possibly but probably not as some combination of external events (credit risk, pension fund insolvency, bond crisis,..) will force a FED pivot. Consumers and governments are over leveraged and need cheap credit to survive.