Excellent advice from Rebecca Patterson, former chief investment officer at hedge fund Bridgewater Associates.
SVB update
SVB Financial Group (SIVB) reported Thursday that it needed to raise $2.5 billion to cover losses on security investments. Its subsidiary, Silicon Valley Bank was closed Friday, with regulators appointing the FDIC as administrator.
Total liabilities of the group are $195 billion, according to its last report, including $173 billion of deposit liabilities. The FDIC guarantees deposits up to $250,000 but many silicon Valley tech companies and hedge funds had far larger deposits at SVB. Assets consist of $74 billion in net loans after provisions and $121 billion in securities investments, including $92 billion of mortgage-backed securities (MBS).
It appears that the bank suffered capital losses due to its maturity-mismatch: investing in longer-term securities which they funded with far shorter-term deposit liabilities and loans. This a typical bank scenario, borrowing short at low rates and lending long to profit from the interest rate margin. Steep rate hikes by the Fed scuppered the bank’s strategy, with interest margins turning negative as short-term rates spiked.
The FDIC are auctioning the failed Silicon Valley Bank, with bids due late Sunday afternoon.
Treasury Secretary Janet Yellen suggested in an interview that a bailout is out of the question but regulators are discussing the creation of a backstop for uninsured deposits.
Conclusion
We consider it unlikely that uninsured deposit holders will incur losses. Even if we double the capital shortfall to $5 billion, this represents only 2.6% of total liabilities. The bank is worth more than the sum of its assets as a going concern, with a strong client base amongst tech companies and hedge funds in the greater San Francisco area. We expect auction bids to reflect this.
If strong bids fail to materialize, regulators are likely to organize a rescue by a consortium of banks — as has been done many times in the past — backed by incentives from the Fed/Treasury (despite Yellen’s protestations).
This was not a liquidity crisis, with the bank holding large amounts of readily-marketable securities — this was a solvency issue.
Other regional banks may have been similarly impacted by the sharp rise in interest rates and we expect the Fed to hold a review (stress test) to assess the impact of rate hikes on other banks, to allay market fears.
The long-term impact is that financial market nervousness will remain high, with banks increasingly reluctant to lend to their peers other than through (secured) repo markets. The problem is far wider than just banks, with many highly-leveraged hedge funds and private equity firms having gorged themselves on cheap debt. If there is going to be a crisis it is likely to emerge from the unregulated shadow banking sector — as has happened many times before* — and not from the regulated banking sector.
We are edging closer to a credit contraction that would precipitate a recession.
Latest News
From Wolf Richter, March 12:
….Now we got it officially, in a joint announcement by Yellen, Fed Chair Jerome Powell, and FDIC Chairman Martin Gruenberg. The bailout of uninsured depositors has arrived, so now all depositors of Silicon Valley Bank and Signature Bank, which was shut down today, will be made whole, not just insured depositors. The banks that are still standing can borrow from the Fed under a new facility. But investors in failed banks are on their own.
“After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13,” the statement said.
Notes
* Shadow banks precipitating a financial crisis go as far back as 1907, when collapse of the Knickerbocker Trust caused a widespread banking crisis that led to creation of the Federal Reserve in 1913. The LTCM collapse of 1998 is another such example. More recently, the sub-prime crisis of 2008 led to the absorption of highly-leveraged major investment banks into the regulated banking system.
Warren Buffet: Fiscal Deficits and Runaway Inflation
“During the decade ending in 2021, the United States Treasury received about $32.3 trillion in taxes while it spent $43.9 trillion. Though economists, politicians and many of the public have opinions about the consequences of that huge imbalance, Charlie and I plead ignorance and firmly believe that near-term economic and market forecasts are worse than useless…..Berkshire offers some modest protection from runaway inflation, but this attribute is far from perfect. Huge and entrenched fiscal deficits have consequences.”
~ Berkshire Hathaway Newsletter to Shareholders, 2022
Comments
There are three potential sources of funding for fiscal deficits of which two are inflationary:
- The private sector. Deficits funded by the private sector have no impact on inflation. The rise in public spending is offset by a decline in private spending/increase in savings.
- Commercial banks. Inflationary. The bank simply swaps one asset on their balance sheet for another: bank reserves at the Fed are exchanged for Treasury securities. Public spending rises but is not offset elsewhere.
- Foreign investors (including banks). Inflationary. Public spending rises but there is no offset. The inflow on capital account is matched by an outflow on current account.
Stocks retreat as Treasury yields rise
The S&P 500 retreated from resistance at 4100. Reversal below 4000 would warn of another test of primary support at 3500. We remain in a bear market, with 12-month Rate of Change below zero.
The recent rally was caused by falling long-term yields, with 10-year Treasuries testing support at 3.5%. Rising yields are now precipitating a retreat in stocks.
Slowing Treasury issuance, ahead of debt ceiling negotiations, may have contributed to declining yields but this has been offset by foreign sales, notably by the Bank of Japan.
The Treasury yield curve remains inverted, with the 10-Year minus 3-Month at an alarming -0.97%, warning of a recession in 6 to 18 months.
Commercial banks borrow short, with most deposit maturities less than a year, while lending on far longer terms in order to capture the term premium. When the yield curve inverts, net interest margins are compressed, making banks willing to lend only to the most secure borrowers. Credit standards (green below) are being tightened but credit growth (pink) remains strong. Credit growth is likely to decline in the months ahead and would warn that a recession is imminent.
Fed operations reduced liquidity in financial markets but this has been partially offset by Treasury’s running down their General Account (TGA) at the Fed (which injects money into the economy). The net result is a $1.2 trillion reduction in liquidity.
The breakdown is illuminating, with the Fed reducing its balance sheet (blue below) by $469 billion to the end of January, while reverse repo operations (green below) removed $2.4 trillion. Treasury, however, partially offset this by running down their TGA account (red) from $1.8 trillion in July 2020 to $0.5 trillion in January 2023.
The net effect is a fall in the money supply (M2) relative to GDP, from 0.90 to 0.82. But there is still a long way to go. The ratio of M2 to GDP should ideally be a constant, with money supply growing at the same pace as GDP. Lax monetary policy instead allowed money to grow at a faster pace than national income, resulting in high inflation as aggregate demand runs ahead of output.
Conclusion
The primary cause of bull and bear markets is liquidity. Stock prices could well remain high, even while the Fed hikes interest rates, if financial markets are awash with cash. Only when credit growth slows, and the Fed sells more Treasuries, are prices likely to collapse. External factors, like foreign investor sales, may also shrink liquidity but are a lot harder to predict.
The pig is still in the python. The large gap between deposits at commercial banks (blue below) and bank lending to private borrowers (pink) is represented mainly by commercial bank holdings of Treasury and agency securities. Only when that has been worked out of the system will financial conditions be restored to some semblance of normality.
Acknowledgements
Christophe Barraud for the Bloomberg link on BOJ Treasury sales.
A bear market for bonds?
In 2009, Warren Buffett wrote:
“Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation…..”
He was wrong about inflation. The next decade enjoyed low inflation, despite loose monetary policy, for two reasons. First, globalization had flooded the global economy with hundreds of millions of Chinese workers — earning a fraction of Western wages — a huge deflationary shock that depressed wages growth. Second, a contracting US economy, after the global financial crisis, added to deflationary pressures. The combined effect offset the inflationary impact from profligate monetary policy.
The world has now changed. On-shoring of critical supply chains and geopolitical tensions with Russia and China are stoking inflationary pressures. Warren Buffett’s warning now seems prescient as the Fed struggles to cope with inflation fueled by combined fiscal and monetary policy during the pandemic.
The abrupt reversal in Fed monetary policy has increased the risk of recession. All traces of the word “transitory” have disappeared from press announcements, switching to the mantra “higher for longer”. The Fed funds rate is expected to reach 5.0% in the next few months, causing job losses later in the year.
10-Year Treasury yields broke former resistance at 3.0%, reaching 4.0% before retracing. Respect of support at 3.0% would confirm that the almost forty-year bull market in bonds is over.
Falling long-term yields caused a massive surge in private debt during the bull market, with non-bank debt more than doubling relative to GDP.
Federal debt, even worse, grew four times relative to GDP.
The surge in debt inevitably fueled speculation in real assets, with a similar rise in stock market capitalization relative to GDP.
Conclusion
The significance of debt to GDP ratios should not be underestimated.
Increasing debt to fund investment in real assets is a sound investment strategy in a bond bull market, so where’s the harm?
When an individual or corporation invests, their goal is to generate income from the investment. The income stream is applied to pay the interest on the debt and repay loan capital over a reasonable period. An investment that fails to generate sufficient income and requires the borrower to capitalize interest against the loan is generally considered a failure. And likely to lead to a forced sale when the economy contracts and access to credit dries up.
The overall economy is headed for a similar predicament. When debt growth outstrips income, it warns that borrowers are capitalizing interest and headed for a disaster. The Fed can attempt to postpone the day of reckoning by suppressing interest rates and injecting liquidity. But this just encourages more debt growth and investment in even riskier assets, compounding the problem.
We are now approaching a watershed. An inverted yield curve warns that credit growth is about to dry up. Banks borrow short and lend long, so a negative spread between long-term and short-term interest rates discourages lending.
The Fed faces a tough choice: (A) allow a bond market to cause a sharp fall in asset prices and an inevitable deep recession; or (B) kick the can down the road, suppressing long-term yields to postpone the inevitable collapse, but make the problem even bigger.
Recent falls in CPI do not mean that the Fed has won the fight against inflation. This is likely to be a long, protracted battle. Winning the first round is a good start, but does the Fed have the political cover to stay the distance?
The bond market is pricing in rate cuts by the end of the year, expecting that the Fed will pivot to plan B.
Gold investors appear to share their conviction.
Nouriel Roubini: “We are in a debt trap”
Nouriel Roubini was mocked by the media — who christened him “Dr Doom” — because of his prescient warnings ahead of the 2008 global financial crisis.
He has now published a book identifying 10 mega-threats to the global economy.
First and foremost is the debt trap. Private and public debt has expanded from 100% of GDP in the 1970s, to 200% by 1999, 350% last year — advanced economies even higher at 420%, China at 330%. Inflation forces central banks to raise interest rates. High rates mean many debtors will be unable to repay.
If governments print money to bail out the economy they will cause further inflation — a tax on creditors and savers [negative real rates threaten collapse of the insurance and pension industry].
We face prolonged high inflation.
Central Banks hiking rates is misguided, economic crisis will be so damaging they will be forced to reverse course.
Supply shocks from pandemic, Russia-Ukraine war and China zero-COVID policy.
Fiscal deficits will rise due to increased spending on national security and reducing carbon emissions.
Twenty years of kicking the can down the road [short election cycle incentivizes this], with politicians unwilling to support short-term costs for long-term gain because they are unlikely to be in power to reap the rewards. Older voters are also unlikely to support change as they may not be around to reap the benefits.
Carbon emissions are increasing due to the energy crisis from Russia-Ukraine war. Carbon tax of $200/tonne required, currently $2.
We need to reduce our energy consumption.
Also increase productivity. Technology is the only solution. AI and automation could lift GDP growth, providing sufficient income to fund the changes needed.
But technology is also a threat. It provides more dangerous weapons which risk greater destruction in the next conflict.
Democracy is still the best system. Autocracies are often corrupt and way too much concentration of power [echo chamber] leads to mistakes. They also increase inequality and political instability.
Nouriel seems bullish on gold because of geopolitical tensions. Also “green metals” because of the need to reduce CO2 emissions.
Our 2023 Outlook
This is our last newsletter for the year, where we take the opportunity to map out what we see as the major risks and opportunities facing investors in the year ahead.
US Economy
The Fed has been hiking interest rates since March this year, but real retail sales remain well above their pre-pandemic trend (dotted line below) and show no signs of slowing.
Retail sales are even rising strongly against disposable personal income, with consumers running up credit and digging into savings.
The Fed wants to reduce demand in order to reduce inflationary pressure on consumer prices but consumers continue to spend. Household net worth has soared — from massive expansion of home and stock prices, fueled by cheap debt, and growing savings boosted by government stimulus during the pandemic. The ratio of household net worth to disposable personal income has climbed more than 40% since the global financial crisis — from 5.5 to 7.7.
At the same time, unemployment (3.7%) has fallen close to record lows, increasing inflationary pressures as employers compete for scarce labor.
Real Growth
Hours worked contracted by an estimated 0.12% in November (-1.44% annualized).
But annual growth rates for real GDP growth (1.9%) and hours worked (2.1%) remain positive.
Heavy truck sales are also a solid 40,700 units per month (seasonally adjusted). Truck sales normally contract ahead of recessions, marked by light gray bars below, providing a reliable indicator of economic growth. Sales below 35,000 units per month would be bearish.
Inflation & Interest Rates
The underlying reason for the economy’s resilience is the massive expansion in the money supply (M2 excluding time deposits) relative to GDP, after the 2008 global financial crisis, doubling from earlier highs at 0.4 to the current ratio of 0.84. Excessive liquidity helped to suppress interest rates and balloon asset prices, with too much money chasing scarce investment opportunities. In the hunt for yield, investors became blind to risk.
Suppression of interest rates caused the yield on lowest investment grade corporate bonds (Baa) to decline below CPI. A dangerous precedent, last witnessed in the 1970s, negative real rates led to a massive spike in inflation. Former Fed Chairman, Paul Volcker, had to hike the Fed funds rate above 19.0%, crashing the economy, in order to tame inflation.
The current Fed chair, Jerome Powell, is doing his best to imitate Volcker, hiking rates steeply after a late start. Treasury yields have inverted, with the 1-year yield (4.65%) above the 2-year (4.23%), reflecting bond market expectations that the Fed will soon be forced to cut rates.
A negative yield curve, indicated by the 10-year/3-month spread below zero, warns that the US economy will go into recession in 2023. Our most reliable indicator, the yield spread has inverted (red rings below) before every recession declared by the NBER since 1960*.
Bear in mind that the yield curve normally inverts 6 to 18 months ahead of a recession and recovers shortly before the recession starts, when the Fed cuts interest rates.
Home Prices
Mortgage rates jumped steeply as the Fed hiked rates and started to withdraw liquidity from financial markets. The sharp rise signals the end of the 40-year bull market fueled by cheap debt. Rising inflation has put the Fed on notice that the honeymoon is over. Deflationary pressures from globalization can no longer be relied on to offset inflationary pressures from expansionary monetary policy.
Home prices have started to decline but have a long way to fall to their 2006 peak (of 184.6) that preceded the global financial crisis.
Stocks
The S&P 500 is edging lower, with negative 100-day Momentum signaling a bear market, but there is little sign of panic, with frequent rallies testing the descending trendline.
Bond market expectations of an early pivot has kept long-term yields low and supported stock prices. 10-Year Treasury yields at 3.44% are almost 100 basis points below the Fed funds target range of 4.25% to 4.50%. Gradual withdrawals of liquidity (QT) by the Fed have so far failed to dent bond market optimism.
Treasuries & the Bond Market
Declining GDP is expected to shrink tax receipts, while interest servicing costs on existing fiscal debt are rising, causing the federal deficit to balloon to between $2.5 and $5.0 trillion according to macro/bond specialist Luke Gromen.
With foreign demand for Treasuries shrinking, and the Fed running down its balance sheet, the only remaining market for Treasuries is commercial banks and the private sector. Strong Treasury issuance is likely to increase upward pressure on yields, to attract investors. The inflow into bonds is likely to be funded by an outflow from stocks, accelerating their decline.
Energy
Brent crude prices fell below $80 per barrel, despite slowing releases from the US strategic petroleum reserve (SPR). Demand remains soft despite China’s relaxation of their zero-COVID policy — which some expected to accelerate their economic recovery.
European natural gas inventories are near full, causing a sharp fall in prices. But prices remain high compared to their long-term average, fueling inflation and an economic contraction.
Europe
European GDP growth is slowing, while inflation has soared, causing negative real GDP growth and a likely recession.
Australia, Base Metals & Iron Ore
Base metals rallied on optimism over China’s reopening from lockdowns. Normally a bullish sign for the global economy, breakout above resistance at 175 was short-lived, warning of a bull trap.
Iron ore posted a similar rally, from $80 to $110 per tonne, but is also likely to retreat.
The ASX benefited from the China rally, with the ASX 200 breaking resistance at 7100 to complete a double-bottom reversal. Now the index is retracing to test its new support level. Breach of 7000 would warn of another test of primary support at 6400.
China
Optimism over China’s reopening may be premature. Residential property prices continue to fall.
The reopening also risks a massive COVID exit-wave, against an under-prepared population, when restrictions are relaxed.
“In my memory, I have never seen such a challenge to the Chinese health-care system,” Xi Chen, a Yale University global health researcher, told National Public Radio in America this week. With less than four intensive care beds for every 100,000 people and millions of unvaccinated or partially protected older adults, the risks are real.
With official data highly unreliable, it is hard to track exactly what impact China’s U-turn is having. Authorities on Friday reported the first Covid-19 deaths since most restrictions were lifted in early December, but there have been reports that funeral homes in Beijing are struggling to handle the number of bodies being brought in.
“The risk factors are there: eight million people are essentially not vaccinated,” said Huang Yanzhong, senior fellow for global health at the Council on Foreign Relations.
“Unless this variant has evolved in a way that makes it harmless, China can’t avoid what happened in Taiwan or in Hong Kong,” he added, referring to significant “exit waves” in both places.
The scale of the surge is unlikely to be apparent for months, but modelling suggests it could be grim. A report from the University of Hong Kong released on Thursday warned that a best case scenario is 700,000 fatalities – forecasts from a UK-based analytics firm put deaths at between 1.3 and 2.1 million.
“We’re still at a very early stage in this particular exit wave,” said Prof Ben Cowling, an epidemiologist at the University of Hong Kong. (The Telegraph)
China relied on infrastructure spending to get them out of past economic contractions but debt levels are now too high for stimulus on a similar scale to 2008. Expansion of credit to local government and real estate developers is likely to cause further stagnation, with the rise of zombie banking and real estate sectors — as Japan experienced for more than three decades — suffocating future growth.
Conclusion
Resilient consumer spending, high household net worth, and a tight labor market all make the Fed’s job difficult. If the current trend continues, the Fed will be forced to hike interest rates higher than the bond market expects, in order to curb demand and tame inflation.
Expected contraction of European and Chinese economies, combined with rate hikes in the US, are likely to cause a global recession.
There are two possible exits. First, if central banks stick to their guns and hold interest rates higher for longer, a major and extended economic contraction is almost inevitable. While inflation may be tamed, the global economy is likely to take years to recover.
The second option is for central banks to raise inflation targets and suppress long-term interest rates in order to create a soft landing. High inflation and negative real interest rates may prolong the period of low growth but negative real rates would rescue the G7 from precarious debt levels that have ensnared them over the past decade. A similar strategy was successfully employed after WWII to extricate governments from high debt levels relative to GDP.
As to which option will be chosen is a matter of political will. The easier second option is therefore more likely, as politicians tend to follow the line of least resistance.
We have refrained from weighing in on the likely outcome of the Russia-Ukraine conflict. Ukraine presently has the upper hand but the conflict is a wild card that could cause a spike in energy prices if it escalates or a positive boost to the European economy in the unlikely event that peace breaks out.
Our strategy is to remain overweight in gold, critical materials, defensive stocks and cash, while underweight bonds and high-multiple technology stocks. In the longer term, we will seek to invest cash in real assets when the opportunity presents itself.
Acknowledgements
- Hat tip to Macrobusiness for the Pantheon Macroeconomics (China Residential) and Goldman Sachs (China Local Government Funding & Excavator Hours) charts.
Notes
* The yield curve inverted ahead of a 25% fall in the Dow in 1966. The NBER declared a recession but later changed their minds and airbrushed it out of their records.
Have stock prices lost touch with reality?
Robert Shiller’s cyclically-adjusted PE (or CAPE) is at a similar level to the 1929 peak before the greatest crash in US history. CAPE uses a 10-year average of inflation-adjusted earnings in order to smooth out fluctuations in earnings. The current reading of 29.2 is almost double the low during the 2008 global financial crisis (GFC).
We use a different approach. Rather than smoothing earnings with a moving average, we use highest trailing earnings as the best indication of future earnings potential. Earnings may fall during a recession but stock prices tend to fall by less, in expectation of a recovery. Our projected value for the end of Q4 is based on highest trailing 12 months earnings at Q1 of 2022. At 20.16, the PE is higher than 1929 and 1987 peaks, which preceded major crashes, but still much lower than the Dotcom bubble.
Forward price-earnings ratio is more reasonable at 17.91.
But S&P earnings forecasts seem optimistic, with no indication of a recession in 2023.
Declining real sales growth, in the first half of 2022, suggests that profit margins will come under pressure, with both earnings and multiples declining in the next 12 months.
Shifting from earnings to a wider perspective, price-to-sales for the S&P 500 avoids distortion caused by fluctuating profit margins. Projected to rise to 2.30 in Q4 (based on the current S&P price and Q3 sales), prices are similarly elevated compared to the long-term average of 1.68.
Price to book value, estimated at 4.01 for Q4, shows a similar rise compared to a long-term average of 3.07.
Warren Buffett’s favorite indicator of market pricing compares stock market capitalization to GDP, eliminating distortions from fluctuating profit margins and stock buybacks. The Q3 value of 2.0 is way above the long-term average of 1.03, suggesting that stocks are way over-priced.
Australia
Data is a lot more difficult to obtain for the ASX, but the ratio of market cap to GDP (Buffett’s indicator) is a lot more modest, at 0.96, indicating prices are close to fair value.
Conclusion
The chart below shows how rising US liquidity (black) fueled rising stock prices as reflected by the ratio of market cap to GDP (blue). The steep rise in the money stock (M2 excluding time deposits) after the 2008 GFC, created a scarcity of investment-grade assets, driving down interest rates and driving up stock prices.
Central banks are now shrinking liquidity, in an attempt to tame inflation, and stock prices are likely to fall.
We estimate that US stocks are likely to fall between 30% and 50% if there is a recession next year. Australian stock prices are a lot closer to fair value and only likely to fall 10% to 20% in the event of a recession.
In our view a recession is almost inevitable in 2023 as the Fed cannot inject liquidity to create a soft landing — as it has done repeatedly in recent times — because of the threat of inflation.
Acknowledgements
- The graphs of Robert Shillers CAPE, S&P 500 real sales growth, and S&P 500 price-to-book value are from multpl.com
- Sales and earnings for the S&P 500 are from spglobal.com
- All other US data is from FRED at stlouisfed.org
- Market cap for the ASX is from asx.com.au while GDP is from the RBA.
Larry Summers | More rate hikes, no soft landing
“Inflation is going to be a little more sustained than what people are looking for. Also it’s much harder than people think to achieve a soft landing……
I suspect they’re going to need more increases in interest rates than the market is now judging.“
Chairman Powell’s speech
Fed Chairman Jerome Powell’s remarks to the Brookings Institution, Wednesday 30th November, addressed two key questions:
- What does the Fed expect inflation to do in the months ahead?
- How is Fed monetary policy likely to respond?
Where is inflation headed?
“Despite the tighter policy and slower growth over the past year, we have not seen clear progress on slowing inflation.”
Powell focuses on core PCE inflation — which excludes food and energy, over which the Fed has little control — as this gives a “more accurate indication of where overall inflation is headed”. Core PCE is divided into three categories: (a) Core Goods; (b) Housing Services; and (c) Non-Housing Services.
Core Goods inflation is falling as supply chain issues are resolved and energy prices decline.
Housing Services is rising but tends to lag actual rental increases by 6 to 9 months. Rents were growing at between 16% and 18% in mid-2021 when PCE housing services inflation was still below 4% which means that core PCE inflation in 2021 was understated by a sizable margin. Housing services inflation is expected to fall “sometime next year” as lower rental renewals begin to feed into the index.
Non-Housing Services — the largest of the three categories — “may be the most important category for understanding the future evolution of core inflation” and, by inference, the evolution of broad inflation.
This spending category covers a wide range of services from health care and education to haircuts and hospitality…..Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.
In short, if you want to understand the future of inflation, look at the labor market.
Demand for labor far exceeds the supply, with job openings at 10.3 million in October far above unemployment at 6.1 million.
The primary causes of the current tight labor market are: (a) a large number of workers taking early retirement; and (b) a surge in deaths during the pandemic.
The Fed believes that there is still some way to go:
So far, we have seen only tentative signs of moderation of labor demand. With slower GDP growth this year, job gains have stepped down from more than 450,000 per month over the first seven months of the year to about 290,000 per month over the past three months. But this job growth remains far in excess of the pace needed to accommodate population growth over time — about 100,000 per month by many estimates…..
Wage growth, too, shows only tentative signs of returning to balance.
Today’s ADP data warns of a manufacturing and construction slow-down but growth in services employment and overall earnings:
Private businesses in the US created 127K jobs in November of 2022, the least since January of 2021, and well below market forecasts of 200K. The slowdown was led by the manufacturing sector (-100K jobs) and interest rate-sensitive sectors like construction (-2K), professional/business services (-77K); financial activities (-34K); and information (-25K). The goods sector shed 86K jobs. On the other hand, consumer-facing segments were bright spots. The services-providing sector created 213K jobs, led by leisure/hospitality (224K); trade/transportation/utilities (62K); education/health (55K). Meanwhile, annual pay was up 7.6%. “The data suggest that Fed tightening is having an impact on job creation and pay gains. In addition, companies are no longer in hyper-replacement mode. Fewer people are quitting and the post-pandemic recovery is stabilizing”, said Nela Richardson, chief economist, ADP. (Monex)
Fed monetary policy
Powell continues, hinting at a moderation in the rate of increases:
Monetary policy affects the economy and inflation with uncertain lags, and the full effects of our rapid tightening so far are yet to be felt. Thus, it makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting.
The Fed is deliberately feeding optimism on Wall Street, but we are unclear as to their motive. Possibly it is an attempt to manage long-term Treasury yields. Keeping LT yields low would most likely raise earnings multiples for stocks and lower mortgage rates for home buyers, slowing the decline in asset values.
More likely, as Wolf Richter points out, a buoyant stock market gives the Fed political cover for further rate hikes. Plunging asset prices would ramp up political pressure on the Fed to cut interest rates, whereas market gains take the heat off the Fed, giving them further leeway to hike interest rates.
Conclusion
Fed policy is likely to be determined by two factors:
- moderation of core PCE inflation to below the Fed’s 2% target; and
- a significant rise in unemployment and/or fall in job openings. Powell describes this as “restoration of balance between supply and demand in the labor market.”
They are likely to continue hiking rates, but at a slower pace of 50 basis points, at least for the next two meetings.
Thereafter, we expect them to raise rates at a slower rate or, alternatively, pause and wait for the impact of past hikes to feed through into the broader economy. It could take 6 to 9 months to see the full effect of past hikes.
Unless something drastic happens, the Fed is unlikely to cut rates. Powell concludes (emphasis added):
It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.
P.S. The Dow rallied 700 points by the close, after Powell’s speech (WSJ). That increases the probability of at least one more 75 basis point hike at the next meeting.