Stocks gave back some ground yesterday after economic data suggested the economy is slowing. Bond yields barely changed while oil prices gave back some of Monday’s sharp gains. Market leadership was led by risk-off stocks as tech and industrial issues slid.
For many months, investors celebrated economic weakness hoping that a slower economy would lead to lower interest rates and an end to the Fed’s program of quantitative tightening. That might be changing. The banking crisis that brought about the collapse of two key banks and turmoil at others has led many to realize that there are collateral costs to tight monetary policy. The Fed, late in getting started in its fight to defeat inflation, now may be at the cusp of being too late to normalize policy. The recent 25-basis point increase in the Fed Funds rate in the face of banking system turmoil punctuates that thought.
Today, investors are convinced that the rate hiking cycle may be near an end. The Fed hints at one more increase in May. Markets expect no more rate increases after that. In fact, markets are predicting two rate cuts before the end of the year even as Fed officials steadfastly insist rate cuts may not happen before 2024.
The Fed wants to see clear and sustained evidence that inflation is moving back to its 2% target before softening its policy. That evidence almost certainly will be backward looking. Fed officials acknowledge they don’t have to wait for 2% inflation to soften the rate environment, but they likely want to see several months of data showing inflation falling to 3% or lower. To that end, last week’s PCE data, showing month-to-month price increases of 0.3% is a step in the right direction. Several more months of similar data would be helpful.
In the meantime, the effects of higher rates are spreading throughout the economy. Yesterday’s JOLTS survey of job openings showed a decline in job listings with a ratio of job openings to the number seeking work the lowest since November 2021. Manufacturing data out this week shows a decline into recession territory. Hence, yesterday’s weakness in industrial stocks.
Surprisingly, as rates continue to rise and parts of the economy slow, both the auto and housing sectors show signs of life. For cars, it’s all about the ending of supply chain problems that kept new car lots empty for an extended period. Helping is the fact that new car prices are coming down. You have read about Tesla’s price cuts. Other traditional dealers aren’t lowering MSRPs but they are making concessions on any inventory on dealer lots for more than a few weeks. As for housing, the spring selling season has been hot despite high mortgage rates. The lack of supply of existing homes for sale has sent buyers to new home communities. Some pricing concessions have worked to close deals. Simply said, both the housing and auto industry are doing better than expected with price the major weapon. That is music to the Fed officials’ ears.
Banks continue to lose deposits. $300 billion per month sounds like a lot but it is a small fraction of total deposits. Banks at any time could increase deposit interest rates or rates on alternative instruments like CDs if they wanted to. At the moment, they don’t. Loan demand is weakening and banks are tightening lending standards in the face of a weakening economy. Already, there is some stress in the banking system. One can point to lower quality auto loans, and some commercial real estate loans as examples. But the stress is nowhere near what it was in the Great Recession. It’s just normal cyclical credit behavior, at least so far.
This is a big week for economic data. On balance, it shows weakness growing, but not at an alarming pace. Friday’s March employment report will give us a better picture. Employment has been very strong for months. A number of net new jobs below 200,000 would be welcome news that higher rates and a slowing economy might finally be affecting the overall economy. One sector that remains strong, leisure, is a source of many of the net new jobs, particularly in the restaurant and hospitality sectors. We will see Friday whether there are any signs of a slowdown here. So far, that hasn’t happened and we may not see material weakness for several more months.
Of course, the focus of the Fed at the moment remains inflation, not the growth rate of the economy. Next Wednesday’s CPI report, therefore, becomes front and center. Its timing will be at the cusp of first quarter earnings season. Both the hope and expectation are that the CPI will show modest improvement on the inflation front. It is particularly important because it will be the last CPI report before the May 2-3 FOMC meeting. If the number is higher than expected, the odds of another Fed Funds rate increase will increase significantly. At the moment, Fed Funds futures suggest a 50-50 chance of one more increase. Next week’s CPI report won’t be the only piece of inflation data needed to support a rate decision on May 3, but it will be important. Given that the Fed wants to see a trend of improvement, not just a single data point, a hot number next week will increase the odds of one more increase in May substantially.
A rate increase would presume that banking system turmoil remains contained. In the very short-term, between now and May 2, that is quite likely. There is no question that higher rates will stress both the economy and the banking system. The real stress may be yet to come. That’s why many believe the Fed should pause soon and accept the fact that there is always a lag between policy implementation and effect. There are also obvious signs that inflation is slowing. New car prices are coming down. Home prices have been coming down for months. Key commodities from oil to lumber, and now food costs, are all in sharp decline. Inflation is abating. Future data will confirm that.
Meanwhile money continues to flow out of banks and into money market funds. The money market funds are using reverse repo facilities essentially reparking the same money at the Federal Reserve that banks did with excess deposits. Fed regulators may see this as a sign that excess deposits still exist within the banking system. That probably isn’t true. Because money can move so quickly today, in seconds not days, needs beyond the next few days or weeks can be parked in a venue that provides high and safe income void of any credit or duration risk. Thus, at least some of the “excess” is the creation of the increased speed that can move deposits around. It also means the duration of deposits, normally very long and sticky in the past, may be far shorter in the future. That will impact the duration of the securities side of bank portfolios, and the need for greater short-term liquidity, particularly during periods of high rates. Banks will respond by tightening lending standards and raising costs to borrowers. Thus, when rates start to decline, look for banks to lower borrowing costs more slowly than rates may indicate.
Since money is the fuel of the economy, making credit less available and at a higher cost will negatively impact economic growth. Looking forward, beyond the current QT rate hiking cycle, investors will have to weigh two factors. First, demographics around the world are weakening and that means slower future growth for all. Governments can pump economies over any short-term but that cannot be sustained without renewed inflation. Second, the cost of money is going to be higher. The Fed cannot revert to a zero interest rate policy again without reigniting inflation. Money in the future will have a real cost. That will actually be a positive in that it will more effectively allocate capital and reduce the risk of too much capacity where it isn’t needed.
For forty years, borrowing money, often for free, helped to accelerate growth. But, ultimately, inflation put a lid on that cookie jar. This Fed isn’t going to repeat the mistakes of the 1970s, but with that said, businesses that borrowed excessively when money was cheap are going to pay the price in a new era of rising rates. Rates will come down in the short run, but won’t return anywhere near where they were in 2020-2021 and they will rise again should inflation reappear. For 40 years, free money covered up a lot of sins, including too much leverage. Going forward, free cash flow generation, an ability to grow in a slow economy, and cost control will be keys to success.
Today, actress Lily James is 34. Pharrell Williams turns 50 and Agnetha Fältskog is 73. Most of us won’t know her by name but she is a quarter of the group ABBA.
James M. Meyer, CFA 610-260-2220