Stocks fell yesterday as bond yields rose and oil prices spiked. As noted often in past Comments, stock movements in the short run, at least until more economic news leads to a change in perception, will be captive to changes in long-term interest rates.
Predicting short-term moves in rates is usually a futile exercise. One can point to a large calendar of new Treasury offerings as an explanation but it is hardly the whole picture. Treasuries, given their credit security and backing of the U.S. government, always jump to the front of the line. But supply and demand go much further, not only in the U.S. but around the world. With that said, there isn’t limitless demand for U.S. debt at low prices.
Longer term rates also reflect inflation expectations. Over the course of 2023, inflationary pressures have been easing. Commodity prices have fallen, as have prices for certain goods from used cars to apparel to TVs. But the cost of services keeps rising. While wage increases have begun to moderate, core inflation is still above 4%.
There have been positive signs in recent weeks that inflation continues to moderate. The government’s preferred gauge of inflation, the PCE index, rose at a rate of a little over 3% last month, although year-over-year increases in the core rate are still over 4%. Employment growth is slowing. Over the past 3 months, the number of new jobs has averaged 150,000, about in line with long-term averages. The labor market is no longer overheated. Job openings are falling and the number of people quitting one job to move to another has fallen sharply.
But even with the recent bump in the unemployment rate to 3.8%, the labor market remains tight. Manufacturing, a weak spot in the economy as businesses adjust inventory levels to slower growth, still runs at close to 80% of capacity. Anything above 80% historically has meant rising inflationary pressures.
Then comes the surprise move upward in oil prices as Saudi Arabia continues to restrain production. This has been an odd year for oil. Normally prices rise over the first five months as demand builds in front of peak driving season. Then prices typically decline through the fall for obvious seasonal reasons. But this year, slowing demand, particularly from China, pushed prices down through most of the first half of the year. While core inflation gauges eliminated commodity movements in food and energy, rising or falling oil prices feed into core inflation as oil derivatives are a key cost component for almost everything. Thus, the recent spike in oil from near $80 per barrel into a newer range of $85+ has sparked fears that inflation is falling too slowly. While most interest rate observers now feel the Fed is finished raising rates, there is risk of one more increase in early November.
These twitches in expectations matter over the short-term but may or may not be relevant over the longer term. If oil prices stay near current levels or even fall as they normally do in the August-November period, that will relieve some upward pressure on rates.
Another near-term factor that could cause some disruption but with little long-term consequence, is the possibility of a government shutdown at the end of this month. It is always in doubt whether the Chiefs or the Indians run Congress. Both leaders of the House and Senate want a continuing resolution passed to keep government open. A continuing resolution would keep government running at current levels until spending bills can be passed. But conservatives in the House want to force restraints on spending now. If they can gather enough support to halt a continuing resolution’s passage, non-essential government activities will grind to a halt. An extended shutdown could knock a few tenths of a percentage point off of Q4 GDP growth, but its long-term impact would be limited. Limited isn’t quite zero. If you are waiting for a renewed passport or an IRS refund, you won’t be a happy camper for a long time should a shutdown occur.
Back to the real world and the economy, there are clear signs of slowing. August was a month when retailers reported earnings. Companies from Wal-Mart to Lululemon reported excellent numbers while others, like Macy’s, Dollar General, Dick Sporting Goods, and Foot Locker were stinko. What that shows is that retailing today is a mine field with pockets of strength from grocery to luxury goods alongside areas of real weakness, especially low end and mid-market discretionary goods. Clearly those are signs of a weakening economy. Lower used car prices and declining sales of existing homes are other obvious signs of weakness. It is hard to expect robust economic growth without resurgent demand for homes and cars.
Does that mean a recession is coming? Slowing growth may or may not mean a recession is near. From the perspective of the Federal Reserve, until a recession actually arrives, if it ever arrives, it can afford to keep short-term rates elevated and keep the fight against inflation ongoing. Once it chooses to lower rates, it will be announcing to the world that it’s second mandate, to promote orderly growth, is now more important than its first mandate, to promote price stability. The danger zone is reached if its need to support the economy forces it to give up the battle against inflation too soon. The word “if” suggests that we are now in the realm of the hypothetical. The more optimistic hope is that inflation falls below 3% before GDP growth goes negative. As of now, that goal is a realistic desire.
If there is a recession, it will likely start by the first half of 2024. Assuming slower activity will help to reduce inflationary pressures, the Fed will most likely be able to moderate rates in 2024 while still keeping the real rate of interest high enough to keep inflation contained. If long-term interest rates stay near 4.25% and the rate of inflation continues to fall, then the real rate, which is the nominal rate (4.25%) less the ongoing rate of inflation, will rise even if the nominal rate stays unchanged. Said differently, the impact of reduced inflation increases the real cost of money assuming nominal rates remain unchanged. At some point that will allow the Fed to start reducing rates while still keeping real rates, adjusted for inflation, high enough to keep inflation in check.
In the ideal, inflation falls toward 2% and the Fed can keep interest rates along the yield curve positive in real terms. That would mean that there is a real cost to money that will serve to restrain excessive growth that would reignite inflation. Since the world doesn’t move smoothly over time, minor tweaks in rates, up or down, are normal and could be expected. In reality, we haven’t lived in such a world this century. When one learns to drive, or to ski downhill, the early tendencies are to oversteer. One gets to the same endpoint, but in a very inefficient manner. For this entire century, the Fed has oversteered. It was too aggressive early on, creating a housing bubble that ignited the Great Recession. Then, from 2008 to 2021, it loosened so much that it made money free in real terms. At the start, given the excess capacity left over after the Great Recession, there was little damage. But eventually free money created yet another bubble. Covid added to the economic mess creating its own set of distortions. Now we are back into tight money correcting the accumulated excesses. The Fed was forced to raise rates at a record pace. That process is ongoing but winding down. Maybe the Fed has learned not to oversteer. Today, the words of moderation are easy to say. If a recession evolves, however, will the Fed keep rates at reasonable levels, or will it open the monetary floodgates once again? If a recession happens in 2024, the Fed will be under intense political pressure to take the easy glide path.
The economically logical path is to lower short-term rates to a level such that growth plus inflation remains below the Fed Funds rate. If real growth is -1.0%, and inflation is 2.5%, the Fed Funds rate should remain above 2%. If growth is zero, a Nirvana soft landing, and inflation is 3%, the Fed Funds rates should settle above 3%. That is still quite a way below the current 5.25-5.50% range allowing some flexibility in a slowing market. But if inflation stays well above 3%, say 3.5% by this time next spring, then letting the Fed Funds rate fall faster would only serve to reignite inflation sooner, leading to more oversteering.
For now, taking all the ifs out, we seem on a reasonable course of slowing inflation amid a slowing economy. Earnings are falling slowly as well. Moderating inflation would limit further rises in 10-year bond yields but not necessarily stop them. As we have noted many times, September and early October are seasonally weak times for the stock market. Rising oil prices complicate the Fed’s mission but don’t alter the course by much unless there is a further spike upward. That seems unlikely as demand ebbs worldwide.
Once we get past the next couple of months and find out whether we enter a recession or not, the long-term focus will be redirected toward sustainable long-term worldwide growth rates as China and other emerging nations grow more slowly. Can investors accept the likelihood of slower worldwide growth without thrusts from central banks to keep growth elevated? That’s a question for tomorrow, not today.
It’s a “Laugh-In” birthday day, as Jo Anne Worley turns 86. SNL alum Jane Curtin is 76 today.
James M. Meyer, CFA 610-260-2220