The FED Mindset…updated
Update at 10:30 AM 3/2/23
Now that all of you have had a chance to read the piece below that I think shows what the FED thinks and its current rate hike play is based. The FED goal of a recession and the S&P to decline to the 3100 area is prominent. My two main premises are that none of that is going to happen, the New Economy, i.e. the Climate Tech economy is nowhere mentioned in that piece. This is the surprise that I see coming.
Posted yesterday: As we all await the fight over next week’s employment numbers here is something that was sent to me today To me this piece is a good attempt to get into the head of the FED Chairman and the Fed itself. It does a good job of looking into the mindset of the people controlling our economy and how we got here.
Memo from rosenbergresearch.com March 1, 2023
Well, I must admit that I’ve rarely, if ever, been as perplexed as I am today over the Fed and its preoccupation with contemporaneous and lagging economic indicators. It’s truly unprecedented. I for sure thought that the Fed would be taking a feather out of the Bank of Canada’s hat and undergo a conditional pause, but that clearly hasn’t happened. The BoC led the way into the tightening cycle and has now been the first to press the pause button. Remember, too, that Tiff Macklem is operating under similar crosscurrents of cycle high lagging and coincident indicators but steadily deteriorating leading indicators, a tight and red hot labor market, and elevated inflation though the latest CPI data north of the border went in the other direction and surprised to the low side, but in Canada the domestic shelter component responds to the high-frequency data with shorter lags.
Now that three more hikes are now priced in and no pivot for this year, the only issue is whether they go even further than three more hikes. What is it they need to see that they haven’t seen? January’s weather-induced economic bounce aside, we came off three quarters with virtually no growth in real private final demand. The New York Fed’s own inflation expectations measure has rolled over, and on Friday, we saw in the Umich survey the 5-year inflation view stuck at 2.9% for the third month in a row despite the shocking January CPI and PCE deflator data, and the Umich number that Greenspan, Yellen, and Bernanke used to focus so heavily on is where it was in the summer of 2019 when Powell was getting set to cut rates three times and with the same level of tightness in the labor market. I find it very fascinating that the last time the headline inflation was where it is today at 6.4%, which was back in October and November of 1990, the Umich 5-year inflation expectation measure was sitting at 4.6%, or 170 basis points from where it is today. Before that, it was July, 1982, and the Umich metric was at 5.3%, or 240 basis points above current levels!
In fact, the 2.9% Umich inflation expectation reading in the past, with monthly data going back over 30 years, coincided with an average headline inflation rate of 1.8% and 2.0% on the nose on a median basis. The Fed should be rejoicing over this entrenched view that this cycle’s inflation build-up will be transitory!
But it isn’t.
This Fed continues to believe it has to fight for its perceived loss of credibility this cycle. It has two fears. One is the memory of Arthur Burns in the 1970s and even Paul Volcker in 1980, which is ending the tightening cycle prematurely. Second, the Fed is consumed with financial conditions, which is a critical input to its macro forecast. Maybe it was a ruse when Powell, at the last post-meeting Q&A shrugged his shoulders over the question of financial conditions, but that issue was put to bed in the FOMC minutes where it became obvious that the risk-on rally since last Fall is not what it wanted to see. Totally undesirable. If you’re bullish on the front end of the curve, the fact that the stock market fought the Fed so hard since October has been more of a headache than any of the economic data. And we have to add that if the Fed was still hawkish at 3,600 on the S&P 500 and was frustrated as it approached 4,200 in early February, or even near 4,000 today.
We know the S&P 500 got as low as 3,600 last Fall and entered a bear market, which in the past was always a signal to either pause or pivot. But that didn’t happen, and there is a message there in its own right.
Here is what the Fed had to say on the matter of “financial conditions” at the most recent FOMC meeting (taken from the minutes).
“However, several participants observed that some measures of financial conditions had eased over the past few months […] Participants noted that it was important that overall financial conditions be consistent with the degree of policy restraint that the Committee is putting into place in order to bring inflation back to the 2 percent goal”.
When we try and model the financial conditions that get the Fed to what it wants to see, we are talking about 3,100 on the S&P 500 and somewhere around 800 basis points on high yield spreads. It actually wants a recession and probably prefers a mild one, because it mentioned recession 4 times in the latest set of FOMC minutes. It didn’t have to show us that. Remember, the minutes are a scrubbed-down screenshot of the meeting, and the words are painstakingly chosen and then have to be approved by the Committee. We haven’t seen so many citations since June 2020, and there are more citations than all the meetings combined in 2008. And the recession is staring us in the face because, just as we saw with inflation and unemployment, the lagging economic indicators from the Conference Board hit a cycle high in January; and as we saw with payrolls and real incomes, the index of coincident indicators also hit a cyclical peak last month. That is not unusual at all. The leading economic indicator, well, it fell for the tenth month in a row to a 23-month low, and this divergence between it and the lagging and coincident indicators is a sure-fire peak-economic-cycle development. Take that along with the depth, duration, and dispersion of the inverted yield curves and the timing of the peak and rolling-over in M2 growth, what history tells us is that the recession becomes a reality in Q2, the third quarter at the latest.
Now even before the upside January surprises to the inflation data when they were cooling off in the last three months of 2022, the Fed was not exactly backing away from rate hikes or signaling more ahead. That global supply chain bottleneck pressures are easing dramatically, freight rates collapsing, or wide swaths of the commodity markets in a bear market, haven’t stopped the Fed. And, of course, the “super core” services inflation measure it recently concocted, representing the grand total of 25% of the price index, is sticky as it always is and a huge lagging indicator. The reason why the Fed is focused on these areas is that between accommodation, restaurants, air travel, health care, and education, these now have the largest gaps between spending and employment levels compared to where they were pre-COVID-19 and where the central bank sees the greatest imbalances and sources of future upward wage pressure that it feels could spill over into the broad economy (within the entire services sector, only personal care services, professional and business services, and ex-air transportation do not fill this mismatch that has the Fed so concerned). It’s this spending-jobs mismatch in this 25% of the economy that the Fed wants to eliminate. There is no such imbalance in manufacturing, which is why the Fed isn’t looking so much at the goods sector; and it seems to realize that the rental components are sending off a reliable signal when stripping this out of its new “super core” measure as well. It all comes down to a handful of service sector segments, mostly related to leisure and hospitality, as well as education and
In any event, it looks to me that everyone has taken leave of their senses ever since that payroll report at the beginning of the month (January also did line up as the top 5% warmest of all time, a 1.5 standard deviation event, so I imagine that influenced all the data, as in the unprecedented plunge in utility output). A ripping +517k surge that was not corroborated by the ADP number (+106k) and ADP has a much larger sample size (460,000 establishments versus 122,000), adjusted for the new population count, the Household survey showed a tepid +82k. Of course, as I keep saying, not all jobs are created equally and every job created since last May has been part-time, full-time employment is actually down a smidge, and so when you adjust for that replacement of part-time from full-time, the real unemployment rate is at 4.0%, not 3.4%. The same holds true when you weigh in the fact that we came off a year where hours worked were cut by 1.2%, which is the equivalent of laying off nearly 2 million. Then adjust from the fact that the Birth-Death model, in the face of a 5% increase in business bankruptcies in the past year and a 2% decline in new business applications, well this alone added 1.5 million to the headline payroll figure in the past year. So, what looks like 5 million new jobs being created at the headline level was really closer to 1.5 million when you take hours and the fudge factor into the equation. All that said, what matters is less the machinations and distortions in the data, which the Fed is fully aware of, and you have an official forecast of 4.6% unemployment and by the time we get there, we will already be at least six months into the official, but this is the sort of slack the Fed wants to see. As it chases lagging indicators, history shows us that the jobless rate bottoms three months into the recession just as it peaks three months into the recovery, which is why it is a classic lagging indicator. Inflation is an even more acute lagging indicator, because it peaks six months into the recession and then doesn’t end up hitting its trough until we are fifteen months into the economic recovery.
Again, the Fed is not filled with stupid people. They know all this. All along, Powell has been devising new macro metrics to justify the wildest tightening cycle since the early 1980s when the economy came off more than a decade of recurring inflationary supply-side shocks that reached a point where inflation became entrenched and institutionalized in the entire economic system. That isn’t exactly the case today, whether or not the way the price data are constructed makes them appear sticky to the downside. Nearly 40% of the CPI is imputed non-transactional prices. The stuff you can actually measure has already slowed to a 2.5% annual rate over the past three months. But again, I’m sure the Fed knows all this. It’s clearly all about eradicating the Fed put and taking the punch bowl away. They still weren’t happy with the S&P 500 at 3,600, but at 3,100, it’s a different story. That’s the only price that really matters. It’s not stopping before that happens, that’s my epiphany. Until then, buy puts and be in T-bills which pay you 5% with no duration or capital risk. If you’re looking to add some risk in something where some real value has opened up this year, try energy credits which have been really beaten up, but the industry fundamentals are stellar. You can now buy 3-year natural gas paper in certain names with spreads of 425 basis points over Treasuries. The BB/B space commands yields in excess of 8% yields with their books fully hedged for this year and leverage below 1.5x on a debt/EBITDA basis for the vast majority of companies. There probably isn’t any part of the bond market right now more attractively priced.