One Giant Leap

In anticipation of this week’s Federal Reserve FOMC meeting, economist Mohamed El-Erian warned, “I think the Fed is going to have to decide between two policy mistakes.” The decision El-Erian referred to was between a policy option light on inflation fighting that risks higher inflation for longer, or a credible inflation fighting policy that risks recession. This week, the Fed shunned “one small step” on interest rates in favor of “one giant leap.” In so doing, they took great strides towards selecting the particular nature of their mistake. Amidst a consumer killing 8.6% decades-high inflation epidemic and an economy slipping increasingly towards recession, the Fed this week increased rates by the largest increment since 1994 and raised the Fed funds rate by .75%. The outsized rate hike was accompanied by a heads-up from Fed Chairman Powell to expect another .50% or .75% rate increase at next month’s July FOMC meeting.

The action raised the short-term federal funds rate to a range of 1.50% to 1.75%, and Fed officials at the median projected it would increase to 3.4% by the end of this year and to 3.8% in 2023. The new projections on the rate hike trajectory represent a substantial shift from projections in March that assumed the fed funds rate would rise to only 1.9% by year-end. The tightening of monetary policy was accompanied by a downgrade to the Fed’s economic outlook. The economy is now seen slowing to a below-trend 1.7% rate of growth this year, with unemployment rising to 3.7% by the end of this year and continuing to rise to 4.1% through 2024. While no Fed policymaker projected an outright recession, the range of economic growth forecasts edged toward zero in 2023.

During Powell’s Q&A session, the Chairman displayed far less conviction in a soft-ish landing outcome than he has in the past. Powell said, “I think that what’s becoming more clear is that many factors that we don’t control are going to play a very significant role in deciding whether that’s a possibility or not.” He continued, “but having said that, there is a path for us to get there, it’s not getting easier, it’s getting more challenging because of these external forces.” In a final sledgehammer to listener confidence, Powell said defensively, “I don’t want to be the handicapper here, I just— That is our objective.” To translate according to how I hear Powell’s answer: While that softish landing is technically still a possibility, it’s no longer a plausible base case to peddle. In fact, it’s kind of embarrassing, but it’s not our fault!

Powell also had some very interesting comments addressing questions over the potential market impacts of balance sheet reduction, or “quantitative tightening.” Powell was asked if QT might cause problems in the present highly illiquid and volatile market environment. A very good question, I might add. Powell’s dismissive answer strained credulity. The Chairman said, “Markets seem to be okay with it… Markets are forward looking and they see this coming. I have no reason to think it will lead to illiquidity and problems, it seems to be kind of understood and accepted and accepted at this point.” Indeed, markets are forward looking. Since the planned policy was announced, the S&P has gone straight into a bear market. That seems to me like a possible message that markets are concerned.

In separate remarks this week, Powell also asserted that the Fed’s commitment to reining in inflation is “unconditional.” The implication from both the strong stance on rate hikes and the unconditional comment is that the Fed has chosen to tackle inflation even if it likely means triggering a painful recession and enduring the ensuing carnage in financial markets. The Swiss National Bank and the Bank of England also joined in on the rate hike party this week, thereby adding to concerns that tighter monetary policies could undermine the post-Covid global economic recovery—a recovery now in serious jeopardy and seemingly hanging on by little more than a thin thread.

Not surprisingly, asset prices suffered during this high-impact week in the wild world of global financial markets. The S&P 500 suffered its worst week since March 2020’s Covid recession, domestic and global bond markets were hit as yields surged, high yield credit markets broke down, and most commodities were crushed to varying degrees. Physical gold and silver were also lower, but offered relative outperformance against most other assets. Only the dollar and some agricultural commodities escaped lower prices on the week.

Not everyone is convinced by the Volker-lite pronouncements of the hawkish Fed or by the FOMC’s latest economic projections. Guggenheim Partners CIO Scott Minerd referred to the Fed’s updated economic projections as “all fantasyland.” Former New York Federal Reserve Bank President Bill Dudley described the Fed’s forecast as “remarkably optimistic,” “unrealistic,” and “highly unlikely.” According to Dudley, to land the plane as forecast, the Fed would have to “pull off something that’s never been accomplished in US financial market history.”

Former US Treasury Secretary Larry Summers also offered his take on Fed projections. In his view, in order to quell inflation, the unemployment rate would need to increase much more than policymakers are forecasting. Summers said, “I would be very, very surprised if we saw inflation come down to 2.5% without also having seen a recession.” Summers also added that even with a recession, he doesn’t see consumer prices dropping “all the way down” to 2.5%. 

Echoing the suspicions of many that the “Fed put” pivot is closer than policymakers are letting on, Summers said, “I don’t think that the recession that Chair Powell says he’s willing to tolerate is necessarily a large enough recession to do what would be necessary with respect to inflation.” According to Summers, there remains “very substantial ambiguity” about what the Fed is really prepared to do and the amount of pain and systemic market dysfunction they will be willing or able to endure. Answers to these questions will have very significant ramifications on exactly how circumstances unfold. Summers concluded by asserting that, “I still think the Fed and most market participants are underestimating the gravity of our situation.”

Even before this week’s rate hike, recent data suggests that the seeds of economic slowdown have started to germinate, but the full flowering remains very much ahead of us. This week’s 75 basis point fed funds rate increase will only accentuate and accelerate the slowdown. While industrial production, manufacturing data, and the overall labor market have remained strong so far, the island of strong economic data is shrinking. The most recent retail sales number posted a surprise contraction. In the labor market, initial jobless claims came in higher than expected this week, and have now started a clear trend higher since the early spring. The trend in the data offers a notable initial signal of a turn toward a weaker jobs market.

Also this week, the Philadelphia Fed’s survey that gauges business conditions fell into contraction with a negative 3.3 reading that fell significantly short of expectations for a positive 5 reading. The result was the first contraction in the survey since the 2020 Covid lockdowns. Significant findings in the survey indicate that new orders contracted dramatically, the number of shipments fell significantly, and the number of unfilled orders dropped notably. In addition, of significance to the labor market, the average workweek hours fell. The most eye-catching result in the survey however, was the negative 6.8 print in the six-month outlook. The outlook was the weakest since 2008.

In the economically critical housing sector, where home values represent $40 trillion of the American household balance sheet, the data this week was no better and continued to point towards trouble. In addition to layoffs at real estate firms, rapidly deteriorating homebuilder sentiment, and plunging mortgage applications and refinances, this week, housing starts and permits missed expectations. Analysts expected a drop in May housing starts and permits of 1.8% month over month (MoM) and 2.5% MoM, respectively. Actual numbers missed significantly, with housing starts down 14.4% MoM and housing permits down 7.0% MoM.

The rapidly eroding housing data reflects, among other factors, a housing affordability crisis. With already sky-high prices, it became supercharged this year as rates for 30-year mortgages increased from around 3% to 5% in just the first few months of this year. However, the situation has gone from extremely bad to way worse. The 30-year mortgage rate has continued to soar at the fastest pace on record, and this week headed toward 6%. Amazingly, these are levels last seen just before the Great Financial Crisis and before the last housing bubble burst.

The average mortgage payment on a median mortgage is up by almost a mind-boggling $800 in just the past six months. This puts the housing market among its most unaffordable levels ever in history. As a result, new single-family home sales have now plunged back down to Covid-trough levels, and the trend is the longest negative sales streak since 2010.

According to real-estate brokerage firm RedFin, the script has already flipped on the post-Covid housing market boom. After a period of unprecedented gains for house prices, Redfin reports that for the four-week period ending June 12th, the firm saw the highest share of sellers on record drop their list price as unaffordable homes caused the pool of potential home buyers to collapse.

Reflecting these dynamics, homebuyer sentiment has completely dropped off the charts. An index of homebuyer sentiment with data back to the early 1980s oscillates over time within a range of nearly 180 at the strongest levels of buyer sentiment to trough readings around 105. The 105 trough levels had only been approached twice in 40 years prior to the post-Covid recovery period. Since 2021, however, the deterioration in homebuyer sentiment has been downright shocking. We have managed to blow right through all prior trough lows in the 105 area to plumb the previously unimaginable depths of the present 43 reading. Unbelievable! The homebuyer sentiment data tells the same story, albeit to an even more dramatic degree than that of last week’s new all-time low in University of Michigan consumer sentiment.

Bank of America’s chief investment strategist Michael Hartnett has been spot-on this past year in calling for markets to react, in procession, to an inflation shock, a higher interest rates shock, and eventually to a growth and recession shock. The combined effect of last week’s hot 8.6% CPI inflation report, University of Michigan data reveling a spike in inflation expectations along with all-time low consumer sentiment, and this week’s 75 basis point increase in the fed funds rate amid weakening economic data all appear, understandably, to have translated into a significant recognition moment for markets. We are aggressively hiking interest rates right into the teeth of a recession. The smelling salts have now been introduced to largely complacent markets that had priced in a soft landing, but not the significant recession risk that looms right on the doorstep. Markets have confronted Hartnett’s inflation shock and interest rate shock to various degrees, but it now appears that the start of the growth and recession shock has arrived. With it comes the outer bands of the incoming hurricane JPMorgan CEO Jamie Dimon spoke of several weeks ago.

Perhaps the quote of the week came from economist and market commentator Ben Carlson, who cynically joked that, “The Fed needs to raise rates as quickly as possible to tame inflation by sending us into a recession where they can then cut rates to save us from the recession.” Hartnett at BofA sums up the situation with significantly more descriptive color. In his assessment, expect an incoming global recession followed by the next round of rate cuts and massive quantitative easing liquidity injections, but not before the S&P 500 heads towards the 3,000 level. Bear market rallies are to be expected along the way, but that Fed put still resides around the lower 3,000 level. According to Hartnett, what awaits on the other side of the next stimulative Fed intervention is a renewed bout of inflation and the sweet spot for real assets as markets officially recognize that secular disinflation is over.

What the market may find in the wake of the next stimulative policy pivot is that the Fed’s incendiary inflationary policy toolkit will play much differently in our new environment that has replaced 40 years of secular disinflation with a shift towards an underlying secular inflationary bias. Structural commodity supply shortages, the need to re-shore or near-shore supply chains, fractured geopolitics, and rapid de-globalization trends all ensure that the underlying inflationary bias within the global economy will be far stronger in the coming years than that seen in the last 40-years.

So far in 2022, despite aggressive declines in stocks and bonds, economically sensitive commodities and real assets (especially in the energy space) have held up remarkably well as their hard asset characteristics and tight supply dynamics have largely overcome concerns over demand destruction. That changed this week. Spiking recession risk recognition and greater fears of demand destruction were enough to spark selling that more effectively dented prices of economically sensitive commodities.

The impact of a recession will likely soften prices in the short term for economically sensitive commodities as demand destruction is priced in. With the new secular inflationary bias, it will also generate an incredible buying opportunity in select, supply-constrained, demand-favored hard assets. In the meantime, economically insensitive gold remains, at present, the safe haven of choice. Gold is watching events with a keen eye on the Fed’s pain threshold and eventual policy pivot point. As ever, forward-looking gold will be among the first assets to sniff out the next round of monetary malpractice and rise accordingly.

Weekly performance: The S&P 500 dropped 5.79%. Gold was down 1.86%, silver was lower by 1.55% on the week, platinum was off 4.20%, and palladium lost 5.68%. The HUI gold miners index was knocked down by 7.71%. The IFRA I Shares US Infrastructure ETF was dinged by 10.04%. Energy commodities were crushed. WTI crude oil was off by 10.51%, while natural plunged by 21.54%. The CRB Commodity Index was lower by 6.22%. Copper lost 6.53%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 5.71% on the week, while the Vanguard Utilities ETF (VPU) was down 9.11%. The dollar was higher by 0.33% to close the week at 104.49. The yield on the 10-yr Treasury jumped by another 10 bps to end the week at 3.25%

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC