by Hubert Marleau, Market Economist, Palos Management
August 2, 2024
The 12 voting members of the Fed have decided - mistakenly - to hold their benchmark interest rate steady at a range of 5.25% - 5.50%, the monetary authorities citing that they wanted greater confidence that inflation was moving sustainably toward their 2% target. Recent prints produced by the Bureau of Labor had shown inflation running at an annual rate of 2.5%, down from a high of 7.0%, just 2 years ago. What is crucial here, however, is that wage pressures are receding. The Employment Cost Index rose at the annual rate of 3.7% in Q2/2024, which is not far from the 3.5% or so that Powell has said on several occasions would be consistent with the Fedās 2% inflation target.
It is now official that productivity surged once more in Q2. U.S. productivity accelerated to a 2.3% annual clip in Q2 and revised up Q1by 0.4%. Believe it or not, the yearly pace is an outstanding 2.7%. Consequently, unit-labour costs - a key measure of wages -rose only 0.9%, registering a yearly pace of 0.5%. Viewed another way, average hourly earnings were up 3.6% in July: not only the smallest gain since May 2021, but almost exactly where the Fed wants them (3.5%).
Moreover, the effect of oil prices on inflation is powerful, and that has gone nowhere for months on end. In this connection, the 2 more months of inflation data available, before the monetary authorities meet again in mid-September, should be cooperative in bringing inflation down even more. Derivative traders in the bond market believe that consumer inflation will be as low as 0.7% next year.
Meanwhile, the Sahm rule has been triggered, which stipulates that when the 3-month moving average unemployment rate moves 0.5 percentage points above its low point of the trailing 12 months, a recession often appears on the horizon. This reading was 0.43% before the Bureau of Laborās Friday report on the June employment situation. Considering where the current federal funds rate, the 5-year Treasury yield and the10-year yield are at present, the New York Fedās calculated recession probability is 50%.
Thus it is justifiable that the monetary authorities are giving more weight to a weakening labour market in their decision process, even though the arrival of a large number of immigrants, an unprecedented increase in business capital formation and a surge in productivity is keeping the economy afloat. According to Employ America, AI is only having a nascent influence on productivity, but starting to pick up, perhaps explaining surreptitiously why the New York Fedās GDPNow model estimate for real GDP growth in the third quarter is still attractive at 2.1%, but much lower than the 2.8% that the Atlanta Fed was a few days ago. This reading does not put me into a diehard hard-landing, but does put me in a scenario where a soft-landing scenario is arriving faster than the Fed thought.
Unfortunately, economies do not lose steam in a linear fashion. As a matter of fact, business activity seems to be losing some momentum: the Citiās Economic Surprise Index keeps on surprising to the downside, falling to minus 34.4 on Thursday. Indeed, there is enough theoretical value and empirical evidence not to discount the fact that the Sahm Rule is flashing red. ADP reported that U.S.businesses had added just 122,000 new jobs in July, with applications for unemployment benefits jumping to a nearly 1-year high of 249,000. At the same time, the BLS affirmed that the economy wasnāt creating as many job opportunities as it once did, printing an increase of only 114,000 in non-farm payrolls in July, a significant drop from the average of 215,000 over the previous 12 months. More importantly still, the unemployment rate rose 0.2% to 4.3%. Although the labour market has not completely cracked, because some hiring is still going on at small businesses, the internals of the employment numbers are not good enough to prevent the unemployment rate from rising further, especially when one factors in lower a quit rate, less job openings, rising labour force participation and contracting manufacturing activity.
The Stock Market's Response
While not a slam dunk, there are strong conjectural reasons to think that inflation will return to the 2% target and that the unemployment rate will rise further. In this regard, Powell may have to cut interest rates by as much as 50 basis points in September to ensure soft landing. Contrary to popular opinion, he did tee it up. By comparison, Goldman Sachs estimated the median optimal interest rate, based on various monetary rules, to be around 4.00%. On Friday, the 5-year Treasury yields - my favourite gauge of where the policy rate should be - fell to 3.60%. Therefore at 5.50%, the policy rate is way too high for the stock market to handle. With this insight, the aforementioned factors force investors to treat bad news as bad. The S&P 500 fell 1.9% this week to 5347 and the tech-heavy Nasdaq tumbled to 10162 into correction territory. In this connection, the Cboe Volatility Index - better known as the fear gauge - touched an unseen level of 30 on Friday, but finished at 23.57, snapping its longest streak without a close above 20 since February 2018, according to Market Watch.
Assuming that the economy will keep up as inflation cools and the Fed will introduce an easy cycle of lower interest rates in September, the blowout in volatility, which was brought about by panic selling, may have created many buying opportunities. One should never underestimate the formidable firepower of the Fed when it's time to move. The time may be here for risk-on. Interestingly, the CBOE Skew Index, a measure of perceived tail risk of the distribution of S&P 500 investment returns over a 30-day horizon, stood at 139.65 on Friday, versus a 52 week high of 170.52 and a low of 127.31, down 6.2% in the past month.
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