Dad joke and finance meme all in one. The Federal Reserve is letting the markets swim on their own in the current environment. | |
- Stocks and bonds fell in April as inflation reports changed the expected Federal Reserve's trajectory of rate cuts. Just a few months ago we were expecting 6 rate cuts; now we are hoping for just one by the end of 2024.
- It seems naive to focus on Federal Reserve interest rate cuts all the time. However, the market rightly recognizes that the Fed is the 800-pound gorilla in the financial marketplace.
- Key leading indicators are setting records for length of time before recession onset. Dodging a recession now will violate decades of reliable warnings from the Leading Economic Indicator and the U.S. Treasury yield curve inversion phenomena.
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Table 1: Market performance estimate as of 4/30/2024 (LIMW) | |
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Inflation data came in a bit stronger than expected during April driving down bonds and pushing up yields. The TV commentators and analysts parse the data quite closely, but tend to take short-term squiggles and extend them to long-term trends.
For example, data from one or two months is annualized (ie multiplied by 12 months) to get a better read on short-term trends in the data. The problem with this approach is that the data is highly seasonal and seasonal adjustments are routinely applied by the Bureau of Labor Statistics (BLS). Six months ago, this approach was forecasting 6 rate cuts; today, this type of analysis is worried about a rate hike. The analysts are chasing their tails.
This problem is easily avoided by analyzing data on a year-over-year basis. Most of our charts take this straightforward approach to avoid the noise of seasonal adjustments.
In the following chart, we have the year-over-year measurement of Core PCE inflation, which is a key datapoint for the Federal Reserve. It has been declining steadily for months and is below 3%. I don't see anything alarming here. This doesn't mean prices are falling, just that their increases are slowing.
Figure 1: Core Personal Consumption Expenditures (PCE) inflation versus Federal Funds rate 2011-2024 (LIWM)
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The monthly inflation data we look at only has a limited impact on long-term interest rates. Bond investors are trying to estimate where they think inflation will be over the next 5-10 years, not just next month.
It is interesting to compare Consumer Price Inflation (CPI) with 10-year Treasury yields over the past few decades. Figure 2 tells the story of ever declining bond yields even with the occasional inflation spike. Up until 2020, the bond market had tremendous confidence in the Fed's ability to manage inflation.
Fast forward to today, and the CPI/10-year yield relationship is in a new universe. Decades of policy work have been undone and now the Fed must once again win back the bond market. The banks, real estate investors and the US Treasury are all quite anxious for a return to lower yields. The real question is what path we take to get there.
Figure 2: Consumer Price Inflation (CPI) versus 10-year Treasury yield by decade (LIWM)
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Massive stimulus is driving growth and inflation | |
Many of you are aware of the enormous stimulus that was implemented in 2020 and 2021 to relieve the pandemic strain. For the last 4 years, the economy has been experiencing spending and government deficits on a scale similar to that of a major war. As with most war time spending, we are experiencing robust economic growth and inflation. | |
Figure 3: Comparison of the post-World War 2 Marshall Plan and all the pandemic stimulus programs (Haver Analytics) | |
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There has been a significant amount of consumer stimulus in the pandemic spending plans. However, this stimulus measured by transfer payments is edging down to the long-term trend line. What this means is that there is less extraordinary stimulus driving growth, so we can expect GDP growth and inflation pressures from this factor to decline in the future. There may be other factors driving inflation upwards, but this one is fading.
Figure 4: US Federal Transfer Payments, $ billions (Jeff Snyder)
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The labor market continues to gradually weaken | |
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We watch the weekly initial claims for unemployment data closely. It was very interesting to see that over the last 7 weeks, five reported data points were exactly the same. For five weeks we had exactly 212,000 new claims for unemployment. I'm not saying they are making up the data, but having the same exact number of initial jobless claims is statistically improbable. And that's being nice.
The corporate payrolls data continues to be ok; household employment continues its broad downtrend.
Figure 5: Household employment versus Institutional Payrolls 2005-2024 (LIWM)
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How close are we tracking the 1970s? | |
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Was there another period in US history of war-level spending, full employment, and social stimulus? Yes, there was. It was the late 1960s and early 1970s.
In the late 1960s, the United States experienced rising Vietnam War spending along with President Johnson's rollout of The Great Society programs (ie: welfare). Both factors played a role in the rise of inflation and the disastrous tail-chase of Fed policy in the 1970s.
A monetary tail-chase describes central bank policy that chases inflation up and down with the data. Higher rates tend to slow growth and inflation; lower rates tend to promote growth and inflation. Sometimes it takes a yield curve inversion to decisively slow things down.
Yield curve inversions describe a situation where short-term interest rates are above long-term interest rates. They are one of the most reliable precursors to recession and stock market volatility. Today, we can compare 3-month T-bills of 5.3% yield with 10-year Treasuries of 4.7% yield to see that the yield curve is inverted by about 0.6% (5.3% - 4.7% = 0.6% inversion).
Comparing today's yield curve inversion to the 1970s shows that today's Fed is not as forceful as the Fed of the 1970s. Then, as today, the Fed policy makers are worried that too much restraint will kill jobs, so inflation was accepted for the sake of the economy.
We are tracking the 1970's pattern closely, so far.
Figure 6: Yield Curve Inversions 10y-FF % 1960-1980 v. 2014-2024 (LIWM)
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Signs of consumer weakness | |
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Just as we discussed rising commercial real estate defaults last month, we have new data from Discover Card on credit card borrower defaults. There have been many articles discussing the aggregate size of credit card debt and how much consumers are paying in interest expense. The numbers are huge.
Of course, if you can't pay, you don't pay. Consumers started their default cycle a few quarters ago based on this data. If home improvement and car buying trends are any indication, broad consumption is contracting.
Figure 7: Discover Card charge-off rate 2007-2024 (re:venture consulting)
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The stock market recently peaked at the end of March 2024. Multiple factors drove this rally: government spending, stable earnings, strong employment and the promise of Federal Reserve interest rate cuts.
As mentioned before, some of these stimulus items are fading out along with the employment situation. Now that the Fed is confirming rate cuts will be a late 2024-2025 event, the stock market is left looking at earnings. Earnings, while stable, are not growing at a rate to support record valuations.
Additionally, the Fed is meeting this week and leaked the following to the Wall Street Journal April 29th:
As financial-market participants anticipate fewer cuts, longer-dated bond yields will rise. In effect, this achieves the same kind of tightening in financial conditions that Fed officials sought when they raised interest rates last year. Higher yields across the Treasury yield curve should ultimately hit asset values, including stocks, and slow the economy’s momentum...
The stock bulls are fighting the Fed here. That is always a dangerous proposition.
Figure 8: S&P 500 has many layers of support (LIWM)
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The bond market appears to be testing the 2023 bottom despite Core PCE inflation data below 3%. There are multiple sellers in the market that are not price sensitive: the US Treasury who sells debt to finance operations, the Federal Reserve who is letting their bond portfolio mature and foreign central banks who may be selling US Treasuries to manage their currency risk. All of these players are providing plenty of bond supply that can push prices down and yield up.
It is still our view that long-term yields above 4.5% are very attractive compared to the 1.3% yield on the the S&P 500 and the sub-3% inflation numbers we see in the current data.
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There is a tendency to look at recent events or triggers to explain sudden moves the markets. This is a bit of a parlor game because it is impossible to know the mindset of all the different players buying and selling securities. Does the options day trader consider the same factors as the pension fund portfolio manager? No, of course not. Every investor has a unique time horizon, risk tolerance and long-term investment goal. For those who have built formal long-term investment plans, these phrases should sound familiar.
Over short periods of time, market choppiness is similar to the annoyance you feel in a small boat on a windy day at sea. Over longer periods of time, the market can seem like a large tide going in and out. By raising interest rates and promising rate cuts, the Fed has acted like the moon driving tides up and down. By changing the expectations of rate cuts in 2024, the Fed has pulled the monetary tide out. Eventually that will become a problem for stocks and the economy.
We believe our key leading indicators are correctly indicating caution for investors. Is it possible they are wrong? Yes, of course. If that is the case, it's not the 1970s we should worry about, but darker periods of monetary history.
If you'd like to discuss any of our research, please feel free to reach out to us.
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Rob 281-402-8284
Chris 281-547-7542
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Christopher Lloyd, CFP ®
Vice President and Senior Wealth Planner
Lloyds Intrepid Wealth Management
1330 Lake Robbins Dr., Suite 560
The Woodlands, TX 77380
281-547-7542
Chris.Lloyd@lloydsintrepid.com
www.lloydsintrepid.com
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