Reprise: Why The Upcoming Rise In Interest Rates Will Be The Fed’s Last Hurrah

The equity market rally this week (ended July 22) looks to us to be a “Bear Market” rally supported by short-covering and the mistaken belief that a soft landing is possible and a recession avoidable. The DJIA closed up +2.0%, the S&P 500 +2.6%, the Nasdaq +3.3%, and the Russell 2000 +3.6%. Still, these indexes are -12.4%, -17.4%, -26.0%, and -26.0% respectively below their recent peaks, with both the Nasdaq and Russell 2000 still officially in “Bear Markets” (see right hand column of the table).

As with all “Bear Market” rallies, the updrafts are much larger than when equity markets are in a “Bull Market” phase. The reason we think this is a “Bear Market” rally is that the incoming data continue to decelerate and deteriorate with most indicators falling faster than in prior months.

Enter the Fed. They meet on the 26th and 27th (Tuesday and Wednesday) with an after-meeting statement and press conference being key to the market’s reaction to what will undoubtedly be a 75-basis point (bps) hike. Already the incoming data have convinced bond traders that, as we indicated in our last blog, this could be the Fed’s “Last Hurrah” (last rate hike for this interest rate cycle), and bond yields have come crashing down. The 10-Yr. Treasury Note yield, for example, was as high as 3.04% on Wednesday, July 20 and closed at 2.78% on Friday, July 22, a huge -26 basis point move in just two days! The good news is that at a Fed Funds rate of 2.25%-2.50%, which will be the rate after the 75-bps increase, the Fed can be content that, at the very least, it has moved interest rates to where economists think is the “neutral” zone (where policy is neither easy nor tight).

Housing Data

Of late, cracks are beginning to appear in housing, a sector many believed (and still do) is somehow immune from recession.

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The following are two well-known leading indicators for the new home market:

  • Homebuilder Sentiment (National Association of Home Builders’ (NAHB)) – these are the voices of the homebuilders, themselves. The overall index fell to 55 in July from 67 in June, still positive (50 is the demarcation between expansion and contraction) but down significantly. This index stood at 79 in March, and, except for April 2020 (the pandemic), July represents the largest one month drop in the survey’s history. Over the past month, 13% of home builders reduced prices.
  • The Prospective Sales Sub-Index fell to 50 from 61, and, Potential Buyer Traffic plunged significantly into negative territory at a reading of 37 from an already negative June reading of 48.

According to Redfin RDFN , in the hot markets of Boise, Salt Lake and Denver, 50% of existing homes for sale have dropped prices. Housing starts have fallen now for four months in a row, and down -2% in June after falling -12% in May. The all-important single-family sector fell -8.1% in June and building permits for single-family starts were also down. These declines are unusually large.

The good news is that multi-family units rose +10.3%, which should help mitigate the rapid rise in rents over the past six months as these, and the current large number of multi-family units already under construction, should come on-line in this year’s second half.

Existing Home Sales fell -5.4% in June, are down -14.2% Y/Y, were at the slowest pace since May 2020 (again the pandemic) and, before that, January 2019. It is important to understand that these are closings whose original contracts were likely signed in April, before the big spike in mortgage rates (chart). We can expect worse numbers in the near future, and can foresee such because mortgage applications are now at a 22-year low, down -6.6% W/W for the July 15 week and off -60% Y/Y. The all-important refi sector was down -4.3% W/W and now down -80% Y/Y. In addition, the mortgage rate spike has caused a significant rise in contract cancellations, now at 15% in June (12.7% in May), the highest rate since April 2020 (i.e., pandemic). Finally, it is quite telling for the housing sector when the large mortgage originators begin to shed staff as both JP Morgan and Wells have just announced.

Sentiment and LEI

The Conference Board’s Leading Economic Indicators fell -0.8% in June after a fall of -0.4% in May, and are now down four months in a row and five of the last six (see chart at the top of this blog). Since its inception in 1959, when the LEI have fallen in four consecutive months, a recession has ensued one-hundred percent of the time.

We have highlighted the University of Michigan’s Consumer Sentiment Index for the last several months. It has been, and still is, an excellent leading indicator. The chart below, from the same survey, shows expected business conditions six months hence. Note the pattern today and note that a similar pattern has appeared prior to every major recession since the late 1970s.

Regional Fed Indexes

The Philly Fed Manufacturing Index fell to -12.7 in June. The consensus estimate was +0.8! which shows how far off the narrative of a soft-landing is. In May, this index was also negative (-3.3). The new-orders sub-index was -24.8 (vs. -12.4 in May). June Expected Business Conditions six months hence at -18.6 was the lowest recorded number since 1979. The May number was -6.8. Every time this index has been -10 or lower, a recession has occurred.

It is noteworthy that the NY Fed Empire Manufacturing Index’s Six-Month Outlook was -6.2 in July. In the history of the Empire Index, this component has only been negative three times: September ’01, and January and February ’09. You all know what happened next!

Back to the Philly Index, the employment, workweek, and inventory measurements were all lower. Finally, and on a positive note, unfilled orders, supplier times, and prices paid and received were all lower, indicating that supply bottlenecks have begun to ease, a positive sign for inflation.

The Changing Labor Market

Initial Claims (ICs) for unemployment have been slowly rising since March with their pace quickening of late, rising to +251K the week ended July 16. They are now +85K higher than their March low. Historically, on average, +76K has been the recession signal.

Those hoping for a soft-landing point to the “strong” labor market where “now hiring signs are omni-present.” However, the indicators, including ICs, are now pointing to a significant change in that labor market narrative.

To begin, the horrible Q1 productivity number (-7.3%) is destined to be repeated in Q2, as businesses over-hired and hoarded labor, believing the overly-tight labor market narrative (i.e., the narrative was self-fulfilling). Right-sizing is starting to occur, as evidenced by the -350K reading in June’s Household Survey (showing negative numbers now in two of the last three months). That Household Survey, by the way, is used to calculate the Unemployment Rate and is much more sensitive to changing labor conditions than the headline grabbing Payroll Survey.

The reason why the Unemployment Rate did not fall in June despite the fall in the number of jobs was because the labor force (the denominator) also shrank. It is now apparent that changes in the labor market have already, or are about to, occur, as inflation, the recession, and falling equity prices push people back into the labor market.

The Washington Post recently reported that 1.5 million of the 3.0 million workers who took early retirement during the pandemic have re-entered the labor force. The reasons given were inflation (65%), falling equity prices (45%), and rising interest rates (30%). A Quicken Survey found that nearly half who planned to retire in 2022 have put that plan off. It appears to us that a rising labor force will soon push up the official Unemployment Rate.

Inflation Has Peaked

As we have been reporting, when July’s CPI is reported (mid-August), we believe that it will prove that inflation peaked in June. On Friday (July 22), the price of a barrel of oil (WTI for September delivery) closed at just over $95, down -22% from mid-June’s $122 level.

Note on the right-hand side of the chart the large role that energy has played in the current inflation saga. Given the much lower price/barrel, we expect the energy component to be downward sloping beginning in July. Note that both food and goods prices have already begun falling.

As further evidence, AAA says that the National Average for regular gasoline per gallon was $4.41 on Friday (July 22), down -11% from $4.96 a month ago. In addition, the prices of both agricultural and industrial commodities, as well as shipping costs, have been falling rapidly. The price of wheat, for example, has fallen -41% since mid-May. And the price of copper (often called Dr. Copper because the stock market often follows its price path) fell about -8% from early March to early June, but then fell another -27% over the past 5 weeks, and that will soon show up in industrial prices.

Final Thoughts

The equity market has been sniffing recession for most of the year, and now the bond market is convinced, as we have opined here for the past few blogs, that the Fed will pivot away from its June dot-plot (3.4% for Fed Funds as of 12/31/22 and 3.8% for 12/31/23). This won’t occur at this week’s Fed meetings (July 26 and 27), but by the time of their September meetings, the incoming data will be such that they will have little choice. The swoon in bond yields this week from 3.04% for the 10-Yr. Treasury Note on Wednesday, July 20, to 2.78% on Friday (-26 bps in two days) and from 3.48% barely a month ago (June 14; -70 basis points since) tells all. We said this in last week’s blog, and we are now repeating it: the upcoming 75 basis point rate hike at the conclusion of this week’s Fed meetings will be the Fed’s “Last Hurrah” for this rate cycle.

(Joshua Barone contributed to this blog)

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