The U.S. Federal Reserve has managed to get the swaps market to price in another 25-basis-point interest-rate hike at its early May meeting. The only other central bank to tighten into a bank failure situation was the Paul Volcker-led Fed with the shuttering of the commercial bank Continental Illinois in May, 1984. It’s important to note that within a year the central bank ended up reversing course completely and cutting the funds rate nearly 250 basis points.
Just about the only thing on which I agree with JPMorgan Chase chief executive officer Jamie Dimon in his annual shareholder letter was his comment that this new chapter of tighter credit conditions has yet to fully play out.
While bank stocks have stabilized, they are still deep into bear market territory, and balance sheets are being squeezed – systemwide deposits have collapsed at a minus-30-per-cent annual rate over the four weeks to March 29. That sharp slump is now being mirrored on the asset side of the banking-sector balance sheets, as outstanding credit has contracted by 3.4 per cent. U.S. consumers have tapped their credit cards to the tune of a 26.4-per-cent annual rate throughout March, attesting to how they are now hanging on by a thread and feeling anxious.
So, I see early May as the final hike, and assuming it happens, the only question is whether enough rate cuts are priced in because I get a strong sense that the turning point in the economic cycle has arrived. (As of Monday, swaps markets have only priced in a Fed interest-rate cut of 25 basis points by December. A basis point is 1/100th of a percentage point.)
We have to keep in mind here that the three Ds as they pertain to the shape of the inverted yield curve – the duration, depth and dispersion – have a 100-per-cent track record, and the last time we had the three Ds behaving like this was in the spring of 1981, just prior to the brutal early 1980s recession.
The prevailing view that the stock market is hanging in there just fine ignores the numbers showing the most cyclical sectors, such as consumer discretionary, banks, real estate and transports, are down 32 per cent collectively from their highs, as are the small caps that have the highest domestic economic content.
Macroeconomic news this month solidified things for me. U.S. job openings slid to a two-year low in the right areas, notably leisure, hospitality, health and education, which are the service sectors that the Fed has been worried about as having the greatest supply-demand mismatch. The same erosion in the new hiring data and the Challenger data, which are forward looking, shows huge declines in each of the past two months in hiring announcements and an epic surge in layoff announcements, and across all sectors.
The real kicker for me is that when you look at the areas of the employment pie that are most closely tied to Fed policy – banks, manufacturing, real estate, construction and retailing – they fell by 33,000 jobs last month in the biggest setback in two years and the second sharpest drop since April, 2020, when the economy was in lockdown mode.
We saw downward revisions to earlier months, a decline in the workweek, and a fall-off in temp-agency employment. These are all leading indicators. The workweek at 34.4 hours matches the lowest since April, 2020, which is important because employers tend to cut hours before they begin to cut staffing, which is already apparent across a wide swath of economically sensitive sectors.
It’s really key that we now have back-to-back months of 0.1-per-cent contraction in the aggregate hours worked – this includes bodies and hours and is the most complete picture of the jobs market. Both February and March were consistent with job losses of 140,000 apiece.
While the labour market appeared to tighten with the unemployment rate slipping back to 3.5 per cent from 3.6 per cent in February, for whatever reason this tightness did not show up in the wage data. Average hourly earnings came in at a year-over-year pace of 4.2 per cent, down from 5.9 per cent at this time in 2022. The near-term trends are pointing to further wage compression, with the six-month pace now running at a 4-per-cent annualized trajectory and the three-month down to just 3.2 per cent annualized, which if sustained would be consistent with 2-per-cent inflation.
Back to the Fed. A few things to wrap up here. First, inverted yield curves – when shorter-term bonds yield more than longer-term bonds – only happen 15 per cent of the time, so we are living through history. Normally, the difference in yield between two-year bonds and 10-year bonds is 120 basis points and the question is how we end up normalizing – will it be the front end leading or the back end?
I say the front end because the inflation cycle has peaked, and the only thing that separates that reality from the construction of the consumer price index is when the distributive lags stop masking what is happening to rental rates in real time.
Second, M2 money supply contracted 0.6 per cent in February and has declined now seven months in a row, at an unprecedented minus 2.4 per cent on a year-over-year basis. The two-year trend has wound all the way down to just a 3.7-per-cent annual rate, which is lower than it was in 2019 when Fed chairman Jerome Powell was cutting rates.
Finally, remember that the one thing that has not changed these past three years is the Fed’s estimate of where the neutral funds rate is – that has been stuck at 2.5 per cent, which means that once it comes to cutting, the Fed is going to have to ease 250 basis points or more just to eliminate the excess amount of monetary tightening currently in the system. This, my friends, is what lies around the bend.
We also must bear in mind that the Fed sounds hawkish today, but the data will inevitably cause a shift in view. It’s only a matter of time. We have, after all, experienced no fewer than 14 Fed rate-hiking cycles since 1950 and each one was followed by an easing cycle. Interest rates, like the economy and the financial markets, do, after all, move in cycles. And the Fed switches when the data tell it to.
In two words or less – buy bonds.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave.
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David Rosenberg