The Fed Is Threading The Needle
Investors,
I hope you’ve had a chance to read my deep-dive on Chevron Corporation $CVX, which I published on February 1st! As someone who doesn’t often consider investing into oil companies, I was rather surprised and impressed by the results of my analysis and I might even start building out a position in the oil giant in 2023. If you missed that report, please check it out here:
I’ve been under the weather for the past few days, so I plan to keep the analysis in this report brief and just focus on macroeconomic analysis. I’ll be updating my analysis on the stock market & Bitcoin in tomorrow’s premium report, which you can sign up for using the link below:
As always, if you enjoy reading Cubic Analytics, please share this with someone who will gain value from reading it.
Let’s get into it!
Macroeconomics:
We had a whirlwind of economic data & events this week, primarily related to the Federal Reserve and the labor market. Starting with the Fed, the FOMC voted unanimously to raise rates by +0.25% on Wednesday, bringing the target federal funds rate to 4.5%-4.75%. This hike shouldn’t have surprised anyone, as the market had reached an overwhelming consensus that the Fed would raise by this magnitude.
Powell exuded confidence in his press conference, using the word “disinflation” thirteen times in his remarks and the Q&A session. This was a stark contrast vs. Powell’s comments after the December meeting, in which he didn’t use the word “disinflation” a single time. In the press release, the FOMC acknowledged that “ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time.” Investors focused specifically on the plurality of “increases” to indicate that there’s still more hikes left in the chamber, most likely.
I’d encourage watching the first 20 minutes of the full press conference below at some point in the near future:
From my perspective, Powell’s comments were neither hawkish nor dovish; however, we are unequivocally in the tail-end of the hiking cycle. Plenty of progress has been made as the Fed continues to embark on monetary tightening. While there is still more progress yet to be desired, Powell and the Fed are likely pleased with the ongoing direction & pace of inflation dynamics. I’ve discussed ad nauseam how the headline CPI, PPI, and PCE data (and their alternative measures of core, median, and trimmed mean) are all decelerating. The Fed is aware of this, while simultaneously being aware that YoY inflation is still too high relative to their goal. Markets are growing increasingly confident about the future path of monetary policy, even if that simply means the Fed is getting close to keeping the federal funds rate stable (aka the notorious “pause”).
Markets despise uncertainty, and Powell’s comments on Wednesday provided enough assurance about the impact and direction of monetary policy. This increasing certainty, in my opinion, is the primary cause for the market’s positive reaction to Powell’s press conference.
Specifically, Powell cited that prior rate hikes & ongoing balance sheet runoff had caused “consumer spending to [expand] at a subdued pace, in part reflecting tighter financial conditions over the past year.” Powell also acknowledged that “activity in the housing sector continues to weaken” and that “higher interest rates & slower output growth appear to be weighing on business fixed investment”, but “the labor market remains extremely tight”. In fact, Powell celebrated the fact that the deceleration we’ve already witnessed in inflation has not come at the expense of the labor market. Up to this point, the Fed has been successful in engineering a deceleration of inflation while not crashing the economy. The desired soft-landing is becoming increasingly likely, highlighting the Fed’s ongoing success of threading the needle.
Powell’s press conference felt like a mini victory lap, while acknowledging that the race isn’t over yet. Powell flaunted the observed success of bringing inflation lower, seemingly for the first time, and the market took this as an opportunity to applaud.
But where do we go from here? How much tightening is left in the chamber?
The bond market has been and will continue to be the arbiter of truth to answer these questions. In the past, notably since February 2022, I have been citing the relationship between the 2-year Treasury yield and the effective federal funds rate. Over the past few months, I’ve become increasingly focused on the 3-month Treasury yield because I think it will provide more meaningful context at this stage of the tightening cycle.
As of Friday’s close, here’s the relationship between the 3-month Treasury yield & the effective federal funds rate:
Why is this important? Clearly, there’s a fairly tight relationship between these two variables with the bond market being more agile than the Fed and having the ability to skate to where the puck is going, rather than where it is. At of Friday’s close:
3-month Treasury yield = 4.66%
Effective federal funds rate = 4.58%
My interpretation of this is very simple: as of right now, the bond market is pricing in 0.08% in rate hikes in the near future, given by the spread between these two figures.
The Fed wouldn’t do a rate hike of this magnitude, so we can interpret this in a few ways:
There’s a 32% chance (0.08/0.25) that the Fed raises rates by +0.25% in March 2022.
The Fed will raise by +0.25% in March, then pause and begin to reverse course.
Personally, my belief is that the Fed will most likely raise by +0.25% in the upcoming two meetings (March & May). Of course, all future actions by the Fed will be dependent on the continued evolution of inflation data & broader macroeconomic conditions.
Incoming labor market data continues to reaffirm the dynamic & resilient nature of the current jobs market. We received a plethora of important labor market data to this week to confirm this trend we’ve been highlighting throughout 2022:
1. JOLTS (December 2022) had 11.012M job openings vs. estimates of 10.3M and prior results of 10.44M. This unexpected increase in job openings is reflective of the fact that companies are hungry to expand their labor force, trying to meet strong consumer demand. This was the largest MoM increase (+572k) since July 2021’s increase:
Within the JOLTS data, the layoffs rate inched higher from 0.9% to 1.0% and the quits rate was stable at 2.7%, where it has been in five of the past six months. On the aggregate, companies still appear willing to expand their labor force and secure skilled & qualified workers on their teams.
That’s not usually what you see during a recession.
2. Initial unemployment claims for last week were 183k, down slightly from the prior week at 186,000. The 4-week moving average inched lower by -6,000 to 192,000. Despite all the doom & gloom headlines about tech layoffs, we’re not seeing a material increase in initial unemployment claims yet. Perhaps the Google, Microsoft, and Amazon employees haven’t rushed to file for unemployment, but the data we’re seeing here is extremely strong for now.
3. Nonfarm payrolls for the month of January grew by 517,000 jobs, a massive result vs. estimates that predicted 188,000. This now marks the 10th consecutive NFP report that came in higher than estimates:
This was the largest increase since July 2022, highlighting the continued strength of the labor market. Essentially, you don’t add 517k jobs during a recession.
Notably, only 5% of people who are currently employed are working more than 1 position. This is a relatively low number given the context of the data series:
This report also showed a decline in the unemployment rate from 3.5% to 3.4%, the lowest level since May 1969! With the labor force participation rate (LFPR) inching higher for the second consecutive month, we’re seeing more Americans return to find new opportunities.
The overall LFPR came in at 62.4% while the prime-age LFPR experienced a significant increase from 82.4% to 82.7%. We’d typically see the unemployment rate and the LFPR move in the same direction (as people re-enter the labor force after being counted as a “discouraged worker”, they become unemployed as they search for a new job). As such, the simultaneous decrease in the unemployment rate and increase in the LFPR also highlights the dynamic & strong nature of the current labor market.
These three reports conclusively verify two things:
The U.S. economy is not in a recession, just in case you needed additional confirmation after seeing the Q4 2022 real GDP growth of 2.9%.
The labor market has achieved historically strong levels.
Here’s the caveat: just because something is strong today, meaning that we’re not in a recession right now, doesn’t mean that it can’t weaken in the near future.
For example:
In May 1989, the unemployment rate was at multi-year lows of 5.0%. The U.S. economy fell into a recession in mid-1990.
In April 2000, the unemployment rate was at multi-year lows of 3.8%. The U.S. economy fell into a recession roughly 12 months later.
In May 2007, the unemployment rate was at multi-year lows of 4.4%. The U.S. economy fell into a recession 8 months later.
Labor market data simply tells us where we’ve been and can’t be used to extrapolate where we’re going with any degree of consistency.
A strong & dynamic labor market indicates that the U.S. consumer is doing well given the overall economic circumstances. Are things perfect? No. Are they good? Yes. As the saying goes, “don’t let perfect get in the way of good”.
My base case scenario is that we will see the labor market deteriorate in 2023, most likely with an unemployment rate above 4.0% by the end of the year. I might be wrong in that prediction, but I cited an array of forward-looking economic datapoints and studies that I’m tracking which are fairly accurate in predicting recessions. I must abide by the forward-looking indicators and acknowledge that weakness is likely to come. For now, there’s nothing to worry about, which makes me happy. I’d rather be wrong than see a recession arrive at our front door.
Best,
Caleb Franzen
DISCLAIMER:
This report expresses the views of the author as of the date it was published, and are subjected to change without notice. The investment thesis, security analysis, risk appetite, and time frames expressed above are strictly those of the author and are not intended to be interpreted as financial advice. As such, market views covered in this publication are not to be considered investment advice and should be regarded as information only. Everyone is responsible to conduct their own due diligence, understand the risks associated with any information that is reviewed, and to recognize that the information contained herein does not constitute and should be construed as a solicitation of advisory services. Cubic Analytics believes that the information & sources from which information is being taken are accurate, but cannot guarantee the accuracy of such information.
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great coverage, thank you