While the general stock market tumbled on Mar. 31, the PMs still remain relatively elevated. However, this week brought about several developments that impaired the PM's medium-term fundamental outlooks.
For example, inflation remains red-hot, as the latest corporate earnings calls show executives fretting about input and wage pressures. Moreover, when the only choices are raising prices or eroding their profit margins, it's a lose-lose situation for the financial markets.
On the one hand, absorbing the costs results in weak quarterly earnings, and investors often punish companies that underperform. On the other hand, raising prices further stokes inflation and increases the chance that the Fed's swift rate hike cycle will push the U.S. economy into recession. As a result, long-only investors face an extremely uncertain future, and the Fed's margin for error is extremely low.
Furthermore, the U.S. labor market remains on fire. With near all-time high JOLTS job openings hitting the wire this past week, The Confidence Board's jobs were "plentiful" metric hitting an all-time high, and ADP's private payrolls also outperforming consensus expectations, the U.S. employment picture remains rosy. As a result, the Fed should light plenty of hawkish fireworks over the next few months.
Speaking of which, more Fed officials made the rounds last week. And with their hawkish rhetoric still steadfast, the S&P 500 and the PMs remained in fundamental denial.
For example, Philadelphia Fed President Patrick Harker said on Mar. 29 that "I am open to sending a strong signal with a 50 basis point increase at the next meeting." Moreover, while he added that "I have penciled in seven…25 basis point increases for this year," and more or less will depend on the path of inflation, a neutral rate of ~2.5% implies roughly 10 rate hikes over the next several months.
Source: Reuters
Likewise, Kansas City Fed President Esther George said on Mar. 30 that "The balance sheet will need to decline significantly," as she cited the “distortive effects” the Fed’s nearly $9 trillion in holdings have on the financial markets. "The interaction of higher policy rates with a large balance sheet will need to be considered."
Moreover, channeling her inner Jerome Powell, she also used the term "expeditiously" when describing the future path of interest rates.
Source: Bloomberg
Making three of a kind, Richmond Fed President Thomas Barkin said on Mar. 30 that he’s "open to" a 50 basis point rate hike in May. Moreover, with his perception of neutral at 2.4% (roughly 10 rate hikes), he sounded quite committed to the path ahead.
Source: Bloomberg
As a result, with Barkin’s assessment of "as we get closer to neutral we can make that call," it’s important to remember that there is a considerable distance from 0.25% (one rate hike where we are now) to 2.4%. As such, while Fed officials make their points loud and clear, the fundamental ramifications of getting to neutral will likely have profound impacts on the S&P 500 and the PMs.
To that point, with Wall Street now aligned with our expectations for future Fed policy, investment banks have increased their rate hike estimates for the coming months.
Source: Bloomberg
Moreover, while Bank of America has been in the hawkish camp for some time, Chief Global Economist Ethan Harris wrote that
"The Fed has accepted that it’s behind the curve and will be emboldened by the resilience of the economy and the financial markets. The remaining question is whether it will be willing to impose serious pain on the economy to rein in inflation."
Furthermore, while he added that the Fed could engineer a growth recession next year that brings inflation down to 2.6% and modestly pushes up unemployment, he cautioned, "that is at the optimistic end of outcomes. The main risks are to the downside."
To that point, with U.S. Treasury yields already screaming at the Fed to tighten, inversions are popping up everywhere. And with the inflationary quagmire creating a lose-lose situation, the bond market highlights the anxiety that should be confronting the Fed.
Source: Investing.com
The red box above highlights how the U.S. 3-year, 5-year and 7-year Treasury yields ended the Mar. 31 session higher than the U.S. 10-year Treasury yield. As a result, those curves have inverted, which is the opposite of what the Fed wants.
Conversely, an upward sloping yield curve results in longer-dated maturities having higher interest rates. And this occurs because longer maturities have more duration risk, and therefore, investors should be compensated with higher yields.
However, with the three-year at ~2.51% and the 10-year at ~2.35%, the short-end of the curve is pricing in rampant rate hikes, while the medium to long-end of the curve is pricing in a material slowdown in growth.
As a result, long-end bond investors are correctly (likely) predicting that the Fed’s expeditious rate hike cycle will scar the U.S. economy. Thus, the lose-lose situation should have drastic implications for risk assets over the medium term.
For your reference, the 10-2 spread, at time of writing, was also close to inverting as well, with the U.S. 2-year Treasury yield ending the Mar. 31 session at ~2.33%. [The curve has since inverted].
However, please note that the ramifications don’t imply lower interest rates. In fact, the U.S. 10-Year Treasury yield often climbs when the Fed hikes interest rates. However, short-term interest rates may increase at a faster pace. To explain, I wrote on Jan. 19:
If the U.S. 10-Year Treasury yield declines in 2022, it will defy nearly 40 years of historical precedent.
The dark blue line above tracks the U.S. 10-Year Treasury yield, while the light blue line above tracks the U.S. Federal Funds Rate. If you analyze the latter's ascents starting in 1987, 1993, 1999, 2004 and 2017, you can see that the U.S. 10-Year Treasury yield always rallies when the Fed increases the U.S. Federal Funds Rate.
Moreover, the U.S. 10-Year Treasury yield doesn't usually peak until after the Fed finishes its rate hike cycles. For example, if you focus your attention on the light blue line's highs, notice how the U.S. 10-Year Treasury yield keeps rising until the Fed stops hiking? And with a rate hike in March likely a done deal and Fed officials projecting anywhere from two to four rate hikes in 2022, is this time really different?
To that point, with the U.S. 2-year Treasury yield rallying hard in 2022, history implies the Fed will play catch-up over the medium term.
The gold line above tracks the U.S. 2-year Treasury yield, while the blue line above tracks the U.S. federal funds rate. If you analyze the right side of the chart, you can see that the former has materially outperformed the latter.
However, Morgan Stanley found that the U.S. 2-year Treasury yield often leads the U.S. federal funds rate by 20 weeks. As such, with the former already moving sharply higher, a dovish pivot by the Fed would also defy nearly 40 years of historical precedent.
Likewise, with U.S. economic data still on solid ground, the Fed should remain on autopilot for the foreseeable future. For example, while it’s a lagging indicator, and therefore less relevant, the U.S. Bureau of Economic Analysis (BEA) revealed on Mar. 30 that U.S. real GDP “increased at an annual rate of 6.9 percent in the fourth quarter of 2021.” For context, U.S. real GDP was running at roughly 2% pre-COVID-19.
On top of that, the BEA revealed on Mar. 31 that the Personal Consumption Expenditures (PCE) Index (the Fed’s main inflation gauge) increased by a new 2022 high of 6.4% year-over-year (YoY). For context, the values at the top represent month-over-month (MoM) percentage changes, while the values at the bottom represent YoY percentage changes.
Source: BEA
Finally, Challenger, Gray, and Christmas released their jobs cuts data on Mar. 31. In a nutshell: it tallies how many employees were fired in March. And while cuts increased by 40.3% MoM, they still declined by 30% YoY. As a result, the data does little to cool the red-hot U.S. labor market. For context, the report also stated:
"In the first quarter of 2022, employers announced 55,696 cuts, down 62% from the 144,686 cuts announced through the same period in 2021. It is the lowest quarterly total since the third quarter of 2021, when 52,560 cuts were recorded.”
The bottom line? While some investors think the Fed can engineer a "soft landing," the data suggests otherwise. Moreover, with job openings, retail sales, and input and wage inflation tracking well ahead of their pre-pandemic trends, normalizing these metrics requires sharp declines.
Thus, reducing annualized inflation from ~8% to 2% requires much more demand destruction than reducing it from 4% to 2%. As a result, investors underestimate the medium-term economic slowdown that will likely unfold during the Fed’s accelerated rate hike cycle.
What To Watch For Next Week
With another full slate of U.S. economic data releases next week, the most important are as follows:
- Apr. 4: The Confidence Board Employment Trends Index (ETI)
With the Fed still fixated on employment, the ETI is a leading indicator of the health of the U.S. labor market.
- Apr. 5: The Institute for Supply Management (ISM) and S&P Global services PMIs.
As a leading indicator of service sector activity, data from the ISM and S&P Global provides a window into the performance of the businesses hardest hit by the pandemic. Moreover, with the service sector poised to grab the inflation baton from manufacturing, it will be interesting to see how these companies respond to the pricing pressures.
All in all, economic data releases impact the PMs because they impact monetary policy. Moreover, if we continue to see higher employment and inflation, the Fed should keep its foot on the hawkish accelerator. And if that occurs, the outcome is profoundly bearish for the PMs.