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US Treasury Actives Curve
Universal Value Advisors
Equity markets were mostly higher on the week, bouncing from clearly oversold conditions. But all the major indexes are still off their highs, by more than 5% for the Dow and S&P 500, more than 10% for the tech heavy Nasdaq, and nearly 15% for the more representative Russell 2000. Nevertheless, while the equity markets have been rising, the bond markets were going in the opposite direction as an increasingly hawkish Fed drove yields up (more so on the short-end of the yield curve) and prices down. The yield on the 10-Yr. T-Note, off of which mortgage rates are priced, rose from 2.15% on March 18 to 2.49% at the close of business on Friday (March 25), a 34 basis point (bps) rise (i.e., +0.34 percentage points). At the turn of the year, that yield was 1.50%, so nearly a 100 bps rise.
The 2-Yr. T-Note yield closed at 2.28% on Friday, up from 1.94% a week earlier and 0.73% on the last trading day last year, up a whopping 155 bps. The 10-2 spread (the difference between the 10-Yr. and 2-Yr. T-Note yields) is now only 20 bps; when this inverts (i.e., the 2-Yr. yield becomes higher than the 10-Yr.), historically, this has nearly always presaged a recession.
The 5-Yr. T-Note also rose dramatically last week (2.39% to 2.58%) and it is inverted to the 10-Yr. T-Note, which, as noted above, closed at 2.49% on March 25. And, if you look at the shape of the yield curve (as shown on the chart at the top of this blog), it is flat as a pancake, another indicator of an oncoming recession.
Most of the rise in yields is due to continuing hawkish talk from the current Federal Reserve Governors. There are now five such governors that support a 50 bps rate hike at the next (May) Fed meeting. As a result, the fixed-income markets have priced in a 70% chance of such action.
Is This Time Different? Answer: Yes
It is very risky to say that “this time is different,” because it almost never is. But, as we show below, there are very big differences between this Fed tightening cycle and the one in the 1980s (the Volcker era) when inflation was as big of a problem as it is today. Before we show how it is different, let’s first talk about the nature of this inflation.
The emerging data tell us that the U.S. and developed world economies are slowing. The Fed, now apparently politicized, must look like it is fighting inflation; thus, the hawkish talk. Fed Chair Powell insists that the economy is strong and has characterized former Fed Chair Paul Volcker’s hawkish policies of the 1980s as heroic acts.
The following chart, however, shows the relationship between inflation (CPI) and the price of oil. Note the strong correlation between the two. In the 70s and 80s, it was OPEC and the price of oil that was responsible for much of the inflation. Look at the right-hand side for today’s culprit. And back in the 80s, it was falling oil as much as the Fed, that quelled inflation.
WTI Crude & CPI YOY (Factor of 10) Index
Universal Value Advisors
Question: Can the Fed fight inflation by lowering the price of oil? Answer: No. It can only lower inflation by raising interest rates and reducing demand. We note, however, that the economy is already slowing. The latest GDPNow forecast from the Fed’s own Atlanta Reserve Bank is now at 0.9% for Q2 (as of March 24). We note there is not much time left in the quarter for any significant increase in that forecast. And let’s not forget that two-thirds of Q1 was pre-Russia/Ukraine (R/U).
At its March meeting, the latest data that the Fed had was February, i.e., pre-R/U. It appears to us that Chair Powell’s view of a “strong economy” and a “tight labor market” is based on both the pre-R/U data and some wishful (fairytale) thinking, or, more likely political pressure. The fact is, the Fed, at its March meeting, lowered its 2022 GDP forecast from a ridiculous 4.0% to a still unmake-able 2.8% (see our Forbes blog “A Hawkish Fed With A Fairytale Forecast”).
So, What’s Different?
There is a very real difference between today’s Fed and that of the Paul Volcker era. That difference is that today’s Fed pre-announces its intentions. Before Ben Bernanke was Fed Chair (2006-2014), the Fed never pre-announced its actions. The dot-plots (the forecasts for Fed Funds of the FOMC members published quarterly) have now become the Bible of the bond market despite a poor track record (the median dot has a 37% correlation with the actual resulting Fed Funds rate according to Economist David Rosenberg). These began in 2012 in the Bernanke era. When Alan Greenspan was Fed Chair (1987-2006), there was no post-meeting statement or press conference. The markets didn’t find out what the Fed decided until the Fed acted. At that time, market gurus tried to gauge what the Fed was up to by non-market factors, for example, the thickness of then Chair Greenspan’s briefcase (we kid you not!).
Today’s Fed has just stopped QE (Quantitative Easing, i.e., adding bonds to its portfolio) and has raised the Fed Funds rate by just 25 bps; so, they have just begun the tightening process. But, unlike in the Volcker era, markets, via the yield curve, have already fully priced-in the complete tightening cycle via the poorly correlated dot-plot. It’s as if the Fed is already where the dot-plot forecast it will be in 2024! That is one to two years earlier than what occurred in the Volcker era.
So, markets are significantly ahead of the Fed (i.e., have fully tightened for them) and as a result, we believe, an economic slowdown will occur much more quickly than in the past. While history says it is a year or more from the beginning of a Fed tightening cycle to a recession, we think this time the recession will occur much earlier, perhaps in six months or less.
Feeling the Pinch at the Pump
- The price of gasoline. The chart says it all. Note that gas prices were already on the rise pre-R/U. From under $2.00/gallon in 2020, they were about $3.50/gallon pre-R/U. On Monday, March 21, less than a month after the invasion, the average price of regular was nearly $1/gallon higher ($4.34). And, if you live in California, it is even higher than that ($5.84/gallon in L.A.). (Maybe even higher today as those prices are a week old as we write.)
- Farm prices are up 24% in the U.S. Y/Y (and farm income by 44%). In the free market, this will cause more planting, even with rising costs and a scarcity of fertilizer. The resulting food price spike is negatively impacting the American household budget.
- Housing: With the rise in interest rates, we are already seeing a negative impact in the housing market. New Home Sales were down -6.2% Y/Y in February (before R/U and the meteoric rise in rates in the last two weeks), and Pending Home Sales fell -4.1% M/M in February and 5.4% Y/Y (again, pre-R/U). And, look at the chart on mortgage refis. (This is where a lot of liquidity is made available to U.S. households).
MBA US Refinancing Index SWDA
Universal Value Advisors
- The latest Mortgage Bankers’ Association weekly mortgage approval index tanked -8.1% and is now down -39% Y/Y. That’s because mortgage rates are now above 4.5% (they were under 3% a year ago). Once again, because of the Fed’s pre-announcement policy, the markets have done in a few weeks what used to take many months, months in which the Fed could, if need be, alter policy.
- European economies appear to be experiencing similar characteristics as in the U.S. as far as recession timing is concerned. In Germany, Italy, Spain, and the U.K., the consumer confidence surveys are all tanking and their food and energy price increases appear to be similar to what is occurring in the U.S. And this data is all pre-R/U.
- Real Disposable Personal Income is now falling (see chart).
Real Disposable Personal Income
U.S. Bureau of Economic Analysis
- The jobs picture is now starting to chill in the U.S. The chart shows softness in both the Conference Board’s latest measure of job availability and that of the National Federation of Independent Businesses.
NFIB Jobs hard to Fill & Conference Board Net Jobs Plentiful
Refinitiv, Capital Economics
The economy has suffered the following shocks over the past two years:
- Pandemic: Government shutting down businesses.
- Fiscal: Free money in 2020 and 2021; now none. This is known as “fiscal drag” because households don’t have that extra free money to spend.
- Interest rate shock: In less than 30 days, markets priced in an entire tightening cycle. The flat yield curve is a reliable historical barometer of an approaching recession.
- Food and energy shock: There are going to be ongoing repercussions of the R/U invasion.
- And the largest shock: Unlike past experiences with high inflation, today’s fixed-income markets, in a matter of a few days, have priced in an entire one to two-year Fed tightening cycle, and into an economy already shocked and slowing. The interest rate shock will accelerate the economic slowdown and cause what appears to us to be an inevitable recession, and much sooner than markets currently anticipate. The question is: Will the Fed recognize this early and reverse its hawkishness?
It is our view that the current Fed’s pre-announcement policy is deeply flawed and, in today’s economy, will only add to recessionary pressures. The current overdone run-up in interest rates by the markets is slowing already anemic growth and is based on deeply flawed Fed dot-plot forecasts. Those most recent dot-plot forecasts, we think, were meant more as a show of resolve than as predictors. According to Rosenberg Research, the Fed’s track record on GDP is only 17% accurate while the median dot-plot accuracy is a lowly 37%.
Rather, we think the Fed should discuss and forecast only their possible near-term actions (say up to the next meeting). While the Fed insists that every decision of theirs is data dependent, such restraint on their forecasts actually would allow market forces, not a hypothetical dot-plot, to determine the height and shape of the yield curve.
(Joshua Barone contributed to this blog)