Should the Fed Comments Worry Investors? Also, My Pre-CPI Trading Plan. Week of February 13, 2023
What if the Fed Chairman speaks and no one listens? This was my thought this past week during an event at the Economic Club of Washington. During the question and answer period, Powell stated that the labor market is extraordinary strong and that the Fed will have to go even further in terms of rate increases. This comes, as we all know, following the strong jobs report.
Many commentators made statements that he was not hawkish enough, part of the rationale for why equities went higher that day.
Given the easing in financial conditions since October, with the rally in equities, and the fact that the jobs report was so strong, I too was in the camp that he should have come out much more hawkish. Instead of commenting on disinflation, why not take this opportunity to try and pull back on the building bullish sentiment? The problem is that as financial conditions ease, it creates more headwinds for the Fed and therefore requires a higher terminal rate, a longer duration at terminal, or both.
Other Fed officials were much more hawkish in tone. As the week progressed, it was obvious that investors were second guessing the bullish impulse on Tuesday. NY Fed President Williams stated that while the dot plots from December indicating a median of 5.1% is still a good guide, further rate increases are data dependent and that current levels of rates are “barely into restrictive” territory. While that doesn’t sound extremely hawkish, his comments that rates will have to remain restrictive for “several years” to ensure inflation moves back to 2% is much more hawkish than people realize. The markets have already started to price in some probability of cuts later this year, not in several years.
Other Fed officials, such as Atlanta Fed President Bostic, also indicated that terminal may have to be increased given the level of economic strength. Minneapolis Fed President Kashkari was very clear (in my opinion) when he stated this week, “There’s not yet much evidence, in my judgment, that the rate hikes that we’ve done so far are having much affect on the labor market. We need to bring the labor market into balance so that tells me we need to do more.”
Let’s think about what we have seen in conjunction with these comments. Not much evidence that rate hikes are having much of an affect is very strong statement by a Fed President! This also indicates to me that in his view, terminal could be quite a bit higher. Afterall, given the magnitude of rate hikes and the US economy generating 517,000 jobs last month, what will it take for the US economy to slow down? This is actually a bit worrisome. We all know that the labor data is a lagging indicator. What if the economy is actually slowing down substantially with jobs being the last domino to fall? I think this is what the bond market is pricing in, and hence why the inversion of the yield curve so pronounced.
So where does this leave us? In my opinion, if the jobs data remains somewhat strong, March and May are highly likely to both have 25bps, with now June is probable. If jobs data starts to indicate a significant weakening, especially services ex-housing, perhaps not June. But at this point, I think June is something to consider as a relatively high probability.
This naturally drives the next question, is the market wrong about Fed cuts later this year? I think the current data leads me to believe that yes, Fed cuts are unlikely this year. Why? If the Fed increases rates in June to reach terminal, what is a reasonable period of time to remain at that level? Taking aside any comments by Fed officials, as they have stated that terminal will be longer than in other periods, what does history indicate?
December 2018 last hike, first cut July 2019 - 7 months
June 2006 last hike, first cut September 2007 - 15 months
May 2000 last hike, first cut January 2001 - 8 months
March 1997 last hike, first cut September 1998 - 18 months
February 1995 last hike, first cut July 1995 - 5 months
December 1989 last hike, first cut July 1990 - 7 months
There are many more interest rate changes, but I wanted to show some history that the Fed usually does not cut rates from terminal immediately. There has to be some period of time for interest rates to remain restrictive to have the desired impact on the economy. The important factor to note is that the current economic environment is one of massive inflation when compared to these periods of time. That is to say, I do not believe someone deciding to use 1995, 2000 or even 1989 as a guide for duration at terminal is appropriate given the current level of inflation.
Why do I mention all of this? If the Fed raises rates in June, and they have already stated that terminal will remain in place for an “extended” period of time, what would that look like? What about slightly longer than the recent past, such as 10 months? That would be April 2024 for the first cut. You can work the calendar, what if it is closer to 12 months, 14 months and so on.
Now, the argument against this type of logic is that the economy will drop off a cliff necessitating the Fed to cut sooner than they currently are predicting. To be honest, that is the only way for the Fed to change their course of action, a massive drop-off in economic activity. Is it possible? Yes, of course, and we are seeing significant slowdown in manufacturing. However, the services sector still remains relatively healthy. I would need more data to increase the probability of such an outcome.
While it may be attractive to use some of the large, and relatively quick, changes in interest rates during the late 1970s and early 1980s, I would be cautious with that approach. The economy and inflationary forces were different during that era. The economy also went from 6% unemployment in 1979 to 10.8% in 1982, with inflation dropped substantially given the economic weakness. Subsequently the Fed did make the first cut in 1982 just 4 months after the last hike. Are we really thinking that unemployment will move in such a drastic extent? Possibly, but given the data surrounding the labor market, it is a very tough call.
Overall Concerns & Possible Scenarios
All of this brings me back to my overall concerns. If the labor market remains stubbornly resilient, the Fed may increase another 75-100bps and could stay at restrictive into 2024. This makes holding the 2 year relatively unattractive, making more sense (in my opinion) to keep cash in very short term paper and rolling into higher yields on the short end.
Longer term bonds may become more attractive. Why? The higher rates go and the longer interest rates remain in restrictive territory, the higher probability that inflation will be pulled back towards the 2% goal in addition to a higher probability of a recession, both bullish for longer-term bonds 10+ years.
Equities are not expecting either much higher yields, nor an extended period at terminal. Again, Fed cuts are being priced in by some market participants later this year. If this changes and investors push out rate cuts further into 2024, it would decrease the attractiveness of current multiples. The market is still at 18 forward P/E, not cheap at all.
All of this is, of course, predicated on the assumption that the labor market remains strong and inflation does not move towards 2% sharply. I can’t predict the future, no one can, but I am relying on history to help guide my decision making. Markets tend to oscillate from one extreme to another (optimism-pessimism), the money tends to made when too many people are crowded on one side of the extreme. It seems to me that too many people believe inflation will subside and the Fed will cut without a significant negative impact to the economy. Seems too optimistic for me.
Speaking of market views, the latest AAII Sentiment Survey (here) last week jumped to a one year high.
Excerpt from the report:
Bullish sentiment, expectations that stock prices will rise over the next six months, rose 7.6 percentage points to 37.5%. This is the highest level of optimism registered by the survey since December 30, 2021 (37.7%). It is also the first time in 58 weeks that bullish sentiment is at or above its historical average of 37.5%.
Bearish sentiment, expectations that stock prices will fall over the next six months, fell 9.6 percentage points to 25.0%. This is the lowest level of pessimism registered by the survey since November 11, 2021 (24.0%). Bearish sentiment is below its historical average of 31.0% for just the fourth time out of the past 64 weeks.
The bull-bear spread (bullish minus bearish sentiment) is 12.5%. This is the first positive reading in 45 weeks and the first above-average reading in 58 weeks.
I would never suggest to trade off contrarian information, but it is something to take into account. If sentiment has swung to bullish, even though the Fed will continue raising rates and earnings are indicating that margins have peaked, how much more upside is left? I would say the risk/reward calculation has tilted to the bearish side.
Earnings
Earnings seasons is not yet done. Through the end of last week, 69% of S&P 500 companies have reported earnings. 82% of these firms have issued negative guidance, above the 10 year average of 67% and 5 year average of 59%, according to FactSet. I won’t go into too much more on this topic, as it is similar to what I discussed last week - in short, this is not a great earnings season. Earnings are set to decline in Q1 and Q2, but analysts still believe a strong Q4 of earnings growth over 10% will come to fruition. I think that is very optimistic, given what we discussed above (higher Fed rate for longer). If the markets are right and the Fed will cut in the second half due to an economic slowdown, will analysts still believe that earnings will grow 10+% under such conditions? That seems very unlikely. All of this is to say, investors who are buying here have to believe that certain events will occur even though there is a small probability (in my opinion). I think it is far more likely that earnings for 2023 and Q4 will be worse than expected, I’ll take the under.
What to Watch This Week
Pretty obvious here, CPI is the main event. Market expects headline to come in at 0.5% m/m and core at 0.4% m/m. I won’t go into too much here, since I have been clear that I have no crystal ball. What I would say is that this number may come in hotter (ie. higher) than expected. Why? Well, there have been some anecdotal data points that lead me to think that at least some of the disinflationary forces have eased and are perhaps turning around. For example, The Manheim Index (here) increased 2.5% in January compared to December. It is still down 12.8% y/y, but this m/m increase may be one of several goods that has increased last month. I don’t have all of the inputs for the inflation calculation to know for sure, but I do know that falling car prices, along with energy, have been a positive for inflation peaking and decelerating. If this rebounds, even slightly, some of the narrative surrounding falling inflation comes into question.
Just a quick note on inflation, one thing to consider is that oil is a large factor for headline CPI. Don’t believe me? Below is the chart of WTI futures and the y/y inflation rate (monthly scale). What if oil turns up and breaks out of this current range? It won’t be great for CPI, although it is removed for core CPI. Still, the pressure on the Fed would not let-up under such a situation.
Retails sales on Wednesday. Expectations are for an increase of 0.9% for core and 1.7% headline. Remember that retail sales data is not inflation adjusted. The report last month at -1.1% core CPI was much worse than expected at -0.5%. This may be of interest and perhaps add to the confusion. What if this comes in again much weaker than expected, how does that fit with the strong labor market? Perhaps early warning signs that the underlying economy is weaker. What happens if this comes in much stronger than expected, concerns over the Fed will be increased. All of this should be tied together with the CPI report (was that stronger or weaker than expected)
Empire State Manufacturing also on Wednesday. Last month was a brutal number, coming in at -32.9 versus expectations of -8.7. Current expectations for this week are -18.4. We all know manufacturing is slowing down, understanding the extent may be of interest, even though the Fed has been clear that services is their primary focus.
Super Bowl Indicator
I have to include the most important consideration of all, the Super Bowl indicator! Of course I am kidding. For those that may not know, some people have looked at the year results in the market after the NFC wins vs after the AFC wins. If the NFC wins, bull markets have tended to occur, if the AFC wins it is more of a bear market. If you are a bull, I suppose one should cheer for the Eagles. This idea of a Super Bowl indicator goes back to Leonard Koppett a sportswriter back in the 1970s. From 1967-2015 it was correct 82% of the time, but since 2016 it has not been correct at all. I really should not say “correct”, I think it is more factual to say that the correlation was off. One more point, for whatever reason, games that are high scoring tend to have years that follow that are also higher in returns. For the record, I don’t put any weight to this type of “indicator”, but it is fun. Hopefully the game will be an interesting one as well!
Equities
This is the weekly chart of the S&P 500. It is very close to the 50% retracement from the peak to trough of last year. Technically speaking, it is somewhat neutral range. While it is above the 200 week and 50 week moving averages, and holding a recent uptrend, it would need to break above the approximate 4300 area to indicate more strength will be coming online. However, as I discussed above, with recent investor sentiment turning much more bullish/less bearish, not to mention all of the other discussion points (Fed, inflation etc…) this is a very hard area to go long with fresh capital. I would be leaning towards a short with additions to short positions in the roughly 4000 area, with the idea that a break of this region would result in a re-test of the 3790 area. However, CPI is this week, so slight change to this plan, outlined next.
This is the S&P 500 daily chart. As I noted last week, I wanted to see the S&P 500 move below the 4110 area. It did end Thursday and Friday quite weak. If CPI was not out next week I would be very inclined to open new short positions, with the idea of adding to it as it moved towards and through 4000. However, inflation could surprise sharply to the downside. I don’t like putting on positions like this at all. Long-time readers know that I am willing to keep a position on through an economic data point, but only if I built up a profitable position and closed some of my profits ahead of time. I think there is a decent probability that inflation will be hotter than expected, but I am not willing to gamble. So, I will wait and see what the inflation data is before entering any positions. If it is clearly hotter than expected, yes the market will move down, but I would most likely still open a new short positions as this could be the beginning of a move towards 3800. Of course, it depends on the move, if it is a silly gap down that is too far, I might try and pick away at building the position over the following days. Really tough to predict ahead of time, but those are some high level thoughts that I am considering.
Fixed Income
As I outlined above, I think there is a good probability that the Fed may hike at each of the next three meetings. As such, I am avoiding the two year for the time being and waiting to see how the 10-year reacts. If the 10-year moves up sharply with the CPI print, close to or above 3.90% I would start dipping my toe into the water with bullish positions.
One note regarding the auctions this past week, there was a lot of demand for the 10-year. The results from the auction were 2.66x bids vs 2.39x for the six month average. More important was that primary dealers took down only 5.36% of the bonds, this is the lowest amount on record! (chart below) Indirect buyers were the largest at 79.45%, this category indicates international investors. This supports my thesis that investors, both foreign and domestic, will continue to step-in to buy 10+ year US government debt this year. I am looking for pullbacks to enter at attractive levels. I think interest will rebound sharply at 3.90%+ (roughly) and above.
Sticking to fixed income for one more minute, this chart is of ICE BoFA BB High Yield Index (blue), the ICE BoFA CC High Yield Index (red) and the effective Fed funds rate (black). Why am I showing this chart? I think high yield credit has come in too much given where the Fed is, and the high probability that the Fed is not yet done raising rates.
I added vertical red lines to show what happened in the past when the Fed stopped increasing rates. You will note that those were relative peaks for BB credit. However, BB credit has tightened recently even though the Fed is not yet done. The higher rates go and the longer the Fed stays at terminal, the higher the probability of an economic slowdown. BB credit, and worse in credit quality, gets hit hard during economic slowdowns.
I also added the CC index to show that just because the Fed stops does not always results in a good buying opportunity for this level of credit quality. In a lot of the cases, credit at CC blew out massively even after the Fed stopped raising rates. Of course, this all depends on the economy, but I would not be buying BB and certainly not CC at current levels. I might actually look to put on a trade that would profit from a widening of CC levels.
Oil has remained in this range for several months. In the past, it has been pretty consistent once it breaks through a range or key support level. The area between $82.50-$83 is quite important. As indicated by the horizontal black line, the market has bounced around this area, using it as both support and resistance. It has been resistance lately. I would be willing to put on a bullish trade and adding to it if it broke through this area to the upside. News surrounding Russia and oil exports is bullish. I don’t think OPEC will make any changes over the next few weeks. China re-opening is also a bullish impulse. It would be a pretty good risk/reward, with an initial target of $92-$94 and stops in the high $77-$79 ( all depending on entry levels and market activity at that time). Again, flat for now but waiting to see if the market moves higher.
Gold
I closed the rest of my gold position at the end of last week. I discussed last week the most recent gold trade. For now, I will wait and see how the markets react to the data this week. We could be in for a period of sideways consolidation.
Thanks for reading!
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