The stock market is facing a poisonous double cocktail: signs of slowing economic growth and central banks trying to contain inflation which, unlike the pandemic, has not abated significantly.
The sharp pressure from those few pressures came into sharp focus last week after a much worse-than-expected reading of retail inflation from August, and beyond.
(Ticker: FDX) stunned the financial world ahead of Friday’s session with disappointing results and withdrawing its earnings guidance due to signs that global business is slowing.
The big shipper’s warning sign was followed by similar weakness in another economically sensitive sector, as shown by a sharp drop in
SPDR Select Subject Sector
exchange traded fund (XLB). (See the Trader column for the gory details.)
As equities slid on the FedEx news on Friday, the bond market was the proverbial dog that didn’t bark. Unlike during previous stock rallies, Treasury securities failed to receive a bid from investors seeking refuge in the sell-off storm. Bonds are clearly reeling from the impact of another big 75-basis interest rate hike at the end of Wednesday’s two-day Federal Open Market Committee meeting. (A basis point is 1/100th of a percentage point.)
To be sure, Treasury yields were much higher during the week, having jumped following Tuesday’s consumer price index report. In particular, the yield on the two-year key notes was up 30 basis points, to 3.871% on Friday, the highest level since October 31, 2007.
As expected, the sharp decline in retail gasoline prices reduced the overall monthly core CPI gain to 0.1%. But “core CPI”, which excludes food and energy costs, rose at a clip of 0.6% – twice the forecast increase.
The unexpected deterioration in price trends has prompted some calls for a whopping 100-basis-point hike in the federal funds target rate next week. By Friday, the Fed futures market was placing an 82% probability of a 75-basis move, according to the CME FedWatch website, matching the prediction in a Wall Street Journal story earlier in the week. That still left an 18% chance of a full percentage point jump.
Despite the CPI increase more than expected, some complaints were heard that the Federal Reserve is doing too much tightening. According to the speculation made by some critics—mainly those who previously feasted on free money from the central bank—the central bank is responding to a weakening indicator by paying attention to inflation.
That notion comes back from John Ryding and Conrad DeQuadros, economic consultants at Brean Capital, who argued last year that inflation would not be temporary, as the Fed insisted at the time. They argue that monetary policy is still far from restrictive, even though inflation is on the rise.
If the Fed raises the fed funds target by 75 basis points next week, the key policy rate would remain lower in real terms than at any time from 1954 to 2021, they write in a client note. That shows the wide gap between the 8.3% annual CPI rise and the current fed funds rate of 2.25% to 2.5%, and a likely new range of 3% to 3.25% after this week’s likely rate hike. In other words, we still have money for nothing and—with apologies to Dire Straits—free beeps (to use market slang for base points).
Since what the Federal Open Market Committee will do is almost certain, the main focus will be on its new Summary of Economic Projections and, as usual, Federal Reserve Chairman Jerome Powell’s post-meeting press conference.
This confab will produce the first new set of economic projections since the FOMC meeting in June, which continued to reflect an optimistic outlook.
In that report, inflation was seen falling toward the 2% neighborhood—the Fed’s long-term target for the personal consumption deflator—although unemployment was only expected to approach its most recent low of 3.7%, and it was projected to economic growth. come in around or slightly below its long-term trend. In the 1980s, such benign forecasts were said to be produced by a government economist named Rosy Scenario.
The FOMC’s outlook (don’t call it a forecast) for fed funds could be taken more seriously, since the target rate is controlled by the panel. The projection for the end of this year will certainly be raised from the 3.4% in June.
As of Friday, December fed funds futures were split between 4% to 4.25% and a year-end range of 4.25% to 4.5%. That would suggest another 75 point hike at the November 1-2 FOMC meeting, followed by a 25 or 50 point hike in December.
Perhaps more telling are projections for 2023 and beyond. The futures market no longer looks for the Fed to cut rates next year, an expectation reflected in the bond market’s lack of reaction to the FedEx earnings news. Futures currently show a peak range of 4.25% to 4.5%, to be hit by February and to remain until July. That’s about twice the current target range.
In a widely read LinkedIn post last week, Bridgewater Associates founder Ray Dalio wrote that a 4.5% fed funds rate could mean a 20% drop in equity prices. But for the anti-inflation target of Jerome Powell & Co.
economists suggest that a rate closer to 5% may be needed.
None of them are admirable for the bulls.
Write to Randall W. Forsyth at firstname.lastname@example.org