Was Thursday’s sharp sharemarket slide (and late bond rally) an acknowledgement by financial markets that they had overreached in urging central banks to boost rates as hard and fast as possible?
That “Please sir, I want some more!” moment in Charles Dickens’ great novel Oliver Twist stands as a metaphor for the way markets have demanded higher rates to control inflation, then higher rates again amid worries about central banks falling behind the curve.
And when the Bank of England, The Swiss National Bank and the central banks of Hungary and Brazil (its 11th rate rise) followed suit with rises of their own – mostly 0.25%, but the gnomes of Zurich went for a 0.50% whack – it proved all too much and shares sold off heavily.
Judging by the extent of the subsequent slump, when investors, traders, analysts and economists got what they’d ordered off the menu, they didn’t like how it tasted. Now are all worried that they have been fed too quickly by central banks, that the quick surge in rates could be too much too soon and that a recession looms. Their eyes, to tie up the food metaphor, may have been bigger than their stomachs, leaving them with a nasty dose of indigestion.
Here in Australia though, Oliver Twist is still the go as the reaction to May’s very strong (record-breaking) labour market report which startled everyone and brought out a new line of thinking – ‘Rate rise to zoom’ rather than ‘loom’.
And yet, Thursday’s selloff in Europe and the US should make the hawks in Australia pause for a while.
But while Oliver Twist was the required reading up till the Fed’s 0.75% blast last week, with the promise of more to come, new authors are being sought for inspiration.
Some have recalled an old adage from central banking that ‘you are just one rate rise away from a recession’. Short, quippy and to the point – the only problem being that you only find out how close you were to a recession after the event.
Thursday’s slide tells us many in the markets worry that while the Fed isn’t there yet, it could be arriving much more quickly than they thought.
Economists at Moody’s think the Fed “could be faced with a Hobson’s choice: push the economy into a mild recession, similar to our scenario, to tame inflation, or wait and cause a more significant recession, since a stagflation scenario is possible next year if the Fed isn’t aggressive enough…the fed has killed expansions before”.
Two points support these new worries (besides continuing inflation): the surprise dip in US retail sales in May which shows consumers are getting jumpy and the quick slide in US Treasury yields.
Thursday and Friday saw a small rally in US bonds – gone was the continual surge to a multi-year high of 3.48% a day on Thursday, the yield was around 3.20% in early Asian trading Friday and looking to go lower as prudent and worried investors look for safe haven cover in the event of a slowdown in the US and other economies.
Up till Thursday’s close the S&P 500 was down 6%, while the Nasdaq had fallen 6.1%. The blue-chip Dow was off by about 4.7% and closing in on its 11th losing week of the last 12.
The S&P 500 and Nasdaq Composite were down around 24% and 34% from their all-time highs. The Dow ended 19% below its January 5 all-time intraday high.
Normally with falls of this large, investors would be excitedly about ‘buying the dip’ – they are, but also being warned about bear traps’ and ‘bear market rallies’.
The ‘dot plot” interest rate forecasts from the Fed tells is when Fed members think the Federal Funds Rate (FFR) will be in the future. The latest, released this week showed it ending 2022 at 3.4%. That was an upward revision of 1.5 percentage points from the March estimate. The Open Market Committee then sees the rate rising to 3.8% in 2023, a full percentage point higher than what was expected in March.
But the end of 2022 forecast would need the current range of 1.50% to 1.75% to be doubled in the next six months. That would have been a major shock had not the bank softened up markets with its Monday whispering to the Wall Street Journal and then other outlets and followed through with its 0.75% boost to the FFR.
And the key forecast for the most important data point – inflation?
The inflation projection as gauged by personal consumption expenditures (so-called PCE inflation) was lifted to 5.2% this year from 4.3%, though core inflation, which excludes rapidly rising food and energy costs, is indicated at 4.3%, up just 0.2 percentage points from the previous projection.
Core PCE inflation (the measure the Fed loves) ran at 4.9% in April, so the projections released by the Fed on Wednesday anticipate an easing of price pressures in coming months as does the headline rate falling back to 5.2% from the current 6.3% rate in April. That required a second look from a lot of analysts.
And ironically, apart from soaring inflation (which is supply side driven thanks to bottlenecks in logistics, shortages of products and the impact of the war in Ukraine on energy prices, especially petrol) the Fed’s post meeting statement painted a rosy picture of the US economy.
“Overall economic activity appears to have picked up after edging down in the first quarter,” the statement said (GDP dipped an annual 1.5% in the first quarter)
“Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.”
But before the Fed’s end of meeting statement, they had time to look at an early signal from the May retail sales data.
In fact it was a warning sign of trouble for the broader economy with a surprise 0.3% fall in US retail sales last month. As well April’s rise of 0.9% was trimmed to 0.7% as economists said the data showed clear sign higher petrol prices were impacting spending patterns.
Economists had been looking for a 0.2% rise but some analysts had been forecasting a fall – as high as 1.1%.
Retail sales are likely to remain sluggish as the Federal Reserve aggressively tightens monetary policy to cool demand and bring down inflation back to its 2% target, with more to come, very likely to further depress consumer confidence (already at recession levels in some US surveys) and spending.
Economists now saying American consumers are dipping into savings to maintain spending, but starting to ration their expenditures as petrol prices rose to and above $US5 a gallon this week. Retail sales are the best indicator of consumption patterns in the economy and what consumers are doing.
All advanced economies depend heavily on consumers and at the moment consumers are starting to pull in their horns and trim spending while using some savings. That can only go on for a bit longer before wallets snap shut and credit cards put away.
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Looking at future Fed decisions, Moody’s economists think the 0.75% rise was a one-off.
Our “new forecast will be for a 50-basis point rate hike at the July and September meetings. This will be followed by a 25- basis point rate hike at the November and December meetings.
“This is a cumulative 150 basis points in rate hikes by the end of the year,” the wrote in their weekly note on Friday.
“The Fed will then raise rates by 25 basis points at each of the first two meetings in 2023, putting the terminal fed funds rate at 3.5%, less than the median projection from the latest Summary of Economic Projections.” (the forecasts released at last week’s meeting.
And finally the Moody’s team made a very good point about all these recession calls/warnings, writing on Friday in their weekly note “it is difficult to declare that the economy is in a recession when the unemployment rate is around 3.5% and trend job growth is strong.”
After the May labour force surge in Australia, the same point is valid here.
To really have a recession, jobs growth has to be reversed, unemployment has to start rising consistently and growth in the size of the labour market has to turn down.
The strong May data will see a rate rise next month and in August from the RBA – the size of the latter will be the important one because it will have the June quarter CPI data to base their decision on.
