Pascale’s Perspective

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Is the Fed delivering the crushing demand shock that will stabilize prices and allow them to pause on the rate increases? The answers are “things are easing” for goods, and “not yet” for services. Last week’s PCE release indicated “core” inflation rose 0.3% monthly and 4.9% annually. Last month was 0% monthly and 4.7% annually. Markets reacted with a bond selloff, sending the 10 Year Treasury up to 3.83%. Spending on goods dropped 0.5% but spending on services jumped 0.8%. This could be seen as a “demand rotation” that will eventually result in an overall economic slowdown. This week’s reports continued the narrative: weak ISM manufacturing index: 50.9% (near contraction territory), construction spending down 0.7% month to month, and today’s ISM services index up to 56.7%.

Today’s ADP report showed businesses added 208,000 jobs in September- surpassing the Dow’s estimation of 200,000 jobs. Note that goods producing industries (manufacturing, mining, natural resources) were down 29,000, but services (trade, transportation, utilities, business services) saw a gain of 147,000. The job increases aren’t necessarily inflationary, it’s the mismatch between open jobs and labor participation. That metric is easing – recent months saw a 2 to 1 ratio of open jobs for each unemployed American. That has dropped to 1.67 in September with increased labor participation and a drop in resignations. With the Fed having raised rates by 3.00% since March, it’s important to point out that the effects may be “lagging indicators.” There’s a case to be made for pausing rate increases to actually quantify the effects without going too far. From recent Fed speeches over the past few weeks, that isn’t happening. A 75 basis point increase in early November is basically a given, with speculation centering on the December and January meetings as slowing (25-50 basis points) or pausing. Stay tuned…

By David R. Pascale, Jr. , Senior Vice President at George Smith Partners

Bond yields spiked over the past week as global financial assets sold off. Stock markets here re-tested the June 2022 lows and the 10 Year Treasury jumped from 3.50% (at the time of the Fed meeting) up to 4.01% yesterday. A 4.0% 10 Year Treasury was last seen in mid-2008. The fear trade was in full effect as markets are getting the message that the “Fed Put” is off the table – the central bank will allow unemployment, market volatility, and higher unemployment in order to control rising prices.

The announcement of large tax cuts in Britain created market turmoil as the already weakened British pound plummeted in value, rating agencies issued harsh downgrades and Gilt bond yields spiked. The Bank of England surprisingly intervened strongly, buying up as much government debt as necessary to restore stability. The BOE statement: “Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability. This would lead to an unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy.” Bond markets worldwide rallied as one of the “Big 7” central banks, who often discuss policy covertly or overtly during crises, stepped up in a crisis. Maybe this sets a new higher standard for monetary or fiscal intervention (“In case of financial meltdown, please break glass, otherwise you’re on your own”). The 10 Year Treasury dropped from 4.01% to 3.69% today, the biggest drop since 2020. Interestingly, the 10 Year British Gilt bond yield spiked to 4.5% before dropping to 4.05% today, which is very close to where the US 10 Year started the day. This week’s big data release is Friday’s PCE. The monthly core rate will be very closely watched, and its elements parsed. Stay tuned…

By David R. Pascale, Jr. , Senior Vice President at George Smith Partners

Today’s 75 basis point increase in the Fed Funds rate was well telegraphed and the vote was unanimous. Today’s increase to a target rate of 3.00% – 3.25%, the highest since 2008, is the beginning of a period of restrictive monetary policy. The previous rate of 2.25% – 2.50% was considered the “neutral” rate, neither accommodative nor restrictive. The increase wasn’t really news, but the projections for “how much higher?” and “how long?” are significant. The terminal rate (peak) was anticipated to be about 3.8% in June. Today, the Fed dot plot and commentary put that rate at 4.6%. Futures markets are predicting another 75 basis point increase at the next meeting (November 2), with another 50 bps expected in December. That will take it to about 4.3%, on its way to the 4.6% terminal rate. The Fed “dot plot” predictions indicate the rate will remain there throughout 2023 with rate cuts starting in 2024. Compare that to June: a 3.25% year-end rate followed by a few more increases to 3.8% and rate cuts starting in the 2^nd half of 2023.

In his remarks, Fed Chair Powell reiterated his concern that employment metrics are “out of balance” and contributing to inflation in an unprecedented manner. See the chart below, job openings are twice the amount of unemployed people. That ratio used to be about 1:2 pre-pandemic. Labor participation has taken a hit due to unprecedented social and behavioral changes in recent years. It will be difficult to tame inflation as long as this imbalance persists. Therefore, Powell is watching quits and upticks in labor participation very closely.

The Fed is abandoning its dual mandate, price stability, and full employment, in order to bring inflation under control. Jobs will be sacrificed on the altar of price stability. Quotes from today: “The chances of a soft landing are likely to diminish to the extent that policy needs to be more restrictive, or restrictive for longer,” and if there was any doubt, “Price stability is the responsibility of the Fed and serves as the bedrock of our economy… We think a failure to restore price stability would mean far greater pain (than higher unemployment)”. Rate increases are quite effective at driving down demand for big-ticket items (houses, cars, etc). The increases so far have put the 30-year fixed rate mortgage at 6.25% (January 1 it was 3.0%) and has contributed to the biggest drop in home sales since 2015. There are other signs that the economy is slowing down – possible “leading indicators” like FedEx’s dramatic drop in volume and dire outlook for next year, California’s drop in projected tax revenues, pauses in hiring from the once soaring tech sector, etc. 30-Day term SOFR is 3.08%, the 10 Year Treasury is at 3.56%, the highest since October 2008. Stay tuned…

By David R. Pascale, Jr. , Senior Vice President at George Smith Partners

Yesterday’s CPI report was expected to show moderating price increases led by falling energy prices. Instead, the 0.6% monthly increase in core prices took markets by surprise, with stock markets dropping dramatically, erasing recent rallies – which were largely based on softening inflation hopes. Price increases are broad-based – shelter costs, health care, restaurants, and travel are all experiencing high demand from a consumer base that has experienced a 6.7% increase in wages over the past year (that figure is the highest in 40 years). The narrative is changing: falling gas prices, improving supply chains, and lower shipping costs were expected to lead to lower prices. That’s not happening as relentless consumer demand keeps driving prices up. This is hardening expectations that the Fed will have to increase rates higher and longer to accomplish its desire to stifle demand. This was the last major piece of data before next week’s Fed meeting. The futures market is now pricing a 25% chance of a 100 basis point increase in the Fed Funds rate at next week’s meeting. The 10-Year Treasury spiked from 3.29% to as high as 3.46% yesterday, closing at 3.41% today. Piling on: A possible Railroad strike could massively disrupt supply chains as negotiations drag on towards a Friday deadline. Stay tuned…

By David R. Pascale, Jr. , Senior Vice President at George Smith Partners

This last week shows how data-dependent markets have become, especially with a highly anticipated Fed meeting approaching. Last Friday’s August jobs report showed a softening in labor demand. This suggested that the labor supply/demand pressures could be slightly easing. Treasuries rallied on Friday in hopes the Fed wouldn’t have to increase rates as much as previously thought. The jury is still out on where the Fed’s “terminal rate” will end up in early/mid-2023. However, Tuesday’s hotter than expected economic reports from the services sector spooked markets as inflationary. The 10 Year yield spiked over 15 basis points up to 3.36% a recent high. Then, today’s Fed Beige Book survey indicated slowing growth and less inflationary pressures. This spurred another rally in treasuries – down to 3.27%. Fed President Lael Brainerd’s comments today were generally hawkish as per the Fed’s recent united message. She used the phrase “for some time” as she gauged how long rates would need to be elevated. But she also provided some hope as she acknowledged the risks of keeping rates high for too long. She indicated that the aggressive stance could “create risks associated with overtightening.” Interestingly, she also implied that the rapid increase in prices over the last 18 months has inflated margins for sellers of goods. She noted that the price consumers pay for cars has risen much faster in the last year than the price dealers pay wholesale. This implies there may be some room for prices to drop in certain sectors.  Futures markets are pricing a 75 bp increase in the September 20-21 meeting. Stay tuned….

By David R. Pascale, Jr. , Senior Vice President at George Smith Partners

Stock and bond markets have sold off every day since Fed Chair Powell’s remarks last Friday at the Jackson Hole Economic Policy Symposium. His eight-minute speech mentioned the word inflation over 40 times. Any hopes of the famous, or infamous, “Fed put” being invoked in this cycle were wiped out as he said, “While higher interest rates…will bring down inflation, they will also bring some pain.” He also set markets straight as to the “schedule” of upcoming rate hikes.

The 75 basis point increase in September is now at 70% likelihood in the futures markets.   Markets expect increases of another 75 basis points total at the November/December meetings.   That would bring the Fed Funds target rate up to 3.75% – 4.25% to open in 2023. That is right where several Fed officials are pegging the “Terminal Rate” – the highest rate hike in this cycle. Markets were assuming that the Fed would then “pivot” relatively quickly with rate cuts in response to a slowing economy. But Powell‘s comment on Friday sought to tamp down those expectations: “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.” NY Fed President John Williams chimed in on Tuesday in a live interview: “We’re going to…have restrictive policy for some time…This is not something we’re going to do for a very short period.” He chimed in on the Terminal Rate speculation, saying that “we do need to get real interest rates…above zero.”    “Real interest rate” = the nominal interest rate minus inflation.  Positive real interest rates would mean setting the Fed Funds rate above the inflation rate. Core PCE is at 4.6% today. Assuming inflation drops to about 4.0% early next year, Williams is estimating the terminal rate at about 4.00% – 4.25%. All of this “forward guidance” has therefore upended market expectations of the pace of rate cuts in 2023. This is causing the 10 Year Treasury to increase as it closed today at 3.21%. Of course, everything is data dependent – but officials are stressing that a change in this stated policy will require a sustained and unambiguous downward trend, not just “a few reports.” Stay tuned…

By David R. Pascale, Jr. , Senior Vice President at George Smith Partners

The 10-Year Treasury is up to 3.10%, rising 32 basis points in the last 10 days. Markets are concerned that Friday’s speech by Fed Chair Powell will lay out a more hawkish path than markets expected earlier this month. He is expected to say that a recession will not stop the fight against inflation. The usual assumption is that the Fed will react to a slowing economy by swiftly lowering rates. This is known as the famous “Fed put.” The fear is that Powell may remove that put this Friday. The futures market is now predicting a 60% chance of a 75 basis point increase at the September 21^st meeting. Remember, markets have whipsawed back and forth between predicting 50 basis points and 75 basis points multiple times in the last month. The Fed’s recent increases are hammering rate-sensitive sectors, such as housing. The National Board of Realtors said “We are in a housing recession,” as July saw the biggest monthly decline in prices since 2011.  Tightening conditions are also hitting employers, both local and corporate. Large companies, like Oracle, Walmart, Apple, and Ford, have announced layoffs.

According to the latest PwC survey of US executives and board members, 52% of companies are instituting hiring freezes. Weekly jobless claims rose to an 8 month high this week. The Fed has made it clear that they are abandoning the long-standing “dual mandate” of full employment and price stability (sometimes referred to as the “2 and 4” rule – targeting a 2% inflation rate and a 4% unemployment rate). They now realize that the inflation-curbing “demand shock” that is being implemented must include a cooler job market in order to calm price pressures. Higher unemployment will be seen as “collateral damage” in the pursuit of wage and price stability. Yet, some sectors of the job market are still “hot” with job shortages. Prices continue to rise (albeit at a slower pace). September will see the Fed increase rates into restrictive territory above the “neutral rate” it’s at today (2.50-2.75%).  Now the focus is “what is the terminal rate?” i.e., the peak rate. Powell may address that this week. The futures markets are pricing the peak at about 4.00% – 4.25%, occurring in the second quarter of 2023. The 2 Year Treasury (most sensitive to anticipated Fed increases) is at 3.39%, a 10 week high. This Friday is action-packed with the release of the July PCE index (the Fed’s preferred inflation gauge). The data will be intensely parsed for (hopeful) signs that inflation has peaked and is slowing. After that early morning release, the Powell speech. Stay tuned….

By David R. Pascale, Jr. , Senior Vice President at George Smith Partners

Yesterday’s release of Fed minutes from the July 27^th policy meeting reiterated the central bank’s determination to “promote price stability.” Markets were looking for clues regarding the path of the Fed Funds rate over the course of the next few meetings. Whereas the Fed embraced “forward guidance” during the beginning of Fed Chair Powell’s term (circa 2018-2020). Yesterday’s Fed is increasingly data-dependent. The minutes indicate that Fed officials feel that hiking the fed funds rate last month to 2.25% – 2.50% puts the rate at the “neutral” level (neither accommodative nor restrictive). Many participants feel that a “restrictive” level will be appropriate which means more hikes to come (Hawkish).

Also in the minutes: “as the stance of monetary policy tightened further, it likely would become appropriate at some point to slow the pace of policy rate increases while assessing the effects of cumulative policy adjustments on economic activity and inflation” (Dovish). The futures market is now predicting a 66% chance of a 50 basis point hike at the September meeting. There is no meeting this month. The Fed also is concerned about its public image: “a significant risk…is that elevated inflation could become entrenched if the public began to question the Committee’s resolve to adjust the stance of policy sufficiently.” This speaks to consumer and employee behavior and expectations being a critical component of wage and price stability. Interestingly, yesterday’s derivatives markets predict that inflation will be approximately 3.3% over the next 12 months. Interestingly, the market prediction last August was also 3.3%. How did that turn out? The 10 Year Treasury has traded in a tight range this week between 2.77% and 2.90%, settling yesterday at 2.87%. Stay tuned…

By David R. Pascale, Jr. , Senior Vice President at George Smith Partners

The July CPI report indicated an 8.5% annual inflation rate, and flat for monthly inflation rate. Gasoline led the decline with a 7.7% drop monthly, but that was offset by increases in food (1.1%) and shelter (0.5%). These numbers were softer than estimates. Markets rallied accordingly on hopes that inflation had peaked. Markets also cheered Monday’s inflation expectations survey from the NY Fed: the median expectation of inflation over the next 3 years dropped to 3.2%. Down from 3.6% last month, and 3.9% in May. That is critical as consumers’ expectations of rising prices can become a self-fulfilling prophecy. The 10-Year Treasury dropped to 2.70% this morning and then settled back up to about 2.78%. Today’s auction of 10-Year Treasurys saw the highest demand in 6 months, a good sign. As far as inflation peaking, it will take multiple months of trending for the Fed to be comfortable that their rate increases have been effective (remember the Fed target is 2.0% annual inflation). Futures markets are already pricing in less hawkish Fed behavior: the futures market shifted from predicting a 75 point increase at the next meeting to a 50 point increase. Tomorrow’s PPI report will be closely watched along with Fed President Mary Daly’s speech. Stay tuned…

By David R. Pascale, Jr. , Senior Vice President at George Smith Partners

Monday opened with yields plummeting on a “flight to quality” as geo-political tensions rose due to the “flight to Taipei” by a US Congressional delegation. Worries dissipated on Tuesday as the focus shifted back to economic data and remarks from Fed officials. Today’s ISM numbers indicate strong demand for services. Factory orders rose in June with surprising demand. Markets may have been expecting recessionary pressures to create demand slack and cool inflation, thereby avoiding predicted interest rate hikes.

Fed officials chimed in as Fed President Bullard said the central bank “has a long way to go” to get back to the 2% inflation target. Fed President Mary Daly then started the September speculation game by saying a 50 basis point hike next month would be “reasonable.” Fed Futures rates softened immediately to a 57% probability of a 50 basis point increase. The markets favored a 75 basis point increase the night before. The 10-Year Treasury dropped to 2.51% Monday, jumped to 2.85% today, and now is at 2.71%. The 38 basis point inversion between the 2-Year Treasury and the 10-Year Treasury went to 40 basis points. Stay tuned…

By David R. Pascale, Jr. , Senior Vice President at George Smith Partners

Today’s 75 basis point increase in the Fed Funds rate was expected as it was “telegraphed” in advance by Fed officials. Coming on the heels of June’s 75 basis point increase, the Fed Funds rate is now 2.25-2.50%. This is the Fed’s targeted “neutral” rate that is neither restrictive nor accommodative. Goldilocks is sipping her porridge. The rate is right back to the post Financial Crisis high as set by newly approved Fed Chair Powell in December 2018. The 10-Year Treasury in December 2018 was hovering around 2.75%, just like today.

Where are we and where are we going? Powell insisted we are not in a recession. “Recent indicators of spending and production have softened,” is his preferred terminology. What about the September meeting and the rest of the year? Markets rallied on perceived Fed dovishness going forward. Nasdaq saw its biggest one-day increase since 2020. He remarked that slowing down from the pace of 75 basis point rate hikes will be appropriate “at some point,” and the Fed is now in a “meeting to meeting” phase; and that it “likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation.” The year-end target and possible “peak” is estimated at 3.25-3.50% – a full 100 bps into “restrictive” territory. Will that cause a recession? Again, Powell chose his words carefully, “This process is likely to involve a period of below-trend economic growth and some softening in labor market conditions, but such outcomes are likely necessary to restore price stability.” The 10-Year Treasury barely moved, closing at 2.76% as the yield curve flattened out (but is still slightly inverted). One-Month SOFR is 2.32%, Prime Rate is 5.75% as fixed and floating rates diverge. Now, time to watch the data – tomorrow: GDP, Friday: PCE, and employment report next Friday. Stay tuned..

By David R. Pascale, Jr. , Senior Vice President at George Smith Partners