Summary
With the debt ceiling solved for the next couple of years, the list of major worrisome items for the US economy includes Fed tightening (both the lagged effects of prior moves and potential future moves), still-high inflation, tighter bank lending standards, and leading indicators continuing to point to a downturn sometime soon. Plus, there are significant geopolitical issues such as the war in Ukraine and simmering tensions between China and the US. (Did someone mention the growing likelihood of Iran’s constructing a nuclear weapon soon? And we’re not going to get into AI becoming self-aware and eliminating the human race.) Still, the job market remains solid, broad equity market indices were mostly up for May, and the economy is clearly not in recession today. But tomorrow?
Economic Activity
The dichotomy between parts of the economy that are continuing to grow and those that are shrinking continues to widen. This was clearly shown in the just-released employment report for May. Overall, the jobs report seemed to indicate still-solid conditions, with nonfarm payrolls (NFP) jumping by 339,000 for the month (and with large upward revisions for the prior two months). Given the state of the labor force and productivity growth today, slower NFP gains of closer to 100,000 per month are needed for wage increases to be consistent with the Fed’s long-term inflation goal of 2.0 percent. Moreover, the April Job Openings and Labor Turnover Survey (JOLTS) showed a substantial increase in job openings. The ratio of job openings to the number of unemployed persons (perhaps the best measure of slack in the job market) rose to 1.79 for the month. This is down from its all-time high of just over 2.00 about a year ago, but it is well above its long-run median of around 0.56 – indicating a very tight labor market. But the dichotomy showed itself with a jump in the U-3 unemployment rate to 3.7 percent. While this is still a low rate historically, the increase from April to May was the biggest since the two months of the Covid downturn (and before that, the biggest since 2010). Additionally, the quit rate from the JOLTS showed a decline to the lowest level in more than two years. People are less inclined to quit their current jobs when new jobs become harder to find. Is the job market weakening or not? Weekly unemployment claims (probably the best high-frequency data for the strength of the job market) are up modestly from their near all-time lows of last fall, but this rise has stabilized over the past few months. The jobs data were uniformly strong as recently as a few months ago, but the increasing presence of some worsening data suggests that the strength in the job market has peaked.
The dichotomy also showed itself with the consumer (the largest part of the economy). Retail sales (and the broader measure of personal consumption expenditures) rose solidly for April, a positive signal for continued economic expansion. But May light vehicle sales gave up virtually all of April’s gain, and both consumer confidence (from the Conference Board) and consumer sentiment (from the University of Michigan) fell in May, with the latter at levels more commonly seen in recessions. Tightening by the Fed is manifesting itself in significantly higher consumer borrowing rates. Commercial bank lending rates on 60-month new car loans rose in the first quarter to the highest levels since 2007 – and with further Fed tightening in the past few months, it is likely that the rates in the second quarter were higher still. Between this rise in financing costs and increasing prices (12-month trend prices for new vehicles in the CPI have “slowed” to only 5.4 percent), it is difficult to see a significant increase in light vehicle sales in coming months. Indeed, a further decline may be likely.
Housing activity was mixed over the past month. New home sales climbed to their highest annualized pace in a year for April, while housing starts edged higher. But existing home sales slipped. Still, as long as the job market remains solid, along with positive demographics, the housing market has little risk of falling sharply in the near term (unless mortgage rates spike or mortgage underwriting standards tighten significantly). Moreover, a continued lack of homes for sale (especially existing homes) is holding up national home prices despite the downward trend in sales.
Measures of business activity have been mixed for a while. The overall index from the Institute for Supply Management (ISM) manufacturing survey for May was below 50, indicating contraction, for a seventh consecutive month. Additionally, the small business optimism index from the National Federation of Independent Business (NFIB) dropped in April to the lowest level since 2013 (yes, even below the levels seen during Covid). On the other hand, the ISM services survey for May, while slowing, continued to show expansion, with a level of 50.3 for the month. This measure has been above 50 every month since the end of the Covid downturn with the exception of an increasingly anomalous 49.2 last December. But the cost and availability of funding for business expansion are worsening. According to the Fed’s Senior Loan Officer Opinion Survey (SLOOS), the percentage of banks tightening standards for commercial and industrial (C&I) loans rose to 46+ percent in the second quarter, a level typically seen around recessions. And the percentage indicating a higher spread for C&I loans relative to the bank’s own cost of funds climbed to around 60 percent, a level also usually seen around recessions.
Despite the dichotomous nature of the economic data recently, the two indicators that we think give the best guidance for economic growth continue to suggest that a recession is looming. The Conference Board’s Index of Leading Economic Indicators (LEI) has now declined for 13 consecutive months, and April’s 12-month change of -8.0 percent is at a level that has always preceded recessions. Additionally, the yield curve continues to be inverted, with short-term rates above long-term rates. Moreover, the inversion is the steepest it has been since at least 1981. Maybe things are different this time, and these two reliable leading indicators of a downturn are giving misleading readings. But at a minimum, they are flashing a cautionary yellow – if not an outright red.
Inflation and the Federal Reserve
While all of the key measures of inflation are down from their peaks of last year, the 12-month trend rates have flattened out recently at levels still well above the Fed’s long-term goal of 2.0 percent. The trend rate for the Fed’s preferred inflation measure, the personal consumption expenditure (PCE) price index (a much broader measure of inflation than the more commonly viewed Consumer Price Index, CPI), accelerated to 4.4 percent for March, while the core rate edged higher to 4.7 percent. The story was the same for the “super core” inflation rate (PCE services less energy and housing), which moved up a bit to a 4.6 percent pace. The trend rate in the Zillow Observed Rent Index has moved lower for 13 of the past 14 months and for April was less than a third of its peak rate in early 2022. We should see the house price components of inflation start to reflect this downward move soon, but it hasn’t had an impact yet and this is a key reason for inflation not falling by more. Instead, inflation remains well above the Fed’s long-term goal.
Trend inflation more than double the Fed’s goal would usually elicit another tightening move at the next Federal Open Market Committee (FOMC) meeting on June 13-14, but several Fed governors have recently suggested that the FOMC may pause its ongoing tightening at that meeting to see if inflation resumes its downtrend (or the economy stumbles). The May CPI report will be released on the first day of the June FOMC meeting, and the Cleveland Fed’s Inflation NowCast is looking for a small drop in the trend rate for the core CPI (and a larger slowdown for overall CPI inflation). Financial markets have changed their view of tightening at the June FOMC meeting, mostly from those statements from FOMC members suggesting a pause could occur, with a 76 percent chance of a pause then (up sharply from 36 percent only a week ago), according to the CME Group. The May CPI report may be a key determinant of Fed policy at that time. Looking ahead, markets expect the Fed will have tightened at least one more time by the end of the July FOMC meeting, with a probability of about 67 percent. After this, markets are looking for a modest easing from the Fed, with a 76 percent chance of the federal funds rate either at or dropping below current levels by year end. Over the past week, financial markets have moved their expectations much closer to the FOMC’s own forecasts of no easing in policy this year.
Financial Markets
There have been no additional bank failures since First Republic on May 1, but the significantly inverted yield curve continues to put pressure on almost all bank net interest margins. The combination of the Fed’s new Bank Term Funding Program (BTFP) and the implicit guaranteeing of all deposits – as seen with First Republic, Silicon Valley, and Signature banks – rather than just those below the FDIC insurance limit of $250,000, appears to have stemmed further bank runs, at least for now.
Concerns about breaching the debt limit had a significant impact on US interest rates over the past month. At the end of April, the yield on the 1-month Treasury note was 4.35 percent, but by May 26 that yield had skyrocketed to 6.02 percent. Only a portion of that rise can be ascribed to actual and expected Fed rate hikes. By June 2, the day after the Senate passed the debt ceiling legislation, that yield had plummeted to 5.28 percent. Longer-term rates were also impacted, but only to a modest degree. Over the same period, the yield on the 10-year Treasury note started at 3.44 percent, rose to 3.80 percent, and then dropped to 3.69 percent. While Treasury rates are back close to where they started before the debt ceiling problem (including changes in market expectations for Fed policy), my Cumberland colleagues David Kotok and John Mousseau have written extensively over the past month on the negative impacts to the bond market of this episode.
Unlike the bond market, equity markets appear to have been little impacted by the debt ceiling drama, with large-cap broad equity averages mostly trending higher over the past month. From the end of April to June 2 (in order to pick up any impacts from the successful resolution of the debt ceiling), the S&P 500 Index climbed by 2.7 percent (up by 11.5 percent for the year), the Dow Jones Industrials edged lower by 0.9 percent (up by 1.9 percent for the year), and the NASDAQ Composite jumped by 8.3 percent (and by 26.5 percent for the year). Note that the bulk of these increases have come from a handful of mega-cap stocks, so the gains have not been widespread. Mid- and small-cap measures continued to mostly underperform but were still up from the end of April through June 2 (by 0.6 and 2.9 percent, respectively.
With the debt ceiling in the rear-view mirror, financial markets should again respond to the usual drivers of growth/earnings prospects, inflation, and Fed policy.
Mon Jun 5, 2023
