Making sense of macro turmoil

The Federal Reserve releases its Monetary Policy Update on Wednesday, June 15.

Stocks in a bear market, crypto plummeting, exorbitant gas prices and interest rates increasing. Turning to the business headlines, ‘Fed’ and ‘inflation’ are two words one seemingly can’t escape from. Just what is going on? Beneath these headlines there are unprecedented and seismic shifts going on in the macroeconomy that are linking all of these together, and this week proves to be a pivotal one with far-reaching ramifications.

This is the first of (hopefully) several articles I’ll write through the summer to explain the current macro environment and what it means for investors and the wider public.

Two events, one past and one upcoming, are pivotal to understanding what is going on in the macroeconomy right now.

The first: Last Friday with the monthly Consumer Price Index report showed inflation at 8.6%, the highest in 40 years. It is undoubtable that inflation is the issue of concern for everyone, everywhere — gas prices have reached record levels, averaging $5 per gallon on as of last Friday. Food prices are escalating as well, with wheat prices 50% higher than a year ago.

The second: This Wednesday, the Federal Reserve will release its latest monetary policy update in where a significant interest rate is expected. Why does the Fed almost single-handedly control the macroeconomic narrative and why are the stakes so high for Wednesday?

The Fed got it wrong

Firstly, a primer on the role of the Fed. The Fed has a dual mandate of high employment and low and stable inflation of 2%, and its main policy tool is setting the Federal Funds Rate, which is a short-term interest rate. Fed’s monetary policy works by changing the tightness of monetary conditions — or the access and affordability of credit that consumers and businesses can access. While the Fed can only directly affect short-term interest rate, longer-term interest rates (think interest rates on home and auto loans) are what affect financial conditions in the broader macroeconomy, and short-term rates indirectly affect long-term rates.

Over the course of the 2021, despite inflation running hot since May, the Fed kept monetary policy at unprecedentedly easy levels — maintaining zero interest rates and purchasing massive amounts of Treasury bonds through Quantitative Easing, which exert downward pressure on long-term interest rates. They repeatedly claimed that the inflation was ‘transitory’ due to COVID-related supply issues and would soon abate, and that easy financial conditions were necessary to encourage more job creation and lower unemployment levels.

However, the past few months have revealed that the Fed had read the situation completely wrong. Employment roared back after the economy reopened in 2021, leading to extremely tight labor markets — with firms having far more unfilled vacancies than unemployed people, resulting in upward pressure on wages that is contributing to the inflationary impulse. On the other hand, far from easing in end-2021, inflation has intensified (with Friday’s reading the highest in 40 years) and broadened past ‘transitory’ categories, far exceeding the Fed’s target of 2%. Crucially, this has led to fears that Fed’s credibility would be undermined in the eyes of consumers and firms, resulting in inflation expectations being unanchored which is the precursor to a calamitous inflationary spiral. Fed officials themselves have acknowledged that they were mistaken: Fed chairman Jerome Powell has said that he regretted labelling inflation last year ‘transitory’ and Treasury Secretary and former Fed chief Janet Yellen has also admitted that mistakes were made that led to this inflation.

Hence, having belatedly woken up to the magnitude of the inflation situation, Fed officials are now adamant about bringing inflation down with its policy arsenal, tightening monetary policy at an unprecedented rate and hoping that inflation declines rapidly as they anticipated.

This is why last Friday’s CPI number was a huge disappointment for the Fed. Beneath the eye-popping headline of 8.6% inflation, which was greater than the 8.3% expected by economists, why this is signficant is that this latest release refutes the narrative that we reached ‘peak inflation’ in March. In fact, price increases broadening out across the economy — core CPI (which excludes volatile food and energy prices) accelerated, increasing 0.6% month-over-month, while nearly all categories of prices registered at least 4% year-over-year increases. This has put paid to those who hoped for inflation dropping significantly in the next few months and the Fed not needing to tighten so much.

Market-based interest rate expectations, as of Monday, predict that the Fed is likely to raise interest rates by 0.75% on Wednesday, and then 0.75% in July with further increases till 3% by year-end. This is the biggest interest rate increase since 1994 and represents extremely aggressive monetary policy tightening.

It’s important to underscore how rapidly the Fed’s policy and monetary conditions have shifted in the span of months. 2 year Treasury yields have skyrocketed from to 3.44%, from 0.75% at the start of the year. And the reaction from last Friday’s inflation report was extremely sudden — Market-priced expectations for the peak Fed interest rate this cycle increased from around 3% to just shy of 4% in the span of a week.

Is a recession coming?

On top of inflation, the other factor weighing on financial markets is the threat of recession. With the economic recovery already weak (contraction in 1Q 22) due to the Ukraine war and supply chain disruptions, there are increasing fears of the economy falling into recession in the second half of 2022, just two years after the last one induced by COVID.

The latest narrative from the Fed is that they want to achieve a soft landing — bringing inflation down without causing a recession. However, their track record is grim — only once has a previous rate-hiking cycle not led to recession, and the financial markets are casting doubt on the Fed:

The yield curve (difference in yield between 2y and 10y Treasury yield) is very close to inverting, a phenomenon that has preceded every single recession , as it reflects expectations that the Fed will cut rates in the medium-term. And an NBER survey of economists released yesterday showed that 70% expect a recession by 2023.

Recent economic data has already shown a deterioration.

Consumer sentiment, which is a reliable leading indicator of consumer spending that forms the bulk of the US economy, is extremely bad — the University of Michigan Consumer Sentiment Index just recorded its worst value ever, even lower than during the 2008 financial crisis and 2020 pandemic. This is due to oppressively high energy and food prices — which are necessities that consumers can’t easily cut back on. Additionally, real wages — or wages after accounting for inflation — fell 2.7% year-over-year.

Secondly, the Atlanta Fed’s GDP nowcast for 2nd-quarter is now at just +0.9%, which if it turns negative would mean that the US would outright enter a recession (technically defined as 2 consecutive quarters of negative GDP growth)

Whither asset markets?

The combined effect of surging interest rates and oncoming recession has meant that risk assets such as stocks have been pummeled. Two main factors derive the value of equities — expected future earnings, and the interest rate that these earnings are discounted by. Assets where most earnings are expected to come further in the future, such as growth indsutries like tech and crypto, are hit the hardest by the rising interest rates. Combined with the lowered appetite for risky investments, this is why the NASDAQ (tech stocks) and cryptocurrencies have suffered the most in particular — with bitcoin down nearly 70% from its all-time high last November.

Though the S&P500 index has dropped 20%, entering a bear market on Monday, most of the decline thus far has been orderly there is likely much more downside, or even a crash, to come.

Beyond equity markets, the ramifications of skyrocketing intrest rates are now seen in wide-ranging places, and have the potential to cause financial crises in one or more areas:

• Firstly, credit spreads — the additional interest rate that firms must pay above the risk-free interest rate — are spiking and approaching conditions during the 2008 financial crisis, as liquidity and risk appetite are deteriorating. This could spark a credit crisis and potentially unravel heavily levered and indebted firms with knock-on effects for the rest of the economy.
• Secondly, bond yields for traditionally indebted countries — like Italy, are similarly skyrocketing — raising the debt servicing costs of these frail economies and threatening their fiscal viability.
• Thirdly, we have currency market dislocations — the Yen has plummeted this year to a 20-year low against the USD, dropping 20% so far this year, due to the Bank of Japan’s yield curve control contrasting against the tightening moentary policies of the Western world
• Lastly, the housing market — 30-year fixed rate mortgages popped to 6%, doubling since the start of the year and rendering housing increasingly unaffordable. This has already led to mortgage demand dropping to 20-year lows. As housing is a reliable leading indicator of the economy, the cooling demand foreshadows an economic contraction.

Worse, further inflationary pressures are likely, threatening to continue the precarious inflation situation.

• China’s COVID lockdowns continuing to cause supply chain disruptions, as its COVID-zero policy has no end in sight.
• The Ukraine war looks set to drag on, further straining energy and food supplies. Furthermore, this means that Europe is almost guaranteed to face a massive energy crisis in the fall — as demand for natural gas picks up and, they have cut off ties with Russian natural gas with the US unlikely to provide as much natural gas exports as Europe needs. Already natural gas in storage facilities is at historical lows whereas in normal years stocks would build during the summer.
• Housing inflation will remain high over the next year as the computation of Owner-Equivalent Rent needed for housing CPI occurs with a 18-month lag, hence the effect of the surging property market in 2020–1 is only starting to be reflected in inflation readings.

Hence, the Wednesday Fed meeting is crucial, not just for whether interest rate will be raised by 50 or 75 basis points, but more so for investors to understand the Fed’s expected future actions — whether they will continue to aggressively tighten monetary policy despite probably plunging the economy into recession. An affirmation of this would cause equities to continue to decline through the year.

It is important to realize that falling asset prices are part and parcel of ‘tightening financial conditions’ that the Fed needs to counter inflation. In the past, such as 2018, the Fed reversed course on monetary tightening when the stock market dropped 20%, and some claim that the ‘Powell Put’ will similarly come into play, preventing asset prices from crashing. However, we are in a completely differently paradigm today, with inflation is at historical highs, so the Fed will likely be willing to sacrifice the stock market to get inflation under control. So at least for the short-term, it is the time to be defensive with our portfolio allocation.

And that’s it for a 30,000 feet view of the current macroeconomic environment, unprecedented and perilous, but really exciting for macro enthusiasts! I only got to touch briefly on several issues like housing, oil, crypto and bond yields but each deserves its own article, particularly if become the epicenter of economic stress in the months ahead. Let me know your thoughts about what I said — feel free to disagree with my viewpoints! And tell me what you want me to talk about in future articles. Follow me on Twitter @thamsuppp, follow my Medium, and stay tuned!

Sources

As a macroeconomic enthusiast, I am thrilled to be learning from many extremely bright minds in the financial and macro world. These are my main sources and I highly recommend anyone interested in macro to listen to them!

• Macro Voices podcast by Erik Townsend
• Bloomberg Surveillance daily podcast
• John Auther’s daily newsletter Points of Return
• A slew of macro Twitter accounts: Jim Bianco, Liz-Ann Sonders, Macro Alf, Raoul Pal, David Rosenberg and many more