Increased market volatility: why it’s the Fed’s fault

Equity markets closed 1Q/22 (Thursday March 31) with the first quarterly loss in two years (since 1Q/2020, i.e. when the pandemic started). Of interest was the rush to sell in the last hour of trading, as if mutual funds and stock ETFs didn’t want to show too many stock holdings for the March 31 reporting period. Unfortunately, volatility appears to be the order of the day, at least for the next several months, as markets must grapple with both the possibility of a recession and the soon-to-be-announced Fed Quantitative Tightening (QT) program (more on this below).

While the media is focused on stocks, the chart above shows that the rapid rise in interest rates in recent months and the concomitant fall in bond prices has been an event of at least three standard deviations, the worst. downdraft in at least 50 years. In addition, there is now a growing controversy between economists who work on the sell side and those who rely more on the story as to whether the flat/inverted yield curve (2-year T-Note yield (2.46 %)> The 10-year T-Note yield (2.39%) remains the reliable indicator of recession it has been in the post-World War II era.

The Fitting Narrative

Every time the Fed begins a tightening cycle, its forecast for the economy must be bullish so that it can forecast a “soft landing.” Imagine if the Federal Reserve started a tightening cycle and told the media that the economy was weakening and that their actions could mean a recession! (This, however, appears to be the reality!) As a result of such necessity, the accuracy of the Federal Reserve’s GDP forecasts (as calculated by Rosenberg Research) is a minimum of 17%! In the current set of circumstances, with a significant portion of current inflation caused by commodity problems affected by the pandemic, war, and drought, it is entirely possible that the Fed’s actions will hurt the underlying economy without rapidly reducing inflation. .

In last week’s blog we showed that, over the last 50 years, inflation spikes were linked to oil price spikes, and inflation recedes when oil prices fall. There is no doubt that current inflation is tied to oil prices, certain agricultural commodities, and specific commodities tied to battery technologies but needed in other industrial products. A significant portion of these price spikes is due to war, sanctions, and geopolitical tensions over which the Fed and other central banks have literally zero control/influence.

The 10-year and 2-year controversy

After World War II 20the century tightening cycles, the Fed did not give any “forward guidance.” The only information the market knew was what actions the Fed had taken in the market, that is, the level of the Federal Funds (FF) rate. If that were the case today, all the market would “know” is that the Fed just raised the FF rate by 25 basis points (bps). During that time, the best indicator of a recession was a reversal of long-term (ie, 10-year) bond yields at the FF rate. Today, with the 10-Yr. at 2.39% and FF at 25-50 bps, there is still more than 200 basis points of positive slope. In his last press conference, Fed Chairman Powell pointed to this positive slope as an indicator that the probability of a recession was remote.

What is different today is the “advance guidance” as shown in the quarterly “dot plot”. (The “dot plot” is the FOMC members’ forecast of the FF rate for the next two years.) With such a “forward orientation”, markets have already priced in the expected trajectory of the Fed’s policy, effectively implementing in a couple of years what the dots suggested would take one to two years. Take, for example, mortgage rates. Last October these were below 3% and they were just over 3% at the beginning of the year. On March 31 they stood at 4.67%. While the FF rate tells us where the Fed is in this expected cycle (early), the markets have moved to 2yrs. through the 10-year yields to the expected end state of this tightening cycle. Because all but the very short stretch of the adjustment regime has already occurred, the 10-2 yield spread is a much better predictor than the 10-FF spread.

In our opinion, the current forward orientation, via dot plots, introduces unnecessary volatility into fixed income markets. Let’s assume, as Chairman Powell has said several times, that the Fed’s policy and actions are “data dependent.” Let’s assume that the economy is weakening, as we have continued to show in these blogs (see more such data below). If the incoming data turns out to be weaker than expected and the dot plots shift down, then the Fed has unnecessarily introduced volatility into the market (based on the three standard deviations shown in the chart above). We believe that “forward guidance” should not extend beyond one quarter. The volatility would be significantly lower.

Quantitative adjustment (QT)

As if the current volatility isn’t bad enough, markets must also contend with the upcoming Fed QT regime. As a backdrop, this will be the Fed’s second attempt to reduce its balance sheet. The first was the failed attempt in 2018. Back then, the withdrawal of a modest amount of liquidity exposed the fragility of the over-leveraged financial system, with overnight interest rates in the interbank reserve lending market soaring to levels of double digits in just a couple of days. The current financial system is significantly more leveraged. Michael Lebowitz (“Will Quantitative Tightening Overwhelm Markets?”) recently calculated the following:

  • During the financial crisis, QE1 injected $300 billion in liquidity. That took more than a year. During Covid, that amount was injected in three days;
  • QE2 injected $600 billion in eight months; during Covid, that took six days;
  • QE3 injected $1.5 billion over 22 months; that took just over a month during Covid!

According to Lebowitz, taking into account various Powell pronouncements, the Fed plans three years of balance sheet reductions of $1 trillion per year. This rate is twice as fast as the QT that caused the liquidity problems in 2018 and in a system that is significantly more leveraged. The implication here is significantly higher market volatility in both the equity and fixed income markets and, in all likelihood, the Fed will have to abandon that QT program.

incoming data

Meanwhile, incoming data continues to show weakness despite Powell’s pronouncements to the contrary.

  • The Manheim Used Car Price Index fell in both February and March. While still high, this is an indicator of cooling demand.
  • Mortgage applications fell -6.8% for the week ending March 25 after falling -8.1% the previous week. They are down in seven of the last eight weeks and are down -42% Y/Y. Refinancing, a major source of liquidity for US households, fell -15% the week of March 25, -14% the week before, and -60% year over year. This is no doubt a function of rising mortgage rates that would not be at this level were it not for faulty “forward-facing dot plots.” This is a great example of why we think the recession will happen faster than in previous tightening cycles, because, without “forward-looking” as it was then, mortgage rates today would move above 3% ( the rate at the turn of the year), not even close to the current 4.67%!
  • The latest national apartment vacancy rate was 4.6%, up from 3.8% last summer (new deal (!) as this blog suggested would be the case). This will impact future (ie lower) inflation and will also negatively impact future multi-family housing starts.
  • Friday’s payroll report looked strong on the surface (+431K), but the strength was not broad-based, being concentrated primarily in leisure/hospitality and professional and business services. The average weekly hours worked fell from 34.7 to 34.6. According to Rosenberg Research, every tenth of an hour represents about 370,000 jobs. Therefore, in net terms, the economy only advanced by the equivalent of around +60,000 jobs, still positive, but more in line with minimal GDP growth.
  • Real Disposable Personal Income fell -0.2% in February and has been in decline for seven consecutive months. Additionally, median hourly earnings increased +5.6% year-on-year, but with inflation at or above 8%, real median weekly earnings have decreased (see chart). That means take-home pay isn’t going as far as it did last year and that’s one of the reasons the Atlanta Fed’s GDPNow forecast for the first quarter is down 1.5%.
  • China’s economy is slowing down significantly (in part due to lockdowns). Its March manufacturing PMI fell in contraction (<50) to 49.5, and its service sector index fell sharply to 48.4 from 50.3. Another manufacturing measure, the Caixin Manufacturing Index also fell in contraction at 48.1.
  • By now, everyone who owns a traditional gas-powered car has experienced a price drop at the pump. (While the price of oil is now back below $100/bbl., we haven’t seen any relief there!) In this inflation, too, food prices have skyrocketed (chart), so it’s a double whammy for consumers and will surely have a negative impact on economic growth.
  • Consumer confidence has always been a leading indicator. As we’ve seen consistently at the University of Michigan (chart), the Conference Board’s Consumer Confidence Index is also signaling a recession.
  • Challenger data for March shows a +40% increase in layoff announcements and a drop in hiring intentions.
  • In the stock markets, stocks of home builders, auto and parts manufacturers, advertising and media companies, and retailers are in sharp corrections (between -10% and -20%) or “bear” markets (price drops of more than -20%). Some markets are already primed for recession!

final thoughts

We anticipate volatility and confusion in the financial markets, especially if the Fed continues its aggressive stance as the economy weakens. Worse, with the economy now more overleveraged than it was before the pandemic; the impact of QT (liquidity withdrawal) is likely to be quite disruptive for equity markets.

(Joshua Barone contributed to this blog.)

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