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Will the FED continue to tighten?

| October 23, 2023

Fortunately, this blog is not a video or audio blog, as I just got done at the dentist office. My tongue may be numb, but let’s hope my brain isn’t also numb (you can be the judge of that).

I titled today’s blog as a question partly because it’s a real question, but also because it seems almost inconceivable. Out to January 2024, there is roughly a one in three chance of another 25 basis points (0.25%) increase in short-term interest rates, according to the markets.

And yet, even last week Powell was still talking tough about the need to potentially raise rates again.

Can I point out one thing in that statement that seems odd to me? Economic growth does not necessarily correspond to high inflation. Now, having just said that I understand that the FED can only work on the demand side of the equation. Meaning that if people have less money (because they have fewer jobs) they will spend less and therefore inflation will come down. That sort of makes sense. If the only tool you have is a hammer, everything looks like a nail!

But what about the supply side? I know, they can’t affect that side of the equation, but the government can. Let me take you back in time to the COVID “shutdown”.

Initially, when the lockdowns went into place, there was less (as in a lot less) demand for services, because everyone was locked in their houses. That demand then shifted to goods. Who didn’t get to know their Amazon delivery person by their first name? At the same time, only “essential” businesses were able to stay open. Of course, the government’s definition of essential varied drastically from other definitions. Let’s take one industry in particular.  The housing industry.

Here are some clips from an NBC story back in 2021. You can read the whole article here.

Who would have thought that when you lock down a large part of the population that housing prices would go up? Clearly not the lumber producers. But that’s exactly what happened. You can see what happened to the price of lumber, both before and after lockdowns and re-openings.

If you remember, the second surge in prices was caused by the second surge in COVID (remember the ‘Delta’ variant?). Today, prices have mostly returned to pre-COVID levels, as supply and demand have fallen more in line.

So, with the ‘market’ only giving a one in three chance of another rate hike, is the FED still determined to raise rates again?

Let’s take a look at the 5-year/5-year forward interest rates. This is what the market expects the 5-year treasury rate to be in 5 years from now.

If inflation risks are so high, why isn’t this showing higher future interest rates? Is it possible that inflation was “transitory”? Remember, we said it was, depending on your time definition of transitory. Days, weeks, months? Nope, not transitory. Several years, yep, transitory. How about this next chart.  Does this look like a chart that should cause the FED to continue to “fight” the inflation dragon?

The blue line is the Consumer Price Index (CPI). The red line excludes shelter from that number. Because of the methodology of how the BLS figures Owner’s Equivalent Rent (basically lags the market by 18 months), housing costs are still keeping inflation above the real-time level. Isn’t 2% the number they are looking for?

Meanwhile, the 10-year treasury is poking above 5% for the first time since the financial crisis.

This is what happens right before recessions. Not necessarily that the 10-year goes up, but that the spread between short and long-term interest rates widens out and “steepens.” Look at the 10/2 year chart.

Recessions don’t typically start until the yield curve goes positive again. Hold on, what am I seeing on the right-hand side of this chart? Yep, the yield curve is almost back to even (before it turns positive). But wait Chris, in the past you have said that a positive yield curve is good, and it says the economy is generally healthy. Yes, that’s true. A positive yield curve is good, and it does speak to a healthy economy. But when we talk about recessions, the reason that the yield curve goes positive is because the FED is usually close to cutting interest rates, because the economy is in or very close to recession.

Now I will give it to you that this economy does not feel like we are close to a recession. But the “official” start of the recession in the financial crisis was December 2007. Things seemed ok then too, although our indicators were already picking up problems in the economy and the markets.

As opposed to the FED, we will look at leading indicators of the economy to see what they are saying.

Most things are no growth or negative. The last thing that we would expect to go negative would be initial jobless claims. Why? Two reasons. The first is that, in general, employers don’t like to let people go unless they have to. The second is the first reason on steroids. Because it was so hard to get people back to work after COVID, employers are really trying to hold on to their employees so they don’t have the same issue they did before. That too will crack soon, in my opinion.

The next headline is not from somebody I particularly care for, as he seems to always show up “talking his book.” When he talks, it’s usually to help his portfolio out. Here’s what he is saying today.

He had been betting that interest rates would go up, and they have. Now he is saying the upside on rates is too risky given everything going on in the world. In this case, I agree with him, even though I still think he’s talking his book. No different than when he came on CNBC crying about hotels (that he owned) being too cheap and how they might go out of business, which of course would have been bad for his portfolio. I guess it pays to be a billionaire.

Here is an article from Bloomberg (speaking of billionaires). You can read it here. I’ll give you a couple of excerpts.

This first one is from Katie Nixon of Northern Trust.

This is from Wei Li of Blackrock.

And finally, Tom Tzitzouris from Strategas.

Tom speaks to the ‘something breaking’ that I have talked about in the past. The further the FED continues with their rate increases and financial tightening, the greater the chance of something breaking. Like Tom says, you won’t know what that is ahead of time.

Ok, that’s enough. It looks like increasing bond duration is something to start getting serious about.

I hope you have a good week and feel free to reach out with questions or an extended conversation, we would all be happy to have one.

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