Fed Actions (Inactions) Are Key To The Economic Outlook

Over the past week or so, we’ve seen some backup in market interest rates. The 10-Year Treasury yield (chart) closed at a 4.15% on Friday (January 19), up 21 basis points from its 3.94% level a week earlier, and 3.79% on December 26th. The rise in market rates was mainly due to the hawkish tone in recent speeches by members of the Fed’s Federal Open Market Committee. It is clear that the Fed does not want the financial market to get too far ahead of it in the rate lowering process. But it isn’t clear when the first-rate cut will occur. We think that they are communicating that to the market because, in fact, they, themselves, haven’t decided on the timing of that first cut. As a result, the market’s odds of a rate cut at the March meeting have come down from 80% to just 51% (as of January 19).

Nevertheless, the equity market continues to march higher with the S&P 500 closing on Friday at an all-time high (4839.81). Market participants must believe that the Fed has engineered, or is in the process of engineering, a “soft-landing” for the economy. We think the odds of this are quite low and get even lower if the Fed keeps rates “too high for too long.” But that, “too high for too long,” appears to be the reality, at least judging from the FOMC’s current rhetoric. We will have a better feel for where they stand at the end of the month (Wednesday, January 31) when the Fed’s next meeting concludes and we get the policy statement and the press-conference with Jay Powell. We expect some interest rate volatility (up or down depending on the rhetoric) at that time.

Inflation

Our view is that this Fed is overly consumed with backward looking (year/year) data. For example, the headline CPI (+3.3%) uses the index level of 12 months ago as the denominator. Using a shorter three-month annualized rate produces an annualized inflation rate of only +1.8%, below the Fed’s holy grail 2% objective. Another example of this occurs in looking at the recent PPI data. Its year/year number is +1.0% (below the Fed’s 2% objective), but its six-month annualized rate is -3.4%, and its three-month is -14%! By focusing too far in the past, as the Fed seems to be doing, one misses the current trends.

Another issue in the war on inflation is the measurement of the “shelter” component of the CPI. Shelter has a large (33%) weight in the index. BLS (Bureau of Labor Statistics) uses lagged data in calculating the shelter component. For December, they used +0.5% for the shelter component. An up-to-date index, like the Apartment List National Rent Index, shows that, in December, rents fell -0.8% and that rents have been falling every month since August. Excluding the shelter component altogether, the year/year growth rate of the CPI is +2.5% (approaching the Fed’s target). However, if the Apartment List number is substituted (-0.8%) for the shelter (rent) component, the CPI headline (year/year) index would be a mere +1.6%. The Fed should now be at “Neutral” (2.5%). It’s not like rents will soon reverse because there is a record number of newly built apartments coming online and the vacancy rate is sure to rise; falling rents always accompany such circumstances.

December also saw a significant number of goods sporting price declines. These include: eggs: -24%; lettuce: -17%; tomatoes: -7%; apples: -6%; TVs: -10%; airfares: -9%; furniture: -6%; toys: -5%; gasoline: -2%; fuel oil: -15%; and used cars (the poster child for this inflation): -1%.

Housing

Healthy economies always have a healthy housing industry. Not the case today in the economy. Existing Home Sales fell again in December, by -1.0% from November levels, and were -6.2% lower than a year earlier. In fact, December was the slowest sales month since August 2010, and the year as a whole was the slowest since 1995!

December closings are based on contracts signed in October or early November. At that time, the rate on a 30-year fixed-rate mortgage was near 8%. That rate is now hovering 100 basis points lower, at 7%, and that likely means that such sales will pick up slightly in the first quarter. But it will take a significant lowering of rates by the Fed to reverse housing’s negative trends.

On the other hand, the median home price in December was +4.4% higher than a year earlier. Much of the price increase is due to a lack of inventory, as high mortgage rates have discouraged homeowners from selling (i.e., those with mortgage rates under 4% don’t want to sell and buy another home with a mortgage rate above 7%). Without competition (i.e., inventory; supply), prices have remained sticky to the upside. As rates come down, however, there will be more inventory (more competition), and that is likely to cause home prices to stop rising and perhaps begin to fall.

But, until there is a meaningful reduction in interest rates, housing will remain in the doldrums. That, of course, depends on the Fed.

Retail Sales

On Wednesday (January 17), the Commerce Dept. reported that December retail sales rose +0.6%, up +0.25% in real (inflation adjusted) terms.

The consumer seems to have more resilience than markets previously thought – although much of this spending was put on credit cards or in the “buy now pay later” program. It appears to us that the consumer exhausted its savings in Q3, and has now maxed out its credit card credit availability. So, we don’t think we will see these robust retail sales again for a while. We also note that auto loan and credit card delinquencies are up and rising, and that the large banks that recently reported Q4 results had their non-performing loans rise 30% on a year/year basis. So, we expect to see a slowdown in consumption over the next few months.

Debt

Debt, or the cost of it, is going to become a large issue in the economy, especially if interest rates remain at their current lofty levels. The current level of the national debt is now more than $34 trillion, and that amounts to 122% of the current real GDP ($28 trillion).

The current interest cost of the debt is $733 billion/year, an average interest cost of about 2.15%. Nearly half of the debt is short-term and matures in one year or less. Currently, the interest rate on one-year Treasury Notes is 4.88%. Roughly speaking, if interest rates on one-year Treasuries remain where they are, the cost of the debt will rise to about $1.2 trillion in 2025, a 63% rise in just one year (i.e., a rise of $467 billion).

The Congressional Budget Office (CBO) has estimated that the debt costs will rise from less than 2% of GDP in 2022 to more than 3.5% of GDP by 2033. But the problem only begins there. The chart above, from Rosenberg Research, shows that more than 22% of Investment Grade and High Yield bonds will be maturing over the next three years, i.e., $1.9 trillion of an $8.5 trillion market.

And according to Rosenberg, at the end of this period interest expenses for America’s corporations will rise by more than $100 billion. This comes at a time when interest expenses have already risen due to Fed policy (see right-hand side of the chart above). This implies added expenses and profit margin compression. When this happens, the typical reaction from the CEO’s office is some form of cost cutting, including layoffs.

Final Thoughts

• We don’t know when the Fed will begin lowering rates or how rapidly they will push them down. Waiting too long, or not lowering fast enough, may exacerbate the coming economic downturn.
• All the inflation trends, especially over the three- and six-month time periods, show sharply falling inflation. Even the headline (year/year) CPI would show inflation under the Fed’s 2% objective if a current shelter index were used. We think that CPI inflation will be below +2% by mid-year, and there is a significant probability that we could see some deflation before year’s end.
• Housing is in a world of hurt, and it will stay that way until mortgage rates fall (to at least 5%).
• The consumer continues to amaze. But, with “excess savings” (i.e., the free-money given out by Uncle Sam) exhausted, and credit apparently maxed out, we expect some pull-back in retail sales soon.
• Everywhere we look, debt is either an issue or about to become one. At the federal level, it is now more than 122% of GDP. Worse, a huge amount will have to be refinanced over the next year. With interest costs rising, more and more of the federal budget will be required just to pay interest.
• Circumstances are similar in the corporate world where profit margin compression is likely as the debt is rolled over at higher interest rates.

(Joshua Barone and Eugene Hoover contributed to this blog)

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