A Hostile Pause

The Federal Reserve is likely to pause at this week’s FOMC monetary meeting for a number of reasons, but none greater than the fact that this is precisely what the market has discounted and is expecting on June 14. To date, the Fed has been successful in molding sentiment for a rate hike well in advance of each meeting and therefore it has not shocked investors with its actions. This is done quite adeptly through presentations and speeches made by various Board Governors in the weeks preceding each FOMC meeting. However, while sentiment is currently looking for a pause, we do not think Chairman Powell is convinced that rate hikes are over. We believe he is being honest when he says that future policy will be driven by future data.

Right now, it is difficult to predict how weak or how strong future data and the economy will be in the second half of the year. As we pointed out last week, there were a number of weaknesses in May’s jobs report that were hidden by a strong headline number. Plus, no one can predict what will happen in October when the moratorium on student loans ends and 40 million borrowers will begin repayment for the first time in over three years. This will be an unprecedented event. What is certain is that it will dampen consumer spending.

Yet as the FOMC meets this week, a major discussion is likely to center on the impact of the debt ceiling resolution on the second half of this year. How the debt markets will respond to what is expected to be the issuance of more than $1 trillion in Treasury bills will be another unknown. This massive debt issuance is a double-edged sword since the increase in supply is expected to result in rates moving higher. And with so much of America’s debt on the short end of the curve, interest payments will also rise, increasing America’s overall debt load. This circular problem of higher rates and more debt issuance may not become a problem in the near term but barring a change in the trend of US debt and US interest rates, it will become a significant problem in the intermediate-to-long-term.

Nevertheless, investors have been celebrating the expectation that the Fed will pause in June and may or may not raise rates again in July. There is a growing consensus that a July rate hike is one and done, or that rate hikes are already done. But keep in mind that this has been what has been fueling the June rally. Recent equity gains are due to a shift in sentiment and not a result of good earnings. Yes, the first quarter’s earnings reports did generally beat expectations, but only because those expectations were already beaten down dramatically. What really matters is whether earnings are growing on a year-over-year basis. According to Refinitiv’s “This Week in Earnings” report, the first quarter earnings results are expected to show a rise of 0.03% on a year-over-year basis, and if the energy sector is excluded, earnings are expected to fall 1.7% YOY. According to S&P Dow Jones consensus data, which uses GAAP accounting, first quarter earnings are expected to rise 6% year-over-year, but from a much lower 2022 base. S&P Dow Jones data shows S&P 500 earnings per share fell 5.4% YOY in calendar 2022; whereas, Refinitiv had earnings rising 4.8% YOY in calendar 2022.

Equity prices have not been rising due to expectations of a stronger economy. According to data from the Mortgage Bankers Association, housing has become unaffordable for most Americans. In April the industry group’s Purchase Applications Payment Index rose to a record high of 172.3. Similarly, a recent report from the National Association of Realtors and Realtor.com states that over 75% of homes on the market are too expensive for middle-class buyers. In sum, a combination of inflation and rising interest rates is having a very negative impact on most households.

There has been some good news recently. The Fed’s balance sheet is contracting again following the liquidity boost in March done to offset the banking crisis. Although reserves are still $50 billion above the low level seen in early March, there is a sense that the banking crisis has eased. Meanwhile, a key liquidity benchmark – the 6-month rate of change in total reserves at the Fed – continues to be negative, indicating that the Fed is generally draining reserves from the system. This could become meaningful in coming months. While an increase in the Fed’s reserves tends to coincide with bull markets, the draining of reserves has been less predictive for the equity market; however, it tends to coincide with flat trends. See page 3.

Money supply (M2) continues to contract at a record pace as bank deposits and other liquid deposits leave the banking system in search of higher-yielding substitutes. This is not surprising, but it does hinder banks that need to borrow on the short end of the interest rate curve and loan at the higher end. It points to the fact that credit will be tighter in the months ahead. See page 4. And since the Fed has raised the fed funds rate nine times in the last twelve months, higher interest rates also impact borrowers. It is notable that the real fed funds rate is now positive for the first time since October 2019. See page 5.

If you wonder why there is a big debate among economists about whether a recession is at hand, or not, the charts on page 6 may help. It might be different this time, but history suggests a recession is on the horizon when we look at historical parallels. The current inversion in the yield curve is the greatest seen in over 42 years, and inversions have historically preceded economic recessions. Economic recessions produce bear markets in equities. The inversion of the yield curve may come early, but an inversion of this depth and length has predicted a recession in every case since 1954. We are of the view that history is a good guideline for defining risks in the equity market despite the fact that market sentiment is now tilting toward a mild recession or no recession. The one indicator that does not (yet) point to a recession is the year-over-year change in employment. That remains positive.

The acceptance of the current advance in stocks has been swift and dramatic and this is worrisome to us. Last week’s AAII sentiment survey resulted in a 15.4% surge in bullishness, now at 44.5%, and a 12.5% fall in bearishness, now at 24.3%. Investor bearishness is currently at its lowest level since November 11, 2021. Bullishness is now above average for the first time since February 2023 and at its highest level since November 11, 2021. Note that November 11, 2021 was less than two months prior to the major top in equities seen in January 2022. The Bull/Bear 8-week Spread remains in positive territory, but barely. See page 11.

Several technical indicators have improved this week including the 10-day averages of new highs, now at 172, and new lows, now at 60. This combination has turned positive with new highs above the 100 benchmark. But our 25-day up down volume oscillator remains neutral at 1.26 and is actually down from last week’s high. More importantly, the NYSE volume has been below the 10-day average for the last nine consecutive trading sessions and has not been impressive. The last high-volume day took place on May 31, 2023 when the DJIA lost 134 points. In sum, we would not chase this rally, particularly the large cap technology stocks that have been in the lead. If it is true that the real catalyst for the advance is the expectation that the Fed will pause in June, the wisest thing may be to follow the Wall Street adage “sell on the news.”

Gail Dudack

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PLEASE NOTE: Unless otherwise stated, the firm and any affiliated person or entity 1) either does not own any, or owns less than 1%, of the outstanding shares of any public company mentioned, 2) does not receive, and has not within the past 12 months received, investment banking compensation or other compensation from any public company mentioned, and 3) does not expect within the next three months to receive investment banking compensation or other compensation from any public company mentioned. The firm does not currently make markets in any public securities.

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