In our opinion, the Federal Reserve will raise the fed funds rate by 25 basis points this week to a target range of 4 ¾% to 5%. And we say this even though we agree with those who say it makes no sense to raise rates during a time of global banking distress. However, the Federal Reserve has backed itself into a corner this week and any move it makes – raise, pause, or pivot — is apt to draw criticism. As a result, Chairman Powell is likely to take the easiest road and follow the consensus view of a 25-basis point increase.
Unfortunately, the Fed is boxed in between a number of bad choices and finds itself in a lose-lose situation. Still, it is a situation of its own making. First, for too long the Fed ignored an inflation problem exacerbated by its prolonged zero interest rate policy and then it rushed to fix its error by raising interest rates 425 basis points in 10 months. The sharp rise in interest rates coupled with the most inverted government yield curve since 1981 proved difficult to handle for some, particularly, for those with no experience with inflation or inverted yield curves. The disruption seen in the banking industry is no surprise to us; although we would have expected the liquidity problems to first appear outside the US and not inside.
It is possible that a 25-basis point increase will soothe the markets. A pause could suggest that the Fed sees too much instability in the banking system to raise rates. A 50-basis point increase could certainly add to the pressure already seen in global banking. Thus, 25-basis points may prove to be the best choice. But it is unclear whether the global banking system has truly stabilized. Clearly, the Fed and the Swiss government stepped in to calm the jitters caused by runs at three regional banks in the US and at Credit Suisse Group AG (CS – $0.97) in Switzerland. Consequently, the tightening policies that were in place are now in conflict and diluted by the emergency liquidity measures put into place to save the banks. Our longer-term concern is that banks will continue to face pressure this year from an inverted yield curve, a shaky commercial real estate market, and rising credit card debt. History suggests that sustainable rallies in equities are not likely without participation from the financial sector. In short, we remain cautious.
Monitoring the risk in the debt markets will be important in the days ahead, even for equity investors. One benchmark we have followed is the ICE BofA MOVE Index (.MOVE – $162.31) which is a measure of expected volatility in US Treasuries. Last week it surged close to $200, its highest level since the financial crisis of 2008. It has since retreated to $162.31 but remains elevated and is a cause for concern. See page 2.
According to History
By studying the relationship between inflation and the economy over the last 80 years, it becomes clear that whenever inflation, as measured by the CPI or PPI, has reached 9% or more, it has been followed by not one, but by a series of recessions. This was true in the post-World War II era as well as the double-digit inflation seen in the 1970 decade. It is possible that the two negative quarters of GDP seen in the first half of 2022 was the first, in what may become a series of economic slowdowns. See page 4.
And it is also important to note that there is a unique difference between past inflation cycles and the current environment. The Federal Reserve has never let inflation rise this far before raising rates. In past cycles, the Fed increased interest rates as soon as inflation began to climb and kept rates in line with inflation. The Fed is way behind the curve in today’s cycle which could make inflation more difficult to control. History also shows that in tightening cycles with very high inflation, monetary policy was interrupted by the onset of a recession. This forced the Fed to lower rates temporarily. Unfortunately, after a decline of a year or more, inflation reappeared, and the Fed’s tightening cycle resumed, lifting interest rates to even higher levels. This is the backdrop for a series of economic recessions. We believe Chairman Powell understands this and will try to avoid the historic pattern of stop-and-go tightening. But he is walking an economic tightrope and it will not be easy. See page 5.
Recent inflation data has been somewhat encouraging. In February, headline CPI fell from 6.4% to 6.0% YOY. Core CPI ratcheted down from 5.6% to 5.5%. Finished goods PPI improved the most falling from 8.7% to 6.4% YOY; while final demand PPI dropped from 5.7% to 4.6%. But the concern is service sector PPI which was unchanged at 5.5% YOY. All in all, these were well above the long-term average pace of 3.4%. See page 6.
The best inflation news was found in trade-related benchmarks. Import prices fell from 0.9% YOY to negative 1.1%. Imports less petroleum eased from 1.4% to 0.2% YOY and export prices dropped from 2.2% YOY to negative 0.8% YOY. But while inflation has moderated by most measures, the real fed funds rate remains 80 basis points below the PCE deflator (5.4%) and 150 basis points below the CPI. See page 7. This is the most compelling reason for the Fed to still raise interest rates by 25-basis points at this week’s meeting.
To add to this mix of data, there were some green shoots in housing data recently. In particular, the NAHB confidence index rose from 42 in January to 44 in February. Yet, despite these gains, all components are still below the 50-equilibrium level. At the same time, existing home sales increased from the 4.0-million-unit rate seen in January to 4.58 million in February. Again, despite this gain, sales were nearly 23% below the rate seen a year earlier. See page 8.
In February the median existing home price rose to $367,500 from $365,400 in January. This was a 0.7% YOY decline and the first year-over-year decline since September 2011. The price of a new home also declined in February and the 3-month average dropped to 3.5% YOY. But while year-over-year declines in home prices are good for future inflation data, total retail sales have a strong relationship to home prices. This suggests that retail sales could also be weak this year. See page 9.
Watch the Russell
We think the Russell 2000 index remains the best technical guide for market direction in the near and intermediate terms. Our forecast has been for a trading range marker and the Russell index is the best example since it continues to trade between support at 1650 and resistance near 2000. The current price of 1777 is just slightly below the midpoint of the range, which could be viewed as slightly positive, i.e., allowing for a brief short-term rally. See page 11. But we remain cautious and would continue to focus on recession and inflation proof stocks with solid earnings and dividend growth. Note: this week we have lowered our 2022 earnings forecast of $200 to $196.82 to match the S&P Dow Jones estimate. See pages 10 and 17.
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.