US Strategy Weekly: Unraveling the Fed Pivot Theory

Last week was a busy time for economic releases and unfortunately, the data was not favorable for those looking for a Fed pivot. The middle of the week was dominated by the release of minutes from February’s FOMC meeting, and it revealed that a few participants favored a 50-basis point increase. All board members were in favor of continuing rate increases in order to reach their target of inflation of 2% but some members wanted to get to a restrictive stance more quickly. The minutes also disclosed that Fed officials felt wage growth of 3.5% YOY would be compatible with a 2% inflation target.

But Friday’s economic releases showed that personal income rose 6.4% YOY in January and disposable income rose 8.4% YOY. The big surprise, however, was that real personal disposable income rose 2.8% YOY in the month — the first gain in real personal disposable income since March 2021! January’s CPI was already reported to be 6.4% YOY, so this gain in personal income closed a 21-month gap between inflation and income growth. See page 3. The savings rate also ratcheted up from 4.5% to 4.7% in the first month of the year. This data was better than expected.

While personal income rose 6.4% YOY, personal consumption expenditures rose 7.9% YOY, up nicely from the 7.5% reported in December but down considerably from the stimulus-driven peak rate of 30% YOY in April 2021. However, current household consumption is coming at a price. The Federal Reserve’s Z.1 report for the third quarter of 2022 showed that debt as a percentage of disposable income rose to nearly 103%, the highest level recorded since the end of 2017. See page 4.

Household Debt on the Rise

According to the Federal Reserve of NY’s latest Quarterly Report on Household Debt and Credit, total household debt rose $394 billion, or 2.4%, to $16.9 trillion in the final quarter of 2022. The $394 billion growth in the fourth quarter represented the largest nominal quarterly increase in twenty years according to the FRBNY. The $16.9 trillion total at the end of 4Q 2022 represented a year-over-year gain of 8.5%, the highest pace of debt accumulation since the first quarter of 2008.

Still, credit card balances were the most worrisome segment of debt. Credit card balances rose by $61 billion, the largest increase in FRBNY data going back to 1999. For all of 2022, credit card debt surged by $130 billion, also the largest annual growth in balances. After two years of historically low delinquency rates, the share of debt transitioning into delinquency increased for nearly all debt types. See charts on page 5. Unfortunately, credit card delinquencies are rising the fastest among 18 to 29-year-olds as compared to all age categories. This may become an even greater problem as interest rates rise.

Mortgages and auto loans grew at a relatively moderate pace in the fourth quarter. Mortgage balances rose to $11.92 trillion; auto loans rose to $1.55 trillion, and student loan balances rose to $1.60 trillion.

All in all, the increase in credit card debt and other revolving forms of credit will be unsustainable in a rising interest rate environment and consumption is apt to slow later in the year. But generally, most of January’s data releases pointed to a surge in economic activity. For example, January included an increase in new home sales to 670,000 (SAAR), an 8.1% rise in the pending home sale index to 82.5, and an increase in the University of Michigan consumer sentiment index from 64.0 to 67 in February. This sentiment index was offset a bit by the Conference Board consumer confidence index, also for February, which slipped from 106.0 to 102.9. Nevertheless, the present condition component of the Conference Board survey increased from 151.1 to 152.8.

The Fed Problem

Last week’s final straw was the report on the Fed’s favorite inflation benchmark, the PCE deflator, which rose by 0.1% in January to 5.4%. This aligns with the CPI which had inflation picking up at the start of the year. The combination of good economic statistics and no significant slowdown in prices sent interest rates higher all along the yield curve. Conversely, stocks fell. The decline in equities is understandable. As we show on page 6, the gap between inflation and the fed funds rate has been narrowing, particularly versus the PCE deflator. But without a further slowdown in inflation, the prospects for higher interest rates will become open-ended. With an effective fed funds rate of 4.57% and the PCE deflator of 5.4%, this 100-basis point gap implies more than two 25-basis point hikes will be required in coming months. And if the Fed is serious about attaining a positive real fed funds rate, it could be even more.

The ISM manufacturing and service surveys will be released this week, but in general, there is little in terms of important economic reports until the February employment report scheduled for March 11. In the meantime, investors will continue to ponder earnings reports and the FOMC meeting on March 21-22, 2023.  

Technical Update

Last week we discussed the 2000 level in the Russell 2000 index and its importance. The RUT has been a leader in the recent advance and the 2000 level was the first significant level of resistance. In our view, the 2000 level would be an important test of the strength of the rally. Unfortunately, to date, this level has rebuffed the advance.

Now our attention shifts from the Russell 2000 to the S&P 500 and its confluence of moving averages, but in particular, the 200-day moving average at SPX 3940. This is an important level of support, and if broken, it could trigger further selling in our view. The SPX’s 200-day moving average currently sits between the 50-day moving average at 3,979.23 and the 100-day moving average at 3919.32, creating a significant range of support between SPX 3919 and 3979. If this range does not hold as support, we would expect the optimism that increased during the January rally will dissipate.

Summary As we noted a few weeks ago, the easy part of the rally may be behind us. Our view calls for a broad trading range until inflation is clearly under control. As seen by January’s data, this process could take another 12 to 18 months. Historically, the popular stock indices have spent 50% of the time in flat trends, so this is not unusual. We expect the broad indices will be contained between the January 3, 2022 SPX high of 4796.56 and the October 12, 2022 low of SPX 3577.03. If we are correct about a trading range market, leadership may rotate throughout the year. But note, while “flat” cycles are unable to sustain an advance above the previous market peak, they can include several bull and bear market moves of 20% or more. In short, the days of a “buy and hold” strategy may have ended for a while. Core holdings in portfolios should include inflation and recession resistant companies and stocks with attractive dividend yields and predictable earnings growth.

Gail Dudack

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