Image Credit: Steve Jurvetson

Will the Fed Bring Down Skyrocketing Inflation and Hit its Employment Targets?

Fed Chairman Powell, who was just reappointed this week, is making no promises as to the results of his attempt at a soft landing. He told Marketplace that he couldn’t assure there won’t be bumps on the ride to inflation getting back to the 2% range while the labor market stays strong. “It’s quite challenging to accomplish that right now,” he said.

The current situation is often compared to the stagflation of the 1970s, but in reality, the last time the country was challenged by high employment coupled with high inflation was 1951.

The Challenge

It has been 70 years since the U.S. last had low unemployment with rapidly rising prices. Today inflation is more than a data point or a CPI headline, at an 8%-9% pace, most in America are feeling the numbers each time they make a purchase. Meanwhile, the job market is historically strong. As of April, only 3.6% of the labor force was jobless and looking for work, the lowest since the last time the Fed considered tightening.

Low unemployment is mostly a positive social and economic measure, but with inflation already climbing to its highest rate in more than 40 years, a tight labor market will lead to wage pressures and more costs for businesses that will be handed down to consumers.

Aggressive monetary tightening is often the medicine for rising inflation; just as low interest rates and quantitative easing stimulates activity, more expensive, and less money in the system reduces activity and that raises unemployment. The person or team of people at the controls are targeting two competing priorities, one is usually sacrificed.

History as a Measure of Success

Before March 2022, you would have to be 71 years old or older to have experienced inflation above 8% while the unemployment rate sat below 4% (Fed Chair Powell is 69). The cause in the early 1950s was the economy experienced a burst of inflation during the Korean War as government spending on national security increased. 

Since 1948, the unemployment rate (monthly) has dropped below the 4% level 146 times. Of those months, inflation registered above 8% only 15 times. So statistically, the combination has occurred less than 2% of the time in three-quarters of a century.

There are bankers and investors like Jamie Dimon of JPMorgan Chase and Bill Ackman of Pershing Square Capital that believe the Fed is behind in its rate-hiking efforts and needs to act more aggressively in order to keep the explosive inflation under control. But the criticism is not without understanding. In April, Jamie Dimon was quoted as saying, “The Fed needs to deal with things it has never dealt with before and are impossible to model.”

Is the Fed Behind?

Former U.S. Treasury Secretary Larry Summers has noted, each time inflation has exceeded 4% while unemployment was below 5% over the past 75 years, which has happened in 70 months, the U.S. has fallen into a recession within two years.

The first quarter of 2022 has already shown negative growth for the economy. A recession is defined as two consecutive quarters of negative growth, we may already be in a recession. It should be noted that the negative 1.5% growth rate followed a quarter of above-average growth.

Investment Portfolio Impact

Stocks tend to do well during tightening cycles. Since 1972 there have been eight of these cycles. Only in the 1972-1974 period did the S&P 500 produce negative results. In the seven periods that followed, with the most recent being 2015-2018, the market returned positive results to investors.

Higher material prices and increased cost of labor both raise the cost of doing business, which could reduce corporate net earnings. This is why inflation is an ugly word in the markets. But stock market results on a total return basis exceed cash or bonds. This makes them attractive and often leads to assets moving into stocks and pushing the market up. At the same time stocks can be a hedge against rising prices.

Different assets react differently to inflation, both within stocks and across other markets. Previously an allocation to value stocks generally performed better than others when inflation grew. Read quality research on the companies you’re considering, a company may have a pricing power advantage. Companies with large inventories or that own advantageous futures contracts may grow profits while their competition’s earnings falter. Making prudent adjustments to an allocation helps position portfolios for a changing environment, stock selection becomes more important, and understanding what is under the hood of an individual company can increaseyour probability of success.

Research provided on Channelchek is by the top-tier equity analysts at Noble Capital Markets. Timely reports are sent daily to your email inbox before the bell, and at no cost. Sign-up here.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://www.marketplace.org/2022/05/12/fed-chair-jerome-powell-controlling-inflation-will-include-some-pain/

https://www.marketplace.org/collection/unemployment-2020/

https://qz.com/2150562/jamie-dimon-wishes-the-fed-all-the-best-on-slowing-inflation/

https://www.bea.gov/data/gdp/gross-domestic-product

https://blog.nationwidefinancial.com/wp-content/uploads/2022/03/Picture1-1.png

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Image: World Economic Forum (May 24, 2022)

Cryptocurrencies in the Hot Seat at World Economic Forum

Considered by some to be controversial, the annual World Economic Forum (WEF) in Davos, Switzerland, each year impacts thinking on everything from economics, health care, environmental actions, and currencies, including cryptocurrency. This year’s summit is full of crypto-related companies seeking attention and a say. Its been over two years since the last meeting because of the pandemic, since then crypto has gained a strong foothold in many of the subjects covered at the WEF. Many crypto-related stakeholders bought exhibitor space and are attending the event. Their plans to be at this Swiss ski resort were made before the recent selloff and problems with the stablecoin TerraUSD.

The Establishment Speaks

Change will always be fought off by whatever is currently in place until or unless it can become a part of it. Cryptocurrencies and stablecoin fall solidly in this category, and it was made loud and clear at the World Economic Forum. Below are some topics discussed and what was said:

Is Bitcoin money? “Bitcoin may be called a coin but it’s not money. It’s not a stable store of value,” said Kristalina Georgieva, managing director of the International Monetary Fund.

Is crypto a good payment system? “Cryptocurrencies are not a reliable means of payment. Someone must be responsible for the value, and it must be accepted universally as a means of exchange. It’s not,” Villeroy said, noting that some “citizens have lost trust in crypto” because of the massive volatility.

How likely is it that cryptocurrencies and stablecoins
will be used as currency? In a panel discussion, central bankers and regulators were in more or less agreement that the recent plunge of Bitcoin, Ethereum, Luna, and TerraUSD is not behavior desired in a currency.

Are Central Bank Digital Currencies likely? Some cryptocurrencies are more akin to a pyramid scheme for the digital age because they aren’t backed by real assets, explained Kristalina Georgieva. She does however believe Central Bank Digital Currencies (CBDCs) supported by governments can be stable.

François Villeroy de Galhau, a governor of the Central Bank of France, concurred, adding that governments looking to adopt digital currencies must do so in partnership with large commercial banks.

What is the real role of cryptos? Sethaput Suthiwartnarueput, a governor of the Bank of Thailand, said that Thailand has been experimenting in the world of digital currencies. But he said it “has to be clear what problem you want to solve.”

“We don’t want to see it as a means of payment,” Suthiwartnarueput said, adding that cryptos are more of an investment than a medium of exchange.

Do they see private crypto benefits? Francois Villeroy mentioned that the experiment by El Salvador to use bitcoin as legal currency shows how risky it can be to embrace cryptocurrencies.

Georgieva noted that digital money could be a “global public good” that can help people send remittances across borders. The key is for interoperability so that it is just as easy to transfer digital currencies as it is paper-backed currencies like the dollar and euro.

Timeline? Panelists wanted to be clear that it will take time for digital currencies to evolve and become mainstream for consumers, major financial institutions, and governments.

Take-Away

While firms involved in digital currencies were out in force during the World Economic Forum, the recent selloff in crypto values provided less strength and enthusiasm. Particularly unenthusiastic were regulators and bankers. Their presentations and forum discussions show it may be a tougher sell than many private crypto advocates may hope for.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://www.weforum.org/agenda/2022/05/can-cryptocurrencies-become-environmentally-friendly/

https://www.cnn.com/2022/05/23/investing/davos-central-bank-digital-currencies-crypto/index.html

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Federal Reserve Board Issues Economic Well-Being of U.S. Households Report

The Federal Reserve Board on Monday issued its Economic Well-Being of U.S. Households in 2021 report, which examines the financial lives of U.S. adults and their families. The report draws from the Board’s ninth annual Survey of Household Economics and Decisionmaking, or SHED, which was conducted in October and November of last year before the increase in COVID-19 cases from the Omicron variant and other changes to the economic landscape in recent months. The report, fact sheet, downloadable data, data visualizations, and a video summarizing the survey’s findings may be found here.

The report indicates that self-reported financial well-being reached its highest level since the SHED began in 2013. In the fourth quarter of 2021, 78 percent of adults reported either doing okay or living comfortably financially. Financial well-being also increased among all the racial and ethnic groups measured in the survey, with a particularly large increase among Hispanic adults. Parents were one group who reported large gains in financial well-being with three-fourths saying they were doing at least okay financially, up 8 percentage points from 2020.

“The SHED results provide valuable insight into Americans’ financial conditions during the late fall of 2021. This important perspective helps the Federal Reserve better understand the economic challenges that existed during that phase of the pandemic recovery,” said Federal Reserve Board Governor Michelle W. Bowman.

The share of adults who reported that they would cover a $400 emergency expense using cash or its equivalent similarly increased to the highest level since the start of the survey—68 percent—and was up from 50 percent when the survey began in 2013. Eleven percent of adults could not pay the expense by any method.

In addition, the survey presents insight into the experiences of workers through the pandemic. Fifteen percent of workers said they were in a different job than 12 months earlier. Most who changed jobs said the job change was an improvement. Remote work also continued to evolve in 2021. During the week of the survey in late 2021, 22 percent of employees worked entirely from home, down from 29 percent in late 2020, but well above the 7 percent who worked entirely from home before the pandemic. Most employees who worked from home preferred to do so, often citing work-life balance and less time commuting. Those working from home indicated that they would be about as likely to look for a new job if required to return to the office as if their employer instituted a pay freeze.

In addition, the
report explores families’ experiences related to banking and credit, income, housing, retirement, student loans, and retirement alongside several new topics, such as the use of emerging financial products including cryptocurrencies and “Buy Now, Pay Later” services.

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Sources

https://www.federalreserve.gov/publications/report-economic-well-being-us-households.htm

https://www.federalreserve.gov/newsevents/pressreleases/other20220523a.htm

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Inflation, War, and Oil: How Today’s Crises Are Rehashing the 1970s

Consumer price inflation has risen to 8.3 percent in April 2022 in the United States and 7.5 percent in the euro area. This raises the question of who is responsible. In the US, President Joe Biden has argued that 70 percent of inflation in March is attributable to Russian president Vladimir Putin. The European Central Bank has suggested that the high inflation should be seen in the context of the pandemic and the Ukraine war. ECB president Christine Lagarde sees steeply rising energy prices as unrelated to the monetary policy of the ECB. But is inflation only due to the war and the pandemic?

According to Milton Friedman, inflation is “always and everywhere a monetary phenomenon” and thereby the responsibility of central banks. Given that in all industrialized countries money supply has for a long time grown much faster than output, the resulting huge monetary overhang should be at the root of rising inflation. Whereas since the turn of the millennium stock and real estate prices have grown fast, consumer price inflation only started picking up in mid-2021, boosted by energy prices. There are five reasons why rising energy prices are linked to the global monetary overhang, which was further strongly increased during the pandemic.

First, because of eroding trust in the dollar and the euro, a flight to real assets has set in. Tangible assets include not only real estate and stocks, but also shares in commodity mines and raw materials, including oil and gas. Secondly, the ultraloose monetary policy of the major central banks has—together with expansionary fiscal policies—fueled aggregate demand and thus also demand for energy and raw materials. When corporations—thirdly—assume that the price increases will be permanent, they hoard raw materials, which further increases demand and prices.

Fourth, energy- and commodity-exporting countries hold large dollar and euro reserves, which are devalued by inflation in the US and the euro area. Since they are often oligopolists, energy- and commodity-exporting countries can hedge against this depreciation by raising prices. Recently, some Arab countries have refused to expand the production of oil and natural gas to lower world market prices. Fifth, energy and commodities are predominantly traded in dollars. If the euro depreciates due to the ECB’s ongoing loose monetary policy, prices of raw materials and energy rise in the euro area.

This leads to the question of the extent to which there are parallels with the 1970s, when high and persistent inflation was accompanied by war in the oil-rich Middle East. Global inflationary pressures emerged even before the first oil crisis in 1971, as they are today. Since the second half of the 1960s, the US had financed the Vietnam War and growing social spending partly through the printing press. Inflation was exported to the many countries whose currency was pegged to the dollar. Then as now, energy- and commodity-exporting countries had an incentive to compensate for real losses in the value of their dollar reserves through price increases. This can be seen as the origin of the cartel policy of the Organization of the Petroleum Exporting Countries and the first oil crisis in 1971.

Persistently loose monetary policies always have negative growth and distributional effects that impair political stability. In extreme cases, there are civil wars, as evidenced by the Arab Spring, or there are armed conflicts between countries. The Yom Kippur War in 1971 was—inter alia—triggered by the Egyptian president Anwar el-Sadat’s desire to distract from domestic political tensions. Since 2014, falling oil prices have been depressing growth in Russia. It cannot be ruled out that one of Putin’s major motivations to go to war was securing his power in Russia. Finally, as in the 1970s, the growing international political instability has further increased global inflationary pressure via rising oil and commodity prices.

In the 1970s, inflation only came to an end when, starting in 1979, the new US Federal Reserve chairman Paul Volcker rigorously raised interest rates to 20 percent (Volcker shock). As a result, oil prices started to fall. Both the Fed and the ECB are still far from taking similar steps. The Fed has decisively announced interest rate hikes, but a rise in interest rates above the inflation rate is still a long way off. In the euro area, President Lagarde has kept all options open despite high inflation.

A decisive defense of price stability looks different. This implies that inflationary pressure will persist for longer, particularly in the euro area, as the high level of government debt can be melted down by inflation, helping to financially stabilize the heavily indebted euro area countries. As this process is likely to come along with persistent economic instability, however, the Ukraine crisis may not be the last political crisis in Europe.

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Wholesale Prices are Still Hot and Passing the Cost Increases on to Final Goods

Last Thursday, while the markets were transfixed on watching a so-called stablecoin on its rapid path down to almost $0.00, the Bureau of Labor Statistics (BLS) released the Producer Price Index Report (PPI). If not for the cryptocurrency distraction, the BLS report may have been the most market impactful data made available so far this May. PPI measures the inputs to manufacturing and services and calculates the average change over time of these production costs. It’s often an indicator of where consumer prices are headed.

For April 2022, year-over-year growth in the producer price inflation data came in at 11%. It has been over 10 percent for five consecutive months. PPI experienced a small drop from March’s year-over-year rate of 11.5 percent but continues to scream that costs are rising at a double-digit pace, at least for those manufacturing goods. The monthly figure was a deceleration from March, but the increase is on a growing base.

Year-over-year changes in the PPI have been over 7 percent for 11 months.

Producer Price Index (PPI)

As with the Consumer Price Index (CPI), the expectations just a few months ago were overly optimistic. Analysts forecast that PPI would moderate significantly in April and signal a downward turn. Instead, the April number disappointed those that were looking for signs of a more transitory rise in prices that then quickly moderate.

The report included some signs that price increases have reduced acceleration, but from a surprisingly high level. Despite the tapered increase, prices are still rising at a historically quick pace. Wholesale food costs rose 1.5% during April from March, this one-month increase is extreme. Even more extreme are shipping and warehousing price increases for the month of 3.6%.

What it Could Mean

There are still no indications that inflationary pressures have reached a peak and will move more toward the Fed’s target of 2% to 3%. And from a policy standpoint, there are concerns that neither the Federal Reserve (US Central Bank), Congress, nor the White House have decided to show plans that decisively wage a battle against the purchasing power erosion of US dollars. So the trend may endure for an extended period.

The Federal Reserve which embraced the stimulative position back in 2008 of adding significant liquidity to the US economy and then expanded its efforts during the government’s reaction to the pandemic starting in 2020 has been a significant catalyst to rising prices. Some analysts fear that its tepid steps do little to extinguish the raging price increases.

After nearly a year of historically relevant elevated inflation rates, the Fed has more or less assured us it will decrease its balance sheet. This would take money out of the system of at least $47.5 billion each month. As compared to the size of the overall economy, these Fed held maturities of US Treasuries and Mortgaged Backed Securities reduce money in the system by a like amount and require non-Fed investors to participate in the rolling of this debt. With consumer inflation running above 8% and 10-year US Treasuries only at 3%, history suggests either interest rates will gravitate upward to compensate investors, or inflation needs to come down. The PPI number on Thursday made it clear that the pipeline of costs that lead to consumer prices has not pulled back by much.

Take-Away

The Fed has raised interest rates twice this year. Word is they will continue to move 50 bp for at least one, probably the next two meetings. In the meantime, the pipeline of rising price inputs to consumer goods hasn’t backed off much. Equity investors view stocks as a natural hedge against inflation. What they do however need to watch is the notion that higher interest rates could cause some money that never wanted to take on risk, may leave the stock market. Fewer investors lead to lower prices.

Paul Hoffman

Managing Editor, Channelchek

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How the Bureau of Labor Statistics Confirms Your Sticker Shock by Measuring CPI

As purchases of pretty much everything cost more than they did a year ago, a correct accounting of average cost per household has recently taken the spotlight. The methods the federal government uses to track changes in prices each month on a hundred thousand goods and services were given little thought during non-inflationary periods. But now, as more consumers are asking whether the 8.3% inflation rate corresponds with their anecdotal 23% increase in groceries or the change in prices they’re experiencing with cars, understanding where the government gets the statistics from is useful information.

Bureau of Labor Statistics

Quantifying the magnitude and pace of inflation is among the Bureau of Labor Statistics (BLS) official jobs.

There are 477 workers that work for the BLS that track price changes. Many of these are “on-the-ground” economists whose job it is to confirm that you just paid $1.37 for a can of tuna and that it isn’t a fluke. Their work literally moves markets, including all those tied to interest rates, the stock market, COLA raises for Social Security recipients, and other prices tied to one of the CPI indices.

After a two-year pandemic-related shift away from in-person confirmation, many price checkers have returned and are back out in stores and visiting service businesses in person to collect data. This could include visiting a reception hall, checking prices on a manicure, asking accountants what they charge for a basic tax return, oil change, etc.

Under the Spotlight

For decades there was little attention paid to inflation. For most of the years, the risk of deflation was the most spoken about concern. Retirees would complain that their COLA was more than eaten up by rising Medicaid deductions, and many of us were amazed each time we decided to buy electronics like a new TV. Not only did it cost less than the last one we purchased, but it had better features.

A recent story in the Wall Street Journal about one of these BLS price-checking economists explains she spends more time than ever at each location. Not because she has more business there, but because business owners want to complain to her about rising prices. The story in the Journal says this checker has six children and lately she’s been called upon by her husband and friends to suggest ways to avoid higher bills. This advice she can share. What she cannot help with is sharing any information she has that is confidential, as it could be market moving and considered insider information.

The job of a price-checker has been described as a treasure hunt. As you might imagine, they have very strict price collection rules. Shop owners are not at all counted on to know any of the rules because there is no financial incentive or accountability for them to care enough to treat the task with the importance required.

The job is exacting. To price an item, BLS workers go through up to an 11-page list of data points to make sure they are pricing the same item as they did the prior month. As an example of how exacting, a can of soup will have 12 different specifications, including flavor, size, brand, organic labeling, material of the packaging and dietary features, such as sodium content.

Challenge of Monthly Measurement

The BLS tracks prices on their list of goods and services, along with 8,000 housing units each month. The bureau determines which items to include using census-collected data on buying habits. This makes sure the measurements reflect the way Americans spend their money and captures new buying habits as they emerge using a four-year cycle.

Business participation in the monthly CPI price gathering is voluntary. Businesses can’t be required to participate.  

One challenge they have recently run into is supply-chain shortages. It has made it more difficult to check prices from month to month over the pandemic since goods are often out of stock.

And what about shrinkflation? The price checkers are challenged with watching for quantity changes. If a container of ice cream or can of Pringles has an unchanged price, but the package has shrunk, the price checker has to account for it as a price increase.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://newscorp.com/business/dow-jones/

https://www.dowjones.com/

https://www.marketwatch.com/

https://www.wsj.com/articles/inflation-bls-price-checkers-who-determine-cpi-11652132333?mod=hp_lead_pos8

https://bigcharts.marketwatch.com/

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Fed Hopes for ‘Soft Landing’ for the US Economy, but History Suggests it Won’t be Able to Prevent a Recession

The Federal Reserve will likely soon learn what gymnasts already know: sticking a landing is hard.

With inflation surging to a new 40-year high and continuing to accelerate, the Fed is expected to again lift interest rates by a half-percentage point at the end of its next meeting. It will be the third of seven planned rate hikes in 2022 – following increases in March and May – as the Fed tries to cool consumer demand and slow rising prices.

By raising interest rates, the central bank is hoping to achieve a proverbial “soft landing” for the U.S. economy, in which it’s able to tame rapid inflation without causing unemployment to rise or triggering a recession. The Fed and professional forecasters project that inflation will recede to below 3% and unemployment will remain under 4% in 2023.

Our recent research, however, suggests that engineering a soft landing is highly improbable and that there is a significant likelihood of a recession in the not too distant future.

That’s because high inflation and low unemployment are both strong predictors of future recessions. In fact, since the 1950s, every time inflation has exceeded 4% and unemployment has been below 5%, the U.S. economy has gone into a recession within two years.

Today, inflation is at 8.5% and unemployment is at 3.6% – suggesting a recession will be very hard to avert.

Behind the Curve

Inflation is fundamentally caused by too much money chasing too few goods.

In the short run, the supply of goods in the economy is more or less fixed – there is nothing that fiscal or monetary policy can do to change it – so the job of the Fed is to manage total demand in the economy so that it balances with the available supply.

When demand runs too far ahead of supply, the economy begins to overheat, and prices rise sharply. In our assessment, measures of overheating – such as strong demand growth, diminishing inventories and rising wages – began to show in the economy throughout 2021. But a new operating framework that the Fed adopted in August 2020 prevented the Fed from taking action until sustained inflation was already apparent.

As a result, the Fed is way behind the curve today in responding to an overheating economy.

Sticking a Soft Landing
is Hard

To bring down surging inflation, the Fed will now try to raise interest rates to curb consumer demand.

The resulting increase in borrowing costs can help slow economic activity by discouraging consumers and businesses from making new investments. But it would come at the risk of causing major economic disruptions and pushing the economy into a recession. This is the soft landing: Interest rates rise and demand falls enough to lower inflation, but the economy keeps growing.

The history of engineering soft landings is not encouraging, however. We found that every time the Fed has hit the brakes hard enough to bring down inflation in a meaningful way, the economy has gone into recession.

While some have argued that there have been several examples of soft landings over the last 60 years, including in 1965, 1984 and 1994, we show in our analysis that these periods had little resemblance to the current moment.

In all three episodes, the Fed was operating in an economy with significantly higher unemployment, lower inflation and lower wage growth. In these historical examples, the Fed also raised interest rates well above the inflation rate – unlike today, where inflation is at 8.5% and interest rates are projected to remain below 3% through 2023 – and explicitly acted early to preempt inflation from spiraling, rather than waiting for inflation to already be excessive.

Why is the Labor Market
Relevant for Inflation?

One reason the Fed’s challenge is particularly difficult today is that the labor market is unprecedentedly tight, meaning the demand for workers is far outpacing the available supply of them. A tight labor market implies that companies need to raise wages to attract new workers.

Usually, the unemployment rate is used as an indicator for labor market tightness. Unemployment is very low today, and the Fed expects it to go even lower. But our research shows that the pressure to raise wages is even higher than indicated by the unemployment rate. The number of job openings are at all an all-time high, and workers are quitting at record rates – both of which are significant for driving up wages.

In a sense, wages are the ultimate measure of core inflation – more than two-thirds of business costs go back to labor – so rising wages put significant upward pressure on inflation. Wage growth today is running at a historic rate of 6.6% and accelerating.

With wages rising so fast, there is little basis for optimism that inflation can slow to the 2% range targeted by the Fed. Our analysis shows that current wage growth implies sustained inflation above 5%, and that historically wage growth does not slow without significant increases in unemployment and a recession.

The U.S. economy today is facing additional inflationary pressures from higher grain and energy prices due to the Ukraine war and more supply-chain disruptions as COVID-19 forces new lockdowns in China. These factors threaten to exacerbate inflation even more over the coming year.

In our assessment, the inflation problem facing the Fed today is substantial and unlikely to be resolved without a significant economic slowdown. Overall, the combination of an overheating economy, surging wages, policy delay by the Fed and recent supply shocks means that a recession in the next couple of years is certainly more likely than not.

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Image Credit: Federal Reserve (Flickr)

The FOMC Decision on Rates

The Federal Open Market Committee (FOMC) voted to raise overnight interest rates from a target of 0.25%-0.50% to the new level of 0.75%-1.00%.  The monetary policy shift in bank lending rates was exactly as expected as Fed Chair Jerome Powell and other Committee members had been telegraphic the policy shift in advance of the two-day meeting. The early reaction from the bond market was almost lifeless as the UST 2-year and UST 10-year barely moved after the statement was released.

The statement accompanying the policy shift also included plans to shrink the Fed’s balance sheet. Once again, there was no surprise at the size of the reduction in bonds owned by the Fed. It will follow the exact schedule as outlined earlier. For Treasury securities, the cap of securities allowed to roll off the balance sheet will be set at $30 billion per month and, after three months, will increase to $60 billion per month. The decline in holdings of Treasury securities under this monthly cap will include Treasury coupon securities and, to the extent that coupon maturities are less than the monthly cap, Treasury bills.

For agency debt and agency mortgage-backed securities, the cap will initially be set at $17.5 billion per month beginning June 1, and after three months will increase to $35 billion per month.

Over time, the Committee intends to maintain securities holdings in amounts needed to implement monetary policy efficiently and effectively in its ample reserves regime.

The Committee also stated it is prepared to adjust any of the details of its approach to reducing the size of the balance sheet in light of economic and financial developments.

Take-Away

Higher interest rates can weigh on stocks as companies that rely on borrowing may find their cost of capital has increased. Additionally, investors that would prefer the “known” result of investing in the bond market or other interest rate products may pull assets out of stocks if they are attracted by the fixed income alternative. Investor money leaving the stock market reduces demand.

The next FOMC meeting is also a two-day meeting that takes place June14-15. If the pace of employment and overall economic activity is little changed, the Federal Reserve is expected to again raise interest rates.

Paul Hoffman

Managing Editor, Channelchek

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Source

https://www.federalreserve.gov/newsevents/pressreleases.htm

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Will Investors Rework their Positions in Response to Fed Statements?

Will the Fed send any new signals after its May FOMC meeting?

Federal Reserve members have set investor expectations for a 50bp increase in overnight rates after the May 4 meeting. It’s a pretty safe bet. Anything different would severely spook the markets. However, where the surprise may come is in what Chairman Jay Powell says related to the future after the two-day meeting. This could adjust expectations which would cause investors to adjust their portfolios.

A New Wrinkle to Watch

 While the markets believe that at the following meeting in June the FOMC will also serve up a 50bp hike, last week’s negative first-quarter GDP report may cause the Chairman to speak more cautiously.  And no one has clarity on what the Fed may do after June. One new wrinkle Fed-watchers are aware of is that the negative Q1 GDP, by definition, places us halfway to a recession. If the current quarter also shows negative growth, we are, by definition, already in a recession.

Tightening monetary policy to stop inflation while the economy is shrinking is stagflation.

Investors will be placing every word in the Fed Chairman’s post-meeting statement under a microscope. Inflation is still running at 40-year highs. Interest rates are well below inflation rates creating negative real yields (interest rate minus inflation). Investors prefer to earn above future inflation expectations.

So what are the Fed’s expectations? We should know tomorrow afternoon.

Current Market Expectations

The half a percentage point increase expected is considered aggressive. The Fed typically acts in 25 bp moves and then measures the results. Fed Funds are currently targeted at 0.25%-0.50%, so doubling the level truly is unusual. Many economists, based on previous Fed-speak, expect that a similar move will be made in June before the policymakers sit back and let the market absorb their moves.

The Fed has a number of accommodative stances in place that it discussed unwinding beginning this year – market participants want to know if anything has changed. One of them is to begin shrinking its $9 trillion asset portfolio, starting in the first half and at a much faster pace than its sidetracked attempt at passively reducing its holdings went five years ago.

Since Last Tightening

In March, Fed officials lifted their benchmark federal-funds rate to a range between 0.25% and 0.50%, from near zero. They also projected they could lower inflation back to their 2% target without raising the fed-funds rate higher than 3%. They have considered 2% their neutral range where the economy would avoid getting too heated and avoid slumping.

Economic reports released since the Fed’s last 2022 meeting suggest price pressures could remain more persistent as employers continue to give in to higher wage pressures along with price inputs. On Friday, a Labor Department measure of worker pay that is closely watched by central-bank officials showed wages and benefits for private-sector workers continued to rise at its highest rate since 2000.

Fed communication with the public is especially important now because the central bank is relying on market expectations about its future policy intentions to play a major role in removing stimulus without undue costs to the economy.

Take-Away

Bond traders who watch the Fed most closely are expecting a 50bp increase. Not 25bp and not 75bp. The Fed would disrupt the market if they did anything different. It’s future expectations that will be managed both for the overnight lending rate and the more entrenched stimulus that has been in the system as the Fed purchased longer-term bonds. “Mopping” up this stimulus, which has had a very positive impact on economic growth, is tricky.

Chairman Powell’s audience will be listening intently to know what the future holds. In reality, not even the Fed Chair himself knows what is coming in the next year or two. But, the market will at least hear what the top banker is expecting. 

The FOMC announcement should come at 2pm on May 4.

Paul Hoffman

Managing Editor, Channelchek

Suggested Reading

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What is the Fed’s Beige Book?

Sources

https://www.federalreserve.gov/monetarypolicy/fomccalendars.htm

https://www.usnews.com/news/business/articles/2022-05-03/asian-shares-mixed-in-light-golden-week-trading

https://www.wsj.com/articles/feds-message-on-interest-rate-path-destination-will-be-scrutinized-11651570200?mod=hp_lead_pos4

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What Will the Fed Choose: Recession or an Economic Crisis?

Last week was all about earnings, as some of Wall Street’s heavyweights released their quarterly reports. Moreover, while mixed results caused sentiment to swing from one extreme to the other, inflation remains front and center, and the outlook for Fed policy is bullish.

For example, whether it’s PepsiCo, Mondelez, or Whirlpool, companies have warned that inflation remains extremely problematic. Moreover, with American Express and Visa highlighting consumers’ eagerness to spend, the pricing pressures show no signs of slowing down. Likewise, S&P Global released its U.S. Composite PMI on Apr. 22, and I wrote on Apr. 25 that it was another all-time high for inflation.

Services:

Source: S&P Global

Manufacturing:

Source: S&P Global

With growth, employment and inflation supporting several rate hikes over the next several months, there is little in the release that implies a dovish U-turn. To that point, please remember that the survey was conducted from Apr. 11 to Apr. 21. Therefore, while investors hope that decelerating growth and inflation will allow the Fed to back off, the PMI data suggests otherwise. As such, the Fed’s conundrum continues to intensify.

Furthermore, with more appetizing earnings reports released on Apr. 28, the results were even more bullish for Fed policy. Likewise, with the precious metals (PMs’) force fields wearing off, they should suffer profoundly as rate hike volatility increases. For example, McDonald’s released its first-quarter earnings on Apr. 28. CFO Kevin Ozan said during the Q1 earnings call:

“In the U.S., I think last quarter, I mentioned that we thought commodities were going to be up roughly 8% or so for the U.S. That number is now more like 12% to 14% for the year. So U.S. commodities clearly have risen (…).”

“On the labor side, in the U.S., it’s probably over 10% right now. Part of that is because, you’ll recall that we made adjustments to our wages in our company-owned restaurants mid-year last year, so we haven’t lapped that. So part of it is due to that and part of it is due to just continued wage inflation.”

As a result, the Fed is losing control of the inflation situation, and the largest restaurant chain in the world is still sounding the alarm. Therefore, with the pricing pressures unwilling to abate on their own (which I’ve warned about for some time), killing demand is the only way to reduce the wage-price spiral.

Please see below:

Source: McDonald’s/Seeking Alpha

On top of that, Caterpillar released its first-quarter earnings on Apr. 28. For context, the company is the world’s largest construction equipment manufacturer. CFO Andrew Bonfield said during the Q1 earnings call:

“We remain encouraged by the strong demand for our products and services. The first quarter of 2022 marked the fifth consecutive quarter of higher end user demand compared to the prior year. Services remained strong in the quarter. We continue to make progress on our service initiatives, including customer value agreements, e-commerce, connected assets and prioritized service events.”

CEO Jim Umpleby added:

“Absent the supply chain constraints, our top line would have been even stronger. When the supply chain conditions ease, we expect to be well positioned to fully meet demand and gain operating leverage from higher volumes.”

Thus, with each new earnings season, companies note that demand remains resilient. As a result, why not raise prices and capitalize on too much stimulus?

Source: Caterpillar/Seeking Alpha

As expected, the “transitory” camp waved the white flag in 2022. However, the merry-go-round of input/output inflation was visible from a mile away. For example, remember what I wrote on Mar. 30, 2021?

Didn’t Powell insist that near-term inflation was only “one-time” and “transient”? Well, despite government-issued CPI data failing to capture the effect of the Fed’s liquidity circus, pricing pressures are popping up everywhere. And with corporations’ decision tree left to raising prices or accepting lower margins, which one do you think they’ll choose?

Continuing the theme, Domino’s Pizza reported its first-quarter earnings on Apr. 28. For context, the company is the largest pizza chain in the U.S. Moreover, when contrasting the quarterly results of Microsoft and Alphabet on Apr. 28, I wrote that investors fail to realize that some companies have succumbed to the medium-term realities sooner than others. Therefore, Domino’s Pizza is another example. CEO Ritch Allison said during the Q1 earnings call:

“Consistent with our communications during our prior earnings call, we faced significant inflationary cost increases across the business in Q1. Those cost pressures combined with the deleveraging from the decline in U.S. same-store sales resulted in earnings falling short of our high expectations for the business (…).”

“We believe that we will continue to face pressure both on the top line for our U.S. business and on our bottom line earnings over the next few quarters. While we remain very optimistic about our ability to drive long-term profitable growth in the near-term 2022 is shaping up to be a challenging year.”

CFO Sandeep Reddy added:

“In addition, we would like to update the guidance we provided in March for 2022. Based on the continuously evolving inflationary environment, we now expect the increase in the store food basket within our U.S. system to range from 10% to 12% as compared to 2021 levels.”

If that wasn’t enough, with unprecedented handouts reducing U.S. citizens’ incentive to work, staffing shortages materially impacted Domino’s Q1 results. Moreover, the development is extremely inflationary and only increases the chances of future interest rate hikes.

Please see below:

Source: Domino’s Pizza/Seeking Alpha

Therefore, while I’ve warned on numerous occasions that the Fed is in a lose-lose situation, investors still hold out hope for a dovish pivot. However, they fail to understand the consequences. For example, a dovish 180 is extremely unlikely in this environment; but even if officials completely reversed course, the long-term economic damage would be even more paramount.

When companies are saddled with input pressures, even value-oriented chains like Domino’s Pizza can only endure margin erosion for so long. Thus, with management searching for new ways to appease investors, Fed officials’ patience will only cause an even bigger long-term collapse once inflationary demand destruction unfolds.

Please see below:

Source: Domino’s Pizza/Seeking Alpha

Turning to the macroeconomic front, some interesting data also hit the wire on Apr. 28. For example, the Kansas City Fed released its Tenth District Manufacturing Survey. The headline index declined from 37 in March to 25 in April. Chad Wilkerson, Vice President and Economist at the KC Fed, said:

“The pace of regional factory growth eased somewhat but remained strong. Firms continued to report issues with higher input prices, increased supply chain disruptions, and labor shortages. However, firms were optimistic about future activity and reported little impact from higher interest rates.”

To that point, both the prices paid and received indexes increased month-over-month (MoM).

Please see below:

Source: KC Fed

Finally, the major surprise on Apr. 28 was that U.S. real GDP contracted by 1.4% (advance estimate) in Q1. The report stated: “The decrease in real GDP reflected decreases in private inventory investment, exports, federal government spending, and state and local government spending, while imports, which are a subtraction in the calculation of GDP, increased.”

However: “Personal consumption expenditures (PCE), nonresidential fixed investment, and residential fixed investment increased.”

Therefore, with supply chain disruptions leading to import stockpiling (which hurts GDP), net trade was the weak link. However, the dynamic should reverse in Q2 and Q3, and if so, shouldn’t impact the Fed’s rate hike cycle.

The bottom line? The Fed is stuck between a rock and a hard place: deal with inflation now and (likely) push the U.S. into a recession later or ignore inflation and watch an even bigger crisis unfold down the road. As such, the first option is the most likely outcome. Remember, while Fed officials may seem out of touch, they’re not stupid, and history shows the devastating consequences of letting unabated inflation fester. Therefore, interest rate hikes should dominate the headlines over the next several months, and the PMs and the S&P 500 should suffer mightily along the way.

In conclusion, the PMs were mixed on Apr. 28, as silver was the daily underperformer. Moreover, while mining stocks were boosted by the S&P 500, the ‘buy the dip’ crowd is fighting a losing battle. With Amazon and Apple down after the bell on Apr. 28, weak earnings guidance should also dominate the headlines in the months to come. As a result, with the USD Index on fire and real yields poised to continue their ascent, the PMs’ medium-term outlooks are extremely treacherous.

What to Watch for Next Week

With more U.S. economic data releases next week, the most important are as follows:

May 2: ISM Manufacturing PMI

Like this week’s S&P Global Report, ISM’s report is one of the most important data points because it covers growth, inflation, and employment across the entire U.S. Therefore, the results are more relevant than regional surveys.

May 3: JOLTS job openings

Since the lagged data covers March’s figures, it’s less relevant than leading data like the PMIs. However, it’s still important to monitor how government-tallied results are shaping up.

May 4: ADP private payrolls, ISM Services PMI, FOMC statement and press conference

With the FOMC poised to hike interest rates by 50 basis points on May 4, the results and Powell’s comments are the most important fundamental developments of the week. However, ADP’s private payrolls will also provide insight into the health of the U.S. labor market, while the ISM’s Services PMI will have similar implications as the manufacturing PMI. Moreover, both will provide clues about future Fed policy.

May 5: Challenger jobs cuts

With the data showcasing how many employees were fired in April, it’s another indicator of the health of the U.S. labor market.

May 6: Nonfarm payrolls, unemployment rate, average hourly earnings

Half of the Fed’s dual mandate is maximum employment, so continued strength in nonfarm payrolls is bullish for Fed policy. In addition, a low unemployment rate is also helpful, while average hourly earnings will showcase the current state of wage inflation.

All in all, economic data releases impact precious metals because they impact monetary policy. Moreover, if we continue to see higher employment and inflation, the Fed should keep its foot on the hawkish accelerator. If that occurs, the outcome is profoundly bearish for the PMs.

Suggested Reading

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Will the Fed be Fighting Inflation Now?

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Image Credit: Yuki kawagishi (Flickr)

‘Great Resignation’ Appears to be Hastening the Exodus of US and Other Western Companies from Russia

Companies across the globe are fleeing Russia in an unprecedented display of corporate solidarity with their governments, appalled over the invasion of Ukraine. Over 750 multinational businesses so far have said they’re curtailing, suspending or severing ties to Russia, more than triple the number that abandoned South Africa over apartheid in the 1980s.

Many corporate statements announcing the decisions have emphasized humanitarian aspects and unity with the Ukrainian people. For example, Pepsi suspended soda sales in Russia, describing events in Ukraine as “horrific”; Ford Motor Co. cited Russia’s “threats to peace and stability” in pausing operations at its three plants in the country; and Ikea closed its stores there and called the war a “human tragedy.”

Detractors of this type of corporate do-goodery have dismissed it as “virtue signaling,” implying there is an ulterior motive to the grandstanding. As scholars of corporate social responsibility, we believe altruism can play a role in corporate decisions like these, but – as virtual signaling suggests – other more profit-focused drivers are usually at work, especially given the stakes when deciding to abandon an entire country.

In this case, the common theme we see for many companies is the “great resignation” – and the fight to attract increasingly picky, younger Gen Z and millennial workers, who say they want to work for socially responsible brands.

Pepsi, which has been in Russia for over 60 years, suspended soda sales, calling the invasion ‘horrific.’  Image Credit: Alexander Zemlianichenko

A Weighty Decision

A company’s decision to entirely sever its operations in a country is seldom taken lightly.

In leaving Russia, companies will incur significant costs from abandoning equipment, stores and factories, or even an entire workforce. For example, Exxon said it expected to lose US$4 billion in assets over its decision to exit Russia, while McDonald’s restaurant closures will cost the company $50 million per month.

And there’s no knowing when the companies leaving Russia will be able to return – if ever.

Yet that isn’t stopping hundreds of companies from making the difficult decision to back away. Amid their condemnations of the invasion and expressions of solidarity with the Ukrainian people, many companies have also acknowledged clear business-related reasons. Appliance maker Whirlpool cited the security of its workers, Japanese automaker Toyota blamed logistical and supply-chain hurdles, and video streaming company Netflix said troubles with payment processing will strain operations.

Growing Power of Workers

While these practical reasons, along with the moral concerns, could be enough to drive the exodus, we believe the great resignation, in which record numbers of workers are quitting their jobs, is amplifying all these other risks of staying in Russia.

Roughly 47 million U.S. workers voluntarily left their jobs in 2021, accounting for well over a quarter of the civilian labor force, according to the Bureau of Labor Statistics. Over 4.5 million quit in November alone, a single-month record, and nearly that many continued to hand in their notices in early 2022.

It’s not just a U.S. phenomenon. Many other countries are experiencing similarly high rates of workers voluntarily quitting their jobs.

This trend has shifted bargaining power to employees, and companies are struggling to acquire skilled workers to fill vacant positions. Employees are demanding higher pay and more benefits, and some are rethinking their careers so that their work is more aligned with their values.

Another sign of the shift in power is the recent success of youth-led labor organizing efforts. A growing number of Starbucks locations are becoming unionized, while Amazon got its first U.S.-based union after workers on Staten Island in New York City voted to form one in April 2022. Starbucks and Amazon have both suspended operations in Russia.

Some industries are experiencing especially high employee attrition rates, including management consulting and oil and gas, according to a recent article in MIT Sloan Management Review. The attrition rate measures how many workers are lost and not replaced over a period of time.

Management consulting, in which a talented workforce is vital, for example, saw an attrition rate of 16% over the six-month period researchers looked at, or over five times the national average.

Employees Demand Solidarity with Ukraine

This is why it wasn’t a surprise to us that companies in these labor-strained industries either were among those that severed ties with Russia or quickly did so after facing criticism from employees.

IT consultant Accenture, with nearly 700,000 employees, seemed to set the tone for what would be expected of companies in its industry when on March 3, 2022, it said it was discontinuing all business in Russia.

“Accenture stands with the people of Ukraine and the governments, companies and individuals around the world calling for the immediate end to the unlawful and horrific attack on the people of Ukraine and their freedom,” it wrote.

Competitors McKinsey and Boston Consulting Group initially planned more timid withdrawals by cutting ties with the Russian government but continuing to honor existing private contracts. But after current and former employees of both companies took to social media to call out their perceived soft stance and even cowardice on Russia, the companies quickly reversed course by announcing they were pulling out completely. All the other consulting giants have done the same, including Bain, Deloitte, EY, KPMG and PwC.

The big Western oil companies have similarly faced employee pressure to exit Russia, with workers going so far as to refuse to offload Russian oil and gas onto their docks. This comes on top of governments pushing companies to take steps that go beyond the sanctions. In severing ties, companies such as BP, Shell and Exxon have abandoned significant assets in Russia, which will result in huge losses on their balance sheets.

Short-Term Costs for Long-term Gains

But accepting these short-term losses appear to be worth it to avoid larger ones down the road.

Recruiting and retaining a talented workforce is an important driver of a company’s long-term profitability.

Training new workers is costly, and the best talent is always hard to recruit – a challenge made worse by the great resignation. Survey after survey has shown workers are increasingly driven by a sense of purpose and expect their companies to reinforce their values.

No company that we know of explicitly cited issues related to the great resignation as a driver of its decision to leave Russia. And industries with high attrition rates and vocal workforces such as Big Tech haven’t seen complete withdrawals. In some cases, such as with Apple, Alphabet and Meta, they’ve suspended some operations but are trying to keep doing business in part because they play important roles in providing free information to Russian citizens to counter Kremlin propaganda.

Every company and every industry has its own unique analysis to go through based on exposure to business and reputational risk in Russia. We believe the great resignation compounds this risk, in some cases significantly. And employees are increasingly reporting feeling stressed out over Ukraine.

Russia’s aggression against Ukraine has been condemned almost universally in the West. Given that, many of the companies that severed ties – while sacrificing short-term profits – likely knew that staying would have been far more harmful for their brand, not only with customers but their employees as well.

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Jack Dorsey, Corporate Boards, and Bad Apples

ESG Policies and Corporate Departures from Russia

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Image Credit: Can Pac Swire (Flickr)

Challenges to the US Dollar as a Reserve Currency and Market Impact

The percentage of US dollars used by foreign central banks as their reserve currency, has fallen dramatically in the past seven years. During this same period, a greater share of global reserves are being held in Chinese yuan. Could this shift impact US investments, including stocks and interest-bearing securities? Will US living standards suffer?

When any reserve currency, including gold, the Euro, the yuan and others, experiences increased demand, its value is enhanced. Fading demand has the impact of decreasing value which pushes upward on inflation for goods transacted in that currency. A weakening currency also demands higher interest rates to attract use. Valuations across all dollar-denominated markets may get dragged down with a declining dollar as well.

Background

The United States dollar has been the world’s primary reserve currency for over 60 years. Before the early 1970s, the dollar had been pegged to gold and most other currencies were then valued off the dollar. Since dollars are easier to work with than gold, greenbacks were used as the main intervention currency for monetary policy adjustments outside (and inside) of the US.

The establishment of the European monetary union and the euro in 1999 led to predictions of the dollar weakening. These fears were not realized. The use of the dollar as the primary reserve currency is based on the US maintaining a position as the world’s dominant economy. US dollars did not reach the position of reserve currency by world leaders somehow meeting and deciding to use dollars. Instead, it was based on trust and size of the US economy and debt market.

It does however make international transactions easier if currencies are priced to one currency.

Recent Trend

Using measurements from just before the Russian sanctions from the West, the percentage of dollars used as a currency dropped below 59% (Q4 2021).  This is down from 62% at the beginning of 2020, and 65% five years earlier in 2015. The trend toward using other currencies has recently accelerated.

The declining use of the dollar is even more dramatic when currency values are factored in. The recent strengthening of the dollar is masking a steeper drop in its “per unit” reserve status; the increase in momentum may have begun in 2018 when the US imposed tariffs on specific goods from China and a few other nations.

The euro is the second most widely-held reserve currency. It had experienced a net reduction over the last decade, but so far this decade has ticked higher. The trend seems to show that central banks are diversifying their reserve holdings.  It would not be surprising if future data shows that the war in Europe has caused a lower level of use of euros as reserves.

Rising bond yields are likely to drive flows to dollars as long as competing currency, real yields (after inflation) aren’t rising more rapidly.

Very recently the Yuan has lost value as Beijing has re-imposed strict lockdowns related to coronavirus activity.  Coupled with rising rates in the US and Europe, the Yuan should be under downward pressure.

Impact on Markets

Ordinarily, a softening yuan against US dollars would add to the two countries’ trade imbalances. Strong dollars make imports cheap. However, if production does not keep up with demand because of new lockdowns, the Chinese may not benefit from increased exports.

Inflation would be dampened somewhat on goods produced in China, but again if there is only a modest increase in imported goods from the US the inflation numbers reported will be barely impacted.

Strengthening dollars drive currency into US markets and could help support price levels during a period, like now, when there is a bearish tone due to a more hawkish monetary policy.

Take-Away

The US economy is experiencing its challenges for many different reasons. So are the other economies of the world. For this reason, central banks are diversifying. However, the US dollar is still considered to be the “risk-free” exchange medium against which others are measured. The size and scope of the US economy is likely to help the greenback retain its position, even as outside central banks decide to spread their risk around more than they have in the past.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://data.imf.org/?sk=E6A5F467-C14B-4AA8-9F6D-5A09EC4E62A4

https://www.chinabankingnews.com/2022/04/25/chinese-renminbi-rises-as-share-of-global-reserves-as-greenback-drops-to-record-low/

https://www.bis.org/publ/qtrpdf/r_qt1812b.pdf

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