The Fed fear factor

Stocks dropped yesterday after a strong manufacturing number caused traders to fear that the Fed may act more aggressively. Treasury bond yields have risen in recent days as inflation fears continue to dominate the market’s psyche.

Good news bad news, bad news good news. Though hope is not a strategy, you can’t blame traders for having it. In this case, I am referring to hopes that the Fed is actually going to stop hiking key lending rates or, better yet, lower them. I am quite confident that both cases will, in fact, occur… eventually, just not now. To clarify, eventually does not mean next month either. The broader market seems to be wrestling with a Fed inflection point sometime in the fall of this year. The inflection point is not likely to include a lowering of interest rates, but more likely, a pause or a smaller, +25 basis point hike. “Why Mark, why are you talking about the Fed and hikes yet again,” you ask? Because that is what is driving the market volatility these days, speculation about what the Fed will do and what effects its actions may have on the economy… more the former. On Tuesday, crude oil spiked after the EU put more curbs on Russian oil, leading traders to speculate that the move would drive inflation higher and the Fed to react with hawkish action, ultimately driving stocks lower. Yesterday, ISM Manufacturing came in at a higher than expected 56.1, which was incidentally higher than the prior 55.4 reading. So, manufacturing PMIs are reflecting stronger conditions in May. That is a sign that at least one part of the US economy remains solid. For reference, the number spent most of 2021 above 60, so a better description may be manufacturing is holding its own, for now. For traders yesterday, “holding its own” led to the belief that inflation will remain high and that the Fed would be forced to raise rates at a faster clip. Good for the economy was bad for stocks. Also, yesterday was the beginning of the Fed’s quantitative tightening in which the Fed would begin shrinking its ginormous balance sheet. It will accomplish that in two ways: 1) by selling bonds, and 2) by letting its existing holdings mature without replacing them. The former could pressure treasury yields as supply comes to the market and the latter is just good housekeeping. The real effects on yields came months ago when the Fed stopped being an active buyer allowing market forces to determine yield. What that means is that all the tightening, selling, and hiking is already likely to be factored into bond yields.

Let’s take a step back and try to figure out what is really, really happening here. Higher yields and interest rates do not by themselves cause inflation to slow down. That is our job as consumers. Higher borrowing costs are supposed to goad us into buying less. Weaker demand will cause prices to moderate… eventually. In reality, borrowing costs have already gone up, and by quite a bit. Average 30-year fixed mortgage rates are around 5.46%, much higher than the 3.5% where they were at the start of the year. There is evidence that those higher rates may be impacting demand. The Mortgage Bankers Association reports its Mortgage Market Index, which is a weekly reflection of mortgage applications. If we observe the 3-month trend, it is not only negative, but it is trending downward, indicating that there have been less and less applications. Given what we know about mortgage rates going up, it makes sense that there have been less applications. What does that mean for the housing market? Well, as you might guess both new and existing home sales have been trending down after sharp rises through the early part of the pandemic. Despite all of this however, home prices are still on the rise. According to the latest data from the Federal Housing Finance Agency, House Prices rose by +18.76% from March of 2021 through March of this year. Now, that is a lagging number, so all we can tell from it is that home prices were still skyrocketing in March… when mortgage rates were at least 1 percentage point lower. There is plenty more evidence that, regardless of interest rates, consumers are shifting their purchase habits based on several factors, the most prominent being inflation itself. We learned a lot from earning releases, particularly those from mass merchants like Walmart or Target. We learned that consumers are choosing food over non-essentials as a result of food inflation. Another factor is the “fear factor”, in which consumers are putting off bigger purchases to wait and see what happens with the economy. Finally, we must give some credit to the Fed, whose “forward guidance” actually impacts companies as well as consumers who react to Fed speak and try to anticipate future moves. All these together will eventually cause inflation to moderate, just not now. When that happens, the Fed will react by moderating its policy… eventually, just not now.

YESTERDAY’S MARKETS

Stocks floundered in the wake of a strong manufacturing PMI release yesterday as traders feared that a more aggressive Fed is imminent. The S&P500 fell by -0.75%, the Dow Jones Industrial Average dropped by -0.54%, the Nasdaq Composite Index gave up -0.72%, and the Russell 2000 Index traded lower by -0.49%. Bonds declined and 10-year Treasury Note Yields gained +6 basis points to 2.90%. Cryptos lost -5.72% and Bitcoin declined by -6.82%.

NXT UP

• ADP Employment Change (May) is expected to show +300k new hires after reporting a +247k gain last month.
• Initial Jobless Claims (May 28) is expected to come in at 210k, same as last week.
• Factory Orders (April) may have gained +0.7% after climbing by +1.8% in March.