Rough surf in a sea of red

Stocks closed mostly lower yesterday as bond yields soared in anticipation of a more aggressive Fed. The PPI showed that inflation is still impacting producers but there is hope, albeit slim, that the pressure is easing.

et voilà! As if by magic, in one fell swoop, financial conditions just got tighter. For the record, financial conditions were already tight last week. Forget that obscure Fed Funds rate for a minute. Inflation, itself, is a tax on a consumer’s income. The higher the inflation the tighter the financial conditions. Oh, and interest rates on real things were already on the climb. Rates on 30-year fixed mortgages were already at 5.5% in the middle of last week while they were just above 3% a year ago. The same house will cost you more per month this summer, based on financing alone; never mind that the same house, itself will cost you around +18% more this year, according to the latest numbers from the Federal Housing Finance Agency. Those facts alone may be enough to turn the heat down in the housing market. If you already own a home and you have an adjustable mortgage, well you will be paying more every month for housing. Are you a renter? Chances are, you were shocked when you got your renewal notice. Yes, rents are higher as well. Landlords rely on bank financing, which has grown on par with mortgage rates and bond yields.

Now back to that obscure Fed Funds Rate. It is the rate at which banks borrow and lend money overnight, TO EACH OTHER. Try to go to your local bank and ask if you can borrow money at that rate. Make sure to wear a clown nose while you are at it, because you are assured to get a laugh out of the loan officer. All jokes aside, the Fed Funds Rate serves as a guide for all other lending and the Fed uses it to set the pace of loan finance. All that stuff in the last paragraph about increased costs and tight financial conditions started last November when the Fed signaled that it would begin to raise its benchmark rate in order to slow the pace of inflation. In the months since the Fed’s admission, it has raised Fed Funds to 0.75% and has all but promised to raise it to at least 2.5% by year end. The hope is that consumers, faced with increasing costs and the threat of more increases, will ratchet down demand and allow prices to moderate. The problem is that its not quite working out yet, as evidenced by that hot Consumer Price Index number from last Friday which showed that inflation spiked to a 40-year high last month. The number surprised many economists and surely caught the eye of FOMC members who started their policy meeting yesterday. Markets reacted immediately starting with 2-year Treasury notes, whose yields jumped to levels not seen since 2007! The rise in yields was not limited to short maturities as the entire yield curve rose. The selling quickly spread into the stock market as fears of rampant inflation and possibly recession caused unrest. Mortgage rates jumped ¼ of a point over night in response to the move. The selling continued Monday…all in preparation for what the Fed might do today. Mortgage rates are now just under 6%, ¼ point higher than last Friday.

Speaking of today, the Fed will announce its rate decision this afternoon at 2:00 PM Wall Street time. Just last Wednesday, markets were expecting a pair of +50 basis point rate hikes in June and July followed by the possibility of a smaller +25 basis point hike in September. That alone was enough to fuel the recent volatility in stocks. This morning, markets are pricing in a 95% chance of a +75 basis point rate hike and a 0% chance of a +50 basis point bump. Just a week ago that same probability of a +75 basis point hike was at a slim 8%. Looking forward to July, markets are pricing in another +75 basis point hike. The probability of that is 93% after being at only 0.8% a week ago. Talk about a shift in sentiment. Looking further yet into the future, forward rate models predict that Fed Funds will end the year at around 3.58%. That is +75 basis points higher than it was a week ago and 1 full percentage point above the neutral rate at which economists believe to be the tipping point between accelerating and decelerating.

All this puts the Fed in a very tricky situation. If the Fed hikes by less than +75 basis points, it runs the risk of losing credibility, knowing full well that it also runs the risk of increasing the chances of recession if it raises by the newly expected amount. Though not likely, the Fed can decide to raise rates more than the expected +75 basis points. One thing is certain, inflation is a problem and the Fed is perceived as being behind the curve, so we can expect tough action…and tough talk. Remember, markets do the heavy lifting, and they typically react to guidance, as evidenced by the spike in mortgage rates and Treasury yields, when the Fed only raised rates by a mere +75 basis points to date. Today’s talk will come from the Fed’s dot plot and projection release. The dot plots will show us what Fed members expect Fed Funds to be in the future. We can compare the new dots to the old to see how much sentiment has changed and how aggressive the FOMC expects to be going forward. Additionally, we will glean FOMC members’ projections on inflation and GDP. We will see when the policy makers expect inflation to cool, and even more importantly, if they are predicting a recession. If all this hasn’t already caused consumer demand to weaken…well, you know.

YESTERAY’S MARKETS

Stocks could not hold on to early gains as positive sentiment waned throughout the volatile session. The S&P500 slipped by -0.38%, the Dow Jones Industrial Average lost -0.50%, the Nasdaq Composite Index gained +0.18%, and the Russell 2000 Index gave up -0.39%. Bonds fell and 10-year Treasury Note Yields vaulted by +12 basis points to 3.47%. Cryptos fell by -1.81% and Bitcoin lost -5.36%.

NXT UP

• Retail Sales (May) may have risen by +0.1%, slower than April’s +0.9% gain.
• NAHB Housing Market Index (June) is expected to have slipped to 67 from 69.
• FOMC Policy Announcement and Projection Release will come at 2:00 PM EST and the Chairman will hold a press conference following the release.