I think we need to start here by considering where the U.S. economy stands with respect to three important factors - inflation, growth and unemployment. As the S&P 500 and Nasdaq 100 near new highs, it might give investors the impression that short-term troubles have waned. In reality, this is largely a function of mega-cap earnings resulting in a mini-rotation back out of cyclicals and into growth sectors. The underlying macro dynamics here are actually looking like the early innings of a cycle shift towards a recession.
Currently, we have inflation accelerating, growth slowing and unemployment rising. Granted, none of these factors are at the point of signaling a major warning just yet, but all three are beginning to trend in that direction. The Fed may not want to use the word “stagflation”, but it’s tough to look at the current trends and conclude that this isn’t at least a possibility later this year. The larger problem is that when you consider these three factors along with the Fed’s generally hawkish stance on policy and the unwillingness to consider the risk of stagflation, it’s beginning to look like there’s a central bank policy mistake ahead.
If rising inflation requires higher interest rates, yet slowing growth & higher unemployment call for lower interest rates, what’s the Fed going to do? From the sounds of it, Powell may be trying to play both sides of the coin. By saying that progress on inflation has stalled, he’s setting the stage for “higher for longer” interest rates, something that makes sense in isolation. Powell’s statement last week that the Fed intends to slow down its balance sheet runoff may reveal his ultimate motive. By slowing the pace of QT, Powell is effectively reasserting the Fed as a potential buyer in the Treasury market and provider of liquidity to the economy. A reduction from $60 billion a month to $25 billion a month doesn’t qualify as “easing” in the literal sense, but I do think the Fed is positioning itself to provide the monetary flexibility to step in and control conditions should they begin deteriorating beyond their liking. The Fed may have been able to achieve the soft/no landing up to this point, but the next phase may be especially tricky. If both inflation and unemployment are trending higher at the same time, Powell may have some really difficult decisions to make.
The asset class to watch here, I believe, is long-term Treasuries, where the 10-year yield has dropped by 25-30 basis points in roughly two weeks. I think there are a few reasons for this. The weak jobs report and the slower-than-expected Q1 GDP report would almost certainly argue for lower rates. The Fed’s QT taper could also be a catalyst that pushes rates lower. Perhaps there’s a little flight to safety kicking in here? I also think it’s interesting that this is happening as the BoJ is intervening in the currency markets. Either the BoJ isn’t using its Treasury stockpile to buy up yen or it is and it’s not having an impact on yields.
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