Authored by Simon White, Bloomberg macro strategist,
The labor market, the yield curve, inflation and a stock-market selloff are poised to force the Federal Reserve into a rate cut sooner than the market is currently pricing.
In markets, it pays to remember that things take longer to happen than you think they will, and then they happen much faster than you thought they ever could. It was only two weeks ago that the market was expecting up to another four rate hikes. Now it’s effectively pricing the end of the rate-hike cycle, and the first cut by the end of the third quarter.
But there are several reasons why there could be another abrupt alteration in the state-of-play, with the first cut coming as early as June, and potentially significant cuts priced in before the end of the year:
Signs of deterioration in the job market that gain momentum very quickly;
A recession that now looks unavoidable and could begin as early as June;
Inflation that is long past its cycle peak; and
A rapid fall in velocity leading to a stock-market selloff
One of the surprising aspects of this cycle has been the resilience in the labor market. But that looks about to change. Unemployment claims are one of the most leading measures of the job market. The headline number has remained low, but the real information content comes from looking under the surface.
The chart below shows that almost a fifth of US states are seeing claims rise more than 25% on an annual basis. This is at a level that is often preceded by a further rapid deterioration and a jump higher in the nationwide number, which has in most cases culminated in a recession.
Moreover WARN notices are rising sharply. These must be filled in by employers 60 to 90 days ahead of plant closings and mass lay-offs, and lead unemployment claims.
Not only does a recession look unavoidable, it could happen as soon as the summer. Yield-curve inversions tell you a recession is on the way at some point, but a more imminent sign is when the curve steepens.
The part of the curve that typically starts steepening first is the 3-month/30-year segment
This began to steepen in early February, and has kept steepening apart from a brief spasm in the wake of SVB. This is historically consistent with a recession beginning as soon as June, and would match the raft of leading indicators that are anticipating a slump.
The Fed typically starts cutting rates 2-3 months before the recession starts, and 6-8 weeks after the 3m-30y curve begins steepening. If the curve bottomed two weeks ago, that’s consistent with the first cut as early as May.
Would inflation stop the Fed cutting, even if the jobs market were markedly worsening and a recession looked imminent? Historically speaking, no. On average, the Fed starts cutting rates six months after CPI peaks. Inflation, in this cycle, peaked nine months ago, and has since fallen by a third.
To be sure, there are still plenty of worrying aspects to inflation, from elevated profit margins, to sticky core measures. But the Fed is adept at moving the goal posts when it needs to, and – barring a rapid re-acceleration – inflation is unlikely to be enough on its own to hold the central bank back from easing if it needs to.
Nevertheless, the elephant in the room is the stock market. With the S&P still hovering around 4,000 the Fed is unlikely to cut. But the banking crisis is leading to a sharp tightening in financial conditions. Don’t be fooled by the recent expansion of the Fed’s balance sheet, velocity is being sucked out of the system rapidly.
Stocks are highly exposed to this fall. As data last week confirmed, deposits are leaving the banking system, and from there heading to higher-yielding money market funds and thus the RRP, where their velocity is effectively zeroed. The fall in deposits is likely to lead to an even bigger contraction in real money growth, precipitating another drop in equities.
This would solve the Fed’s financial conditions dilemma, in that it will not ease until these tighten. The dirty little secret about FCIs (financial conditions indexes) is that they are highly correlated to equities. If stocks are soon a lot lower after a velocity-induced selloff, there will be little to stop the Fed cutting rates, perhaps by a lot, when the economy is showing marked signs of distress.
Cutting rates would also, at a stroke, improve the solvency of the regional-bank sector, the focal point of the current crisis. Estimates are that the US banking sector overall is harboring losses of $2 trillion in hold-to-maturity portfolios, which would rapidly diminish as rates fell, as well as reducing the need (for now) of more Fed lending programs.
The market does not currently see the first full cut priced until September, but it could come much more abruptly than you think. Another rate hike looks like a distant possibility – the Fed would gain little when the front of the curve is now so inverted – leaving July and August Fed Funds futures with excellent risk-reward.
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