by Marc Chandler
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The outcome of the Federal Reserve Open Market Committee meeting on July 27 is the most important event in the last week of July. After a brief flirtation with a 100 bp hike after the June CPI accelerated, the market has settled back to a 75 bp move. The Fed funds futures are pricing about a 10% chance of a 100 bp hike. The market anticipates that after the second 75 bp hike, the Fed will most likely return to a 50 bp hike in September.
Fed Governor Wall, a leading hawk, pushed back against the larger move but kept the door open pending new data. He specifically cited retail sales and the housing data. Retail sales were stronger than expected (1.0% vs. 0.9% median forecast in Bloomberg's survey), and the May series was revised to show a 0.1% decline instead of -0.3% as initially reported. In addition, June housing starts expectedly declined by 2% (the median forecast was for a 2% gain), though May's 14.4% decline was revised to only 11.9%. Existing home sales slumped 5.4% in June (the median forecast was for a 1.1% decline). It was the fifth consecutive monthly fall.
The eurozone and the US reported disappointing flash composite July PMIs. They both unexpectedly fell below the 50 boom/bust level. This warns that the Q3 has begun off with poor momentum. Indeed, as policymakers note, the path to a soft landing has narrowed. At the end of June, the Fed funds futures implied a year-end rate between 3.25% and 3.50%. Since the CPI, the market has mostly been holding at the range's upper end. However, the year-end rate pushed toward the lower end of the range after the US PMI. The data boosted the market's confidence that the Fed will have to cut rates next year. The implied yield of the June 2023 Fed funds contract is now about 23 bp lower than the December 2022 contract. The December 2023 contract is about 58 bp lower than the December 2022 contract.
At least in its declaratory policy, the Fed emphasizes inflation expectations. The preliminary University of Michigan July survey saw the 5-10 year inflation expectations fall to 2.8%, matching the lowest level since April 2021. The 10-year breakeven (the difference between the conventional yield and the inflation-protected security) is virtually unchanged this month at around 2.35%. It peaked in late April slightly above 3.07%. A fall in retail gasoline prices has perhaps encouraged the lower expectation. According to the American Automobile Association, the national average has been easing every day since the June 13 peak of slightly more than $5.00 a gallon. It has pulled back about 12% from the high and is below its 100-day moving average for the first time since January.
Some pundits continue to argue that the Fed has lost its credibility by being so slow out of the gate at first to end its asset purchases and then to hike rates. Yet, without a metric to measure it, claims stay in the realm of subjective feeling. On the contrary, we think the Fed retained its anti-inflation credibility. The decline in the market-based inflation measures illustrates this. The fact that the 10-year yield has been in a 2.75%-3.10% range this month suggests the Fed's credibility is intact. That nominal yield is only justifiable if one expects inflation to average less than that, even while recognizing that inflation over the next year or two remains elevated.
Many of these pundits were crying for a Volcker-like moment, harkening back to Volcker's decision to squeeze out inflation even at the risk of a recession. Investors seem to recognize the Volcker pivot at the Fed, and some critics bemoan the economic slowdown, with some claiming the US is already in a recession. They are making a fetish of a recession, which has no agreed-upon definition. Two-quarters of contracting activity serves the purpose of Econ 101 but is an over-simplification for businesses, investors, and policymakers. Indeed, two recent downturns in the US did not meet that textbook concept, and the National Bureau of Economic Research, the official arbiter, still said they fit the bill.
The day after the FOMC meeting concludes, the US publishes its first estimate of Q2 GDP. The Atlanta Fed's GDPNow tracker has been a good diviner of US growth. It sees a 1.6% annualized contraction in the April-June period. The median forecast in Bloomberg's survey has fallen to 0.8%. It had been steady at 3% from April through June. However, of the 55 forecasts, a dozen of them, or almost 22%, project a contraction. Action Economics does its own survey, and its median is 0.6%. One of the things that would make this a highly unusual recession is that, as the chart below since 1970 illustrates, unemployment consistently rises into a recession. This time it has not risen and remains in its trough of 3.6%, which is also where it was in Q4 2019 before Covid struck.
The labor market momentum may have slowed, but it remains strong. The four-week moving average of initial jobless claims has risen to about 240k from a low of 170k and is above late 2019 levels. However, continuing claims remain stuck near their lows (1.384 mln vs. 1.306 mln in late May), which suggests a job churn more than a significant reversal of fortunes.
The day after the US GDP report, the eurozone issues its first estimate of its Q2 growth and the preliminary estimate of July CPI. The eurozone economy has lost momentum in Q2 as the energy price and the cost-of-living squeeze bite. The eurozone reported a 1.8% (of GDP) current account surplus in the first quarter. It appears to have fallen into deficit in Q2, which will act as a significant drag on the economy. Eurozone growth is expected to have slowed to 0.2% quarter-over-quarter after the 0.6% expansion in Q1.
Economists (median forecast in Bloomberg's survey) see the CPI falling by 0.1% this month, which is still consistent with a small rise in the year-over-year rate from 8.6% in June. The US core CPI has eased for three months through June. The risk is the the eurozone's core measure makes accelerated to a new high after slipping to 3.7% in June from 3.8% in May.
Economists recognize that the risk of a recession, whatever that means, has risen dramatically since Russia invaded Ukraine. In January and February, economists in Bloomberg's survey (median) saw a 17.5% chance of a recession in the next 12 months. It had doubled by April and now is at 45%.
The ECB's 50 bp hike brings the deposit rate back to zero for the first time since 2014. President Lagarde explained that the larger move reflected rising price pressures, the depreciation of the euro, and the confidence that the new Transmission Protection Instrument (TPI) gave officials. She recognized growth was slowing but identified several countervailing forces to push back against recession fears, but the market was not persuaded. In a similar vein, several Fed officials have countered arguments in some quarters that the US is already in a recession. Fed Chief Powell has made similar arguments and will likely continue to talk about the resilience of the US economy.
Lagarde was explicit. She said there was no forward guidance but had already indicated that further rate adjustments were likely. The central bank is data-dependent. However, she clearly meant inflation data dependent. Moreover, at the September meeting, the staff will update its forecast. The swaps market is pricing in about an 20% chance of a 75 bp hike in September. Indeed, the swaps market is pricing 120 bp of hikes in the remaining three meetings of the year.
The initial restart of the Nord Stream 1 pipeline at 40% capacity was the best-case scenario. Yet, the story is not over. The US and Europe have weaponized nearly everything they could. Banks have been sanctioned, and most have been blocked from the dollar and euro market. The central bank itself has been sanctioned. Russia's foreign assets have been largely frozen, as have some oligarchs. The US and Europe are arming Ukraine, which would be regarded as an act of war in other circumstances. Europe is trying to reduce its dependence on Russia's energy. Russia has few leverage points, but energy is still one of them. Therefore, it seems only prudent to expect Putin to continue to use it.
The quick unraveling of the Draghi unity government in Italy poses a new risk. However, as we have noted, the electoral reform has not been complete. While the Chamber of Deputies will be smaller, many other issues, including the threshold to parliament participation and the bonus seats given to the largest party to facilitate stability are unaddressed. In addition, the reforms needed to secure more of the 200 bln euros from the EU must be approved. With the large-scale bond purchases during Covid, access to more funds, and fiscal forbearance may have sapped some of the anti-European thunder from the center-right, which seems likely to win the late September election.
The euro often moves inversely to the Italian premium over German. That premium spiked in June to almost 250 bp, which may have helped spur ECB officials into action, with the TPI as one of the outcomes. It narrowed to less than 190 bp but has been rising since the political tensions have mounted. Italy's premium finished last week slightly below 230 bp after approaching 240 bp. More important for the transmission of monetary policy, Italy's two-year yield was slightly less than 50 bp at the start of July. However, it rose above 132bp last week, the most since Q2 20 before pulling back to around 122 bp before the weekend.
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