What matters for bond markets and the Fed are real variables, including unemployment, real GDP growth, and real consumer spending.
What matters for the stock market is nominal variables, including earnings growth, sales growth, and output prices.
The chart below shows that with inflation coming down, we should also expect to see a slowdown in nominal sales growth and nominal earnings growth.
There are two competing narratives in markets at the moment.
One narrative is that the global economy is simply normalizing after Covid. As that process continues, inflation will come down, and we will have a soft landing as labor markets, product markets, and supply chains continue to normalize.
The other story is that the Fed is stepping hard on the brakes, and the lagged effects of Fed hikes and rates staying higher for longer will weigh on nonfarm payrolls, capex spending, and consumer spending over the coming 12 to 18 months, which will cause a recession.
Looking at a broad range of leading indicators, including rising delinquency rates for credit cards and auto loans, rising default rates for HY and loans, rising weekly bankruptcies, slowing weekly loan growth for banks, and leading indicators for jobless claims (see charts below), we continue to see the recession narrative as the most likely outcome.
Rising rates have already had a negative impact on more leveraged consumers, firms, and commercial real estate. And with the Fed on hold for “a couple of years,” the negative effects of higher rates will continue. In that sense, if the economic data soon starts to re-accelerate, then housing inflation will start to move up again, and the Fed will raise rates even more to slow down the economy.
Let’s not forget that a hard landing will always start out by looking like a soft landing.
Our chart book with daily and weekly indicators for the US economy is available here.
The chart below summarizes the reasons to be bullish on the US consumer and the reasons to be bearish.
In this presentation, we look at the outlook for consumer spending on housing, cars, restaurants, travel, and other consumer goods and services.
About 450,000 new businesses have opened every month since the onset of Covid-19, which is 50% higher than in 2019 when the number of new businesses opening every month was 300,000, see the first chart below.
The main sectors with significant growth in the number of firms are retail trade, professional services, and construction, see the second chart. Within the retail sector, online shopping accounted for 70% of all applications in 2020.
The bottom line is that the US economy was already the most competitive and dynamic economy in the world, and the level of entrepreneurship and innovation has increased further during the pandemic.
The Fed started raising rates last year, and credit growth continues to slow and credit conditions continue to deteriorate, which is what should be expected as the Fed tightens policy and continues to cool down the economy and inflation. This transmission of monetary policy will continue to drag down the economic data over the coming 12 to 18 months, see charts below and this presentation.
In many European countries, a wage-price spiral is institutionalized through collective wage agreements, see chart below. If inflation is high, then wage inflation will also be high.
The Fed is shrinking its balance sheet, but they still own 35% of all Treasuries with a maturity of 10 years or more, and they own about 20% of the belly of the curve, see chart below.
The supply of Treasury bonds and notes will stay high over the coming months because of QT, ongoing budget deficits, and the existing large stock of T-bills maturing.
We are beginning to see inflation gradually start to come down, but it’s still above the Federal Reserve’s 2% inflation target—so we can expect higher rates to stick around for longer. Broadly speaking, the narrative now is starting to turn away from inflation to focus more on growth and recession concerns. On that theme: Weekly data for retail sales has seen a steady decline since the Fed started raising interest rates in March of 2022—with the most recent print landing in negative territory.
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Since the beginning of this year, the consensus has lowered the probability of a recession in Europe and UK. But for the US, the recession probability has remained constant at 65%. In fact, the consensus now thinks there is a higher probability of a recession in the US in the next 12 months than in Europe and UK, see chart below.
Since the Fed started hiking in March 2022, interest rates on auto loans have increased from 4.5% to 7.5%, interest rates on credit cards have risen from 16% to 22%, and loan growth has been slowing for both small and large banks, see the first three charts below.
With the Fed still hiking and saying they will keep interest rates at current levels “for a couple of years,” the ongoing slowdown in consumer spending will continue, see the fourth chart.
The bottom line is that monetary policy is working exactly as it is supposed to: Higher rates are leading to slower growth.
