The Fed's Challenge & Other Economic News

for the Week Ending Jan 7th 2022

Bonds were hammered on the news, with the 10-year Treasury yield spiking 26 bps to 1.77%, while the 5-year note leapt 25 bps to 1.51%. When Yields rise, prices are dropping signaling investors are looking to dump bonds in expectation of higher coupons in the near future.

This was in response as the Federal Reserve released its Minutes of the Federal Open Market Committee, December 14-15, 2021 and the market found the tone to indicate a preference for tightening monetary conditions. Meaning they will basically reduce the money supply.

The Committee decided to reduce the monthly pace of asset purchases by $20 billion for Treasury securities and $10 billion for agency Mortgage-Backed Securities. The target federal funds rate remained unchanged at 0 to ¼ percent.

Last Thursday’s December ISM Non-Manufacturing Index reading declined to 62.0 which was well short of expectations but still solidly expansionary (50 is the magic number).

Friday’s Nonfarm Payroll report saw an increase of nearly 200,000 in December, but expectations were for 450,000. Taking these into account, the unemployment rate dropped to 3.9% in December. Perhaps most interesting, is that the U.S. job market has more than 10 million openings and the quit rate was 3% which was the highest reading since the year 2000.

The Fed at Fork in the Road

Famed baseball player and coach Yogi Berra was also known for his many famous “Yogisms” one that comes to mind now is “When you come to the fork in the road, take it” this was in reference to Yogi giving directions to someone driving to his home because both routes would take you to the same place. But this does not apply to economics. We are at the proverbial fork in the road. Raise interest rates and risk stalling the economy or let inflation stall the economy.  The Fed has removed it usage of transitory from it minutes and replaced it with “elevated” when addressing inflation. This we feel is a sign of the Fed caving to pressure from the media and politicians. This almost always ends in disaster since, the Fed was meant to be independent and operate without outside influences. Now the Fed appears to have become a political motivated entity and the long-term result may be catastrophic (For those familiar with our newsletter, we have taken the position and still believe that the current rate of inflation will subside probably by mid-2022).

The current data is showing a weakening economy and for the Fed to address both at the same time will result in a very bumpy landing since each issue requires the opposite remedy.

The Fed has a real dilemma. Politically, they must “fight” the inflation that they no longer consider “transitory” (even if it really is). Which means a tightening monetary policy, not just reducing the level of monetary ease. The economy is slowing at a much faster rate than is commonly viewed as we will discuss below. 

Under such a scenario, actual monetary tightening almost always results in recession. Economist David Rosenberg recently pointed out that when the yield curve has the flattish shape that currently exists, 100% of the time, (repeat, 100% of the time) real GDP has slowed in the ensuing year, and by an average of two percentage points

So, let’s take a look at some of the data.

The employment survey was taken the week of December 12-18 when concerns over the omicron variant were low/just starting to emerge, and no one was paying any attention to those saying that the upcoming holiday festivities would cause a spike in infections. But we believe that the January survey week (January 9-15) will contain such concerns, and weakening job growth, together with a continued upsurge in wages will keep pressure on the Fed. 

Markets almost always react to the Fed’s “announcement,” of its action, not to the action itself. The 10-year Treasury yield is the benchmark for mortgage rates. It has risen 40 basis points (.4 percentage points) since the middle of December (from its 1.37% low on December 16 to a 1.77% high on January 7) due to various “hints” coming from inside the Fed. Pending home sales were already toppy in November (-2.2% M/M and down in four of the last five months). The rise in the 10-year benchmark yield is sure to have a negative impact on mortgage rates and future housing data.

We closely watch the weekly jobs data, Continuing Claims (CCs) (those receiving benefits for more than one week), and Initial Claims (ICs). The December CC data are especially concerning, up nearly one million since Thanksgiving. Similar for ICs where the NSA number went from 258K to 315K in the latest weekly data release, still significantly above its pre-pandemic 200K level (see chart). 

The high and rising levels of omicron infections can’t help but weigh on employment and economic activity as the quarter progresses. It is already apparent in Open Table’s measure of restaurant activity, and we’ve seen it in the “call-in sick” issue that caused a plethora of airline cancellations over the year-end holidays.

Auto sales, at 12.4 million units (annualized) in December, are down nearly 24% Y/Y and have fallen in seven of the last eight months. A “normal” month is 16 million. 

The latest data show that U.S. consumers went on a borrowing binge of $40 billion in November (consensus was $20 billion), this after drawing down the savings rate to 6.9%, a four-year low, from 10.5% earlier in the fall. With weak employment growth, savings nearly exhausted, and not much hope of additional “helicopter money” from the federal government, debt repayment will be a negative for growth in 2022

Both the ISM Manufacturing and Services Indexes plunged in December. The Manufacturing Index fell to an 11-month low to 58.7 from 61.1 (once again, the consensus (60.3) missed on the high side). Services got whacked, sliding to 62.0 from 69.1 (consensus – yes, missed on the high side at 67.0). Last week, the Chicago Fed’s National Activity Index (NAI) for November was at half of its October level.

While the above information does not paint the rosiest picture, we are not predicting an outcome we are just sharing observations. Economic outcomes are dependent on collective human behavior. No one would have thought the economy and the market would have navigated itself as it did over the last two years with such a large portion of our population out of work.

Understanding the Fed

The Fed conducts monetary policy by governing the Fed Funds Rate and the supply of money in our system M2. To do this, they buy and sell Treasury securities via open market operations. When the Fed wants to lower rates, they buy Treasury debt. In doing so, they reduce the supply of investible debt, making remaining debt more expensive (lowering yield). They most often buy or sell short term Treasury Bills to affect the short-term Fed Funds rate. Open market operations also add or drain the banking system’s liquidity to help further hit their target.

More recently, with Fed Funds at zero percent, they have conducted QE or large-scale asset purchases. These operations manipulate rates across the maturity curve and not just Fed Funds. QE, as with traditional open market operations, reduces supply, boosts prices, and lowers yields.

Think of the asset markets as a big swimming pool. The kiddie pool is for risk-averse investors, and the deep end is home for the riskiest of investors. While the depth of the water varies extensively, the water level is the same throughout the pool.

Imagine the Fed comes to our pool with a giant bucket and removes gallons of water from the shallow end. What happens to the water level for the entire pool? It falls, and consequently, there is less water to swim in. The effect is more obvious in the shallow end as the depth was lower to begin with. Regardless of appearances, the water level in the deep end falls by the same amount.

Some of our risk-averse shallow end swimmers will now take a step or two towards the deep end. They may move from Treasury Bills to short term corporate bonds or mortgages. As investors take on more risk, they start crowding out other investors and pushing everyone toward the deep end. Those older investors typically need to be more cautious and rightly so are risk adverse. When the Fed is forcing them into other investments, they expose themselves to potential losses, which may take time to recoup. Source Michael Leibowitz

A Technical Analyst Perspective

The following is from Canterbury Investment management, the firm uses technical analyst to evaluate trends and market movement.

One week into the new year, and a new year has brought new market leadership (sectors). A theme we saw in the last 8 months of 2021, and consistently in the last several years, was that growth-oriented stocks had led the markets. A growth-oriented stock would typically be associated with technology-related securities, which make up the largest component of the S&P 500 index and many other broad market indexes. 

Just two weeks ago, we mentioned that we were beginning to see a rotation in the markets. On a risk-adjusted basis, technology-oriented sectors were falling down the ranks, while more “defensive” sectors like Utilities and Staples were climbing. The first week of the new year continued that trend. While the broad markets were generally down for the week, S&P 500 Large Cap Value Outperformed S&P 500 Large Cap Growth by 5.5%. This was led by Consumer Staples, Financials, and Energy, with the latter two getting a considerable bounce off of the low points. 

Technology & growth-oriented stocks, on the other hand, have not fared too well in recent weeks. The Nasdaq 100, which heavily favors technology-related securities, reached a relative peak on December 28th. In the 9 days since, as of Friday’s close, the index is down -5.85%. The technology index’s lowest volatility level occurred in mid-September and was CVI 56 (Canterbury Volatility Index—56 is almost an extreme low rating). As of Friday, and should continue through Monday, the index’s volatility is above 100, which is high. 

This increase in volatility is being led by the market’s largest components. As we stated in a previous update, the largest 9 stocks (8 companies) in the Nasdaq 100 make up 50% of the index’s capitalization, meaning 50% of the index’s movement comes from just those 9 stocks. Collectively, the peak to trough decline of those stocks has been -6.70% from December 28th through Friday. Each stock’s individual peak to trough decline over that timeframe is listed below.

Whenever markets begin to experience larger-than-average trading days, investors can get a sense of nervousness. When we look at the stocks-only advance decline line of the S&P 1500, it has moved sideways over the last few weeks with no clear divergence. That is a good thing. In other words, while volatility on technology stocks has certainly increased and we are starting to see larger trading days, value-oriented stocks have been strong. At this point, this seems to be a normal rotation in market strength. Growth stocks had been strong for several months and were due to decline in relative strength at some point. Source Canterbury Investment Management a third party SMA.
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Be Cautious with the advice you take

There is no shortage of advice in the financial industry. Everyone one claims to be an expert and most are just good at framing a specific narrative that fits their own specific agenda.  Whether it’s a fund manager on CNBC or a local financial advisor directing you to place your hard-earned money into specific financial products, every one of them has an agenda. Having been in this industry for more than 20 years I have seen my share of great sales people that have no clue of the underlying mechanics of the financial products/ advice they offer. Often, they are affiliated with a firm that is requiring them to meet certain production goals so that they can continue with their level of compensation. Usually based on a percentage of their production. 

The problems never really come to light until it is too late. Whether the advice is to use only index funds, buy bitcoin or to put your money into an annuity the advice can be harmful depending timing and on your specific situation and most importantly the change in your needs. Your responsibility as a consumer is to educate yourself just enough to understand the pros and cons of the advice. Never pull the trigger or jump into a financial product until you have taken the time to research it. What we can tell you is this, no one and we mean no one, can predict the outcome of the markets. It’s all based on the behavior and decisions of too many people. The person giving you advice needs to fully understand you, your needs, your situation and find a way to best serve you. 

The Week Ahead

After last week’s huge move in rates, focus will shift to several key events this week. First, on Tuesday Fed Chair Powell will testify for the Senate Banking Committee and will surely be grilled on policy after last week’s developments. Next, U.S. inflation data mid-week is expected to show slight easing MoM, but the core rates will be closely inspected for any increases. Keep an eye on the U.S. dollar’s reaction, as the greenback has been holding up but trending sideways for the past 7 weeks. Treasury auctions may add some volatility to the mix given the market’s current sensitivity to rate movements. The end of the week will bring December’s retail sales with the holiday spending numbers. On the international calendar, China will release its inflation data late Tuesday, where the waning power crisis is expected to cool consumer and producer prices, and trade data drops late Wednesday. The Eurozone schedule will feature industrial production numbers, while the UK delivers a monthly GDP update that is not expected to steer the Bank of England off course from raising rates again next month

This article is provided by Gene Witt of  FourStar Wealth Advisors, LLC (“FourStar” or the “Firm”) for general informational purposes only. This information is not considered to be an offer to buy or sell any securities or investments. Investing involves the risk of loss and investors should be prepared to bear potential losses. Investments should only be made after thorough review with your investment advisor, considering all factors including personal goals, needs and risk tolerance. FourStar is a SEC registered investment adviser that maintains a principal place of business in the State of Illinois. The Firm may only transact business in those states in which it is notice filed or qualifies for a corresponding exemption from such requirements. For information about FourStar’s registration status and business operations, please consult the Firm’s Form ADV disclosure documents, the most recent versions of which are available on the SEC’s Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov/