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The Fed Jumped the Gun on Rate Cuts - Charts from the Podcast

The article accompanies the Lake Street Review Podcast Episode recorded April 10th, 2024

Financial Conditions

Most folks are probably under the impression that financial conditions are "tight", and that's mostly because the Federal Funds rate remains at 5 1/4 percent, the highest in 23 years. However, financial conditions encompass a lot more than the Federal Reserve's policy rate, and just about every other component is currently "loose" by historical standards.

It doesn't matter which financial conditions index we look at - Goldman, Bloomberg, Chicago Fed - they've been trending down for six months plus (trending down means money is getting easier to come by).

Financial Conditions Index, ten years

Credit is flowing freely

The US credit impulse turned negative in the first half of 2023, coinciding with those two quarters of negative GDP we saw at that time. However, at the end of March, credit was growing at about half a percent of GDP per quarter, which is just shy of the ten-year average and well into "economic growth" territory. The GDP numbers for the first quarter of 2024 won't be released until April 25th, but with credit conditions as they are, we can expect economic growth to be average or above (2 percent plus).

Purcell Research Credit Impulse Indices

Credit is a coincident indicator of economic growth. As shown below, dips in the flow of credit to the household and business sectors tend coincide with recessions.

Credit Impulse Track Record

Inflation is no longer trending downward

For the last 5-6 months, the financial media has taken to calling the current state of inflation the "Last Mile". They've reported as though a return to two percent inflation is a foregone conclusion and it's only a matter of time before we arrive at that target. Even Thursday morning, the day after the March inflation data "surprised" markets and sent interest rates up by a quarter percent, the Wall Street Journal's Nick Timiraos once again invoked the phrase.

At best, the reality is fuzzy. At worst, the reality is the complete opposite. If we continue the trend of the last six months, it will be time for the press to eat some crow. But we won't be holding our breath as they never do. Things still look relatively good if all we look at is the year over year change in "Core" inflation (inflation without food and energy costs - a stupid metric, I know).

Year Over Year "Core" Inflation still shows a Downtrend

We prefer to look at the month over month change in prices to get a feel for how inflation is developing. It's a more chaotic looking chart, but if there is a change in the direction of inflation, you'll see it in the monthly numbers long before it's evident in the annual numbers.

The month over month core inflation rate hasn't been in a downtrend for six months.

There hasn't been a new low since July 2023 (0.2 percent, translating to 2.4 percent a year). Everyone who skims the news saw that the annual core inflation rate was 3.75 percent. What most folks didn't see, because the media doesn't report it this way, is that the monthly change in prices of 0.4 translates to an annual rate of 4.8 percent.

"Core" Inflation Month over Month Change

Market response - Bonds

The response in US bond yields and interest rate futures was - no other word for it - huge. The average daily fluctuation in both types of instruments is .03 to .05 percent - in other words 3 to 5 basis points. A basis point is one one-hundredth of a percent.

The ten year bond yield shot up 19 basis points reaching 4.55 percent. Since the ten-year bond is a sort of benchmark for bonds backed by conventional thirty year mortgages in the US, this move translated to a rise in mortgage rates as well.

The two-year bond yield went up 23 basis points to 4.97. These are the highest levels we've seen in bond yields since the Fed started hinting at rate cuts in October, and about where we were the week before the cascade of regional bank failures in March 2023.

US 2-year Treasury Note Yield. 1st line - Regional Bank Failures, 2nd line - Fed's last rate hike, 3rd line - Fed Board members start talking cuts

Interest rate futures impact

Interest rate futures are not a good forecasting tool, but the investment community understands the rates on these futures contracts to be the market's "best guess" as to where short term interest rates will be at a given point in time. Since the Fed is setting short term interest rates, they are a barometer of what markets "think" the Fed will do next.

Since most of the talk in the last several months has centered around rate cuts "by the end of 2024", we'll look at the Futures contract expiring in December 2024.

As the Fed started hinting at rate cuts in October 2023, the contract rate dropped by more than a full percent over the next several months. In January, the market was "pricing in" seven rate cuts by the end of 2024.

SOFR futures contract rate for December 2024. 1st red line - Fed's last rate hike in July 2023, 2nd red line - Fed Board members start talking rate cuts.

The inflation news on Wednesday sent the December contract rate soaring by 20 basis points in a single day, a huge move for this market. Remember, daily fluctuations average only 3-5 basis points. All of the contract rates expiring between December 2024 and December 2025 saw huge increases.

Job Market

The headline numbers we get from the Department of Labor still appear strong. Under the hood, there are signs of weakness. When sales are weak, businesses typically opt to cut hours and take on more part time help, rather than layoff employees. We see that playing out in the form of a divergence between full time and part time jobs growth.

There hasn't been a new high in full time employment since July of 2023 (the month after GDP growth had been negative for two quarters). The dark blue line shows the number of people employed part time for economic reasons. In other words, those who have a part time job because it's the only thing available, and would prefer to work full time. That figure has been gradually rising since December 2022 (just before GDP growth was negative for two quarters).

Full Time (left scale) and Part Time (right scale) Employment since 2014

The Sahm Rule is a labor market indicator which says that the start of a recession coincides with, or is led by, a 0.5 percent increase in the headline unemployment rate off of its 12 month low. The 12 month low was 3.4 percent in April 2023, unemployment rose to 3.9 percent (breaching the Sahm indicator) in February, and fell back to 3.8 in March. A reading somewhere between 3.9 and 4.1 or higher in April would indicate that we are in for a recessionary cascade of layoffs. We won't know that figure until the first Friday of May.

Going forward

The longer interest rates remain high, relative to the last decade, the more the US Treasury will have to spend in interest payments on its debt. That means that Fed Chair Jerome Powell and the Board of Governors will be under increasing political pressure to cut rates.

Treasury Secretary Yellen, when asked about interest rates, has given every indication that she expects lower rates by the end of the year. We're looking at a few different possibilities because, again, the overall economic picture is fuzzy.

  1. Inflation stays around 3-4 percent and the unemployment remains low. In this scenario, the pressure to cut rates is only coming from the White House and Congress due to the increasing interest expense. Powell will either maintain high rates or cave to Janet Yellen at the Treasury. Historical experience says Powell doesn't really care what the government thinks, and will maintain or even hike rates in this case, as long as unemployment stays low.

    1. But if he does cave, expect the Fed to come out with a new inflation target, and give several sophisticated-sounding reasons as to why 3-4 percent is better than 2. Expect the Wall Street Journal and Bloomberg to pedal this nonsense with no pushback whatsoever.

  2. Inflation stays around 3-4 percent and unemployment keeps rising. In this situation the pressure on Powell to cut rates will come from just about every corner of the world. In September 2019 he faced a choice between normalizing interest rates and bailing out the investment banks; he chose the latter. In March 2020 he faced a choice between normalizing interest rates and funding 5 trillion dollars of federal deficit spending; he chose the latter. We will be surprised if Powell maintains high rates in the face of a recession.

  3. Inflation falls back to target - with or without unemployment. This scenario will almost certainly bring rate cuts. The Fed doesn't want to see the Treasury spending a trillion dollars on interest every year, and they believe the economically "neutral" rate of interest is 2.5 percent. If the economy keeps growing, they will cut slowly because they can. If the economy shrinks and unemployment rises, they will cut fast out of necessity.

The next major test for financial markets. Since March 2020 the financial system has been in what's often called an "abundant reserves regime". The Fed injected enough cash into the banking system that it is "spilling over". One way to measure just how much excess there is is to look at the Fed's reverse repo facility.

Think of it as "where the banking system goes to park the cash that it doesn't know what the hell else to do with". If the amount of money in the facility is rising - cash reserves are increasingly abundant. If the amount of money in the facility is falling, cash reserves are less abundant. A year ago there were 2 trillion dollars in the facility, now there's about half a trillion. As the Fed keeps draining cash from the system, this number will, at some point, reach zero.

Total Cash in the Fed's Reverse Repurchase Agreement Facility

The banking system still effectively has a "crutch" of abundant reserves, and this enables the bond and stock markets to keep functioning smoothly. If the system is truly resilient, there shouldn't be a problem when the reverse repo facility hits zero. At the current pace, the facility will hit zero sometime in September 2024.


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