Hope in the Lesser of Two Evils
This week marked another significant chapter in our ongoing and evolving saga. Consequential events revolved squarely around Jay “Volker” Powell and the Fed, labor market news, and potential developments out of China involving future Covid-zero policy.
As expected, Fed Chairman Powell and the FOMC raised interest rates Wednesday—a fourth straight 0.75% jumbo hike. While this latest jumbo hike was expected, markets also anticipated a dovish softening of rhetoric from Powell and indications that the Fed would tread more cautiously on the extent and pace of further interest rate hikes. The initial statement released by the FOMC included new language that seemed to affirm such expectations. Specifically, “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” This was what rally-hungry markets had been waiting for: balance, caution, and an indication that a deft and all-powerful Fed would both whip inflation and stick the finish on their tightening cycle with a beautiful soft-landing. Markets rallied aggressively, but also prematurely.
A half-hour after the FOMC released its statement, Powell held a press conference. In it, he pulled the rug out from under the imminent-pivot narrative and soft-landing hopes. While Powell acknowledged that the pace of future hikes will eventually slow, he also said, unexpectedly, that the terminal rate of hikes was likely to be higher and last longer than markets expect. He then proceeded to explicitly attack the notion of an imminent pause to rate hikes. “It’s premature to discuss pausing. And it’s not something that we’re thinking about. That’s really not a conversation to be had now. We have a ways to go [on hikes].”
The Chairman also made clear that he wants people to understand, “our commitment to getting this done. And to not making the mistake of not doing enough or the mistake of withdrawing our strong policy and doing that too soon.” That was not what markets wanted to hear. What had been a rally in markets abruptly turned into the largest post-FOMC intraday sell-off in history. Following Powell’s communiqué, Deutsche Bank’s reaction was rather clear, if understated, “It raises our conviction that a recession will happen next year… It also raises the risk that it will be a deeper one.”
In its efforts to wage war on inflation, the Fed has now jacked the federal funds rate from the 0%–0.25% near-zero bound up to the 3.75%–4% range in 10 months. This is an unprecedented pace of hikes. Monetary policy is a blunt instrument, and, as the Fed itself acknowledges, it works on a considerable lag. Given that blitzkrieg tightening is occurring amid a record pile of interest rate-sensitive debt, in an economy fully acclimated to near-zero interest rates, history, reason, and leading economic indicators all suggest that by the time the Fed is confidant they’ve done enough, it will be crystal clear to all that they’ve also done too much. Images of Wile E. Coyote speeding off the cliff do come to mind.
As HAI has said all along, the Fed is trapped in a minefield with nothing but bad options. If Powell tightens heroically to quell the inflation menace and a crisis erupts, he can, with the relative safety of much greater political cover, subsequently pivot, attempt to ease, reflate, and pick-up the pieces. If the Chairman tries such a pivot before a crisis and inflation accelerates, Powell is done—as is Fed institutional credibility. Far from Volker, worse than Burns, in such an instance, Powell could risk terminally unhinging financial markets and the economy. In his press conference, Powell candidly admitted as much, saying, “The risks are asymmetric. If the Fed does too much, it can cut. If it doesn’t tighten enough, then you’re in real trouble.”
The stakes are incredibly high. A premature pivot further stoking inflation would eviscerate any pretense that the Fed possesses an effective monetary policy brake. A monetary system once governed by the gold standard and subsequently the Fed standard will take its next evolutionary step toward being governed by no standard. Like a seesaw, in such an instance, as Fed credibility and any belief in the existence of a disciplinary monetary policy brake plummet, the risk of out-of-control markets and a devastating inflationary Austrian crack-up-boom dynamic will increase proportionately. The risk in such a scenario is that the system comes undone at the seams. As stated: no good options. With that said, aggressive tightening into a rapidly approaching recession is still likely the lesser of two evils.
As to the current impact of aggressive tightening to date, this week provided more superficial evidence of a strong and tight labor market—but labor is the most lagging economic indicator. The JOLTS data showed job openings unexpectedly increasing, and the Friday non-farm payrolls report by the Bureau of Labor Statistics also beat expectations. The broad market interpretation of labor market data was generally consistent with the view expressed by Bloomberg chief economist Anna Wong, who wrote that her “takeaway is that the labor market is still very tight and much adjustment still needs to occur before unemployment is close to a neutral level.” In other words, the labor market is still too strong. It’s still stoking inflation, and the Fed has more tightening work to do to create more slack (unemployment) in the jobs market. As a result, Wong said, “We expect that the Fed will ultimately have to raise interest rates to 5% next year.”
While the labor market has undeniably been tight, some cracks are now beginning to show. For one thing, headline job numbers may be somewhat overstated. During the first nine months of this year, seasonal adjustment has boosted private payrolls by a half-million extra jobs over the same year-to-date periods from 2013 to 2021. This divergence from historical average has been most pronounced in recent months.
At the same time, the most interest rate sensitive sectors in the economy—the canaries that would lead other sectors in broad labor market deterioration—are beginning to look unsteady. Headlines out of the tech, housing, and construction industries this week warn that the leading edge of a labor market downturn may already be upon us. A laundry list of companies including Apple, Amazon, Lyft, Opendoor, Stripe, Chime, and Twitter all announced layoffs or hiring freezes just this week.
In addition, October firing data from Challenger, Gray & Christmas shows that the real estate sector has announced 7,206 cuts so far this year, up 564% from the 1,085 announced through October 2021. Weakness in housing and real estate is also spreading to the construction sector. Construction recorded an increasing pace of job cuts in October to 2,177, making up the bulk of the 3,983 cuts announced so far in 2022.
Another indication that the labor cycle is now turning comes from DailyJobCuts.com which tracks aggregate job cuts. As of Thursday, the November tally of cuts stands at 4,215. Just three days into the new month, we already have nearly a quarter of October’s total of 17,857 and more than half of September’s total of 7,657 cuts. With the lagging impact of previous rate hikes still hitting and the Fed continuing to tighten, expect this weakening trend to accelerate and broaden into the new year.
Another major event this week emanated from China. On Friday, Bloomberg reported that China is preparing a plan to end Covid flight suspensions. The news further ignited rampant speculation surrounding unconfirmed reports earlier in the week that Chinese officials are planning to significantly alter the nation’s Covid-zero policy in March of next year. China is the world’s top commodity consumer, and the possibility of a large-scale reopening implies a significant additional increase in demand for commodities already in critically short supply. On Friday, the news triggered an absolute frenzy of speculative buying across the commodity complex. The rally was disproportionately focused in hard asset commodities over financial assets. At one point Friday morning, while the S&P 500 traded unchanged on the day, 32 out of 34 commodities tracked on the MWM dashboard were in the green. Most were up significantly.
While the surge in commodities on China speculation is no doubt premature, the market reaction underscores the risk that, with commodity supplies so tight, any uptick in aggregate demand can send prices surging. Furthermore, if commodity prices start to trend higher again, the implications are dire. It would supercharge sticky-high global inflation and force central banks to continue restrictive economic policies. The combined effect would increase both the risk and potential severity of global recession, crisis, and serious and persistent stagflation. The battle lines are drawn over the intermediate time frame between growing global recessionary demand destruction dynamics and extremely tight commodity supplies. Anything that tips the balance between the two factors will be crucial and examined closely. Regardless, extreme volatility throughout the commodity complex is certain.
The profound risks embedded within our current global dynamics are uncomfortable to consider, but nevertheless very real. Another in a growing list of cautionary warnings from prominent sources was picked up this week by the Financial Times. On Wednesday, the paper reported on a letter to clients from Elliott Management, one of the world’s biggest and most influential hedge funds. According to the FT, in the letter Elliot Management warned its clients of an “extremely challenging” situation for the global economy and for financial markets in which an “extraordinary” set of financial extremes “[has] made possible a set of outcomes that would be at or beyond the boundaries of the entire post-WWII period.”
Ominously, the letter added, “Investors should not assume they have ‘seen everything’” just because they have experienced financial crises such as the 1970s bear market and oil price shock, the 1987 market crash, the dotcom bust, or the 2008 financial crisis. Such extreme outcomes are not fated, but the risks are alarmingly high. As such, The HAI mantra remains the same: helmets on and seat belts securely fastened as we navigate a perilous road ahead with all eyes on both risks and opportunities.
Weekly performance: The S&P 500 was down 3.35%. Gold was up 1.93%, silver was up 8.55%, platinum gained 1.20%, and palladium lost 3.04%. The HUI gold miners index was flat, up 0.02%. The IFRA iShares US Infrastructure ETF was similarly flat, down 0.11%. Energy commodities were higher on the week. WTI crude oil was up 5.36%, while natural gas surged 12.60%. The CRB Commodity Index jumped 5.48%, while copper had a big week, up 7.51%. The Dow Jones US Specialty Real Estate Investment Trust Index was lower by 2.18% on the week, while the Vanguard Utilities ETF (VPU) lost 0.54%. The dollar was up by 0.15% to close a very volatile week at 110.77. The yield on the 10-yr Treasury increased by 15 bps to end the week at 4.17%
Best Regards,
Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC
