The outcome of the Federal Reserve Open Market Committee meeting on July 27 is the most important event of the last week of July. After a brief flirtation with a 100 basis point rise after June The CPI accelerated, the market returned to a movement of 75 basis points. Fed funds futures price around a 10% chance of a 100 basis point hike. The market is anticipating that after the second 75bp hike, the Fed will most likely go back to a 50bp hike in September.
Fed Governor Wall, a prominent hawk, pushed back on the larger move but kept the door open pending further data. He specifically cited retail sales and housing data. Retail sales were stronger than expected (1.0% vs. 0.9% median expected in the Bloomberg survey), and the May series has been revised to show a decline of 0.1% instead of -0.3% as initially announced. Additionally, June housing starts are expected to have fallen 2% (the median forecast was for a 2% gain), although May’s 14.4% decline has been revised to only 11.9%. Sales of existing homes fell 5.4% in June (the median forecast was for a drop of 1.1%). This is the fifth consecutive monthly decline.
The euro zone and the United States published disappointing flash composite PMIs in July. They both unexpectedly fell below the 50 boom/bust level. This warns that Q3 started with poor momentum. Indeed, as policymakers note, the path to a soft landing has narrowed. In late June, Fed funds futures implied a year-end rate of between 3.25% and 3.50%. Since the CPI, the market has mostly held at the high end of the range. However, the year-end rate pushed down the range after the US PMI. The data bolstered market confidence that the Fed will have to cut rates next year. The implied yield on the June 2023 federal funds contract is now around 23 bps lower than the December 2022 contract. The December 2023 contract is around 58 basis points lower than the December 2022 contract.
At least in its declaratory policy, the Fed emphasizes inflation expectations. July’s preliminary survey from the University of Michigan saw inflation expectations 5-10 years ahead falling to 2.8%, matching the lowest level since April 2021. The 10-year balance (the difference between the conventional yield and the inflation-protected security) is virtually unchanged this month at around 2.35%. It peaked at the end of April slightly above 3.07%. A drop in retail gasoline prices may have encouraged lower expectations. According to the American Automobile Association, the national average has fallen each day since the June 13 peak by just over $5.00 a gallon. It has retreated about 12% from the peak and is below its 100-day moving average for the first time since January.
Some pundits continue to argue that the Fed has lost credibility by being so slow to end its asset purchases and then raise rates. Yet, without metrics to measure it, affirmations remain in the realm of subjective feeling. On the contrary, we believe that the Fed has retained its anti-inflationary credibility. The decline in market-based measures of inflation illustrates this. The fact that the 10-year rate has been in the 2.75% to 3.10% range this month suggests that the Fed’s credibility is intact. This nominal return is only justifiable if average inflation is expected to be lower than this, even recognizing that inflation over the next year or two will remain high.
Many of these pundits wept for a Volcker moment, recalling Volcker’s decision to eliminate 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 saying the US is already in a recession. They make a fetish of a recession, which has no agreed definition. Two-quarters of contracting activity serves the purpose of Econ 101, but is an oversimplification for businesses, investors, and policymakers. Indeed, two recent downturns in the United States failed to fit this classic concept, and the National Bureau of Economic Research, the official arbiter, has always said they fit the bill.
The day after the close of the FOMC meeting, the United States publishes its first estimate of Q2 GDP. The Atlanta Fed’s GDPNow tracker has been a good guesser of US growth. It recorded an annualized contraction of 1.6% over the April-June period. Bloomberg’s median survey forecast fell to 0.8%. It had remained stable at 3% from April to June. However, out of the 55 forecasts, about ten of them, or nearly 22%, predict a contraction. Action Economics does its own survey, and its median is 0.6%. One of the things that would make this recession very unusual is that, as the chart below illustrates since 1970, unemployment has been steadily rising in recessions. This time it hasn’t risen and remains in its low of 3.6%, which is also where it was in Q4 2019 before Covid hit.
Labor market momentum may have slowed, but it remains strong. The four-week rolling average for initial jobless claims has risen to around 240,000 from a low of 170,000 and is above late-2019 levels. However, continuing claims remain stuck near their lows (1.384 million vs. 1.306 million at the end of May), which suggests job turnover more than a significant reversal of fortune.
The day after the US GDP report, the euro zone publishes its first estimate of its growth in the second quarter and the preliminary estimate of the CPI for July. The Eurozone economy lost momentum in the second quarter due to energy prices and cost of living pressure. The eurozone recorded a current account surplus of 1.8% (of GDP) in the first quarter. It appears to have fallen into deficit in the second quarter, which will significantly dampen the economy. Eurozone growth is expected to have slowed to 0.2% quarter-on-quarter after expanding 0.6% in the first quarter.
Economists (median forecast in the Bloomberg survey) see the CPI falling 0.1% this month, which is still consistent with a slight rise in the year-over-year rate from 8.6 % in June. The US core CPI eased for three months through June. The risk is that the core eurozone measure will accelerate to a new high after slipping to 3.7% in June from 3.8% in May.
Economists acknowledge that the risk of recession, whatever that means, has increased significantly since Russia invaded Ukraine. In January and February, economists in the Bloomberg survey (median) saw a 17.5% chance of a recession over the next 12 months. It had doubled in April and is now at 45%.
The ECB’s 50 basis point hike takes the deposit rate to zero for the first time since 2014. President Lagarde explained that the larger decision reflected rising price pressures, the depreciation of the euro and the confidence that the new Transport Protection Instrument (TPI) gave officials. She acknowledged that growth was slowing but identified several countervailing forces to fend off fears of recession, but the market was unconvinced. Along the same lines, several Fed officials have denied claims that the United States is already in a recession. Fed chief Powell made similar points and will likely continue to talk about the resilience of the US economy.
Lagarde was explicit. She said there were no forward-looking indications but had previously indicated that further rate adjustments were likely. The central bank is dependent on data. However, she clearly meant that the inflation data was dependent. In addition, at the September meeting, the staff will update its forecasts. The swap market is pricing in about a 20% chance of a 75 basis point hike in September. Indeed, the swaps market expects 120 basis points of increases during the last three meetings of the year.
The initial restart of the Nord Stream 1 pipeline at 40% capacity was the best-case scenario. However, the story is not over. The United States and Europe militarized almost everything they could. Banks were sanctioned and most were blocked in the dollar and euro market. The central bank itself was sanctioned. Russia’s foreign assets have been largely frozen, as have some oligarchs. The United States and Europe are arming Ukraine, which would otherwise be considered an act of war. Europe is trying to reduce its dependence on Russian energy. Russia has few leverage points, but energy is still one of them. Therefore, it seems safe to expect Putin to continue using it.
The rapid collapse of the Draghi unity government in Italy poses a new risk. However, as noted, electoral reform is not complete. While the Chamber of Deputies will be smaller, many other issues including the threshold for participation in parliament and bonus seats given to the larger party to facilitate stability. Moreover, the reforms needed to obtain more of the 200 billion euros from the EU must be approved. With large-scale bond buying during Covid, access to more funds and budget forbearance may have undermined some of the centre-right’s anti-European thunder, which looks likely to win the late election september.
The euro often moves at the opposite of the Italian premium over the German. This premium reached nearly 250 basis points in June, which may have helped prompt ECB officials to act, with the TPI being one of the results. It has tightened to less than 190bp but has been rising since the rise in political tensions. Italy’s premium ended last week slightly below 230 bp after approaching 240 bp. More important for the transmission of monetary policy, the Italian two-year rate was slightly below 50bp in early July. It did, however, rise above 132bp last week, the highest since Q2 20 before falling back around 122bp ahead of the weekend.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.