A Perfect Storm of Economic Uncertainty

Last week, the federal government’s Bureau of Labor Statistics reported that the US economy added one hundred and seventy-five thousand new jobs, far less than the consensus forecast of two hundred and forty thousand jobs.  At the same time, the unemployment rate ticked up from 3.8% to 3.9%.  These numbers, at first glance, hardly seemed that soft, but Fed officials went out of their way to embrace this data as justification to renew their calls for lower rates over the coming months. In fact, after a few prior months of strong jobs growth and slight upticks in inflation, the Fed was happy to not just welcome these numbers as proof that lower rates were back on track, but they also announced that they were going to slow down the pace of reducing their balance sheet.  The Fed claimed that their ”restrictive” monetary policy was doing the trick of slowing the economy and breaking the back of inflation.

The Fed has been looking for every possible excuse to lower rates since last fall. Every downtick in inflation has been described as a confirmation that inflation was well on its way back to the official 2% target, while higher inflation readings were viewed as little bumps on a steady downward path. Considering how badly the Fed had bungled its analysis of inflation back in 2021, with its persistent declaration that the inflation was transitory, I found the Fed’s dovish attitude especially surprising. Moreover, the Fed’s own Financial Conditions Index suggested that the Fed’s policy was particularly loose, not restrictive. Therefore, the Fed’s frequent proclamations about its restrictive policy made no sense.

I have to admit that at first, I was cynically thinking that the Fed’s motivations may have been political, as we have a Presidential election coming up, and it was plausible that perhaps the Fed wanted to juice the economy and turbo-charge the stock market in order to try to keep the current party in office.  The Financial Conditions Index was showing conditions that were as easy as they were BEFORE the Fed started hiking rates in 2022.  I knew that the Fed officials, with 400 full-time PhDs economists, were almost certainly well aware of their own Index.  Upon further consideration, I realized that if Powell’s decision to persistently pretend that financial conditions were restrictive was not political, then there must be something very sinister happening in the economy.  Otherwise, Powell’s comments about the restrictive policy made no sense at all. 

Consider the following chart.  I think the numbers are self-explanatory.  Financial conditions are in fact very loose.

Last June, the Fed even put together another index to measure financial conditions.  They tinkered around with the numbers somewhat as they were anxious to show that financial conditions were not as loose as the Financial Conditions Index suggested.

Even this chart, however, showed modestly loose financial conditions, so the chart didn’t really do the trick.  The Fed’s own analysis suggested that if anything, the Fed should be hiking rates, not cutting them, so barring a political motivation, I was more and more convinced that there must be some very scary things lurking below the surface.  The Fed and the Treasury just didn’t want us to know what these scary things might be.

The last chart shows the relationship between the S&P 500 and a different financial stress index.  The S&P 500 clearly likes the easy financial conditions in the economy.  As long as the economy is achieving moderate growth and tolerable inflation data, the stock market has further legs.  On the other hand, what happens if suddenly economic data starts to turn ugly?  For sure the Fed will respond aggressively with multiple rate cuts.  Initially, the equity markets will rally with the rate cuts, but for how long? How likely is this?  As I have noted, the Fed has a huge staff of full-time economists, and they have access to heads of every major brokerage firm, technology company, manufacturer, and so forth.  They should absolutely have an accurate sense of the strength or weakness of the underlying economy.  Why are Fed officials so focused on cutting rates when their own data is screaming at them to tighten, or worst case, wait?

I think I am finally understanding what the Fed and the Treasury Department have been focused on.  While the Fed officials stick to their story that the economy is fine, the job market is strong, and inflation is heading lower, the reality is quite a bit different.  The actual job data has been quite poor. The interest rate policy of the Fed has been anything but restrictive, so let’s have a look at the jobs data more closely.  I think that it is in the data we can see what is making Powell nervous, since he didn’t only insist that it is only a matter of time when, not if, inflation will fall sufficiently to justify much lower rates.  He also started talking about the Fed’s dual mandate of maximum employment and modest inflation.  If the job market were so solid, why is Powell talking about the need to focus on job creation?  

When Powell said that he saw no “stag” in the economy, he basically lied.  In fact, although the total jobs in April rose by 175,000, total employed workers rose by only 25,000.  The part-time jobs situation in the US is really a key component of the story.  Over the past two and a half years, there is now a gap of 3.6 million jobs versus the number of employed persons.  That is a staggeringly large difference.  Over just the past nine months, the household survey shows the total number of employed people is essentially unchanged while the total jobs creation shows 1.8 million jobs.  Over the past five months, the number of employed people has dropped by 375,000 as the monthly jobs reports have shown large job creation every month.  Put simplistically, we currently have a recession in full-time jobs. In the jobs sector, there is absolutely a lot of “stag.”

Temporary jobs are often the first jobs to be eliminated as companies can quickly scale back their operations without the added expense of significant severance. This is not just a phenomenon found here in the U.S.  It is an international practice in a weakening economy.   Moreover, there are plenty of signs the economy is really starting to slow.

The Philadelphia Fed’s manufacturing index is in recession territory, as is the Richmond Fed’s manufacturing survey.  The Leading Indicators Index is pointing to a slowdown, and industrial production is softening quickly.  The economic growth that we have experienced has been fueled by huge deficits and a massive Fed balance sheet.

Consumers are choking on excessively high costs of living as the implied tax of inflation has dug in.  They are maxing out their credit cards and working multiple jobs just to try to stay afloat.  The problems don’t end here, however, as the Treasury Department has absolutely massive funding requirements that need to be managed on a regular basis. Additionally, owners of commercial real estate need to refinance several trillion dollars’ worth of debt while they are also burdened with record vacancies. 

The housing market is largely in shock due to the limited inventory and high mortgage costs.  Credit card debt is at record levels, and the US economy may very well face the very real prospect of a hard landing.  In fact, there is a decent probability that the US economy is only a hair’s breadth away from falling into a rather sharp economic downturn.

The reason the Fed wants so badly to cut rates is because they know that the true economic conditions in the US are quite tenuous.  The Fed is absolutely determined not to let interest rates rise to combat possible future price inflation.  With a bit of luck, the softening economic growth numbers will lead to a further easing of inflation. The officials further hope that the subsequent easing in rates will get the economy moving again on a sounder footing.  Otherwise, we better gird ourselves for potential stagflation as economic conditions continue to soften.

Remember that in 2008, long after the Great Recession had begun, Fed Chairman Ben Bernanke was telling viewers on TV that there was no recession on the horizon.  The Fed has a history of being either very wrong, or intentionally misleading, so we need to be very vigilant.  I believe that Bernanke knew the truth of the economy at that time.  He just didn’t want to frighten people and warn them about the imminent economic shock we were about to experience.  This warning would have guaranteed a dramatic selloff in stocks and a sharp recession, and he was hoping that perhaps we could muddle through the mess without economic chaos. In the same way, Powell knows how tenuous the data is, but he is putting on a brave face in the hope that the economy picks up some steam with Fed interest rate cuts.  If the Chairman of the Fed tells everyone that the economy is much weaker than it looks, that the data is misleading, and that we could potentially be entering a period of severe stagflation, then consumers and businesses would panic, ensuring a very unpleasant fate.

In terms of the markets, my write-up last week about dollar/jpy being toppish anywhere close to 160.00 yen per dollar looks quite good so far.  The Japanese authorities intervened twice, and they drove dollar/jpy from 160.15 down to 152.00.  I am not sure whether the market needs one more attempt at 160.00 dollar/jpy, but I remain convinced that in the big picture, dollar/jpy is a great sale anywhere close to 160.00.  Intervention alone won’t turn a market unless the fundamentals eventually justify the shift, and I expect the fundamentals to justify a sharp selloff in dollar/jpy.

As the U.S. economy continues to soften, I expect the Fed to cut rates perhaps twice in 2024, and then two or three more times in 2025.  Rates cuts in Canada and Europe will very likely start before US dollar rate cuts, so we could easily see some initial pronounced Canadian dollar weakness against the US.  The euro will probably be relatively steady, as the rate cuts by the European Central Bank are largely discounted already.  I still like euro/cad higher, as I wrote  on November 19, 2023.  The only country that is unlikely to cut rates in the coming months will be Japan, so it is quite likely that the yen will eventually strengthen against most other currencies.

The carry plays in the yen will be forced to unwind, and that alone will fuel a major turn in dollar/jpy.  The economic data will further reinforce this move, as interest rate differentials narrow, and problems start to emerge more publicly in the US.  These things will take time to play out, particularly in an election year, so we need to be patient as these trends develop.

I am still very constructive on both gold and silver, and I think that the recent price action is exactly the sort of corrective price action that we need before these two precious metals rally on to new multi-year highs.  After these markets put in their recent highs, I warned my readers about an imminent period of corrective consolidation.  That is exactly what we have been getting, but that consolidation might end quite soon.

Ten-year treasuries in the US will rally again as the market has become very extended.  The 4.65% level in the 10-year treasury that I wrote about last week was critical, and I was hardly surprised that the market was unable to hold that level.  That level was similar to the 5% yield level in the 2-year bonds, which likewise was summarily rejected by the market last week.  It is in the shorter end of the curve that I expect the most movement, so eventually we could finally see the yield curve steepen.  This won’t happen fast, but over time this should take place.

Stocks are tricky, as the market will try to continue rallying as the interest rates come lower.  I think this could prove to yield the biggest surprise since I can easily envision stocks trying to rally when the US gets some soft economic data, but the market could ultimately fall apart when people realize that the weaker earnings won’t justify the lofty numbers. 

Bottom line, get ready for lots of volatility.  We are looking at some significant shifts in economic data over the coming months, and the markets will fly around as people try to adjust.  This is a great environment for option strategies as the short-term volatility could become quite extreme.  Throw in the potential chaos of a bitterly contested political election in November, and you have the makings of a perfect storm of economic uncertainty.

Wishing you the best of luck.

Andy Krieger