Don't Say The Quiet Part Out Loud

THU 02 JUN 2022

Earlier this year the monthly US employment report was significant as a key input for the Fed’s reaction function and short term interest rate outlook. Of course, consensus beliefs have already shifted materially following recent Fed actions and promises (guidance) with the Eurodollar rates now largely priced most of the plausible tightening cycle by mid-2023 (to around 3% or so).

However, what the Fed won’t say out loud is that intention of rate hikes, liquidity withdrawal and tighter financial conditions is to slow final demand and cool the labor market (increase unemployment) to moderate inflation pressure. Moreover, for market participants waiting for a Fed pivot, it is important to note what Jay Powell communicated two weeks ago, “this is not the time for tremendously nuanced readings of inflation. We need to see inflation coming down in a convincing way. Until we do we are going to keep going [hiking rates].” Put another way, do not anticipate a market friendly Fed pivot anytime soon even if some of the leading indicators of the cycle deteriorate.

As we observed last month, there has notable shift in the prevailing bias from inflation to growth fear. The shift in consensus beliefs is likely a function of consumer, business confidence and the tightening in financial conditions (fall in equity prices). Indeed, consumer expectations is already close to recession-like levels (chart 1).

On the positive side, it is plausible that the weakness in sentiment is an emotional overreaction. After all, current labor market conditions remain strong. Moreover, household income and consumption remains above trend (even adjusted for inflation -chart 2). Household cash levels as a share of GDP also remain near a record high. Recall that household consumption is around two thirds of GDP and key to aggregate final demand.

On the negative side, the cyclical component of GDP – the manufacturing inventory cycle – is consistent with a material deterioration in growth and corporate earnings over the coming quarters. Of course, that is a key reason why equity prices have already fallen (chart 3). Nonetheless, as we have noted recently, most of the decline in equity prices (so far) has been driven by valuation multiple de-rating, with earnings downgrades still to come.

The final point to note is that the labor market tends to lag growth. If labor market strength persists in the near term, that will reinforce the Fed’s motivation to hike rates, withdraw liquidity and tightening financial conditions until inflation moderates in a convincing way. In conclusion, we remain relatively cautious on the near term outlook for equity risk.