There is an interesting debate about whether July or September will be the final Federal Reserve rate hike of the cycle but for markets it doesn’t really matter. A terminal rate of 5.25-5.50% or 5.50-5.75% isn’t material.
Where it gets interesting is at 6% and above and there’s a path to get there.
Three data points released today illustrate how:
1) Initial jobless claims
It’s increasingly looking like unemployment will stay low.
Claims are once again falling and are far short of the 300K minimum number that the Fed wants to see. The jobs market is tight and right now there’s nothing showing that it will significantly loosen. Yes, JOLTS have come down a bit but just because the red-hot jobs market is over, it doesn’t mean that wage pressures are gone.
Yields are rising today and it’s largely due to this report. There’s simply no weakness and if we’re still at these levels in six months, then the Fed will still be hiking. Bill Gross once said that if he only had one economic indicator, it would be this one and that’s good advise for the comings months.
2) Manufacturing
If there’s one area of the US economy that’s in recession, it’s manufacturing. The numbers are undeniable with production contracting and more likely to come once automotive inventories are fully rebuilt. But this caught my eye today; it’s the six-month index in the Philly Fed manufacturing survey.
six-month index Philly Fed
The indicator of future optimism has rapidly improved and highlights that manufacturing recession will soon end. The whipsaw effect is slowly working its way through the post-pandemic economy but companies are finding that demand has stabilized. There has also been an inventory drawdown that could soon reverse.
There are massive amounts of US fiscal stimulus in the pipeline and a pickup in manufacturing in 2024 would be a major red flag for the Federal Reserve, especially if demand for raw materials boosts commodity prices.
3) Home Building
Housing is a major driver of economic activity and there’s a strong argument that it will pickup in 2024. Home builders came into this year cautiously, cutting lot options and worried about higher interest rates. What they’ve found is that short-term buydowns to bring mortgage rates down a couple percentage points for two years have been a winning combination for home buyers.
Confidence is growing and today, US home builder D.R. Horton raised its revenue forecast. Existing home sales data today also underscored what’s probably the most-misunderstood economic indicator in the US — the lack of homes available for sale.
There simply aren’t enough homes.
What’s the solution? Building. When building happens it creates an enormous amount of economic activity. You take a $500,000 house and all the spend goes towards building it in a year while the credit to pay it off is created over 30 years. That’s enormous economic leverage and there are a multitude of spinoffs to construction workers, banks and commodities.
The last one on that list is the crux of the issue.
As we go into 2024, there’s a good chance that a pickup in manufacturing and home building leads to a fresh round of commodity inflation. I expect y/y prices in the CPI report to hover around 3% for the remainder of the year and — all else equal — would start to fall in 2024 as some early 2023 comps are lapped.
The risk is that fresh strength in manufacturing, home building and the jobs market results in a stronger economy coupled with rising commodity prices. Part of what restrained the economy in 2023 was the expectation of a recession and all the corporate and personal hunkering down that came with that. The magic of Fed hikes was partly in creating the worry about a recession.
How that we’re within reach of the supposed Fed terminal rate, there’s no recession. Instead, companies and consumers are breathing a sign of relief and that means more spending and investment.
The risk I see in July is that Powell takes a hawkish turn. That he strongly hints at more hikes to come, though perhaps at a continued measured pace. That would mean a Nov 1 hike to 5.50-5.75% and would put an end-January or March hike on the table.
What the path to +6% looks like is something like a 2.8% y/y inflation print in February along with signs of an acceleration in manufacturing and home building along with continued resilience in jobs and consumer spending. To confirm it, commodity prices would have to be rising as well.
Now perhaps Powell decided to tolerate 2.8% inflation while hoping for the long and variable lags of monetary policy to kick in while forecasting a return to 2% in 2025. That’s plausible but it’s equally plausible that they continue to hike to 6% and beyond. Given dovish market positioning, I see the risks skewed towards higher rates and a higher US dollar with it.
How I could be wrong
While there are plenty of signs of resilience in the US economy, that’s not the case everywhere. Higher rates hit consumers harder around the world and there is more slack elsewhere, particularly in Europe. The dovish case is that even if the US stays strong, that a recession in Europe and some emerging markets results in global softness. That would keep commodity prices at current levels or lower. The divergence in economies would also boost the US dollar, making imports cheaper and putting downward pressure on prices.
This is an entirely plausible outcome and it partly hinges on how hard China opts to stimulate its economy. Right now, they’re delivering a piecemeal approach that hasn’t satisfied the market but with Chinese inflation low, they have plenty of levers to pull.