Bad News is Good News on Heels of Latest Jobs Report
Both U.S. equity and bond markets experienced a meaningful pullback in the month of April as strong inflation and economic data caught investors wrong-footed. Bonds unwound predictions on the frequency and timing of interest-rate cuts from the Federal Reserve, with the anticipated policy path reversal delivering the worst month for global bonds since September. Investor fears were assuaged last Wednesday, however, after Fed Chair Jerome Powell remarked in his post-FOMC meeting press conference that it’s unlikely that the next policy rate move will be a hike. The Fed also confirmed it will start to slow the pace of its balance sheet run-off in June, and will substantially reduce the monthly cap on how many Treasuries it will allow to mature without being reinvested from $60 billion to $25 billion. Then, markets continued to rally after a weaker-than-expected payroll report on Friday. Markets interpreted this bad economic news positively because it conceptually gives the Federal Reserve the ability to take a more dovish posture, and deliver interest rate cuts sooner, and at a faster pace. Shortly after the jobs report, we got the latest Citi U.S. Economic Surprise Index, which measures whether data measures are stronger or weaker relative to market expectations. The index printed its lowest level in over a year.
Another data point from Friday was the Institute of Supply Management’s (ISM) monthly survey of services and manufacturing industries. The overall indices for both sectors dropped back below the 50 level that demarcates contraction versus expansion. U.S. services activity fell into contraction territory for the first time in over a year. Excluding December 2022, this is the lowest level since the 2020 pandemic. Meanwhile, prices paid rose to a 3-month high. A slowing economy with growing price pressures is not the macro environment that the Fed wants. While Chair Powell discussed Wednesday that the U.S. job market is getting into better balance, wage data complicates that dynamic. A broad measure of labor costs released last Tuesday rose by the most in a year in the first quarter, with the 1.2% increase surpassing economist estimates. The momentum in disinflation that we witnessed through most of last year has stalled. In the U.S., rent accounts for roughly one-third of the CPI inflation index, making it a key driver of prices. Rents in most major U.S. metropolitan areas have risen approximately 1.5 times faster than wages in the last four years according to Zillow. Meanwhile, mortgage rates continue their upward trend. The mortgage payment needed to buy the median priced home for sale in the U.S. has increased 95% over the last four years (from $1,480 to a record $2,890). Lower income cohorts have exhausted pandemic savings, and with a skyrocketing cost-of-living, they will soon demand even higher wages to deal with the squeeze. This will undermine the Fed’s inflation fight even further. The Fed’s data dependence translates into a market obsession with government economic data releases. There is concern about complacency in equity valuations given inflation staying too hot, geopolitical tensions, oil, the U.S. dollar, and tight credit spreads.
The key driver of the U.S. dollar has been interest rate differentials between the U.S. and the rest of the world. With foreign central banks cutting rates, especially in emerging markets, this makes the Fed relatively more hawkish. This has played out in Japan where the Bank of Japan announced that it wasn’t going to raise rates further. This prompted the yen to slide to its lowest level against the dollar since 1990 as Japanese investors looked to park their money in U.S. assets. Japanese officials had to intervene twice in the span of four days in order to relieve the pressure on their currency.
The market has shown a willingness to rally on drastically different narratives. At the end of last year, the thesis was that the Fed had engineered a soft landing and rate cuts were coming as soon as March. Then, that has shifted to no soft landing, rates are going to remain higher for longer, but earnings and growth are robust, so that remained supportive for risk assets. U.S. Treasury yields typically peak for the cycle around the time of the last Fed rate hike. Absent further hikes, it’s likely that October’s peak in yields will hold despite the continued deluge of issuance ($125 billion this week alone). Expect further volatility in rates however as markets recalibrate to changing data. Strong Q1 earnings have supported stocks, but a change in leadership within equities is needed. Markets eagerly await next week’s consumer price index report as the next key piece to the puzzle.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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