Resilient Labor Market Keeps the Fed on Course
U.S. equity markets have been volatile as investors digest concerns of corporate earnings growth, the impacts of Federal Reserve policy, and dour economic warnings from several U.S. bank CEOs. Among all the asset market turbulence, the spread on the U.S. 2s-10s Treasury yield curve has sunk to a new low of 82 basis points, the most since the early 1980’s. The yield curve spread suggests that the Fed’s monetary policy tightening cycle is almost over either because a recession is imminent, or because inflation is likely to keep falling without a recession. This stands in contrast to the data however as strong U.S. jobs data showed lower workforce participation, propping up wages, and confirming that a tight labor market should help keep inflation persistently higher. The Federal Reserve has raised the funds rate six times in 2022 at the fastest pace on record. While inflation has moderated in some areas, with the Personal Consumption Expenditures Index’s latest reading of a 6% annual increase, it remains significantly higher from the Fed’s target rate of around 2%.
Fed Chair Powell gave a speech at the Brookings Institute last week that signaled a deceleration in rate hikes, perhaps as early as this month. He reiterated that it’s likely that interest rates will need to go “somewhat higher” than what policymakers had forecast in September, and that Fed officials will be looking for “significant positive” real rates across the yield curve, among other asset classes, to assess how restrictive monetary policy is. He noted that signs that wage growth is moderating are only “tentative,” and this point was underlined by the robust November jobs report last week. Given the resilient labor market, Fed officials may have to raise their terminal rate forecast. The markets had been front-running the idea of a Fed pivot for several months and are now recalibrating for inflation sticking around longer than expected.
Another notable development was Blackstone’s $69 billion flagship private real estate fund limiting redemption requests from investors once they exceeded the quarterly limit, prompting Blackstone to temporarily put up the gates. These occurrences will often trigger a negative feedback loop as investors become more apt to get out at the next opportunity. The investment world is watching this situation closely as it is a stark indicator of the property industry and private investing more broadly.
The moves in the yield curve are signaling that markets believe the Fed’s current policy is very restrictive. The forecasted earnings growth rate for 2023 is currently over 5%. This seems optimistic given an environment of elevated interest rates and slowing economic growth. Downward revisions to earnings estimates could be a catalyst for another leg down in equity markets. We are a highly levered economy, driven by a decade of ultra-low rates, that is experiencing a breakneck tightening cycle. Powell left the door open that a “softish” landing is still possible, but bond markets currently believe otherwise.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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