Capital markets perspective: Have interest rates peaked?
Capital markets perspective: Have interest rates peaked?
Capital markets perspective: Have interest rates peaked?
“You have arrived at your destination.”
A few years ago, we took our kids to Mexico. It was one of those all-inclusive resorts, and it was every bit as awesome as we hoped it would be: unlimited beach time, great food, new friends, the whole deal. We hope to go back some day.
But if there was one disappointment, it was that we simply failed appreciate how long it would take to actually get there: after hours on an airplane, we landed in Mexico ready to sip margaritas and hit the beach. Instead, we had to endure a long, sweaty line at customs, a two-hour drive from the airport to the resort and a few other odd and unexpectedly long delays before finally arriving poolside. A minor inconvenience in the grand scheme of things to be sure, but still a disappointing reminder that simply arriving at your destination doesn’t necessarily mean the most arduous part of your journey is over.
Interest rates edge upward
I have a sneaking suspicion that capital markets might be falling victim to the same delusion that caused my wife and I to imagine that we’d each be handed a cocktail and snorkeling gear at the airport the second we touched down in Playacar: after the most aggressive Fed tightening cycle since at least the 1980s, Fed Chairman Jerome Powell finally seemed to be hinting to the world that interest rates in the U.S. had at last arrived at its final destination – that magic zone where economic growth isn’t collapsing and inflation might finally be brought to heel and no further rate increases were necessary. Markets didn’t exactly party after Wednesday’s announcement, but they didn’t collapse, either: equity markets ended the week mostly flat to mixed, despite the fact that there are almost certainly still a few arduous miles ahead in our journey toward stable prices and a robust economy. Beyond small-caps, most U.S. stock indices are still higher for the year and Friday was the second-best day for the Dow Jones Industrials so far in 2023. (For those keeping score, it was also the fourth best day for the S&P 500 Index and the sixth best day for NASDAQ.)
But first things first: how do we know that Powell is finally signaling an end to the serial rate increases that have brought us to this point? Well, for one, the pundits are telling us so. (And they’re never wrong, are they…?) But more to the point, absent from the post-FOMC statement that was issued Wednesday alongside the Fed’s tenth rate increase in as many opportunities was the phrase “additional tightening may be appropriate.” Instead, it was replaced with a promise to simply be mindful of the cumulative effects of so much tightening, as well as the lag between tighter policy and the damage it can do to the economy and the financial system in general.1 That’s not exactly a guarantee that the Fed is ready to pause, but as close as we’re likely to get. And Powell even went a half-step further, suggesting that in his estimation, the U.S. was more likely to sidestep a recession than not. (Forgive my skepticism, but that sounds a lot like the bartender at the swim-up bar in Mexico who reassured me that I wouldn’t get a hangover as he continued to pour me tequila shots.)
So what about that hangover? The most obvious impact of the Fed’s tightening campaign so far has been stress on small- and mid-sized banks that began with the failure of Silicon Valley Bank in mid-March and has claimed a small handful of other victims since. Last week’s failure belonged to First Republic, another Bay-area lender that famously received a huge dollop of deposited cash from a veritable Star Chamber of big banks back in mid-March that was designed to shore up confidence among the bank’s other big depositors, sort of a statement that “see, we’ll park a bunch of dough here because we’re sure we’ll get it back if something bad happens, so you should stick around, too.” That was a great idea, but it didn’t quite work: when the FDIC passed up the opportunity to formally restate its maximum deposit guarantee to something above $250k, the deposit exodus at First Republic continued and the bank had to be rescued early on Monday morning.
That was the latest evidence that the mini-banking crisis may still not be over despite repeated reassurances from banking luminaries and the Fed itself. For their part, investors were less willing to shrug off First Republic’s failure than they were worries about some future economic slowdown, and stocks struggled for the first few days of last as everyone tried to assess the potential for even more bank failures. The KRB Regional Bank Index – once a little-known benchmark full of cute little banks but now notorious among market commentators for its potentially toxic contents – fell 12% through last Thursday before rallying back a little bit on Friday. I wish I could tell you that we’ve seen the last of it, but unfortunately nobody can.
And that includes famed 92-year-old investor Warren Buffett, founder and CEO of Berkshire Hathaway, who began Saturday’s annual shareholder meeting by seating himself and Vice-Chair (and fellow oldster) Charlie Munger behind signs that read “Available for Sale” and “Held to Maturity.” That was a cheeky reference to the accounting treatment of balance sheet assets that helped cause Silicon Valley Bank (and others like it) so much trouble in the first place. But when commenting on whether the banking crisis was over, Buffett simply replied that this banking crisis, like others before it, is being driven by fear and that sometimes fear is justified while other times it isn’t. Ambiguous, sure, but also precisely accurate: we probably won’t know if the mini-crisis was justified or simply an over-reaction until its finally over. Let’s hope that’s soon.
Other things on Buffett’s mind as he reported better-than-expected first-quarter profits included the economy itself (he expects most companies in his diverse portfolio of operating businesses to report lower earnings this year,) as well as a relative lack of opportunity to invest Berkshire’s huge reserves of dry powder (his firm now holds around $130b in cash – less than during the height of the pandemic, but higher than he’s held in a year and more than enough to buy a half-dozen regional banks and a resort or two on the Mexican riviera.)
Labor market demand cools
Thankfully, there’s not a whole lot to say about last week’s labor market data that would otherwise have upstaged the Fed or the banking crisis. Tuesday’s JOLTS data was probably the most reassuring of last week’s big reports because it showed a pretty significant cooling of labor market demand. There were just under 9.6 million open positions at the end of March, still far too many but well below estimates and the lowest in two years.2 At the same time, layoffs continued to mount – even if more slowly than in recent months. So far this year, companies have formally announced plans to drop around a third of a million workers, more than three times as many as last year and the highest year-to-date total since the Great Recession.3 So the jobs market seems to finally be getting the message that the Fed has been sending for a year now: cool it, or else.
On the other hand, both ADP and the Bureau of Labor Statistics estimates of job creation suggest the U.S. saw something of a hiring splurge in April, with both reports coming in uncomfortably warm even as other indicators suggest the labor market may be slowing somewhat.4,5 Maybe the most disheartening datapoint in Friday’s labor situation report was word that the unemployment rate ticked back down to 3.4%, matching its Vietnam-era low and keeping alive fears that the labor market may still not be at an appropriate level to keep inflation at bay.
But its also important to remember that unemployment that’s too low and payroll growth that’s too high aren’t necessarily problems in and of themselves. Instead, what matters to the inflation debate is whether or not either of those two trends are creating unsustainable pressure on wages. And there, last week’s data was a little more mixed: unit labor costs rose a much-higher-than-expected 6.3% during the first quarter of 2023,6 but ADP’s more frequent read showed that compensation costs eased again last month.7 As long as you trust ADP’s numbers more than the BLS’, and as long as that cooling-off continues to happen, I guess there’s no real reason to wring your hands nervously while the jobs market goes continues to outperform.
Finally, if looming recession, a slow-motion banking crisis and a still-arguably-too-hot labor market aren’t enough to keep you guessing, I suppose we should close this part of the Perspective with at least a brief mention of the debt ceiling debate. Last week, President Joe Biden beat a tactical retreat by softening his earlier “no negotiations” pledge and inviting congressional leaders to the White House to discuss things. That’s good news (but frankly probably shouldn’t have really surprised anyone given the political climate.) Meanwhile, though, Treasury Secretary (and former Fed Chair) Janet Yellen sent a letter to Congress warning that incoming tax receipts suggested to her that the so-called “X-Date” – the day when “extraordinary measures” are no longer sufficient to allow the U.S. Treasury to keep paying its bills – might arrive as soon as June 1.8 That’s at least a week or two earlier than previous estimates and brings into sharper focus the next big thing likely to drive market sentiment: a potential default on U.S. Treasury Debt. That particular kind of nastiness could have all sorts of implications that markets haven’t yet seemed to contemplate but may soon have to stop ignoring.
What to watch this week
Economic events, May 8-12
Monday: Senior Loan Officer’s survey; earnings: n=280+
Tuesday: NFIB small business sentiment; earnings: n=580+
Wednesday: CPI inflation, hourly earnings; earnings: DIS, n=450+
Thursday: PPI inflation, Weekly jobless claims; earnings: n=500+
Friday: UofM consumer sentiment, EXIM prices; earnings: 180+
Earnings season enters its last sprint to the finish this week, with far too many companies to mention and many of the more notable releases already in the books. This week’s prospective calendar includes nearly 2,000 companies, including Disney on Wednesday, but only a handful of others that might be expected to grab the spotlight from this week’s economic releases. With the bulk of S&P 500 companies now having reported, trends are mixed. So far, earnings growth has declined a relatively modest -3.6% quarter-over-quarter – a better showing than expected. Firms have also proven slightly more likely to beat analyst estimates in the recent past, with 78% beating lower outlooks; last quarter, fewer than 70% achieved that feat.
Among this week’s economic releases to watch will be a pair of inflation releases, CPI on Wednesday and PPI on Thursday. Further down the list but still potentially relevant will be import/export prices on Friday. Collectively, these reports will help test the prevailing theory that inflation is on the wane. Hints to the contrary will likely be met with heightened volatility.
Two checks on sentiment are also due out this week, the National Federation of Independent Business’ small business confidence survey on Tuesday and the University of Michigan’s first read on May consumer sentiment on Friday. Both reports routinely ask respondents to comment on things other than their confidence about future growth, such as the direction of prices and inflation. Look to those reports for further evidence that concerns about inflation are receding.
Finally, one report certain to get far more attention than it usually does is Monday afternoon’s senior loan officers’ survey (or “SLOOS.”) This report is compiled quarterly by the Federal Reserve and ordinarily gets about as much attention as Prince Harry at a royal coronation, but this time around could be a true turning point. The so-called “SLOOS” asks bank officials responsible for setting lending standards how willing they are to make loans and whether credit conditions are tightening or getting looser. Little surprise that banks have recently been somewhat more reluctant to lend to commercial and industrial customers as the economy falters, something that was true even before the regional banks started to fail. With that now in the mix, many economists – including those at the Fed – are watching this data closely for signs that a decreased willingness to lend may hasten the economy’s descent toward slowdown or recession. For context, tighter credit conditions are independent of the Fed’s interest rate policy but nonetheless act as an additional brake on economic activity.
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