Quantitative tightening's (QT) acceleration in September will cause the Fed balance sheet dynamics that have been helping risk assets to rebound in a rally in July likely to disappear by Q4.
Despite this, Powell just gave a very clear speech in Jackson Hole expressing that the Fed will not make another mistake. After inflation was underestimated in 2021 and they delayed the tightening cycle, they will not stop too soon now.
They will keep at it until they are confident the task has been completed. And, in doing so, the economy and markets will suffer a substantial loss.In this post, we'll go through the following topics:
Now let's take a look at the latest economic data and explore the dynamics influencing the Fed balance sheet as well as how markets are interpreting recent Powell's Jackson Hole speech.
The slowing of housing activity is a big deal. Housing market spending and activity make up for nearly 20% of GDP in many countries, so when it changes, the economy feels it. What's more, since housing is so leveraged and interest-rate sensitive, it's usually one of the first sectors to change when financial conditions or economic cycles are changing - making it an important indicator of where the economy is heading.
The National Association of Home Builders Index (blue, on the RHS) against the Unemployment Rate (orange, on the LHS) is shown in the chart below. With the exception of 2020, when the world economy ground to a halt due to a pandemic, significant variations in the NAHB Index have led to changes in unemployment rate by approximately 12 months.
The NAHB index has just dropped 30+ points as a consequence of the slowing momentum of US house sales, which is worse than in 2007.
In the past, whenever there was a drop like this, it was always followed by a 3% increase in Unemployment Rate. If that trend were to continue, that would mean Unemployment Rate in the US would be above 6% by 2023.
You sure this is going to be a soft landing?
Aside from housing, other prominent economic indicators have shown significant deterioration in recent months. The US Conference Board compiles the top 10 leading economic indicators and presents them as a convenient diffusion index in the chart below.
As demonstrated by the recessions in 1980, 1981-1982, 1990-1991, 2001 and 2007-2009, every time the index falls below 0 twice , we are heading into a recession - not just a technical one, but also one that will result in sustained weakness in the labor market. Recently, this trend has become evident once again and as of now, the last print was 0. So let's see what happens next.
In a nutshell, tighter monetary and financial conditions takes a few months to fully register in leading indicators and several quarters to have an impact on hard coincident indicators like the labor market and real consumer spending. It appears that we are getting there, but the road ahead does not appear to be smooth.
What about the QT?
QT has reduced the amount of interbank liquidity (bank reserves) while also adding net collateral (bonds) that the private sector needs to absorb. This has caused repo rates and risk taking to rise. But recently, something interesting happened: despite QT still occurring, bank reserves actually grew.
The Federal Reserve's balance sheet (blue, RHS) has two sides: assets and liabilities. When the asset side shrinks, so must the liability side. This isn't just due to bank reserves, but also includes the Treasury General Account (TGA) and Reverse Repos (RRP).
According to the TGA (orange, LHS), the $1 billion barrier was almost broken in May.
The federal government just took a portion of that TGA money and spent it in the real economy and as they did so the RRP outstanding fell by almost nothing. It was the drop in TGA rather than bank reserves that took the hit of QT. While this marginally supported risk assets, it's not a trend that will continue through Q4.
As the TGA is close to standard levels and money in the Reverse Repo facility likely has difficulty getting out due to the lack of T-Bills issuance, bank reserves are going to be under pressure - and when they are, risk assets usually slump and the yield curve flattens further.
While Central Banks can have a significant impact on front-end yields, long-term yields are mostly influenced by expectations for future growth and inflation. QE helps to raise these expectations, whereas QT lowers them, resulting in flatter curves.
In a nutshell: Market movements are influenced by Central Bank balance sheet changes, and as QT accelerates and bank reserves are affected by economic downturns, risk assets tend to suffer.
Powell's Jackson Hole speech was direct and clear: the Fed won't make the mistake of stopping too early or allowing financial conditions to ease before the job is done. In fact, given dangerous inflationary pressures, they may want to tighten further. Thus, markets need to focus on pricing Fed Funds and inflation in 2023 and 2024 - this is how it looks today.
The fact that bond markets detect a sharp economic downturn suggests they are certain that inflation will swiftly decelerate to 3%. Given the Fed's clear declaration that it will "keep at it until the job is done," they have priced Fed Funds at 3.4% by Q4'23 - Q1'24.
In his Jackson Hole speech, Powell made it clear that he is willing to sacrifice growth and increased unemployment if it means getting inflation under control.
This is what he's saying: get ready for sluggish long-term growth and inflation expectations. This means that despite tight financial conditions, overall growth will be slow. Why does this matter? It matters for two reasons: long-term asset allocation and short-term tactics. For long-term portfolios, the combination of these factors creates a negative environment for risk assets' valuation. Tactically speaking, in the short term Powell's Jackson Hole speech has created an environment where bonds are doing well and interest rates are going up.
For the next 6-12 months, I'm staying on the defensive side. My short bias for the Long/Short Portfolio has not changed. After witnessing the insane rally in July where people thought that stocks would continually rise because of The Fed's pivot, I believe that equity markets will remain weak. This is especially true since The Federal Reserve wants to keep financial conditions tight and real yields high while earnings could soon become a serious disappointment. Cyclicals will suffer more than other sectors.
Next week's economic data from the Institute of Supply and Management will give us a better look at which sectors might be interesting for our long/short portfolio.