The bond market is weird, but it’s full of clues. We have 8.6% inflation, but the highest interest rates have gone recently is about 3.4%, meaning real rates were still negative to the tune of 5%.

If you look back at history, there were long periods with negative real interest rates and long periods with positive real interest rates. You might also notice that the periods with positive real interest rates were the good times and the periods with negative real interest rates were the bad times. We are currently in the bad times. We didn’t realize how good we had it.

Why are real interest rates still negative? Well, I have a couple of theories. One is that the bond market knows this inflation is mostly transitory and will quickly revert to the mean of around 3%–4%. The whole transitory thing is a running joke now—the Fed said inflation was transitory, and then it went up its nose, and it had to stop itself out of that view… but it really might be transitory.

Think about it: All the factors that led to this inflation—quantitative easing, money printing, fiscal spending, and pandemic hoarding—are all gone. As much as liquidity expanded in 2020–21, it is now running in reverse. The Fed is actually doing quantitative tightening, where it sucks money out of the money supply. We had the biggest expansion of liquidity and credit since WWII followed by what is now the biggest contraction. Small wonder the stock market isn’t down more.

In fact, if you created a one-factor model that attempted to predict the direction of the stock market using only liquidity as an input, it would be a pretty robust model. Never mind all the sentiment stuff about meme stocks and crypto—it’s all a function of liquidity.

The recent history is that bond yields gapped higher after the 8.6% CPI print a few weeks ago and are now edging lower. We saw the 6.28% print on 30-year fixed mortgage rates and panicked, but things are returning to normal. I expect yields to drop further in the near future. Whatever happens, though, my sense is that most investors are not paying enough attention to the bond market right now—we’re going to talk about this more in the coming weeks.

I’m not sure how much attention you pay to the rates market, but recession bets are getting quite popular.

All recessions are different. If we have a recession, it will be an odd sort of recession. First of all, nobody is losing their jobs; the labor market is quite strong. There are still two job openings for every applicant. I think this is a function of the lagged effects of the pandemic spending, and it will return to normal over time. But right now, we have leading indicators, like manufacturing PMIs collapsing, while the job market is still pretty strong.

Of course, the Fed, which is driven by politics, probably won’t respond to recessionary signals until the most lagging of lagging indicators, unemployment, starts to move higher. This is why we can expect a 50-basis point hike in July and another in September. Right now, inflation is still a bigger political priority, and the Fed is going to want to see substantial progress on inflation before it even thinks about cutting rates. Shorter: The Fed will overdo it, like it overdoes just about everything.

 

US Economy

 

  • According to the ISM PMI report, US manufacturing growth slowed in June but held in positive territory (PMI > 50).
  • However, demand deteriorated, with new orders declining for the first time since 2020.

 

 

  • Manufacturers see new orders as being low relative to inventories.
  • Factories reported a drop in their workforce.
  • Employment and new orders are now a drag on the ISM PMI index.
  • Supplier bottlenecks are easing.
  • But price pressures persist.
  • Forward-looking indicators point to weakness in US factory activity in the months ahead. Here is the ratio of cyclical to defensive equities.

 

 

  • US automobile sales remain depressed.
  • Public construction spending eased as road construction expenditures slumped in recent months.
  • The percentage of consumers struggling to meet expenses increased sharply in recent weeks.

 

 

  • Treasury yields declined sharply over the past couple of weeks.

 

 

  • Automobile inventories remain tight, keeping prices elevated.
  • Outside of autos, retail inventories have risen sharply, as imports surged.
  • Supply bottlenecks are still an issue (mostly in retail).
  • One area of concern in the FOMC report was employment. Service firms are now shedding jobs.
  • The ISM Services employment print (above) doesn’t bode well for job growth.
  • Initial jobless claims are still very low for this time of the year (below 2019 levels). The job market remains tight (for now).
  • Layoffs have picked up, but most workers are finding jobs quickly.
  • Mortgage applications ticked up going into the holiday weekend but are still some 17% below last year’s levels.
  • The decline in mortgage applications and higher mortgage rates point to much slower home price appreciation in the months ahead

 

Source: Pantheon Macroeconomics

 

Source: Piper Sandler 

 

 

  • More sellers have been cutting prices.

 

 

  • Demand for vacation homes has been falling.
  • Homebuilder sales continue to deteriorate.

 

 

  • It’s hard to see US utilities lowering prices even if natural gas prices don’t rebound.

 

The Fed

 

The FOMC minutes showed an increased focus on inflation expectations and a willingness to keep tightening well into restrictive territory.

– Concerns about “unanchored” inflation expectations:

… many participants raised the concern that  longer-run inflation expectations could be beginning to drift up to levels inconsistent with the 2 percent objective. These participants noted that, if inflation expectations were to become unanchored, it would be more costly to bring inflation back down to the Committee’s objective.

Many participants judged that a significant risk now facing the Committee was that elevated inflation  could become entrenched if the public began to question the resolve of the Committee to adjust the stance of policy as warranted.

– Tightening financial conditions by projecting a hawkish stance:

… participants stressed that appropriate firming of monetary policy, together with clear and effective communications, would be essential in restoring price stability.

– Prepared to go the distance:

Participants concurred that the economic outlook warranted moving to a restrictive stance of policy, and they recognized the possibility that  an even more restrictive stance could be appropriate if elevated inflation pressures were to persist.

– Prepared for collateral damage (recession):

Most participants assessed that the risks to the outlook for economic growth were skewed to the downside. Downside risks included the possibility that a further tightening in financial conditions would have a larger negative effect on economic activity than anticipated …

– Frontloading (and perhaps a pause at the end of the year?):

Participants noted that, with the federal funds rate expected to be near or above estimates of its longer-run level later this year, the Committee would then be well positioned to determine the appropriate pace of further policy firming and the extent to which economic developments warranted policy adjustments.

——————–

 

The equity market took the hawkish FOMC minutes in stride, as oil prices continued to fall.

Treasury yields jumped and the curve moved deeper into inversion.

The Fed’s securities portfolio saw its first meaningful reduction in recent days (quantitative tightening).

 

 

 

The dollar continued to advance.

 Surging core inflation measures remain a challenge for the US central bank.

 

 

There is quite a bit of debate about how far the Fed will be forced to hike rates. The market still sees the terminal rate below 3.5%. At that level, the peak inflation-adjusted fed funds rate will be negative.

 

Market Data

 

  • Copper is in oversold territory

 

 

  • Gold hit a death cross.

 

 

  • This chart shows the year-to-date returns globally.

 

 

  • Who owns the US equity market?

 

 

  • Investor sentiment remains bearish.

 

 

Quote of the Week

 

“Expecting a trouble-free life because you are a good person is like expecting the bull not to charge you because you are a vegetarian” – Jeffrey Holland

 

Picture of the Week

 

 

 

All content is the opinion of Brian J. Decker