The Weekly Beat: 11 July 2022
Breaking the Yield Curve, Commodities Retreat?, and Stocks to Watch
· The meeting minutes from the FOMC’s June meeting confirmed that the committee was tying itself to the mast for at least two additional meetings with rate increases. The entire yield curve shifted up, but the flattening of the past month got worse (Charts 1 & 2). The Fed is in a metaphorical staring contest with inflation and the yield curve is the best measure of eye strain for the Fed that this writer knows of.
· Reading between the lines of the minutes the committee seems to be eyeing a further 100 basis points of cumulative rate increases at the following two meetings that, when combined with the 75 bps in June, will represent a move into “restrictive” monetary policy. Another one percentage point of rate increases would, not coincidentally, leave the yield curve almost – but not quite – entirely flat.
· “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.”
· The bond market might not cooperate with the Fed’s goals, which is the biggest risk the committee faces right now. If growth prospects continue to decline, then long-term yields will continue to decline with them and cause yield curve inversion to occur before the Fed gets its 100 points of tightening. Alternatively, concerns about inflation and the possibility of asset sales could send the bond market into a panic and send yields significantly higher.
· Five-year rates quickly ran out of gas once they caught up to 30-year rates, and short-term rates are catching up to the middle of the curve very quickly (Charts 3 & 4). This all implies the need for the Fed to implement yield curve control to maintain an upward sloping yield curve while maintaining tight, but not too tight, monetary policy. I recently gave a webinar on this topic, slides here.
· Real rates are now above zero for nearly the entire bond yield portion of the curve, which is probably related to the series of arbitrage-related financial disasters taking place in crypto (Charts 5-8). Expect to see more of these, and we will get to see how big the crypto shadow banking system really got during its brief boom.
· One of the most important sentences in the minutes came from the Staff Economic Outlook section of the report (emphasis added): “The level of real GDP was still expected to remain well above potential over the projection period, though the gap was projected to narrow significantly this year and to narrow a little further next year.”
· The staff economists at the Fed appear to agree with this writer that potential growth for the U.S. economy is below zero and therefore a “recession” is not really a recession but a return to trend growth.
· Stocks to Watch: ABBV, AMCR, AMGN, AZO, CPB, HRB, IBM, K, MMP, MPLX, OHI, PBFX, PM, PRTS, SPH, T, WMB
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Commodities
· The Yardini Boom/Bust index continued sliding last week and given the speed of the decline, the implications remain ambiguous (Chart 13). Some level of increase in initial unemployment claims was necessary to add liquidity to the labor market to avoid a wage-price schedule (Chart 14). In addition, relief from soaring commodity prices can hardly be called a bad thing (Chart 15). With the numerator falling and the denominator rising the index is crashing, but arguably for good reasons.
· Perhaps the most ominous sign that the decline in commodity prices is not benign has been the failure of emerging market equity prices to rally as oil has pulled back from recent highs (Chart 16). The worst case right now would be that the usual positive correlation between commodity and emerging market equity prices will reassert itself on the way down, causing stock prices to collapse further.
· In addition to the precipitous rise in food and energy prices, another disturbing sign of brewing financial trouble is the soaring value of the dollar relative to other stores of value. It isn’t just crypto prices that have come down, other advanced economy currencies and gold have all declined relative to the dollar (Charts 17 & 18). The question remains as to whether the issue is a rise in the price of the dollar due to a shortage of lending (supply) or an increase in demand due to concerns about the use of other stores of value.
· One indication that the issue is based in the “supply” of dollars, is that the price of gold has held up remarkably in the face of rapidly rising real interest rates (Chart 19). Gold is currently holding at support levels that were previously associated with much lower real interest rates. That means demand for gold is higher than it was in 2021 and that prices will likely rebound aggressively to any decline in real interest rates in the U.S.
· Oil prices have moved up significantly in nominal terms this year, but in real terms the price remains well below its pre-2014 levels. Currently the real price of oil is equivalent to its price in 2018 and nominal interest rates reflect this equivalence. So, although painful, oil prices in the U.S. are far from the kind of demand destruction seen in 2008 or the 1970s. A positive feedback loop between food and energy prices could quickly and unexpectedly turn into a wage-price spiral, as warned about in this year’s BIS Annual Report.
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