Fed Tightening in the Face of A Weakening Economy

The stock market will likely trade cautiously this week as it moves through Tuesday/Wednesday's FOMC Meeting and key US economic data on Thursday/Friday.  A large 75 BP hike when evidence is mounting of a broad-based softening in economic activity is a recipe for recession and not positive for stocks.  Nevertheless, a relief rally is possible if the Fed signals the possibility of a downshift in tightening ahead and the key data are in line with consensus.  But, the drag on earnings from slow growth or recession is becoming more of a downside risk.  So, a rally would likely be short-lived.

With the Fed generally expected to hike by 75 BPs at the July 26-27 FOMC Meeting, the question will be whether officials signal the possibility of a smaller rate increase at the September meeting.  My guess is that Fed Chair Powell may acknowledge that a 50 BP hike is a possibility, but emphasize that it is still a significant move and that the Fed will not diverge from tightening until inflation -- both Total and Core -- falls back to the Fed's 2% target.  Such a mixed message could spark volatility in the stock market.  But, the volatility could end on the upside, as the idea grows that the Fed will be responsive to the real economy and that the worst of the tightening could be over.  The 75 BP hike also should lead to a further inversion of the Treasury yield curve, with mixed implications for stocks -- while the inversion would be viewed as pointing to recession, the lower longer-term yields would be seen as already moving in a way to cushion the economy's weakening.

Cycles of overshooting weakness and strength will likely mark the outlook for the economy and stock market over the next few years.  A standard econometric model of the US economy -- like the one used by the Fed -- can generate successive business cycles after a shock.  So, after the pandemic slammed the economy, the bounce-back overshot to the upside.  To squeeze out the consequential inflation, the economy has to weaken sharply -- and overshoot to the downside to prevent a wage-price spiral.  This weakness has to be accompanied by a sizable increase in the Unemployment Rate -- perhaps to a level above its long-run, full-employment level.  This overshoot should then be followed by an easing Fed that risks boosting economic growth and the stock market too much.  And, so on.  

At this point, the US economic data are only beginning to show weakening signs, although these signs are building.  This week, the most important releases should be the first print of Q222 Real GDP and Employment Cost Index.  

Consensus looks for a slight increase of +0.4% (q/q, saar) in Q222 Real GDP -- essentially a flat print but stronger than the Atlanta Fed model's estimate of -1.6%.  These estimates can change, possibly significantly, after advance prints of June Trade Balance and Inventories are released ahead of the GDP print.  An increase in Q222 Real GDP would show that recession has not yet begun, in contrast to the message from a decline like the Atlanta Fed model's estimate.  This would be a positive for the stock market.  But, flattish or lower GDP would argue that the recent strength in job growth was overdone (and should show up in a decline in Productivity).   It would point to a sharp slowdown in Payrolls ahead.

The ECI is broader than Average Hourly Earnings, so it will be important to see if the latter's slowdown is confirmed.  Consensus looks for the ECI to slow to 1.2% (q/q) in Q222 from 1.4% in Q122.  This estimate is consistent with the slowdown seen in AHE  (see table below) and would be a market positive -- even though it still would be historically high, almost double the pre-pandemic pace (2019 avg).

                                                (Q/Q Percent Change)         

                                                AHE            ECI

              2019  Avg                    0.7                 0.7

              2021 Avg                     1.2                1.0

              Q122                            1.2                1.4

             Q222                             1.0                1.2 (e) 

Consensus expects other US economic data this week to show declines in June New Home Sales and Total Durable Goods Orders.   But, the more important question is whether the expected uptick in Ex Transportation Durable Goods Orders is too high.  All manufacturing surveys indicate a pullback in new orders, and confirmation from Ex Transportation Durables would spark more talk of a softening in the manufacturing sector.   Consensus also looks for the Core PCE Deflator to speed up to +0.5% m/m from +0.3% in May.  This old news, as it mostly reflects the already-released CPI.  But, it would underscore the difficulty in bringing down inflation.  A smaller-than-consensus increase would be a market positive.