Strong US Economic Data Expected This Week -- But Some Caveats

The stock and Treasury markets could clash again this week in the face of strong US economic data.  But, not all considerations support the consensus estimates.  So, there is a chance the stock market rally will survive this week's data prints and the longer-end of the Treasury market will stay in its range.

The markets will have to contend with a string of strong US economic data this week, if the consensus estimates are correct.  Strong prints are expected for March Conference Board Consumer Confidence, ADP Estimate, Chicago PMI, Mfg ISM, Nonfarm Payrolls and Unemployment Rate.  In particular, consensus looks for +655k m/m Payrolls and a 0.2% pt decline in the Unemployment Rate to 6.0%.

While most evidence would seem to support the consensus estimates, there are a couple of caveats.  /1/ All business surveys that so far have reported for March posted an increase.  But, many of them missed the increase in the February Mfg ISM.  So, at least some of their March gains could have been catch-up and thus give an overly positive view for the March Mfg ISM.  Indeed, a widening impact of chip shortages could weigh on the latter.  /2/ The Claims data argue for a speedup in March Payrolls and a decline in the Unemployment Rate.  However, at least some of the job strength could be offset by an increase in the Labor Force in the calculation of the Unemployment Rate.  The Claims data do not say anything directly about Labor Force.  So, the Rate may surprise to the upside relative to the consensus estimate.

An increase in the Labor Force, particularly the Labor Force Participation Rate, would be a positive for stocks and Treasuries.  It would suggest that strong economic growth could be accommodated without putting stress on the labor market -- and thus avoiding higher wage inflation.  This possibility would support corporate profit expectations and make economic growth less of a concern for Treasuries.

The near-term US economic growth outlook is strong, nonetheless -- which could mitigate, if not prevent, month-end/quarter-end selling of stocks.  Besides the additional fiscal stimulus and expanding re-openings, there should be a bounce-back from the bad winter weather in parts of the country.  Inventory re-building could be a catalyst for new orders and production in coming months, as well.  The Claims data improved notably in the latest report.  And, the ECRI Leading Index has made new highs for the year in mid March (see chart below).

ECRI Leading Index (level, weekly)

     

             Jan 1, 2021                     Feb 5            Feb 26           Mar 19                

 

What Did the Fed Do?

The markets are likely to remain focused on Fed policy this week, as Fed Chair Powell testifies to Congress and other Fed officials make speeches.   They are not likely to diverge from the views expressed in last week's FOMC Statement.  There also will be Treasury auctions this week, with the most important perhaps being the 7-year -- which showed weak demand at last month's auction.  The degree of demand this time would bear on whether yields have moved up enough.

The Treasury market so far has clearly not been convinced of the benign Fed outlook of modestly above-trend growth and slight uptick in inflation in the next couple of years, despite a strong recovery from re-opening in 2021 and continuation of very low short-term rates.  It apparently is concerned that inflation will rise faster.  In addition, the markets were hit with Friday's announcement of the Fed's unexpected decision to allow the expiration of an easing of banks' reserve requirements at month end. 

Market commentators focused on the possibility that a renewal of the requirement for banks to hold reserves against deposits and Treasury holdings will force them to sell Treasuries.  But, this implication may not be right from a macro perspective.  The Fed may have to buy Treasuries in order to supply the increased demand by banks for reserves (otherwise short-term rates would rise -- contrary to the Fed's desire).  The more important implication may be that the Fed in effect tightened by increasing the bank reserve requirement.  As market commentators point out, the increased requirement could lead to banks to cut lending (eg, by tightening lending standards).  From this perspective, the Fed did half of an operation twist but one that should be a positive for the longer-end of the curve -- tightening but not by raising short-term rates.  It also should hurt cyclical as well as bank stocks. 

There is irony in curtailing bank lending, particularly if, as reported, Congressional Democrats argued strongly for the Fed to renew the reserve requirement.  By holding back this channel of monetary policy, other channels -- most importantly stocks and longer-term Treasuries -- have to work harder to achieve the Fed's goal of full employment. One result is the need for low short-term rates to continue.  Another is an exacerbation of unequal wealth distribution.  This happened in 2009 when Democrats pushed for tighter restrictions on banks.  

The broader question is whether the Fed is right in its forecast of only a modest increase in inflation over the next couple of years.  Fed officials argue that this is the most likely outcome as long as longer-run inflation expectations remain contained.   So, reports like the University of Michigan 5-Year Inflation Expectations should become more market significant. (This measure is at 2.7%, the high end of its recent 2.5-2.7% range.)   Current inflation prints are less important since they can be impacted by temporary factors. 

The most important determinant of inflation is the pace of labor costs.  Unfortunately, almost all measures of aggregate labor costs have been distorted by large compositional shifts between high- and low-paid workers as a result of the uneven impact of the virus on jobs.  Perhaps the least affected is the Employment Cost Index, since it holds job distribution constant.  The ECI shows no significant acceleration, if any, so far. 

In regard to wage inflation, the most important piece of information in the next couple of weeks could be the March Unemployment Rate.  The markets could view a steady to higher level as taking some upward pressure off wage inflation.   Even Fed Chair Powell admits to an inverse relationship between the Unemployment Rate and Wage Inflation, although he says the relationship between wage and price inflation is not one-for-one.

The currently low inflation rate should be seen in the February Core PCE Deflator in this week's report.  Consensus looks for a modest +0.1% m/m with a steady 1.5% y/y.   Most of this week's other data -- Existing and New Home Sales, Personal Income and Consumption -- are expected to decline, reflecting temporary factors like the bad weather.  The declines should be dismissed.   The most interesting of the real-side data will be Initial Claims to see if they unwind the prior week's difficult-to-explain jump.

 

 

March FOMC Meeting

The markets' focus this week will be on whether the FOMC responds in any way to the recent market volatility and growth/inflation concerns.  There are a number of ways it can.  But, it is also conceivable the FOMC won't do anything, particularly since the markets appeared to begin stabilizing last week.  The markets may very well quickly shift their focus back to evidence on the extent to which economic growth is speeding up in response to re-openings and fiscal stimulus once the Meeting is out of the way.  This week's US economic data, indeed, risk dampening these expectations.

The FOMC could decide to respond to the recent market concerns by changing policy.  It could decide to increase purchases of longer-term Treasuries, just like the ECB did last week.  Or, it could do an operation twist, lifting short-term rates as well as increasing longer-term purchases.  

There is a potential problem with increasing purchases of longer-term Treasuries, however.  The additional monetary stimulus could exacerbate the growth/inflation fears in the Treasury market.  So, the increased purchases could backfire and result in higher yields.  An operation twist would presumably prevent this problem.  But, it's not clear the Fed would move now to tighten the short-end of the curve, as current core inflation remains soft. 

Instead of a policy change, the Fed could tweak the FOMC Statement to promise a quick response to future inflation, if needed.  This could be done in the Statement or by Fed Chair Powell in his post-meeting news conference.  The prior meeting's Statement said:

 "The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee’s goals. The Committee’s assessments will take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments." 

Theses sentences would seem to cover the possibility the Fed would respond quickly to an unwanted speedup in inflation.  But, it could be tweaked to increase emphasis on a response to inflation pressures.  Also, the sentences appear in the last paragraph of the Statement.  It could be moved to a more prominent position, but that could be construed as a more aggressive signal than officials want to send.

The markets will also likely pay attention to updates to the Fed's Central Tendency forecasts.  The Treasury market could react negatively if officials boost the growth/inflation outlook without changing the expected Fed Funds Rate trajectory.  But, this reaction could be muted if Powell emphasizes downside risks to the outlook or if the growth speedup is seen as temporary, as is likely. 

The Fed's Central Tendencies will likely show a much stronger Real GDP trajectory, particularly for 2021, as the new fiscal stimulus is built in.  But, Powell is still likely to emphasize downside risks to the outlook stemming from the virus and its more-contagious strains, as did the Fed staff at the January FOMC Meeting.  As a result, the Central Tendencies could show a 2021 speedup in GDP Growth followed by more subdued growth in the following few  years.  The Central Tendency for Inflation will probably be little changed, as it already built in a modest speedup over the 2021-23 period.  For 2021, the PCE Deflator is expected to be up 1.7-1.8% (Q4/Q4).  In January, it was up 1.5% (y/y).  The combination of only a temporary speedup in GDP Growth and modest acceleration in inflation could temper market concerns of an overly easy monetary policy.

This week's US economic data could temper near-term growth expectations.  February Retail Sales, both Total and Ex Auto, are seen falling by 0.5% m/m.  The risk is to the downside.  Besides the drag from bad weather, particularly in Texas, a pullback often follows a strong advance such as January's.  Note, though, that the best measure of Retail Sales will be Ex Auto/Ex Gasoline.  Gasoline Sales will reflect higher prices.  There is downside risk to the consensus estimate of +0.6% m/m in February Industrial Production.  Chips shortages were still curtailing motor vehicle production that month.  Also, Total Hours Worked in Manufacturing fell 0.3-0.4% m/m.  Consensus looks for little change in February Housing Starts and a decline in Permits.  Bad weather represents downside risk to this forecast.

 

Ahead of the March FOMC Meeting

The markets' reactions to this week's Treasury auctions and US economic data could determine whether the Fed adjusts policy to address unsettled markets at the March 16-17 FOMC meeting.   A sharp rise in yields and drop in stocks. particularly after the auctions, presumably would be required to move the Fed.  While the Fed would likely discount a high February Core CPI as transitory, an increase in the University of Michigan 5-Year Inflation Expectations could raise eyebrows.  Last week's February Employment Report had a very strong headline figure, but some of the internals were not strong.  So, it is not enough to move the Fed.

Treasury auctions 3- and 10- year notes and a 30-year bond on Tuesday, Wednesday and Thursday, respectively.  Yields on these securities already have risen sharply.  Since the last auctions in mid-February, the 3-year is up about 15 BPs and the 10- and 30-years are up about 40 BPs.  A question is whether these higher yields will attract a lot of demand.  But, even if the yields have to push higher ahead of the auctions to do so, the ultimate question will be if there is a relief rally or at least a flattening in yields subsequent to the auctions.  A stabilization of yields could be more important to the Fed than their level and hold back any change in policy.  

Expectations for the February inflation data are benign.  Consensus looks for a trend-like +0.2% m/m for the February Core CPI, keeping the y/y at 1.4%.  The components are likely to be mixed, with some components, like housing rent, held down by the impact of the virus and others boosted by pass-throughs of higher oil prices or weaker dollar.  Consensus sees the February Core PPI slowing to +0.3% m/m, after the 1.2% jump in January.   Consensus also expects the U of Michigan 5-year Inflation Expectations to stay at 2.7%, which would keep it at the high end of its range.  

Evidence on the real-side of the economy is more mixed than might be obvious from looking at headlines.  Leisure and Hospitality re-openings were behind the bulk of the +379k m/m February Payroll increase, with jobs elsewhere rising modestly for the most part.  Total Hours Worked in the month actually fell 0.5%, as the Workweek dropped back from an outsized level in January.  The 2-month average of THW is only 0.6% (annualized) above the Q420 average, arguing that the Atlanta Fed model's latest forecast of 8.3% for Q121 Real GDP Growth is much too high.  The Phil Fed's ADS Business Conditions Index puts GDP growth only slightly above its 1.8-2.0% trend so far in Q121.

Other developments also take the edge off the idea of very strong growth immediately ahead.  The fiscal stimulus bill coming out of the Senate looks to be somewhat smaller than the $1.9 Tn House bill, as both one-time payments and Unemployment Benefit supplements were cut back.  And, the pass-through of higher oil prices will offset much of the stimulus to households' purchasing power.  Oil prices appear to be heading even higher into the Spring, as OPEC decided not to boost output in April.

 

Fed in a Corner

The sell-off in the Treasury and stock markets may force the Fed to adjust its monetary policy at the March 16-17 FOMC Meeting.  The run-up in yields and drop in stocks, if left unchecked, could undermine the economic recovery.  The immediate question is whether the market sell-offs have to continue up to the Meeting in order to convince the Fed to move.

Fed Chair Powell and other Fed officials have continued to downplay recently rising prices as transitory and have restated their goal to let inflation rise moderately above their 2% target until full employment is achieved.  This was the import of Powell's and Fed Governor Brainard's talks this week.  However,  the Treasury market sell-off is a vote of no-confidence that this policy approach will be accomplished without stoking a significant increase in trend inflation.  It suggests the Fed's policy approach was unrealistic -- even if currently higher prices are temporary, keeping rates low would be undermined by market reactions to hints of a speedup in inflation.

Some Street economists argue that the Fed should implement an "operation twist," raising short-term rates and increasing their purchase of longer-term Treasury securities.  Even if small, this action could stabilize the markets, as it would signal the Fed will not let inflation run away.  This policy shift would lift the dollar and pull down commodity prices.  The balancing of higher short-term rates against lower longer-term yields would mitigate any drag on the economy.

The Fed could justify an operation twist in the context of its stated intentions accordingly.  It could say the offsetting dual impacts on the Treasury market are essentially neutral in terms of the economy, so that monetary policy remains highly supportive.  Officials could get solace from thinking the new fiscal stimulus will more than make up for any residual net drag from the policy.   

From a broader perspective, there is another justification for a change in policy approach now.  The Fed's current approach to achieving full employment relies on a straight-forward path.  It promises to keep rates low and asset purchases high until the economy fully recovers.  Sometimes,  however,  a successful policy requires deviations from such a path.  Overly easy policy now could require overly tighter policy later, making any economic recovery short-lived.  Policy may need to be tightened at times along the way to ensure a long period of economic expansion.  A policy adjustment at the March FOMC Meeting could be interpreted along these lines, thereby making it a stock market positive.