This Week's FOMC Meeting -- A Short-Lived Disappointment?

The stock market may be disappointed by the outcome of this week's FOMC Meeting.  But, the disappointment could be short-lived.  After rallying on the belief that the Fed will downshift rate hikes after this week's 75 BP hike, stocks could pull back somewhat if the Statement and Fed Chair Powell do not say so explicitly but emphasize data dependency in discussing future tightening.  Although this emphasis would keep open the door for a downshifting at the December FOMC Meeting, it is no guarantee.  It could depend on whether US economic data released up to the December meeting show lower inflation or weaker economic growth. 

The Fed could stick with its data dependency approach to tightening because so far there is little evidence that it is achieving its goals.  Economic growth picked up in Q322 and core inflation remained high.  Without evidence of success, the bond market could sell off if the Fed downshifts -- viewing it as premature.  

This week's October Employment Report (due Friday) and September JOLTS data (Tuesday), however, could fit the bill and keep alive the market's belief in a December downshift -- and thereby sustain the rally.  Consensus expects the October Employment Report to show a Payroll slowdown, an uptick in the Unemployment Rate and a modest increase in Average Hourly Earnings.

The Claims data support a forecast of a smaller Payroll in October than September's +263k m/m,  Consensus expects +220k.  Anecdotal evidence also suggests some jobs softness.  News reports indicate that retailers may hire fewer-than-normal holiday workers this year.  Retail job weakness may show up more in November and December than in October, however.  A Payroll slowdown would be in the right direction from the Fed's perspective, but a slowdown to +100k or less would be needed to clearly indicate a softening in labor market conditions.  

The consensus expectation of a 3.6% Unemployment Rate, up a bit from September's 3.5%, also does not suggest a significant easing in labor market conditions.  The uptick could be just noise.  The Rate needs to rise to 3.8-3.9% by year end to meet the Fed's expectation seen in its Central Tendency Forecasts.  

Possibly the most market-positive part of the Report would be a modest 0.3% m/m in Average Hourly Earnings, as consensus expects.  It would offer hope that labor costs are trending down.

The September JOLTS data also could provide encouraging evidence that the labor market is cooling.  A drop in Job Openings to sub-10 Mn from 10.05 Mn in August would indicate that excess demand for labor is winding down.  To be sure, Job Openings were in the 7 Mn range prior to the pandemic.  So, excess labor demand is likely to remain a problem for the Fed at this point.

In contrast to these softer Reports, the risk is for a counter-consensus increase in the October Mfg ISM (Tuesday), based on some regional manufacturing surveys.  Consensus looks for a dip to 50.0 from 50.9 in September.  The manufacturing sector is mixed.  The motor vehicle industry is escaping from the shortage problem.  Although some analysts raise concern about the impact of higher borrowing costs on vehicle sales, there is probably pent-up demand that needs to be satisfied.  Airlines, too, appear to be placing orders for additional planes now that air travel has bounced back.  Increased defense spending and a shift to "on-shore" production also are positives.   But, construction-/housing-related manufacturing likely is facing difficulties. An increase in the Mfg ISM could help persuade the Fed to stick to data dependency in talking about future tightening.

Will Bonds Let Stocks Break To The Upside?

The stock market may continue to be buoyed by the possibility of Fed downshifting after the November 1-2 FOMC Meeting -- a possibility highlighted by Friday's WSJ article.  But, a stock market bounce could be short-lived if longer-term Treasury yields jump as a result.  

Such reaction by yields is conceivable.  The Treasury market could be concerned that monetary policy downshifting is premature.  If the market is not persuaded that economic growth and inflation will slow, the yield curve could steepen.  This would be a problem for stocks.  With the Fed relying on tighter financial market conditions to bring inflation under control, bond yields have tended to jump when stocks bounce in response to a positive fundamental factor, like profits, or to holding technical support.  The higher yields have undermined the stock market's move, forcing it back to supporting the Fed's goal.  This "vigilante" role of the bond market could prevent stocks from reacting positively to a hint of future downshifting by the Fed at the November 1-2 FOMC Meeting.

To be sure, there are secondary effects of a policy downshifting that could help hold down longer-term Treasury yields.  A consequential reduction in the volatility of short-term rates as well as of dollar exchange rates should flatten the curve, according to some models.   

Evidence that the Fed is achieving its goals (lower wage/price inflation and softer labor market) may be what's needed to prevent a run-up in longer-term yields.  With the Fed succeeding, financial markets would not have to "work" as hard to support the Fed.   So the Treasury market could be comfortable with stocks breaking to the upside.

In this light, the Q322 Employment Cost Index (ECI) could be the most important US economic data to be released this week.  It is a broad measure of labor cost inflation and little affected by compositional shifts.  Consensus looks for the ECI to rise +1.3% q/q, the same as in Q222.   This estimate may be somewhat high.  /1/ While Average Hourly Earnings (AHE) sped up a bit in Q322, it remained below 1.3% (see table below).  But, AHE is a narrower measure of labor costs than the ECI, not covering many types of workers nor types of compensation, such as bonus payments.  As a result, the two can diverge considerably in a quarter, as was the case in Q421.  /2/ Away from AHE, a reduction in sales commissions, such as for realtors, could hold down the Q322ECI.

A below-consensus print for the ECI probably would be positive for the markets, but a print of 1.0% or higher still could be problematic for the Fed.  It would be well above the 0.6--0.7% trend prior to the pandemic.  A sub-1.0% print may be needed to satisfy the Fed and to truly lift stocks.

                         (q/q percent change)

            Avg Hourly Earnings        ECI

Q321              1.3                          1.2                                                

Q4                  1.5                          1.0                                               

Q1                  1.2                          1.4                                           

Q2                  1.1                          1.3

Q3                  1.2                          na

 

Stocks Not Out of Woods Re Fed

The stock market is not out of the woods with regard to the Fed after last week's key events.  The September FOMC Minutes and Fed Vice Chair Brainard's speech underscored officials' intent to bring down inflation, but they appear to plan sticking with the measured pace of tightening seen in the Fed's Central Tendency forecasts.  The high September CPI should not derail their adherence to this plan at the November 1-2 FOMC Meeting.  But, a slowdown in underlying inflation by early next year could be critical to their continued adherence.

The high 0.6% m/m September Core CPI underscored the stickiness of underlying inflation.  While the largest component, Shelter (includes Owner's Equivalent Rent) is largely backward looking and still moving up as a result of past increases, the Core Excluding Shelter rose +0.5% m/m in each of the past two months.  Although this pace is slightly less than the 0.6% m/m average over H122, it needs to slow to 0.2% or lower to get to the Fed's 2% target.

The real-side of the economy may not be slowing enough to knock down inflation. Ex Auto/Ex Gasoline Retail Sales slowed to +0.3% m/m in September from +0.6% in August.  The slowdown could be just the typical follow-through after a strong month, however.  The Atlanta Fed model's estimate of Q322 Real GDP only edged down to 2.8% (q/q, saar) from 2.9% as a result of the Retail Sales data.  Regarding the labor market, Initial Unemployment Insurance Claims have moved up a bit so far in October, but they remain below August levels.  Demand for labor remains strong.

One favorable feature of the current economic situation is that longer-term inflation expectations have been well contained -- which should mollify Fed officials to some extent and argue against the need to tighten more aggressively than what is embodied in the Central Tendencies.  The University of Michigan Consumer Sentiment Survey's 5-year inflation expectations rebounded to 2.9% in Mid-October from a low 2.7% in September.  The level is still low.  It has been in a 2.7-2.9% range since July, after a 3.0-3.1% range in H122. 

Fed Vice Chair Brainard, in her speech, acknowledged the contained longer-run inflation expectations.  And, she pointed out some evidence suggesting a re-balancing of the labor market.  Regarding monetary policy, she said it will take time for the cumulative effect of higher rates to bring inflation down.  This view suggests the Fed will not be derailed from its deliberate path of tightening because of currently high inflation prints. But, at some point, a continuation of high inflation data could prompt a more aggressive tightening path than now penciled in. 

She ended her speech with, "In light of elevated global economic and financial uncertainty, moving forward deliberately and in a data-dependent manner will enable us to learn how economic activity, employment, and inflation are adjusting to cumulative tightening in order to inform our assessments of the path of the policy rate."  The issue will probably become more critical early next year, when there will have been more time to see the effects of the recent tightening.   A further slowdown in underlying inflation would need to be seen by then.

 

 

 

Risks to the September CPI and Q322 Corporate Earnings

The stock market will likely be held down this week by fears of the September CPI (due Thursday), September FOMC Minutes, and upcoming Q322 corporate earnings.  But, the risks are that the consensus estimate of the CPI is too high and corporate earnings may be better than expected.  

Consensus looks for +0.2% m/m Total and +0.5% Core CPI in September.  But, some components may surprise to the downside.  Airfares could fall sharply, after not falling as much as anecdotal evidence suggested in August.  Also, some survey data suggest the CPI's measures of housing rent could slip.  High inventories, lower oil prices, and the strong dollar could exert downward pressure on a number of items, as well.

Consensus looks for a sharp slowdown in Corporate Earnings to 3.1% (y/y) in Q322 from the big gains in the prior two quarters (9.6% and 11.6%, respectively).   The macro evidence supports the idea of a slowdown (see table below).  But, not all evidence is negative, so earnings may surprise to the upside.    Profits from oil should weaken, as oil prices fell.  A strong dollar and slower economic activity outside of the US should hurt earnings from abroad.   But,  US economic growth looks like it could have sped up on a y/y basis.  And, profit margins may have held up -- besides prices having risen by more than wages, prices sped up while wages slowed.

The September Employment Report was not as bad regarding Fed policy as the markets made it out to be.  While the decline in the Unemployment Rate to 3.5% shows the labor market remained tight, wage inflation was subdued.  It raised the possibility that the Unemployment Rate might not have to rise as much as thought to hold down wage inflation.  The Q322 Employment Cost Index (due October 28) conceivably could provide some confirmation.  And, while the +263k m/m increase in Nonfarm Payrolls was well above the +100k pace needed to keep the Unemployment Rate steady, their slowdown was in the right direction.  The latest Unemployment Insurance Claims suggest a further slowdown in October.

At this point, a 75 BP hike at the November 1-2 FOMC Meeting seems to be a near-certainty, but the evidence does not guarantee Powell's threat of more aggressive tightening beyond the FOMC Central Tendency forecast of measured hikes terminating at 4.6% in 2023.   The September FOMC Minutes will probably emphasize this forecast.

A lot of news commentary is citing the still high 5% y/y increase in Average Hourly Earnings to argue that inflation is not falling fast enough. But, this is a backward looking way to measure wage inflation. The m/m change, +0.3% in both August and Sept, is a more current measure. The 0.3% pace (3.7% annualized), in fact, is consistent with the Fed's 2% inflation target once productivity is taken into account.

                                Macroeconomic Evidence Regarding Corporate Earnings

                                                                                                                                           Markit
                                                                                                                                          Eurozone                        Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)
Q119            3.2                -12.8                 +7.9                             3.2           2.1               51.9 
Q219            2.7                -12.2                 +5.9                             3.1           2.1               47.8    
Q319            2.1                -19.2                 +3.6                             3.2           2.3               46.4
Q419            2.4                  -3.6                 +1.7                             3.2           2.3               46.2

Q120           -5.0                -16.5                 +2.9                             3.1           2.3               47.2

Q220         -10.6                -53.5                 +5.9                             6.5           1.4               40.1

Q320           -2.8                -27.8                 +1.0                             4.8           1.7               52.4

Q420           -2.4                -25.5                  -1.9                             4.8           1.6               54.6

 

Q121            0.4                  26.3                 -4.4                              4.9           1.4               58.3   

Q221          12.2                  32.1                 -8.3                              1.2           3.4               63.1 

Q321            4.9                  72.7                 -3.4                              4.2           4.1               60.9

Q421            5.5                  82.4                +1.3                              4.6           5.0               58.2  

 

Q122            3.5                  63.4                +2.7                              5.4           6.4               57.8  

Q222            1.8                  60.9                +5.3                              5.3           6.0               53.9

Q322            1.9                  34.7                +9.0                              5.1           6.3               49.3

                                                                           

* Based on the Atlanta Fed Model's latest projection of 2.9% (q/q, saar). 

 

 

Markets Hoping for Calming Evidence, But...

The stock market hopes to see evidence that would lower the risk of Powell's threat to tighten beyond what was projected in the FOMC Central Tendencies.  Last Wednesday's bounce showed the sensitivity of the markets to official actions or hints to that effect.  The reversal of Wednesday's market moves, however, showed that evidence of a more concerted downshift in Fed views is needed to support the hope that Fed tightening will be "contained."  It is probably too soon to see a more general relaxation in Fed views, particularly since this week's key US economic data may not be weak enough. 

The most important report is the September Employment Report.  There is either mixed or no evidence regarding the risks surrounding the mostly benign consensus estimates.

    a.  Consensus looks for a slowdown in Payrolls to +250k m/m from +315k in August.  The slowdown would be welcome, but the magnitude of the gain is still too high.  Job growth needs to be closer to +100k to be in line with population growth, unless Labor Force Participation rises.  The evidence is mixed.  The Claims data do not suggest a slowdown.  There is still a possibility, however, that Payrolls could catch up to the smaller job gains indicated by the ADP Estimate during the summer.  

     b.  Consensus looks for a steady 3.7% Unemployment Rate, which is consistent with the Claims data.  An increase may be what's needed for the markets to feel the Fed is getting closer to meeting its goals.  The currently low Unemployment Rate is a sign that the problem facing the Fed is that the level -- not the pace -- of economic activity is too high.  

     c.  Consensus expects +0.3% m/m for Average Hourly Earnings, the same increase as in August and a "good" number regarding the Fed's desire to see wage inflation moderate.  There is no evidence to indicate the risks to the consensus estimate.  However, the low August print may have been just an offset to the high 0.5% July print.  If so, September could revert to the 0.4% trend.

Some of the disparate evidence could be reconciled if many companies are freezing hiring and letting natural attrition reduce job count.  If this is the channel through which the labor market eases, it could show up in /1/ slower job growth, /2/ no effect on Unemployment Insurance Claims,  /3/ little change in the Unemployment Rate, and /4/ lower wage inflation as higher-paid workers retire.  At the same time, companies could maintain listings of Job Openings but without intention to fill them soon.  While there have been news of some large companies freezing hiring, it is not clear how extensive this is.

Another important report this week will be the August JOLTS data.  The Fed sees excess demand for labor in the high levels of Job Openings and Quits.  At 11.2 Mn in July, Job Openings remain close to the pandemic peak of 11.4 Mn.  They were around 7.0 Mn prior to the pandemic, suggesting excess demand of 3.2 Mn jobs.  At 4.1 Quits in July, they are not far below the 4.5 Mn pandemic peak and well above the 3.5 Mn pre-pandemic levels.   A lot of people presumably are changing jobs for higher pay -- not good if the goal is to reduce wage inflation.

Consensus expects a decline in the September Mfg ISM to 52.3 from 52.8 in August.  The evidence is mixed.  But, the most accurate in recent months has been the Chicago PM, and it predicts a decline.  The fundamentals behind the manufacturing sector are mixed.  Defense-related industries are being helped by a restocking of guns and ammunition.  Motor Vehicle production is slowly recovering from supply constraints.  And, recent legislation boosted new infrastructure spending and encouraged a shift of production from China to the US.  But, the stronger dollar is making imports more competitive, allowing them to expand market share, while also making exports less competitive abroad.  Any expansion of the manufacturing sector would put upward pressure on interest rates, crowding out other economic activity, given the Fed's goal to weaken the economy.

Fears that the markets were in the process of overshooting may have been behind the Bank of England's bond buying and the calming comments by a couple of Fed Bank Presidents last Wednesday.  Philadelphia Fed Bostick and SF Fed President Daly asserted that the Fed is not aiming for recession.  Daly's comment is significant because she had dismissed concern about the labor market earlier this year.  It remains to be seen whether these comments were isolated or the start of a more concerted effort by officials to calm the markets.  At this point, other Fed officials' comments appear to adhere to Powell's hawkish stance, which may help explain why the stock market fell back on Thursday and Friday.  A number of Fed Bank Presidents will give speeches this week.