An Elephant on a Tightrope
With "Soft Landing" Looking out of the Picture - How HARD will the landing be?
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In today’s market, the Fed meeting is rightfully the most highly anticipated event.
The meeting sets the tone for how those in charge will control the thermostat of the economy. As a temperature check, the most recent meeting gave off “Dad on a budget” vibes as Powell really put the pressure on to cool down the economy.
Time to bust out those sweaters and blankets - no more heating for you.
While the Fed doesn’t normally predict recessions, they got pretty close when Powell said:
“No one knows whether this process will lead to a recession or if so, how significant that recession would be… The chances of a soft landing are likely to diminish to the extent that policy needs to be more restrictive, or restrictive for longer. Nonetheless, we’re committed to getting inflation back down to 2%.”
The main meeting takeaways:
Interest rates = Faster, Higher, Longer
Inflation = Stickier core PCE
Jobs = Too strong now but we will see cracks
Housing = Look out below
Recession = Likely
So let’s dive in…
This week, in <5 minutes, we’ll cover the FOMC meeting:
Meeting Recap 👉 Higher for Longer
Dot Plot 👉 What is it? How Did it Materially Change?
The Two Most Important Things 👉 Jobs, Core PCE
Housing 👉 “Probably Have to Go Through a Correction”
Let’s get started!
1. Meeting Recap 👉 Higher for Longer
Over the course of the presser, the tone regarding the path for interest rate hikes was higher, quicker, and longer-lasting.
Although equities briefly rallied on the back of a widely priced in 75 bps hike (bringing the Federal Fund Rate to 3.00 - 3.25%), they finished the day as they should’ve - with a sharp move down.
It looks like a mythical “soft landing” is no longer in the cards as Powell expressed that the more restrictive monetary policy is—and the longer it stays there—the higher the probability of recession. While many have held out for the possibility of a goldilocks Fed that can tamper inflation without choking growth, this now seems like a distant dream.
The problem is how sticky and persistent certain parts of inflation are, which I will get to more on below.
Pundits will always talk about what is “priced in” and that it’s the surprises that should affect movements. While the 75bps hike was largely telegraphed, it was the subsequent comments that shook investors.
Powell kept the same tone as he did in Jackson Hole by saying that history was unkind to prematurely cutting rates and that the Fed will remain at restrictive levels “until the job is done”.
He expressed that the Fed remains steadfast in moving inflation down to 2% (which has been the target rate for quite some time) and that they will remain “data dependent” on their way there.
During a more hawkish than expected meeting, the goalposts that many market participants watch carefully also shifted - the Dot Plot.
Yes, the same Dot Plot that we had all talked about so frequently back a couple of years ago when people were trying to target just where the terminal rate would land.
Let’s take a look at what it is and how it’s used.
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2. Dot Plot 👉 What is it? How Did it Materially Change?
A dot plot is a data visualization tool that displays the number of data points that fall into each category or value on the axis, showing the distribution of a set of data. When it comes to the Fed’s Dot Plot, each dot represents an FOMC member’s expectation of where the federal funds rate will be at the end of a particular period.
Usually, the overall FOMC outlook for interest rates in any given year is reported as the median of the dots that show up on the plot.
As of June 2022, the Dot Plot looked like this:
The line here to note is the green line, the median. So, for the implied fed funds target rate, we used to have:
Longer Term: 2.5%
The September Dot Plot looked like this:
So for the median line we now have:
2022: 4.375% (+1.0% Higher)
2023: 4.625% (+0.875% Higher)
2024: 3.875% (+0.5% Higher)
Longer Term: 2.5% (unch)
This means that the Fed Fund range by the end of the year moved from 3.25 - 3.50 to 4.25 -4.5. From current levels of 3.00-3.25, this implies another 75bps in November and 50 in December, while a further hike of 50bps more will be needed in 2023.
Collectively, this is the Fed’s best guestimate of where rates will need to go in order to be sufficiently restrictive to move inflation back down to the 2% target.
Thus, this gives us the conclusion: Faster, Higher, Longer.
Before we continue, let’s check in with our Outrageous Chartered FinMEME Analyst Dr. Patel!
3. The Two Most Important Things 👉 Jobs, Core PCE
We know that the Fed has a dual mandate: Prices (inflation) and Jobs (employment). While the rhetoric for the better part of six months has been that jobs are strong, we are starting to see cracks in the jobs market and Powell told us to brace for this to accelerate.
The Fed is currently uneasy about the limited impact that its tightening has had on the labour market, but the median estimate has the unemployment rate rising to 4.4%, up from 50bps in June, as growth slows to 0.2% this year and settles at 1.2% next year.
Powell has expressed that 4% is around the normal rate but with unemployment expectations coming up while growth slows, others are saying that these are clearly indicators of a pending recession.
The main culprit behind the hawkish rhetoric is stickier inflation than anticipated. When we look at core PCE, it removes price and energy, which can have massive swings. There are so many geopolitical moving pieces when it comes to the energy complex, so by leaving out this and food (which also swings drastically with seasons and supply chains), we get to the main goods and services people are buying.
When we look at projections, core PCE is now seen at 3.1% in Q4/23, up from 2.7% as predicted in June. The increase on its own is unremarkable, but the fact that this number has risen AND the assumption for hikes has come up means that the Fed now views supply chain problems as enduring longer than anticipated.
While nations are currently running around putting out fires on the energy front, this is a shorter-term impact on long-run inflation, so it’s the core PCE longer-term projections here that are troubling.
Without unemployment rising and inflation falling, the Fed will remain firmly on the hawkish gas pedal.
These are the two most important things.
4. Housing 👉 “Probably Have to Go Through a Correction”
As I’ve written extensively in the past - something has to give with the housing market. Affordability has fallen off a cliff and housing prices have not yet fully moved to reflect this.
There is paralysis on both sides so we can’t get a proper dataset.
Sellers don’t want to sell because: a) They would record a loss (~20-25%) if measured from Feb 2022 highs, and b) They’ve locked in such a low fixed rate that purchasing a new home at the current, higher fixed rate would be extremely unaffordable.
Buyers aren’t buying because: a) There isn’t much inventory due to the above, and b) They can’t qualify for a mortgage at the higher rates, and if they can, again—it will be highly unaffordable.
This isn’t rocket surgery, and Powell understands this:
"There was a big imbalance ... housing prices were going up at an unsustainably fast level. For the longer term what we need is supply and demand to get better aligned so housing prices go up at a reasonable level, at a reasonable pace and people can afford houses again. We probably in the housing market have to go through a correction to get back to that place."
You could make the case that a falling housing market is great for those looking to “trade up” in the market: buying newer, bigger houses as the absolute dollar trade works in their figure. BUT if this transaction is not 100% cash, affordability is still getting crushed by the interest rate move even for these buyers.
Across the board, there will be more blood in the housing market.
Everything in the economy happens in cycles. As the credit market expands and contracts, the stock market over and undershoots these movements. We have been binging on a period of low interest rates for far too long which has caused a lot of asset bubbles.
Corrections are normal.
While staying the course is always the best advice, each decade does not necessarily look the same. The best investments for the next 10 years may not be the ones that worked over the previous 10.
In times like these, look to deploy capital into the market, shorten your duration by buying free cash flow generative companies, and continue to dollar-cost average in.
When you ask investors where most of their “return regret” is, they will not say, “Oh! I wish I bought x instead of y in the bull market.” They will regret not putting more capital to work in bear markets.
Until next time. Always Yours. Incessantly Chasing ROI,
-Genevieve Roch-Decter, CFA
What else we Grittin’ On?
PUTIN. Vladimir Putin announced a partial military mobilization this week. The Russian president called on 300,000 reservists.
DEBT. Americans are starting to rack up long-term credit card debt. 60% of creditors owe debt for a year or more.
iBUYING. OpenDoor lost money on 42% of its iBuying transactions in August. Apparently, they learned nothing from Zillow.
HIKES. The Fed rose interest rates by an expected 75bps this week. All signs point to 50bps in December followed by 25bps in February.
OIL. US oil prices fell below $80 a barrel for the first time since January. Prices have declined for 4 consecutive weeks.
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