Market Volatility Rises – Markets Shoot First And Ask Questions Later

They say life can change at “the drop of a hat.” Markets too!

Interest rates had gapped significantly higher Monday, Tuesday, and Wednesday of Thanksgiving week only to plunge back to even lower levels by Friday’s close (November 26) based on the fear that the newly identified Covid-19 variant (omicron) could, like its delta-variant sister, once again disrupt the world.

Friday, after Thanksgiving, has always been a shortened market day with most senior market participants on the sidelines. Junior traders often have the green light to sell, but not to buy, perhaps partially the reason that, on Friday, the major equity indexes also tumbled more than 2%. What happens Monday depends on updates regarding omicron, but it is clear that over the near-term horizon, both the equity and fixed income markets are going to display a level of volatility that we haven’t seen for the past 18 months. Still, we can’t simply dismiss the Monday, Tuesday, and Wednesday interest rate spike as if it never happened.

The Yield Curve

Apparently, bond investors expected President Biden to appoint Lael Brainard as Federal Reserve Chair. Ms. Brainard is considered quite “dovish” (i.e., would keep monetary policy ultra-easy). Powell’s reappointment appeared to partially ignite the yield curve upward spike with the end result being that three 25 basis point (.25 percentage points) increases in the Federal Funds rate (what banks pay to borrow from the Federal Reserve), beginning in mid-2022, got priced in. That was quite a change from the prior Friday view that there would only be one rate hike in late 2022.

• To characterize Powell as a “hawk” seems like a stretch. Over the last few months, he has resisted any forecasts of rate increases insisting that such increases are data dependent (i.e., based on the performance of the economy). 
• Powell has set Q2 or Q3/2022 for the Fed’s evaluation of inflation. That is, the Fed expects the “transient” period to be as long as another year. In Fedspeak, that should signal no rate action till at least Q3 if inflation is still elevated (hardly “hawkish”).
• Brainard was appointed as Vice-Chair and Biden has three more FOMC vacancies to fill. Given his Administration’s policy actions to date, we expect those seats to be filled by people with a dovish bent. 
• In our view, markets were making unwarranted assumptions (i.e., Shoot first!).

The Labor Market

Also impacting the bond market on Wednesday was the Weekly Initial Unemployment Claims (ICs) data for the week of November 20. It showed a modern-day record low of 199,000 ICs seasonally adjusted (SA). As we have opined for the past 18 months, trying to seasonally adjust the impacts of a pandemic (that has been around for less than two years) is troublesome and could lead to unwarranted conclusions. 

The table below shows ICs for the first three weeks of November. Note the downdraft only occurred in the SA numbers for the November 20 week. Note also that the SA numbers are rounded to thousands (000s) indicating that there is a lot of “estimation” occurring. It does appear a bit bizarre that for the first two weeks of the month, the SA and NSA (Not Seasonally Adjusted) numbers were similar in size, but that for the week of November 20, the SA number fell significantly (-71K) while it rose on an NSA basis (+18K).

We note that in the accompanying chart (NSA data), the data for the last six weeks seem to have plateaued. Thus, jumping to conclusions from one week’s worth of SA data is risky; it would appear prudent to wait a couple weeks to see if the NSA data corroborate. We suspect that the SA factor has been biased by the prospective Thanksgiving week. Even so, it is clear that the bond market shoots first and asks questions later, as rates spiked up on this data release, just as they spiked down on the omicron fears, i.e., prior to any real analysis of this new Covid strain.

Retail Sales

Retail sales rose +1.7% M/M in October. The large rise was powered by a 4.0% M/M growth in non-store sales (read that as “Amazon AMZN ”). Even adjusting for inflation, the rise appears to be +0.8% in real terms. Once again, we are looking at SA numbers. On an NSA basis, sales only grew 0.3% M/M and were negative after adjusting for inflation. 

We suspect that the SA data are misleading. While we don’t have any hard survey data or GDP numbers, every household in our sphere of influence has begun their holiday shopping early because of the “shortages” narrative in the daily media. As a result of demand being “pulled forward,” the seasonal factors would bias the SA number upward. We suggest that December SA retail sales may not be as robust as markets now believe. One way or the other, those December sales will give us a clue to the strength of the economy in 2022 and whether (and when) there will be rate hikes by the Fed. That data is still 45 days away.

Shortages

Regarding “shortages,” in one of his recent daily blogs, David Rosenberg showed a picture of a Walmart WMT store’s bicycle inventory early in the year, mid-year, and in October. Early in the year, there was little inventory; by mid-year, the bicycles took up about half the available space. But, by October, it appeared that there wasn’t any space for even one more additional bike. Looking at data from some of the big retailers, we find that Target’s TGT inventories are 18% higher than a year earlier, Home Depot’s HD 27%, and Walmart’s 12%. There certainly are some manufactured items that have much longer “lead times” than normal, but it doesn’t appear to us that “shortages” are going to ruin Christmas!

How We Got This Inflation

The government shut-down the economy in 2020. This reduced output (i.e., “supply”). At the same time, the government sent out free money, making sure incomes didn’t fall. Thus, “demand” remained near pre-pandemic levels. A fall in supply with no fall in demand gives a textbook economic result: higher prices!

Add to this the idea that appears to have been adopted in Washington D.C. (called Modern Monetary Theory – the government can print as much money as it wants with no consequences) in the form of $5-$6 trillion of budget deficits. The resulting inflation we currently have appears to be mainly due to the federal government.

Meanwhile, in the background, The Fed has continued its QE (Quantitative Easing) policy. Remember, in the Great Recession, QE was an emergency measure taken to ensure smooth functioning of the financial markets. While the Fed has promised that this QE will end sometime next year, we observe that the financial system is awash in liquidity with excess bank reserves now above $1.5 trillion on a daily basis. An earlier end to this QE policy seems to be in order; perhaps we will see such an outcome from the upcoming December Fed FOMC meetings.

Is the Inflation Endemic?

Will it last? Here are some observations:

·     The Baltic Dry Index has fallen -55% from its peak over the last month and a half. This is the cost to ship bulk items (like iron ore) (though we observe that Amazon has partially solved its shipping issues by loading its containers on top of the bulk cargo in the holds of some of those vessels – the wonders of capitalism!). The fall in the Baltic Dry Index may have a lot to do with China’s stuttering economy – nevertheless, this still has worldwide implications.

·     The University of Michigan’s latest consumer sentiment survey hit a low in November not seen in decades; this is usually a good leading indicator. Intentions to purchase autos and homes are at 50-year lows (see chart at top).

·     Goldman Sachs’ Industrial Metals Index is off -11.6% from its high.

• Aluminum: -17%
• Zinc: -16%
• Copper: -10%
• Iron Ore, Lumber, Steel all down more than -20%.

·     The Regional Fed Surveys are reporting that corporations are raising prices at a pace faster than their costs are rising. (Because of the ubiquitous “inflation” and “shortage” narratives, customers aren’t objecting to the outsized price hikes believing that they are lucky to get the shipment at all!) Since the metals indexes are now falling, it appears to be only a matter of time before input costs mellow. Corporations will come out with fatter margins, but the excuse to raise prices will not be there, and, if demand falters, we may even see some prices decline.

·     Rents have a 30% weight in the CPI, and they are rising. Once again, we can trace much of this back to federal actions which included moratoriums on evictions and foreclosures. Now that these have been lifted, rents are rising. We note that home prices have skyrocketed in 2021. Once again, we refer to the University of Michigan’s Consumer Sentiment Index indicating 50-year lows on home purchase intentions, and observe that housing starts are now falling. That fall, however, is concentrated in single-family starts (-10.6% Y/Y (October data)). On the other hand, multi-family starts are up +37% Y/Y and are at a 47 year high. We believe those multi-family starts will mitigate the “rents” issue in the CPI by mid-2022.

Conclusions

The Fed, under Powell, is likely to be patient, waiting to see how “transient” inflation might be after Q2/2022. Other signs that may influence Fed policy include:

• The Federal Government has stopped most of its free money programs. We believe that we will soon see significant job growth and an upward move in the Labor Force Participation Rate.
• The SA rise in retail sales in October (and likely November) appears to be demand pull-forward due to the “shortages” narrative. The skimpy NSA numbers give a truer picture.
• Inventories of most consumer goods are up at major retail chains.
• Corporations are using the “inflation” and “shortages” narratives to increase profit margins. This is a temporary phenomenon.
• Commodity prices are now falling.
• Rents are rising as moratoriums have ended; but multi-family housing starts are at a 47-year high. Supply is catching up!

The evidence continues to point to inflation that will prove to be “transient.” However, it may be around for a few more quarters. But investors should beware!  Markets appear to have entered a period of significantly higher “volatility,” where they tend to react before all the facts are known. Shoot first!

(Joshua Barone contributed to the blog)