Fed fears add fuel to market unrest

Each week, we present our featured topics in the context of the major themes listed below from Nuveen's 2022 Outlook:Nuveen's 2022 Outlook

• U.S. economy: No recession this year, although market risks persist.
• Global economy: Both headline and core inflation likely peaked in March.
• Policy watch: Fed signals aggressive tightening, but we think fewer rate hikes will be needed.
• Fixed income: Strong credit fundamentals and attractive valuations favor taking credit risk over duration risk.
• Equities: Despite further bouts of volatility ahead, equity returns should be positive for 2022 as a whole.
• Asset allocation: We’re leaning toward “risk-on” positioning. Rebalance prudently.

Quote of the week:

"The ideal attitude is to be physically loose and mentally tight.”  –  Arthur Ashe

A steeper, more perilous climb for the Fed

Last week’s Federal Reserve meeting delivered lots of action but few surprises. With inflation stuck at decades-high levels, the Fed formally announced its two-pronged strategy to bring prices down: raise interest rates more rapidly and shrink its massive (around $9 trillion) balance sheet.

Part 1. Rise up. The Fed hiked its fed funds target rate by 50 basis points (bps), double the 25 bps increase announced at March’s meeting and the largest such move at a single meeting since 2000. So now the target rate sits at 0.75%-1.00%, still very low by historical standards, but another 50 bps boost is a near-certainty at the Fed’s next gathering in June, and we expect yet a third 50 bps hike in July. At his post-meeting press conference, Chair Jerome Powell dismissed talk of any 75 bps increases, even as markets have begun to price in that possibility.

After July, we think the Fed may decide that a slower rate-hike trajectory is once again appropriate. However, over the past few months, public comments from nearly all of the Fed’s voting members seem to point to a swift return to a “neutral” fed funds rate of 2.5%, given white-hot inflation and a tight labor market. (“Neutral” represents the Fed’s estimate of the rate at which monetary policy is neither accommodative nor restrictive.)

Looking further ahead, we’ll keep close tabs on how inflation and labor market data evolve, specifically the intersection of the two: wage growth. On the one hand, the Employment Cost Index rose by more than expected in the first quarter, which the Fed will consider a clear sign that tighter policy is needed to forestall a wage-price spiral. On the other, average hourly earnings growth has clearly decelerated in recent months, including April, according to the jobs report data published last Friday (more on the U.S labor market below).

Part 2. Trim down. The Fed also announced that it will start to shrink its balance sheet, a process known as quantitative tightening, or QT. This involves unwinding the quantitative easing (QE) asset purchases it has made in response to the pandemic over the past two years by allowing maturing assets to roll off without replacement. These maturities will reach up to $60 billion/month of U.S. Treasuries and $35 billion/month of agency mortgage-backed securities, phased in over a few months.

It’s hard to speculate how long QT will remain in place. However, the Fed noted that the roll off is likely to end “when reserve balances are somewhat above the level it judges to be consistent with ample reserves.” That’s Fedspeak for Powell and his associates preferring to stop QT too early than too late, especially as they consider interest-rate hikes to be their preferred and primary tool for tightening policy.

While few investors were surprised by the meeting’s outcome, they were certainly aware that the U.S. economy unexpectedly contracted 1.4% in the first quarter, according to the government’s advance estimate released the week before. Although the underlying details were stronger than the headline result — households and businesses continued to spend briskly — no central bank wants to embark on a tightening cycle when the economy is shrinking. Striking the right balance between lowering inflation and keeping the U.S. economic expansion intact will challenge both the Fed’s policy acumen and its rhetorical powers as it seeks to achieve a “soft landing” for the economy.

An unusual U.S. employment report provides little clarity on the labor market’s direction

Carly Fiorina, the former president and chair of Hewlett Packard, once stated that, “The goal is to turn data into information, and information into insight.” Although we agree with her assessment, doing so can, at times, be challenging. Take last month’s jobs report, for example. Even the simple question of whether employment grew or contracted can’t easily be answered by viewing the data. But let’s sift through the numbers and divine a conclusion as best we can.

According to the establishment survey, an estimate of changes in the number of jobs and compensation based on data from employers, top-line job creation grew a healthy 428,000 in April, identical to March’s barely revised figure. But the household survey, which asks individuals about their employment situation, showed a significant contraction in both (1) the size of the labor force, as the labor force participation rate fell from 62.4% in March to 62.2% and (2) the number of employed individuals.⁴

Taken together, these measures left the unemployment rate unchanged at 3.6%. Retirements alone can’t explain this lack of movement, because the participation rate among prime age workers (those aged 25-54) also ticked down in April after increasing in each of the first three months of 2022.⁵ This is as good a lesson as any that examining trends in data is more instructive than looking at any single point. In a few months, this report’s household survey will either look like the start of a weakening trend in the labor market…or merely a blip.

Combining the employment data and accounting for the drop in labor supply, it’s reasonable to conclude that the labor market tightened in April. That was less apparent, however, by analyzing average hourly earnings, which rose 0.4% last month and 6.4% over the past year for non-supervisory workers.⁶ While high, these numbers represent a deceleration in wage gains despite a record number of job openings (11.5 million) according to March’s JOLTS report.⁷

Squaring this circle, strong payroll growth and a low unemployment rate are unreliable indicators of the labor market’s current health, because each can rise or fall for different reasons, depending on whether supply or demand is the constraint. Right now, demand for workers easily outstrips supply. If left unchecked, this dynamic could continue to push up the pace of wage growth, which is inconsistent with moderating inflation. In our view, the Fed will see the same muddled message as we do from this report, but the direction of monetary policy – higher rates at a faster pace – won’t change.