AXL Capital Management monitored the September 21 FOMC meeting with concern, as Fed Chairman Jerome Powell and the other FOMC members were very hawkish, as can be seen in the macroeconomic projections they published, which we will tell you more about:
It is shown that the unemployment rate is projected to increase by 0.6 percentage points (from 3.8% to 4.4%), which represents the destruction of around 1 million jobs.
Fed Chairman Jerome Powell also mentioned that he does not doubt that the housing market will experience a severe correction, and despite this, he was not convinced that the U.S. economy will enter a recession.
In the past (in past downturns), the weakening of the labor market and the correction of the real estate sector have been two of the necessary conditions for entering a recession.
As you can see, the interest rate curves are inverted, and that is visibly a sign that the market also sees a risk of recession.
Now let's look at the dot plot where the median of the FOMC members' opinions (there are 19 members) where each dot reflects their opinion of where the level of the federal funds rate will be located in 2022, 2023, 2024, and 2025.
You can see that by 2023 they expect it to be at 4.6% if we focus on the green line that reflects the median of all the opinions of those members. But, if you look at the purple line, that is what the money market expects, which does not believe that it will reach that 4.6% level and that rates will be high for less time than expected for a very simple reason, that the economy is expected to be closer and closer to recession.
If we have to decide which is more accurate, the FOMC members or the money markets, history has shown that the Fed's projections are optimistically far from the market's estimates.
Now, look at their estimates of where interest rates will be by 2024, which range from 4.6% to 3.6%, clearly revealing that they are not entirely sure where rates will be by then.
Therefore, we are more inclined to look at the interest rates that are being negotiated in the money markets.
What consequences can we draw from the long term?
- Technically we are already in recession with negative 2Q
- Interest rates less high than FOMC expects
- And higher rates for less time than the FOMC expects.
What about the short term?
In the following chart, you can see what is leading the Fed's behavior, which is the interest rate on the 2-year notes, you can see it in a clear uptrend, and therefore, the Fed is likely to keep raising the benchmark interest rates.
Possible inflation peak?
There is a strong possibility of this happening, as they have been wrong repeatedly, but why would this be happening again?
We can find that if we break down core inflation and detail the reason why inflation has been rising a lot and fundamentally in the services sector, with rents representing 40% of the basic basket.
As you can see in this index that shows the evolution of the price of rents (Zillow index) has already turned downwards, so we can consider it as the most likely scenario that core inflation is slowing down and this is what the money market is taking into account.
In this sense, we can say the same thing about used cars, because they have been one of the factors that have led to an increase in inflation. However, you can also detail that according to a report from JP Morgan it is undergoing a correction.
Finally, there is another detail to look out for...
Many economists believe that the Federal Reserve System will raise interest rates until something breaks, the question is what?
Evidently, the stock market crash took a back seat to Fed Chairman Jerome Powell and the other members, as the S&P 500 has fallen 25% from its January 2022 highs, and they are still being very hawkish, so they are telling us to forget about the "Fed Put" remember? When at the beginning of the year investors and investment banks believed that once the S&P 500 fell to the 4,000 point level or even 3,800 it would change its monetary stance to a looser one.
In the perception of this, it seems that the economy has taken a back seat since in their projections, they foresee a deterioration of the main macro indicators so that the soft landing can be discarded. See the GDP forecast to get an idea:
At the forefront is the fight against inflation through interest rate hikes and QT, but at what cost?
AXL Capital Management looks at what would be required for the Fed's endless rate hikes to stop, and that is for the financial markets to crash, but what do we mean by that?
If you take a look at the dollar index, it is unbalancing the currency markets with its sharp rise, causing two significant facts:
- Those countries that import products which are priced in dollars like energy are paying a very high price and are therefore importing inflation.
- Those emerging countries and indeed China have a large debt in dollars, and therefore, as their currencies have depreciated by around 20%. We find that their debt has increased by the same amount.
If these countries begin to default on their interest payment obligations, partial repayments or total repayments on the bonds issued, a credit event could be generated that would trigger a crisis that could spread throughout the financial system.
At the moment, we must look at liquidity...
When central bankers see that in these markets where bonds issued by emerging countries such as China are traded, or that banks are not lending to these emerging countries or to the companies of these countries, at that moment they would abandon their restrictive policy.
An example of this is what happened with the Bank of England (BoE), but we will talk about this in the next Insight.
