The Federal Reserve raised short-term interest rates by three-quarters of a percentage point (75 basis points) on Wednesday. The day before, the Fed released M2 money supply data for June and it fell slightly, the second decline in three months. At his press conference after the rate hike, Fed Chairman Jerome Powell was vague about the Fed’s future intentions on rates but was not asked one single question about the money supply. Interesting how little the press knows about monetary policy!
For now, with the federal funds rate at 2.375%, the futures market is leaning toward a rate hike of 50 bps in September. The Fed has apparently abandoned “forward guidance” partly because it has already pushed rates close to what many Fed members said is “neutral.”
Meanwhile, the 10-year Treasury yield has fallen from north of 3.4% to under 2.7% suggesting the market thinks the Fed will either slow down rate hikes, or maybe even cut them next year. Unless inflation falls precipitously, this makes no sense. “Core” PCE inflation is closing in on 5% and a “neutral” interest rate should be at least that high, or higher. The Fed has never managed policy under its new abundant reserve system with inflation rising this fast. No one, even the Fed, knows exactly how rate hikes will affect the economy under this new system.
Many think the economy is in recession already, because of two consecutive quarters of declining real GDP. But this is a simplified definition. Go to NBER.Org to see the actual definition of recession. A broad array of spending, income, production and jobs data rose in the first six months of 2022. GDP is not a great real-time measure of overall economic activity for many reasons. Jerome Powell does not think the US is in recession, and neither do I. What we do know is that inflation is still extremely high and the only way to get it down and keep it down is by slowing money growth.
And that does look like it’s happening. So far this year, M2 is up at only a 1.7% annual rate, after climbing at an 18.4% annual rate in 2020-21. By contrast, M2 grew at a 6.2% annual rate in the ten years leading up to COVID.
Slow growth (or even slight declines) in M2 is good news. The problem is that the Fed never talks about M2 and the press never seems to ask. Moreover, slower growth in M2 may be tied to a surge in tax payments – when a taxpayer writes a check to the government, the bank deposits in M2 fall. Data on deposits at banks back this up. However, banks have trillions in excess reserves and total loans and leases are growing at double digit rates. At this point, it is not clear that the new policy regime can persistently slow M2. Will higher rates stop the growth of loans? This looks to be happening in mortgages, but it appears to be demand-driven, not supply-driven.
The bottom line is that the Fed seems determined to bring inflation down but thinks raising short-term interest rates, all by itself, can do the job effectively, even at the same time that it is willing to hike more gradually when inflation is well above the level of rates. This is not a recipe for confidence in the Fed. Expect rates to peak higher than the market now expects and keep watching M2.
According to FactSet Research, we have seen 56 percent of the S&P 500 report earnings for the second quarter of 2022. Of the 280 companies that have reported, 73 percent have beaten earnings expectations, 4 percent have met expectations and 24 percent have fallen short of expectations. When looking at revenue expectations, 66 percent of the companies that have reported have either beaten or met expectations while 34 percent have fallen short. The overall blended earnings growth rate for the S&P 500 for Q2 2022 is currently 6.0 percent. As of June 30th, the expected earnings growth rate for the S&P 500 for the second quarter was only 4.0 percent. Thus far into the earnings season, earnings continue to pace ahead of expectations. That is the reason the markets are climbing. Markets are up over 10% for July alone.
My prognosis is for the markets to continue this wave up then stall and create a second wave after the third quarter earnings continuing through the election to the end of the year. I am not cautiously optimistic but simply optimistic about the markets and the strength of the economy. I believe the worst is behind us and that the markets are beginning a new phase up. Keep the faith. Politicians cannot stop corporations from making a profit enough to stop the growth within a secular bull market.
Some investors think the US is already in a recession. As I wrote two weeks ago and as recent data have confirmed, I don’t think that’s the case. Industrial production is up at a rapid pace so far this year, while payrolls have expanded at a monthly pace of 457,000 and the unemployment rate has dropped to 3.6% from 3.9%. Real gross domestic income (Real GDI), a companion to real GDP that is just as accurate, but which arrives a month later, rose at a 1.8% annualized rate in Q1.
Nonetheless, the recession story is out there and some claim adjustable rate mortgage resets are going to knock the economic legs out from under consumers. The idea is that with the Fed raising rates rapidly, as the rate on adjustable mortgages reset, homeowners are going to have to make higher payments, which means less money to spend on other goods and services.
Let’s start off by noting the most basic problem with this theory, which is that even if mortgage resets increase some families’ payments, the holders of those mortgages will get the extra payments and their purchasing power will increase. On net, purchasing power should remain unchanged.
But, to be cautious, let’s indulge the reset theory by pretending the extra payments are money that just disappears, with no one on the other side of the transaction. Even then, my calculations show the theory doesn’t add up. Households have about $12 trillion in mortgage debt, according to the Federal Reserve, so, yes, the top-line number sounds scary. But, according to the Federal Housing Finance Agency, only 3.7% of these loans are adjustable, or about $450 billion. In Canada that percentage is over 50%!
Now let’s say that one-third of these mortgages reset every year. That’s $150 billion worth of mortgages resetting. Still a big number, still potentially scary. But when we calculate how much a reset would change the payments on these loans the problem suddenly gets much smaller. An extra two percentage points in interest on $150 billion in debt is $3 billion. Obviously, the people making these extra $3 billion in payments won’t like it. But the extra payments equal only 0.018% of annualized consumer spending. That’s not a typo. Not 1%, not 0.1%, but only 0.018%. Which means that even if all of the $450 billion in adjustable-rate mortgages reset upward by two percentage points at the same time, we’d be talking about 0.05% of annual consumer spending.
The bottom line is that I think a recession is eventually on the way because monetary policy will have to get tight enough to wrestle inflation back down and that should be tight enough to cause a recession starting in late 2023 or beyond. But those rate hikes won’t work like they did in 2006-07 when nearly half of all mortgages were adjustable in ‘05. The mortgage reset story makes superficial sense. But when you work through the actual numbers, it’s not something to worry about.
I have been explaining all the misperceptions in the news for several weeks, in an attempt to ease your mind about this downturn. All downturns are scary and disconcerting. But some, like this one, are temporary and should result in a fairly quick upturn once the markets digest earnings and when the inflation numbers begin to recede, which they will. This is the typical fear mongering that is prevalent in this industry. Stay calm and this too will pass…even fathers can share this wisdom.
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