Analyzing the Divergence Between Fed Data and Market Sentiment, and its Impact on the Fed's Future Decisions:
Source: iStock
Figure 1- Fed Fund Total Probabilities, Source: CEM FedWatch Tool
As the next Federal Reserve meeting on June 14th approaches, there is a divergence of signals between the data released by the Fed and the sentiment reflected in the market. The information from the Federal Reserve suggests a certain direction or stance, while the market's perception and expectations may be indicating a different sentiment or viewpoint. This disparity creates a situation of mixed signals, leading to uncertainty and potential market volatility as participants await the outcome of the upcoming meeting.
Data in Figure 1 outlines the probabilities for different outcomes in upcoming FOMC meetings. Based on the data, it is evident that the market is currently pricing in a 77% probability of no change to the Fed Funds Rate while assigning a 22% chance of a rate hike. The main question that naturally arises is what is the Fed going to do? As of May 19th, Fed Chairman Jerome Powell has indicated a possible rate pause in June.
What are the Economic Indicators Pointing Towards
The Labour Market: As it stands Nonfarm payrolls increased 339,000 last month after an upwardly revised 294,000 advances in April, a Bureau of Labour Statistics (BOL) report showed Friday. The unemployment rate rose to 3.7%, while wage growth slowed. The main signal for inflationary data here was the additional jobs added were significantly higher than median estimates which suggested an increase of 195,000 according to Bloomberg. However, it is important to note that 440,000 were out of a job in the month of May; hence suggesting the rate of growth of unemployment exceeds that of employment; Therefore, explaining the increase in the unemployment rate to 3.7% (0.3% MoM).
Despite the Nonfarm numbers suggesting a hot labour marker; other indicators such as average hourly wage growth and jobless claims in the US show signs of a cooling labour market. This trend is evident from the slowdown in the wage growth to 0.3% MoM which was 0.1% lower than expectations. In addition, Jobless claims in the US have risen by 28,000 to 261,000 as of 3rd June, as suggested by the chart below:
Figure 2- Applications for Jobless Benefits
The four-week moving average, represented by the white line, is a significant factor to consider when analysing jobless benefits. This is because it helps account for potentially fraudulent claims, which can artificially inflate the absolute figures. Upon examining the data, it becomes evident that the four-week moving average has been increasing recently, indicating a slowdown in the labour market.
According to Goldman Sachs, the potential risks to the economy have been reduced, as demonstrated by the resilience observed in tangible indicators such as consumer spending and the labour market. Although certain survey data have shown weaknesses, the bank believes that the positive performance of hard data outweighs these concerns. Recently, Goldman Sachs revised its prediction of a recession, assigning a lower probability of 25% (previously 35%). The bank argues that progress towards a soft landing is being made, supported by improvements in the job market, a decrease in labour shortages, and a slowdown in wage growth. Overall, the economy is on track for a more stable trajectory.
Supply-side inflationary risk:
Figure 3- Fed Index of Global Supply-Chain Stress
According to recently published data, the Global Supply Chain Pressure Index experienced a notable decline from -1.35 in April to -1.71 in May. This represents the lowest level recorded since data collection began in 1997. In contrast, the index reached its highest point of 4.31 in December 2021. The significant decrease in the index indicates a reduction in supply chain pressures globally. This data suggests a potential easing of strain on global supply chains, which could have positive implications for various industries and international trade.
The New York Fed reported that the Global Supply Chain Pressure Index (GSCPI) experienced a notable decline, reaching its lowest level on record in May. The decrease in the index was primarily attributed to significant downward contributions from Great Britain's backlogs and Taiwan's delivery times. On the other hand, Euro Area delivery times and backlogs were identified as the largest sources of upward pressure during the same period. Examining the underlying data, it becomes apparent that all regions tracked by the GSCPI are currently below their historical averages. The drop in the index, which encompasses 27 components such as global shipping costs and purchasing manager survey responses, indicates a significant alleviation of the supply chain pressures that began with the onset of the Covid-19 pandemic. These pressures had contributed to rising inflation around the world. The abatement of these pressures suggests a potential stabilization in global supply chains and may have positive implications for inflation levels moving forward.
Effects of Regional Banking Crisis
The failure of regional banks in the US has raised financial stability risks and had deflationary effects on the economy. To maintain solvency, banks have reduced issuing new loans leading to a decrease in Commercial and Industrial (C&I) lending levels, as shown in the chart below:
Figure 4- Change in C&I Lending
The recent collapse of SVB has sparked a banking turmoil that is likely to result in further tightening of bank credit. Although the run-on banks have ceased, there is anticipated increased scrutiny from financial regulators and investors, along with deposits flowing out of the system into money-market funds.
This will create funding pressures for banks. As a result, banks will become more hesitant to lend. It is worth noting that large banks, which have experienced a significant outflow of $741 billion in deposits since April 2022, account for over 65% of commercial and industrial loans. If these banks reduce their credit offerings, it will have a substantial impact on investment. From the data, it is evident that larger banks' proportionality reduced C&I lending less relative to.
On the flip side, when considering savings, Bloomberg estimates reveal the presence of approximately $1.4 trillion in excess savings, with a significant portion held by high earners. While some of these savings are liquid, the report indicates that they are sufficient to sustain consumption for the next nine months. As a result, the potential credit crunch may not have as deflationary an impact as initially anticipated, contrary to Goldman Sachs' suggestion that the crisis mimicked a 50bps hike.
What Should the Fed Do in its Next Meeting?
Based on the available data, there are indications that the economy is experiencing a cooldown, suggesting that a pause in interest rate hikes is the most likely course of action. However, this does not imply that the risk of high inflation has been completely eliminated. The presence of sticky PCE inflation and relatively stagnant average hourly wage growth still justifies the need for further rate hikes. It is important to note that economic data tends to be backwards-looking, and does not reflect the cumulative lag effects of previous rate increases. Therefore, it is likely that the Federal Reserve will opt to pause and assess the current state of the economy to avoid overthinking and make informed decisions regarding future rate adjustments.
Written by: Sagar Bar, Natural Resources Market Analyst
Sources: Bloomberg, Capital IQ
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