July 2022

The S&P 500 has recovered from its early summer swoon and is currently trading midway between the high and low print for the last year, supported by the two most recent economic wayposts.  The July employment report and the consumer price index (CPI), were both better than investors had forecast, indicating that the Fed may not need to be as aggressive in tightening policy as thought just a month ago. 

Following a mixed June employment report, the July tally blew past all expectations.  Coming in at 528,000 new jobs added, the report more than doubled the consensus expectation of 250,000 and exceeded the highest expectation of 325,000.  Moreover, the details were equally eye popping, with average hourly earnings up 5.2%, year-over-year, and the unemployment rate ticking down to 3.5%, equaling the low touched on September 2019.  The bond market didn’t like any of it.  The yield curve that placidly drifted below 3% recently, convulsed back above that measure on the day.  Month to date, the 2-year note is 30 basis points higher, and the 2-year/30-year interest rate spread went negative for the second time this year. 

An inverted yield curve is usually a precursor to a recession, and in this case, coming contemporaneously with the second consecutive quarter of negative GDP.  The logic is that as the Fed hikes rates, the economy will cool and drive inflation, and real interest rates lower, so investors should lock in long rates now before they fall.  The problem is that real rates are deeply negative, and the Fed is in the early innings of tightening monetary policy.  Our expectation is that economic growth would continue to decelerate through August and into the late September FOMC meeting, and that the Fed would decide to modify their rate hike trajectory and perhaps decrease the magnitude of rate hikes to 50 or 25 basis points. 

Following the strong employment report, investors were braced for more bad news with the July consumer price index (CPI) but were mildly relieved with the report.  The expectation was that the year-over-year measure would register 8.7%, down modestly from the 9.1% registered the month before.  Instead, the year-over-year change came in at 8.5%.  Moreover, the month-over-month price change was 0.00%.  Could it be that prices have finally stabilized?  Possibly, but there is still an enormous amount of excess liquidity in the system and the Fed’s quantitative tightening has been slow to drain that liquidity.  In addition, the labor force is still at full employment and consumer sentiment is that inflation will continue to be a problem for the foreseeable future which, historically, is a leading indicator of future inflation.  Also contributing to the negative inflation outlook is the continuing high price of energy.  It’s been a blisteringly hot summer this year and that’s going to be reflected in electric bills, which is likely to have a tag-on effect of depressing consumption spending.

The first two Federal Reserve member to speak following the CPI release were cautious not to sound a dovish note.  The Chicago Fed’s Evans said that market participants should expect rates to continue to rise through the rest of this year and into next.  Despite that comment, the Fed Fund futures market is indicating only about a 50% chance of a 75-basis point hike in September, and that Fed Funds will peak to 3.6% in first quarter of next year.

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