QQQ - Will The Fed Engineer A Soft Landing With Resilient Payroll Figures?

2023-12-08 10:00:42 ET

Summary

• Markets remain on edge heading into the December rate decision, as stronger-than-expected November payrolls data offsets separate readings from earlier in the week that support a cooling labor market.
• Meanwhile, the consumer remains resilient, with robust GDP growth of 5.2% in Q3 despite the steady decline in inflation to 3.2% in October.
• However, inflation remains uncertain, with recent fluctuations in core prices and the re-emerging wealth effect from equity markets complicating the trajectory to the Fed's target 2% range.
• Taken together, we believe the market's recent optimism for a soft landing and substantial rate cuts next year remain premature, with heightened sensitivity to incoming economic data likely to harbinger further market volatility in the near term.

Following the market’s ( SP500 , NDX ) November rally – the biggest monthly upsurge since the Global Financial Crisis in 2008 – momentum kicking into December has been losing steam. Equities saw a brief relief rally following the release of the October JOLTS data earlier this week, which supported a consistently cooling labor market that complements slowing inflation observed in October, and optimism for impending rate cuts. The related gains were wiped out mid-week though, before a revived upsurge on Thursday, partially driven by the release of continuing jobless claims data that remain elevated. The resurgence of an AI rally following Google’s ( GOOG , GOOGL ) release of its newest Gemini large language model was likely also at play. Related gains were wiped out once again following a slightly stronger than expected payrolls report for November, which portends prospects for a “higher for longer” stance on monetary policy.

Meanwhile, the economy has remained strong, thanks to the resilient consumer. U.S. GDP grew 5.2% during the third quarter on a seasonally adjusted basis, even as inflation moderates from a record high of 9.1% in June 2022 to 3.2% in October amid one of the most aggressive monetary policy tightening cycles observed in more than four decades. And while the labor market is starting to show signs of cooling, it has remained largely resilient, with the unemployment rate rising slightly from a 50-year low of 3.4% in April to stabilizing at 3.9% in recent months before tipping back to 3.7% in November.

While the latest slate of economic data does buoy optimism for a soft landing, it also cautions ongoing uncertainties given the mixed labor market outlook and the ensuing impact on consumption. We also remain cautious of underlying inflationary risks that are still at play within the economy, which could thwart the Fed’s main focus of bringing the pace of price increases back to the 2% target range and keeping it there for good. And this job is far from done – inflation still needs to show signs of a consistent cooldown from the current 3.2% to 2% and prove it could stay in that level. This means interest rates will likely stay “higher for longer” at the minimum, with incremental hikes still on the table.

Looking ahead, the mixed combination is likely to drive continued volatility in markets. We believe the latest rally on optimism for a soft landing and impending rate cuts next year remain premature, with a hard landing still very much a possible scenario given rising cost-of-living pressures on Americans amid persistent inflation and soaring borrowing costs, which bodes unfavorably with rising risks of an accelerated cooldown in the labor market.

Cooling Labor Market

The American economy has continued to show emerging signs of a consistent cooldown in the labor market based on the totality of jobs data in recent months.

• JOLTS : The decrease in October U.S. job openings to levels last seen in 2021 was the first of a trio of recent data supportive of a cooling labor market desired by the Fed. Specifically, job vacancies have gradually declined from a peak of 12 million positions in mid-2022 to 8.7 million in October, and fell through the average economist estimate of 9.3 million. The average number of vacancies per unemployed person fell to 1.3 in October, down from the measure’s peak of two-to-one in 2022 and 1.5 in the preceding month. The quits rate also stabilized at a 2.5 year low of 2.3% for four consecutive months now, while layoffs have moderated. Taken together, the combination of JOLTS data collectively points to continued easing in the labor environment and, inadvertently, moderating wage growth, which is supportive of the Fed’s mandate to restore employment stability while taming inflation.
• Weekly jobless claims : Meanwhile, continuing jobless claims for the week ended November 25 fell by the most in four months to 1.86 million (-64,000 w/w), but remains elevated. This is consistent with a two-year record high in the four-week moving average of recurring jobless claims, underscoring a cooling labor market as the job-seeking period extends. Initial claims also remained on the rise to 220,000 last week, which corroborates a slowdown in hiring. Specifically, recent market data shows 45,510 roles have been eliminated in November, up 24% from the prior month, with seasonal end-of-year hiring – particularly in the retail sector – also at its lowest in 10 years. This is likely to contribute to wage growth moderation heading into the new year, which would support tightening financial conditions and a slowing economy needed to keep inflationary pressure at bay.
• Non-farm payroll : U.S. non-farm payrolls for November increased by 199,000 from the prior month, topping the average estimate of about 185,000. Meanwhile, the unemployment rate also slipped from the previous 3.9% that has held steady in the prior two months to 3.7% in November, which also showed a more resilient labor market than expected. The latest data offers a mixed picture on the labor market outlook when paired with JOLTS and jobless claims data released earlier this week, underscoring continued uncertainties to monetary policy stance in the near-term, and the broader macroeconomic trajectory – particularly the Fed’s work in restoring employment and price stability.

The cooling trend is in line with broader market expectations that the lagging impact of monetary policy tightening typically kicks into effect on the labor market about 18 months to 24 months following the initial rate hike. Yet the hotter than expected non-farm payrolls data for November brings the “higher for longer” narrative back to the table, as it supports the Fed’s view that there remains insufficient evidence that financial conditions are persistently tightening and contributing to a structural slowdown in the economy. This is in line with the subsequent surge in the rate-sensitive two-year Treasury yield (US2Y) by 11 bps to 3.71%, while money markets also take a step back on rate cut projections for the following year by 10 bps to 1.1%.

The ideal scenario would be for labor demand/supply to come back into a balance without tipping the economy into recession by impacting consumers’ ability to spend. And this has been supported by a relatively stable unemployment rate at 3.7% to 3.9% in recent months, while job openings and employers’ intention to hire is likely starting to slow, supporting tempered wage growth.

Meanwhile, the consumer has also stayed resilient. As discussed in the earlier section, U.S. GDP grew 5.2% during the third quarter, with consumer spending representing 2/3 of expansion. The continuation of this resilience is further corroborated by robust Black Friday / Cyber Monday (“BFCM”) sales to kick off the holiday shopping season. Specifically, online sales during the annual post-Thanksgiving shopping weekend grew 7.4% y/y . This contributed to market expectations for an overall 4.8% growth in online sales during the final two months of the year, outpacing last 2022’s performance, despite remaining “well below the annual average rate of 13% growth before the pandemic” to support a cooling economy.

However, we remain incrementally cautious of a consumer that could be rapidly losing steam heading into the new year. Specifically, pandemic-era savings are expected to run out by the end of the year, while consumer-level debt and related delinquency rates are on a rapid rise amid the high borrowing cost environment. Payment data showed a rise “ buy now pay later ,” or BNPL, checkouts during the latest BFCM shopping frenzy to more than $7 billion , with the figure expected to rise 17% y/y to a total of $17 billion by the end of the holiday season. Meanwhile, delinquencies on consumer loans are also steadily surpassing pre-pandemic levels. The rate of premature withdrawals on retirement savings amongst Americans are also on the rise, with many citing the need to meet near-term housing and medical cost requirements.

This is in line with recent data that shows about 80% of Americans now have less cash savings on hand than they did before the pandemic, with the most affluent 20% now only being 8% better off after adjusting for inflation. The data brings caution to real weakness in consumer spending power ahead, which could harbinger a recession when paired with a potentially accelerating cooldown in the labor market.

Inflation’s Uncertain Trajectory

Although prices have been growing at a slower clip, nearing a two-year low at 3.2% in October, there is likely still some ways to go before getting to the Fed’s 2% target and staying there. While the effects of tightening monetary policy continues to flow through the economy, there remains several counteracting factors to taming inflation on the horizon:

Fluctuations in Core Prices

The consistent decline in U.S. CPI this year through June had been key to driving this year’s market rally, as investors held onto optimism that the end of the latest monetary policy tightening cycle is near, while also complementing the surge of interest in AI technologies. Yet the resurgence of energy prices over the summer driving season, complicated by OPEC+ supply cuts led by Russia and Saudi Arabia that pushed Brent crude to its year-to-date peak of more than $90 a barrel, helped usher markets into pricing in the Fed’s “higher for longer” narrative instead. CPI subsequently went on a three-month uptrend during the third quarter to 3.7% in September, driven primarily by the surge in energy prices by as much as 10.5% during the period. Although oil prices have since mellowed, the current supply glut due to the tepid global economic outlook and its ensuing impact on demand is incentivizing extended curbs from key OPEC+ members, including Saudi Arabia, Russia, Algeria and Kuwait, to rebalance the market.

Rising food prices have also been a key strain on household budgets. The increase in food prices reaccelerated in October to +0.3% m/m, up from +0.2% m/m observed in the preceding three months. Specifically, prices for fresh produce have climbed 14% from early 2020, far outpacing the less than 1% increase observed in the four years preceding the pandemic. Meanwhile, meat, fish and egg prices have remained a key driver of inflation in the food category, rising about 40% on average compared to early 2020 levels. Taken together, Americans are now spending about 32% more on their grocery bills compared to 2020, underscoring the compounding effect of elevated inflationary pressures on food over the past several years, and the limited margin to absorb unpredictable “price spikes” due to weather, disease, and/or other natural disaster.

Meanwhile, housing costs also remain a key contributor to elevated inflationary pressure. With U.S. home prices surging for the eighth consecutive month through September to new record highs, rising shelter costs are likely to remain a sticky component of persistent inflation, despite the slowing pace of increase observed in October. Although rising interest rates have pushed mortgage rates to record levels above 7% , demand remains from the most affluent and least price sensitive homebuyers. Meanwhile, supply remains limited, as prospective home sellers wait for a stronger demand environment to gauge even better prices. This has resulted in a housing “inventory crunch” that has kept prices on the rise – specifically, home prices grew 3.9% y/y in September, accelerating from the 2.5% y/y increase observed in August. This trend could complicate the sustained pace of slowdown needed in housing prices to keep core inflation in check.

Re-emerging Wealth Effect

In addition to continued fluctuations in core prices that could still complicate the overall trajectory of taming inflation and reaching soft landing for the economy, the resurgence of wealth from equity markets is also diverging from the need for tighter economic conditions. Specifically, the “ tighter financial conditions ” stemming from rising long-end Treasury yield, which Fed Chair Jerome Powell has recently alluded to for helping keep inflation at bay, has yet to demonstrate sufficient persistency to warrant rate cuts.

So, obviously we’re monitoring, we’re attentive to the increase in longer-term yields and – which have contributed to a tightening of broader financial conditions since the summer. As I mentioned, persistent changes in broader financial conditions can have implications for the path of monetary policy. In this case, the tighter financial conditions we’re seeing – [coming] from higher long-term rates, but also from other sources, like the stronger dollar and lower equity prices – could matter for future rate decisions, as long as two conditions are satisfied. The first is that the tighter conditions would need to be persistent. And that is something that remains to be seen…The second thing is that, that the longer-term rates that have moved up – they can’t simply be a reflection of, of expected policy moves from us that would then – that if we didn’t follow through on them, then the rates would come back down.

Source: Fed Chair Jerome Powell’s Press Conference, November 1, 2023 .

Powell’s remarks indicated the need for persistent tightening of financial conditions, as well as a structural elevation in long-term yield in order for the metric to contribute to the Fed’s job in slowing the economy and taming inflation. Yet this ship has essentially sailed, as markets continue to price swaps linked to rate decisions based on anticipated policy moves.

This is in line with the rapid decline in long-end Treasury yield following the November policy meeting in response to market’s expectations that the Fed is done with raising rates, which led to a record monthly rally in equity valuations. Specifically, 10-year Treasury yields (US10Y) have come down close to 90 bps to the sub-4.2% range, compared to the October peak of above 5%. Money markets have started to price in rate cuts beginning as early as March 2024, with a full percentage point of reductions to the Fed Fund Rate from the current 5.25% to 5.50% range by at least a full percentage point. The resurgence of wealth resulting from resurrected equity valuations continue to be supportive of economic strength. Meanwhile, the slightly hotter than expected November payrolls data is triggering a slight move in reverse to end the week, with Treasury selling off again and markets pricing in a smaller extent of rate cuts in the coming year.

Paired with underlying risks that could keep inflation stubbornly above the Fed’s 2% target, we believe the best-case scenario remains “higher for longer,” with incremental rate hikes still on the table, which together could potentially thwart prospects for a soft landing.

What Happens Next?

While recent data shows the economy is gradually slowing into a balance, we believe it is getting to a point where the forward trajectory of Fed policy becomes tricking. On one hand, labor market conditions appear to be cooling, which is supportive of taming wage growth and stabilizing prices while the consumer remains resilient – if this persists with inflation falling to 2%, the Fed will have orchestrated a soft landing. Meanwhile, on the other hand, the cooldown in labor market conditions could accelerate from here on out based on historical observations, and push the economy into recession as consumers are already struggling to make ends meet. Alternatively, there are also signs that monetary policy is not yet sufficiently restrictive, while inflation also faces persistent underlying risks for a resurgence, which keeps the possibility for another rate hike or an extended period of restrictive monetary policy stance on the table. This would essentially turn prospects of a hard landing inevitable.

Taken together, we expect further market volatility ahead, with recent valuation gains likely to pare further heading into 2024. This is consistent with observations of structural market recovery trends following the dot-com bust and 2008 global financial crisis – markets did not fully restore its structural uptrend in equity valuations until a recession was declared and the FFR eased back to the 0% to 1% range, with long-end Treasury yield normalizing to the 3% range. Admittedly, these are trends that have followed a hard landing (i.e., recession), which the Fed hopes to avert this time around.

Although historical trends have shown a consistent decline in benchmark 10-year Treasury yields averaging 107 bps between the final rate hike and first rate cut within the monetary policy cycle, which is likely what market is starting to price in, current economic conditions argue that uncertainties remain on whether the last rate hike has really been registered as inflationary risks persist.

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