Fed Likely To “Pause” Rate Cuts; Interest Rates “Higher For Longer”

The equity markets were flat to down all week, perhaps digesting the upturn after the election. After all, year to date, equities are up in the 20% range. But, on Friday, after some hawkish remarks by Fed Chair Powell on Thursday at a Dallas Fed event, markets moved to the downside. On Friday, alone, Nasdaq was down -2.24%, capping off a -3.15% week. As shown in the table, the other major indexes suffered a similar fate.

It was no better for the Magnificent 7. All were down for the week with Meta off nearly -6%. An equal weighted index of the Mag 7 was off -2.66% for the week with Tesla as the best performer of the group, down only -0.16%. (Note that on Monday, November 11^th, Tesla hit an all-time high, but has backed off -8% since.)

So, what was it that spooked the markets at week’s end? We see several causes:

· It is natural for some of the market euphoria over the election results to come off.

· Equities are already “priced for perfection,” with the forward Price/Earnings (P/E) multiple at 23x (normal is 16x-17x).

· Inflation, as measured by both the Consumer and Producer Price Indexes (CPI & PPI), while not indicating an inflation resurgence, appear to have stopped, or at least significantly slowed the disinflation momentum seen over the past six months.

· Incoming macroeconomic data, seemingly at odds with surveys, continue to show healthy economic growth (see discussion of Retail Sales below). As a result, the markets’ expectation of lower interest rates has been tempered.

· And, no doubt, the markets reacted to the hawkish comments made by Fed Chair Powell at a Dallas Fed event on Thursday (November 14^th) where he hinted that the Fed might “pause” its rate reductions at the upcoming Fed meeting in early December. He said:

• “Inflation is running close to the Fed’s goal of 2% annual inflation…But we’re not there yet.”
• “The economy is not sending any signals that we need to be in a hurry to lower rates.”

“It may be the case that we slow the pace of what we’re doing.”

The Bond Market was already worried about an economy still growing at a near +3% rate, and that was compounded by Trump’s solid election win. Because his platform is pro-business, the bond markets see success there as causing rates to rise; so, they’ve risen in anticipation of such. In the chart, the left side shows the recent upswing in the two-year Treasury yield, the right side shows a graph of the 10-year Treasury yield. Note the sharp rise in yields recently.

Inflation

On Wednesday (November 13^th), the Consumer Price Index came in as expected with a +0.2% reading for the headline number (+0.24% to the second decimal) and +0.3% (+0.28%) for the Core reading (ex-food and energy). The October change in the raw index was 0.77 which was the largest index change since last April. That put the much-watched year/year change for October at 2.6%, disappointingly up from September’s 2.4%. (Some of the rise was due to “base effects,” i.e., the change in the index a year ago. In October ’23, there was a very small change in the index, about one-third the size of this October’s change; thus, the rise in the year/year calculation.)

Core Goods prices (ex-food and energy) were flat in October and have been flat or down in seven of the last eight months leaving Core Goods prices down -1.0% from a year earlier. The culprit in the index was “Services,” particularly “Shelter Costs” (Rents and Owner’s Equivalent Rent) which account for a more than a one-third weight in the CPI. This is problematic because of the lag in the data used by the Bureau of Labor Statistics (BLS). In October, BLS indicated that there was a +0.4% increase in “Shelter Costs.” As shown on the chart, rents, a large component of shelter costs, have been negative for quite some time. CPI is going to improve dramatically as the lagged negative rent data get into the calculation.

Owners’ Equivalent Rent (OER) plays a large role in the calculation of the shelter component. Unfortunately, OER isn’t observable. It comes from a question in the BLS’ survey asking homeowners the dollar amount at which they think they could rent their home. Since the average homeowner is not in the real estate business, this number, more than likely, imparts an upward bias to the shelter cost data. Eliminating shelter from the index results in a +1.3% year/year CPI reading, quite an encouraging result.

Another encouraging sign is that the annualized six-month trend in the CPI is +1.4%. That means, if, over the next six months, CPI performs the same as it has over the last six months, the all-important year/year trend in the index will be substantially below the Fed’s +2.0% bogie, and the bond vigilantes will be able to rest easy. Note from the chart how many categories are lower in price now than they were a year ago.

Then on Thursday, Producer Prices (PPI) showed up as +0.2% in October, in line with expectations, but higher than September’s +0.1%. Some economists believe that disinflation has stalled, and that, along with rampant speculation that the incoming Trump Administration could rekindle inflation, has led to rising bond yields. Adding to that speculation were comments from Jay Powell that, as noted above, if the data indicates a slower pace of rate cuts, then that would be the “smart thing to do” and the Fed doesn’t need to be “in a hurry” to reduce rates.

As a result of both the slowdown in the disinflation data and Powell comments, the bond market pushed rates up again, with the 10-year Treasury closing at 4.45% on Friday (it had been as low as 3.64% on September 9^th). (See the 2-Yr. and 10-Yr. yield chart above.)

Retail Sales

Retail Sales rose +0.4% in October, slightly better than the +0.3% market expectation. Ex-autos, Retail Sales were only up +0.1%. What caught the markets by surprise was the huge upward revision to September’s Retail Sales, raised to +0.8% from the +0.4% reported last month. Because wages are not rising as fast as Retail Sales, the Consumer Savings Rate has all but evaporated. As a result, a continuation of spending growth above the growth rate in income just means higher consumer debt, and such trends brings the next downtrend ever closer.

Final Thoughts

Equity markets were off last week, and bond yields continued to trend higher. Part of the giveback in the equity markets was, no doubt, attributable to the rapid rise in prices the week prior (post-election). But there are other underlying reasons:

• Equity prices appear to be “out in front” of earnings as the market P/E ratio, at 23X, is significantly higher than its long-term average (16X-17X). So, hesitation to move even higher is understandable.
• Disinflation, as measured by the CPI, appears to have “paused,” causing concern that the Fed will “pause” lowering rates at its December conclave. While both CPI and PPI for October were in line with expectations, the closely watched year/year CPI index rose to +2.6% in October, up from +2.4% in September. (Truly, the last mile is the hardest!)
• Fed Chair Powell, on Thursday (November 14^th) reinforced these concerns in his remarks at a Dallas Fed event.

As discussed in past blogs, because BLS uses lagged data in calculating Shelter Costs, we believe that CPI is overstating current inflation, and that by year’s end or early in 2025, when negative rents are in the calculation, the rate of inflation will be below the Fed’s 2% goal. We are encouraged that the annualized six-month CPI inflation rate is +1.4%.

Retail Sales continued to be robust in September and October. But, because that growth has been faster than the growth in consumer income for several quarters, the savings rate has fallen and consumer indebtedness rose, neither of which are healthy economic trends.

As noted at the top of this blog, the macroeconomic data appear to be at odds with survey and more micro data. Analyst future earnings expectations for public companies have been falling throughout Q3 and into Q4 (increasing the PE ratios). Many companies are reporting consumer resistance to high prices. As we noted, consumption is rising faster than incomes, a trend that cannot last.

Given these trends, we think it is highly likely that the Fed “pauses” at its December meeting, i.e., no change in its benchmark Fed Funds rate. We think Chair Powell gave strong indications of such last Thursday at the Dallas Fed event. That means the recent upswing in interest rates will be with us for several months.

(Joshua Barone and Eugene Hoover contributed to this blog.)