Blaze of Glory
This week is a two-for on the Musings front - song and a movie. John Bon Jovi recorded "Blaze of Glory" in 1990 while on a break from his band.
The song was written by Bon Jovi after borrowing a script for Young Guns II. The song was nominated for Best Original Song at the 1991 Oscars, but lost to Madonna's "Sooner or Later" from Dick Tracy. Two notes of trivia: first, Bon Jovi actually appeared in the film as a prisoner in a pit; second, screenwriter John Fusco used the Bon Jovi hit "Wanted Dead or Alive" as inspiration when writing the script for the first movie, Young Guns.
Right now, Fed Chairman Powell reminds me of Emilio Estevez in Young Guns II - willing to go out in a Blaze of Glory.
"I'm going down in a blaze of glory
Take me now but know the truth
I'm going out in a blaze of glory
Lord, I never drew first
But I drew first blood
I'm no one's son
Call me young gun"
The Fed's Trolley Car Problem. With runaway inflation raging (more on that in a minute) and a recession on the horizon, Fed Chairman Powell is like a conductor of a trolley car system.
Which way will he guide the trolley car (U.S. economy) - trying to avoid higher inflation or trying to avoid a recession? At the June 15th press conference following the last rate hike, Powell made two conflicting statements:
“We at the Fed understand the hardship high inflation is causing. We are strongly committed to bringing inflation back down.”
“So, we’re not looking to have a higher unemployment rate (4.1%), but I would say that I would certainly look at that as a successful outcome.”
If the Fed is committed to bringing inflation down, they are not exactly doing a bang up job, given this week's CPI print. So, we're likely in for more rate hikes. If the Fed is willing to let unemployment rise in order to fight inflation, the economy will likely slip into recession. Last week's Jobs Report showed an Unemployment Rate of 3.6%. If, based on Chairman Powell's statements, unemployment rises to 4.1%, such a move would cost the U.S. labor market approximately 750,000. What do you think those people who lose their jobs are going to do about spending money? They'll certainly reduce spending, which, in turn could further slow down an economy already struggling to grow.
This week, markets responded to the CPI print by selling at the prospect of greater rate hikes.
The year-over-year Consumer Price Index for June was +9.1%, an increase of +1.3% over the previous month. The Producer Price Index for June was +11.3%, which far exceeded expectations. In fact, the decline in PPI for May was revised higher, meaning we didn't really get a reprieve in higher inflation last month. Market expectations for a rate hike have been all over the place this week.
Just last week, futures on July's Fed Rate Hike showed a 94% probability of 75 basis points. After the CPI print on Wednesday, futures jumped to an 84% probability of 100 basis point hike. This morning, futures are basically split (50:50) on either a 75 bp or 100 bp rate hike. Reminder - there hasn't been a 100 bps rate hike in a single meeting since 1994. Last week's Jobs Report showed Average Hourly Earnings were flat month-over-month, but actually decreased on a year-over-year basis.
Inflation is outpacing the consumer's ability to earn wages. In addition, while Inflation is soaring, Consumer Sentiment is plummeting. Riddle me this - when an economy already slowing down faces higher interest rates and further erosion of earnings, does growth increase or decrease? I think the latter is more likely.
Homage To The '80s. As a child of the 1980s, I've thoroughly enjoyed the Stranger Things series on Netflix (foreshadow for next week's Musings perhaps). The attention to detail with regard to clothing, household items, and vehicles from that era in the show is really something. Seeing as we're now dealing with runaway inflation not seen since 1981, the struggles of the early part of that decade seem relevant.
The price of oil in 1981 was $117/barrel and we hit a high of $119/barrel earlier this year. Inflation began to dip in 1981 to +9.8% (YoY) and we're at +9.1% currently. Where things begin to differ are the conditions of the labor market and interest rates. In 1981, we were coming down from a period of record high interest rates (15.8% on 10-yr Treasury vs 2.93% today). The Unemployment Rate was 7.5% in 1981 versus 3.6% currently. Though we are hitting highs not seen since the '80s on Inflation, not everything is exactly the same as the aforementioned decade of MTV. However, without some changes and economic growth soon, we could be headed for decade like the 1970s.
The most recent reading from the Goldman Sachs Current Activity Indicator shows all 5 elements of the indicator either negative or just barely positive.
In fact, each of the components is lower both on a month-over-month basis and on a year-over-year basis. Housing activity in June was negative for the 3rd consecutive month and Consumer activity was negative for the 2nd consecutive month. The NFIB Small Business Optimism Index has reached the lowest level (89.5) since 2013 and the last time we reached 89.5 while on decline was the 2008 Financial Crisis.
Oil production in the U.S. and Saudi Arabia has continued to improve, while Oil prices have moved higher, until just recently. The price of gas at the pump on average has declined $0.47/gallon over the last 30 days. While oil production has improved, it's demand destruction that has caused oil supply to increase. U.S. API Oil Stock inventory has increased in 10 of the last 15 weeks, indicating that demand for oil could be waning. Global volume for Venture Capital deals has also slowed significantly. VC volume is down for the last 2 consecutive quarters and shows a decline of 27% year-over-year. According to Goldman Sachs' IT Spending Index, CIOs are expecting weaker spending 2022 versus just 1-year ago.
What Could Interest Rates Be Trying To Tell Us? Interest Rates have been volatile since the beginning of the year, but even markedly more volatile of late.
The ICE BofA MOVE Index provided a measure of bond market volatility. It's the bond market equivalent of the VIX. Currently, the MOVE index is at 136.1, which is substantially higher than the historical average of 83. Just a few days ago, the MOVE Index was at 147. Interest Rates have pushed bond prices all over the place, but the more recent trend has led to a yield curve inversion.
The 10-year and 2-year inversion occurred on April 1st of this year, but has re-occurred on July 6th and has remained inverted. This is a tale-tell sign (although, not 100% accurate) of a coming recession. However, what's more concerning is the movement between the 10-year and 3-month T-bill. The inversion on that more extreme short end of the yield curve is typically a more immediate signal of coming recession.
The difference in yield between the 10-year and the 3-month has shrunk from 112 bps just 5 days ago to only 56 bps as of today. If that gap continued to shrink, it could be another signal of recession on the horizon. When the 10-year and 3-month invert, the 1-year returns for the S&P 500 Index have averaged -14.39%. The low unemployment rate and still historically low interest rate level could help shorten the depth and length of a likely recession. The Fed is the wild card in this scenario and future policy decisions could determine whether the U.S. economy indeed slip into recession and how steep.