Dow slumped on the renewed concern of a hard landing

Wall Street Futures were mixed Monday on tech boost, lingering U.S. debt limit deal suspense, and mixed Fed talks. On Tuesday, some focus of the market was also on U.S. retail sales apart from the ongoing political soap opera on U.S. debt limit negotiations between Democrats and Republicans.

On Tuesday, the CB flash data shows seasonally adjusted U.S. retail sales for April around $686.052B vs 683.179B sequentially (+0.4%) and 675.277B yearly (+1.6%); i.e. the U.S. retail sales grew +0.4% sequentially and +1.6% yearly in Apr’23. U.S. retail sales increased +0.4% mom in April’23, rebounding from two consecutive months of declines, but well below market forecasts of a +0.8% increase. However, the so-called core-core retail sales which exclude automobiles, gasoline, building materials, and food services, increased at a faster 0.7%, in a sign of sustained consumer demand. The U.S. core retail sales (w/o food & fuel) increased +0.6% sequentially and +1.6% in Apr’23.

In Apr’23, retail sales were boosted by motor vehicles and part dealers (+0.4%), and other increases were seen in sales at building material & garden supplies dealers (+0.5%); food services and drinking places (+0.6%); health and personal care stores (+0.9%); merchandise stores (+0.9%); non-store retailers (+1.2%); and miscellaneous store retailers (+2.4%). On the other hand, sales at gasoline stations unexpectedly declined -0.8%, despite a rise in the price of gasoline and sales at food and beverage stores went down -0.2%. Other decreases were also recorded for clothing (-0.3%); electronics (-0.5%); furniture (-0.7%); and sporting goods, hobby, musicals, and books (-3.3%).

Overall, the average monthly retail sales are now around $687.419 in 2023 vs $672.612B in 2022, up by +2.20% against pre-COVID (2019-18) period growth of +3.06%. Further, if we consider U.S. inflation, the U.S. real retail sales growth has now turned negative; sequentially -1.42% and yearly -0.08%; the sequential rate of -1.42% is equivalent to -17.04% annualized rate. The market is now concerned about real subdued consumer spending, which will inevitably affect earnings more going forward (amid higher borrowing costs and lingering macro-headwinds). Thus the Wall Street earnings recession may prolong more and equities are sliding on the concern of a hard landing.

Wall Street Futures were already under stress early Asian session Tuesday on subdued economic data from China (fixed asset investment, industrial production, and retail sales). U.S. and China, the world’s 1st and 2nd largest economies are quite dependent on each other’s consumer spending for prosperity & growth. Weak consumption in China is also negative for export-savvy U.S. MNCs, especially for merchandise products (goods).

Meanwhile, Fed speakers are trying their best to maintain financial (Wall Street) as well as price stability amid the debt limit fiasco:

On early Tuesday, Fed’s Mester said:

·         I don't think we're at that hold rate yet

·         There are four weeks to go until the next meeting, need to see more data

·         I don't put it in terms of a pause, I put it in terms of a hold

·         I would like the policy rate to get to a point where it could equally be a potential increase or decrease

·         It will require resolve to stay the course and get inflation back to 2%

·         I need to see more evidence that inflation is coming down

·         Some effects of monetary policy are yet to play out

·         I am seeing some slowdown in the labor market conditions; I still think that the labor market is quite tight

·         We know part of the total rate increase has not affected the economy yet

·         I can't say we're at a level to hold given the stubborn inflation

·         Whether banking turmoil is adding to the pullback in credit, we're monitoring it

·         We know that commercial real estate on bank balance sheets is another risk factor

·         Labor market dynamics in this expansion could be quite different

·         want to assess how much more credit pullback will occur

·         I expect inflation to come back down with appropriate monetary policy; we will see material improvement this year

On Tuesday, Fed’s Barr said:

·         The agency is considering stricter rules on accounting for unrealized losses for banks over $100 bln in assets

·         The Fed is looking carefully at commercial real estate risks

·         Community banks are sound and resilient

·         I expect to be able to present thinking on the Fed's holistic capital review by the summer

·         We consider expected credit tightening when making monetary policy

On Tuesday, Fed’s Barkin said:

·         The number one lesson from the 1970s is don't quit too soon

·         If more increases are needed to bring down inflation, then I am comfortable with that

·         The message in last the FOMC statement was one of optionality

·         Businesses will not give up pricing power unless they're forced to do it

·         But when it comes to downsizing, businesses are quite cautious and reluctant to let staff go

·         Most of the people I talk to anticipate a downturn over the coming quarters

·         The job market is still quite hot, it has not softened as expected

·         I expect my unemployment rate forecast to come down a bit

·         Commercial real estate is not an unknown vulnerability but it is one I am focused on

·         The commercial office sector is where you hear the most concern about CRE

·         Deposit flows are stable at banks in my district; I am encouraged by the resilience that I've seen

·         There is a lot of data until the June FOMC, plus the debt ceiling

·         I like the optionality implied in the statement from the last meeting

·         I'm still looking to be convinced about inflation

·         Demand is cooling but not yet cold

On Tuesday, Fed’s Williams said:

·         The banking system is sound and resilient

·         The current banking situation is nothing like the 2008 banking crisis

·         Inflation is moving gradually in the right direction

·         It takes time for Fed decisions to have an impact on the economy

·         Expect the economy to expand further this year

·         Starting to see demand and supply rebalance

·         The economy is beginning to return to more normal patterns

·         Inflation is unacceptably high in the economy

On late Tuesday, Fed’s Goolsbee said:

·         Wants to get inflation back down to target

·         We're starting to see some slowing in activity

·         It is far too early to discuss rate cuts

·         Service Inflation is more persistent than previously thought

·         Housing inflation has not yet decreased, but we anticipate that it will

·         I'm not sure if we've restrained the economy sufficiently yet

·         On the May rate decision, I thought it was a close call

·         I have not decided anything for the June rate meeting

·         It is a mistake to commit to a rate move when more data is coming

Also, the market is now concerned about the ongoing U.S. debt limit standoff:

The U.S. Treasury Secretary Yellen said late Monday that the U.S. is already witnessing a substantial increase in borrowing costs for debt limit uncertainty:

·         A U.S. default would result in an unprecedented economic and financial storm, resulting income shock could lead to a recession

·         A default could see financial markets break' with worldwide panic triggering margin calls, runs, and fire sales

The House Rep. Speaker McCarthy said:

·         There has been no progress in debt talks since last night

·         We need to get a framework for a debt deal by this weekend

·         They need to get a framework of a deal by this weekend

·         A bill will move through the House in 3-4 days and the Senate in a week

·         I believe in Yellen's early June deadline

·         I'm not going to argue with you on that

·         We are still a long way apart but it is possible to get a deal by the end of the week

·         We've set the stage to carry on further conversations in debt talks

·         I would like to hold more meetings today

·         Biden has selected two people from his administration to negotiate directly with us

·         This meeting with Biden was a little more productive, but nothing has been resolved in this negotiation

·         Rep. Graves and his staff will meet with White House officials including the OMB Director

·         I'm not more optimistic about getting a deal by the end of this week

On late Tuesday, Biden said:

·         I have made clear to the speaker that we will speak regularly over the next several days

·         There is still work to do

·         I had a good and productive meeting on the debt ceiling

On late Tuesday, the White House said:

·         President Biden is optimistic about the bipartisan budget deal

·         Biden directed staff to continue to meet daily on outstanding issues

Market impact:

On Tuesday, Dow lost over -330 points, while the S&P 500 and the Nasdaq dropped 0.6% and 0.2%, respectively, on renewed concern about an earnings recession. Home Depot tumbled after the company reported its largest revenue miss in over two decades and lowered its guidance for the current year. Also, energy producers weighed on sentiments as Exxon Mobil and Chevron slid (lower oil amid subdued Chinese economic data and below-expected quantity U.S. SPR buying).

Late Tuesday, Dow Future recovered by almost +100 points from around 33032 and close around 33090 on hopes of an imminent debt limit deal after a report said U.S. President Biden has decided to return to the U.S. Sunday, immediately following the completion of the G7, to ensure Congress takes action by the deadline to avert default. As per reports, Biden and McCarthy's aides discuss tightening work requirements for welfare programs.

On Tuesday, Wall Street was dragged by real estate, energy, utilities, materials, industrials, banks & financials, consumer staples, healthcare, and consumer discretionary, while helped only by communication services and tech to some extent. Nasdaq was boosted by AMD and Microsoft.

The US has raised the debt ceiling 78 times since 1960 and has never once defaulted. On late Tuesday, the U.S. Senate Republican Leader McConnell said: “We are confident that we will not default.” Echoing his ‘good friend’ the U.S. Senate Majority Leader Schumer also said: “Yes we are closer to a deal”.

On Tuesday, Gold also stumbled as U.S. debt deal political drama may be over by next week and Fed is on the way for another rate hike on 14th June.

Conclusion:

Fed was already behind the inflation curve from early 2021 when the economy opens fully after the 2020 COVID disruption. Fed should have started to normalize its ultra-loose monetary policy in early 2021 rather than terming higher inflation as transitory and starting the process (telegraphing about QE ending and potential rate hikes) in late 2021. In the process, Fed created synchronized global inflation/stagflation as almost all major G20 central banks usually follow Fed policy action for currency (USD) and bond yield differential. The late action of the Fed coupled with supply chain issues and policy paralysis in the White House created synchronized elevated sticky core inflation globally (except in China).

Now (till the banking crisis emerged in 2nd week of Feb’23), seeing inflation out of control, both Fed and ECB were engaged in ultra-hawkish jawboning to tighten monetary/financial conditions, resulting in a rapid increase in bond yields and HTM (bond portfolio) loss of mid-size U.S. regional banks, who are not so much efficient to manage interest rate increase in an efficient/professional manner. Fed is itself now suffering from huge MTM loss (unrealized) as it’s offering trillions of dollars at higher reverse repo rates to banks; Big U.S. banks are major beneficiaries of higher reverse repo rates (risk-free return) from Fed. But small/mid-sized U.S. regional banks like SVB and FRC have a significant mismatch between asset and liability, resulting in the current failure.

Fed is now going to pause after at least one more hike as it believes banks, especially smaller ones will tighten lending norms, which will eventually tighten financial conditions more and consumer demand thereby, helping lower inflation. For the last year, Fed was too occupied with jawboning to control the market and may not have focused adequately on bank supervision/regulation; especially for vulnerable small/mid-size U.S. regional banks. Here is also Fed was far behind the curve, nearly inviting another 2008-type GFC.

But, as the immediate concern of financial stability eases, Fed may go for their planned rate hikes in a calibrated manner to ensure price and financial stability as well as credibility. Thus Fed had gone for a +25 bps rate hike on 3rd May, and may also do the same on 14th June for a terminal repo rate of 5.50% and then may pause depending upon the actual trajectory/outlook of core inflation. Fed will ensure financial stability with liquidity tools and price stability with interest tools as unlike during 2008-10, core inflation is still substantially higher than the +2% targets, while the unemployment rate is still near a record low of 3.5% (at maximum employment level).

As per Taylor’s rule, for the US: (Fed’s favorite)

Recommended policy rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.5-2.00) =0+2+3.5=5.5%

Here for U.S. /Fed

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation=5.5% (average of core PCE and CPI)

In a way, while there is a question mark for June hike now in the market, there will be no rate cuts at least till mid-2024 contrary to market expectations. After mid-2024, Fed may begin talking about rate cuts (just ahead of the Nov’24 U.S. Presidential election) to boost Wall Street (risk trade) and also to ensure lower bond yields to rescue U.S. regional banks and itself. Fed has to also ensure lower borrowing costs for the U.S. government as well as businesses and households.

At the present run rate, U.S. core CPI may take another 6 months; i.e. Sep’23 to fall to around +5.0% and Sep-Dec’24 to further fall around +4.0%, still substantially higher than Fed’s +2.0% targets. Thus Fed needs to keep the real interest rate restrictive /positive enough for a longer period, so that core inflation falls towards +2% targets by Dec’25. Fed may keep the repo rate at 5.50% by June for a real positive U.S. interest rate. Fed should have communicated earlier in a clear way that a real positive interest rate is the basic requirement for ensuring price stability along with supply-side actions by the fiscal authority/government (including peaceful resolution of the Russia-Ukraine/U.S./NATO proxy war).

The average U.S. core CPI is now also running around +5.6%, almost +100 bps higher than Fed’s preferred core PCE inflation and this gap of +100 bps is running since Jan’22. The average core inflation (PCE+CPI) is now around +5.25% and thus Fed may keep the terminal repo rate at least at +5.50% till Dec’23 (real positive/zero interest rate) to curtail demand (slowing economy) and bring inflation towards +2.0% core inflation target.

As monetary/fiscal authority on both sides of the Atlantic will not allow any banks to fall in reality, both Fed and ECB may continue their rate hike plans as there will be no 2008-like GFC this time. Both Fed and ECB are now running well behind the inflation curve and are reacting to data rather than the desired opposite action. Both central banks are not confident enough to spell out the plan to keep the real rate of interest at least zero or +25/50 bps for a considerable time to manage price stability durably because of their fear of financial /stock market stability and also political/social stability. In the process, they are creating more confusion and bubbles as the market is also taking the next rate cut moves as granted.

Fed/ECB should have communicated earlier in a clear way that a real positive interest rate (wrt at least core inflation) is the basic requirement for ensuring price stability along with supply-side actions by the fiscal authority/government (including peaceful resolution of the Russia-Ukraine/U.S./NATO proxy war) to bring down inflation. AEs can’t have durable price stability only by higher borrowing costs; they have to ensure a cheap supply line source like China (DEs) without a lingering cold war mentality and appropriate supply-side reform/fiscal stimulus (to increase supply and match higher demand).

Fed may go for another +25 bps hike in June for a terminal repo rate of +5.50%, while ECB may further hike by +25 bps each in June and July. Moreover, if core inflation does not dip below +5.00% in the Eurozone by August, then ECB may have no option but to go for a further +25 bps rate hike each in September, October, and December for a terminal repo/MLF rate +5.25%. ECB wasted at least 3 months to match Fed’s rate action and thus now scrambling to match as a consistently weaker EURUSD will also result in higher imported inflation, everything being equal. Europe may be the biggest loser of the Russia-Ukraine/U.S./NATO war/proxy war as it’s an importer of both food and fuel apart from various other commodities. The high cost of living crisis in Europe may invite bigger social and political unrest in the coming days if inflation does not come under control in the coming days.

Fed increased the repo rate by +500 bps in the last year, whereas core inflation was reduced only by -100 bps, in line with a 2Y bond yield increase of about +150 bps. The market is expecting a rate cut by Fed by almost -100 bps by Dec’23 despite Fed trying to pour cold water on that market expectation. The U.S. paid around 9% of its revenue last year as interest on public debt and can’t afford to increase the same well into double-digit around Japan’s 15%; China and Europe are now paying around 5..5% of revenue as interest on the public debt (deficit spending). Thus the U.S. has no option but to pause soon after a possible hike in June but to also reduce elevated inflation by both monetary and fiscal action.

Bottom line:

Apart from monetary action to reduce demand, the U.S. also needs proper/targeted fiscal stimulus/action to increase the supply side of the economy. But such supply-side reform/stimulus needs bipartisan political agreement, whereas present political and policy paralysis is hampering such initiative. Biden admin (Democrats) is now a minority government and has to depend upon the political whims & fancies of opposition Republicans. The same was true when the Republican Trump admin was turned into a minority government after two years of the mid-term election. The U.S. needs some political/legislative reform to allow a stable government to operate for at least 4/5 years (like India) without causing political & policy paralysis year after year.