A June to Remember

This month’s main article, A June to Remember, recaps the June FOMC meeting and discusses the reasoning behind, and potential implications of the Federal Reserve’s decision to raise rates by 75 basis points.

• Credit Vista: Consumers Save the Day?

• Trading Vista: Intensifying Pressures
  

Economic Vista: A June to Remember

Jon Schwartz, Senior Portfolio Manager

June 2022 is likely to be remembered for years to come, thanks to both impressive levels of daily volatility and a very aggressive Federal Reserve rate hike that seemed unlikely even just a few weeks ago. The chief culprit behind it all: inflation. We continue to see elevated inflation data on a monthly basis, as well as emerging evidence that inflation expectations are becoming unanchored. Arguably, this latter factor is of more concern for the Fed, as sometimes these expectations can become troublesome for future economic growth. If consumers expect inflation to persist, they may adjust their spending behavior today to avoid higher prices in the future. This is the exact scenario the Fed is tasked with avoiding.

Leading up to the June Federal Open Market Committee (FOMC) meeting, two key data points forced the market to recalibrate expectations for the Fed:

1. Consumer prices surged in the month of May with a month-over-month (MoM) change of 1.0% vs. expectations of an increase of 0.7%, with the year-over-year (YoY) headline number coming in at 8.6% vs. expectations of 8.3%. This is the highest print for the index since 1981. Energy comes in front and center as a leading driver of inflation, as gasoline, natural gas and fuel oil prices increased 4.1%, 8.0% and 16.9%, respectively, MoM. Food price pressures also affected the inflation data, as the “food at home” category increased 1.4%, which is a continuation of a strong trend. “Food away from home” also increased 0.7% MoM. We also saw strong pricing pressure on rents and owners’ equivalent rents, which increased 0.63% and 0.60%, respectively. This pace of growth is the highest seen in decades and is not showing any signs of abating. Energy prices are being passed on to consumers by the airlines, as airfares advanced by 12.6% MoM, which marks the third consecutive monthly double-digit gain. Lastly, auto prices, both new and used, increased by 1.0% and 1.8%, respectively.

 

Figure 1

 

2. The consumer sentiment index for the month of May was released on Friday, June 10, and it clearly showed some pessimism. The index dropped from 58.4 to 50.2 — its lowest level in history. This was paired with rising inflation expectations hitting multidecade highs. Fed Chairman Powell regularly points to “anchored inflation expectations” as a contrast to where consumer sentiment was in the 1980s, but this anchoring is starting to show evidence of becoming unmoored.

Figure 2

Figure 3

These two economic data points (consumer prices and consumer sentiment) hit the tape the Friday before the June FOMC meeting and sent the markets into a tailspin. Interest rates spiked across the curve, as the market revised expectations from a 50-basis point (bps) hike for both June and July to a 75-bps hike for each of the next two Fed meetings. The yield in the 2-year Treasury climbed over 54-bps over a two-day period, which was the biggest two-day jump since 2008. 

Figure 4

At the June FOMC meeting, the Fed delivered the first 75-bps hike since 1994, as expected, and shared its updated Summary of Economic Projections (SEP). The general theme of the economic update was lower growth, higher unemployment and increased inflation expectations. Real GDP was revised from 2.8% down to 1.7% for 2022, Core Personal Consumption Expenditures (PCE) was increased from 4.1% to 4.3% for 2022 and unemployment expectations were increased from 3.5% to 3.7% for 2022.

Figure 5

The Fed Says

Powell’s message was balanced regarding the condition of the economy and the likelihood of a soft landing in the face of the largest policy accommodation removal in decades. He continues to highlight the Fed’s mandate of getting inflation under control, and he acknowledges the effect inflation is having on the consumer. The supply side factors that affect inflation — namely the war in Ukraine and supply chain disruptions from China’s zero-COVID-19 policy — are expected to continue to push inflation higher.

In the press conference following the FOMC announcement, Powell made it clear these factors are “making their job harder” to reign in upward price pressures and to orchestrate a soft landing. He highlighted that the consumer feels headline inflation the most, which is driven by food and gas prices, and that these are factors in this inflation figure that the Fed cannot affect. All inflation (not just core inflation) is under their mandate, and it’s the food and energy components that affect inflation expectations the most. It was very telling to hear Chairman Powell comment on the likelihood of a soft landing: “There is now a much bigger chance that factors we cannot control, which [are] fluctuations and spikes in commodity prices, could wind up taking the option out of our hands … we are very focused on getting inflation back down to 2%, which we think is essential for the benefit of the public.”

Given the excessive volatility seen in the markets lately and ongoing uncertainties, risk management remains paramount to our asset management approach. Indeed, this June has been one to remember. We remain defensive with our fixed income investments, yet we hope to be able to invest opportunistically as well, and we appreciate the continued trust we have earned from our clients.

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Credit Vista: Consumers save the day?

Fiona Nguyen, Senior Credit Research Advisor

After the June FOMC meeting, the markets continued to digest the record-high inflation readings, the pivot to a more hawkish monetary stance and the growing possibility of a looming recession. Recent economic data has been weaker than anticipated over the past few months, and this has only exacerbated recession fears. Can or will consumers step in to save the day, as they have done so many times in the past? Perhaps a closer look at the data can help us determine if the Fed-orchestrated slowdown will be a hard or soft landing.

In May, the consumer price index accelerated to 8.6% YoY, which was an upside surprise after slowing to a still-high 8.3% YoY in April.

High inflation not only has an impact on market sentiment, but as we discussed in the previous section, it also places a somber mood on consumer confidence. The consumer sentiment index published by the University of Michigan pointed to the lowest reading since the Great Recession more than a decade ago. According to the same report, 36% of consumers attributed their negative sentiment to inflation.

Figure 1

 

Adding to the plethora of economic concerns are the low consumer savings rate (Figure 3) and high revolving credit balance (Figure 4). The US consumer savings rate as a percentage of disposable income fell to 4.4% in April, while the balance of revolving credit outstanding has started to climb back to pre-COVID-19 levels. Together, this data suggested that rising inflation has prompted consumers to not only tap into their pandemic savings, but also to take on additional debt on their credit cards to maintain their standards of living.

Figure 2

Figure 3

At first reading, investors can easily get discouraged by all this seemingly unfavorable data. However, there are reasons to remain optimistic about the health of the average consumer and, by extension, the health of the US economy. For example, looking at the real retail sales data (adjusted for inflation), one can confidently say that demand remains higher than pre-COVID-19 levels and spending has not shown signs of abating despite elevated inflation. This might be explained by the significant pent-up demand that was fostered by shelter-in-place orders, heavy doses of stimulus and the more recent supply chain disruptions.

Figure 4

Looking elsewhere in the economy, it’s clear that the conditions that precipitated the last recession are not what we are facing today. This time it really does seem different. In the housing market, for example, house prices are supported by the lack of inventory vs. substantial (and highly stimulated) demand. Mortgage underwriting is also in a much different (stricter) position than 10 years ago when subprime lending and dubious credit checks were the norm. Today, the percentage of mortgage debt extended to borrowers with FICO scores below 700 is only 20% vs. the 40% extended during the housing crash.¹ Strong US employment is another factor that has helped keep consumer credit from slipping into significant delinquencies.

While credit card balances are on the rise, deterioration in asset quality remains modest. Three major US credit card lenders² collectively reported mild increases in charge-offs in April compared to the previous month, a sign of normalization rather than a significant shift in credit quality. Bank of America, another large credit card lender, recently noted that consumer credit at their bank remains in great shape.

Another bedrock of the economy is the banking system. Compared to the financial conditions in the last recession, banks today are far better capitalized and in a stronger position to continue extending credit to households and businesses. Plus, multiple rate hikes provide a favorable environment for banks to expand their net interest margin and earnings, thus keeping them profitable.

As market conditions continue to tighten, it’s understandable that some investors may be anticipating a recession on the horizon. But don’t count out the consumer just yet. The good news is there are still bright spots in the economy if you dig deeper into the data, and that might help lessen the probability of a hard landing.

<sup>1. Source: Moody's
2. American Express, Discover Financial Services and Capital One Financial.</sup>

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Trading Vista: Intensifying pressures

Jason Graveley, Senior Manager, Fixed Income Trading

Monetary policy remains at the forefront of investors’ minds, as the hiking cycle has intensified. This is unlikely to change over the short term. The pivots by the Fed and the corresponding volatility have been significant. If we look at the 2-year Treasury — the point considered to be the most sensitive to changes in monetary policy — yields have demonstrated some headline-worthy moves. Consider that the month-to-date moves this June have seen yields on the 2-year Treasury skyrocket close to 80-bps at their peak, while retracing almost 25-bps in the hours following the most recent FOMC announcement and subsequent press conference. If you further shorten that spectrum to the trading sessions that preceded the June FOMC meeting, the 2-year Treasury yield staged its biggest two-day jump since 2008. If investors are curious what’s driving the intensifying pressure, look no further than the most recent inflation data.

If we look back at the evolving market expectations — beginning with the December 2021 FOMC meeting around the time that the Fed finally retired the word “transitory” used to describe inflation — there has been a substantial uptick in the implied federal funds rate. Fast-forward to today, and it is now estimated that the fed funds rate might level off around 3.5% by year-end 2023. However, this figure was still below 1.0% as recently as December 2021, below 1.5% after the January FOMC meeting and still below 2.5% after the March meeting (and the first hike in three years). The most recent sharp move higher was attributed to an article in The Wall Street Journal in the week prior to the June meeting, which caused a repricing across both markets and bank forecasts. It was reported that the Fed could “consider surprising markets with a larger-than-expected 0.75-percentage-point interest rate increase at their meeting.” This indicated that expectations were once again changing, and it was a pointed contrast to only last month when Chairman Powell stated that a “75-bps hike is not something that the committee is actively considering.” Apparently, the Fed reserves the right to change its mind — and quickly.

How have markets reacted? With heightened volatility, of course, as evidenced by equity drawdowns that have culminated in splashy “Bear Market Territory” headlines. In our area of focus, though, the story remains one of rates and monetary policy, as opposed to any dire credit concerns. Although we have witnessed some credit spread widening in the front end, overall levels have held up well compared to other asset classes. And as rates react to account for a more hawkish Fed, higher yields are materializing through different investment options for our clients. For example, government money market funds (MMFs) have repriced in the 1.40% range, the 1-year Treasury bill is currently yielding 2.85% and purchases in corporate credit have surpassed 4% recently.

While volatility can obviously be unsettling, any dislocations tend to present opportunities, which we believe can allow for some opportunistic buys. And when coupled with higher benchmark rates, it allows for overall higher-yielding client portfolios. If anything, this intensifying monetary policy just might have a silver lining.

Markets
Treasury Rates*:		Total Returns**:
3-Month	1.59%	ICE BofA 3-Month Treasury	0.06%
6-Month	2.19%	ICE BofA 6-Month Treasury	0.12%
1-Year	2.86%	ICE BofA 12-Month Treasury	0.22%
2-Year	3.19%	S&P 500	0.18%
3-Year	3.35%	Nasdaq	-1.93%
5-Year	3.37%
7-Year	3.37%
10-Year	3.28%
Source: Bloomberg, Silicon Valley Bank *Treasury yields as of 6/15/2022 **Total return for ICE BofA indices as of 5/31/2022