Jay Powell Meets Wall Street Expectations

Something For Everyone, Just Not A Lot Of Reality

Today everyone on Wall Street got something positive.

Inflation hawks got their 25bps federal funds rate hike. Inflation doves got reason to believe the Fed will not hike again at the next FOMC meeting in September. Stocks had reason to rise, and so did bond exchange traded funds. Even treasury prices rose (treasury yields declined).

The FOMC announcement this afternoon contained all the usual boilerplate, with very little that was original other than the rate hike itself.

The U.S. banking system is sound and resilient. Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. In support of these goals, the Committee decided to raise the target range for the federal funds rate to 5-1/4 to 5-1/2 percent. The Committee will continue to assess additional information and its implications for monetary policy. In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments. In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in its previously announced plans. The Committee is strongly committed to returning inflation to its 2 percent objective.

Everything is sound and resilient. Economy is strong but not too strong. Tighter credit is slowing everything down just enough but not too much. Rates are rising but not too much, and the Fed won’t raise again if Wall Street gets spooked in September.

Nothing but good news here, at least as far as Wall Street is concerned.

The Dow Jones warmed to Jay Powell after the announcement and definitely loved the press conference that followed.

Treasury yields responded to the rate hike announcement by dropping across the yield curve, with significant declines in the 1-Year, 2-Year, and 10-Year Treasuries.

The assessment of Wall Street was that yields had priced in a bit more than was needed for the rate hike, with the 10-Year Treasuries showing the largest relative correction.

As a result of the yield declines, bond-related Exchange Traded Funds (ETFs) rose significantly on the rate announcement.

Much of the pricing reflected the Wall Street consensus that the Fed will not raise rates again in September, with the overwhelming assessment being that of another pause.

Why was Wall Street so positive?

Powell’s upbeat assessment of the US economy during the press conference that followed the rate hike announcement was almost certainly a factor in the relatively optimistic response to the rate hike. In summarizing recent economic data, he continued the Wall Street narrative that the recession has been cancelled, that the moderating pace of economic growth is sufficient to bring down inflation without tipping into recession (he’s wrong, but in the way Wall Street wants to hear).

Recent indicators suggest that economic activity has been expanding at a moderate pace. Growth in consumer spending appears to have slowed from earlier in the year. Although activity in the housing sector has picked up somewhat, it remains well below levels of a year ago, largely reflecting higher mortgage rates. And higher interest rates and slower output growth also appear to be weighing on business fixed investment. The labor market remains very tight. Over the past three months, the job gains averaged 244,000 jobs per month, a pace below that seen earlier in the year but still a strong pace.

Of course, that rosy assessment of the labor situation hinges on looking at just the headline unemployment rate with the fudge factors seasonal adjustment factors applied. When the U-6 alternative rate is examined without seasonal adjustment, the employment picture is not quite so optimistic.

Powell also gave Wall Street reason to hope that September will not mean another rate hike.

I will also say, since we’re talking about it, between now and the September meeting we get two more job reports, two more CPI reports. I think we have an ECI report coming later this week, which is employment compensation index, and lots of data on economic activity.  

All of that information is going to inform our decision as we go into that meeting. I would say it is certainly possible that we would raise funds again at the September meeting if the data warranted and I would also say it’s possible that we would choose to hold steady at that meeting.  

At the same time, he took the opportunity to pat himself on the back for threading the needle by not causing a recession (he did, but everyone wants to pretend that he didn’t).

The overall resilience of the economy, the fact that we’ve been able to achieve disinflation so far without any meaningful negative impact on the labor market, the strength of the economy, overall that’s a good thing. It’s good to see that, of course. It’s also—you see consumer confidence coming up and things like that. That will support activity going forward.

This, of course, ignores the reality that the US Manufacturing PMI showed contraction within manufacturing for the third straight month.

This reality was reiterated by shrinking industrial production through June (last month on record) both month on month and year on year.

This reality is further confirmed by the shrinking capacity utilization in this country, which through June again shrank month on month and year on year.

A shrinking manufacturing sector is generally not synonymous with an expanding “resilient” economy, but for today Jay Powell conveniently chose to overlook this fact. Both he and his Wall Street media audience did not want to acknowledge that, as Bank of America analysts have concluded, America is experiencing a “rolling recession”.

The recession Wall Street predicted to death is hitting the economy sector by sector rather than all at once – and that's slashed the risk of a sudden hard landing, according to Bank of America executive Keith Banks.

"We've got a $26 trillion economy that is basically made up of different sectors, operating at different speeds. So what we saw over the first half was a rolling recession in manufacturing, in energy, and in housing," Banks said in an interview with CNBC on Friday, pointing to economic weakness that stayed contained in those areas. 

Powell also was once again his usual disingenuous self on consumer price inflation, touting the 3% headline inflation rate per the Consumer Price Index while ignoring all the ways in which prices are not only still high but also getting higher.

Inflation Drops To 3%. Is There A "But..."?

Powell continues to make the rather asinine mistake of focusing exclusively on the headline print rather than how the inflation rate breaks down sector by sector.

So if you go back to what we’re trying to do here, we’re trying to achieve a stance of policy that’s sufficiently restrictive to bring inflation down to 2 percent. At the last meeting we wrote down our individual estimates of what that would take. And the meeting of that was an additional two rate hikes.

So I would say we looked at the intervening data, and, as I mentioned, broadly consistent; not perfectly consistent, but broadly consistent with expectations. And as a result, we went ahead and took another step. And that’s, you know, a labor market that continues to be strong but gradually slowing.

I mentioned that the inflation report was actually a little better than expected. But, you know, we’re going to be careful about taking too much signal from a single reading. And, you know, growth came in stronger than expected. So that’s how we look at it. And so we did take that step today.

It was what Wall Street wanted to hear, however, so they chose to believe it—despite both Howard Schneider from Reuters and Jay Powell acknowledging that loan demand is declining for both commercial and consumer loans, which typically is regarded as heralding a recession.

Q: On the—on the credit side, I’m wondering if you saw anything in the—in the latest SLOOS data that made you think you’re getting a quantum of credit contraction beyond what you’d expect? The bank lending data really is—the growth rate’s edging down towards below—heading below zero, which is usually, you know, a recession indicator.

MR. POWELL: So I guess that the SLOOS will come out early next week, and I would just say it’s broadly consistent with what you would expect. You’ve got lending conditions tight and getting a little tighter. You’ve got weak demand. And you know, it gives a picture of pretty tight credit conditions in the economy. I think it’s really hard to tease out whether—how much of that is from this source or that source, but I think what matters is the overall picture is of tight and tightening lending conditions. And that’s what this SLOOS will say.

The reality, of course, is that loan demand has been in negative territory for both corporate and consumer loan products since before the first of the year.

There is little reason—and Powell himself gave no reason—to expect that loan demand will look better in the 3rd quarter when the next Senior Loan Officer Opinion Survey. With consumers and commercial borrowers declining, calling the economy “resilient” is simply absurd.

There was, however, one group that was left out of the Wall Street/FOMC love-fest: currency traders. The anticipation that the Fed is done with the rate hikes was all the forex markets needed to sell off dollars, causing a decline in the dollar index and against most of the major currencies.

Still, while the forex markets are anticipating a weaker dollar without future rate increases, we should be mindful that the dollar index has been slipping for most of the year, with the dollar showing increasing strength really only against the yuan and the yen.

Moreover, since the Pandemic Panic Recession, the dollar has done fairly well against most currencies, with the dollar index itself up over that period, while the dollar has strengthened against the yuan, the yen, and the Indian rupee.

Given China’s ongoing economic decline (if not outright collapse), forex markets are essentially projecting the US economy is going to fare slightly worse than Europe and overall better than China certainly for the remainder of this year.

China's Downward Spiral

What remains to be seen is whether forex markets’ anticipation of dollar weakness in any way reflects a potential for a renewed banking and liquidity crisis, the possibility of which has been raised this week given the revelation that PacWest Bancorp, one of the troubled banks that had been lined up to be the next banking dominor to fall, would be acquired by Banc of California.

JPMorgan Chase & Co (JPM.N) will buy almost $2 billion worth of mortgages to facilitate Banc of California's (BANC.N) purchase of PacWest Bancorp (PACW.O), a source with knowledge of the matter told Reuters.

The investment bank has entered into an agreement to buy $1.8 billion of single-family residential loans at a discount, the source said.

Banc of California and PacWest on Tuesday announced an all-stock merger with a $400 million equity raise from Warburg Pincus and Centerbridge Partners to create a bank with $36 billion in assets.

On the surface, the merger is merely another bit of consolidation among US banks. However, with the possibility of renewed deposit outflows as a result of the federal funds rate hike, the merger may prove to be timely defense against a liquidity shock. Certainly there is significant exposure and vulnerability among the larger banks especially to further dislocations caused by deposit flight.

Big Bank Boom? Or Bust?

Whether PacWest was a case of a bank cashing out before that banking storm broke over them won’t be known unless and until a liqidity crisis resumes. With treasury yields actually declining despite the rate hike, and the corresponding rise in bond ETF prices, the initial reaction to the rate hike works against an immediate resumption of the liquidity crisis. However, with two months before the next rate hike decision, there is ample time for liquidity issues to arise if that is what is going to happen.

Jay Powell and the Fed had something for just about everyone on Wall Street with this latest (and possibly last?) federal funds rate increase. The one thing Powell did not have for anyone was any assurance that the inflation dragon has been tamed without tipping the economy into a deeper recession. In truth there is no assurance to offer.

The narrative of the US avoiding a recession hinges on the service sectors of the economy sustaining sufficient growth to offset the contraction in manufacturing. That’s a problematic presumption, with the ISM Services PMI trending down since January of last year.

While the S&P Global Services PMI has shown strength of late, that strength is fading, and the recent peak was significantly below the 2022 peak, indicating steady weakening in the services sector.

Consequently, services are contributing a diminishing amount to the overall economic outlook, as evidenced by the declining S&P Global Composite PMI.

If manufacturing weakness continues and is joined by services weakness, the US economy will have spiraled into a deep and potentially long-lasting recession—deeper and longer if the current disinflation flips into outright deflation for more than just energy prices.

Powell’s optimism was everything Wall Street wanted to hear, and Wall Street rewarded Powell with an initially rising stock market. However, as has so often been the case with Powell, what he presents as optimism is really just empty hopium. There is no indication that the “gradually slowing” economy will stop slowing while still in nominal growth territory. There is no reason to believe that disinflation will stop at or around 2%, and not slide down into outright deflation, triggering a repeat of the US “lost decade” of the 2010s. That may yet come to pass, but there is no evidentiary basis for projecting that deflation will somehow be avoided.

Powell ultimately chose to hike the federal funds rate while the US economy is sailing into a deepening recession, which is not a “rolling” recession but rather a spreading one, with the service sectors of the economy already showing signs of incipient weakness. If the current trends continue, even by the much-manipulated standards of Wall Street, Powell will soon have the recession sought by his rate hike strategy, but will have no credible plan for stopping the economic contraction now unfolding.

Doing nothing would have been by far the better option.