The Federal Reserve has signaled that it will forgo an interest-rate increase at its policy meeting later this month. That ironically may reflect the financial impact of the debt-ceiling deal more than the latest economic indicators, notably May’s employment data released on Friday.
The effect of the end of the federal debt-ceiling impasse could be equivalent to another 25-basis-point (one-quarter percentage point) increase in the key federal-funds policy rate, currently 5% to 5.25%, according to some estimates. Even so, the monetary authorities are likely to disabuse notions that no further rate hikes are coming as long as unemployment remains historically low and, most important, inflation continues to run far above the Fed’s 2% target.
For equity investors, it’s bad news. Excess liquidity injected into the financial system—the result of the Treasury running down its cash balance since early this year, when it first hit the former debt ceiling—has helped provide fuel for the rally in technology stocks by investors giddy about the potential for artificial intelligence.
With Congress’ approval of a deal that suspends the debt ceiling through 2025, this liquidity flow is about to be reversed. The Treasury will ramp up sales of short-term bills to rebuild its cash balances, which drains liquidity. Good for income investors, less so for those chasing AI stocks.
As for economic data, the May jobs report on the surface was a positive blowout. Nonfarm payrolls surged by a seasonally adjusted 339,000 last month, vastly exceeding economists’ guesses of a still-solid 195,000 increase. Revisions in the preceding two months added 93,000 on top of that.
Once again, however, the so-called birth-death adjustment (for net business formations assumed by the Bureau of Labor Statistics) accounted for a substantial portion of the unadjusted rise in private payrolls, some 26% in the latest month after the 44% boost in April’s increase, according to Joshua Shapiro, chief U.S. economist at MFR. Over time, the birth-death adjustment is reasonably accurate, but it can cause distortions in months where its impact is large, he adds in a client note.
In contrast to the payroll numbers, the separate survey of households showed a surprise rise in the jobless rate, to 3.7% last month, compared with economists’ estimate of 3.5% and April’s 3.4%. Other apparent signs of softening of the labor market included a 0.3% dip in the average workweek and an easing of average hourly earnings gains to 4.3% from a year ago.
Combining those last two factors, labor income grew at a 4.2% annualized rate in the latest three months, “which is OK when core inflation is running at 2%, but not OK when it is running at 4%,” writes Michael Feroli, chief U.S. economist at J.P. Morgan, in a client note. That neatly sums up the squeeze on middle- and lower-income consumers evident in recent earnings reports and guidance from retailers such as
Macy’s
(ticker: M).
The Fed’s preferred core inflation rate, which excludes food and energy costs, is now 4.7% in the latest 12 months, above its optimistic projections of an annualized 3.6% by the end of 2023 and 2.6% a year later, let alone its putative target of 2%. That means continued restraint, even though central bank officials indicate they plan to forgo a rate hike at the June 13-14 meeting of the Federal Open Market Committee. This past week, Fed governor Philip Jefferson, who has been nominated as vice chair of the Fed Board, proposed holding rates steady at the coming confab to assess the lagged effects of past tightening, while not ruling out future hikes.
Instead, the tightening of financial conditions will largely be effected by the replenishment of the Treasury’s coffers, plus the shrinkage of the Fed’s balance sheet (so-called quantitative tightening). The impact of the reduction of the central bank’s holdings of Treasury and agency mortgage-backed securities was blunted in part by the Fed’s assistance in the wake of the failure of regional lenders such as Silicon Valley Bank and First Republic.
The Treasury’s cash management will flip from adding the equivalent of 3% of nominal gross domestic product over the past five months to financial markets to draining the equivalent of nearly 10% in the next three months, according to TS Lombard Chief U.S. Economist Steven Blitz.
“This type of liquidity event always impacts equities,” Blitz writes in a client note. Changes in the Fed’s balance sheet, the Treasury’s cash balances, bank reserves, and other factors have dovetailed well with the year-over-year changes in the
S&P 500
index. “Liquidity has improved since the end of 2022, and the equity market has responded in kind (regardless that the performance has been skewed to a few tech stocks),” he adds. His model suggests a reduction of his liquidity gauge back to where it stood five months ago, so a stock market reversal should follow, although, he adds, the relationship may not be one-to-one.
Fed-funds futures on Friday put a 70% probability of no rate change at this month’s FOMC meeting, in contrast to projecting a 64% chance of a 25-basis-point hike a week earlier, according to the CME FedWatch site. Clearly something has changed.
Jefferson’s speech suggesting the Fed would probably stand pat came ahead of the surprising (but ambiguous) May jobs report. It also preceded the key consumer price data slated for release on June 13, just as the FOMC sits down for its confab. What the monetary authorities do know for sure is that the Treasury will be draining significant liquidity in coming weeks, which will do some of their tightening job. What will matter is their message beyond that.
Write to Randall W. Forsyth at [email protected]
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