Headwinds are on the economic horizon, fueled by uncontrolled inflation, rapidly rising interest rates, a housing market correction, and signs of emerging labor market weakness.
CPI is up 8.2% year over year as of September. While the headline reading is not the worst this year, the underlying numbers paint a bleaker picture: core inflation is up 6.6%, the highest since 1982, and food prices are up more than 11% year-over-year. Inflationary pressures are likely to continue, meaning the Fed is likely to keep its foot on the gas with respect to interest rates.
Interest rates continue to rise as the Fed is aggressively moving to combat inflation. The two-year Treasury yield increased by 130 basis points (bp) in the most recent quarter to 4.22%, the highest level since 2007. The ten-year yield increased 85bp to 3.83% quarter-to-quarter and has traded near the 4.00% level, the highest since 2010. Currently, the yield curve is inverted (2s to 10s) by nearly 40bp, a further signal of recessionary conditions.
The FOMC’s last three rate hikes were 75bp each, the most aggressive course of tightening since the Volcker era, and the target range has increased 300bp since March. Fed funds futures have priced in a more than a 60% likelihood of an additional 150bp or more of rate hikes by the end of the year, with the consensus Fed funds target above 4.50% by the end of 2022. Recent comments by Fed officials indicate that tightening will continue, and Fed funds futures probabilities for 2023 are consistent with that outlook.
The widespread housing bubble that persisted in the U.S. for 20 months has ended, cut off by sharply rising mortgage rates and higher prices that have impeded affordability for many buyers. The average 30-year fixed mortgage rate is now approaching 7.00% for the first time since 2002, having more than doubled in the last year.
All 20 markets in the S&P/Case-Shiller Composite Index posted consecutive monthly gains from August 2020 through April 2022 – a record – but 13 markets posted declines in June, the most since March 2019. The FHFA index increased in Q2 for most markets, but weakness in June was likely masked by April and May data that was included in the quarterly number. The Q3 release is expected to show declines. Mortgage rates in June averaged less than 5.50%, thus as rates continue to rise, we expect the price declines to accelerate and become more widespread.
Auto sales remain muted on supply chain disruptions and record-high prices. Sales in September were nearly flat at an annualized rate of 13.5 million units, and were little changed since June. Used car demand has fallen off, as the Manheim Used Vehicle Value Index, which had soared to a new record of 236.3 in January (1995=100), retreated to 204.5 in September, the lowest reading in a year, but still above the norm.
Unemployment reached 3.5% in September, matching the pre-pandemic low. Nonfarm payrolls have finally recovered all of the jobs eliminated when the economy was closed in response to the pandemic, but that still doesn’t account for growth, which would have added roughly four million jobs over the last two and a half years. This explains the gap between current job openings and the trend level of openings in 2019. To reach equilibrium will require either another year of above-trend payroll growth, or a recession to bring down the level of job openings. The latter appears more likely; layoff announcements have accelerated, and job openings have declined by about two million since March.
GDP contracted in the first two quarters of 2022, by 1.6% and 0.6%, respectively, meeting the traditional definition of a recession. While some data indicates that the economy may not be in recession, debate on the topic is more political than academic. Current labor market strength is still a function of recovery from the forced shutdown of the economy in response to the pandemic, and previously strong consumer activity is fading rapidly in the face of higher prices, with consumer sentiment at recessionary levels. Government spending is unlikely to fill the gap given the impact it has already had in fueling inflation, and the Fed can ill afford to shift to accommodation until inflation is under control.