Source: Sahm, Claudia, Real-time Sahm Rule Recession Indicator [SAHMREALTIME], retrieved from FRED, Federal Reserve Bank of St. Louis, July 31, 2024.

The chart above shows the uncanny consistency of the Sahm Rule. Since 1960, the Sahm Rule has had just one false positive (in 2003) and no false negatives. Thus, the persistent and consistent upward trend in the Sahm Rule since October, 2021 all but locks in a recession signal in the coming months.

Powell Downplays Sahm

The question hung in the air for what felt like an comfortable several minutes while Fed Chair Jerome Powell flipped through his notes: “how worried are you about unemployment rising to the point where it triggers the Sahm Rule, and would that potentially affect how quickly you cut rates?” For a while there, I thought the question caught Fed Chair Jerome Powell by surprise. After he stopped flipping his through his notes he responded by first reassuring everyone he is familiar with the Sahm rule. He even explained the implication of the rule – that a severe downturn in employment is imminent. He also clarified that the Sahm Rule is not really a rule with predictive power, it is a “statistical regularity.” In other words, past performance does not guarantee future results. Powell concluded his response by insisting that the labor market is normalizing and remains healthy. He also reminded everyone that a lot of “received [economic] wisdom” has not worked in this post pandemic business cycle, like the predictions of recession based on the inverted yield curve.

What is the Sahm Rule?

The definition of the Sahm Rule is buried in a policy proposal from economist Claudia Sahm. Sahm sought to create an automatic rule for initiating economic relief payments to take the edge off a recession.

“Automatic lump-sum stimulus payments would be made to individuals when the three-month average national unemployment rate rises by at least 0.50 percentage points relative to its low in the previous 12 months.”

The graph provided by the St Louis Federal Reserve calculates the percentage points used in that rule. Clearly, this rule looks like a very good harbinger of recession.

What are the implications of the Sahm Rule?

While history may only rhyme, I strongly suspect the buzz about the Sahm rule will produce a drum beat synchronous with history’s rhyme. The irony is that, for now anyway, Wall Street will welcome increasing fears of a recession as those worries will act like co-signers to a September rate cut. The predicted near certainty of a rate cut initiated a dramatic market rotation favoring a whole host of rate sensitive sectors over growth, big cap tech stocks. That rotation looked ready to take its next logical step as the iShares Russell 2000 ETF (IWM) surged to a new 2-year high. However, the ETF of small caps faded back to a 0.6% gain and failed to confirm the invalidation of a prior blow-off top. Still, I remain patiently bullish on IWM (a short-term IWM calendar call spread hit my initial profit target as IWM surged intraday).

And then there are bond yields. Lower yields should correlate with an intensifying recession obsession. For now, I am sticking to the presumed trading range on iShares 20+ Year Treasury Bond ETF (TLT). TLT closed right at the top of that range. If TLT breaks out, I will draw a new presumed trading range; I still think ballooning U.S. debt levels and persistently strong economic data provide catalysts for downward pressure on TLT. I bought a fresh round of TLT put options near the close on the assumption TLT will have at least one more fade back to some support level.

The latest recession obsession in the form of the Sahm Rule is sure to produce additional trading opportunities…and surprises to come. At a minimum, the Sahm Rule provides dominant context for each month’s latest job report. Next up – this coming Friday.

Be careful out there!

Full disclosure: long IWM shares and calls, long TLT put

The post The New Recession Obsession: The Sahm Rule appeared first on Inflation Watch.

Valetta declared “recent data suggest that inflation may have peaked.” The latest inflation projection shows a gradual decline toward the Fed’s 2% average goal around 2025 or 2026. Valetta cautions that “repeated upside surprises” to inflation mean that “the risks to this forecast [are] weighted to the upside.” In other words, we should expect the Federal Reserve to keep its interest rate higher for longer in order to ensure inflation’s glide path stays pointed downward. The graph below shows the recent peak and successive higher forecasts for inflation since March.

After on-going upside revisions, PCE core price inflation is now expected to approach the 2% target somewhere around 2025. (Source: Federal Reserve Bank of San Francisco)

The cost of peaking inflation is slower growth. Valetta expects “growth to remain well below trend this year and next year before converging back to trend in 2025.” Conveniently, that return to trend occurs just as inflation returns to the Fed’s target. Most importantly, Valetta points to a mere one percentage point increase in unemployment “through 2024.” This expectation means that the onset of a recession next year will create a mild economic slowdown. Today’s unemployment rate is still near the historic low of 3.5%. Unemployment below 5% is surprisingly low for a recessionary environment. The high job vacancy rate softens the economic blow of slowing growth as there is plenty of room to cool off labor demand without disrupting the labor market.

Valetta acknowledged that the inversion of the yield curve suggests that odds are high for a recession: “such yield curve inversions have proven historically to be reliable predictors of recessions over the subsequent 12 months. After some divergence earlier this year, two leading measures of the yield spread have now both become inverted.” However, Valetta does not want readers to decide that a recession is a foregone conclusion: “their predictions come with substantial statistical uncertainty, however, and are not definitive indications that a recession is looming.”

Inverted yield curves have preceded recessions since the late 1980s. (Source: Federal Reserve Bank of San Francisco)

The Fed’s success in fighting inflation has come from a “proxy funds rate” that is much higher than the effective funds rate. According to the SF Fed, “this measure uses public and private borrowing rates and spreads to infer the broader stance of monetary policy.” The gap between the proxy and effective rate is higher than ever. No wonder Fed Chair Jerome Powell can so comfortably reiterate that the Fed can now slow the pace of rate hikes.

With peak inflation finally here, traders and investors should focus on how long the Fed intends to keep a restrictive stance on monetary policy. Given the extended period over which the Fed expects above target inflation, monetary policy should remain restrictive for longer than the market currently expects. In turn, the implication for the stock market of restrictive policy and below trend growth means valuations must come down further and cap upside in market returns for 2023 and perhaps 2024. Time will tell of course.

The S&P 500 (SPY) is out of bear market territory and now trying to fight its way through restrictive monetary policy.

Be careful out there!

The post The Fed Plants A Flag On Peak Inflation and An Economic Soft Landing appeared first on Inflation Watch.

Pandemic-era inflation pressures were not transitory after all. The inflation watchers I follow never believed the narrative given the Fed’s insistence on maintaining historically accommodative policy well past its expiration date. Indeed, the transitory in the economy turned out to be the deflationary psychology of Federal Reserve Chair Jerome Powell.

The journey has been quite a ride for Fed-speak. In July 2020, Powell reassured an economy in lockdown shock that the Fed is “not thinking about thinking about raising rates.” When murmurs and then gripes about creeping inflation emerged in early 2021, Powell insisted inflation pressures would be transitory. In late April of that year, Powell explained the theory at that time behind transitory inflation. Transitory stretched out longer and longer and longer, until finally in December, 2021 testimony Powell essentially asked everyone to leave him alone about the unfortunate and untimely phrase. Now, with inflationary pressures worsening, Powell has found inflationista fervor. Powell even declared that the Fed is ready to take rates higher than the neutral rate. The mad scramble has begun; the Fed wants to get a raging fire under control.

A Pivotal Speech

Today, March 21, 2022, Powell gave what I think is the pivotal speech of his career as Fed chair. With the appropriately ominous title “Restoring Price Stability“, Powell started with this proclamation to the 38th Annual Economic Policy Conference National Association for Business Economics assembled in Washington, D.C. (emphasis mine):

“…the current picture is plain to see: The labor market is very strong, and inflation is much too high. My colleagues and I are acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials like food, housing, and transportation. There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level, and then to move to more restrictive levels if that is what is required to restore price stability. We are committed to restoring price stability while preserving a strong labor market.”

For the folks who might still be in transitory thinking, Powell went on to clarify “…the inflation outlook had deteriorated significantly this year even before Russia’s invasion of Ukraine.”

In racing against the wildfire, Powell and the Fed have an ambitious goal. They want to avoid a recession by tapping the brakes on excessive demand in the economy just enough to gently match limited supply. The strong labor market is both a blessing and a curse in this effort. Powell did not use the term “wage-price spiral” inflation spiral”, but he essentially described such a potential dynamic for today’s economy. Companies are struggling to hire. Employees are shifting into new jobs to gain higher wages.

“There are far more job openings going unfilled today than before the pandemic, despite today’s unemployment rate being higher. Indeed, there are a record 1.7 posted job openings for each person who is looking for work. Record numbers of people are quitting jobs each month, typically to take another job with higher pay. And nominal wages are rising at the fastest pace in decades, with the gains strongest for those at the lower end of the wage distribution and among production and nonsupervisory workers”

Powell summarized: “Overall, the labor market is strong but showing a clear imbalance of supply and demand.” Thus, the Fed feels compelled to “moderate demand growth.” In the process the Fed hopes that the labor market’s very strength will withstand a period of aggressive monetary tightening.

Powell explained that the big surprise came from the stubborn persistence of “supply-side frictions.” The economy cannot handle the rapacious demand in today’s economy without sending prices ever higher. In turn, spiraling inflation threatens to erode wage gains especially for lower-income workers.

No Time to Wait Anymore

Interestingly, Powell provided automobile prices as a good example of the inflation problem. There was a time when commentators insisted soaring car prices would be transitory. Auto prices are now transitory complete. Powell lamented “production remains below pre-pandemic levels, and an expected sharp decline in prices has been repeatedly postponed.” Prices for new cars soared almost all of last year and suddenly look ready to take off again. Used car prices soared even more and could lift again if new car prices rev up again. Regardless, no “base effects” here as worker’s wage gains look sure to come under more pressure.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: New Vehicles in U.S. City Average [CUSR0000SETA01], retrieved from FRED, Federal Reserve Bank of St. Louis, March 21, 2022.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: Used Cars and Trucks in U.S. City Average [CUSR0000SETA02], retrieved from FRED, Federal Reserve Bank of St. Louis, March 21, 2022.

These mounting pressures have forced the Fed’s hand. The Fed senses it has no time to wait anymore. The Fed is no longer content to wait for the conventional expectations of normalization to bear fruit. In an inflation emergency the Fed needs to act now… (emphasis mine).

“It continues to seem likely that hoped-for supply-side healing will come over time as the world ultimately settles into some new normal, but the timing and scope of that relief are highly uncertain. In the meantime, as we set policy, we will be looking to actual progress on these issues and not assuming significant near-term supply-side relief.”

Inflation is so strong now that Powell has to look out 3 years to envision inflation returning to the Fed’s target of 2%: “I believe that these policy actions and those to come will help bring inflation down near 2 percent over the next 3 years.”

Recession? What Recession?

No Federal Reserve has ever predicted a recession. The central agent trying to command the economy has a vested interest in projecting utmost confidence in its navigation abilities. Accordingly, Powell looked to history as proof that the Fed can pull off the spectacle of the soft landing for the economy:

“I believe that the historical record provides some grounds for optimism: Soft, or at least soft-ish, landings have been relatively common in U.S. monetary history. In three episodes—in 1965, 1984, and 1994—the Fed raised the federal funds rate significantly in response to perceived overheating without precipitating a recession…In other cases, recessions chronologically followed the conclusion of a tightening cycle, but the recessions were not apparently due to excessive tightening of monetary policy. For example, the tightening from 2015 to 2019 was followed by the pandemic-induced recession.”

The Fed is also encouraged by an economy “well positioned to handle tighter monetary policy.”

Powell formerly insisted the Fed would hold rates lower for longer in order to achieve an exceptionally low unemployment rate. The current path flips to the opposite direction. The Fed is willing to go right past the point of neutral rates to get the fire under control: “if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well.”

Transitory complete. Bring on the inflation hawks.

Be careful out there!

The post Transitory Complete: Fed Chair Jay Powell Gets Comfortable With the Inflation Hawks appeared first on Inflation Watch.