Fed Sticks to Script
May 5th, 2023
The Dow Jones Industrial Average rallied 500+ points on Friday on better-than-expected results from tech juggernaut Apple and as regional bank shares climbed off their recent lows. Despite the move, the Dow still came up short for the week, down -1.24%. Friday’s rally failed to make up losses from earlier in the week as renewed regional bank contagion concerns unsettled markets and as the Federal Reserve decided to hike interest rates another 0.25% to a range of 5%-5.25%. This is the bank’s 10th interest rate increase in a little over a year and its highest benchmark range since August 2007. The hike came despite revived concerns over the health of the regional bank sector, where on Monday mega-bank JPMorgan agreed to take over troubled regional lender First Republic. The deal sparked optimism that the worst of the banking crisis has now passed but bears and short-sellers simply shifted their sights on Thursday to California-based PacWest after it announced it is weighing strategic options with several possible partners and investors. The news startled markets given that PacWest had not experienced “out-of-the-ordinary deposit flows.” Higher interest rates have devalued many of the assets held by regional banks, and investors have increasingly adopted a “sell first, ask questions later” attitude in response to any sign of instability, even for banks whose assets and deposits are fundamentally unchanged.
The labor market continued to exhibit resilience against the headwinds faced by the Fed’s rate hikes, inflation, and the banking uncertainty. Friday’s Employment Situation Report showed that businesses added 253K new hires in April, significantly stronger than the previous month’s 165K (revised) and consensus estimates of 178K. Within the report, wage growth accelerated with average hourly earnings rising to 4.4% YOY. This was higher than the 4.3% (revised) YOY growth rate posted last month and higher than the 4.2% consensus estimate. The unemployment rate also declined to 3.4%, below the consensus estimate of 3.5% and tied for the lowest level since 1969. The strength in the situation report mirrors that seen in Wednesday’s ADP payrolls which were higher than expected as private payrolls rose by 296K, above the 142K downwardly revised figure from the previous month. April’s payroll report was double the Dow Jones estimates for 133K. Together, the two reports show that broad based employment gains continue within the economy, anchored by hospitality and leisure (which is still below pre-pandemic levels), but also extending to healthcare, professional, and business services. While the market responded favorably to the report on Friday, it could complicate the picture for the Fed.
Recent signs of a consumer slowdown may be taking shape in retail sales, but businesses themselves continued to see improving operating conditions in April. The ISM Services Index rose 0.7 points to 51.9. Numbers above 50 indicate expansion while numbers below indicate contraction. Growth in the services sector was driven by new orders and supplier deliveries. Meanwhile, the ISM Manufacturing Index rose 0.8 points to 47.1. While that places the sector in contraction territory, new order flow rose 1.4 points in April to 45.7 while production rose 1.1 points to 48.9. Prices for goods still remain an impediment with the price sub-index rising 4 points to 53.2. That said, higher rates and tighter lending conditions have yet to take their toll on business’ outlook with survey respondents believing conditions will continue to improve as the year progresses.
As expected, the Fed stuck to its messaging this week by hiking 25 bps, while also signaling a potential end to the tightening cycle. This is the prudent course given the ongoing regional banking chaos and the fact that the data itself is – on balance – trending favorably towards the Fed’s targets. This shift in posture may come as welcome news by markets, but it would not be without precedent for additional hikes to follow in the future. In May of 2006, the Fed increased rates by 0.25% and adopted nearly identical language to that which the Fed has just adopted. In 2006, they said “The extent and timing of any such firming will depend importantly on the evolution of the economic outlook.” Wednesday’s release stated, “In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook.” Oh, it must be nice to be an FOMC copywriter who can simply recycle 17-year-old material. The funny thing is that while both these statements were issued to signal the Fed’s inclination to pause, the statements stress just as equally that the Fed remains data dependent. In the case of 2006, the economy and rising inflation unexpectedly accelerated during the first quarter of that year, worrying some Fed members that enough momentum remained in the economy that it should remain vigilant on inflation. This resulted in the Fed raising rates by an additional 0.25% in late June of 2006. June’s hike was ultimately the last of that cycle, but importantly the Fed then held rates at that terminal level (5.25% – same as today) through August of 2007. Whether Wednesday’s hike is the last of this cycle or whether the Fed has one more left, it probably only matters for academic purposes. It is the fact that the market anticipates the Fed will start cutting rates somewhere around year end that is likely more problematic. Inflation averaged 3.26% in 2006 and GDP growth was 2.78%, and yet the Fed held rates steady for over a year. Today, inflation is 5.0%-5.6% (headline and core), but GDP growth has slowed to 1.1%. The market is clearly betting that the deceleration in GDP will pull inflation down, but the indications from the ISM, PMI, consumer sentiment, hiring, and even equity analyst forecasts are for an improving economy in the second half of the year. In the meantime, markets were clearly elated by the “pause” contained in this week’s Fed statement, but investors would be wise to remember that when it comes to future rate hikes – nothing is written in stone.
The Week Ahead
Next week, we will be watching inflation with upcoming consumer and producer price reports.
Happy Cinco de Mayo
Today is Cinco de Mayo which means fifth of May in Spanish. It is a holiday that celebrates the Mexican army’s unlikely victory over powerful French forces at the Battle of Puebla on May 5, 1862. It is commonly believed that Cinco de Mayo is a celebration of Mexican Independence Day. However, Mexican independence was declared more than 50 years prior to the Battle of Puebla. Independence Day in Mexico celebrates the beginning of the Mexican War of Independence in 1810 that led to the end of 300 years of Spanish colonial rule in Mexico. The holiday is commemorated each year on September 16th.
From 1858 to 1861, Mexico experienced a civil war called La Reforma, or the War of Reform, that left the country in financial ruins. The war was fought between liberals and conservatives over promulgation of the country’s constitution. By 1862, Mexico had virtually no money in its treasury and owed tens of millions of dollars to foreign debtors.
The Mexican government suspended payments on the debt it owed to Britain, Spain, and France. In response, those countries sent naval forces to the port city of Veracruz, Mexico to demand repayment. Britain and Spain negotiated with Mexico and withdrew. However, Charles Louis Napoleon Bonaparte (Napoleon III), who was the emperor of France at the time and also the nephew of Napoleon I, saw an opportunity to carve out a French empire in Mexican territory and ordered 6,000 well-armed troops to proceed towards the capital, Mexico City.
The city of Puebla, 100 miles southeast of Mexico City, was along the route taken by the French. The French military had not lost a battle since Waterloo five decades before and was considered one of the best in the world. The Battle of Puebla lasted from daybreak through evening. After nearly 500 French soldiers had died and less than 100 (out of 2,000) Mexican troops had been lost, the French withdrew their army and retreated.
The Mexican triumph over a larger and much better equipped French army became a symbolic victory for the people of Mexico. The battle did not end the war, however, and the French later returned to Puebla with 30,000 troops and took the small town before capturing Mexico City. The French installed Maximilian of Habsburg, Archduke of Austria, as Emperor of Mexico, but the French occupation of Mexico was short lived. It ended in after just three years in 1867 under strong Mexican resistance and pressure from the U.S. that the French presence in Mexico violated the Monroe Doctrine. The Monroe Doctrine was crafted under President James Monroe in 1823 and declared that the U.S. would stay out of European affairs if Europe stayed out of North and South America. Additionally, the doctrine stated that any attempt by a European power to oppress or control any nation in the Western Hemisphere would be viewed as an act of aggression against the U.S. Napolean III ordered the withdrawal of French troops from Mexico. Maximilian was captured by Mexican forces and executed.
The Cinco de Mayo holiday has become more popular in the U.S. than in Mexico. Since the 1800s, the holiday has evolved into a widespread celebration of Mexican patriotism, history, heritage, food, and culture for Mexican Americans and others across the country who celebrate the holiday.