The current narrative in the mkt is that growth gently slows & pulls inflation back to trend such that the Fed is allowed, nay compelled, to cut rates by 25 bps a couple times by the end of the year

Economies historically have not moved so predictably. This is also difficult in light of the credit tightening that we discussed yesterday. Jay Powell referenced this at his presser in May too

“These tighter credit conditions are likely to weigh on economic activity, hiring and inflation,” Powell said. “The extent of these effects remains uncertain.”

When he says uncertain, he means the effects will be bad, he just doesn't know how bad. In spite of 100s of PhDs on staff, it seems it is not something the Fed, the regulator of banks, has looked into

“We have a broad understanding of monetary policy. Credit tightening is a different thing,” he said. “There is a lot of literature on that, but translating it into rate hikes is uncertain.”

So we, & by we I mean they, are flying blind. Well the chart today hopes to cast some perspective on what we are seeing. The purple line is the tightening of credit conditions (inverted here). The white line is the NFIB small biz optimism index that came out yesterday

You can see both are plumbing new depths. This is expected to pull GDP in blue lower with it, which in turn will pull inflation in white lower too. Looking over the last 30 yrs or so, this pattern has generally seemed to work at least directionally.

From a magnitude perspective it is a little more difficult. The amount of tightening & small biz negativity is not as bad (nor as brief) as Covid & not as severe (yet) as the Fincl Crisis. However it is worse than all other periods

We shouldn't expect rate cuts from the Fed yet because inflation isn't close to target. Powell said this: “Demand will have to weaken a little bit, & labor market conditions will have to soften a bit more to begin to see progress there.”

So we should expect more downside in these metrics as the FOMC myopically focuses on pulling the orange line lower. The other line we haven't spoken about yet, in yellow, is Russell 2000 earnings

Earnings are also impacted. Inflation helps at first as revenues are nominal & margins are not squeezed. As we have seen each of the last 3 qtrs, margins have been squeezed & nominal revenue is slowing

We should expect lower earnings per share which means lower stock prices. The economy drives earnings & earnings drive stocks. This is where we are headed unless GDP stops above 0%, CPI stops right at 2%, & the Fed decides to also cut rates. You know, a soft landing

“It’s possible that we can continue to have a cooling in the labor market without having the big increases in unemployment that have gone with many prior episodes,” he said. “And that would be against history. I fully appreciate that would be against the pattern.”

Against pattern indeed

Stay Vigilant

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