As the Federal Reserve maneuvers through post-pandemic economic recovery, its mission is to achieve what's known in financial circles as a "soft landing." This balancing act aims to decelerate inflation without halting economic growth or triggering a recession, akin to a skilled pilot aiming to touch down gently, avoiding the jolts of a turbulent descent.
To engineer this, the Fed adjusts interest rates and the money supply to ease the economy's velocity just enough to temper inflation but not so much as to stifle the market and employment.
The October payroll report provided a mixed bag for economic observers. With only 150,000 new jobs added - below the 180,000 expected and a significant drop from September's 297,000, the employment situation indicates a cooling economy. The unemployment rate's uptick to 3.9%, crossing the Federal Reserve's 3.8% target, further suggests a weakening labor market.
Simultaneously, wage growth has tempered to 0.2% month-over-month, indicating a decreasing inflationary pressure on wages. However, despite this deceleration, the 4.1% annual increase remains on the higher end, signaling persistent underlying inflation.
Interpreting the Bond Market’s Response
The bond market's reaction to the payroll report was immediate and telling. Two-year Treasury Note futures jumped, and yields fell sharply from 2% to 1.87%, suggesting that investors anticipate the end of the Fed's rate hikes and foresee rate cuts beginning in mid-2024. The yield on the 10-year Treasury Bond also dropped, with a decline in real yields as indicated by the 10-year TIPS.
These movements reflect the bond market's expectation of a slowing economy, with the Fed easing rates in response and a rising demand for Treasuries as a safe-haven asset amid economic uncertainty.
Is the Soft Landing a Precursor to a Hard Landing?
While current indicators may paint a picture of a soft landing, history teaches us that such a phase can precede a hard landing or recession. The key question is timing. When will we see a shift from job creation to job losses, a hallmark of a recessionary phase?
Crude oil prices' failure to rally on the payroll report, despite geopolitical tensions, hints at the market's fears of a broader economic downturn. This, coupled with the depletion of pandemic-induced consumer savings and a slowing job market, could significantly dampen consumer spending, a primary engine of economic growth.
The Ominous Shadow of the Yield Curve
An inverted yield curve, which has persisted for a year, has historically been a reliable harbinger of recession, usually manifesting within 12 months post-inversion. This condition can constrict business credit, lead to job losses, and precipitate credit events, especially in over-leveraged firms, all classic recession triggers.
S&P 500 Reaction and Future Prospects
Despite the economic headwinds, the S&P 500 has shown resilience, bouncing back from a recent 10% correction. Supportive global monetary policies and positive Treasury refunding outcomes have bolstered bond prices, which, combined with the soft landing signals, have provided the impetus for the rebound.
For the S&P 500 to maintain this momentum, it must overcome key technical resistance levels, potentially positioning it to revisit yearly highs. The market's reaction to forthcoming economic data will be crucial in determining whether the soft landing gives way to a steeper decline or if the feared recession can be staved off.
Inflation Baked into Prices
Inflation, while reportedly slowing, has not reversed into deflation. Prices have plateaued at best. The cost of living continues to outpace wage growth, eroding real income and purchasing power.
For instance, furniture that has risen in price during the inflationary surge will unlikely return to pre-inflation costs, leaving consumers perpetually catching up. The recent Census Bureau data underscores this, indicating a tangible decline in median household income when adjusted for inflation. Even with modest improvements in wage growth, the financial strain for many is unlikely to ease swiftly, leaving the prospect of a "soft landing" out of reach for those already struggling.
Undoing the Fed’s Damage
Normalizing interest rates, intended to combat inflation, may cool down housing prices. However, this normalization brings its own set of repercussions. Those who secured low-rate mortgages during the days of cheap money are unlikely to sell in a higher interest rate environment, leading to a potential stagnation in the housing market. Furthermore, the ripple effects on employment mobility cannot be overstressed, as relocating for job opportunities incurs a prohibitive financial burden under the new rate regime.
No Quick Fixes
The path to a balanced and healthy economy, purged of artificially inflated market conditions, is not a short one. The "normalization" process will carry significant hardships for American families, who are still reeling from the recent economic volatility. The adjustments necessary to rectify the prolonged period of low interest rates and high liquidity involve tough choices and, possibly, severe consequences, such as a recession or financial downturn.
The Federal Reserve's efforts to mitigate these issues may avoid a catastrophic economic downturn, but this should not be misconstrued as a victory. The analogy of an arsonist putting out the flames of a fire he started resonates here. The long-term goal is stability and equitable growth, but the journey there is fraught with complexity and, for many Americans, ongoing financial pain. As such, the concept of a "soft landing" remains, for the time being, an elusive ideal rather than an attainable reality.
Strategic Considerations for Investors
Given this complex backdrop, what is the prudent course for investors? The potential for a year-end rally might entice traders, but long-term investors should approach cautiously. With a recession looming and attractive yields on 12-month Treasuries, a conservative stance is likely warranted.
Moreover, several risks could upend the current rally. Geopolitical upheavals affecting oil prices, inflation, bond market supply-demand dynamics, and the looming threat of a U.S. government shutdown on November 17th are all factors that could dramatically alter market trajectories.
While the data may suggest a soft landing for the U.S. economy, the historical precedent, coupled with current market risks, points to the likelihood of this being a precursor to a more challenging economic period. Investors would do well to stay informed, remain cautious, and prepare for the potential of more turbulent times ahead.