Fed Easing Will Be Aggressive. What To Watch (July 9, 2024)

A handful of lesser-known indicators suggest monetary policy easing will be more dramatic than markets expect

By Lisa Beilfuss
July 9, 2024

A relatively bold call from Citigroup may be just the start of a rapid rethink around economic conditions and monetary policy.

Citi economists late last week predicted 200 basis points in rate cuts starting in September, with consecutive quarter-point cuts pulling the Fed funds rate down to 3.25%-3.5% by July 2025. The Fed itself forecasts a 3.9% to 4.4% policy rate at the end of 2025.

Citi’s call came before Fed Chairman Jerome Powell said during his semiannual testimony that a “considerable softening in the labor market” had brought the risks between inflation and growth into balance. The comments helped firm up expectations for a September rate cut, with odds now at 70%. But markets may be too focused on the timing of the first cut and underestimating how aggressive the Fed may actually be. The CME’s FedWatch Tool shows traders still place 65% odds on a Fed funds rate at or above 4% by next July.

As readers might expect, we think a soft landing is unlikely and that the true state of the U.S. economy is less rosy than Fed predictions imply. But many investors and policy makers are flying blind as typical recession signals–such as an inverted yield curve–have flopped and as falling survey response rates and substantial downward revisions raise data-quality questions. 

This week Praxis looked for ways to help investors find economic truth. 

It is worth noting that Powell described “considerable softening” in the job market despite still-robust nonfarm payrolls. Strategists debate which of the monthly employment report’s divergent surveys is more accurate–the stronger establishment nonfarm payroll or the weaker household employment survey–but Powell’s characterization suggests emphasis is on the latter. 

There are several signals to heed in the household survey. First, Citi economists warn that the closely-watched Sahm Rule recession indicator will be triggered in August if the unemployment rate continues to rise at its current pace. The rule has had a perfect record since 1970 and tends to trigger several months after the start of a recession.  

Second, long-term unemployment has risen for five consecutive months to the highest since February 2022, when the indicator was still recovering from pandemic lockdowns. What is more, the June jump in those unemployed for 27 weeks and over was the biggest since November 2020; over the past year, the number has risen by 399,000. As one trader notes, long-term unemployment is pernicious because the longer a person is unemployed, the harder it is to find a job. In most states, jobless benefits expire after 26 weeks.

Looking beyond unemployment gives potentially earlier clues. Consider construction. Dwindling construction investment is often a first sign of an economic downshift, and so it makes sense that many economists watch construction payrolls to mark economic turns. It is easy to think there is nothing to worry about: The latest jobs report showed residential building construction payrolls hit a new cycle high, coming in at the highest level since July 2007.

But construction payrolls look vulnerable–even as one construction worker in five is over 55, meaning firms are hanging onto workers longer than they otherwise might. Sales of new single-family homes dropped to a six-month low in May, U.S. construction spending fell in May for the first time in the past 19 months, and the pending home sales index fell for a second straight month to a record low. 

That is as the American Association of Architects’ architectural billings index, which leads nonresidential construction activity by 9 to 12 months, fell in May for the fourth consecutive month. Billings declined at firms in all regions of the country, and a significant drop in design contracts signals softness in the pipeline of new work, the trade group said.  

Now look at tax receipts. As Richard Farr of Pivotous Partners says, daily income tax receipts received by the U.S. Treasury are some of the timeliest data available. Some analysts have pointed to rising tax receipts as evidence that downturn concerns are silly; at the beginning of June, withheld individual income tax collections were up 4% year-to-date.  

Fast forward to the end of June. Farr says tax receipts fell 1.1% in June from a year earlier, and he warns that falling tax receipts coincide with consumer delinquencies. Farr notes that the data are volatile and can reverse quickly. He also acknowledges a 1.1% drop might not seem like a big deal. But when you consider average hourly earnings and consumer prices are respectively up 4.5% and 3.3% year-over-year, it is a notable divergence, he says. 

“How can tax withholdings be down when nominal sales and wages are up? This shouldn’t be possible. It speaks to something breaking,” says Farr. Coincidentally, the New York Fed’s latest household debt and credit report, released in May, showed that overall debt levels increased 1.1% in the first quarter. Delinquencies rose for the third straight quarter, with 9% of credit card balances and 8% of auto loans transitioning into delinquency.

Here is one more. Economist Jim Paulsen created the Walmart Recession Signal, or WRS, on the ideas that recessions are typically felt first and most dramatically by lower-income households, and that slowdowns push consumers toward discounters and away from luxury brands. The WRS compares Walmart’s stock price performance to the S&P Global Luxury Index. A rise in the WRS warns of possible recession. 

Paulsen then compares the WRS with corporate credit spreads. Since 2007, the WRS and corporate credit spreads have closely tracked. But when they have diverged, the WRS has proven correct. He gives two examples, caveating that the indicator’s history isn’t long. When credit spreads widened significantly in 2015-16, implying a recession was near, the WRS didn’t jump. And when tight credit spreads in the second half of 2019 suggested the economy was healthy, the WRS spiked in advance of the 2020 recession. 

The WRS and credit spreads have again diverged since the end of 2023, Paulsen says. Spreads have been tightening all year and remain close to historic lows, suggesting strong balance sheets and a lack of any significant financial pressure. The WRS has meanwhile been rising all year, currently standing at the highest level since the 2020 recession.  

Investors should prepare for deteriorating economic data to prompt Fed easing that may be more  aggressive than many expect. Citi’s call for two percentage points in rate cuts over the next year looks bold–for now. Conventional wisdom is that rate hikes have less bite because more households and businesses are shielded from rising rates. If the corollary is true, quantitative easing may return sooner than later.