The Silver Lining In a Rate-Cut Disappointment (December 11, 2023)

March is probably too soon to expect a rate cut. But economic cracks beneath the headlines suggest more intervention will be needed the longer the Fed pauses. 

Investors betting on March interest-rate cuts are probably on track for disappointment. It may be to their benefit.

Some recent pain points ebbed in the November employment report’s household survey: The historic gap in employment indicated by households versus businesses narrowed as household employment grew the most since January. Multiple job holders fell by 15,000 from October, when the metric was near record highs. And after rising to 3.9% and sparking concerns that the Sahm Rule was about to signal recession, the unemployment rate slipped to 3.7%.   

As David Rosenberg of Rosenberg Research summed it up, “the household survey really stole the show. The message is that the labor market tightened in November.” The bottom line, at least as far as the latest jobs report goes: The Federal Reserve will “think twice about cutting rates as early as the first quarter of next year,” Rosenberg says.

But there are at least two reasons to bet that the risk assets will rise in the coming months.

First, a deeper look at the latest employment data reveals an ongoing slowdown, with weakness in the most economically sensitive areas of the economy.  Second, the longer it takes for the Fed to cut rates, the more government intervention will be required.  

On the first point. Rosenberg argues that the establishment side of the November jobs report–where a 199,000 gain in nonfarm payrolls was the main takeaway–has less verve than headlines suggest. Consider downward revisions of 35,000 to the prior two months, a 49,000 increase in government jobs, a 99,000 rise in education and health-related jobs, and some 30,000 returning auto strikers.

Government, healthcare and education jobs “tell you nothing about the economy,” Rosenberg says, so he strips them out. He then adjusts for the last two months’ downward revisions, accounts for the returning UAW workers, and replaces the 40,000 surge in leisure and hospitality jobs with the 7,000 decline reported by payroll provider ADP.  

“It’s as if the payroll report showed a 61,000 decline,” he concludes, “which definitely is more in keeping with what business contacts were telling the Fed in the most recent Beige Book.” 

Whether or not one appreciates Rosenberg’s engineering, the bigger point is that the more cyclical parts of the economy look weak. Heading into the holiday season, retailers shed more than 38,000 jobs as transportation and warehousing employment fell 5,000. Banks cut 3,300 employees in November to mark the fifth straight month of shrinking payrolls. Temp agency employment–one of the few leading indicators in the monthly jobs report– fell by about 14,000 and has been flat or down for 10 consecutive months. 

Stephen Miran, co-founder of investment manager Amberwave Partners, says the job-market slowdown has momentum. He points to the Labor Markets Conditions Index, produced by the Kansas City Fed, which has been weakening all year. But while markets have interpreted labor-market cooling as indicative of normalization and a soft landing, Miran questions the logic. “Why [would] a weakening labor market just stop weakening?” 

That question is particularly important given that the labor-market slowdown is happening as inflation still looks stubborn. Deutsche Bank economists say their own monthly median inflation estimate rose 12 basis points in the latest month, to 3.6%. The November jobs report showed average hourly earnings rose 0.4% from a month earlier, the fastest pace since July. Wages rose 4% from a year earlier, matching the prior month’s increase. Fed Chairman Jerome Powell has suggested that wage inflation would need to slow to 3% for the Fed to achieve its 2% inflation target. 

As Miran puts it, the slowdown in the labor market “will require a pretty big shock to turn around.  The slowdown in inflation is brittle and will require only a small shock to turn around.”

Put it all together and it seems reasonable to suspect that while March may be too soon to cut rates because of inflation, economic conditions are nonetheless deteriorating. Therein lies a second reason why risk assets may continue to gain even if markets are overly optimistic about the timing of rate cuts. The longer the Fed pauses, the amount of fiscal and monetary intervention inevitably required will grow.  

There are signs already of fiscal support. This week’s Treasury sales are on track to surpass the record set in 2020. Joseph Wang calls fiscal deficit spending “the other printer,” because such spending creates a Treasury security that increases the purchasing power of the private sector. 

He explains it like this. When an investor buys a Treasury, the cash goes to the government to spend and ends up back in a private-sector account. Despite holding less cash, the investor can easily monetize the Treasury security by selling it in the Treasury cash market or borrowing against it in the Treasury repo market.  

Meanwhile, the Biden administration announced another $4.8 billion in student debt cancellation for 80,300 people, with student-debt forgiveness now totaling $132 billion and affecting roughly 3.6 million borrowers. That is alongside bipartisan legislation to promote homeownership for about 500,000 households via a new federal tax credit. Lael Brainard, director of the White House's National Economic Council and former Fed governor, suggested the administration may not wait for Congress to act to offer down-payment assistance and expand rental assistance to hundreds of thousands of people.

Then there is the Fed's Bank Term Funding Program, or BTFP, launched in the wake of March 2023 bank failures. The emergency program, which offers loans for up to a year to banks and other eligible institutions, has more than doubled from mid-March and sits at $121.7 billion. 

The BTFP seems all but guaranteed to be extended beyond its March 2024 expiration date. Analysts have debated whether it amounts to a form of quantitative easing. While the Fed isn't directly buying securities off banks' balance sheets, it is creating bank reserves. And because there aren't restrictions around the use of emergency funds, it can't be assumed that none of the new money flows out of bank reserves and into the real economy.

More important than the semantics around the BTFP is the idea that the Fed will revive old emergency programs and create new ones as trouble spots emerge, says one bank adviser and former regulator. “They will do whatever it takes,” he said, whether or not the Fed is concurrently cutting rates.

Investors may soon find they have gotten ahead of themselves about the timing of rate cuts. But there is a silver lining of sorts, with under-acknowledged economic cracks setting up the need for a stimulus wave that may benefit risk assets more than rate cuts themselves.