Economic downturn lingers as data gives final signal for another Fed rate hike
Summary
Recent data shows a slowdown in the economy that will likely grow more evident in the next quarter. The cumulative effects of monetary tightening, dwindling business investment, a decline in consumer spending, tightening credit conditions, a looming debt ceiling, and a slowing labor market, only raise the likelihood of an economic downturn in the coming months and give the Fed the green light to raise interest rates in its policy meeting this week. Meanwhile, major bank and corporate earnings for Q1 were released, showing mixed results.
First quarter GDP shows slow growth
On Thursday, first-quarter gross domestic product (GDP) data, showcased a slowing U.S. economy. The U.S. economy grew at a 1.1% annual pace in the first quarter of this year, which was much softer than the 2% forecasted, and marked a significant drop in GDP from quarter four of last year at 2.6%. A decline in business investment largely accounts for the soft headline number, masking the strong consumer spending that contributed to the growth. The relatively strong labor market and unseasonably warm weather drove consumer spending at the start of the year. The momentum in consumer spending only slowed as the quarter progressed, however, as recent economic data, including March’s low retail sales numbers demonstrated.
Source: Commerce Department, Haver Analytics
The weary consumer
The changing consumer mindset was illustrated with Tuesday’s release of the consumer confidence index in April, which came in at 101.3, a nine-month low. Fears of a recession in the upcoming months linger as the labor market slows, credit tightening continues, and high inflation and high interest rates persist. Personal Consumption Expenditures (PCE), which considers how consumers alter their spending in the face of rising prices, was released Friday. It provided evidence that U.S. consumers are cutting back on spending. PCE rose 4.2% in March — its lowest level since May 2021 — and was down from 5.1% in February. Core PCE was up 4.6%, easing slightly from 4.7% in February but still too high for the Fed, giving the Fed the final cue to raise the federal funds rate another 25 basis points at this week’s FOMC meeting. According to the CME FedWatch Tool, the market is pricing in ~90% probability of this move, bringing the fed funds rate to 5.00%-5.25%.
The "not cool enough" labor market
Although the labor market is starting to cool as illustrated by decreasing job openings this year, job openings remain historically high, and wages are still rising. The Employment Cost Index, released Friday morning, showed wage growth remained elevated in Q1 at 1.2%, which was more than expected at 1.0%, giving further reason for the Fed to raise rates next week.
The markets react
With a slew of mixed earnings reports and economic releases throughout the week, U.S. Treasury yields moved in cadence. Notably, on Tuesday, First Republic Bank’s earnings displayed the effects of last month’s banking fallouts as its deposits fell nearly 41% over the period — even after an injection of liquidity from larger institutions. Treasury yields fell and rates dropped around 10 basis points as the banking sector fears resurfaced. Shares of First Republic continued plunging throughout the remainder of the week. Its share price closed at $3.50 on Friday with the expectation of a buyout over the weekend. As of Monday morning, Federal regulators announced their takeover of First Republic and have made a deal with JPMorgan Chase to sell a large portion of its operations. JPMorgan will inherit $92 billion of First Republic’s deposits and purchase most of its $200 billion in assets.
Other banks, namely Deutsche Bank and Barclays, emerged unscathed from the turbulent previous month. The banks showed strong profit growth in the first quarter on Thursday, easing banking concerns. Thursday also featured strong corporate earnings for Facebook parent Meta Platform, Microsoft, and Google parent Alphabet. In response to better-than-expected earnings, the 2-year Treasury yield rose to 4.097% and the 10-year Treasury yield to 3.756% on Thursday. On the commodities front, almost every commodity excluding NYMEX Henry Hub was down from the previous week as economic uncertainty covers the markets.
A tremendous amount of uncertainty looms over the U.S. economy regarding the stability of regional banks, the U.S. debt ceiling, and persistent inflation — all impacting interest rate, FX, and commodity markets. As a result, companies that are unhedged are considering hedging their risk via swaps or caps to increase protection over the next few years.
The week ahead
Following the third failure since March, the market will pay close attention to the stability of other regional banks this week. All eyes will be on Fed Chair Jerome Powell as he announces the next Fed funds rate move on Wednesday following May’s FOMC meeting. Another 25-basis point hike would not be a surprise to markets, but markets will watch closely for any read of the Fed’s monetary policy beyond May — specifically how soon the Fed plans to pause rate hikes and any discussion of a recession. Jobs data, which is released Friday, will also be something to watch.
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