How High Will Rates Go? (Joe Keating’s Economic Forecast)

Welcome back to the community bank podcast I’m Caleb Stevens thanks for joining the conversation today if this is your first time joining us welcome this podcast is all about creating value for you the community banker whether that’s talking about the economy and interest rates or culture leadership strategy and a digital banking we wanna run the gamut and cover all the topics that we think are relevant in today’s banking world so thanks for joining the discussion today we are turning our attention back to the economy our director of strategy and research Tom Fitzgerald sits down with Mr. Joe Keating from NBC securities to talk about the recent moves by the Fed and what it means for the economy at large and for community banks Speaking of the economy before we get to the conversation I want to tell you about two webinars that we have coming up this month in February the first is on February 22nd and it’s all about how do you manage your bank in an uncertain rate and economic environment if you’re a banker and you’re concerned about inflation the uncertainty of the economy thinking through your future earnings streams this webinar is risk and uncertainty for your bank and balance sheet strategies to help you win in 2023 so February 22nd it’s at 2:00 PM all you have to do to register is click the link in the show notes of this episode and you will be all set for 2:00 PM on February 22nd the second webinar we have coming up this month is on February 28th it’s going to be at 1:00 PM and it’s all about loan pricing and structuring in the face of an inverted yield curve how do you increase that interest margin how do you increase fee income during an inverted yield curve how do you make an inverted yield curve work to your banks advantage we’re going to talk about how to pick up additional loan yields 5 tactics for better deposit performance how the best banks are using floating rate loans to offset rising funding costs and why fee income in today’s environment is essential for your community bank same thing to register click the link in the show notes of this episode we’ll have a link for the the balance sheet webinar on the 22nd and will also have a link for the loan pricing webinar on February 28th at 1:00 PM so we hope you’ll join us for both of those webinars and for now here is Tom Fitzgerald and Joe Keating well Joe it’s good to have you back again and it seems like every time we do have you back there’s always a plethora of things to talk about and this is certainly uh no exception to that rule but again thanks for coming on and sharing your views with us we always appreciate it Tom I’m pleased to be here well let’s just let’s just get right into it you know the consensus view Joe was that the economy surprised to the upside in the fourth quarter you know real GDP grew at about a 2.9% annual rate what is your take on the economy is 22 drew to a close well Tom the as you said the the Commerce Department did report a 2.9% annualized growth rate in the fourth quarter which would be pretty strong however that figure in our opinion materially overstated the underlying growth in the economy during the quarter for two reasons first an inventory build added one and a half percentage points to the quarter’s growth rate and that inventory bill was due to soft demand repairs of supply chains and over ordering that had occurred additionally net exports added 6/10 of a percentage point to the quarters growth rate as households pulled back on their purchases of imported goods which fell at a 5.6% rate another sign of weakening domestic demand without the boost from the inventory build and net exports real GDP growth last quarter would have been a much more modest eight tenths of 1% I think a much more accurate representation of the economy’s growth rate last quarter was the 7/10 of 1% advance in real domestic private final sales which is the sum of consumer spending business capital spending and residential construction spending once you get inside the data the key insights are the ongoing shift in demand in the economy and a broad based slowing in economic activity which resulted from the tightening of monetary policy real consumer spending grew at a 2.1% rate following gains of 2% and 2.3% in the previous two quarters so right in line however outlays for goods rose at only a 1.1% rate but that rate was better than declines in the previous three quarters a higher pace of motor vehicle purchases accounted for the bulk of the gains in goods spending on services was the strongest sector of the economy last quarter growing at a 2.6% rate and ended the year with a 3.2% gain over the fourth quarter of 2021 the shift in household outlays from goods to services has now taken place for seven consecutive quarters helping to balance the shortage gap between supply and demand of goods that developed as the economy reopened following the pandemic the recession in the housing market continued with residential construction outlays following at almost a 27% annualized rate however you know I think there are some signs that housing will stabilize as we go through 2023 business capital spending slowed again to a gain of only 7/10 of 1% last quarter with equipment outlays falling at a 3.7% pace as businesses pared back their spending as the economy’s growth rate has slowed and the risks of a mild recession this year have have risen capital spending on structures was flat but remains in a recession the bottom line looking at the fourth quarter data is that in general the economy stalled in 2022 under the weight of elevated inflation with the interest rate sensitive sectors of the economy bearing the brunt of the slowdown the fourth quarter 2022 report was very soft despite a reported 2.9% rise in real GDP but I think you’ve kind of taught me to take a look at that that you know that the final demand for domestic purchasers you know a line item because like you said it kind of strips out a lot of those you know those one off you know inventory and and and trade elements that can kind of give you a different or you know kind of a a misleading view of the economy so they’re also noisy yes yeah we talked about you know flat out stalling and that’s you know something you know been together a few times here in the last year and that’s kind of how you described the economies list for the first half of 22 what is your kind of current outlook for the economy in 23 and is the economy more at risk this year of falling into recession so the the the economy ended 2022 on what I would call a fairly sour note with retail sales pointing to growing sluggishness in consumer spending by following 1.1% in December which followed a 1% drop in November the leading economic indicators have declining for ten straight and have fallen 4.2% over the past six months housing remains in a recession as we already mentioned along with capital spending on structures business capital spending on structures and the purchasing managers surveys indicated that the manufacturing sector was in contraction in November December and in January you know you add in industrial production decline at a 5.2% annualized rate in the fourth quarter and seven Federal Reserve Bank surveys of business conditions indicating that economic activity in their districts are in contraction and the odds are pretty high that the manufacturing sector stalled or even entered a mild recession as 2022 drew to a close for now rather than the economy the entire economy falling into session it appears that overall the economy has stalled using that term again Tom and a series of rolling recessions are occurring in the most interest rate sensitive sectors of the economy with offsetting pockets of strength in consumer spending on services and business investment in intellectual property you know we we we mentioned in in last month’s call that we are not looking for a deep and prolonged downturn in the economy and worse we see the economy hitting a mild recession that’s at worst one of the key reasons is the message being sent to the credit markets once fixed income investors sense a serious recession is ahead the extra yield required on both investment grade and non investment grade corporate debt to compensate investors for the default risk which comes with corporate debt increases currently the yield spread on both investment grade and non investment grade corporate debt is below the average yield strength namely the current yield spread on investment grade corporate debt is about 130 basis points while the average yield spread since December of 1996 a 152 basis likewise the yield spread on non investment grade corporate debt is 443 basis points compared to an average yield spread since December 1996 of 542 basis points we’d be far more worried about the path ahead for the economy if credit yield spreads had recently blown out to a level above their averages but that is not the case currently taken with a relatively healthy jobs market and the easing of inflationary pressures over the past few months we continue to look for the economy to hit somewhere between a soft landing and a mild recession as we go through 2023 this is probably a good spot to bring up that latest jobs report as we record this we have the January jobs numbers come out on Friday and they were you know much better than expected you’ve kind of talked down or or or kind of explained why that at 2.9% GDP number wasn’t really as strong as it looks on its face can you kind of speak to that January jobs figure 2 is is there something similar going on there as well well you know it it was a blowout report Tom as you know and and I I believe the whole labor market is rather confusing right now I think there’s a couple of things going on one is the distortions in the economy from the pandemic and the policies to address the the impact on shutting down the economy over the last couple of years has really distorted the way the economy is is working and I think the largest distortion I mean obviously it showed up in supply chains big time during the end of 21 and during all of 2022 and and the ongoing impact I think is is still showing up in the labor market so when when I saw that report as I’m sure you did too you know I really had to dig into it a bit um because we knew there was going to be some noise in the report but but no one figured there was going to be anywhere near as strong as it was so my take is that the Super strong January jobs report underscores that employers are more worried about not having enough workers and they are about a slowing economy I Red Hat pandemic distortion and and it probably implies a fair amount of Labor hoarding that is not laying off seasonal workers you know when when you take a look at the non seasonally adjusted data for the employment in January we actually had two and a half million fewer jobs in January than in in December as seasonal workers were laid off however it appears that that some employers decided to keep some portion of those seasonal workers on board because they fear being able to have enough labor as they go through 2023 and I think that’s really what what occurred that last month less less late letting people go and a little bit more trying to keep some of those folks on board so as you and I were chatting before we started this you know probably will we’ll get some kind of a washout or a better read through on this data when we get to February employment report but for right now it is clear that the the January report was stronger than expected I do think it was more labor hoarding as opposed to just a blowout you know surgeon in hiring by but as we’ll talk about in assume in a bit it it does impact in in my view the impact of what the fed’s going to do as we grow slightly as we go through 2023 and I think yeah in that regard obviously the Fed meets in late March so they’re going to have well they have the January jobs number they’re gonna get the February jobs numbers and they’re going to get two inflation reports and Speaking of of inflation you know the price pressures that we saw started to ease you know in the in the second-half and particularly in the fourth quarter what kind of what is your projection going forward on the inflationary pressures do you see it’s kind of being sticky still around 3% do we really accelerate or or is the path to 2% kind of where you see it well I think the path to 2% is their time and and we talked about this last time we got together you know it’s it’s been our position that in the fourth quarter of 2022 the inflation reports were going to be just the beginning of a series of inflation readings which would show inflationary pressures easing goods deflation appears to have taken hold not disinflation deflation goods prices have fallen at five in the past six months supply chains across the economy have loosened and by some measures have returned to pre pandemic conditions imported consumer goods prices have declined in three of the past four months rise in unwanted inventories has led retailers to place more items on sale as demand weakens used car prices are moving down rapidly and gasoline prices are down some 30 to 32% since mid June additionally the pace of rent increases in new leases has slowed considerably although it has not shown up yet in the inflation reports because the labor department’s measure of rents reflects what renters at large are paying both those who just signed leases and those who signed them up to a year ago as a result the owners equivalent rent component of the inflation measures tend to lag behind changes in rents or newly signed leases when large swings in rent take place with rental costs accounting for about 24% of the core consumer price index and roughly 20% of the core consumer PCE price measures using a real time rent price index would likely show inflation very close to the federal reserve’s 2% target currently this rent impact is expected to show up in the inflation data later this year so there’s there’s more good inflation news in the pipeline pricing pressures have clearly eased with the three month annualized rate of change in the core consumer price index and the core PCE prices rising at a pace of only 2.2% and 2.9% percent respectively in four Q 2022 those who want to make the argument that inflation isn’t cooling we’ll look at the year over year numbers which are still you know up in the four to 6% range depending upon the inflation measure however I think you really need to look at the three month annualized rates of change in the fourth quarter which as I just said are running in the 2 to 3% range additionally the prices paid component in the manufacturing purchasing manager survey has declined for ten months in a row and we were just talking about the the blowout January jobs report average hourly earnings in that report said that over the past twelve months at which hourly earnings are up 4.4% compared to a peak of 5.9% last spring so currently there’s a divergence of justice under 150 basis points between the federal reserves year end 2023 core PCE inflation forecast which is two you know 3 1/2% and the implied one year inflation forecast in the treasury market of basically 2.1% we think the convergence will take place the federal reserve’s forecast for inflation falling during 2023 Mr. Powell hinted at that a bit in the in the press conference last week and going out further in time the implied inflation forecast in the treasury market out 2/5 and 10 years are all running just a touch over 2% basically in line with the central banks inflation target and that is it’s funny too just before we came on I was going back and looking at the the monthly numbers on CPI from last year and this quarter actually five of the next six months you’re going to see some really what I call crooked numbers coming out of the calculations I’m talking about like 6/10 of a gain eight tenths of even one month we had 1 / 1% of a gain so those numbers are going to fall out of those year over year calculations in the first half of this year and so I think you know even with you know just a modest improvement in in the inflation picture on a month to month basis we’re still going to see some big chunks coming out of those year over year numbers which I think has got to be encouraging for the Fed and for for everyone migrant and you know that that’ll wind up for a lot of folks being a quote UN quote surprise whereas if if you’re if you’re you know doing the work like you are in terms of taking a look at you know what were the monthly month over month changes last year they’re going to drop out and or looking at like I do the three month annualized rates of change you know there there’s really no surprise coming we we we know the inflation statistics are going to ease as we go through 2023 and I do think that was part of the of the demeanor of Mr. Powell in last month’s press conference following the FMC meeting that’s right he was he was I wouldn’t call him dovish but he was certainly less hawkish than he’s been for gosh almost a year now that’s right and Speaking of the Fed now they’ve in that they they kind of laid on us four straight 75 basis point hikes from going back from June to November and then they finally kind of moderated that to a 50 basis point hike in December and then they just did a 25 basis point hike for the January meeting or I guess like guess it was February 1st meeting based on your outlook Joe where do you see kind of the Fed policy as it plays out over the course of 23 well as I mentioned I you know I I need to do a little bit of an adjustment on my perspective given the January jobs report and I’ll and I’ll cover that as we go through that go through this you know the chair Powell emphasized during the press conference that the committee anticipates ongoing increases in target range would be appropriate and that line was also in the policy statement so he had a hawkish tone additionally by saying there’s still more work to do and repeated the view that the risk of doing too little is greater than the risk of doing too much and I think that that’s that’s just the positioning of that that the the Fed spokesman Mr. Powell as well as other officials need need to keep saying in order to keep financial conditions from loosening too much however the committee did introduce new text in the policy statement that inflation has eased somewhat but remains elevated that was the first explicit acknowledgment by the Federal Reserve since the rate hiking cycle began a year ago that pricing pressures are slowing and underpinning market expectations at the end of the rate hiking cycle is is near during the press conference chair Powell and a notable pronouncement by stating it was gratifying to see disinflation starting to show up in the data and acknowledging that softening in wage pressures is a positive sign for future inflation Mr. Powell expanded on the disinflation theme in fact he used the word disinflation 11 times during the press conference by saying we can now say for the first time the disinflationary process has started we can see that and we see it really in goods prices so far so while Mr. Powell said the FMC committee was going to be cautious about declaring victory on relative to the inflation battle he basically said the path to victory was insight so relative to our expectation you know we were looking go back and and remember the the the comments I made about the manufacturing rays and industrial production and retail sales and all as we went through the fourth quarter of 2022 we were looking for them for the upcoming March rate hike to be the final rate hike and that the Fed could actually cut rates by year end however we we we have said that you know Mr. Powell made it pretty clear that assuming the inflation spiral had been broken rate cuts will depend on the jobs data a software jobs market could warrant cutting rates whilst still strong jobs market would not so now we go to the January jobs report and based on that and let’s let’s let’s assume that it it is a quasi real number in terms of you know taking along with the initial unemployment claims that have been consistently running under 200,000 on a weekly basis that I think we’re probably going to see another rate hike in may uh and then I think the Fed will will basically attempt to stop and and hold those those rates at that level as long as they can uh while the while the lag affects of the raising of interest rates begins to show up further in the economic data so the concept of higher for longer I think is going to be the way things will play out here in 2023 and likely any rate cuts likely will be at the either the very end of the year or in 2024 although the futures market does have a rate cut coming before year end so so there there is in in terms of our expectation for the Fed there is an impact out of the the January jobs report I’m putting in another rate hike in may and pushing out when it is that the Fed will actually begin to cut rates yeah and I think like you mentioned that you know the prior to that Friday jobs report the market was pricing in 50 basis points of a rate cuts this year now I think they’ve throttled that back to just maybe 1 at least from you know the so that’s sort of that impact or that January jobs number does kind of has kind of filtered through into a lot of different areas as far as market expectations go and Speaking of that as far you know treasury yields themselves you know they declined last month and they were they decline from October to November from the October November peaks and then they moved kind of took some of that back in a higher in in December but where do you see treasury yields kind of moving as we as we progress through 23 and and also kind of relatedly the the inversion that we’re seeing in in in a lot of curves namely the 2:10 where do you see that persisting through 23 sure well as you said very appropriately Tom we did see treasury yields back up a bit during December the the 10 year ended December at 388 and the the two year ended December at 4:43 so we did see yields come down during January and they came down through Thursday of last week but what was happened on Friday with the jobs report we’ve now got the yield on the two year basically back to where it was at the end of the year working 440-2443 and the yield on the 10 year sort of halfway between where it was at year end and where it was at the low last week you know running today at about 362 so down but not down as as much as they were yield curve as you mentioned is now inverted to the term to the tune of roughly 80 basis points compared to 55 at the end of the year and 70 back at the end of November this remains a significant degree of inversion and and you know basically a 40 year high the inverted treasury curve in our opinion is A6 sign that investors think the Federal Reserve is close to winning its inflation battle regardless of the cost to economic activity I do think the message from the inversion as well as rates coming down from year end uh the the message from the market the treasury market is the stall and the economy is likely to continue through 2023 as I said before we’re looking for the economy to land somewhere between a soft landing and a mild recession and in in the simplest terms inverted yield curve implies that investors are pretty confident that short-term rates will be lower in the longer term than there will be in the near term typically that is because investors anticipate the Federal Reserve will need to cut rates to revive a faltering economy so the bottom line on a lot of this time is that the Federal Reserve is having an impact and is approaching the end of the tightening cycle I think investors have turned their focus to the beneficial impact of the Federal Reserve tightening monetary policy as the implied 10 year expectations embodied in treasury securities has now fallen from 264 back on May 31 and I picked May 31 because that’s right before the Fed did their first of the 475 basis point hikes so from 264 down to two and a quarter five years from just under 3% to about two and a third and two years from just under 4% to about 2.3% the beneficial impacts of tightening policy include the slowing in the economy from an unsustainable pace in 2021 and the easing inflationary pressures so in terms of rates we think the 10 year treasury should trade between 3 1/4 and 375 over the next couple of quarters as the Federal Reserve shrinking its bond portfolio by $95 billion each month will keep some upward pressure on yields but it’s going to be going against an ongoing slowing slowing in the economy and a continued easing of inflationary pressures we we look for longer dated IE 10 year treasury yields to decline towards 3% later this year as inflation moderates further in the economy’s growth rate remains you know at worst at stall speed the the yield on two year treasury securities likely to fall later in 23 and possibly into 24 in anticipation of the Federal Reserve moving to lower rates with treasury yields poised to fall over the course of the year and we’ve been looking for the the rise in yields last year to have set the stage with the best returns in the fixed income market since yields collapsed during the pandemic and on that note the Bloomberg US aggregate bond index did return a little bit over 3% last month so even though there were some pain with yields rising it is showing up here in 2023 with a little bit better returns in the fixed income sentence good I think all of our listeners could could use a little bit better returns than their fixed income markets for for 23 and Joe as is our custom we can’t let you leave until we get your view on stocks and you know they had a fairly strong rally coming off the October 12th low December saw pretty good pushback as we ended the year and but then that you know had a nice rebound in January do you think those October 12 lows are going to hold and where do you see stock prices kind of as we move through the course of 23 well um so I answer your question I think there’s a real good chance October 12 will hold and I’ll give you some reasons for that and I I think returns this year will be lackluster but better than in 2022 so you know thinking about whether or not October 12 will be the ultimate low I went back and reviewed the concerns of investors back on October 12 and when and when you look at it it does lend lend some credence to the position that the low could hold So what were investors concerned about back in October and how have those concerns played out since October 12 the five big concerns back in you know mid-october with the fear of inflation remaining stubbornly high the Federal Reserve aggressively tightening monetary policy which could have pushed the economy into a deep and prolonged recession energy shortages in Europe which could have sent energy prices higher and pushed the global economy into a deeper and more more prolonged downturn China’s pandemic isolation which was prolonging supply chain disruptions and aggravating the imbalances between demand for and the supply of goods and labor shortages which were placing upward pressure on wages and prices in the service sector so since October 12th the market has basically climbed the proverbial wall of worry followed by a bit of a relief rally in January as the worst outcomes for those concerns did not play out with the S&P 500 basically higher by about 14% to the end of January actually through through today As for those five big concerns the inflation rate has dropped rapidly with the producer price index largely unchanged in four Q 22 three month annualized rates of change and the other widely followed measures of inflation running in the area 2 to 3% as I mentioned earlier compared to much higher levels over much of 2022 the Federal Reserve stepped down the size of its rate hike in December as we talked about 50 basis points and raised rates by 25 basis points last week Europe is on track and the winter of 2020 2223 with a record amount of natural gas and storage due to the mild weather and China shocked the world in November by announcing a drastic relaxation of COVID regulations and shutdowns effectively ending at zero COVID policy lastly some relief on wages as we already talked about was evident in the January jobs report with average hourly earnings being higher by 4.4% so the distortions and already talked about this the distortions created by the pandemic and its after aftermath on the outlook for the economy inflation earnings central bank policy and the financial markets remain substantial and continue to make the outlook for early here 2023 murky providing a relatively high level of uncertainty conditions will normalize as the pandemic and the impact of the pandemic policies which were unprecedented recede further in the rearview mirror but the question is how quickly the outlook will turn will return to a more normalized track so as we as we open up 2023 the backdrop is much more positive not only have the reported inflation data eased inflation expectations in the treasury market have declined to the area as we already talked about to 2.1 to 2.3% out to 10 years and there are many signs that the inflation spiral has been broken the Federal Reserve is largely finished hiking rates and yields on longer dated treasury securities are about 60 basis points below their peak levels back in late October pointing to slower growth and lower inflation so the most significant challenges to the economy we think are most likely in the rearview mirror and an increasingly looks like the economy will be spared the typical scar tissue of a steep economic downturn if the jobs market can weather the federal reserves inflation fight sales and earnings will be primed to grow again when the Federal Reserve pauses its rate hikes and eventually eases policy and we are on board with that expectation eventually all bear market downturns are completely erased by a bull market rally and that will be the fate of the 2022 bear market at some point in the future so glimmers of light ahead for you know for stocks at least and for the economy and the market is oh which is which is a positive and it kind of struck me Joe as you were speaking I remembered Powell’s press conference at the last fed meeting and he was asked repeatedly about financial conditions and the fact that you know the rally that we saw in January and he didn’t push back on that he didn’t really say you know we you know that makes our job harder which is what they were saying in the in the summer when we had more you know market rallies and so I think they feel pretty confident that they’re in a good place right now and that they you know that stocks can run a bit and they’re not going to be that concerned about it at least that’s the impression I got from from Powell at the last meeting that that wasn’t you know the financial conditions being a little bit looser is not a is not as big a concern as it was say six months ago you know I agree Tom you know as as we’ve already kind of mentioned there there is lower inflation in the pipeline most likely OK and and and they understand that very well and I think that that’s part of the the the reason why Mr. Powell positioned himself the way he did like like I said before they they don’t want to declare victory but but they do see lower inflation on the horizon and that’s obviously has a a good implications relative to what the fed’s gonna do as we go through 2023 because of what inflation is going to do well Joe once again thank you so much for all of the insights and and and the information that you provide to our listeners the next fed meeting is is late March I think March 27th so hopefully we can get you on right after that maybe early April and kind of dissect what we’ve learned in the in the meantime and and what it means for the rest of 23 so again thanks for thanks for today and hopefully we’ll get you back in a couple of months to kind of provide us another force correction for 2023