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Wagers on Fed Tightening Expectations Jump on the Back of a Disappointing PCE Report: Feb. 24, 2023

Wagers on Fed Tightening Expectations Jump on the Back of a Disappointing PCE Report: Feb. 24, 2023

Posted February 24, 2023 at 12:33 pm
Jose Torres
IBKR Macroeconomics

Just days after minutes from the last Federal Reserve meeting showed unanimous support among policy makers for ongoing rate increases, this morning’s Personal Expenditures Price Index (PCE) depicts strong, ongoing inflation and strong consumer spending, strengthening expectations of substantial monetary tightening in the coming months. This morning’s PCE, which is the Fed’s preferred inflation gauge, rose 5.4% in January year-over-year (y/y) following a 5.3% y/y December increase. The core PCE index, which excludes volatile food and energy prices, climbed 4.7% y/y compared to the 4.6% increase in December. Both the broad PCE and Core PCE climbed 0.6% month over month (m/m), much higher than expected while consumer spending was strong. Base effects are no longer helping the inflationary outlook, with January’s data showing an acceleration in both m/m and y/y figures.

Markets are plunging on the news as bond yields reach fresh 2023 highs while the yield curve inversion along the 2 and 10-year maturities widened to 85 basis points this morning. In bear-flattening fashion, the 2-year yield is up a staggering 13 basis points to 4.82% while the 10-year is up 9 basis points to 3.97%, nearing the pivotal 4% level. The dollar index is catching a strong bid on the back of higher yields, rising .6% to 105.24. Equities are tanking this morning as investors realize that inflation and the Fed remain strong headwinds, with the S&P 500 Index and the tech heavy Nasdaq Index down 1.50% and 2%, respectively. Crude oil has reversed earlier losses to a gain of 1.3% to $76.30 driven by supply uncertainty as a 312,500 barrel-per-day refinery in Deer Park, Texas, experienced a fire this morning.

Many investors have expected Fed Chairman Jerome Powell to run the ball for some short yardage in March with a 25 basis points (bps) fed funds increase. Following this morning’s PCE data, however, odds of a 50-bps hike have increased to 30%, striking fears that Powell may begin quarterbacking riskier wide receiver post routes, or maybe even a Hail Mary to break the back of inflation for good.

Many investors have expected Fed Chairman Jerome Powell to run the ball for some short yardage in March with a 25 basis points (bps) fed funds increase. Following this morning’s PCE data, however, odds of a 50-bps hike have increased to 30%, striking fears that Powell may begin quarterbacking riskier wide receiver post routes, or maybe even a Hail Mary to break the back of inflation for good. In July, investors are pricing 31% odds of another hike to a possible terminal rate of 5.63%. The bears are on offense this morning, as the bulls dismissed the threat of inflation rearing its head again, a mistake made in the 1970s and 80s. History doesn’t repeat itself, but it often rhymes. 

While many earnings reports show consumers curtailed spending on goods during the fourth quarter, today’s PCE and other recent data, including the retail spending report, shows that trend has reversed. Household spending rose 1.8% in January m/m and 1.1% when adjusting for higher prices after having declined in December. With unemployment at a 53-year low, incomes are increasing with the PCE showing that personal income grew 0.6% in January. The gains were significant, while analysts expected personal spending to increase 1.3% and personal income to increase 1%. Wages increased during the month and increases in Social Security payments, furthermore, partially offset the end of certain government benefits, such as the temporary expanded childcare tax credit and one-time Covid-19 relief tax credits from states.  Americans also squirreled away more money, contributing $918.8 billion to their savings, up from $858.2 billion in December, while savings as a percentage of disposable incomes increased from 4.5% to 4.7%.

Consumers feeling the blow of inflation during the final months of 2022 was highlighted last night when Beyond Meat disclosed its quarterly earnings results. Beyond Meat’s revenues of $79.9 million beat the expectation of $75.7 million and its net loss per share of $1.05 was less than the expected loss of $1.18 per share, but that was the limit of the good news. Beyond Meat discounted its products during the fourth quarter, but the total pounds of the company’s products hauled home by consumers plummeted 16.9% during the quarter. The company also expects its sales to decline by as much as 10% this year.

Price conscious consumers may be trading down to lower cost options, such as real meat rather than meat substitutes, or by seeking deals at big box retailers, but they are continuing to splurge on travel following the end of Covid-19 restrictions, a powerful trend that is supporting persistent inflation within the services industry. Online travel agency Bookings Holdings last night said its fourth quarter revenue totaled $4.05 billion, beating the Zacks consensus estimate by 4.98% and up substantially from $2.98 billion in the fourth quarter of 2021.

While travel companies ride the surge of consumers enjoying the end of pandemic restrictions, advertisers are tightening their budgets, an unsettling development for Warner Bros., which last night reported fourth quarter revenue of $11.01 billion compared to the expected revenue of $11.36 billion. Its TV advertising revenue dropped 6% and the company reported a loss of 86 cents per share for the quarter. Warner Bros. joins Meta, Alphabet and other businesses that reported steep declines in advertising revenues.

progress on inflation is reversing, with base effects no longer helping

For most of 2022 and in the earlier months of this year, investors bet that the Fed won’t stick by its guns in fighting inflation. As our chart above illustrates, that looks like a money losing bet as inflation progress is reversing while the outlook for corporate earnings has deteriorated. According to FactSet, positive earnings surprises and the magnitude of earnings surprising for the fourth quarter are below their five- and 10-year averages. As more earnings results have been reported in recent weeks, the actual decline in fourth quarter earnings has increased. Analysts, meanwhile, anticipate S&P 500 earnings declines of 3.0% and 2.4% for the current quarter and the second quarter of this year. The forward 12-month P/E ratio is 17.8, which exceeds the 10-year average of 17.2 The strong market rally earlier this year was driven by valuation expansion even as yields have risen as the 12-month EPS estimate has decreased since December, resulting in a forward 12-month P/E ratio of 17.8, which exceeds the 10-year average of 17.2. Market exuberance as illustrated by expanding valuations and deteriorating risk premium is now facing a rude awakening as investors assess the combination of high and persistent inflation, weakening corporate earnings and the potential for the Fed to grow more hawkish in the coming months.

Visit Traders’ Academy to Learn More about the Personal Income & Outlays Report and Other Economic Indicators.

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