The first quarter was historically bad for fixed income, and April did nothing to break the bearish trend
Recent economic data support the narrative of an overheated labor market and inflation risks
There are plenty of potential obstacles for future economic growth, including global catalysts (Russia/Ukraine and China slowdown) and tighter monetary policy in the U.S. and abroad
Last month, we highlighted the fact that the first quarter was the worst for broad fixed income in 42 years. April was not the start of a rebound. The ICE BofA US Broad Market Index slid another 3.67%, bringing the YTD return to -9.50%. Since the index began in January 1976, the second worst start of a calendar year through April was 1994 at -3.57%, nearly 6 points better than the current year (see Exhibit 1). Uncertainty related to the path of inflation and the consequential Fed response continues to be the most significant driver of volatility in the bond market, and the fed funds futures market is now priced for four 50 basis point rate hikes at the next four FOMC meetings. This would get the funds rate back to the Fed’s current neutral policy rate by September, and any hikes after that would take policy into restrictive territory. To be clear, the actual neutral policy rate is never known with certainty in real time, and if you polled a group of economists on what the neutral rate is, you would likely see a wide range of opinions. Nevertheless, this aggressive steepening of the forward path of short-term rates has had its impact on the full-term structure of interest rates, and fixed income spreads resumed the 2022 widening trend in April after a brief pause in the second half of March.
Recent economic data releases did little to change the narrative of an overheated labor market fueling high inflation rates. There was some attention paid to a surprise contraction of the U.S. economy in Q1 according to the first estimate of GDP. Headline growth contacted by 1.4% q/q (annualize) versus expectations of a 1% gain, but the miss was largely attributable to a drag from trade and inventories. The former included a significant increase in imports relative to exports, representing ongoing strength in consumer demand, but inflation played a big role as well, with the GDP price index rising by 8% q/q (annualized), the highest since 1981. Consumption by businesses and consumers was decent in Q1, with private domestic demand up 3.7% (highest since Q2 2021), but consumer spending did come in below expectations at 2.7%.
Wage inflation was another big area of focus at the end of the month. The Employment Cost Index (ECI) surged 1.4% q/q in the first quarter (see Exhibit 2), 20 bps more than the previous record in 2003 (inception Q4 1996). ECI is a preferred measure of wage inflation by the Fed because it also includes bonuses and other in-kind benefits, and it undoubtedly caught the attention of Fed leaders already worried about the inflationary implications of an overheated labor market.
Globally, there are multiple areas of concern that could ultimately impact U.S. growth. Risk of escalation in the Russia/Ukraine war remains at the forefront, and the European economy faces higher recession risk in the next 12 months as it deals with surging energy costs and expectations for tighter monetary policy to combat inflation. China has made headlines in recent weeks related to the draconian lockdowns in major population centers like Shanghai as part of its “zero Covid” approach, which threatens to impact both global growth and inflation.
Perhaps the biggest question mark for the U.S. economy is how consumer demand will be able to weather current inflation pressures and higher interest rates. Household balance sheets began the current inflation cycle in relatively strong financial condition as measured by household liquid assets and wealth. Pre-Covid, household liquid assets (checking, savings, and money market accounts) grew by approximately $500 billion per year over the prior decade according to Federal Reserve data. These assets rose by $2.7 trillion in 2020 and $2.2 trillion in 2021, including a $700 billion increase in Q4 2021. This growth in consumer buying power was boosted by unprecedented fiscal and monetary stimulus and has allowed companies to more easily pass along cost increases to end users. However, according to a recent Wall Street Journal article, some corporate executives are suggesting that “inflation fatigue” may be starting to take effect. Some companies selling consumer staples suggest shoppers are not turning more to discount brands, and others selling bigger-ticket home goods, such as mattresses and other home items, have warned recently of falling demand.
Another question mark is the ultra-hot housing market, where we have seen national home price averages soar. With mortgage rates up more than 200 basis points this year, affordability has become an even greater issue for homebuyers. All this said, Fed Chair Pro Tempore Powell and his colleagues have made clearer recently that getting inflation under control is a higher priority than achieving a soft landing, as it should be for any central bank. In other words, it will likely take clear signs of inflation risks subsiding before providing less hawkish guidance, even if recession signals are rising.
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