I must admit that I’ve rarely, if ever, been as perplexed as I am today over the United States Federal Reserve and its preoccupation with contemporaneous and lagging economic indicators. It’s truly unprecedented. I thought for sure that the Fed would be taking a feather out of the Bank of Canada’s hat and undergo a conditional pause, but that clearly hasn’t happened.

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David Rosenberg: Fed should have followed Bank of Canada's lead — but here's what investors can do Back to video

The Canadian central bank led the way into the tightening cycle and has now been the first to press the pause button. Remember, too, that governor Tiff Macklem is operating under similar crosscurrents of cycle-high lagging and coincident indicators, but steadily deteriorating leading indicators, a tight and red-hot labour market, and elevated inflation, though the latest consumer price index (CPI) data went in the other direction and surprised to the low side, but the domestic shelter component in Canada responds to the high-frequency data with shorter lags.

Now that three more hikes by the Fed are now priced in and no pivot for this year, the only issue is whether it goes even further than three more hikes. What is it that it needs to see that it hasn’t seen?

The fact that the stock market has fought the Fed so hard since October has been more of a headache than any of the economic data

But this Fed continues to believe it has to fight for its perceived loss of credibility this cycle. It has two fears. One is the memory of Arthur Burns in the 1970s and even Paul Volcker in 1980, which is ending the tightening cycle prematurely. Second, the Fed is consumed with financial conditions, which is a critical input to its macro forecast.

Maybe it was a ruse when Fed chair Jay Powell, at the last post-meeting Q&A, shrugged his shoulders over the question of financial conditions, but that issue was put to bed in the Federal Open Market Committee (FOMC) minutes where it became obvious that the risk-on rally since last fall is not what it wanted to see. Totally undesirable.

If you’re bullish on the front end of the curve, the fact that the stock market has fought the Fed so hard since October has been more of a headache than any of the economic data. And we have to add that the Fed was still hawkish at 3,600 on the S&P 500 and was frustrated as it approached 4,200 in early February, or even near 4,000 today.

We know the S&P 500 got as low as 3,600 last fall and entered a bear market, which in the past was always a signal to either pause or pivot. But that didn’t happen, and there is a message there in its own right.

Here is what the Fed had to say on the matter of “financial conditions” at the most recent FOMC meeting (taken from the minutes): “However, several participants observed that some measures of financial conditions had eased over the past few months … Participants noted that it was important that overall financial conditions be consistent with the degree of policy restraint that the committee is putting into place in order to bring inflation back to the two-per-cent goal.”

When we try to model the financial conditions that get the Fed to what it wants to see, we are talking about 3,100 on the S&P 500 and somewhere around 800 basis points on high-yield spreads. It actually wants a recession and probably prefers a mild one, because it mentioned recession four times in the latest set of FOMC minutes. It didn’t have to show us that. Remember, the minutes are a scrubbed-down screenshot of the meeting, and the words are painstakingly chosen and then have to be approved by the committee. We haven’t seen so many citations since June 2020, and there are more citations than all the meetings combined in 2008.

The recession is staring us in the face because, just as we saw with inflation and unemployment, the lagging economic indicators from the Conference Board hit a cycle high in January; and as we saw with payrolls and real incomes, the index of coincident indicators also hit a cyclical peak last month. That is not unusual at all.

The leading economic indicator, well, it fell for the tenth month in a row to a 23-month low, and this divergence between it and the lagging and coincident indicators is a sure-fire peak-economic-cycle development. Take that along with the depth, duration and dispersion of the inverted yield curves and the timing of the peak and rolling over in money supply growth, and history tells us the recession becomes a reality in the second quarter, the third quarter at the latest.

Now, even before the upside January surprises to the inflation data when they were cooling off in the last three months of 2022, the Fed was not exactly backing away from rate hikes or signalling more ahead. That global supply chain bottleneck pressures are easing dramatically, freight rates are collapsing or wide swaths of the commodity markets are in a bear market haven’t stopped the Fed. And, of course, the “super core” services inflation measure it recently concocted, representing the grand total of 25 per cent of the price index, is sticky as it always is and a huge lagging indicator.

The reason why the Fed is focused on these areas is that between accommodation, restaurants, air travel, health care and education, these now have the largest gaps between spending and employment levels compared to where they were pre-COVID-19 and where the central bank sees the greatest imbalances and sources of future upward wage pressure that it feels could spill over into the broad economy (within the entire services sector, only personal care services, professional and business services, and ex-air transportation do not fill this mismatch that has the Fed so concerned).

It’s this spending-jobs mismatch in this 25 per cent of the economy that the Fed wants to eliminate. There is no such imbalance in manufacturing, which is why the Fed isn’t looking so much at the goods sector; and it seems to realize that the rental components are sending off a reliable signal when stripping this out of its new super core measure as well. It all comes down to a handful of service-sector segments, mostly related to leisure and hospitality, as well as education and medical care.

As the Fed chases lagging indicators, history shows us that the jobless rate bottoms three months into the recession just as it peaks three months into the recovery, which is why it is a classic lagging indicator. Inflation is an even more acute lagging indicator, because it peaks six months into the recession and then doesn’t end up hitting its trough until we are 15 months into the economic recovery.

Again, the Fed is not filled with stupid people. They know all this. All along, Powell has been devising new macro metrics to justify the wildest tightening cycle since the early 1980s when the economy came off more than a decade of recurring inflationary supply-side shocks that reached a point where inflation became entrenched and institutionalized in the entire economic system.

That isn’t exactly the case today, whether or not the way the price data are constructed makes them appear sticky to the downside. Nearly 40 per cent of the CPI is imputed non-transactional prices. The stuff you can actually measure has already slowed to a 2.5-per-cent annual rate over the past three months. I’m sure the Fed knows all this. It’s clearly all about eradicating the Fed put and taking the punch bowl away.

The Fed still wasn’t happy with the S&P 500 at 3,600, but at 3,100, it’s a different story. That’s the only price that really matters. It’s not stopping before that happens — that’s my epiphany. Until then, buy puts and be in T-bills which pay you five per cent with no duration or capital risk.

If you’re looking to add some risk in something where some real value has opened up this year, try energy credits, which have been really beaten up, but the industry fundamentals are stellar. You can now buy three-year natural gas paper in certain names with spreads of 425 basis points over Treasuries. The BB/B rating space commands yields in excess of eight per cent with their books fully hedged for this year and leverage below 1.5x on a debt/EBITDA basis for the vast majority of companies. There probably isn’t any part of the bond market right now more attractively priced.

David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. You can sign up for a free, one-month trial on Rosenberg’s website.

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