Monthly Macro with Richard de Chazal—September 2023

Housing, retail sales, and the Sahm Rule. Hear what macro analyst Richard de Chazal outlines in his latest Monthly Macro podcast, and what’s in store for the markets as we near a critical FOMC meeting next month.

Podcast Transcript

Chris Thonis
Hi everybody. On today's episode of Monthly Macro, we welcome back William Blair macro analyst Richard De Chazal this time to look back at September, somehow already. Richard, thanks for joining it's always a pleasure. September seemed to be more of this cycle of economic uncertainty, both for investors as well as the Fed. In your recent Economics Weekly, you mentioned that one of the more difficult areas for investors to negotiate is differentiating and distinguishing between all this day-to-day noise that's been bombarding us about the state of economy and the more powerful long term structural trends that are actually playing out across the economy.

You go on to say that disentangling the two is also proving hard for the Fed, as the latest FOMC meeting showed. So, we'd love to start there. Maybe you can go through some of the core takeaways from the meeting. Maybe first, starting with the committee's views on the long run, real interest rate, and what it means for the long-term interest rate outlook and then we can just go from there.

01:22 - 01:54
Richard de Chazal
Sure. So thanks very much. Nice to be back. Crazy to think how much really goes on in a month since we last spoke. So here we are. I think definitely we get a lot of macroeconomic data and for sure it's not always easy to distinguish what’s signal and what's noise out there. And I think for analysts, economists, and investors as well, we're always trying to filter through all of that to try and figure out what's important from a cyclical outlook as well as from the longer-term structural outlook.

I think having a good sense of what the economy's underlying structural economic growth rate is can then really help to put some color or context around what's happening today and how much weight to attach to any developments we see happening in the market or whatever. And, you know, clearly that's important for investors because those dislocations can really create some opportunities, both in terms of short-term and long-term trade.

Perhaps areas where the market might not be seeing the forest for the trees and unfortunately, it's probably a little bit cloudier than usual at the moment in terms of both the cyclical and structural outlooks. And I think that has plainly been on view in what we're seeing play out in the Fed's forecasts on growth and interest rates, which they just gave us at the last FOMC meeting.

So not only do we have a lot of cyclical noise going out where you're sort of arguing about soft landings or hard landings, the impact of government shutdowns, that kind of thing. But unusually, I guess there's also a kind of valid discussion going on about the degree to which we're actually seeing a major structural shift in the economy.

And I think differences around that discussion are also being reflected in the Fed's longer-term interest rate estimate of its main policy rate. So that's the one that's published in the quarterly summary of economic projections. So this isn't actually the Fed's official sort of r-star rate, which is the estimated real neutral rate of interest. But it's kind of close.

And I think what we've been seeing over the last few meetings this year is that while the median rate has stayed relatively stable at 2.5% or 0.5% real, assuming a 2% inflation rate that's been kind of steady since 2019, the spread of estimates provided by those FOMC participants has actually widened pretty significantly. So, if you look at what they call the central tendencies, which show sort of the range of forecast from those FOMC members that range certainly at the top end has widened quite significantly.

So from being at 2.5% at the start of the year, that upper band has now moved to 3.3% today. And that's actually the highest that it's been since 2016. That's a pretty big jump in a short space of time for what's really supposed to be a structural rate of interest or something that shouldn't really change all that much if it's meant to reflect structural growth.

So I think what that divergence would clearly suggest is there definitely some confusion at the Fed around not just the sort of shorter-term cyclical dynamics, but clearly plenty of debate around the differences of opinion about what's going on longer term and structurally. And I think it shows that some on the Fed probably think that something significant has changed since the pandemic to structurally alter the longer-term interest rate of the economy over time.

And, how that should move up in order to be consistent with a 2% rate of inflation. So, you know, if we kind of think what that could be, what drives that structural interest rate, I think we have to look at what actually drives structural growth, which is really seen as a function of growth in the labor force, growth in the capital stock, and multifactor productivity.

And I think we know that labor force growth isn't going to be all that much because demographics are shifting and etc., etc., aging baby boomers. But I think there is some good reason to believe that we could see some better growth in the capital stock and productivity growth going forward, which could be enough to at least sort of nudge up that longer term neutral rate a little bit.

I think maybe that's what we're seeing coming out in at least some forecasts from FOMC members. So, getting back to your original question, what does it mean for longer-term interest rates or shorter-term rates over the longer term? I think it would suggest that when rates really do finally start to come down, the Fed believes that they'll probably have to stay a little bit higher than what it believed was previously the case because structural growth and productivity could be a little bit higher.

And if short rates stay a little bit higher for longer, or maybe it's better to say that they don't decline by as much as historically might be expected. And then if we think that long rates are really the sum of expected future short rates plus inflation and a term premium, maybe longer rates might not fall quite as much as previously was expected either.

And I think that's something right now when we're seeing longer-term bond yields moving around quite significantly, maybe that's what's playing out right now.

07:28 - 07:47
Chris T
Got it. So the Fed forecasting policy, I know you mentioned in your report that according to current forecasts, the market and the Fed are expecting policy to remain restrictive until as long as 2026. What's the potential impact of that? I was surprised to see that, but maybe some people are not.

07:47 - 08:13
Richard d
Yeah. So I think the way to think about that is, again, it kind of goes back to this sort of r-star discussion in that any time the main policy interest rates are the Fed funds rate is above the r-star neutral rate. You can probably say that policy is in restrictive territory and conversely, whenever it's below it, you can say policy's relatively accommodative.

So with that in mind, we can also then compare expectations that are provided, say, by the Fed in their SEP (Summary of Economic Projections), as well as what future markets are pricing in in terms of forward Fed funds futures contracts relative to what's expected or what you estimate that neutral rate to be over the next, say, three or four years? And I think what we can see is that while both the Fed and the market believe that the short-term policy rate will come down over the next three years, neither believe that it'll fall below what that neutral R-star rate is estimated to be, which means that both the Fed and investors are expecting policy to remain, I guess, restrictive for the foreseeable future. So that effectively also means that neither the Fed nor the market are now expecting any kind of recession because historically early in a recession, you'd expect that policy rate to obviously swing from being restrictive down below the R-star rate into accommodative territory pretty quickly. And that's doesn't seem to be what's being priced in the futures market or the SEP.

Personally, I think that's a little bit optimistic and I suspect as the economic data deteriorates through 2024, we'll start to see those estimates coming back down. And if they don't, clearly the impact will be for a more significant downturn, but maybe we'll have to wait to we see maybe a couple of negative non-farm payroll prints before we see that adjustment taking place.

10:05 - 10:27
Chris T
Right. So let's talk about the potential soft landing that the Fed is suggesting in a lot of people's minds that's great news. But then, you know, in your report, these projections don't quite stack up with these expectations toward where it sees the unemployment rate heading in the coming years, which is a contradiction of the Sahm rule. Do you mind just unpacking that a bit?

I think it's worth explaining the Sahm Rule first, if you don't mind doing that and then going from there.

10:34 - 11:27
Richard d
Yeah. So the Sahm rule basically is named after the Economist who used to be at the Fed, Claudia Sahm. I think she was on their forecasting committee and basically, it's been that she's looked at the data back to the 1960s and found that any time the three-month moving average of the unemployment rate has moved up 50 basis points above the low in the previous 12 months, that's been associated with being in recession, so the start of the recession. Typically, it goes a lot higher than that. But that's kind of the starting point. And I think that's we're seeing playing out in terms of the Fed's economic forecasts for the unemployment rate. And what we're seeing in terms of their forecasts for interest rates are kind of conflicting a bit.

There's a bit of confusion going on, not only with the widening of those longer-term rate forecasts but, for example, if you look at the dot plot of the expected future rate changes, the Fed going forward, as I was kind of alluding to earlier, is really only expecting 50 basis points of rate cuts next year and another 50 in 2025.

So again, not much, particularly if we actually have a recession. So in that sense, in the past the Fed has on average cut rates by around 500 basis points in a recession, and you could probably add to that more if you calculate for factoring QE on top of that. So 100 basis points over the next two years and inflation coming back to 2% in its forecast is clearly a soft landing forecast.

But in the SEP, the Fed also has the unemployment rate moving up to a range of 3.9% to 4.4%, and that's above the current low of three and a half percent. So that would still be consistent with a Sahm Rule recession flag being raised. And Claudia Sahm herself doesn't claim this is an absolute rule. I think she says it's more of an empirical regularity, not kind of a law of nature.

But I think if it does happen, the historical precedent would be consistent with a recession there. So I think from that perspective of the Fed's forecast and rates and unemployment, there's a bit of an inconsistency there. And maybe the Fed is saying this time is different, but we'll see.

13:21 - 13:49
Chris T
Okay. Well, moving along, let's focus our attention toward some of the key September readings. Let's first start with August housing starts. Those were released mid-month in September. The headline was that the housing starts dropped 11.3% in August and multi-family starts fell 26.3%. Doesn't sound great. I take it interest rates are the main culprit here. But in your opinion, how does this data read to you? Is it good news? Is it bad news?

13:49 - 14:18
Richard d
Yeah, I guess we could probably say a couple of things here. First is that we're in this really weird period where there's been a huge increase in mortgage rates from, you know, about 3% to over 7.5%. And both house prices and new home sales have actually remained pretty firm, even though affordability has collapsed and existing home sales have fallen quite significantly as well.

And we're seeing mortgage applications which are actually at their lowest level since 1995. So I don't think this so-called resurgence in housing has a lot of legs to it. And secondly, that's what we're also starting to see from the homebuilders themselves. So they're starting to get a little bit more concerned about what they think could happen going forward.

And we're seeing this both in the performance of the homebuilders' stock price index, which is rolled over. And in the NAHB’s survey of homebuilders sentiment, which has moved back down into contract territory. They're starting to get a little bit more concerned. And I think they've perhaps surprisingly had a pretty good run of it for the last year or so even though mortgage rates have shot up. When those rates moved up, that basically removed a pretty big chunk of competition from the playing field. So, your existing homeowner, they basically left the playing field and left the homebuilders out there is really the only one, the only game in town, the only ones with any real supply to offer.

And they've obviously loved it. They've had a great time of it. But I think looking forward, we can see that there's still a large amount of new supply in the pipeline, particularly for multi-family homes, which there are a lot that weren't able to be completed so are still in the pipeline because of supply chain issues. They didn't get the windows, the steel trusses, that kind of thing.

And as these supply chains are clearing, those homes are being completed and that will just add more supply to the market. Certainly for that sector, it's less of a problem for single-family home, but more for multifamily and affordability is still really poor. So I don't think it's a great near-term environment. I think what we're seeing certainly on the housing starts, it's also indicative of the Fed's higher rates kind of starting to bite.

I don't think there's a very stable equilibrium at the moment and I suspect we'll continue to see some weakness here for a bit going forward as the supply and demand dynamics continue to play out.

16:51 - 17:38
Chris T
Got it. Then you've got this August retail sales report that came in well above expectations on the headline rate rising by, I believe was it by 0.6% and there was a 0.1% increase that was expected. It's a completely different story than housing starts is to see how this is all very conflicting and how must be keeping the Fed's head spinning. I mean, who would have expected that total sales would be 2.5% higher than a year ago? Right. When excluding autos as an example. So as you say in your note, it shows a consumer that's still hanging in there with low unemployment and steady income, excess savings, and then confidence that seems to be recovering as the economy continues to defy recession predictions. In your opinion, how likely is it that this is going to continue?

17:38 - 18:17
Richard d
Yeah, So I think yet again, this is another area where we have these weird conflicting things going on. I think we're seeing spending decisions that require financing, particularly housing. Obviously, fading banks are unwilling to lend. They've increased their lending standards pretty significantly, but there's clearly still some spending on other lower-ticket items. But then I think what's important to note is that any consumer slowdown is at least starting from a pretty solid foundation for the U.S. consumer.

So it's not like activity is going to suddenly fall off a cliff like it did in 2008 or 2009. I think consumers today, you know, are not massively overleveraged, like nothing like they were back in 2008 or in the run up to 2008 and 2009. And we're also probably in a structurally tighter labor market, which is helpful as well.

But I think, again, we're starting to see some cyclical pressures building. So I think you've got a situation where you know, this excessive things that they had that's really petering out and largely depleted by the end of this year or very early into next year, we had post-COVID behavior, the revenge travel, spending, entertainment. That's probably been done. And some of that demand has been satiated.

You know, the boost from the Beyonce, the Taylor Swift, the Barbenheimer, that's probably out of the way as well. Taylor Swift can't tour forever.

19:18 - 19:19
Chris T
It seems like she could.

19:19 - 19:43
Richard d
Well, maybe, but on top of that, you know, student debt is kicking back in again so it's accruing again starting in September or October payments restart so that for some could be quite significant. And then on top of that, we got gasoline prices, which have been pushing up at least about 10% over the last month or so.

Who knows where they're going to go this winter if Putin maybe had some tricks up his sleeve and tightened supply again, something we feared might happen last winter didn't really happen. Inventories this time around are much lower, particularly if it's a cold winter. So that's a risk in the coming months. So to me, it looks like at least the tailwinds for the consumer are dissipating and there's clearly a number of new headwinds that are also emerging.

So from that perspective, I still think it would be difficult to avoid at least a mild recession in the coming year as these factors kind of play out.

20:25 - 20:50
Chris T
Okay, Got it. Finally, last question. Thanks again for being here. But I want to touch on your economics weekly report from the beginning of September that talks about tight high-yield spreads and why they may not last much longer. So explain that with all of the concerns about a looming recession over the last year, one of the weird kind of curious features of the financial markets has been the fact that high-yield credit spreads have remained exceptionally tight.

And you're going to say these spreads are always a good barometer of the macroeconomic environment. And then so far they've been the dog that quote unquote, hasn't barked. How likely is it that this remains the case?

21:03 - 21:30
Richard d
Yeah, again, I think it's this sort of hard landing versus soft landing view, which is still playing out in the market. And I think if you believe in a soft-landing scenario, continuing a rising rate environment actually isn't bad at all for high yields. Why is that? Well, basically because rates are high only because the economy is strong and can withstand that.

So that's still good for high-yield or risk assets. It's really when those rates start to bite, that things start to get a little bit more uncertain and investors then start to demand a bigger risk premium for those more speculative types of debt. It's definitely interesting to see today with this kind of strong backup in Treasury yields that we've been seeing playing out, higher yield spreads actually have tightened further.

So they haven't been widening on the back of that. So again, that would speak to the market, continuing to expect a soft landing and that'll benefit high yield and not that treasuries are necessarily rising for other bad reasons. So there's also some supply-demand dynamics playing out here in the sense that there was a huge amount of corporate bond issuance through ‘20 and ‘21 and then virtually none in ‘22 and so far in ‘23.

So investors don't have a lot of supply to invest in. But I think we're getting closer to the point when fixed rate corporate bonds will start to have to be refinanced again, particularly for higher-yielding debt, which tends to have shorter maturities. And remember that they can't always wait until it actually matures. They typically need to refinance before those bonds kind of hit that maturity wall.

And I think that's likely to put some pressure on this market going forward, particularly if we see a combination of more moderate economic growth, continued higher interest rates, energy costs have been increasing, pricing power has been coming down as inflation is coming down and we're still seeing some sticky wages. So pulling back a little, I think we can see that there's a lot of areas where there really are, you know, some cyclical divergences going on.

But we can also see structural trends that are still quite supportive in the longer term. So I think that's kind of what we're seeing maybe in high yield as well. But I think in the near term it's again, a story of what I think will be some more cyclical weakness playing out again, maybe some longer-term, more structural trends going forward.

23:58 - 24:12
Chris T
All right, Richard, as always, it's been a pleasure catching up with you. Thanks again for joining. Looking forward to connecting again next month. I'm sure it'll go even quicker than this month as every month seems to do. That's about it. So thank you, Richard, again, appreciate it.

24:12 - 24:12
Richard d
Pleasure, Chris.