Crypto News: Forget the election. The Fed and the economy matter more

Boy, has the political landscape changed since I last wrote here. The Democrats seem to be surging based on the latest polling. And so, the burgeoning "Trump Trade" in capital markets that I dissected last week — premised on a Trump victory as inevitable — has somewhat unwound. But politics aside, the reality is that the election will take a backseat in markets for the next few months.

Cast an eye forward to next week's Federal Reserve meeting, because what matters now is the palpable risk of recession and whether it can be overcome. Only when we are closer to Election Day will politics and the US government deficit become a driving factor again. In the meantime then, think of this as a bond story, with the one- to two-year Treasury range being most sensitive.

The corporate earnings season now underway will help us understand the risks. But any equity fallout probably won't occur until the next quarterly earnings season in October, right ahead of the election, potentially turning this presidential race into a nail-biter.

Issues to consider:

Bill Dudley's column that encapsulates the alarm
Here's why you want to watch jobless claims
Let's remember Warren Mosler's view, though
Earnings seasons is a big tell, especially Schwab
Tesla is a good gauge of why we should wait
So, I'm looking at the yield curve more
Q3 earnings will be the most telling about recession
Ultimately, economic slowing could even decide the election

If you haven't read the latest Bloomberg Opinion column from Bill Dudley, I suggest you do right now because I am about to break down why it's significant. Click here to read it.

In a sense, the headline says it all. The man who once ran the NY Fed is so alarmed at the slackening in the labor market that he thinks the Fed should buck market pricing and go ahead and cut rates next week.

Obviously, that's not going to happen, and Dudley gives you three reasons why. But I would also add a fourth, namely that market pricing shows almost no chance of a cut. And we know the modus operandi at the Fed has been to continuously give enough forward guidance about policy that, when the decision comes, it isn't a surprise. They're not going to change that behavior now — if only because doing so would engender panic.

The mere mention of the word "panic" in an economic context conjures up memories of Hugh Hendry's 2010 quip on BBC Newsnight as the European Sovereign Debt Crisis gathered steam, " I would recommend you panic." A completely different and more alarming scenario, to be sure. But the goal is to act with forethought so that you don't have to panic.

And what that means is taking Dudley's analysis seriously. This point is his most compelling:

Historically, deteriorating labor markets generate a self-reinforcing feedback loop. When jobs are harder to find, households trim spending, the economy weakens and businesses reduce investment, which leads to layoffs and further spending cuts. This is why unemployment, having breached the 0.5-percentage-point threshold, has always increased a lot more — the smallest rise was nearly 2 percentage points, trough to peak.

Translation: US labor markets are oh so close to the tipping point from which, historically speaking, there is no return. Labor market slack will build tremendously after we reach that level. And the result has always been recession.

A recent missive from JPMorgan's Michael Feroli reinforces my long-held view that jobless claims are going to be our canary in the coal mine. That's because he finds that only 44% of the variation in jobless claims are explained by layoffs, whereas the "gross hires measure explains 72% of the variation in claims." Why? People who file claims not only get laid off but also can't get a new job. As Feroli puts it, "even if layoffs remain muted, unemployment can still drift higher if gross hiring (and the associated job finding probability) continues to drift lower."

Over the last twenty-odd years, my rule of thumb for recession has been any uptick in jobless claims of 50,000 over a small period. Having tested this for both six-month and one-year lookbacks, I've found that a jump of that magnitude always has meant recession. And that rule of thumb helped me to successfully predict the last three recessions in real time.

My very first post in March 2008 on the now-defunct Credit Writedowns blog, which this newsletter replaces, claimed "the economy is definitely in recession" with a start date of December 2007 or January 2008. By then, non-farm payrolls had already started to trend down. But for me, jobless claims were the first warning sign. I laid out the following June that every time you crossed a threshold for both initial and continuing jobless claims — up 50,000 for initial claims and up 200,000 for continuing claims over a year's time — "for more than 5 weeks we have had a recession. And there have been absolutely no false positives in 40 years. None."

Where are we now? Average initial claims are 2,500 lower than a year ago and continuing claims are 82,000 higher.

So the numbers say no recession. In fact, the numbers were worse last year when everyone was worried about a recession. Still, the uptick in the unemployment rate is alarming enough for me to think a cut at every meeting from September should be the base case simply to forestall this from occurring.

I am reminded, for the third week running, of Warren Mosler, the godfather of MMT. He told us 7% deficits and recessions are strange bedfellows. Now, there's nothing axiomatic about huge deficits eliminating recessions. But they certainly give the Fed an opportunity to act before we reach the tipping point where the debt distress building in the economy overwhelms all of the financial-asset wealth transfer that deficits give us.

From a yield curve perspective, both of these scenarios have the same outcome: steepening the curve. The way I put it a couple of weeks ago on the MLIV blog on the terminal was this:

The likely outcome of so much fiscal spending is inflation. That will continue to force an offset from the Federal Reserve in the form of a more contractionary monetary policy, making long-term interest rates higher than they otherwise would be — even in a recession.

Think of it this way: Would you want to own 30-year government bonds in this uncertain economic and inflation environment or two-year government notes? And if you own the 30-year bonds, how much juice are you going to get from a recession that lowers rates but that causes the government deficit to go from 7% to, say, 12%? I'd say not a ton, because those deficits mean the economy will snap right back. With deficits adding more demand to an economy near capacity, inflation risk would keep the Fed on rate hike alert for years to come. You'll get your biggest bang for your buck over the period when the Fed would cut rates, say one to two years.

And so, you should expect, even in a recession, for the deficit anchor to pull up the value of one- to two-year bonds relative to long-term debt obligations with their higher inflation and interest-rate risk. That's my takeaway from Mosler and MMT. I'll come back to that conclusion later.

4.39%

The yield on a two-year US Treasury note at noon on Jul 24. That's the lowest since February, a sign the market expects cuts soon.

I don't think equities get hit yet. How robust they are will tell us how close we are to recession, though, as weakening profit growth would presage job cuts. And so far, this quarter is just fine. We have a long way to go in reports but the financial sector is a good bellwether here.

Sector leader JPMorgan Chase, for example, saw revenue up 20% in Q2. "JPMorgan earned $18.1 billion in net income in the second quarter, up 25% from the previous record a year earlier and ahead of analysts' expectations." Investment banking fees were up 46% and equity trading was up 21%, signs of a return of M&A and of potentially more equity market optimism to come.

Arguably Charles Schwab's result show us why the Fed needs to cut, though. The company is promising to shrink its banking operation. As I detailed with colleague Annie Massa in the Spring of 2023 — when the regional bank crisis was hot and heavy — Schwab is the poster child for the strategy of loading up on long-term safe assets that got the regional banks in trouble. The issue is two-fold.

One, Schwab has a ton of low-yielding assets on its books that are worth a lot less after the Fed jacked up interest rates. Treasuries and mortgage-backed securities sporting pandemic-era yields aren't worth nearly as much in a world where the upper bound of the fed funds rate is 5.5%. And you can't get these assets off your books either, because selling them would crystallize loses. That's exactly what caused the panic over a year ago after Silicon Valley Bank sold some of its dud assets. That means you have to accept lower income for months and years to come.

The second problem is on the liability side of the balance sheet. Schwab gets a lot more money from net interest income in this zero-commission world than you might think. That's because the brokerage business model depends a lot more on management fees and the "free interest income" on idle cash after commissions went to zero. Every dollar in your brokerage account that's not invested, and sitting around as cash, is money that the broker can use to invest. It's much the way banks take the money in your savings account to invest and earn a spread between what they give you on your savings and what their investments earn. The income they earn, usually from bonds and other fixed-income products, is a lot greater than what you're asking from them in interest.

Trouble is, getting pennies in interest is only fine when the fed funds rate is zero. It's not so great when fed funds is 5.5%. So people have been either yanking their funds or demanding higher interest products from regional banks (and Schwab). And that's even while a huge portion of those institutions' assets are earning low pandemic-era returns. Schwab's earnings report showed us this problem is persistent, and perhaps intensifying. The stock plummeted after it reported.

In conjunction with the rising unemployment rate and the squeeze on private markets, this is why the Fed should be thinking about cuts.

How would I wrap this big picture up into a conclusion then? I'd start with the quarterly earnings reports first. They're good enough so far. JPMorgan Chase and Alphabet are decent proxies for how well the best companies are performing. At the same time, the Schwab miss tells you we should be worried not just about economic deceleration, but also about the negative impact on the health of US financial institutions.

Tesla is a second kind of bellwether in all this. It's the weakest of the Manificent Seven stocks in my view. Here's a company whose business model has taken on water since the beginning of 2023. And while we were led to believe that it had weathered the downturn in electric vehicle adoption growth because of massive discounting, we now see that Tesla's reprieve was an artifact of the bullish market mindset that the boom in artificial intelligence seeded.

Tesla's revenue is actually declining now, not growing. But the stock still has a trailing price-earnings ratio of 100 times — as if it will reassert massive growth in due course. So even though the stock is down more 10% on the day after earnings alone, it's well off of 2024 lows, suggesting the bullish upward market isn't over quite yet.

So look at the recent US equity market pullback as indicative of a market biased to the upside that had run too far too fast. We're still in what I've called a summer "drift" phase, but with a slight upward bias.

That leaves bonds as the asset class to watch. About two weeks ago, in a piece geared toward bond market professionals, I wrote that the curve steepener, where long-term bonds underperform their short-dated counterparts, was the trade to watch. My exact words were:

Treasuries in the one- to two-year space should rally most, while longer-term bonds will remain anchored by large supply from deficit spending and an increasing term premium. The faster the rate cuts come, the more aggressively 2s10s should play catch-up. Right now, we're working with a 2s10s curve that is almost 60 extra basis points flatter than the 5s30s. In pretty much all scenarios, we should expect that gap to close.

Let me break that down a little further for those of you who aren't bond traders. As I've been saying, the Mosler argument about deficits suggests more inflation, some offset in more hawkish policy from the Fed, and thus higher long-term interest rates. We've seen that play out to the point now where at the very longest maturity end of the spectrum, 30-year Treasuries are close to yielding the most relative to 5-year bonds since the Fed started hiking.

I'd say then that this move is mostly done. It's the difference between the interest-sensitive 2-year and the whole curve's benchmark, the 10-year, that will now play catch up. When I wrote the piece two weeks ago, the 2s10s, the difference in the 2-year yield and the 10-year, was almost -30 bps - meaning you were paying the Federal government less to take on interest rate and inflation risk for 10 years than 2. That gap is now under 20. And I think it will close entirely soon.

If we avoid a recession — which seems likely to me at this juncture — then it will be a so-called bear steepening that gets us to "uninvert" the curve, as people finally believe in this recovery and ask to be compensated for taking on the risk of holding long-term debt as deficits balloon. But even if the economy falls into a recession, those long-term yields will be held higher by the deficits and inflation they bring, also making two-year notes more attractive when the Fed cuts to alleviate the pain.

We won't know which way the economy goes definitively until the fall. I don't think the Fed cuts next week. I think they cut in September. And between then and the October earnings, we'll know where the economy is by election time in November. Given the bump in polls after President Joe Biden dropped out and the likely bump to come from a vice presidential pick and the Democratic Convention, this race is going to be wide open. Whether the economy holds up will, therefore, be hugely important politically and for markets. But wait until October to give the election any consideration. Until then it's all about the economy.

One last thing. Since we're talking about the election, I want to go to bat for my MLIV colleagues and ask you some of their questions on the so-called "Trump Trade" here. For example, would the return of Donald Trump to the White House strengthen or weaken the dollar? What would perform best as a haven during a Trump presidency? Which currency would suffer the most? Please share your views in the latest MLIV Pulse survey.

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