Is the US Economy Hitting a Soft Patch?

Is the US economy hitting a soft patch?

Over the last 18 months, the US economy has proved to be a stunning exception not only to slowing global growth, but to expectations for economic activity at the business end of a tightening cycle. However, softer GDP growth of 1.6% in Q1 2024 (compared to 3.4% in Q4 2023) may have been the first indication that the historically sharp pace at which the Fed has raised rates is beginning to have an effect on activity.

It certainly appears to be having an effect on inflation – April’s CPI read came in at 3.4%, the first release of the year not to exceed analyst estimates. It also marked the first fall in the headline number of 2024, after progress on bringing inflation down stalled in June of last year. While it is not yet the progress that the Fed either wants or needs to see before gaining enough confidence to cut rates, the acceleration in inflation seen in the previous two releases has not continued.

At the same time, we see indications that the restrictive stance of monetary policy is beginning to impact businesses across multiple sectors. These include the ISM indicators for both the Services and Manufacturing sectors, as well as the Philly Fed Manufacturing Business outlook survey.

The sentiment index for the manufacturing sector dipped back below 50 (indicating that respondents see business conditions deteriorating) after trending positive following the Fed’s last hike in July 2023.

The Philly Fed Index for general activity has also been trending down since reaching record highs last seen in the 1980s. The current index value is 4.5, whereas a value less than 0 reflects contraction in the manufacturing sector in the northeast region.

We also see indications that tight monetary policy is beginning to impact households: consumer sentiment fell by roughly 13% in May (a statistically significant change which brings sentiment to its lowest reading in six months), Walmart reported an increase in sales volume (driven by higher income households purchasing lower-priced items) and new housing starts are were lower than expected (1.36m vs expected 1.42m) with previous months suffering downward revisions.

We also see a steady-but-small increase in the proportion of income being used to service outstanding debt from a pre-cycle low of 7.1% to 7.6% in Q3 2023. While a 0.5 point move in the US’s ratio is small when compared to Australia and Norway, we note that this number is now 8 months out of date and that the current value is likely higher.

A small acceleration in this metric can have an outsized influence on a highly-leveraged, interest rate-sensitive economy like that of the US. For such an example we need look no further than the credit crunch that led to the GFC in 2008, which saw just a 1.6 point increase in the debt servicing ratio.

Signs of stress of a squeeze on households and private sector balance sheets as a result of interest rates are even clearer in other countries, and may be cause for concern for global liquidity levels. For example, the debt servicing ratio for both households and the private sector has climbed dramatically as a result of rapid hiking cycles in several economies.

We believe that we are seeing early signs that nearly 12 months of “restrictive” monetary policy is beginning to weigh on both businesses and households. With the concern over a reacceleration in inflation moderately abated by last week’s CPI reading, our attention is now turned fully towards signals that the economy may be headed towards a soft patch. The downturn in these measures of the health of the economy looks especially at odds with the market sentiment over monetary policy when we consider that the market continues to price out the cuts that it foresaw at the beginning of the year.

Market Pricing for Cuts

While not immediately alarming on their own, the possible signs of a downturn in economic activity are strange to see at a time where the market has priced out cuts to a somewhat extreme level. For example, markets saw the 1 year forward Fed Funds rate at close to 3.75% at the beginning of January – more than six 25bps cuts to the 5.25-5.5% range at which it remains.

The extent to which markets have reversed those expectations has been extreme. The chart below shows the relative market-implied probabilities of the mid-point of the target range at the final meeting in 2024.

At the beginning of the year, the markets priced for 3 or more cuts (all areas except yellow) in 2024 with certainty. As sticky inflation figures were released, the probability of 3 or more cuts fell, reaching low levels at the beginning of April. Around this time, the markets began to price for no cuts (yellow area), which peaked on 29th April, as it was seen as a more likely scenario than 3 or more cuts.

Is the market correct to price out cuts so aggressively? Strong growth, sticky inflation, and tight labour markets have each contributed to the higher-for-longer narrative, but are markets really so confident that the economy will continue to sustain its remarkable resilience?

Swaption Volatility

Despite responding to the Fed’s messaging in the meeting on 1st May, markets continue to price out many of the cuts that they had foreseen at the beginning of the year and offer swaption volatility near to the cycle lows.

We also observe a smaller “rollup” (if rates don’t move and the market doesn’t change the pricing of the 1Y swap rate, then the forward rate will “roll up” towards the higher spot rate on the 3-month forward rate curve than we have seen earlier in the cycle). For example, the 3 month forward rate is at 5.15%, pricing in some cuts below the current spot level of 5.43% and closer to the lows than the highs of the cycle. The chart below shows the spread of the spot 1Y swap rate above the 1Y swap rate 3 months forward.

The 3 month forward rate traded at the closest level to the spot rate in late April, showing just how far the market went in pricing out cuts in the short term before the Fed closed the door to further rate hikes in their FOMC meeting last week. Now, the forward rate trades at 5.15%, around 28 bps below the spot rate at 5.43%. The 3M forward 1Y rate has fallen further than the spot 1Y rate, but the rollup remains lower than the spread recorded for much of 2023.

The implied volatility of ATM receiver swaptions is also near its lowest levels over the past 18 months as swaption vols have crashed to levels not seen since several US banks crashed in March 2023.

At the beginning of the year, when markets had priced in the dovish December FOMC meeting and were expecting cuts to begin in March, the 1Y forward rate traded at 4.93%. It is odd that volatility is priced near to the cycle lows given the potential uncertainty to come regarding the path of monetary policy. However, in short term there are few events in the macroeconomic calendar that could generate volatility can materialise ahead of the next FOMC meeting on the 12th June, with the exception of the Non-Farm payroll release 5 days before on 7th June.

Crypto Volatility

With few events in the macroeconomic calendar before the release of NFP figures on 7th June, we think that there are few chances for a sharp reversal in market sentiment to drive volatility across risky assets in the short term. Bitcoin in particular has been driven by macroeconomic factors alongside other risky assets. This can be seen in the chart below, which shows an increasing correlation of BTC to the NDX after the launch of the ETF in January allowed more institutional investors to add crypto to their risky-asset macro portfolio.

In addition, we see fewer Bitcoin-specific narratives in the near-term following the strong performance in the first quarter of the year. The halving has passed with little fuss, and there has been a muted reaction to Ethereum’s ETF news when compared to ETH’s reaction to BTC’s ETF announcement. We see this lack of narrative compounding upon the lower volatility across the board, meaning that this low volatility regime may be particularly strong for BTC.

Indeed, the strong correlation between volatility and spot returns observed in the first 3 months of the year has seen both stall, with BTC remaining range bound since mid-March. Both implied and realised volatility have dwindled lower, but delivered volatility has fallen further and faster, resulting in implied volatility trading significantly higher, particularly at longer tenors (as the chart below shows).

This corresponds with an upward sloping term structure of implied volatility, where longer tenors hold richer implied volatility that is even further above the level most recently delivered. The shape of BTC’s term structure is also at extreme odds to ETH’s, which is significantly inverted following the surprise re-appraisal of the probability of an ETH ETF approval.

In addition, BTC’s volatility smile is skewed towards calls, meaning that derivatives markets are expressing a demand for upside exposure that is also strongest at longer tenors, corresponding to the higher implied volatility assigned to tenors at the back end of the term structure. This is at odds with our view of a range-bound spot price in the short term -- after rallying to all-time highs following the ETF announcement and lacking an obvious narrative to drive it higher, we do not expect spot to break out of its range to the upside. We believe that it is more likely to drift to the bottom of the range, as it has done so frequently over the previous two months.