MAGGIE LAKE: Investors are stuck in a tug of war. On one side, we have central bankers, which are trying to convince us all that they're serious about inflation and are going to keep hiking rates. And on the other side, bond investors who remain unconvinced. Which side is right, and what will it mean for your investments? Hey, everybody, that's the question we're going to try to answer today. I'm Maggie Lake here with Darius Dale, founder of 42Macro. Hi, Darius. How are you doing?
DARIUS DALE: Maggie, it's great to see you. How have you been?
MAGGIE LAKE: I'm doing well. And I feel like that's the question of the moment. Certainly at this point in the summer with the data coming in, with all these Fed officials who are just constantly in front of the microphone, this seems to be the big question everyone's asking themselves. And there's a lot of disagreement, there doesn't seem to be much consensus.
DARIUS DALE: No, not at all. I think you can boil the question down even further to its first principles, which is, is the market going to care about the rate of change of inflation rolling off the peak? Or is the market going to be more concerned about the level of inflation remaining high and persistent, and ultimately causing the Fed to have to ultimately do more than what's currently priced into the markets? And depending on your answer to that, that will ultimately determine your asset allocation and your portfolio construction.
MAGGIE LAKE: That is a fantastic point. And so, to be clear, we're talking about like, let's just throw some numbers on it, if we're getting inflation, monthly inflation prints that are 9% or 8.1%, the question is, does the Fed want to see that come down to some absolute number, 4%, 3.5%? Or do they just want to see that it's declining in some pattern, and that's the thing that they'll look at? So, traditionally, it might be high at 6% or 7%, but as long as the slope is falling, that's what they'll judge policy on. Is that right?
DARIUS DALE: Yeah. Well, so I tend to be in a camp just based on listening to every single word that these people say every single day and taking detailed notes on it. It's pretty clear that they have a set of thresholds that needs to be met. If you look at it from the perspective of financial markets, they want to see certain set of financial conditions, tightening objectives achieved, particularly achieving real positive real rates across the curve.
That's something that they were on their way towards accomplishing in late June, early July, but have since moved back in the wrong direction, largely as a function of the easing of financial conditions we've seen throughout July partially driven by Jay Powell's gaffes in the press conference last Wednesday. But then from a structural inflation standpoint, they want to see obviously, longer term inflation expectations, if you look at five-year five-year forward breakevens, or if you look at consumer confidence measures, like the University of Michigan consumer confidence measure that's up at 2.9%, it's got to get probably close to around 2.5% for them to feel comfortable that inflation is back to being reanchored.
But then ultimately, they need to see some actual progress in the data. Brian, if you pull up that chart, slide 87 from our Macro Scouting Report, this chart is pretty damning in the sense that we are moving in the wrong direction. These are all June prints, in terms of what we're showing here in the gray bar on that chart, is the prior month over month annualized rate of change. And the blue bar is the most recent print with the June month over month annualized inflation print.
And as you can see, going across these four indicators, we are very much moving in the wrong direction from a rate of change standpoint. And obviously, the levels are way too high to begin with. We're going to have to discuss that. But the first cluster bar shows the Dallas Fed true median PCE inflation, that's what Jay Powell started talking about last week, at 6.9% on a month-on-month annualized basis, that's obviously well above where we need to be in terms of 2% for the target, but that's also the fastest rate we've seen in 40 years.
Cleveland Fed median CPI, that 9% annualized is an all-time high. The Atlanta Fed sticky CPI at 8%, that 8.1%, that's the fastest we've seen since January of 1991. And then lastly, core PCE, which is their unofficial target, if you will, at 7.1% month-on-month annualized. That's a pretty ridiculous number relative to not only their target, but also relative to moving in the wrong direction.
MAGGIE LAKE: Yeah, personal consumption expenditure is basically what we pay for goods and services. That's why they look at it. A lot of people are saying, okay, well, people have jobs, they can afford it. This is the worry, right? As long as you're working, how can we-- there's something to worry about in terms of inflation, and how can we be in a recession if everyone's got jobs?
We have a big jobs number tomorrow, but we had weekly jobless claims today, and they rose again. There are more Americans filing for unemployment benefits. What do we look at when it comes to the labor market? Is it as hot as it seems?
DARIUS DALE: Yeah, the labor market is still overheating, without a question. Jobless claims have been inching up since I don't want to say they put in the bottom in like March, but we've not really seen the kind of movement you would anticipate if we were actually heading into what we call an actual recession as opposed to a mere technical recession.
There's a couple of ways you can slice and dice the labor market to understand how tight it is, and ultimately playing this back into the initial question of the show, which is why we have not seen such a-- we haven't seen catharsis or capitulation on the behalf of equity and credit markets, because we still have an economy that is "hanging in there".
Just unpacking the jobs so you can look at it from a couple of lens, one from a levels, and secondarily, from a momentum perspective. Brian, if you pull up chart 82, this walks you through some of the levels that investors, like myself, and the Fed are looking at to understand the labor market dynamics. The first on that chart 82, the first panel on that chart shows JOLTs divided by total number of unemployment, so JOLTs is total job openings, we're at 1.8 in terms of that ratio, that's double where the ratio trended in the pre-COVID era.
The second panel is the private sector quits rate, which is about 70 basis points higher than where it trended in the pre-COVID era at 3.1% most recently. And then lastly, the bottom panel, we got this number last Friday, we got the employment cost index, total compensation for private sector workers at 5.5%. That's an all-time high, as you can see in the chart, but it's literally 300 basis points higher than where we trended in the pre-COVID era 2.5%.
2.5% is consistent with 2.5% core PCE so clearly, got a problem here from a levels perspective, and the levels-oriented economists at the Fed are going to see that and say, hey, this is a labor market that we can very much afford to continue tightening into. The second part of that is on slide 83, Brian, where we show a similar analysis of just looking at the labor market from a momentum perspective as well. And as you can see, the first cluster of bars will show the light blue bar, that's the pre-COVID trend in that particular indicator.
The first cluster of bars is private payrolls growth, showing everything on a three-month annualized basis. And the dark blue bars is the most recent prints of the June jobs report. As you can see, we're double the pre-COVID trend in terms of the three-month annualized rate of change of private payrolls, move over one, we're double the three-month pre-COVID trend in terms of average hourly earnings, and then move over two, you go to the far right cluster of bars, and you aggregate all those statistics, you wind up with aggregate private sector labor income and at 8%, we're effectively double where we trended in the pre-COVID trends.
So, no matter how you slice and dice the labor market, this is one that is the Fed should feel very comfortable and confident in terms of tightening into the slowdown in growth.
MAGGIE LAKE: We have seen, and certainly those in the camp who think that things are slowing down, and this is a transition, that's why you got this-- you've still got labor market, but maybe some of that lags. And if you look at things like ISM, which we know a lot of people in the analysts community look at that starting to show things slowing down and some of the manufacturing surveys.
Does that indicate that we're in a transition, and we're not sure if we're entering recession? Or do you think all of that stuff again, even if it's decelerating, is strong enough to withstand to show that the economy is robust enough to withstand these rate hikes? Because clearly, the Fed must see that.
DARIUS DALE: Yeah, totally. And look, the Fed, Jay Powell has consistently reiterated that they're comfortable to slow down, even more or less confirm that they're comfortable with a recession in order to get inflation under control. I don't think that-- I think you could remove the Fed from this particular aspect of the debate. I think the real aspect is going back to the investors. Investors, there's two camps of investors right now. There's the rate of change investors that look forward and see an economy slowing and Fed tightening into that.
And then there's the levels-oriented investors, you used the word robust, which I think is a very important word to use at this particular time. If you look around, the labor market is very robust, corporate earnings, they're slowing, but they're still very robust, certainly on expectations based, relative to expectations in Q2. You're looking around, and you're still seeing robust levels of economic activity looking through the nominal lens in particular.
But then when you obviously look at it on the rate of change basis, and oh, by the way that ISM services print from yesterday was just rock solid. You had basically new orders pushing to 60, the big reacceleration, where it all mattered. It's very clearly that the economy, the real economy has not yet fallen off a cliff, but it's certainly moving in that direction when you look at some of the leading indicators.
Obviously, housing is the most leading sector in the economy is already in recession. You look at the three-month annualized growth rates of things like housing starts, building permits are down 40%. You look at something like ISM new orders minus inventories, that's putting us at somewhere between 38. You Just look at the ongoing tightening in liquidity conditions, Fed continuing to hike, balance sheet continuing to contract. And ultimately, the rate shock that we've accumulated through the first half of this year will have ramifications on a lagged basis over the next few quarters.
MAGGIE LAKE: This is such an interesting conversation, because it's giving us a different question to look at, which I think is really important, and maybe is going to be easier for us to all track. And that is the rate of change. People are in the camp that the Fed's going to pivot, because they're going to start to see deceleration. The absolute level people are saying, listen, as long as it remains strong, there's room and the Fed's going to keep going.
There was a really interesting thread on Twitter that caught our eye. And I think it speaks to this. And it was, I think, a screenshot, Lyn Alden tweeted it out but I think it's a screenshot of a couple of tweets that went out right in a row from her, from Alf, from Adam, suggesting that basically, the Fed is willing to sacrifice jobs, they intend to weaken the labor market until they get inflation under control.
That sounds like there's a lot more downside, Darius, and based on what you're saying, there's a lot more pain in the economy, and they're going to go until we're in recession.
DARIUS DALE: Yeah. 100%, that's our base case view is that because the Fed is operating on-- they're using variables that lag the broader economic and market cycle to guide their policy. They're anchoring, and Powell pined on this last week, and then we got daily, Evans, we got Bullard, who else do we have, and Mestre out this week, confirming that, hey, look, yeah, everything's robust. We're going to keep hiking, we haven't made enough progress yet.
The problem with guiding policy through the lens of the labor market, and through the lens of inflation is both of those things are very late cycle, they're lagging the broader economic cycle, and they're extremely procyclical. It sets you up for a scenario this fall and into this winter, where the Fed is still tightening policy. And markets don't really want them to be still tightening policy.
Right now, things are, again, as we discussed, are robust enough for investors to look around and say, maybe we overpriced too much at the June lows, which I don't disagree with, not the least of which the inflation and the net liquidity cycle, which we can touch on later in the discussion. But eventually, we're going to have to come back to-- the chickens will come home to roost on the broader cycle, because again, you're setting up for increasing divergence between policy tightening and the economy. And right now, that divergence is somewhat narrow, but it's only going to get more and more divergent over time.
MAGGIE LAKE: And welcome to the conversation. Great questions coming in from Tom, Yoyo, Mark, Gang, DT. We're going to get to them in a second. We talked about that tension between the Fed and the bond market, the bond market's mispriced right now, it sounds like you're saying,.
DARIUS DALE: I don't disagree with that. I don't know if I agree with that. Let's be honest here.
MAGGIE LAKE: Because you're thinking they're going to pivot?
DARIUS DALE: Yeah. The bond market, I would separate the bond market from the money markets. The money markets, Eurodollars, overnight index swaps, Fed fund futures, they're pricing in a December, the last hike being in December, and ultimately, the Fed's starting to fade and cuts by let's call it May of next year. That's the central modal outcome. You may look at Eurodollars at around March of next year.
Do I think that's probably wrong? Based on everything I know today, I would say I would fade that. I would say the curve is probably underpriced relative to the policy rate shocks we're going to continue to receive. And as a function of that, we're probably going to have the Fed's balance sheet contracting for longer, and then that liquidity function contracting for longer because again, as long as the Fed continues to hike the policy rate in an environment where there's a scarcity of T-bills, it's very likely we continue to see the reverse repo facility balance climb as well, so that is usually a negative sign for liquidity.
As it relates to the bond market. I think there's a real debate. There's a very interesting debate in financial markets right now, which I think is as important as the debate on where do risk assets go, which is, what's the neutral Fed funds rate? Powell outlined last week that 2.5% is neutral, and I would be in the Larry Summers camp, Olivier Blanchard camp that says that's just wrong.
We're talking about no matter what metric you're looking at, you're talking about if it's the trim mean, PCE inflation, which Powell is now anchoring on, if it's median inflation, both of those statistics are somewhere between 200 and 400 basis points higher than they were in Q4 2018 when Powell said neutral is 2.5%. We may have to go through a process over the next few months of debating, discussing and debating whether or not neutral is in fact 2.5%, and if we see anything that looks like a positive revision to that, then the entire yield curve has to shift higher.
It may be the case that we haven't necessarily seen the ultimate lows in bonds. But ultimately, we do believe that the more the Fed prioritizes fighting inflation to save the bond market implicitly, they're effectively sacrificing the economy and the equity market and credit markets on the other side of that.
MAGGIE LAKE: Yeah. It's so important, Darius, and great example. And we're going to keep digging into that. Let's jump into the questions because I think some of them will help us tease out some of that. As we're talking about this, the Bank of England, it's not just the US, we're talking about central banks around the world on this inflation fight. The Bank of England raised rates by half point today, biggest hike in 25 years at the same time, said, economy's going into recession, a long one, maybe the worst one since the great financial crisis. That's pretty harrowing.
Yoyo asking, how long do you see the US recession based on the BOE's comment of more than a year? Are we looking at a severe, because the Fed's going to do it until they get inflation under control, are we looking at a long recession here as well?
DARIUS DALE: You'd be a fool and I would be a fool to answer that question with any specificity so I'm not going to. But almost by definition, a recession is impossible to predict, because it's such a statistically significant deviation from any model on a sample basis that you could train it on.
It's not possible in my opinion, by the way, I've tried for the last 14 years to build these kinds of models, you really can't do it. What you can do is identify the conditions that are in place that will put you in a significantly negative enough economic state to see other legitimate actual recession, you obviously need to be coming off a very high level of total employment, a very low level of unemployment, and obviously, you typically need a significant amount of financial, you need some shock, whether it be through energy, whether it be through fiscal policy contraction, or whether it be through monetary tightening.
And unfortunately, we had all three, so we can assume that the recession risk is very much rising, which we can imminently observe by the collapsing three-month 10Y yield curve, I think we're somewhere around 27, 28 basis points. We were at 200 basis points in that yield curve, like two months ago, three months ago. Clearly, the markets are very concerned about recession. I don't know if I even answered the question, but--
MAGGIE LAKE: No, I think you did. And I think this is a really good place to interject something. And we have a couple of these questions coming in like, where do you see the S&P, all of this, no one has a crystal ball to these answers, especially when you're in this really hard transition period. I think what you do, and a lot of the people, analysts fund managers, Raoul talks about this all the time, is trying to get the