Taper Time?

U.S. retail sales fell by more than expected in July.

Month-on-month sales fell by 1.1% (vs. consensus expectations of a 0.3% decline) as weak motor vehicle sales served as a drag on headline sales. Core retail sales, which exclude food, gasoline, autos, and building supplies, fell by 1.0%. Importantly, the decline in sales still leaves the level of total sales well above pre-pandemic levels and some of the weakness is likely tied to the early expiration of enhanced unemployment benefits in some states. We see the Fed as being more focused on labor market and inflation data. Later this week, investors will get a fresh look at inflation with the personal consumption expenditure (PCE) deflator being reported for the month of July. As the Fed’s preferred measure of inflation, a surprise to the upside or downside may be material.

Separately, U.S. housing starts also disappointed

Starts fell to an annualized pace of 1.534 million in July – down from a pace of 1.650 million in June. Most of the decline in sales occurred in the more volatile multifamily starts. We would also point out that building permits came in higher-than-expected which could mean that we will see a rebound in starts in coming months.

This week could prove to be a pivotal one for financial markets with investors focused on the Fed’s virtual August 27th Jackson Hole conference. It seems unlikely that the Fed will make a tapering announcement at this meeting given the ongoing concerns about the Delta variant (though it can’t be ruled out), but investors will be looking for clues on the Fed’s timeline for tapering its $120 billion a month asset purchase program ($80 billion in U.S. Treasuries and $40 billion of mortgage-backed securities). In the July 28th Federal Open Market Committee (FOMC) meeting minutes, the transcript showed that most participants thought that it could be appropriate to start reductions in bond purchases this year.

Citi Research’s view is that tapering will be announced in September and start in December (with a chance that it starts earlier) and that the Fed will taper Treasury purchases by $10 billion a month and mortgage-backed securities by $5 billion a month. If Citi Research’s base case is correct, then it will take about 8 months for the Fed to wind down its bond purchases. Of course, this does nothing to reduce the size of the balance sheet, which currently stands at about $8.2 trillion with Treasuries making up $5.2 trillion of that balance and mortgage-backed securities making up about another $2.4 trillion of the balance. Since February 2020, the Fed’s balance sheet has essentially doubled – climbing from $4.1 trillion to $8.2 trillion – with the Fed now owning about 25% of the total Treasury market and about 27% of all outstanding MBS securities (see figures 1-2).

This chart shows the Federal Reserve’s Balance Sheet increase from 2008 to 2021.

This chart shows the percentage of outstanding U.S. treasury securities held outright by the Fed from 2008 to 2021. Most investors expect the Fed to announce a tapering of bond purchases soon.

There are two takeaways from this: 1) the Fed is a major buyer in the market and is keeping rates abnormally low when compared to the current levels of economic growth and inflation and 2) the path to a full normalization of the balance sheet is likely a very long one and may not even be reached before the next recession.

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After the Global Financial Crisis, the balance sheet ballooned from about $800 billion to about $4 trillion, but the Fed only managed to bring down the balance sheet by about $740 billion between January 2015 and August 2019. This time around, they would need to reduce the balance sheet by nearly $4 trillion to get back to pre-pandemic levels. While the potential for tapering may be leading investors to tread cautiously with defensive sectors like Healthcare outperforming of late (the sector is up 10.6% since the start of June), we would note that most 10% drawdowns in the S&P 500 have happened outside of periods when the balance sheet was expanding. With many crosswinds converging (the Delta variant, Fed tapering, potential tax increases to offset infrastructure spending, peak economic growth, peak corporate earnings growth, etc.) we can not rule out a correction, but with Fed policy still very accommodative, the odds of a large market correction seem reduced (see figure 3).

This line chart shows the S&P 500 Index vs. the Federal Reserve’s Balance Sheet from 2008 to 2021. Large market drawdowns tend to occur outside of periods of Fed balance sheet expansion.

While August and September do tend to be weak months for equity markets and strong months for Treasuries; thus far, the S&P 500 is actually up 2.0% in August and the 10-year Treasury yield is little changed. While the path of bond yields has been puzzling with the 10-year yield falling about 50 basis points since the end of March, the path lower has not been completely divorced from past seasonal patterns with yields often falling in the second and third quarters and then rising in the fourth quarter (see figure 4). If this seasonal pattern plays out once again, then a 10-year yield in the 1.50% range by year-end seems reasonable.

This chart shows the average Quarterly S&P 500 Returns since 1950 versus Average Quarterly 10-Year Treasury Yield in percent since 2010. Equities are often weak in the third quarter, but tend to rally in the fourth quarter.

Despite the prospect for near-term volatility, if we use the 2013 “taper tantrum” as a playbook, the stock market actually held up quite well over the longer-term – returning an average of 12.2% over the next four years as the economy continued grow (see figure 5). Returns were indeed negative in 2018, but we would argue that rising U.S. – China trade tensions likely played a critical role.

This chart shows the annual S&P 500 total return during fed balance sheet normalization from 2011 to 2020. The Fed started to taper bond purchases in December 2013, but the market experienced positive returns over the next four years

U.S. Economic Data May Be Normalizing

Moving on from the potential impact of the very early stages of a normalization in Fed policy, let us talk about some of the economic data of late. Concerns of a slowdown have risen some as consumer sentiment unexpectedly dropped in August, housing sentiment dipped, and July retail sales missed expectations. Each of these reports are important and urge some caution, but we think it highlights a bigger trend that is worth pointing out. Since June 2020, U.S. economic data have been surprising to the upside with Citi’s economic surprise index holding above zero for well over a year. However, since the start of August, the Citi economic surprise index has dipped into negative territory (see figure 6).

This chart shows Citi’s U.S. Economic Surprise Index in percentage terms. A positive reading of the economic surprise index suggests that economic releases have on balance beat the consensus expectations; a negative reading means they have missed expectations.

Importantly, the index was in negative territory in mid-2017 and mid-2019 and real U.S. gross domestic product (GDP) continued to grow at a moderate pace, but it may be signaling that the business cycle is starting to mature into a more mid-cycle expansion. This is to be expected. Enhanced unemployment benefits were not intended to last forever and the pace at which the population fled to the suburbs was also unlikely to be a lasting trend. We think this normalization in economic data could contributing to a growth scare for some investors. However, retail sales are still tracking at 15.8% higher year-on-year and e-commerce (online) sales are still 30% higher year-on-year. Even with the weaker retail sales data included, the Atlanta Fed’s GDPnow tracker is still projecting 6.1% growth in the third quarter of 2021.

Perhaps more importantly, high frequency data are not showing a material slowing in the economy. Initial jobless claims have been steady and employers are reporting a record high 10.1 million job openings, which suggests that the most employers are not changing hiring practices as a result of the Delta variant (see figures 7-8). Likewise, the number of seated diners and people flying may have moderated, but nowhere near the extent seen in early 2020 (see figures 9-10). Perhaps we have seen peak economic growth, but that does not need to imply weak economic growth ahead. In our view, U.S. economic data are more likely showing early signs of a period of economic normalization following the darkest days of the global pandemic.

This chart shows a steep decline of weekly U.S. initial jobless claims in the thousands from January 2021 to August 2021.

This chart shows the total number of U.S. job openings from 2001 to 2021.

This chart shows the Number of Seated Diners in the U.S. and Gobally (Percent Change from 2019) from March 2020 to August 2021

This chart shows the U.S. TSA Checkpoint Total Number of Traveler Throughput from January 2020 to August 2021.

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