Coming into 2023, we have to admit the expectation the U.S. economy was headed for a recession was probably at the highest level we had ever seen in our careers. Sure, there is always that hope the Fed could somehow magically engineer the ever elusive ‘soft-landing’. However, when a central bank raises rates by 450 basis points (bps) in less than a year AND implements quantitative tightening (QT), one could be forgiven for assuming the only plausible outcome would be an economic contraction.

With the release of the blockbuster January jobs report, there has been a detectable shift in the narrative surrounding the economic outlook. Besides the surge in new job creation to begin the year, investors also discovered that the service sector of the U.S. economy is no longer in contraction territory either. Indeed, the ISM Services gauge essentially reversed the prior month’s decline completely and now stands at 55.2 (a reading below 50 is associated with contraction territory), a round-trip of sorts from where the index stood for most of the last six months of 2022.

Certainly, one of the factors in the bond market rally in January was the notion that more economic data were beginning to rollover. Now in one fell swoop, that narrative has changed somewhat. But, we ask the question has it really? We have highlighted in the past the weakness in housing and manufacturing, accompanied by the recent drop in capacity utilization rates. So, it seems maybe we’re just back to square one of sorts. While signs are prevalent of economic slowing, the labor market apparently remains on solid footing, a factor that has certainly captured the Fed’s attention.

We pose the question: what about the financial side of the ledger. Arguably, the lion’s share of attention has been placed on ‘real-time’ economic data, and rightfully so, but what about the pass-through effects of Fed tightening on bank credit and loan activity, a very important part of the equation that doesn’t seem to capture the headlines. According to the December Consumer Credit report (the latest data available), household borrowing rose at its smallest amount in nearly two years. In addition, the Fed’s Senior Loan Survey for January revealed tighter lending standards and weakening demand for credit.

Let’s go back to a measure we’ve discussed in prior weeklies, Assets and Liabilities of Commercial Banks in the U.S., otherwise known as bank credit, and another Fed-sponsored report. Total bank credit is finally beginning to show signs of softening over the last few months. For the record, bank credit is made up of securities holdings and loans. Certainly, on the securities side, negative readings became prominent during the final months of 2022, but what was more interesting was the deceleration that was witnessed in the ‘loans and leases’ component of the report. For December, total loans and leases in bank credit rose at a seasonally adjusted annual rate of +5.2%, or only about half of the level of increase two months earlier of +10.2%. In fact, the latest reading was a visible step-down from the +9.4% gain only one month earlier in November.

Interestingly, real estate loans have managed to still produce a decent performance, rising by +9.7%, with both residential and commercial credit providing support. Perhaps more telling on where things could be headed was found in the commercial & industrial (C&I) and consumer sectors. C&I loans decelerated to a +6.2% pace in December, a rather large drop from the +14.2% reading of the prior month. On the consumer side of the equation, the gain fell to only +2.4% as compared to increases in excess of +9% in September and October.

As last week’s trading activity underscored, Treasury yields can come under renewed upward pressure just as quickly as when they tumble, as was the case to begin the year. In fact, the rally in Treasuries that was envisioned for 2023 took place in just the first month of the year alone, so some payback seemed reasonable. Where rates go from here is a two-fold proposition. Based upon recent Fed-speak, Powell & Co. seem intent on potentially raising rates at least once, if not two more times, pushing the fed funds target perhaps over the 5% threshold. However, the Fed is also now in full data dependent mode, which means ‘hang on’, things will remain rocky for a while longer in the bond market.