Wall Street almost flat on mixed Fed, TSY, and Gaza war talks

Wall Street Futures were boosted for the last few trading sessions on hopes & hypes of big Chinese structural reform and stimulus (fiscal + monetary), a permanent Gaza War ceasefire, and mixed Fed talks. Fed is now preparing the market for an eventual rate cut cycle of 75-100 bps in H2CY24. Although the market was expecting an earlier & deeper Fed rate cut of 150 bps from March/May’24, various Fed policymakers including Chair Powell are now carefully jawboning the market in a well-planned (co-ordinated) manner to control inflation expectations and also bond yields for the intended soft & safe landing of the Wall/Real street (economy) ahead of Nov’24 U.S. Presidential election.

Overall, Wall Street is now in full control of the Fed, but if Trump wins again in the Nov’24 election, we may see Trump again take control of the market (like during 2016-20) as he will continue his fight with the Fed, China and also EU. But all policies will depend upon whether Trump or Biden can win the trifecta (White House, House, and Senate) for a majority government; otherwise, a minority government at the White House may continue to affect U.S. policies in the absence of bipartisan politics/agreement between Democrats and Republicans. The U.S. needs to deploy substantial infra-stimulus and targeted fiscal stimulus to increase the supply capacity of the economy to match the growing demand for durable price stability and also to stimulate the economy rather than too much emphasis on ‘easy Helicopter money’ (monetary stimulus, direct grants/subsidies etc).

On late Wednesday, the U.S. CBO said:

·         CBO forecasts US net interest (on public debt) costs at 3.1% of GDP in FY24 vs 2.4% in FY23, rising to 3.9% in FY34

·         CBO forecasts US public debt to rise to 116% of GDP at the end of FY34 from 97.3% at the end of FY23

·         CBO forecasts US real GDP growth of 1.5% in calendar 2024, 2.2% in both 2025 and 2026 after 3.1% growth in 2023, Q4 vs Q4

·         CBO forecasts Core PCE price index inflation at 2.4% in 2024, 2.3% in 2025 after 3.2% in 2023

·         CBO forecasts the US FY25-34 cumulative deficit at $20.016 trillion vs the previous FY24-33 deficit estimate of $20.314 trillion

·         CBO forecasts Q4 unemployment rate at 4.4% in 2024 through 2026 after 3.7% in 2023

·         Reductions in 10-year deficit projections primarily due to discretionary spending caps enacted in 2023 and stronger GDP growth and employment than previously projected

Overall, as per the latest CBO estimates, the U.S. is now paying almost 15% of its core revenue as interest on public debt, which may increase to almost 18-19%; i.e. around 20% by FY25 against the EU/China average around 5.5%. This is a red line for an advanced economy like the U.S. and truly speaking, may also invite another rating downgrade in the coming years despite the advantage of USD, being the undisputed ‘king’ (global reserve currency), always in elevated demand by other countries (despite almost 24/7 print by the US Fed/Treasury-like a toilet paper). Thus Fed has to bring core inflation back to below 2% and also the US10Y bond yield below +0.50% in the coming years on a sustainable basis so that the U.S. pays around 10% of its core revenue as interest on public debt (at pre-COVID levels).

In the early European session, Wall Street Futures were undercut by higher USD/US bond yields after BOJ made it almost clear that the Japanese Central Bank will not raise its REPO/Lending rate significantly, presently at +0.30% even after ending its complementary negative reverse repo rate -0.10% (with tiering).

On early Asian Session Thursday, BOJ Dy. Governor Uchida said:

·         Won't assess or comment on market perceptions of the future rate path

·         Believes the likelihood of sustained achievement of price target gradually increasing

·         Just terminating YCC does not mean bond buying will stop suddenly

·         Annual wage bargains are crucial in determining a positive economic cycle

·         Sees hopeful signs of rising prices leading to higher wage growth

·         Economic developments will determine whether the balance sheet expands or contracts when stimulus is withdrawn

·         BoJ to maintain cautious approach towards rate hikes

Japan is now paying around 13% of its core revenue as interest on public debt and thus also can’t afford too high interest rate/bond yield/coupon rate and BOJ has to manage government borrowing costs in a balanced manner along with price stability and quality employment. Japanese government/BOJ is now literally begging for higher wages from the Japanese private sector/corporates/business to increase wages of employees substantially for a positive economic cycle from the spiral of present deflation. But the Japanese private sector is also not in a position to increase wages and price of their products & services significantly due to lack of pricing power/robust demand and fierce competition.

On Thursday, Fed’s Barkin said:

·         The Fed is focused on inflation & unemployment, not US debt

·         If the economy turns south, that's a case for a rate cut

·         I am cautious that economic data around the turn of the year can deceive

·         When asked about Powell's comments last week on a possible March rate cut: Chairman Powell always speaks for the committee

·         I won't prejudge the outcome of the March FOMC meeting

·         I need to see good inflation numbers being sustained and broadening

·         It's certainly possible that the neutral rate has risen

·         We have time to be patient with rate changes

·         We don't have to be in any hurry to cut rates

·         I won't take too much signal from any one month at the moment

·         That said, I'm cautious about the accuracy of numbers at the turn of the year

·         The risk of deflation seems quite remote for the US

·         The hope and expectation is banks are ready for commercial real estate stress

·         Commercial real estate risk is on banks' radar

·         It might be good to have a modest range around the inflation target in the future

·         I'm comfortable debating the inflation target range once 2% inflation is achieved

·         The jobs market is tight, but not as tight as data suggests

·         Cautious of the January jobs numbers due to the size of seasonal

·         The January jobs data points to an incredibly vibrant job market

·         If inflation goes back to 2% amid strong demand, it would signal a higher neutral rate

·         We will learn a lot about inflation over the next six months

·         No objection to reversing course on rate cuts if needed

·         The confidence to cut will be driven by more inflation abatement

·         I would like to see rents and service prices cool more

·         I would like to see a broadening in forces lowering inflation

·         It's hard to know what to do with rates based on economic models

·         In aggregate, past rate hikes are still working their way into the economy

·         There's ample evidence that Americans continue to spend

·         Inflation has surprised to the upside before

·         Upcoming inflation data is likely to be favorable

·         Recent economic data has been remarkable

·         Upside inflation risks are still around

·         The possible path back to 2% inflation will be bumpy

·         Business contacts are less worried about recession risks

·         Firms are more stable on employment, see less pricing power

·         The Fed can take time on its decision to cut rates

·         I need to see more data to build confidence inflation is falling

·         No one wants inflation to flare up again

·         Doesn't believe market liquidity is growing scarce

·         I don't expect bank reserves to shrink back to pre-pandemic levels

·         Standing repo facility mitigates risks around trimming the balance sheet

·         So far the Red Sea disruptions haven't rattled the inflation landscape

On Thursday, Fed’s Collins said:

·         My baseline for rate cuts this year is 'similar' to the 75 bps in the SEP

·         Higher productivity provides some room for higher wage growth

·         Some wage growth exceeding inflation is consistent with the continued move toward 2% inflation

·         I expect an orderly slowdown in growth this year

On Thursday, the U.S. Treasury Secretary Yellen said:

·         There will be losses and stress in commercial real estate (CRE)

·         I believe CRE won't end up being a systemic banking risk. We don't have to get prices down because wages are going up

·         The Fed's preferred inflation gauge running at exactly 2%

·         I don't expect the level of prices to go down, but the pace of increases has slowed, and wages have risen considerably

·         It's obvious that there is going to be banking stress and losses associated with commercial real estate

·         The FSOC has discussed commercial real estate at almost all recent meetings

·         In an extreme case, it is possible to see issues with selling debt

·         No sign of issues with the treasury's debt-selling ability

·         Most forecasters and CBO suggest that interest rates are expected to decline somewhat

·         I believe the US needs to reduce deficits to stay on a fiscally sustainable path

·         My baseline for rate cuts this year is similar to the 75 bps in the Fed policymaker median view from December

Conclusions:

The 12M average between the US core CPI and core PCE inflation is now around +4.5%, which the Fed may consider as underlying core inflation, the target of which is +2.0% on a durable basis. The 6M rolling average of core inflation (PCE+CPI) is now around +3.9% or around +4.0%.

Fed may cut 75-100 bps in H2CY23 if the 6M rolling average of core inflation (PCE+CPI) indeed eased further to +3.0% by H1CY24.

As per Taylor’s rule, for the US:

Recommended policy repo rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(4.50.00-2.00) =0+2+2.50=4.50% (for 2024)

Here:

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation for CY23

Fed has to ensure a 2% price stability (core inflation) target keeping the unemployment rate below 4% and also 10Y bond yield below 5.00-4.50% so that borrowing cost for Uncle Sam remains manageable/sustainable to fund +34T debt (never-ending).

In any way, at the current run rate and trend, the average US core PCE inflation should be around +4.0% in 2023, +2.5% in 2024, +2.1% in 2025, and +1.5% in 2026, in line with Fed’s Dec’23 SEP. Similarly, the U.S. core CPI inflation average should be around +4.6% in 2023, +3.2% in 2024, +2.5% in 2025, and +1.8% in 2026.

If US core CPI indeed dips below +3.0% by May-June’24 and if it seems that the 2024 average core inflation will be around +3.2%, then the Fed may start cutting rates from July’24 and may cut cumulatively 75 bps at -0.25% pace till Dec’24 for a repo rate at 4.75%, so that core real rate continues to stand around +1.50%, in line with the present restrictive stance (5.50% repo rate-4.00% average core CPI for last 6M).

Looking ahead, the Fed may try to balance the financial/Wall Street stability and price stability by expressing intentions to cut (dovish jawboning) from Mar’24 (Q1CY24) to ensure a soft landing while bringing down inflation. Also, whatever the narrative, the Fed has to ensure lower borrowing costs for the U.S. Government (Treasury) endless deficit spending and mammoth public debt of almost $32T. The U.S. is now paying around 15% of its revenue as interest on public debt against China/EU’s 5.5%.

As a result of higher bond yields around 4.50%-5.00% (for 10Y UST); i.e. lower bond prices, the Fed is now in deep MTM loss for its huge bond holding. Fed is also providing higher interest to banks & financials for reverse repo operation than it getting under repo operation; i.e. Fed’s NIM/NII is now negative and theoretically the Fed is in negative profit to the tune of -$130B. The same is also true for various banks & financials, most of which are now in deep MTM loss for higher bond yields; i.e. lower prices for their HTM bond portfolio holdings due to Fed hikes. The US10Y TSY market price fell from around $140 to $105 from Jan’20 (pre-COVID) to mid-Oct’23; i.e. a fall of almost -33% in around 4 years; it recently recovered to almost $113 levels.

This is a red flag, and thus Fed has to operate in a balancing way while going for calibrated hiking to bring inflation down to target, avoiding an all-out recession; i.e. to ensure both price & financial stability and soft-landing. Fed has to bring down inflation to +2.0% targets by the  US 10Y bond yield below 4.50-5.00%, and an unemployment rate below 4.0% without triggering an all-out or even a brief recession in the US Presidential election year (Nov’24). The Fed will ensure that the US10Y bond yield is below 4.50-5.00% at any cost for lower borrowing costs for Uncle Sam (U.S.), everything being equal. Thus, overall Fed is methodically jawboning on both sides (hawkish/dovish) from time to time to achieve all its goals at the same time.

Considering all pros & cons, Fed may wait for core inflation data (average for core PCE and core CPI) for at least Dec’23-Mar’24 and if it goes down to around +4.00% from the projected 2023 average of +4.5% (4.80% core CPI and +4.20% core PCE), the Fed may cut rep rates/FFR by -25 bps in July; further if such disinflation trend continues, Fed may cut -25 bps each in September and December for a cumulative -75 bps.

We may see a synchronized global easing from H2CY24. As the Fed is the world’s unofficial central bank because the USD is the ‘King’ (the world’s most preferred FX or global reserve currency), all major G20 central banks are now bound to follow the Fed policy stance to maintain present policy/currency/bond yield parity, everything being equal.

Thus the market is now expecting a synchronized global easing (rate cuts) by major G20 global central banks including ECB, BOE, BOC, PBOC, and even India’s RBI, whatever may be the domestic macro-economic narrative (just like post-COVID synchronized global tightening to bring inflation down to targets).

Fed policymakers will now jawbone the market in a balancing way to keep the US10Y bond yield between the 3.25-5.25% range or around 4.00-4.50% on an average to maintain price/labor market/financial (Wall Street) and also Main Street/White House stability in the election year (2024). As the U.S. labor market is still robust with healthy wage growths, the incumbent Biden admin may prefer price stability and lower inflation in the coming months along with a sub/below 4% unemployment rate; i.e. price stability over GDP growths. As the 10Y bond is the main instrument for raising debt and a benchmark for US/global borrowing costs, the Fed may not allow it to hover above 5.00% for long under any circumstances, everything being equal. Fed needs to lower borrowing costs for the U.S. government from the present 15% to 10-7% over the next few years.

Fed hiked rate last in July’23 for a +5.50% repo rate and in hold mode with a hawkish stance since Aug’23; subsequently, US10Y bond yield gradually surged from around +3.75% to +5.00% by late November. As a result of higher borrowing costs and tighter financial conditions, the demand of the economy was affected to some extent, resulting in lower inflation. Now Fed has to keep on hold (neutral mode) for at least 10-12 months from July’23, so that the impact of higher borrowing costs is gradually transmitted to the real economy in full, resulting in core inflation back to targets.

Thus Fed has to wait till at least July’24 for the expected 1st rate cut; otherwise, its credibility may be at stake. If the US10Y bond yield again falls below +3.0% in the coming days (from the present +3.95%), then it may cause less restrictive financial conditions, resulting in higher core inflation. Thus Fed has to jawbone the market so that the US10Y bond yield hovers around 4.0-4.50% in the coming days so that the Fed can ensure relatively lower borrowing costs and price stability (soft landing).

Fed has to ensure 2% price stability and below 4% unemployment targets along with financial/Wall Street Stability and also keeping public/government borrowing costs at the lowest possible by directly/indirectly controlling bond yield (like YCC by BOJ). Fed is now targeting 2% core inflation with below 4% unemployment and 4.50% bond yield (10Y US) to keep borrowing costs lowest for the Government.

Bottom Line:

Fed, ECB may cut rates from July’24; i.e. in H2CY24 for a cumulative 75-100 bps (synchronized global rate cuts amid a synchronized easing in core inflation); every major central bank including PBOC has to follow ‘King Fed/USD’, whatever may be the narrative.

Market wrap:

On Thursday, Wall Street Futures were boosted by hopes & hypes of Fed pivot, Chinese stimulus, and Gaza war ceasefire, but also dragged by hawkish Fed talks. In any way, Wall Street was also buoyed by Yellen’s dovish comments, resulting almost flat end.

Technical trading levels: DJ-30, NQ-100 Future, and Gold

Whatever may be the narrative, technically Dow Future (38798), now has to sustain over 39000 levels for a further rally to 39200/39500 levels in the coming days; otherwise, sustaining below 38850 levels may again fall to 38400/38200*-38000/37300 levels in the coming days.

Similarly, NQ-100 Future (17850) now has to sustain over 18000 levels for further rally; otherwise, sustaining below 17950-17750 may again fall to 17375-16390 in the coming days.

Also, technically Gold (XAU/USD: 2034) now has to sustain over 2045-2055 for a further rally to 2065-2085-2105/2120 and 2130/2152 levels; otherwise sustaining below 2040, may again fall to 2020-2010-2000-1990-1975-1960/1940 in the coming days.