M5: Midweek Memo – Macro-Insights & Market Momentum Analysis: November 22, 2023

Fed Not Even Thinking About Thinking About Cutting Rates - Do not believe a word they say

The minutes from yesterday’s FOMC meeting they conveyed a clear message: the term "restrictive" appeared seven times, predominantly about the necessity of maintaining a sufficiently restrictive monetary policy stance to gradually bring inflation back to the Committee's 2 percent goal.

With the core PCED increasing by 3.7% year-over-year as of September, the Federal Reserve is unlikely to lower the federal funds rate until inflation approaches 2.0%. Optimistically, this scenario might unfold by mid-2024.

Recalling June 10, 2020, it was during a press conference post-FOMC meeting that Fed Chair Jerome Powell first publicly asserted that the central bank was "not even thinking about thinking about raising rates," while the benchmark interest rate remained fixed between 0% and 0.25%.

However, the resurgence of inflation in the latter half of 2021 prompted Powell and his team to reconsider and start raising interest rates, a move they began in earnest in March 2022.

In the news

The October's U.S. Chicago Fed national activity index experienced a decline of -0.47, reaching a seven-month nadir of -0.49, underperforming the anticipated zero level.

October's U.S. existing home sales witnessed a -4.1% month-over-month drop to a 13-year low of 3.79 million, falling short of the forecasted 3.90 million.

The minutes from the FOMC meeting held on October 31 - November 1 they portrayed a tone ranging from neutral to slightly hawkish.

The minutes highlighted, "All participants agreed that the committee was well-positioned to proceed cautiously and that the entire spectrum would inform policy decisions at each meeting of incoming data."

Furthermore, the consensus among FOMC members was that interest rates would remain high for an extended period.

Market predictions suggest a 5% probability of a +25 basis points rate increase at the upcoming FOMC meeting on December 12 - 13 and the same likelihood for the subsequent meeting on January 30 - 31, 2024. There's a 24% chance of a -25 basis points rate reduction at the March 19 - 20, 2024, FOMC meeting and a 71% probability for a similar rate cut at the April 30 - May 1, 2024 meeting.

A whiff of deflation

If inflation turns out to be a passing phase, what lies ahead? My anticipation leans towards a return to the prolonged period of low inflation seen before the Great Virus Crisis.

Yet, signs of deflation are already becoming evident. Should deflation emerge as the next economic trend, it's likely to stem from China's economy, currently burdened by a deflating real estate bubble and the challenges of an increasingly aging population.

The inflation scenario 2024

The Federal Reserve prioritizes core inflation over headline inflation significantly. This preference stems from believing that food and energy prices are too volatile and largely unaffected by Central Bank monetary policies. This may seem ironic given the everyday need for food and transportation, but it's the prevailing view. Focusing on core CPI, what constitutes this index?

• 40% is housing inflation ("shelter").

• 35% is core services.

• 25% is core goods.

So, the question arises: how and when do we reach the 2% inflation target?

1. Core Goods

Currently, core goods are experiencing deflation due to the resolution of supply chain issues and an oversupply in specific sectors. Even Walmart's CEO anticipates further deflation in goods. It seems plausible that significant progress has been made in this 25% segment of the index.

2. Housing Inflation

Although housing inflation, which forms 40% of the basket, is still high at around 7% year-over-year, there's an expectation that official CPI measurements will soon align with actual rent growth (with Zillow's rent data typically leading by 12-15 months). If this trend continues, the shelter CPI might stabilize around 4% year-over-year and 2-3% monthly annualized by mid-2024.

3. Core Services Excluding Housing

This is the most persistent inflation part, currently hovering around 4-5%. Predicting this segment's future is challenging, so let's conservatively estimate it remains around 4% in the first half of 2024.

By this simple calculation, core inflation in the U.S. could trend at 3% by the first or second quarter of 2024.

4. Takeaways

A) The markets could see a 3% core inflation trend quite positively, especially if the path towards lower inflation beyond 3 % continues.

B) However, the Fed's target is 2%, not 3%. Thus, the situation could get more intriguing if the Fed wanted to achieve the 2 % goal 2024. In this case, they would have to break the economy. Luckily, this is not the case, as the 2 % goal is due to be reached in 2025, according to the official papers from the Fed.

Now what?

The stock market in 2024 will be defined by declining inflation and declining interest rates coupled with declining economic growth.

The bearish scenario is that we will experience a pretty extensive recession. Still, rates will not be able to come down (a lot) because inflation remains quite sticky, and the debt situation of the U.S. will require higher rates for the U.S. to get the bills, notes, and bonds sold. This is the Polarlocks scenario.

The bullish scenario is the exact opposite. There will be a shallow recession/no recession. Earnings will hold up well, the consumer will hold up well, and interest rates will decline quickly as inflation proves transitory. This is the Goldilocks scenario.

I am leaning towards the latter. And the Fed is not even thinking about cutting rates? Please don't believe a word they say :-)

Historically, stock markets in an election year have performed exceptionally well.