Dow, gold may slip as Fed may delay rate cuts until QT done

On Thursday, Wall Street Futures, Gold, and UST/US bond surged, while USD slumped on hopes of less hawkish Fed rate action in the coming days after softer than expected US PPI. But overall market the market is now implying -75 or even -50 bps rate cuts from September or October’24. Wall Street Futures were also under stress as the U.S. warned about an imminent missile/drone attack by Iran on Israel; gold and oil surged. Additionally, Gold was also boosted by increasing geopolitical tension between China and Taiwan. All the metals including industrial metal Silver and Gold to some extent are also boosting hopes of an early economic recovery by China (worst may be over) and increasing optimism/usage in AI Chips.

On Friday, Chicago Fed’s President Goolsbee said:

·         The US is in an environment of cross-currents

·         Multiple inflation readings are higher than we want

·         The long arc on inflation shows it coming down from high levels, if PCE shows better readings that will make us feel better

·         If PCE is reflating, the Fed will stabilize prices

·         The question of the last mile on inflation is a little harder, supply may not help as much

·         The most important number in the immediate term on inflation is what is happening with housing

·         I thought housing inflation would be coming down by now

·         If shelter inflation does not come down to where it was before the pandemic, it will be hard to get back to target

·         The Middle East instability is a wild card for the Fed in terms of oil prices and gas, a negative supply shock is not good

·         Market movements are mostly noise, though financial conditions do impact the economy with a long lag

·         The US is in an environment of "cross currents"

On Friday, KC Fed’s President Schmid said:

·         A better balance in the jobs market is needed for price stability

·         The current stance of US monetary policy is appropriate

·         I would like to see a much smaller Fed balance sheet

·         Wage growth signals ongoing labor market imbalance

·         The Fed needs to tolerate interest rate volatility

·         The bank reserves are abundant, and Fed balance sheet cuts are not causing strain

·         Inflation levels are still too high

·         The job sector is strong, and the economy growing above the trend

·         Economic resilience is creating monetary policy uncertainty

·         I urge patience on interest rates until it is clear inflation is ebbing to 2%

·         A large Fed balance sheet is suppressing market rate signals

·         The large Fed balance sheet is depressing market rates

·         The current stance of US monetary policy is appropriate

·         We're at a bumpy stage now with inflation

·         There is reason to think rates will stay higher for longer

On Friday, Fed’s Bostic said:

·         My 2024 outlook is one rate cut toward the end of the year

·         I am not in a hurry to cut interest rates

·         Inflation will keep easing, but slower than I would like

On Friday, Fed’s Collins said:

·         I wouldn't say there's no risk of the Fed waiting too long

·         The policy is moderately restrictive at this point

·         I now see the Fed cutting later than previously thought

·         I need to see what the data is telling us, it has been mixed so far

·         I am seeing much less reason for concern in the labor market

·         There is a broad agreement to slow the pace of balance sheet runoff

·         Inflation will come down even with a healthy labor market, but will take time

·         It may take more time than previously thought to gain the confidence to begin easing policy, possibly warranting fewer rate reductions this year

Conclusions:

The 6M rolling average of US core inflation (PCE+CPI) is now around +3.5%. Fed may cut 75 bps in H2CY24 if the 6M rolling average of core inflation (PCE+CPI) indeed eased further to +3.0% by H1CY24. The Fed wants to keep the real/neutral rate around +1.0% in the longer term (assuming +3.0% repo rate and +2.0% core inflation). But in the meantime, till core inflation/headline inflation goes down to around 2.00%  on a sustainable basis, the Fed wants to maintain the real rate at around present restrictive levels of +1.50% (assuming the present repo rate +5.50% and 2023 average core CPI around +4.00%).

As per Taylor’s rule, for the US:

Recommended policy repo rate (I) = A+B+(C-D)*(E-B)

=1.50+2.00+ (2.60-2.00)*(4.50.00-2.00) =1.00+2+ (0.60*2.50) = 3.00+1.50=4.50% (By Dec’24)

Here:

A=desired real interest rate=1.50; B= inflation target =2.00; C= Actual real GDP growth rate for CY23=2.6; D= Real GDP growth rate target/potential=2.00; E= average core CPI+PCE inflation for CY23=4.50

The Fed may go for -75 bps rate cuts in September, November, and December’24. By 18th September (Fed MPC date), the Fed will have complete data for core inflation and also unemployment/real GDP data for H1CY24 and also Aug/July’24 to have the required ‘higher confidence’ to go for rate cuts. Fed may bring down the repo rate to +4.75% by Dec’24 from present +5.50%.

Fed may announce a plan for QT tapering/trajectory/closing in the May meeting and should have closed the same before going for any rate cuts cycle. Fed, the world’s most important central bank may not continue QT (even at a reduced pace) and go for rate cuts at the same time as QT, and rate cuts are contradictory (like QE and rate hikes). But Fed/Powell kept that absurd option of simultaneous QT and rate cuts open, at least theoretically. Thus assuming a bizarre phenomenon, the Fed may go for -75 bps rate cuts in H2CY24, most probably from Sep’24 after deciding about the possible B/S size to ensure money market stability

Looking ahead, the Fed may keep B/S size around $6.60T, around pre-COVID levels to ensure financial/Wall Street stability along with Main Street stability (price stability and employment stability). Fed’s B/S size is presently (Mar’24 end) around $7.48T around 25% of estimated nominal GDP for $30T by Dec’24. Depending upon the actual rate/reaction in the repo/funding market, the Fed may taper the QT from the present $0.095T/M to 0.050-0.075T/M for 18-12 months from May’24;i.e. Fed may end the QT by May’25-Dec’25 at B/S size around $6.60T. This is lower than the earlier market estimate of $7.00T and thus should be seen as more hawkish. Also, rate cuts along with QT (even with slower pace/tapering) should be less hawkish.

Ahead of the Nov’23 U.S. Presidential election, White House/Biden/Fed/Powell is more concerned about elevated inflation rather than the labor market; prices of essential goods & services are still significantly higher (around +20%) than pre-COVID levels, which is creating some anti-incumbency wave (dissatisfaction) among general voters against Biden admin (Democrats) on some economic issues (higher cost of living).

Thus Fed is now giving more priority to price stability than employment (which is still hovering below the 4% red line) and is not ready to cut rates early as it may again cause higher inflation just ahead of the November election. Fed may hike only from Septenber’24, which will ensure no inflation spike just ahead of the Nov’24 election (as any rate action usually takes 6-12 months to transmit in the real economy), while boosting up both Wall Street and also Main Street (investors/traders/voters). Fed hiked rate last on 26th July’23 and may continue to be on hold till at least July’24; i.e. around 12 months for full/proper transmission of its +5.25% cumulative rate hikes effect into the real economy.

Overall, the Fed’s mandate is to ensure price stability (2% core inflation), and maximum employment (below 4% unemployment rate) along with financial/Wall Street stability as well as lower borrowing costs for the government. As the US is now paying almost 15% of its tax revenue as interest on debt, the Fed will now not allow the 10Y US bond yield above 4.50-5.00% at any cost (against present levels of average core CPI around +4.0%).

But the Fed may also blink on rate cuts in H2CY24 just before the US election:

Ahead of Nov’24 US Presidential election, as evident in the last Congressional testimony, the Fed is under huge pressure from opposition Republican lawmakers (Trump) and also supporters for ‘assisting’ Biden admin (Democrats) in booting the election win probability by facilitating rate cuts. Thus Fed may not go for any rate cuts till Nov’24 or even Dec’24 to show that it’s politically independent. In the meantime, the Fed may close the QT at the present pace of around -0.095T/M for the next nine months (April-Dec’24) for the targeted ample B/S size around $6.60T (@22% of CY24 nominal GDP around $30T, just above 20% minimum requirement of $6.00T).

The most logical step would be Fed to close the QT completely before going for a rate cuts cycle and then go for any QE, if required to counter another economic crisis down the years. Fed has to prepare its B/S for the next round of QQE and thus has to normalize the B/S first.

Now going by various Fed comments in the last few weeks, it seems the Fed is ‘extremely’ worried about the pace of slower disinflation. Fed is also apparently confused about the dual combination of QT, even at a slower pace (QT taper) and rate cuts in the months ahead as these two instruments (tools) are contradictory/opposite (like if Fed goes for QE and rate hikes at the same time). Ideally, the Fed should finish the QT first for a proper B/S size (bank reserve) to ensure ample liquidity for the US funding/money/REPO market.

But the Fed may continue QT (even at a slower pace) and go for a rate cut cycle at the same time despite these two policy actions being contradictory. Thus the Fed may go for rate cuts of -75 bps cumulatively in September, November, and December’24 for +4.75% repo rates from the present +5.50%. Fed may bring down further its B/S size from present around $7.5T to $6.55T through QT tapering by May-Dec’25 to keep minimum/ample liquidity for the US funding/money market and also to prepare itself for the next cycle of QE, whatever may be the next recession excuse.

The market is now expecting 3-2 rate cuts (75-50 bps) in 2024, while some Fed policymakers are now arguing for lesser rate cuts of 1-2 rate cuts or even no rate cuts at all. Looking ahead, the Fed may not cut rates at all in 2024 considering the slower rate of disinflation, political issues ahead of the Nov’24 election, and the logic that it should not go for any rate cuts while doing QT, which is the opposite. Also, the reduction of B/S from around $8.97T to around $6.60T (projected); i.e. around $2.50T (~$2.37T) reduction over 2.5-3.00 years is equivalent to a rate hike of around +50 bps (higher 2Y bond yield).

In that scenario, if the US core CPI average for 2024 comes down to around +3.00% by Dec’24 from present levels of +3.8%, the Fed may cut rates by -100 bps in 2025 for a repo rate +4.50% (from present +5.50%) for a real restrictive repo rate +1.50% (repo rate 4.50%-3.00% projected average core cpi for 2024). Presently, the real restrictive repo rate is also around +1.50% (repo rate 5.50%-4.00% average core CPI for 2023).

At present, in its last (Mar’24) SEP/dot-plots, the Fed projected -75 bps rate cuts each in 2024, 2025, and 2026 and -50 bps rate cuts in 2027 for a terminal neutral repo rate +2.75% against pre-COVID neutral repo rate +2.50%. Now various Fed policymakers are arguing for a slightly higher neutral repo rate at +3.00% against projected core CPI of +2.00%; i.e. neutral real rate at +1.00%.

Thus depending upon the actual trajectory of core CPI, the Fed may cut -100 bps each in 2025, 2026, and -50 bps in 2027 for a terminal neutral repo rate of +3.00% from the present +5.50%. Fed had boosted its B/S from around $3.86T in late September’2019 (after the QT tantrum) to around $8.97T in Apr’22; i.e. over $5T in a matter of 32 months (@0.16T/M) to fight previous QT and COVID induced financial crisis.

Now Fed may announce a plan for QT tapering from $0.095T/M to $0.075/M and end the QT by 15th Mar’25 around B/S size $6.60T before going for any rate cuts from mid-March’25; Fed may opt for four QTR rate cuts (-25 bps) each in each quarter in 2025, 2026 and two half yearly rate cuts in 2027 to ensure price/employment/financial stability. Although, the Fed’s official QT rate is -$0.095T/M ($90B/M), in reality, the effective average QT rate is already around -$0.073T/M. As the Fed is now managing the funding/money market through ON/RRP, there is a lower risk of a 2019 type of QT tantrum this time.

Fed’s mandate is now 2% price stability (core inflation), below 4% unemployment rate, and below 4.75-5.00% US 10Y bond yield to ensure lower borrowing costs for the government and overall financial stability. Fed, as well as ECB, BOE, and BOC, are now struggling to keep bond yield and inflation at their preferred range despite non-stop jawboning; perhaps they are talking too much too early and thus FX market is not being influenced by them significantly, moving in a narrow range. The BOJ is now trying to talk down the USDJPY desperately, presently hovering around 152 levels, causing higher imported inflation and a higher cost of living back home, although it may be beneficial for exports. However, most of the Japanese are not happy at all due to higher imported inflation in Japan for the devalued currency.

Bottom line:

Original scenario: -75 bps rate cuts each in 2024, 2025, 2026, and -50 bps in 2027 for a neutral repo rate of +2.75%

If the rate of disinflation accelerates, the Fed may go for -75 bps rate cuts each in 2024, 2025, and 2026 and -50 bps in 2027. Fed may continue the QT (even at an officially slower pace) and rate cuts at the same time (in 2024) despite being contradictory.

Alternate scenario: -100 bps rate cuts each in 2025, 2026, and -50 bps in 2027 for terminal neutral repo rate +3.00%

Fed may announce a plan for QT tapering from -$0.095T/M to -$0.075T/M from April’24 (even before the May’24 meeting) and close the QT by Mar’25 at B/S around $6.60T. Then Fed may start the rate cut cycle from Mar’25 with -100 bps rate cuts each in 2025, 2026 (@-25 bps at each QTR), and finally -50 bps in 2027 (@-25 bps in Q2 and Q4).

Market impact:

On Friday, Wall Street Futures, Gold, and UST/US bond wobbled on Iran’s plan of a calibrated/friendly Israel attack (with advance information) to avoid an all-out regional war and also to satisfy all stakeholders. Overall, the one-and-done Iran attack Saturday night on Israel (looks like a well-informed live war drill between Iran and Israel/US/UK) may be negative for Gold and oil and positive for Wall Street futures (equities).

Now from geopolitics to economics, on Friday, Wall Street/Dow Future was also undercut as earnings from JPM and Wells Fargo missed Net Interest Income (NII) estimate.

Moreover, JPM CEO Dimon issued a virtual guidance warning:

·         Warned investors that trouble could lie ahead

·         Many economic indicators continue to be favorable. However, looking ahead, we remain alert to several significant uncertain forces

·         First, the global landscape is unsettling — terrible wars and violence continue to cause suffering, and geopolitical tensions are growing

·         Second, there seems to be a large number of persistent inflationary pressures, which may likely continue

·         And finally, we have never truly experienced the full effect of quantitative tightening on this scale

·         We do not know how these factors will play out, but we must prepare the Firm for a wide range of potential environments to ensure that we can consistently be there for clients

On Friday, Wall Street was dragged by almost all the sectors led by materials, techs, consumer discretionary, energy, healthcare, communication services, banks & financials, industrials, real estate, consumer staples, and utilities. Script-wise, Wall Street was dragged by almost all major scrips except Apple, Travelers, Visa, and Walmart. Blue chip DJ-30 tumbled -475 points, tech-savvy NQ-100 tumbled -1.6%, while broader SPX-500 lost -1.4% (worst day since Jan’23). For the week, the S&P 500 lost 1.6%, the Dow dropped 2.4% and the Nasdaq fell by 0.6%.

Banks & financials slid after JPM, Wells Fargo, and Citigroup reported that high-interest rates had negatively impacted their net interest income and also caused MTM loss for the HTM bond portfolio. Big techs/chip makers like Microsoft, Nvidia, Alphabet, AMD, and Intel slid as China had instructed its major telecom carriers to phase out foreign/US processors.

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

Whatever may be the narrative, technically Dow Future (38242), now has to sustain over 38550 for a rebound to 39500-40000/40200-40600/40700 to 42600  levels in the coming days; otherwise, sustaining below 38500/38350-38295/38150*, may again fall to 37950/37700-37600 and 37050-35550 levels in the coming days.

Similarly, NQ-100 Future (18175) now has to sustain over 18000 for a rebound to 18500-18750 and 19000/19200-19450/19775 and 20000/20200 in the coming days; otherwise, sustaining below 18000, NQ-100 may gain or fall to around 17800/17575*-17150/16850 and 16650/16490-15900/15700 in the coming days.

Also, technically Gold (XAU/USD: 2340) now has to sustain over 2380-2415 for any further rally to 2425/2455-2475/2500; otherwise sustaining below 2410-2405, may again fall to 2375/2350 and 2320/2315-2305/2300 and 2290/2270-22245/2240, and 2220/2210-2200/2195-2190/2180 and 2175/2145*, and further to 2120/2110-2100/2080-2060/2039 and 2020/2010-2000-1995/1985-1975 and even 1940 may be on the card.