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Dow Future under stress as Fed may indicate QE tapering and gradual rate hikes with technical adjustment in IOER

calendar 16/06/2021 - 13:10 UTC

Dow Future lost almost -0.88% this week (till early Wednesday, ahead of Fed) after losing -0.81% last week; it made a 3-week low around 34084. Overall, Dow Future is under stress on meme stocks, bitcoin chaos, Biden’s infra/fiscal and Fed’s monetary stimulus uncertainty. The market is concerned that Fed may indicate QE tapering and gradual rate hikes from Dec’22/23 with an immediate technical adjustment in IOER (interest on excess reserve) to address the current distortion of the money/funding market. Fed is already doing backdoor QE (reverse repo) to the tune of $600B almost every other day to absorb huge excess liquidity from the money/funding market. Fed is also withdrawing various COVID emergency liquidity facilities.

The market is now concerned that Fed may now begin to think about thinking QE tapering and may also pencil one hike by Dec’23 in June dot-plot amid surging inflation and upbeat economic data.  Fed is already sucking huge liquidity to the tune of $600B excess money market liquidity by reverse repo (backdoor QE tapering; equivalent almost 5-months of QE buying) and also withdrawing various COVID emergency liquidity/lending tools it created with the support of the U.S. Treasury/Congress. Thus Fed may now officially begin to think about QE tapering and may go for the same by Dec’22, not Dec’21.

On Tuesday, data shows that U.S. core PPI surged +4.8% in May from +4.1% recorded in April, but right on the expectations of +4.1% (y/y). On a sequential basis (m/m) U.S. core PPI increased by +0.7% in May, at the same rate in April, but higher than the market expectations of +0.5%.

The U.S. core PPI index was at 117.9 in May’20, at COVID low, and 123.6 in May’21, the yearly increase was +4.8%. Further in 2020, the average monthly increase was at +0.08% against +0.11% in 2019 due to COVID disruption (both supply and demand-side). Now in 2021, the average monthly run rate is around +0.45% (till May 21), translating to an average annualized rate around +5.40%. Now, even if the core PPI increased by an average of +0.45% in June from May (sequentially) instead of +0.70% run rate in May, the annualized core PPI would be around +5.04% (June’21). Thus, there is something beyond the Fed’s narrative of lower base and transitory effects for the elevated inflation scenario in the U.S. Fed may say it will wait patiently till Dec’21, until those transitory effects fade. Fed will assess the situation only in early 2022, whether it’s transitory or permanent.

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Fed will go for QE tapering when it sees substantial further progress (from Dec’20 levels) for its dual mandate of maximum inclusive employment and price stability (core PCE inflation at +2.0% on a sustainable basis- without transitory and base effects and on the course of moderately over +2.0% for some time). Overall, the U.S. Goldilocks NFP job report may help Fed for QE tapering only from Dec’22 rather than Dec’21. And Fed may target for average core PCE inflation around +3.4% in 2021 to compensate for previous misses.

All these pre-conditions for starting the normalization process of COVID monetary stimulus/super accommodative policies may ensure Fed to go for QE tapering from Dec’22 and gradual rate hikes from Dec’23. The U.S. economy should be fully reopened by Dec’21 (after full vaccinations including children/adolescents) and various transitory factors like labor shortage, supply chain disruptions, pent-up demand should be normalized by Q1-2022. The Fed will provide sufficient time to ensure sustainable economic/employment recovery and 2% price stability (core PCE inflation, without transitory factors).

But at the same time, as U.S. inflation is already spiking, the Fed may employ jawboning strategy (‘powerful forward guidance’) instead of any real action to keep everything in control (balance); too weak USD, especially against Chinese Yuan will cause more imported inflation. Thus Fed may now officially say they are thinking about thinking of QE tapering; already various Fed officials are actively discussing the pros and cons of QE tapering and preparing the market for the eventuality.

Some market participants also think that Fed may not only officially indicate QE tapering thinking, but may also provide a firm indication for the same in Aug’21 Jackson Hole Symposium speech (by Powell), which is a historical place to telegraph the market for such important policy change. In that scenario, Fed may also officially indicate its QE tapering and gradual rate hikes plan in its Sep’21 policy meeting (dot-plots) and may go for actual QE tapering and gradual rate hikes from Dec’21 and Dec’22 respectively. Thus, USD is getting a boost, and every decline causing short covering or fresh buying.

But going by Fed’s pre-conditions for this normalization process and the fact that this time Fed will act only on real data, not any forecasts, Dec’21/Dec’22 may be too early for such QE tapering/gradual rate hikes. The U.S. inflation bound to spike under unprecedented monetary and fiscal stimulus (excess supplies of liquidity), but Fed has already changed its goalposts for its dual mandate. Fed will go for inclusive maximum employment and average inflation targeting instead of simple headline unemployment number below 4% and core PCE inflation at +2.0%. But in trying to do so, there is also a real risk of stagflation (lower/stagnant economic growth, higher inflation, and higher unemployment). The Fed is now trying for reflation in line with Biden’s policy (investment/infra-led economic growth-like China).

In may the number of unemployed people declined by 496K to 9316K while employment rose by 444K to 151620K in May, but still well below 1587735K employed persons in Feb’20, just before the COVID; i.e. the U.S. economy still needs to employ around 7115K (7.12M) or roughly 7M (7000K) more workers to reach maximum or pre-COVID employment levels.

At around 540K present 4M moving average and expected accelerated rate after Sep-Dec’21 (PUA expiry and children/adolescents COVID vaccinations), it may take around April-June’22 for the U.S. economy to make substantial progress on maximum employment as-well-as price stability (core PCE inflation). Fed will consider maximum inclusive employment for its policy decisions, not mere headline unemployment number. Thus in that scenario, Fed may go for QE tapering from Dec’22 with an indication from Aug’22 Jackson Hole speech and official FOMC indication in the Sep’22 policy meeting.

Bottom line:

Fed may indicate QE tapering from Dec’22 and gradual rate hikes from Dec’23 against market expectations Dec’21 and Dec’22; i.e. one year later. In other words, Fed/Powell may sound less hawkish or more dovish than expected. This will be positive for risk assets (EQ, Gold) and negative for USD. The combination of Fed’s monetary and Biden’s fiscal stimulus may result in Dow scaling 41K levels by Mar’22, while Gold may scale 1930-1960 levels in the coming days. And if Fed/Powell sounds more hawkish than expected, expect the opposite.

Technical view: SPX-500, DJ-30, and NQ-100 Futures:

 

 

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