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Wall Street Futures were almost flat, but under pressure early Wednesday despite less hawkish Fed talks as the market is concerned about the Chinese slowdown amid zero COVID policy, recurring partial/full lockdowns, and some reports of public/worker’s unrest in Apple’s iPhone factory. But Dow Future jumped after soft economic data, which may influence the Fed for a ‘smaller’ +50 bps rate hike on 14th December instead of another ‘jumbo’ hike of +75 bps (the market already knows/discounted about 50 bps hike in December).
Overall on Wednesday, the U.S. market was boosted by lower USD/US bond yields. The market was helped by consumer discretionary, communication services, techs, industrials, banks & financials, consumer staples, and healthcare, while dragged by energy (lower oil amid Russian price cap suspense and negative inventory report), real estate, materials, and utilities to some extent.
On late Tuesday, Fed’s George said:
· A more stable labor market with less churn may reduce inflationary pressures
· According to current data, savings are increasing across the board
· It may take some time for a higher interest rate to persuade households to keep their savings
· Increased savings could provide additional impetus to consumption
· As we tighten policy, the dynamics of excess savings will be a critical factor in the economic outlook
· House prices in the United States remain above their pre-pandemic trend, which some attribute to quantitative easing
On Wednesday, ahead of the Thanksgiving day holiday weekend, some focus was also on U.S. jobless claims, which serves as a proxy for the unemployment trend/overall labor market conditions.
The U.S DOL flash data shows the number of Americans filing initial claims for unemployment benefits (UI-under insurance) rose to 240K in the week ending 19th November from 223K in the previous week, above market expectations of 225K. The latest initial jobless reading of 240K is the highest in a 3-month high, reversing from the 5-month low of 190K scaled just 9 weeks ago, which may be an indication of some softening in the labor market amid difficult macroeconomic and geopolitical (external trade) environment coupled with higher borrowing costs and the deluge of tech layoffs.
The 4-week moving average of initial jobless claims, a better indicator to measure underlying data, as it removes week-to-week volatility, increased to 226.75K on the week ended 19th November from 221.25K in the previous week.
The continuing jobless claims in the U.S., which measure unemployed people who have been receiving unemployment benefits for more than a week or filed for unemployment benefits at least two weeks ago (under UI), increased to 1551K in the week ending 12th November, from 1503K in the previous week, higher than the market expectations 1517K, consecutive increase for 6-weeks and highest since 1st week of March. The continuing jobless claim is also a proxy for the total number of people receiving payments from state unemployment programs; i.e. overall trend of unemployed persons (insured).
Overall, as per continuing jobless claims under all categories (UI) of around 1274K and assuming average uninsured employees (not getting any UI benefit) of 5000K, estimated unemployed persons would be around 6274K in November. Further, if we assume the labor force is around 164800K, the unemployment rate would be around +3.8% with an estimated number of employed persons around 158526K, a contraction of around -82K (as per Household survey).
On Wednesday, all focus was also on FOMC minutes for the 2nd November meeting, in which Fed hiked +0.75% as highly expected with a hint of a lower pace of hikes (not pause) in the coming months. Wall Street Futures, Gold surged, while USD slumped after FOMC minutes showed: “A substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate”.
Highlights of FOMC minutes:
· Many participants expressed significant uncertainty about the ultimate level of the Fed funds rate required to contain inflation, with various participants suggesting it was higher than previously anticipated
· Participants observed that the labor market remained tight, and many noted tentative signs that it may be gradually moving toward a better balance of supply and demand
· Participants agreed that the risks to the inflation outlook remained skewed to the upside
· Some participants stated that stricter policy was consistent with risk management others observed an increased risk of overtightening.
· A substantial majority of participants thought a slowing in the pace of interest rate hikes would be appropriate soon
· All participants agreed that a 75-basis-point increase was necessary (in November) and a next step toward making monetary policy sufficiently restrictive
· Participants agreed that there were few signs of inflation pressures easing
· A few participants suggested that slowing the pace of rate increases could reduce financial system risks; others suggested that slowing should wait for more progress on inflation
· With monetary policy approaching a "sufficiently restrictive" level, participants emphasized that the final destination of the Fed funds rate had become more important than the rate (pace) itself
· Participants agreed that a slower pace of rate hikes would allow the FOMC to better assess progress toward its goals "given the uncertain lags" associated with monetary policy
· Participants observed that the labor market remained tight; many noted tentative signs that it may be gradually moving toward a better balance of supply and demand
· Participants agreed that there were few signs of inflation pressures easing
· Participants observed that, despite elevated interest rate volatility and signs of strained liquidity conditions, the treasury securities market functioned orderly
· Most Fed officials support slowing the pace of rate hikes soon
· The Fed discussed market resilience in light of the UK turmoil
· In discussing potential policy actions at upcoming meetings, participants reaffirmed their strong commitment to returning inflation to the Committee's 2 percent objective, and they continued to anticipate that ongoing increases in the target range for the federal funds rate would be appropriate in order to attain a sufficiently restrictive stance of policy to bring inflation down over time
· Many participants commented that there was significant uncertainty about the ultimate level of the federal funds rate needed to achieve the Committee's goals and that their assessment of that level would depend, in part, on incoming data
· Even so, various participants noted that, with inflation showing little sign thus far of abating, and with supply and demand imbalances in the economy persisting, their assessment of the ultimate level of the federal funds rate that would be necessary to achieve the Committee's goals was somewhat higher than they had previously expected
The market is now expecting Fed will hike +50 bps on 14th December to +4.50% and then another 50-100 bps by Mar’23 to 5.00-5.50% depending upon the actual core inflation trajectory. Fed is now preparing the market for a possible series of smaller hikes (50 bps) and pauses down the road after reaching around +5.50%. But Fed is also confused about levels of an appropriate terminal rate and may start the debate in the December meeting to take a firm decision with a fresh SEP. Fed may go from meeting-to-meeting to a QTR-to-QTR approach in 2023 after Q1 ( if required further hikes). Fed may keep the terminal rate around +5.50% for at least 2023 to bring down core PCE inflation back to +2.00% on a sustainable basis.
The U.S. housing market and also the overall economy are slowing down. The U.S. employment is still almost at Fed’s maximum level despite some cooling, while inflation (core CPI/PCE) is still substantially above the Fed’s price stability target of +2.00% without any meaningful sign of cooling. Moreover, UM 1Y inflation expectation continues to hover above +5.00%, almost double the average pre-COVID rate.
Fed needs 1Y inflation expectations around +2.75% consistently for its +2.00% price stability mandate. The primary objective of the rapid Fed tightening is to first bring 1Y inflation expectations back to pre-COVID or even 4% consistently so that the inflationary mindset will change for both consumers and producers and actual inflation comes down. But that’s not happening despite a series of jumbo hikes by the Fed as the real rate of interest is still negative, even considering core inflation; Fed is still much behind the inflation curve, especially after market expectations of a Fed pivot in the coming days.
Thus Fed is now jawboning the market for a real positive rate, at least wrt average core inflation (CPI/PCE) of +5.50%. Fed is now preparing the market for a slower rate of increase, but higher for longer. Fed will now focus on an appropriate terminal rate, restrictive enough (real positive) to bring down inflation towards the +2% target over the medium term. When the cost of borrowing turns real positive or there is an elevated cost of capital, overall economic activity/demand bounds to slow down, leading to lower inflation (as lower demand will try to catch up with the constrained supply capacity of the economy).
There is also a need for supply-side reform to lower inflation. But unless Russia-Ukraine/NATO war/proxy war, geopolitical tensions, and subsequent economic sanctions resolve, supply-side lacunas may continue to linger. Europe, being the net importer of food & fuel and being overly dependent on Russia, is the biggest victim of this Ukraine war.
As per Taylor’s rule, for the US:
Recommended policy rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.5-2.00) =0+2+3.5=5.5%
Here for U.S. /Fed
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=5.5% (average of core PCE and CPI)
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