Wall Street flat on hopes of 25 bps Fed rate hike in March

Wall Street Futures, Gold slipped, while USD jumped further in the Asian Session Wednesday after Fed Chair Powell sounded more hawkish than expected in his Congressional testimony Tuesday. Powell signaled a higher terminal rate than previously projected in the December SEP amid hotter-than-expected economic data including inflation and employment. Powell also indicated a faster pace of rate hikes should the overall trend of incoming economic data be warranted. Fed policy rate future now is pricing almost 75% likelihood of a +50 bps hike in March against 30% before Powell’s testimony. Fed swaps are also now pricing at a higher terminal rate of 5.75% FFR (5.50-5.75%) in September against 5.50% (5.25-5.50%) before Powell’s ultra-hawkish testimony.

On Tuesday, Wall Street Futures, Gold tumbled, while USD jumped after Fed Chair Powell said in his prepared remarks:

“Although inflation has been moderating in recent months, the process of getting inflation back down to 2 percent has a long way to go and is likely to be bumpy. As I mentioned, the latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated. If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes. Restoring price stability will likely require that we maintain a restrictive stance of monetary policy for some time.”

On Wednesday, Powell started with comments he made for the last question Tuesday's Congressional testimony. Further, on Wednesday's European session, risk trade recovered briefly due to technical short covering and ease of growing U.S.-China cold war tensions. But Wall Street Futures again stumbled on hotter than expected ADP private payroll and JOLTS job opening data, which may keep the Fed for a faster rate hike of +50 bps on 22nd March instead of +25 bps and go for a higher terminal rate in 2023. But risk trade also recovered briefly after Powell said Fed is still undecided about the quantum of rate hikes on 22nd March. Fed will decide in due course of time after seeing various other important economic data like the NFP job report (on 10th March) and core inflation data on 14th March.

Powell made some changes to the above para in his prepared remark to the U.S. House on his 2nd day of Congressional testimony: "-----If--- *and I stress that no decision has been made on this* --- if the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes."

Further, it seems that Powell was deliberately asked by the House Committee Chair (Republican) about Fed’s March hike plan for an opportunity to clear the market confusion - 'what are you thinking regarding the March meeting' and Powell instantly read from notes to say FOMC is still undecided and would take a decision after seeing economic data (NFP job and core inflation).  As a result, Wall Street Futures, Gold bounced back briefly but again slid as Powell was virtually non-committal about any pause timeline. Additionally, Wall Street Futures were also affected by the concern of higher regulatory capital plans for large banks and growing talks by U.S. Lawmakers about ‘abnormal’ profitability by various big U.S. corporates, causing higher inflation!

Highlights of Fed Chair Powell’s comments during the Q&A session on the 2nd day of his semi-annual Congressional testimony (before the U.S. House Committee):

·         I stress that no decision has been made on the pace of rate hikes

·         We have critical information before the March meeting

·         I haven't seen JOLTS data yet

·         We have not decided on the March meeting and it is data dependent

·         The terminal rate is likely to be higher than we expected

·         The extraordinary strength of the jobs report and the inflation report both pointed in the same direction

·         Nothing on banking capital standards has been proposed to the board, and discussions are ongoing

·         No one should believe the Fed can protect the economy in the event of a debt default (in any hypothetical situation, where a Republican-controlled House may not pass the debt ceiling bill)

·         Congress would have to approve retail CBDC

·         Small banks won't face the same capital requirements as their big counterparts

·         The US dollar is the only serious contender for the world's reserve currency

·         We (Fed) can pay our bills even if we have a negative income (not by borrowing, but by issuing/printing)

·         Inflation is decreasing, but it is still very high

·         China's faster reopening could have an offsetting/neutral effect on inflation as it may put upward pressure on commodity prices, but may also result in faster supply chain healing; So far, we do not believe the net effect will be significant, but Europe may be affected more due to dependency on imported energy (Oil and Natural Gas)

·         The costs of failing to reduce inflation will be extremely high

·         We are aware of monetary policy effect lags, they are highly uncertain in timeframe though

·         However, there is still some data to come (whether the terminal rate would be around 5.50%)

·         The slowing pace of rate hikes this year is a way to see the effects of lags more clearly

·         Fed independence is critical

·         It does not appear likely that low long-term low rates will be maintained

·         The repo market is functioning reasonably well these days

·         We want wages to rise in tandem with productivity over time

·         The Fed is not attempting to cause a recession. (non-committal about a plan of any pause in the coming months)

·         Corporate margins will fall as shortages and supply chain issues improve. That will be part of how inflation comes down

·         Demurs when asked whether Fed would accept a $1T coin from Treasury if the debt ceiling is not raised timely

·         The balance-sheet reduction process (QT) is going well

Conclusion:

On Tuesday, on Wednesday most of the opposition Republicans also pointed to ‘massive’ deficit spending by the Biden admin as the ‘root cause’ of hotter inflation (Bidenflation), while Democrats are mainly blaming it for Putinflation. Democrats are also blaming Republicans for blocking certain bills aiming at easing supply chains to reduce overall inflation, while Republicans are blaming Democrats for hampering fossil fuel production, causing energy inflation. And almost all the Lawmakers on both sides of the aisle are now extremely concerned about the growing interest burden for the huge U.S. debt and increasing borrowing costs (bond yields) coupled with the possibility of an employment recession down the year.

Powell, on the other side, looked smarter than Tuesday and use the 2nd day of his testimony as an opportunity to scale back the possibility of a 50 bps hike in March. Powell pointed out about less rate sensitivity is still elevated & sticky core service inflation, which may require further significant time to soften. Powell again clarify as inflation and other economic data are still substantially hotter than earlier expected, Fed has no option but for a higher terminal rate. And if the overall economic data requires a faster pace of rate hikes, then Fed may also go for the same. Fed will take this decision about faster tightening, if any on 22nd March after seeing NFP job and inflation data on 10th and 14th March.

Fed clearly said as average core inflation at around +6.00% is still substantially higher than +2.00% targets, but unemployment is at historically lower levels (3.4%), Fed has no option but to go for ongoing gradual hikes (calibrated tightening). The U.S. economy is now slowing down, but price pressure/core inflation and the labor market are still substantially hot. And the Fed is now clearly preparing the market in a calibrated way for a minimum 5.50% terminal rate by June’23 and then may take a pause to assess.

Fed will ensure price stability along with financial/ Wall Street stability avoiding a hard landing. Fed will keenly watch the core inflation trajectory for Q1CY23 and the outlook thereof and then make a fresh SEP on 22nd March for the projected terminal rate for 2023. In that sense, Feb’23 NFP job report on 10th March and the inflation report on 14th March may be important for the Mar’23 Fed SEP (dot plots).

Fed has already fallen much behind the inflation curve and is now reacting to data rather than the opposite. Fed should have hiked from late 2021 when core CPI jumped above 2% rather than waiting to cool down the ‘transitory inflation’ on its own. The result of the huge COVID stimulus, direct grants, and later Russia-Ukraine war coupled with lingering supply chain disruptions in China/other Asian exporters made the inflation situation worse and out of control. Now Fed wants lower/negative wage growths and a higher unemployment rate, which is creating social unrest and also making life difficult for politicians, who generally prefer lower interest rate regimes to fund never ending deficit spending with lower/affordable borrowing costs.

U.S. is now paying almost 10% of tax revenue as interest on public debt and CBO projected around 13% and 15% for 2023-24 even after assuming an average 10Y US bond yield of around 3.80-3.90%. This is a red flag for U.S. fiscal math. China and the EU’s debt interest/tax revenue is currently around 5.5%, while Japan’s is 15%.

As a debt manager of the government, every central bank including Fed has to ensure lower borrowing costs for deficit spending, whatever may be the narrative. Thus Fed will take a balanced approach to control inflation, employment, and bond yields. Fed may not allow a US10Y bond yield above 4.25-4.50% under any circumstances (presently around 4.00%), whatever may be the narrative. Fed also has to ensure a softish landing, if not soft (mild employment/economic recession and 2% price stability) at any cost.

The sequential core PCE inflation comes around +0.6% in Jan’23; i.e. an annualized rate of +7.2%. Fed will not take any rate decision based on one month's data, which may be seasonally distorted. Fed will wait for at least a 3M/6M rolling average. As per continuing jobless claims of all types (seasonally unadjusted), the U.S. labor market may be softer in February than in January.

As per Taylor’s rule, for the US: (Fed’s favorite)

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)

Depending on various inflation and employment data/scenarios, Fed may keep the terminal rate between 5.50-6.00% (against average core PCE/CPI around 5.50-6.00%); i.e. real rate is at least zero/positive and not negative. For March, Fed may go for a +25 bps rate hike rather than +50 bps as Fed may not go by only January data, which is seasonally distorted. Fed may consider at least Q1CY23 or 3M/6M rolling average date and outlook thereof for any higher pace of hikes for May and June (front loading). If the overall trend of core inflation remains on the downside, Fed may also go for calibrated hikes at a +25 bps place from March to June/September’23 for a terminal rate of 5.50-6.00%.

On Tuesday/Wednesday, overall, Powell almost confirmed a higher terminal rate anywhere between 5.50-6.00%, but the faster pace (+50 bps instead of +25 bps) will depend upon the ‘totality’ of economic data; i.e. it will depend upon 3M/6M rolling average rather than just 1-2 months (January-February in this case). Fed has to tell the market about its plan for any real rate (wrt at least average core inflation) rather than creating unnecessary confusion.

When real interest rate/borrowing costs turn positive, then it bounds to affect elevated demand, so that it can match with constrained supply, resulting in softening of inflation and sustainable economic growths (goldilocks economy), which is both Fed and White House/Congress looking for. As the Biden admin has now turned into a minority government, it’s creating policy paralysis types of situations in the U.S. For effective dealing with elevated sticky inflation, appropriate policy actions are required from both monetary and fiscal authorities. Also, admin/U.S./G7 needs to resolve the Ukraine war effectively and avoid the cold war mentality with China/Russia. Powell clearly said Putinflation is now not a big issue with U.S. inflation/overall economy, but for Europe, it’s still the case.

Also, U.S./Europe (AEs) need to spend more on infra/CAPEX (like China or even India-especially in high-speed modern railway), which has a multiplier effect of almost 1:3 on the overall GDP growth; but AEs spend more on social security (grants), which is causing elevated inflation and also disruption in local supply chains.