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Wall Street surged on less hawkish talks by Fed

Wall Street surged on less hawkish talks by Fed

calendar 22/11/2022 - 19:59 UTC

Wall Street Futures surged Tuesday on less hawkish Fed talks and the increasing probability of a ‘smaller’ +50 bps rate hike on 14th December instead of another ‘jumbo’ hike +75 bps. The risk-on sentiment was also boosted by retailers as upbeat guidance by Best Buy calms fears of a dull holiday sale amid higher cost of living (sticky inflation). Best Buy soared after forecasting a smaller drop in annual sales than previously expected. Best Buy is confident that a deluge of shopping deals and discounts will lure more customers in the X-mas holiday shopping season despite the higher cost of living and higher borrowing costs. But overall buoyancy of the retail sector was capped by a comparable fall in Dollar Tree.

Overall on Tuesday, the U.S. market was boosted by lower USD/US bond yields. The market was helped by energy (higher oil), materials, techs, financials, consumer discretionary, communication services, healthcare, industrials, consumer staples, and utilities.

On Monday, Wall Street Futures, oil was already under stress after a Friday rout amid faster Fed tightening concerns and China may further tighten COVID curbs. China reported its first Covid-related death in almost six months and a city near Beijing rumored to be a test case for dropping all curbs enforced a slew of restrictions. China reportedly asked Saudi Arabia for less oil supply in December, while in October; China’s oil imports were down -6% (y/y). But Dow Future was also boosted by Disney briefly as the company fired embattled and brought back former leader Iger as CEO, a surprise capitulation by the board after a string of disappointing results/guidance. Oil plunged on a WSJ report that OPEC may hike production by +0.50 mbpd from January, but recovered after Saudi Arabia denied any such plan

On early Asian Monday, Fed’s Bostic said:

·         Until inflation is on track to 2%, the Fed has to resist the temptation for rate cuts even if the economy weakens

·         I expect 0.75 to 1 percentage point more tightening to be sufficient to control inflation

·         I'm ready to move away from 0.75 percentage point increases at December the meeting

·         The landing rate could be higher, but once reached, the Fed should let some time pass before making future increases

On Tuesday, Fed’s Mester said:

·         I do not anticipate a recession

·         We are attempting to avoid both over- and under-tightening

·         If there is no meaningful progress on inflation next year, we will have to act

·         I believe we can slow down from 75 at the December meeting

·         I believe we need to enter the more restrictive territory, right now, we are barely there

·         I don't believe market expectations of the fed funds rate are significantly off

·         We are starting to see the results of our efforts

·         However, rate hikes are far from over

·         We've had some good news on inflation, but we need more and more consistent good news

·         I can now be very deliberate in policymaking

·         It makes sense to slow down a bit on the pace of the rate hikes

·         Fed policy is beginning to enter a restrictive stance

·         No evidence of a wage-price spiral

·         Expectations for longer-term inflation remain reasonably anchored

·         Wage growth is still lagging below inflation in most sectors

·         Labor demand continues to outpace worker supply

·         Maintaining price stability is a critical objective that will be accomplished using all available means

On Tuesday, Fed’s Daly Said:

·         It is far too early to say that inflation has peaked and is beginning to cool off

·         I am on the hawkish side of the Fed policymaker spectrum

·         At some point, it will be right to slow the rate hike pace

·         If inflation data does not cool, the Fed may raise rates beyond 5%

·         Nothing is off the table for the December FOMC

·         I'm not sure what hike the Fed should do in December FOMC

·         The Fed is still very far from its inflation target

·         A 5% rate peak is a good starting point, but it could be raised

·         Inflationary forces are half supply problems, half demand issues

·         The Fed's digital dollar efforts are unaffected by crypto sector issues

·         There is a housing shortage in the US

·         Rates peaking between 4.75% and 5.25% are reasonable

·         We are still far from price stability, and the Fed has more work to do

·         Currently, the Fed funds rate is expected to peak around 5%

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Conclusions:

Fed’s Bostic, Mester, and Daly sounded less hawkish than some of their colleagues (led by Bullard & Co). Mester, Daly and Bostic are now advocating for a ‘smaller’ +50 bps hike each in December, and February to reach a terminal rate of +5.00%, which is slightly dovish than Bullard’s assumption of a minimum +5.00 to 5.25% terminal rate; both are almost same.

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)

As per Bullard: A=0.50; B=2; C=1.25-1.50; D=0; E=4-5% and I=5-7%

 

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