Wall Street surged on softer US PMI and upbeat earnings

Wall Street closed mixed last Friday as the recovery from the Iran-Israel duet panic low was not sustainable for NQ-100 and also SPX-500 due to the slide in techs amid subdued guidance by Netflix and NVIDIA, while DJ-30 was boosted by an upbeat report card/guidance by AXP (American Express). Further on Monday, the recovery (short covering) of Wall Street gathered momentum as Iran clarified on the weekend Israel's retaliation was insignificant and militarily worthless. Gold eventually plunged from the Israel-Iran panic high of around $2425 to almost $2290 early US session Tuesday, but recovered to almost $2334, while Dow Future also recovered from 37465 to almost 38788 on hopes of an early Fed pivot after softer than expected US Service PMI data; USD, US bond yield slips.

On Tuesday, the USD also briefly slid after a report that the Bank of Jokers Japan (BOJ) may discuss the impact of the Yen’s rapid slide (now around 155) at this week’s policy meeting. BOJ and also Japanese government now seem clueless about how to normalize policy by substantially hiking and saving the further devaluation of the currency to manage elevated imported inflation. Japan is already paying around 11-15% of core tax revenue as interest on public debt and thus can’t afford higher bond yield/coupon rate/borrowing cost.

Earlier in the last week, Wall Street was already under pressure on fading hopes of an early Fed pivot amid hawkish Fed talks and hotter-than-expected inflation data. Also, SPX-500 is around 5000 and $192.43 CY23 EPS, and the TTM PE of the S&P 500 is still around 26, substantially above the mean/fair PE of 20. The projected fair range of SPX-500 is now around 4300/4800-5400 for CY: 20224-25. Overall, as of 19th April, the current/TTM PE of DJ-30 (Dow Jones Industrial Average) was around 26.52 against a mean/fair PE of 20, while Nasdaq-100 (NQ-100) had a PE of around 30 against a median/fair PE of 22 and S&P 500 had PE around 26 vs mean/fair PE of 20. Thus there was a healthy correction on the Iran-Israel friendly war drill excuse.

On Tuesday, the S&P Global flash data showed the US Manufacturing PMI slid to 49.9 in April, the lowest in four months from 51.9 sequentially and below the market consensus of 52.0. The U.S. private manufacturing sector again fell into contraction (below 50.0 boom/bust red line) after Dec’23.

The Apr’24 US manufacturing PMI reading pointed to broadly unchanged business conditions, as manufacturers drew down their stocks of purchases for the second consecutive month, and at the most marked pace since August last year. Firms made some efforts to limit the pace of depletion, however, raising their purchasing activity slightly. There remained signs of spare capacity in supply chains amid relatively muted demand for inputs. Suppliers’ delivery times were shortened for the third month running. Although modest, the latest improvement in vendor performance was more pronounced than that seen in March. Finally, stocks of finished goods ticked and the slight rise in post-production inventories reflected a slowdown in demand which left firms holding unsold goods

On Tuesday, the S&P Global flash data also showed the US Services PMI slips to 50.9 in April, the lowest level in five months and well below the market consensus of 52.0. The decrease in new business was attributed to high-interest rates and prices (elevated service inflation), which limited demand for services. Employment also saw a significant decline, the largest since mid-2020. Excluding the initial wave of the COVID-19 pandemic, staffing levels in services hit a low not seen since the end of 2009. Service providers mentioned increased staff and shipping costs, although overall cost increases were at their second-lowest in three-and-a-half years. There was also a slowdown in charge (input) inflation.

Finally, the S&P Global flash data shows US Composite PMI declined to 50.9 in April 2024 from 52.1 sequentially, just above the contraction res line, signaling a slowdown in the US private sector business activity, which was the softest since Dec’23. Business activity increased at a slower pace across both the manufacturing and service sectors, with rates of growth easing to three- and five-month lows, respectively. Inflows of new orders declined for the first time in six months, and employment decreased for the first time since June 2020 amid signs of demand weakness due to elevated interest rates and inflationary pressures weighing on demand. Additionally, backlogs of work declined for the third month running. On the price front, both input costs and output charges rose at slower rates but remained high overall. Finally, business sentiment dipped to a five-month low.

The S&P Global comments about the US Composite PMI in Apr’24:

“The US economic upturn lost momentum at the start of the second quarter, with the flash PMI survey respondents reporting below-trend business activity growth in April. Further pace may be lost in the coming months, as April saw inflows of new business fall for the first time in six months and firms’ future output expectations slipped to a five-month low amid heightened concern about the outlook.

The more challenging business environment prompted companies to cut payroll numbers at a rate not seen since the global financial crisis if the early pandemic lockdown months are excluded. The deterioration of demand and cooling of the labor market fed through to lower price pressures, as April saw a welcome easing in rates of increase for selling prices for both goods and services.

Notably, the drivers of inflation have changed. Manufacturing has now registered the steeper rate of price increases in three of the past four months, with factory cost pressures intensifying in April amid higher raw material and fuel prices, contrasting with the wage-related services-led price pressures seen throughout much of 2023.”

Overall, the S&P PMI data for November indicates a sudden slowdown in private business activity in April and steepest job cuts since the early COVID lockdown; but there was also an uptick in goods inflation, whereas service inflation remains elevated. The market may be assuming that the Fed may cut from July instead of September as the US unemployment rate may surge ahead of the Nov’24 election; the Fed already vowed for an early rate cut if it sees sudden deterioration in the US labor market. But the Fed will not take any rate action solely based on 1-2 months of data, which may be noise and thus Fed will consider at least 6M or even 3M rolling average of inflation and employment data before getting the required confidence to go for any rate cuts/policy action.

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 a +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 reo 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).

All other major G20 Central Banks including ECB, BOE, BOC, RBI, and even PBOC may be compelled to follow the Fed’s real rate action to keep present policy differential with the Fed as USD, being the primary global reserve/trade currency, any meaningful divergence with Fed will result in higher imported inflation, everything being equal. For example, if the ECB goes for -75 bps rate cuts in H2CY24, while the Fed goes for hold, then EURUSD may slip further towards parity (1.0000), which will result in higher imported inflation as the EU is dependent quite heavily on imported goods, foods and fuel/commodities.

In this way, no major G20 Central Bank will take such rate action/cuts alone as there is a routine/regular coordination/consultation between all major central banks for a coordinated/synchronized policy action to avoid disorderly FX movement; the Fed also not seeking very strong USD as it would eventually affect US exports competitiveness. Thus all major central banks are now focusing on maintaining proper balance and coordination with the Fed, whatever may be the domestic inflation/economic narrative/jawboning.

Market impact:

On Tuesday, Wall Street Futures surged on hopes of an early Fed pivot after softer-than-expected US Composite PMI data for April and hopes & hypes of an upbeat earnings report card for Q1CY24. Blue chip DJ-30 surged over +200 points, broader SPX-500 jumped +1.2% and tech-heavy NQ-100 soared +1.6% amid better-than-expected report cards from many blue-chips, including GM, GE Aerospace, PepsiCo, UPS, and Lockheed Martin. Tesla surged after market hours as it reported in line with expectations earnings and also clarified it will make more affordable EVs by 2025. Visa and Texas Instrument also surged on the upbeat report cards, while PepsiCo slipped on earnings disappointment.

Danaher's stock surged after the company reported better-than-expected earnings and revenue. UPS, General Motors, and GE Aerospace soared following upbeat results. But Lockheed Martin pared earlier gains and finished edged down despite announcing increased sales, particularly in missiles, air-defense systems, and space hardware amid elevated geopolitical action under the Biden admin; Democrats are somehow war savvy and positive for US military industry; and this military industry is also a huge political donor for both Democrats and Republicans and has significant geopolitical policy influence on the government in favor of them.

Thus the US is generally a war-savvy country thousands of miles away from their soil in Asia/Middle East/Africa and even part of Europe (Russia-Ukraine). The US is supplying Ukraine with billions of military equipment to continue fighting Russia. The US military industry is a direct beneficiary and the US Treasury may have also kept Ukraine’s Gold reserve in its custody (instead of grants/loans). Also, the global reserve currency status of USD is helping a lot as despite almost 24/7 printing, USD is always in great demand globally as it’s the preferred global trade currency for most of the nation due to faith/confidence in the US and its paper currency. USD is the king and ‘Gold’ of global paper currency.

On Tuesday, Wall Street was boosted by almost all the major sectors led by communication services, techs, industrials, healthcare, consumer discretionary, real estate, banks & financials, energy, utilities, and consumer staples, while dragged by materials. Wall Street was also boosted by Verizon, American Express, Microsoft, Goldman Sachs, Caterpillar, Walt Disney, JPM, Amazon, Salesforce, Home Depot, Visa, Apple, P&G and Amgen, while dragged by Walmart, United Health, Boeing, Intel, Nike and Merck & Co.

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

Whatever may be the narrative, technically Dow Future (38800), now has to sustain over 38950 for a further rally to 39100/39200-39500/39700 and 40000/40200-40425/40600-40700 to 42600 levels in the coming days; otherwise, sustaining below 38900-38800 may again fall to 38450-38300/38050-37650/37500*, and further fall to 37400/37200-37050/36600 and 36300/36300 and even 35700 levels in the coming days.

Similarly, NQ-100 Future (17750) now has to sustain over 17800 for a further rally to 17900-18100/18250 and 18550/18700-18800/18900-19000/19200-19450/19775 and 20000/20200 in the coming days; otherwise, sustaining below 17750, NQ-100 may again fall to around 17400-17100-16800/16595*-160000/15800 in the coming days.

Also, technically Gold (XAU/USD: 2330) now has to sustain over 2350 for a further rally to 2375/2385-2395 and 2400/2410-2425/2435* for any further rally to 2455-2475/2500; otherwise sustaining below 2335-2335, may again fall to 2315-2300 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.

 Summary: Fed may not go for any rate cuts before Sep’24 or even Mar’25 (after QT); all other major CBs bound to follow the Fed