Why March Fed Cuts are Unlikely and Caution to Bullish Fixed Income Traders
Jobs Data
Since the financial media has covered this data point, I will just briefly outline my thoughts. The jobs data does not indicate that we are in a recession (obvious point), although as I will discuss below (and have done so recently), the holiday season does skew the data somewhat in terms of decision making by companies related to their labor force.
The Fed will be taking a close look at wages, which did increase 4.1% y/y and up 0.3% m/m. Seasonally adjusted and annualized wages are running at a 5.4% m/m rate, up from 3.2% in October. Elevated wages are a big concern for the Fed, as those are difficult to control through monetary policy. Note that construction held in strong even as a rate sensitive sector. The current rate of wage growth is not conducive to a 2% inflation target. Now, we all know there are lags to monetary policy and I do not think the Fed will make any sudden moves, but they will need to see wages start to decelerate. The average workweek did move down slightly by 0.1 hour.
While the headline number was slightly above estimates, note that the two prior months were revised down by 71,000 in total. October produced 105,000 jobs versus the initially reported 150,000, and November produced 173,000 versus 199,000 initially report. It will be interesting to see a) what the revision will be for December, and b) how Q1 data will be given the start of the new year.
This data point does not increase the probability of rate cuts, but it does not increase the probability of rate hikes. It’s not a great number (ie. wages higher than expected) but not terrible either. What it does indicate is that the Fed will have to keep rates where they are for a little while longer. This is where I am landing, in that I think the discussion over the “last mile” of inflation fighting are important. I think the last little bit of inflation will be hard to wring out, especially if wages are increasing at this pace. I also talked about fluctuating/oscillating data points. We will not get a straight line in terms of data, it will move up and down along its path, as such expect for strong reactions by the markets.
While my base case, contrarian as it is now, that the economy will enter a period of contraction, if we don’t see that in the first half of 2024 and inflation falls towards target I will reverse my position quickly and we could see a very strong second half (more on this below). That is to say, I am not going to stand in front of a freight train, if the data indicates that there is no slowdown one must adjust. However, there are signs that overall activity is slowing, the question is what happens next, an actual contraction of re-acceleration? Hard to predict at the moment, other than using history as a guide.
Also note that private lending has grown massively over the past decade. How will this sector react given a) higher rates, for both new debt and refinancing activity, and b) under economic stress of a traditional (ie. non-covid) recession? We have no idea, since this sector has grown substantially since the GFC. I think the risks here are not being priced accordingly, as defaults through the private lending space have not been tested before and could cause a cascade event through the economy. As this has not been tested, it is a theory but one that I am worried about if the economy slows and frankly even if it does not (to a lesser degree) given the new size and scale of this sector.
ADP Data
I know people do not put much weight behind ADP data, but I think it is worth at least taking a brief overview. Their data (ADP data is located here) this month is similar to BLS data, with a bump higher in leisure & hospitality. Construction was also relatively strong, with an increase in education and health services. Manufacturing had a decrease in employment.
In short, there is no canary in the coal mine with this report, it is consistent with the BLS information that the economy is strong relatively resilient. As noted earlier, the holiday season is an important consideration (more below).
Fed Cuts
In summary, I believe that these data points (so far) do not indicate that the Fed will cut rates in March. I think the market is far too aggressive in pricing in cuts so early. This was my call all of last year as well. When the time to cut will occur, I think the Fed will be more aggressive in the number of magnitude, but that discussion is far too early.
Currently, the market is pricing in a 64.7% probability of March Fed cuts, down from 73.4% one week ago. I think this is still too high of a probability. Given the data and continued resilience of the economy, I would think less than a 1 in 3 probability is more realistic, unless inflation drops substantially. However, given the strength in wages, services sector and housing, all of these inputs should keep inflation from dropping sharply over the near term (ie. this month or next).
Following the dovish press conference by Fed Chair Powell, other officials have been pushing back. Richmond Fed President Barking was quite clear in a speech last week (full speech here). I thought these comments were spot-on:
“I see four risks. The U.S. economy could run out of fuel. We could experience unexpected turbulence. Inflation could level off at a cruising altitude higher than our 2 percent target. And the landing could be delayed as the U.S. economy continues to defy expectations.”
In terms of cuts, Barkin stated “But the range of estimates was pretty wide, from no cuts to as many as six.” He is trying hard to convey the message that a large number of cuts are not set in stone! There may be some, or none. While the markets are leaning heavily to the side of a large number of cuts, that means by definition any deviation from that path will be swift and violent (ie. large counter trend). In my opinion, this potential of volatility may create some great trading opportunities in 2024!
FOMC Minutes
The FOMC minutes were out this week and I have been hearing from some that the Fed was a lot more hawkish than people thought following the Powell press conference.
In my opinion, I would not call the minutes “hawkish”. I think they were balanced, which is also tricky. What I am trying to convey is a committee that is being pulled on both sides, those worried about inflation and those worried that the economy may contract.
I think Powell was in a tough spot and took a path to try and appease both camps. The Fed tries to convey the impression that while there are some differences of views, ultimately they are unified in their approach. To get to this “unified” view (as I don’t believe it really is as unified, rather the optics are such), Powell took a more dovish approach to the press conference.
Equity participants tend to be bullish. The whole industry (RIAs etc..) is set-up to get people to invest and be bullish over the long-term. I am not opposed to that view, rather just noting that many market participants will take any sign that is even slightly bullish and further extrapolated it, forcing any bears/shorts to cover.
Is it possible that the Fed may have to raise rates? Of course it is, as inflation is not at target and certain factors, such as wages, remain strong. For the FOMC to come out and say with 100% certainty that they would never raise again would be extremely foolish.
Having said that, I think the bar is extremely high. Powell already noted that his view (and many others on the FOMC) is that monetary policy is already restrictive. If inflation does not drop down towards target soon and remains sticky, the Fed’s first impulse will not be to raise rates. Rather, they will sit as-is and see if the existing level of monetary policy can continue to work through the economy.
This is positive, as we can lower the probability of any further rate hikes to a very low chance.
For those thinking that the minutes would outline in detail their rate cutting cycle, that would have been an odd discussion. With inflation not at target, it is not the time to be discussing that level of granular detail with regards to beginning the reduction of monetary policy restrictiveness in the economy.
All of this is to say - they are data dependent. I know, it’s a term often used and many people don’t think it means much, but I believe if there was a time that the Fed was literally dependent on the data it is now.
Both camps at the Fed (those worried about inflation vs economic weakness) will be using the data to support their views (stay put/cut) over the next few months. The data points may even be more volatile than last year. Everyone (well, almost everyone) is leaning on the easing camp - what if the data indicates a no landing and inflation re-accelerates? Oh boy, watch out for a massive swing the other way.
For the record, I am not calling for a re-acceleration of inflation, as I just don’t see it in the data at the moment, but who knows - things may very well change.
The FOMC minutes are located here.
You don’t have to take my word at all, just read what they said:
“Participants generally perceived a high degree of uncertainty surrounding the economic outlook. As an upside risk to both inflation and economic activity, participants noted that the momentum of economic activity may be stronger than currently assessed, possibly on account of the continued balance sheet strength of many households. Furthermore, participants observed that, after a sharp tightening since the summer, financial conditions had eased over the intermeeting period. Many participants remarked that an easing in financial conditions beyond what is appropriate could make it more difficult for the Committee to reach its inflation goal.”
The economy has been stronger than almost anyone has expected and this momentum may continued. Having financial conditions ease (ie. lower yields, higher equity prices) is not helping the Fed. They will not be too happy if the trends from the last couple of months in 2023 continue. If that were to occur, I would fully expect pushback from at least some Fed officials.
On the other side of the camp:
“Downside risks to economic activity noted by participants included the possibility that effects of past policy tightening may be larger than expected, the risk of a marked weakening of household balance sheets, possible negative spillovers from lower growth in some foreign economies, geopolitical risks, and lingering risks of further tightening in bank credit….Participants also noted that tighter financial and credit conditions facing households and businesses would likely weigh on economic activity, hiring, and inflation, although the extent of these effects remained uncertain.”
In short, there are a lot of uncertainties and they are sitting in the middle waiting to see how things play out.
I don’t think this is a bad stance to take, really what else could they do? There are some signs that the economy is starting to slow, but no sign of it falling off a cliff. Inflation is also slowing, but it’s not at target. To raise rates or cut them at this point is contrary to what they have described as their process.
The increase in money market rates is perhaps an early sign that the liquidity draining influence of the Fed’s balance sheet reduction may decrease the orderly level of operations. The minutes discussed the the Fed’s balance sheet runoff (ie. QT):
“… amid the ongoing balance sheet normalization, there had been a further decline over the intermeeting period in use of the ON RRP facility and that this reduced usage largely reflected portfolio shifts by money market mutual funds toward higher-yielding investments, including Treasury bills and private-market repo. Several participants remarked that the Committee’s balance sheet plans indicated that it would slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level judged consistent with ample reserves. These participants suggested that it would be appropriate for the Committee to begin to discuss the technical factors that would guide a decision to slow the pace of runoff well before such a decision was reached in order to provide appropriate advance notice to the public.”
With tapering and ending of QT, the Fed could push out cuts but make such a move (ending QT) to appease the doves within the Fed. They are watching closely for signs of stress. It may very well be the case that they will move to end QT earlier than expect, to avert disorderly market functioning but keep the Fed funds rate at current levels longer than expected to further squeeze inflationary pressures. I think that is a much more likely scenario than pre-emptive Fed cuts that may put fuel on the inflationary fire (or at least not put out the flames entirely).
The Importance of Q1
Q1 is going to be very important. We know that companies have been hesitant to layoff people post-pandemic. Even with some slowing down of the economy last year, given the holiday season I was of the opinion that few would make significant reductions in staffing.
Well, the holidays are over. As 2024 starts, what companies see in terms of sales and forecasts will be extremely important.
If companies think that the worst is over and a strong 2024 will ensue, they will keep their staffing levels at approximately where they are currently.
If this occurs, and inflation continues to move towards target resulting in Fed cuts, this may prove to be the recipe for a very strong back half 2024.
Why?
With the economy moving along at a steady pace already, those Fed cuts will be a nice tailwind to help drive further economic growth. Inflation may come back, but that won’t be seen as a concern for a few months/quarters and we could have some companies begin to raise their estimates. A world of steady inflation, strong economic starting point and Fed cuts would be music to the ears of equity bulls.
Under that scenario, returns will be extremely strong for the S&P 500
However, if companies think see revenue slowing and are forecasting slower growth, or even contraction, in 2024, they will start to reduce their labor force.
If this occurs, inflation should continue coming down.
The Fed will cut, the question is by how much. I think that while there may be some pockets of economic strength, such as the AI sector, the vast majority of the economy would feel the impact of an economic slowdown.
Stocks will have to re-price lower growth due to an economic contraction, but the Fed cuts will help mitigate the downside as analyst start to re-price a rebound in 2025. Weakness in equities should arise under the scenario, for some time period.
The worst scenario is for economic weakness and inflation remaining too hot. This is an absolute sell for equities. Slowing growth and higher Fed funds rate to squeeze inflation would be terrible for the economy and corporate earnings.
The key is to watch the labor market over the next few months. What companies do in terms of labor force and their forecasts during earnings season will be indicators of what will occur in 2024.
What to Watch Next Week
CPI is the big data point this week. Core m/m is expected at 0.2% down from 0.3% last month. Since average hourly earnings ticked higher, I would not be surprised to see core slightly higher, although not a high conviction call.
PPI is also out this week. Core is expected at 0.2% m/m, an increase from 0.0%.
$37bn 10 year on Wednesday and $21bn 30 year on Thursday auctions
With February refunding expected to increase sizes on both of these tenors, most likely auction concessions will occur.
As the 10 year auction will be out before the CPI print, along with increased auction sizes expected, I think that buyers may be cautious to step in and bid up the price. Auction participation will be interesting to get a sense of where market participants think yields are headed and their comfort level over existing levels. I am becoming cautious given these headwinds, along with the move already made in markets over the past couple of months. I think we could get a back up in yields across the curve.
Equities
This is the S&P 500 index (SPX). To recap the last little while, I was long (and still am) from the 4400 region, taking profits in the 4590, 4730 regions. I still have a core position with an addition profit target of 4800ish, at which point I would keep a remaining 1/4 of my position open with no set target but rather just a trailing stop to close the rest of my position.
We all knew that a pullback would occur, the question is how deep. I had previously written that my trailing stops would be moved up to the 4640-4670 range (several of them). They have not been triggered as the pullback has been shallow so far. CPI will drive price action next week, along with earnings and any pre-announcements.
Nothing else has changed other than an idea has arose that I may actually re-enter a small portion of my long that was closed if the market can move above the 4735ish level. I am trading around the edges admittedly, but I do like to squeeze as much as I can out of the market. If that were to occur, it would be interesting. Why? After such a strong move from October, I would have fully expected more profit taking. If buyers re-emerge and sellers pull their offers on another move higher, that would be an indication of even further strength, perhaps another push to hit the 4800 level. If I did enter a new long, I would move all move stops up towards the 4670-4675 region.
Fixed Income
While the Fed signaled 75bps of rate cuts, markets have run far ahead. However, given the headwinds outlined above, I think the number of aggressive buyers will start to wane in the fixed income markets over the next little while. Yields have moved very far, the market is pricing in cuts very soon, the economy is still generating jobs with strong job gains and most important of all, inflation has not yet dropped towards target (not knowing the print this week of course). Bullish traders may start to re-think just how aggressive they want to be given the underlying conditions (ie. prices may pullback as a result).
I would be cautious and wait for the volatility to come back into the market with selling pressure as the data comes in outside of consensus and market participants adjust their Fed cut expectations by pushing out those views by another couple of months. That is to say, the risk:reward has adjusted to not be favorable (in my opinion) for bond bulls at the moment. Now, I would not go short but would look for opportunities to go long on pullbacks.
I have been long the 2 year in the 4.80%-4.84% “with an eye at the 4.35% region as an initial profit taking zone”, which I did take some profits at those levels. With a last print at 4.38% level, I am going to close this position on Monday. As I discussed above, I think the market is too aggressive on rate cuts. I think the inflation print may come out a tick hotter than expected, that will spook the markets as well. I would not short it, even though I am tempted, but rather will just take profits from my long. I still like the 2 year, but I think there will be opportunities to buy it again at lower prices (higher yields).
Oil
After I closed out my short, I am inclined to go long. The price action is very interesting, but geopolitics and war are very tough to get correct. I would like to see a few more days of consolidation, then strength to the upside. The $75.50-$76 area is very interesting, I would want to see how the market reacts in this region. It may very well enter into a lot of selling/resistance, or conversely sellers may be overwhelmed by buyers. Patience and the sidelines for now.
Gold
While I thought that perhaps I might open a small long position in gold, given the light holiday trading I decided not and took some time off. I do not like the way gold has been moving lately. I will sit on the sidelines and wait for an attractive risk:reward set-up.
Spread Trades
Given the amount of work I am involved in, I will cease publishing spread trades for the time being unless there are readers interested in this information. If there are, please let me know (email address is below).
Thanks for reading!
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