Why the Fed's Inclination to Wait for More Data is a Positive & Oil Market Looks Interesting
One of the more interesting pieces of information last week was the release of the Fed minutes. Yes, they are stale given the recent economic data but it confirms that one of my main fears remains a low probability event - that the Fed would cut rates too soon.
The main takeaway from the Fed minutes is that they were more concerned about cutting too soon, and that was before a hotter than expected jobs and inflation print (CPI not PCE, which is out this week). The recent data will even further support their decision not to cut rates.
I have written about this over the recent weeks, so I will not waste your time repeating what I have said, but the economy and stock market would accelerate significantly if the Fed were to cut anytime soon. This would be a positive for stocks over the short-term, but negative over the long term as inflation would most likely flare up again, and rates be required to move even higher. This would also unhinge inflation expectation for the fixed income markets and I would fully expect yields to move above the recent highs.
No, they are firmly planted in the camp of inflation worriers. While equities are still enjoying the goldilocks scenario of strong corporate returns as excess savings are being spent and increased use of credit cards, history would suggest a) that it is rare for inflation to drop from such peaks to target, and b) for the inversion of the yield curve to remain in place for so long without some level of economic contraction. Could inflation drop to target without a recession, sure - anything is possible. However, I would caution against betting too much given the small number of such events in the past.
My main worry is on the fixed income side, as I have been long equities for quite a while and just recently closed my position. Now being flat in equities, I am not too worried either way. However, my worry with yields is that if inflation does not continue the path down towards target, long duration investors may begin to worry that prices will remain elevated for a considerable period of time and start to adjust higher their inflation expectations. This would be bond bearish for price, resulting in higher longer-term yields.
I think it is too early to make that call, as we just had one inflation print that was hotter than expected, and that came with the turn of the new year when many prices were adjusted higher by businesses. Additionally, the strong jobs data was at least partially as a result of the holiday season hiring. How much of either we should discount is very hard to say, and as such we (and the Fed) need additional data points to see if the trend is really reversing or these were aberrations. I think history would indicate that these are most likely aberrations, and if so the markets have over-reacted (as they usually do) to the upside in yields.
PCE
The Fed’s preferred inflation gauge will be out this week on Thursday for the month of January. Given the higher than expected CPI print, one has to believe that markets will also be expecting that PCE will tick higher, most likely to 0.4% m/m. While housing is less of a component in PCE versus CPI, what PCE does have as a higher weight are core services. As we know from the CPI report, core services (along with housing) came in hotter than expected.
The differences between CPI and PCE for Housing and Utilities is that CPI has a weight of 37.76% while PCE has a weight of 17.77%. However, PCE has a weight of 16.15% for Health Care versus the CPI’s weight of just 6.54%.
I am worried that the health care costs will result in PCE remaining elevated, not to mention the continued housing component. Now, as mentioned before, recent data appears to indicate that rental prices for new contracts are not accelerating, so we should see that category (if this is true and flows into the official data) result in lower housing related input and potentially even disinflation over the course of 2024. However, the health care sector is one that remains quite strong.
If the markets begin to fear that inflation will remain stickier or even increase, this would be bearish for both stocks and fixed income. For the time being, I am worried but not enough to pivot yet. I need to see more data. Markets tend to over-react in both directions, so the question is if this data is an over-reaction, is this an attractive entry point? More on that below.
Equities
This is the Nvidia show and the entire market is along for the ride! Very strong numbers by Nvidia helped propel that stock, along with most equities, higher last week.
I discussed last week the possibility of a new short entry, after an extended long position was closed, but SPX never moved down to my entry level.
I remain flat and have pulled all orders for now. I will wait and see for a better entry point, either long or short. Given the move higher, I am inclined to think that the next move will be lower.
I have been adding options to protect my long-term retirement accounts from a pullback this year. Going back to the scenario of early Fed cuts, which appears not to be a high probability event, I think the odds are the markets will either move down or up quite a lot this year versus staying flat. The reason I say that is the market is really being pushed by a handful of names. You don’t need me to go into the Magnificent 5 (are we down to 5 now?), as WSJ/Bloomberg etc… are covering that story. However, if there is even a hint of an economic slowdown, that no one seems to be pricing in, what will happen to the market? A pretty big selloff. I am not predicting that will happen, but just stating my view that the probability of that occurring is larger than the market is pricing in, and thus option pricing is relatively attractive for either outright volatility trade, or hedges.
Just quickly on Chinese equities. I did put on a long volatility trade in Chinese equities as I discussed the last few weeks, and so far this is in the money nicely. I think there is more to come and am holding my position.
Fixed Income
This is the 10 year yield. Without question the recent data has scared some investors, or at least pushed back their entry points. When I talked to people prior to the jobs data and inflation print, including some foreign buyers, they were interested if yields would ever move back up to the 4.20-4.25% area. With the hotter than expected jobs & inflation data, they moved back their buy levels, but were still interested in adding duration. Some thought 4.30% now looked attractive, others 4.40% etc… When I asked why they wanted to buy if they were really worried about inflation and/or jobs, they said (anecdotal yes, but interesting nonetheless) that the data around December/January is being taken with a grain of salt. If there were additional months, that would concern them, but then they trust that the Fed will keep the brakes on the economy to prevent inflation from re-igniting. The Fed minutes were even further supportive of this view. These are long-term institutional buyers, they really are thinking about a multi-year holding period. Pushing cuts out from March to June does not concern them, what they are more worried about is if the economy takes off, along with inflation, increasing inflation expectations for a multi-year period.
I cannot predict the future, but I am worried if the economy does take off. I liked the buying on Friday, but I may look to reduce a little exposure and book profits if we see yields move back into the 4.0-4.05% level, as I have added on this move higher in yields in the 4.25%-4.35% range. For the very long-term, I think that so few market participants think a recession will not occur that if one does at some point in 2024, the move back lower in yields will catch some investors off guard. Trading this with options may also be a prudent strategy to limit downside risks. As I discussed above, there are several reasons to believe that the latest data prints were not the start of a new trend, but in realty no one actually knows for sure, we are all data dependent. We can only look to mitigate risks and enter at attractive levels.
Oil/WTI
The price of oil has been building a base, but the recent highs are providing to be stubborn resistance. US production still running above 13 million bpd, hear the all-time highs. If it were not for the Saudi Arabia cuts of approximately 1 million bpd, the price of oil would be much lower.
IEA recently reported that global oil stocks dropped by 60 mb in January, a very sharp decline not seen since 2016. The report notes that a drop in Chinese demand during Q4 2023 was a big factor for overall global oil demand. If efforts by Chinese authorities are even marginally successful in boosting demand, this decline could quickly reverse.
It should be noted that the oil market is in backwardation. Front months are trading higher than backs, this is an indication that demand on the front end is driving prices higher. Hard to know how long this strong demand will remain, but this is the type of situation that when combined with positive technicals (if oil can break higher), could really drive the price. There is strong demand right now, if these buyers need even more oil right now (or soon), price will follow higher.
There are also some reports that the global oil surplus is less than the average over the past two decades. If Saudi Arabia can hold back on adding any additional bpd for the next couple of months, we should see prices move higher. Once the spring/summer comes along, I would expect to see some of these barrels come back onto the market, especially if prices move higher. Also from talking to people in these markets, they are suggesting that no further geopolitical risk is being priced in, so any turn for the worse would be a shock to the market (ie. higher price).
I did go long, as I discussed last week at approximately $77.50. I would add to the position on a move above $78.50 and $79. I would be looking for an initial profit taking zone in the $83.50 level and stops in the $75.25-$75.50 region. If WTI can get through the $83.50 the next level of resistance I think would be in the $88 region, followed by a move into the low $90s.
Gold
Still caught in a range, I remain flat for the time being.
Thanks for reading!
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