We open the week with stocks making new record highs.

Over the next two days, we’ll hear from the “big tech” oligopoly on earnings.  And for the third consecutive quarter, we should expect the earnings calls to be dominated by the discussion on AI – the businesses they’re developing, the investments they’re making, the new customers they’re reaching and the visibility on the total addressable market in front of them.

Microsoft, Google, Amazon and Meta are all working on the frontier of generative AI.  So, more important than the record revenues, and double-digit earnings growth that will come from these tech giants, will be the education gleaned from their work on, and outlook on, AI.

Now, for the better part of this month, we’ve talked about the build up to the December PCE data (the Fed’s favored inflation gauge), as it relates to “how early” and “how aggressive” the Fed will be cutting rates this year.

The data is in, and once again, the Fed has underestimated the pace of disinflation. From the report this past Friday, inflation over the past three and six months is running below 2% (annual rate) — below the Fed’s target.

As we discussed last week, this should be concerning territory for the Fed (deflationary risk).  With the Fed holding rates above 5% as inflation is closer to 2%, they are putting more and more downward pressure on the economy AND inflation.

On the latter, the Fed has told us that they will have to start cutting rates “well before two percent” (the Fed’s 2% inflation target).  Why?  As Powell has said, if they wait for two percent, “it would be too late.”

What does “too late” imply?  It implies that they would overshoot to the downside.  And an overshoot to the downside means the Fed would risk inducing a deflationary spiral.

With that said, we have the Fed meeting this week (Wednesday).  And the Fed has, over the past few weeks, in contradiction to the discussion above, successfully convinced the markets that it won’t be aggressive on the timing and number of rate cuts it will deliver this year.

This sets up for a positive surprise for markets on Wednesday.  In this case, a positive surprise would mean a more dovish stance, which could come in the form of a discussion on winding down their quantitative tightening program, and/or rebuilding market expectations for a March rate cut.

Even among all of geopolitical risks and events, the most meaningful drag on stocks over the past two years has clearly been Fed policy.

And that’s reversing.

As we discussed in my Thursday note, with the Fed doing its best to strangle the economy, we still had 6% nominal growth last year. Clearly it could have been much stronger, with the (still) strong undercurrent trillions of dollars of money supply growth that was front-loaded from the pandemic response.

With that in mind, the Fed also did its best to strangle the stock market, in the name of taming inflation.  Yet with the Fed Funds rate still on the cycle highs, stocks are now UP a few percentage points, from the date the Fed started telegraphing a tightening cycle (in late 2021).

With $3 trillion of excess money still sloshing around the economy (referencing the below chart), how high might stocks go when the Fed formally releases the strangle hold?