Pro Perspectives 4/1/24

 

 

 

 

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April 01, 2024

The Fed's favored inflation gauge was reported this past Friday morning (February PCE).  
 
Of course, markets were closed for Good Friday.  And with markets closed, it created the potential for a Sunday night reaction to the data in what is a very illiquid time for the futures markets.  
 
Probably no coincidence, hours after the PCE data, the Fed Chair was sitting on a stage at a San Francisco Fed conference for an interview on monetary policy.
 
The first question he was asked, was on the morning's inflation report. 
 
His response: "Pretty much in-line with expectations."
 
As you can see in the chart below, despite all of the hand-wringing on the inflation data, the path has been clear, and the target is nearly achieved. 
 
Arguably, as the pace of disinflation has slowed, it has created the perfect scenario for the Fed to sit and watch.  Inflation is low, and despite the highly restrictive policy stance of the Fed, the economy remains good (despite being throttled) and the job market remains solid.
 
This scenario actually plays into the Fed's historical policy making tendencies/preferences, which is reactive, not proactive.  
 
And as we discussed last week, Jerome Powell happened to lay out some conditions in his post-FOMC press conference last month, that would warrant a Fed reaction: 1) unexpected weakening in the labor market, 2) the continued trend of falling inflation, toward the target and/or 3) any stress bubbling up in money markets (i.e. a liquidity shock).
 
So, with the Fed Funds rate nearly 300 basis points above the rate of inflation, the Fed has restocked the ammunition (to stimulate or protect downside risks with rate cuts), and now can respond to any negative event, or deterioration in the economy (or markets).
 
This is a Fed stance that markets are very familiar with, unlike the stance throughout the tightening cycle, where the Fed was explicitly trying to bring demand down, trying to destroy jobs and was happy to see a weaker stock market (the latter, to help achieve the former).
 
As we discussed last week, the evolving current stance looks like a return of "the Fed put."  

Pro Perspectives 3/27/24

 

 
 

 

 

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March 27, 2024

The stock market rally broadened today, with the equal-weighted S&P 500 and the Russell 2000 (small caps) leading the way.  Importantly, this represents broader stock market strength.

As we discussed in my note yesterday, the Fed’s Financial Conditions Index had a turning point in October, from an historically tight level.  That turning point was triggered when Jerome Powell verbally signaled the end of the tightening cycle.

And as we also discussed yesterday, turning points from levels of historically tight financial conditions, have been good for stocks in the subsequent 12-month period — especially for small caps.

With that, as the major U.S. stock market indices have been routinely making new record highs, the proxies for broader stock market confidence and demand have been lagging.  The equal-weighted S&P 500 printed new record highs earlier this month (finally recovering the losses of the past two years).

But the Russell 2000 (small caps) remains 15% away from the 2021 record highs.

 

We’ve talked about the opportunity for small caps, the laggards, to catch up to the performance of the major indices.  The good news, today the Russell traded to the highest level since January of 2022.

With the P/E on the S&P 500 running north of 20, which is historically high, there remains plenty of deeply undervalued stocks for investors to suss out.  That bodes well for this chart above to continue narrowing the losses against its 2021 record highs — and to narrow the divergence in this chart …

For my AI-Innovation Portfolio members, please keep an eye out for a note from me tomorrow morning.  We will be making a new addition to the portfolio.  If you are not a member, you can join us here. 

 

Pro Perspectives 3/26/24

 

 
 

 

 

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March 26, 2024

Yesterday we talked about the Fed’s overly tight policy stance, and the downward pressure it puts on the economy.  And related to that, we looked at the recent percentage point decline in the Atlanta Fed’s Q1 GDP projection.

With that, let’s revisit the Fed’s new financial conditions index, which gauges the impact of financial conditions on future economic growth.

They just made an update to the index last week.  Let’s take a look …

Remember, this index is designed to incorporate the lags of monetary policy, and project (in this case) one-year forward what the impact will be on real GDP growth.

If the line is above zero, it’s a drag on growth (restrictive policy).  If it’s below zero, it’s a boost to growth (stimulative policy).  As you can see to the far right of the chart, it’s still projecting a drag on growth one-year forward. 

They introduced this “new” index back in June, and Jay Powell included a footnote directing attention to this index in a speech he made back in early December.  We discussed it in my December 4th note (here) and stepped through some analysis of the turning points of the index, and the subsequent return on stocks.

Here’s a revisit of that analysis: 

1) Financial conditions were at historically tight levels, as you can see in the chart above (“Oct ’23”).

2) Each of the periods in the chart that shared the characteristic of “historically tight levels,” were soon followed with some form of Fed easing (either rate cuts, QE, or in the case of 2015-2016 – walking back on projected rate hikes). 

And, 3) in each of the turning points in financial conditions, denoted in the chart, stocks did very well in the subsequent 12-month period — and small caps outperformed. 

     

 

 

Pro Perspectives 3/25/24

 

 

 

 

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March 25, 2024

Let's revisit Jerome Powell's comments last week on the employment situation.
 
Remember, the Fed has a mandate from Congress to achieve price stability AND maximum employment. 
 
With that, they've recently started acknowledging that the pursuit of the former (at this stage), might create a problem with the latter (job losses).
 
And that's because of this chart …
 
 
This chart above shows the current level of the Fed Funds rate in purple (where the Fed has set the short-term benchmark rate).  And it shows the most recent inflation reading in orange (January PCE). 
 
Remember, the difference is the "real" interest rate (Fed Funds rate minus inflation).  And that real interest rate is at historically high levels.  So the Fed continues to put downward pressure on inflation and on economic activity.  And with the Fed keeping rates steady, as inflation has been falling the real rate has been rising, which means the Fed has been getting tighter and tighter (i.e. more downward pressure on inflation and the economy).
 
On a related note, the Atlanta Fed's Q1 GDP projection has been adjusted down by over one percentage point over the past few weeks (the green line in the chart below).  And as we know from the most recent jobs report, the unemployment rate ticked up in February.   
 
 
So, what did Jerome Powell say last week about the employment situation? 
 
He said, "unexpected weakening in the labor market could warrant a policy response."
 
So that's a condition to start rate cuts.  And, as he said, they are monitoring "very, very carefully" … for "cracks."    
 
What's another condition?  The continued trend of falling inflation, to satisfy the Fed's need for "confidence" that the stair step toward 2% remains intact.  With that, we get another inflation report this Friday (February PCE). 
 
What's another condition?  Any stress bubbling up in money markets as they try to navigate the end of quantitative tightening, and the level of reserves to be left in the banking system.  As Powell admitted, the last time they tried this (2018-2019), they triggered a liquidity shock, and returned to easing.
 
So, the Fed has a 300 basis points of restrictive cushion, should inflation remain sticky at current levels.  But the longer the duration of restrictive policy, the more likely the employment situation deteriorates, which triggers Fed action.
 
This is looking like the return of the Fed put.    

Pro Perspectives 3/21/24

 

 

 

 

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March 21, 2024

The Bank of Japan's move on Tuesday was the beginning of the end of its role as the global liquidity backstop/support to Western world economies.  And with that, as we discussed, global central banks may now have less leeway to hold rates too high, for too long. 
 
That said, although the Fed didn't budge on policy yesterday, Jerome Powell did say (twice) that an "unexpected weakening in employment would warrant a policy response."  And he did discuss the strategy to end quantitative tightening, and the related risks of liquidity problems — and he voluntarily brought up the 2019 cash crunch, where the Fed's first ever attempt at quantitative tightening induced a liquidity shock.
 
So, if there was any doubt going into the Fed meeting about whether or not the Fed was entertaining the idea of another rate hike, there should be no doubt now. 
 
And if there were doubt on whether or not this easing cycle would materialize, there shouldn't be now.  Why?  Because the easing cycle was kicked off this morning in Switzerland.  In a surprise move (for markets) the Swiss National Bank cut rates by a quarter point. 
 
As we've discussed here in my daily notes, the major central banks of the world have coordinated closely throughout the crises of the past 15 years.  They all went to ultra-easy emergency level policies in response to the pandemic, and now all (exception Japan) have interest rates set ABOVE the rate of inflation (restrictive territory).
 
And they will all be cutting rates, in coordination, in the coming months, mostly to ensure that global liquidity doesn't become too tight, and (related) that their respective government bond yields (borrowing rates) don't run away (higher).

Pro Perspectives 3/20/24

 

 

 

 

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March 20, 2024

Earlier this month, we talked about the takeaways from Jerome Powell's semi-annual testimony on Capitol Hill, and from the surrounding media-tour chatter from Powell's colleagues.  
 
The Fed seemed comfortable not messing with an economy that was doing well, despite a Fed Funds rate north of 5%.
 
After today's Fed meeting, that seems to remain the case. 
 
Interestingly, they made some tweaks to their December Summary of Economic Projections.  After undershooting on growth all of the last year, by a lot, they dialed UP growth estimates (through 2026).
 
They see employment remaining strong, and inflation getting to target ("over time"). 
 
Take a look at this highlighted area …
 
  
These projections suggest the economy will be stronger, without stoking inflation, all while the Fed will be tighter than they thought just three months ago.  As you can see, they've revised up the Fed Funds rate for 2025, 2026 AND in the longer run. 
 
What would explain this?  Maybe the productivity boom that is underway yet continues to be a topic the Fed is bizarrely quiet about.
 
As we've discussed, generative AI might be the productivity enhancing technological advancement of our lifetime.  Hot productivity gains promote wage growth (which we're seeing), which is needed to reset wages to the increased level of prices (which restores quality of life). 
 
It can do so without stoking inflation, and that formula is playing out.
 
As for economic growth, Jerome Powell himself, presented back in 2016, on productivity growth as a driver of the long-term potential growth rate of the economy.
 
Let's take a look at some charts …  
 
 
Heading into this Fed decision stocks have continued to hug this trendline, which originated from October, when Jerome Powell verbally signaled the end of the tightening cycle (similar line for Nasdaq) — and we finish on new record highs (again).
 
This "end of the tightening cycle," has been just that, to this point — no easing.  But today, Jerome Powell introduced the coming taper of quantitative tightening.  
 
What does that mean?  They will slow the reversal of the Fed's balance sheet.  And they will slow it "fairly soon" he says, making steps toward stopping/ending QT. 
 
This first step will slow the decline of the line in the chart below, slowing the extraction of liquidity from the economy.
 
      
As we discussed yesterday, the Bank of Japan has played the critical role of global liquidity provider the past two years (the liquidity offset to the Western world's liquidity extraction/tightening policies).  And they just made the first step toward exiting this role. 
 
With that, it is perhaps no coincidence that the Fed is ready to wind down the liquidity extraction.  Jerome Powell has the scars of 2019.  After the Fed spent nearly two years draining liquidity from the financial system (quantitative tightening), they created a cash crunch (a scramble for dollars in the interbank lending market). 
 
The pendulum swung from too much liquidity, to too little. 
 
And the Fed was forced to pump liquidity back into the financial system, and at a record rate (i.e. a return to QE).
 
With that in mind, the notable charts of the day were the dollar, which put in a bearish technical reversal signal … 
 
 
And commodities, led by gold, which may make new record highs tonight … 
 
 
 

Pro Perspectives 3/19/24

 

 

 

 

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March 19, 2024

Overnight, the Bank of Japan declared victory over three decades of deflationary pressures.
 
They think they will achieve "price stability" (two percent inflation target) toward the end of the year.
 
With that, they raised rates, ending negative interest rates in Japan. 
 
They ended yield curve control, a seven-year old policy that gave the BOJ a license to do unlimited asset purchases whenever the 10-year government bond yield traded to the high of its stated ceiling. 
 
And they ended ETF purchases (exiting the BOJ's explicit involvement in, not just Japanese equity markets but global equity markets — via ETFs).
 
These are big and bold moves for a central bank that has been the (important) global liquidity provider of the past two years. 
 
Remember, the BOJ continuing ultra-easy policy (including QE), as the rest of the world was tightening, was the only way the major central banks around the world were able to raise rates to combat inflation, without losing control of their respective government bond markets (i.e. runaway yields).  And runaway government bond yields, at record government debt levels, are a recipe for global debt defaults.    
 
So, the Bank of Japan was (had to be) pumping liquidity, as Western central banks were extracting liquidity.
 
With that, this scrapping of emergency policies by the BOJ comes with risks.
 
We will see how it plays out.  For now, the Japanese 10-year yield went down, not up — the yen went down, not up. 
 
They stopped buying stocks, and yet Japanese equities went up, not down.
 
As you can see from this long-term chart of inflation in Japan, the visits to the target 2% area have been brief over the past thirty years.  Despite the wage increases in Japan, which they think will underpin inflation, disinflation has been the global trend since the middle of last year.  And high productivity rates (at least in the U.S.) have been successfully enabling wage growth, without inflation pressure.
 
So, a sustainable escape from deflation in Japan is highly questionable.       

 
 
As we know, the global rate hiking cycle is over for the rest of the world.  Global inflation is falling, and most central banks are in restrictive territory, and rate cuts are next.
 
With the BOJ's move, global central banks (led by the Fed) may now have less leeway to hold rates too high, for too long.   With global government debt at record levels, they need to ensure that government bond yields (borrowing rates) continue the path lower. 

Pro Perspectives 3/18/24

 

 
 

 

 

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March 18, 2024

It’s a big week.  Nvidia kicked off its annual developers meeting this afternoon.  We have the Bank of Japan tonight.  And the Fed determines policy on Wednesday.

As we discussed last week, there has been a clear effort by the Bank of Japan (BOJ) over the past several months to start setting expectations in markets that they will exit emergency level policies.

Last week, there was talk that they might end negative interest rates tonight.  Today, the Nikkei Asia (a Japanese news source) suggested they will also end yield curve control and ETF purchases.

While they would continue with QE, this would be an aggressive exit from a very long period of ultra easy monetary policy.

Given the fragile nature of global financial markets, and the very deliberate telegraphing of policy moves made by the Fed and other major central banks for much of the past 15 years, this seems like it would be an unnecessarily abrupt move by the Bank of Japan.  It would create risks to global liquidity at worst, and global market stability and confidence at best.

Keep in mind, the major central banks of the world have coordinated policies and worked as partners throughout the crises of the past 15 years (they talk a lot).  With that, we should expect the Bank of Japan to be reluctant to cause any disruption in global markets.

On Nvidia:  As we’ve discussed here in my daily notes, since its May earnings call last year, Nvidia has become the most important company in the world.

When Jensen Huang speaks, founder/CEO of Nvidia, he’s educating the world on the evolution of generative AI, and (as he calls it) the “rebirth of computing.”

Today he did so to an arena full of the world’s leading technologists.  He announced Nvidia’s new chip.  And he says it will be the most successful product launch in the company’s history.  Keep in mind, this is a company that nearly quadrupled in size over the past year, growing quarterly revenue by $16 billion (year-over-year).

As we’ve discussed earlier this month, Huang has said the future of accelerated computing is where “the digital world meets the physical world.”  He talked more about this today.

Nvidia’s Omniverse technology will power it, and it will reshape $100 trillion worth of global industry.

Importantly, the richest and most powerful companies in the world are spending billions of dollars a quarter on Nvidia’s AI chips, and partnering with Nvidia on projects ranging from infrastructure to research, to applications.  They are all-in.  And so is (virtually) everyone else.  These are companies collaborating with Nvidia …

 

It’s a new industrial revolution.  And it’s still very early. 

 

Pro Perspectives 3/14/24

 

 

 

 

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March 14, 2024

Stocks were broadly down today, globally.  Bonds were down, globally (yields up).  And most commodities (excluding energy) were down.
 
The selling was largely attributed to hotter than expected producer prices in February (another inflation data point).  And retail sales for February "rebounded." 
 
Does that mean the Fed's going to push the beginning of rate cuts out further.  Does it mean they won't cut?  Does it mean that might return to the view of raising rates again?
 
None of the above.  
 
Keep in mind, the producer price index has been under 2% (year-over-year change) for ten consecutive months.  And the "rebounding" retail sales, rebounded from a contraction in January, which was revised even lower in today's report. 
 
So, for perspective, if we look at where we are today, compared to where we were going into last Friday's jobs report:  The market has simply priced out a small possibility of a fourth rate cut this year.
 
Remember, the market view in early January was for six quarter point rate cuts this year (with a small chance of seven), while the Fed had projected just three.  And over the past two months, the Fed has successfully manipulated the market view to align with the Fed's projections, of just three quarter point cuts this year. 
 
That's where we stand heading into next Wednesday's Fed meeting, where the biggest news will likely be, what numbers the nineteen meeting participants determine to go in these yellow boxes (projections of PCE inflation and the end of year Fed funds rate).  
 
 
Now, we head into this Fed meeting with most advanced economies in the world preparing to cut interest rates (ease monetary policy) after the fight with four decade high inflation.  We should expect them to do it in coordination, as they did with the response to the pandemic, and with the response to the related inflation.
 
In coordination, the major global central banks were able to curtail record inflation, without having to raise interest rates above the rate of inflation — the historical inflation beating formula, but also a formula that would have crippled the economies of the Western world.
 
And as we've discussed along the way, that Western world victory over inflation has only been made possible by the liquidity that continued to pump into the global economy from Japan.
 
With that, there has been a clear effort from the Bank of Japan (BOJ), over the past several months, to start setting expectations in markets that they will, at some point, exit emergency level policies.  And that communication to markets has been dialed up in recent days, telegraphing the end of negative interest rates in Japan.
 
Today there were rumors that it could come as early as next week's BOJ meeting.
 
Negative rates and QE in Japan have been the BOJ and Japanese government's strategy to fight decades of entrenched deflation.  Only with the post-pandemic global ballooning of money supply, might they have it beat.   
 
But an exit at this point seems premature, unnecessary, and dangerous.
 
What's dangerous about it?  Japan's negative rates (and unlimited QE) have promoted (implicit and explicit) investment into global stock and bond markets.  Importantly, the BOJ bought a lot of sovereign debt of the Western world to help keep important global rates in check, while central banks were fighting inflation. 
 
With that in mind, while the U.S. inflation data got a lot of attention this morning, it was another report that likely triggered the sell-off in stocks, and this spike (below) in yields.  News was circulating this morning that the BOJ could act as early as next week.
 
 
 

Pro Perspectives 3/12/24

 

 
 

 

 

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March 12, 2024

We had the February inflation data this morning.

It looks like this …

As you can see, the headline Consumer Price Index (CPI) has stalled around the 3% mark.  And it happens to have leveled off from where the Fed made its last rate hike.

The speculation has been that the move from 3% to 2% will be longer and more difficult than the move from 9% to 3%.

But the Fed’s favored inflation gauge, the Personal Consumption Expenditures Price Index (PCE), has had a much cleaner path.  At the current 2.4% level, it’s not far from the Fed’s target.

What’s the story?  As we’ve discussed over the past few months, the insurance component of CPI has been a significant drag.  Jerome Powell said the same recently.

Take a look at the direction of household insurance …

And the direction of auto insurance …

As we’ve discussed here in my daily notes, the massive monetary and fiscal response to the pandemic (plus the subsequent agenda spending binge) ramped the money supply by 40% in just two years.  That was almost a decade’s worth of money supply growth (on an absolute basis), dumped onto the economy in a span of two years.

That inflated asset prices.  And the insurance industry spent the past two years raising the price to insure those higher priced underlying assets.  But as we’ve also discussed this is a lagging feature (likely a late stage feature) of a hot inflationary period.

If we just pull out shelter from the consumer price index (which is influenced by changes in insurance premiums), CPI drops below 2%.