Dow and gold slid on another US govt shutdown political drama

On Thursday, Wall Street surged on hopes of no government shutdown and a less hawkish Fed stance after Q2FY23 real GDP growth was finalized at +2.1% against market expectations of +2.2%, while overall CY22 real GDP growth was also revised lower at +1.9% against earlier +2.1% owing to various yearly seasonal adjustment. In Q2CY23, consumer spending was also revised lower, while the latest continuing jobless claims and pending home sales were softer than expected.

On Thursday, Wall Street was also boosted by less hawkish Fed comments. Fed's Chair Powell doesn't address rates or economic outlook in his town hall meeting with economic teachers across the U.S.

On Thursday, Fed’s Goolsbee said:

·         Long-run inflation expectations are well-anchored and can help lower inflation with less economic pain than previously

·         Evidence points to the outbreak of inflation in 2021 as largely supply-related, ignoring supply improvements as a recipe for overshooting

·         The risks to the outlook include oil prices, the slowdown in China, the possibility of a protracted US auto strike, or a "disruptive" government shutdown

·         The importance of expectations and Fed credibility makes proposals to raise the inflation target from 2% quite risky

·         Better productivity could mean the long-run potential is not as low as some have feared, allowing more growth without inflation

·         Housing will be key to continued inflation progress in the next few quarters, with the risk that rising home prices could also boost market rents

·         The Fed needs to be "extra careful" of tying policy to historical relationships that may not hold up in the current economy

·         Holding to the inevitability that job losses are needed to slow inflation risks a near-term policy error

·         Recent data, with inflation slowing without job losses, has run against past US patterns

·         Some analyses show inflation reaching the target soon, without further policy tightening and only a modest slowdown in growth

·         Wages typically lag prices, so short-term movements should not be used to predict inflation

·         The Fed will return inflation to the target but has a chance to do something "rare" by accomplishing that without a recession

·         I have been pleasantly surprised that monetary tightening did not cause broader financial stability problems

·         If long rates continue increasing, the Fed will have to take account of that as a form of tightening

·         I'm still trying to process why long-end interest rates are increasing

·         Once the Fed is back to the 2% target, or on a clear path to it, then it would be perfectly appropriate to discuss the target itself

·         I have not been a big fan of an explicit inflation target

·         It matters a lot how long the auto strike lasts in terms of GDP impact

·         If the Fed sees a lack of progress on the pricey side, it will have to tighten more

·         Inflation targets do risk giving a false sense of precision around a noisy variable

·         The Fed will have a legitimate debate about how the current framework worked in this period of inflation

·         The recent inflation was mostly supply though there was a demand component

·         I have not decided what to do at the next meeting

·         I'm trying not to put too much weight on conventional measures of overheating

·         If the Fed sees a lack of progress on the price side it will have to raise the restraint

·         Fed will return inflation to target and can do it without a recession

On Thursday, Fed’s Barkin said:

·         The last five months of inflation data have been encouraging

·         It is very hard to imagine inflation easing a lot while growth is very strong

·         I don't see trauma coming into the labor market

·         It is too soon to say what's next for monetary policy

·         I see the next quarter as solid, not robust

·         Growth will moderate from earlier in the year

·         Growth still seems solid in the economy

·         It makes sense for lower and middle-income spending to adjust to a slower pace

·         Recent data on consumer spending is stronger than expected and solid

·         A lack of data due to a shutdown would complicate understanding the economy

·         A government shutdown would create uncertainty

Wall Street Futures and gold were already under stress, while USD/US bond yield surged since the Fed’s more hawkish than expected hold on 20th September and subsequent hawkish comments by various Fed policymakers, indicating a higher for longer stance. Fed is now insisting that one more +25 bps hike for a terminal repo rate +5.75% is not a big issue and will not cause an outright recession, but the Fed is now evaluating the duration of such terminal rate before going for any appropriate cuts in line with any meaningful fall in core inflation. This coupled with less hawkish talks by the ECB, BOE, and BOJ is boosting USD/US bond yields.

Overall, the Fed is not in a hurry to cut rates in H1CY24 and the market is now expecting two rate cuts of -25 bps each in September’24 and December’24, contrary to earlier perceptions of -50 bps rate cuts each in H1 and H2CY24, totaling -100 bps cuts in 2024. Fed has indicated only -50 bps rate cuts in 2024, stressing higher rates for a longer stance, which is affecting risk trade sentiment of Wall Street; boosting USD/US bond yields, dragging gold and stocks. Subdued discretionary consumer spending may affect corporate earnings significantly amid higher cost of living, higher cost of borrowing, and lingering macro-headwinds.

Apart from the concern of higher borrowing costs, Wall Street Futures were also affected by growing political and policy paralysis for the Biden admin, which is now running a minority government effectively after losing the House to Republicans in the Nov’22 mid-term election. Republicans are now planning another government shutdown and even an impeachment motion against President Biden. Moody's said: “A US government shutdown would underscore institutional and governance weakness, and would be credit negative for the US sovereign.” ‘Capitalist’ Wall Street is concerned about Biden’s ‘socialistic’ approach to striking UAW/auto workers; politics is getting priority over economics.

On early Friday, Dow Future got a further boost on positive Chinese and European cues. The market is expecting some spending boost during China’s Festival season (Golden week), targeted Chinese fiscal/monetary stimulus, and a reduction in the cold/trade war with the U.S. amid the discussions of a potential summit between the Presidents of the US (Biden) and China (Xi). China's Vice Premier He Lifeng and Foreign Minister Wang Yi are talking about prospective trips to the U.S. to get ready for a future summit between Xi and Biden.

On Thursday, China’s President Xi said:

·         China to push forward peaceful relations with Taiwan

·         China will increase job creation

·         China is set to boost macroeconomic controls

On early Friday, European markets were also buoyed after softer than expected core inflation reading for September, which may keep the ECB for a pause/pivot. In September, the Euro Area core inflation slumped to +4.5% from +5.3% sequentially lower than the market expectations of +4.8% and lowest since Aug’22.

On Thursday/Friday, the WH Economic Adviser Bernstein said:

·         The US economy is expected to keep going in a pretty good way' absent a policy mistake or exogenous shock

·         The US economy is facing headwinds from a possible shutdown, student debt restart, higher interest rates, and UAW strike

·         A shutdown is completely avoidable

·         There are risks to the economy, but it has remained resilient

·         Core inflation is now in the pre-pandemic range

·         US inflation data is absolutely good news

·         The economy has been very resilient and the last thing we need is a government shutdown

On Friday, BEA flash data showed U.S. real core PCE inflation (seasonally adjusted at 2017 constant prices) for August eased to +3.9% from +4.3% sequentially, in line with the market expectations and lowest since May’21.

On a sequential (m/m) basis (seasonally adjusted at 2017 constant prices); the U.S. real core PCE inflation increased by +0.1% in August from +0.2% in July, below market expectations of +0.2% and lowest since Nov’20. The +0.1% increase in real PCE in August reflected an increase of +0.2% in spending on services and a decrease of -0.2% in spending on goods. Within services, the leading contributors to the increase were transportation services (led by air transportation) and health care (led by hospitals and nursing homes). Within goods, the largest contributor to the decrease was motor vehicles and parts (led by new motor vehicles).

But if we consider the estimated real Core PCE price index at 2012 constant prices (in line with previous series of data), the sequential rate was around +0.20% rather than +0.10% and in line with market expectations.

Overall, the 3M rolling average of underlying core PCE inflation, the Fed’s preferred gauge of price stability measurement is now running around +3.7%, while core CPI inflation, also now in the focus of the Fed is around +4.4%. The Fed is now looking into the 6M average (H1/H2) of core inflation; the 6M (H1CY23) average of core PCE inflation is now around +4.5% and core CPI at +5.4% (in old series), both substantially higher than +2.0% Fed targets. Fed is now also primarily targeting core CPI rather than core PCE inflation as the PCE is usually -100 bps less than the CPI and core CPI is more closely associated with headline inflation.

On Friday, Wall Street Futures, Gold got some boost after softer than expected core PCE inflation sequentially at +0.1%, but soon the risk trade reversed as the sequential rate in the old series continues to be around +0.2%, in line with market expectations or even more. In any way, overall core PCE inflation or core CPI inflation is cooling down gradually, but still substantially hot enough or above Fed targets and does not alter the Fed’s plan for at least another hike in Nov’23 to end the current tightening cycle.

On Friday, Fed’s Williams said in an article: Peeling the Inflation Onion, Revisited

·         The Fed will need a restrictive policy stance for some time to achieve goals

·         GDP should moderate next year to about 1.25%

·         Unemployment to rise just over 4% next year

·         I see inflation ebbing to 3.25% this year, heading to 2% in 2025

·         The Fed is at or near the peak for the Federal Funds rate

·         I see ample signs that inflation pressures are waning

·         The future is uncertain, data will drive future policy choices

·         It will still take a while for full monetary policy tightening to affect the economy

·         Inflation is still too high, price stability is essential for the economy

·         The jobs market is strong, and the current unemployment rate matches the long-term trend

·         The jobs market moving toward a better balance

·         Monetary policy is having the desired effect on the economy

Full Text: Peeling the Inflation Onion, Revisited-Written by NY Fed President Williams, an influential FOMC policymaker and right-hand man of Chair Powell

“The Federal Reserve has two main monetary policy goals, often referred to as the “dual mandate”: maximum employment and price stability. As I will discuss in more detail, we are doing well on our maximum employment mandate, but we still have a ways to go to fully restore price stability.

Although inflation has come down from the peak reached last year, it is still too high. Price stability is the bedrock upon which our economic prosperity and stability stand. The Federal Open Market Committee (FOMC) has set a 2 percent longer-run goal for inflation and is committed to attaining that goal on a sustained basis.

The Inflation Onion

After peaking at just over 7 percent in June of last year, inflation is now 3-1/2 percent, based on the 12-month percent change in the personal consumption expenditures price index. To understand why inflation rose so much and how it’s coming back down, I find it useful to use the metaphor of an onion with various “layers” of inflation.

The outer layer of the onion consists of prices of globally traded commodities—lumber, steel, grains, and oil. The pandemic caused global demand for commodities to skyrocket. Russia’s war against Ukraine set off a second sharp rise in commodity prices. Since then, global demand has come into better balance with supply, and inflation in this layer has come down significantly.

To give an idea of how big the swings in these inflation rates have been, food price inflation soared to over 10 percent and energy price inflation skyrocketed to over 40 percent in June of last year. Over the past 12 months, as supply-demand imbalances receded, food price inflation dropped to about 3 percent, and, despite the recent rebound in oil and gasoline prices, energy prices have declined by about 3-1/2 percent.

The middle layer of the onion is made up of goods like appliances, furniture, and cars. In the pandemic and its aftermath, demand for goods rose, supply-chain disruptions contributed to shortages, and prices increased sharply. Today, demand for goods has lessened, in part due to higher interest rates, and supply chain bottlenecks have improved dramatically, resulting in a sharp drop in the inflation rate for goods excluding food and energy to around 1/2 percent.

Economists at the New York Fed developed a useful tool to measure the extent of supply chain disruptions, called the Global Supply Chain Pressure Index. This index shot up to an all-time high reading in late 2021, reflecting the wide range of delays, cost increases, and impediments to supply chains that hampered the production and movement of goods during the pandemic. Since then, these issues have mostly been resolved, and the index is now indicating favorable overall supply chain conditions. Research at the New York Fed shows there is a strong relationship between this index and prices of goods, which helps explain the big swings in goods price inflation over the past two years.

The center layer of our onion is underlying inflation, which includes measures for shelter and other non-energy services. This is the most challenging layer of inflation, as it reflects the overall balance between supply and demand in the economy and tends to change more slowly. Shelter inflation has been one of the most important drivers of the rise in inflation over the past few years, reflecting increased demand for housing and limited supply. This category of inflation has been coming down gradually, and data on rents for newly signed leases points to further declines in shelter inflation in the coming months.

Overall, we are seeing inflation moderate in the three layers of the onion, with the fastest and largest improvements in the outer layers, and progress in the innermost layer more muted. Two useful metrics capture these shifting inflation dynamics.

The first is nearer-term inflation expectations. According to the New York Fed’s monthly Survey of Consumer Expectations, one-year-ahead inflation expectations have fallen dramatically since peaking at nearly 7 percent last June, and are now only about 3/4 percentage points above average levels seen over 2014-2020. Medium-term expectations in the survey are fully back to pre-pandemic levels.

The second is the New York Fed’s Multivariate Core Trend (MCT) inflation, a statistical method that slices and dices the data to measure the underlying rate of inflation in the economy. The July reading of MCT inflation was 2-3/4 percent, a huge improvement over the 5-1/2 percent reading we saw last year.

Labor Markets: Returning to Balance

I’ll now turn to the other side of our mandate, maximum employment. The overall labor market is strong, as seen in the unemployment rate of 3.8 percent, which equals my estimate of the unemployment rate expected to prevail in the economy in the long run. Indeed, the issue we have been facing is that labor demand exceeds available supply, and this imbalance has contributed to high inflation, especially in the services sector.

There are numerous signs that labor market imbalances are diminishing. The rate of people quitting jobs and the rate of new people being hired have moved back to pre-pandemic levels. Surveys of employers and households both show a return to pre-pandemic conditions. The number of job openings, while still high by historical standards, has declined toward more normal levels. And wage growth has slowed considerably from earlier peaks.

Both lower demand and improved supply have helped restore balance to the labor market. Labor supply has rebounded through increases in labor force participation and immigration. However there are limits to how much further supply will increase going forward, and further reductions in demand are needed to bring balance to the labor market.

Monetary Policy and the Economic Outlook

Against this backdrop of still-high inflation, the FOMC has set a restrictive stance of monetary policy to restore balance in the economy and bring inflation down to 2 percent over time. Last week, the FOMC kept the target range for the federal funds rate unchanged at 5-1/4 to 5-1/2 percent.

Our monetary policy actions are having the intended effects but will take time to fully work their way through the economy and inflation. As monetary policy continues to bring demand into better balance with supply, I expect GDP growth to slow next year to about 1-1/4 percent and the unemployment rate to rise modestly to a little over 4 percent. I foresee inflation of around 3-1/4 percent for this year as a whole, declining to around 2-1/2 percent next year, before closing in on 2 percent in 2025.

My current assessment is that we are at, or near, the peak level of the target range for the federal funds rate. I expect we will need to maintain a restrictive stance of monetary policy for some time to fully restore balance to demand and supply and bring inflation back to our 2 percent longer-run goal.

Conclusion

In conclusion, monetary policy is having the desired effects on the economy and inflation. The future is inherently uncertain. As we work to achieve our dual mandate goals, we face two-sided risks. Our decisions, as always, will be guided by the data, with our eyes squarely on our goals.

Market wrap:

On Friday, Dow Future surged to the session high around 34126 soon after softer than expected sequential core PCE inflation headline, but soon stumbled on details and the fact that overall core inflation is still substantially higher than the Fed’s target for at least another +0.25 bps hike on 1st November for a terminal repo rate +5.75%. Also, month/QTR end portfolio/fund flow adjustments caused some volatility. Fed’s Williams also indicated at least another hike for a restrictive repo rate of +5.75% and hold the restrictive rate for ‘some time’; i.e. till at least H1CY24.

Wall Street was also spooked by the concern of another government shutdown political soap opera. The opposition party Republicans are now insisting on a CR/stop-gap funding bill to spend the next two weeks and passing full-year spending bills during a shutdown. But ruling party Democrats (Biden) are not ready for such a compromise.

On Friday, blue-chips Dow Future stumbled over -500 points from the session high and closed around 33732 (-0.47%); broader SPX-500 edged down -0.27%, while tech-heavy NQ-100 closed almost flat after a substantial fall from the session/day high.

On Friday, Wall Street was dragged by energy (lower oil amid higher US production near 13 mbpd), financials, healthcare, communication services, industrials, consumer staples, and materials, while supported by consumer discretionary, tech, real estate, and utilities. Dow-30 was dragged by travelers, JPM, Wall Mart, Merck, Caterpillar, Chevron, and IBM, while helped by Nike, Walgreens Boots, Walt Disney, Intel, Microsoft, Boeing, and Apple. Nasdaq was supported additionally by Carnival, Nvidia and Tesla.

Conclusion:

The Fed is now preparing the market for another hike in November and then a possible end of the tightening cycle by Dec’23. Overall, the U.S. labor market and core inflation trajectory are still hot enough for another Fed hike. Fed never surprised the market with its rate action and by mid-October (after core inflation and labor/wage data for September), it will be clear whether the Fed will go for another +25 bps hike in Nov’23 before going for a final pause in Dec’23.

As per Taylor’s rule, for the US:

Recommended policy repo rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.50.00-2.00) =0+2+3.50=5.50%

Here:

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation (CPI+PCE) =5.50% (for 2022); H1CY23 average core inflation around +5.40% (~5.50%)

As there is no significant easing of core inflation, especially core service inflation, the Fed may go for another +25 bps hike in Nov’23 and possibly the end of a tightening cycle. But, if core CPI inflation indeed eased further to below +4.0% by Oct’23, then the Fed may refrain from any further rate hike in 2023 and may also indicate some rate cuts in Q2CY24 in the Dec’23 SEP (ahead of the US Presidential Election in Nov’24) to keep real repo rate around +1.00% levels (restrictive zone).

Looking ahead, oil prices may stay elevated in the coming months between $75-95 instead of the earlier $65-75 despite US efforts to bring more supply from, Mexico, Brazil, Iran, Iraq, and Venezuela. OPEC/Saudi Arabia will not ‘cooperate’ with the U.S. for ‘breach of trust’ in refilling SPR (as agreed ‘verbally’). Elevated oil prices around $90 will continue to boost energy/transportation/logistics costs and core inflation. Saudi Arabia/most OPEC producers and even Russia are now seeking $85 oil prices on a sustainable basis to fund budget deficits, EV transition, and also the cost of the Ukraine war. China may also deploy more targeted stimulus to bring out the economy from the deflationary spiral in the coming days, which may also support elevated oil prices.

The U.S., as a producer, is also benefitting from elevated oil prices. The U.S. is also a beneficiary of the Russia-Ukraine war and other geo-political tensions involving North Korea, China, and Iran. The U.S. defense/military industry is now booming. Also, the lingering Cold War mentality with China is resulting in supply chain disruptions and elevated inflations. The global economy continues to face the daunting challenges of macro-headwinds- elevated inflation, high levels of debt, tight and volatile financial conditions, continuing geopolitical tensions, fragmentations, and extreme weather conditions.

Going by the present trend/run rate, the U.S. core CPI may fall to +3.8% by Dec’23 and +3.4% by Feb’24, which may keep the Fed to hold on rates at +5.7% till at least Aug’24 before going for any rate cuts -25 bps or even -50 bps each in Sep’24 and Dec’24. Fed would like to boost Wall Street as well as Main Street before Nov’24 U.S. Presidential election. Fed has to ensure a soft landing; i.e. price stability along with financial/Wall Street stability and Main Street stability.

Looking ahead, the Fed may try to balance the financial/Wall Street stability and price stability by expressing intentions to cut from June’24 (H2CY24) to ensure a soft landing while bringing down inflation. Also, the Fed has to ensure lower borrowing costs for the U.S. Government (Treasury) endless deficit spending and mammoth public debt of almost $32T. The U.S. is now paying around 9.5% of its revenue as interest on public debt against China/EU’s 5.5%. This is a red flag, and thus Fed has to operate in a balancing way while going for calibrated hiking to bring inflation down to target, avoiding an all-out recession; i.e. to ensure both price stability and soft-landing.

Overall, it seems that the White House would be quite happy if the Fed could bring back core inflation towards 2% on a durable basis, while keeping the unemployment rate below 4% ahead of Nov’24, the U.S. Presidential election. The Fed is itself eager to cut its losses by cutting rates. The U.S. 2Y bond yield is now hovering around +5.13% and may soon scale 5.25-5.50% in hopes of another +25 bps Fed rate hike for a terminal repo rate of +5.75%.

Bottom line:

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

Whatever may be the narrative, technically Dow Future (33732) now has to sustain above 33500 levels for any recovery to 33850/34000-34150/34250 and 34300/34555-34600/34825-35070/200-415/850 levels; otherwise, sustaining below 33450 may again fall to 33240/200-32500/31750 levels in the coming days.

Similarly, NQ-100 Future (14867) now has to sustain over 14600-550 levels for any recovery to 14925/15150-15325/15500 and 15750/900-16000/655 in the coming days; otherwise, sustaining below 14500 may further fall to 14300/175-100/13890 and 13650-13125 levels.

Gold (XAU/USD: 1876) now has to sustain above 1843-1837 for any recovery to 1867/1875-1885/1900 and 1910/1920-1926/1937 and 1952/1970 levels; otherwise, sustaining below 1835, may further fall to 1825/1813*-1798/1770 level in the coming days.

Looking ahead, Wall Street Futures, Gold, EURUSD, GBPUSD were extremely oversold, while USDJPY/USD/US bond yields overbought, a slight dovish comments by Fed, or softer than expected NFP payroll/BLS job data and the end of U.S. government shutdown political drama/no shutdown may ignite a huge short covering/value buying rally from the 1st week of October. Also, any hawkish comments by BOJ, ECB and BOE may weaken USD/US bond yields.