Dow and Gold wobbled on Fed’ less dovish hold and QT tapering

On Wednesday all focus of the market was on the Fed’s policy decision, where the Fed was expected to hold the rate with a confirmation of QT tapering and an indication of rate cuts in the ‘later part of the year’. But although it first seems that the Fed goes for higher QT tapering at $40B/M against market expectations of $65B/M from the prior $95B/M, the effective QT rate was actually around $70B/M and thus the overall reduction in QT was around $30B/M, in line with market expectations. Also, Fed Chair Powell failed to guarantee/assure 75 bps rate cuts in H2CY24.

Fed may not cut rates at all from Sep’24, just months before Nov’24 US election to avoid political controversy, and may/may not cut rates in Dec’24; Fed may revise dot-plots in June meeting. Moreover, if we consider actual effective rate of QT around $70B/M from June’22 till Apr’24 (B/S size reduced from around $8.97T to $7.40T), and subsequent QT rate of $40B/M from June’22, the effective pace of B/S reduction reduced by $30B/M ($70B-40B), which is in line with market consensus of $30B/M QT tapering rate. Also, the Fed will gradually shift its MBS holding to UST in the coming months/years (B/S optimization) to reduce the QE/QT effect directly on the US mortgage market.

Overall it’s a hawkish hold or less dovish hold by the Fed. Thus Wall Street Futures, Gold, and UST surged initially on higher than expected QT tapering; i.e. slower rate of B/S reduction, which will reduce present restrictive/tighter financial conditions to some extent. But Wall Street, Gold and UST also stumbled to some extent after Powell's presser as it becomes almost sure that the Fed will not cut 75 bps this year.

On Wednesday, the U.S. Fed held all primary policy rates for a 6th consecutive meeting as unanimously expected; i.e. the target range for the Federal Fund's Rate (FFR-interbank rate) at +5.38% (median of 5.25%-5.50%); primary credit rate (repo rate) at +5.50%; IOER (reverse repo rate) at +5.40%; overnight repurchase agreement rate (RP) at +5.50% and RRP (Overnight Reverse Repurchase Agreement Rate) at +5.30%, keeping U.S. borrowing costs to the highest level since January 2001 (23-years). Fed cited a slower/almost stalled disinflation process and still tighter labor market for keeping patience about rate cuts; the Fed is now still pursuing for higher longer policy stance. Fed is still not confident enough that the present disinflation process will eventually lead to a 2% inflation target within a reasonable period (mid-term).

The US core CPI inflation is still quite elevated at around +3.90% on average (6M rolling average), while the unemployment rate around 3.8% (6M Rolling average) is hovering just below the Fed’s longer-term sustainable target of 4.0%. Thus there is still a need for a higher (restrictive) longer policy stance, which may further produce additional slack; i.e. restrict economic activities and demand, helping to match with the present constrained supply side of the economy and bring down inflation further in the process towards +2.0% targets on a sustainable basis. Fed believes that the rate of disinflation accelerated in H2CY23 due to supply-side easing including the labor market, which may not be repeated in 2024 due to various issues.

In its March dot-plots/SEP, the Fed projected a -75 bps rate cut each in 2024, 2025, and 2026 and a -50 bps rate cut in 2027 (longer term) for indicative repo rate to 4.75%, 4.00%, 3.25% and 2.75% terminal rate from present 5.50%. Similarly, in its Mar’24 SEP, the Fed projected US real GDP growth for 2024 at 2.1%; 2.0% for 2025, and 2.0% for 2026. Fed projected headline PCE inflation for 2024 at 2.4%; for 2025 2.2%. Fed projected the core PCE inflation for 2024 at 2.6%; and for 2025 at 2.2%. The unemployment rate is seen at 4% for 2024; and for 2025 at 4.1%. Fed always maintains that although shorter-term (6-12M) SEP/dot-plots may be relevant or most likely to happen; longer-term SEPs are not and are always subject to some revision as per actual economic data. Fed will revise the SEP/dot plots in its June meeting in line with its latest narrative.

Full text of Fed’s statement: 1st May 24- Federal Reserve issues FOMC statement

“Recent indicators suggest that economic activity has continued to expand at a solid pace. Job gains have remained strong, and the unemployment rate has remained low. Inflation has eased over the past year but remains elevated. In recent months, there has been a lack of further progress toward the Committee's 2 percent inflation objective.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. The Committee judges that the risks to achieving its employment and inflation goals have moved toward better balance over the past year. The economic outlook is uncertain, and the Committee remains highly attentive to inflation risks.

In support of its goals, the Committee decided to maintain the target range for the federal funds rate at 5-1/4 to 5-1/2 percent. In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.

In addition, the Committee will continue reducing its holdings of Treasury securities agency debt and agency mortgage‑backed securities. Beginning in June, the Committee will slow the pace of the decline of its securities holdings by reducing the monthly redemption cap on Treasury securities from $60 billion to $25 billion. The Committee will maintain the monthly redemption cap on agency debt and agency mortgage‑backed securities at $35 billion and will reinvest any principal payments in excess of this cap into Treasury securities. The Committee is strongly committed to returning inflation to its 2 percent objective.

In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals. The Committee's assessments will take into account a wide range of information, including readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments.

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Thomas I. Barkin; Michael S. Barr; Raphael W. Bostic; Michelle W. Bowman; Lisa D. Cook; Mary C. Daly; Philip N. Jefferson; Adriana D. Kugler; Loretta J. Mester; and Christopher J. Waller.”

The major difference in FOMC's May statement: Risks to achieving employment and inflation goals 'have moved toward better balance over the past year,' as opposed to 'are moving into better balance' in the March policy statement.

Implementation Note issued 1st May’24: Decisions Regarding Monetary Policy Implementation

The Federal Reserve has made the following decisions to implement the monetary policy stance announced by the Federal Open Market Committee in its statement on May 1, 2024:

The Board of Governors of the Federal Reserve System voted unanimously to maintain the interest rate paid on reserve balances at 5.4 percent, effective May 2, 2024.

As part of its policy decision, the Federal Open Market Committee voted to direct the Open Market Desk at the Federal Reserve Bank of New York, until instructed otherwise, to execute transactions in the System Open Market Account in accordance with the following domestic policy directive:

"Effective May 2, 2024, the Federal Open Market Committee directs the Desk to:

Undertake open market operations as necessary to maintain the federal funds rate in a target range of 5-1/4 to 5-1/2 percent.

Conduct standing overnight repurchase agreement operations with a minimum bid rate of 5.5 percent and with an aggregate operation limit of $500 billion.

Conduct standing overnight reverse repurchase agreement operations at an offering rate of 5.3 percent and with a per-counterparty limit of $160 billion per day.

Roll over at auction the amount of principal payments from the Federal Reserve's holdings of Treasury securities maturing in May that exceeds a cap of $60 billion per month. Beginning on June 1, roll over at auction the amount of principal payments from the Federal Reserve's holdings of Treasury securities maturing in each calendar month that exceeds a cap of $25 billion per month. Redeem Treasury coupon securities up to these monthly caps and Treasury bills to the extent that coupon principal payments are less than the monthly caps.

Reinvest into agency mortgage-backed securities (MBS) the amount of principal payments from the Federal Reserve's holdings of agency debt and agency MBS received in May that exceeds a cap of $35 billion per month. Beginning on June 1, reinvest the amount of principal payments from the Federal Reserve's holdings of agency debt and agency MBS received in each calendar month that exceeds a cap of $35 billion per month into Treasury securities to roughly match the maturity composition of Treasury securities outstanding.

Allow modest deviations from stated amounts for reinvestments, if needed for operational reasons.

Engage in dollar roll and coupon swap transactions as necessary to facilitate settlement of the Federal Reserve's agency MBS transactions."

In a related action, the Board of Governors of the Federal Reserve System voted unanimously to approve the establishment of the primary credit rate at the existing level of 5.5 percent.

This information will be updated as appropriate to reflect decisions of the Federal Open Market Committee or the Board of Governors regarding details of the Federal Reserve's operational tools and approach used to implement monetary policy.

Full text of Fed Chair Powell’s opening statement: 1st May’24

My colleagues and I remain squarely focused on our dual mandate to promote maximum employment and stable prices for the American people. The economy has made considerable progress toward our dual mandate objectives. Inflation has eased substantially over the past year while the labor market has remained strong and that’s very good news. But inflation is still too high, further progress in bringing it down is not assured, and the path forward is uncertain. We are fully committed to returning inflation to our 2 percent goal. Restoring price stability is essential to achieve a sustainably strong labor market that benefits all.

Today, the FOMC decided to leave our policy interest rate unchanged and to continue to reduce our securities holdings, though at a slower pace. Our restrictive stance on monetary policy has been putting downward pressure on economic activity and inflation, and the risks to achieving our employment and inflation goals have moved toward better balance over the past year. However, in recent months inflation has shown a lack of further progress toward our 2 percent objective, and we remain highly attentive to inflation risks.

I will have more to say about monetary policy after briefly reviewing economic developments.

Recent indicators suggest that economic activity has continued to expand at a solid pace. Although GDP growth moderated from 3.4 percent in the fourth quarter of last year to 1.6 percent in the first quarter, Private Domestic Final Purchases, which exclude inventory investment, government spending and net exports, usually send a clearer signal on underlying demand, 3.1 percent in the first quarter, as strong as the second half of 2023.

Consumer spending has been robust over the past several quarters, even as high-interest rates have weighed on housing and equipment investment. Improving supply conditions have supported resilient demand and the strong performance of the U.S. economy over the past year.

The labor market remains relatively tight, but supply and demand conditions have come into better balance. Payroll job gains averaged 276 thousand jobs per month in the first quarter, while the unemployment rate remains low at 3.8 percent. Strong job creation over the past year has been accompanied by an increase in the supply of workers, reflecting increases in participation among individuals aged 25 to 54 years and a continued strong pace of immigration.

Nominal wage growth has eased over the past year and the jobs-to-workers gap has narrowed, but labor demand still exceeds the supply of available workers. Inflation has eased notably over the past year but remains above our longer-run goal of 2 percent. Total PCE prices rose 2.7 percent over the 12 months ending in March; excluding the volatile food and energy categories, core PCE prices rose 2.8 percent. The inflation data received so far this year have been higher than expected. Although some measures of short-term inflation expectations have increased in recent months, longer-term inflation expectations appear to remain well anchored, as reflected in a broad range of surveys of households, businesses, and forecasters, as well as measures from financial markets.

The Fed’s monetary policy actions are guided by our mandate to promote maximum employment and stable prices for the American people. My colleagues and I are acutely aware that high inflation imposes significant hardship as it erodes purchasing power, especially for those least able to meet the higher costs of essentials like food, housing, and transportation. We are strongly committed to returning inflation to our 2 percent objective.

The Committee decided at today’s meeting to maintain the target range for the federal funds rate at 5-1/4 to 5-1/2 percent and to continue the process of significantly reducing our securities holdings, though at a slower pace. Over the past year, as labor market tightness has eased and inflation has declined, the risks to achieving our employment and inflation goals have moved toward better balance. The economic outlook is uncertain, however, and we remain highly attentive to inflation risks.

We have stated that we do not expect it will be appropriate to reduce the target range for the federal funds rate until we have gained greater confidence that inflation is moving sustainably toward 2 percent. So far this year, the data have not given us that greater confidence. In particular, and as I noted earlier, readings on inflation have come in above expectations. Gaining such greater confidence will likely take longer than previously expected. We are prepared to maintain the current target range for the federal funds rate for as long as appropriate.

We are also prepared to respond to an unexpected weakening in the labor market. We know that reducing policy restraint too soon or too much could result in a reversal of the progress we have seen on inflation. At the same time, reducing policy restraint too late or too little could unduly weaken economic activity and employment.

In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. The policy is well-positioned to deal with the risks and uncertainties that we face in pursuing both sides of our dual mandate. We will continue to make decisions meeting by meeting.

Turning to our balance sheet, the Committee decided at today’s meeting to slow the pace of decline in our securities holdings, consistent with the plans we released previously. Specifically, the cap on Treasury redemptions will be lowered from the current $60 billion per month to $25 billion per month as of June 1. Consistent with the Committee’s intention to hold primarily Treasury securities in the longer run, we are leaving the cap on agency securities unchanged per month and will reinvest any proceeds above this cap in Treasury securities.

With principal payments on agency securities currently running at about $15 billion per month, total portfolio runoff will amount to roughly $40 billion per month. The decision to slow the pace of runoff does not mean that our balance sheet will ultimately shrink by less than it would otherwise but rather allows us to approach its ultimate level more gradually. In particular, slowing the pace of runoff will help ensure a smooth transition, reducing the possibility that money markets experience stress, and thereby facilitating the ongoing decline in our securities holdings that are consistent with reaching the appropriate level of ample reserves.

We remain committed to bringing inflation back down to our 2 percent goal and to keeping longer-term inflation expectations well anchored. Restoring price stability is essential to set the stage for achieving maximum employment and stable prices over the longer run.

To conclude, we understand that our actions affect communities, families, and businesses across the country. Everything we do is in service to our public mission. We at the Fed will do everything we can to achieve our maximum employment and price stability goals. Thank you. I look forward to your questions.

Highlights of Fed Chair Powell’s comments in the Q&A: 1st May’24

·         US Interest Rate Decision Actual 5.5% (Forecast 5.5%, Previous 5.5%)

·         Monetary policy actions guided by dual mandate

·         Inflation data received this year have been higher than expected

·         Nominal wage growth has eased over the past year, but the labor demand still exceeds supply

·         The labor market remains relatively tight

·         Private domestic final purchases were as strong as second half of last year

·         We are highly attentive to inflation risks

·         Risks to achieving the dual goals have moved into better balance over the past year, but inflation has shown a lack of progress

·         A restrictive stance has put downward pressure on inflation and the economy

·         Inflation is still too high and further progress is not assured

·         Inflation eased substantially over the past year but is still too high

·         The economy has made considerable progress toward dual goals

·         The Fed does not expect it will be appropriate to cut rates until it has gained greater confidence inflation is moving sustainably toward 2%

·         Economic activity continues to expand at a solid pace, job gains have remained strong, and the unemployment rate has remained low

·         Inflation has eased over the past year but remains elevated

·         Fed vote in favor of the policy was unanimous

·         The Fed will slow the decline of the balance sheet by cutting Treasury redemption cap to $25 bln per month from $60 bln starting June the 1st

·         Fed maintains mortgage-backed securities redemption cap at $35 bln per month, will reinvest excess MBS principal payments into treasuries

·         With principal payments on agency securities currently running at about $15 billion per month, total portfolio runoff will amount to roughly $40 billion per month (official/effective QT rate)

·         Total portfolio runoff (QT rate) will be about $40 billion per month

·         It is to ensure that the process of shrinking the balance sheet down to where we want to get it is a smooth one and doesn’t wind up with financial market turmoil the way it did the last time we did this, and the only other time we’ve ever done this

·         Gaining greater confidence will likely take longer than previously expected

·         We do not expect it will be appropriate to cut rates until we have greater confidence inflation is going back to 2%

·         We will make decisions meeting by meeting

·         The policy is well-positioned to deal with the risks and uncertainties we face

·         The policy rate is restrictive

·         Slowing the pace of runoff will ensure a smooth transition for money markets

·         The decision to slow runoff will reduce the possibility of money market stress (like in late 2019)

·         Slowing the pace of QT does not mean our balance sheet will shrink less than it would otherwise

·         I do think policy is restrictive and is weighing on demand

·         I saw evidence of that today in the JOLTS report

·         Quits and hiring rates have normalized

·         We believe over time policy is sufficiently restrictive to bring inflation back down to 2%

·         It is unlikely the next policy move will be a hike

·         To hike rates, we'd have to see evidence that the policy isn't sufficient to bring inflation back down to our goal

·         We are focused on how long to keep policy restrictive

·         We think policy is well-positioned to address different paths the economy might take

·         If inflation proves more persistent and the labor market remains strong, then it could be appropriate to hold off on rate cuts

·         Other paths would point to rate cuts, but that would be if we gain greater confidence and unexpected weakening in the labor market

·         I do think the policy is restrictive and weighing on demand

·         There's not an obvious connection between easing in financial conditions and inflation

·         I wouldn't rule out that we could still have strong growth or that the labor market and inflation continue to fall

·         We will probably have to see wage growth ease to more sustainable levels to reach inflation goal

·         (When asked about 3 rate cuts this year), only that the Fed needs more confidence on inflation and didn't see progress in Q1

·         When we get confidence in inflation, rate cuts will be in scope

·         The signal we are taking is that it will take longer to get on a sustainable path to 2% inflation

·         We do need to take a signal from three worse-than-expected inflation readings

·         Since December, we have had higher goods and housing inflation than expected

·         My confidence in inflation moving back down is lower than before

·         My expectation is we will see inflation move back down this year

·         It looks like substantial lags in when lower market rents will turn up in the data

·         I am less confident than before that 2024 inflation will ease

·         I don't understand where talk of a stagflation scenario is coming from given US data

·         I don't have great confidence either way on whether there will be rate cuts this year

·         I don't know if inflation will fall enough, or won't fall enough, to merit rate cuts

·         As inflation has come down to below 3%, the Fed's employment goal comes back into focus

·         There are paths to not cutting and paths to cutting, it will depend on the data

·         I don't know if productivity will run persistently above the trend

·         I don't see stagflation regarding growth or inflation

·         We could have a significant increase in potential economic output

·         We saw a year of very high productivity growth in 2023

·         We believe our policy stance is in a good place

·         We are not satisfied with 3% inflation

·         Restrictive monetary policy needs more time to do its job

·         We are at peace that we will do what we think is right when we think it is right

·         Fed is politically neutral

·         If wage increases run higher than productivity, there will be inflationary pressures

·         We've seen pretty consistent progress on slowing wage growth, but bumpy

·         We will take some time, but we will bring inflation to 2%

·         Restrictive monetary policy is working with the supply side

·         Other countries considering rate cuts are not experiencing the growth that the US has

·         It would have to be a broader thing that would suggest it would be appropriate to consider cutting rates

·         A rise in unemployment would have to be meaningful for us to react

·         It is possible that labor can stay strong with lower inflation

·         Political events won't influence Fed decisions--We just don't go down that road-- You can go back and read the transcripts for every meeting. This is my fourth presidential election; Read all the transcripts and see if anybody mentions in any way the pending election

·         Hard to predict the economy's path; There are paths to cutting and there are paths to not cutting (interest rates); It's gonna depend on data, which from the first quarter didn't live up to the expectations

·         The Fed is not satisfied with the 3% inflation and will continue its battle until the 2% goal is achieved. I don't know if inflation will fall enough, or won't fall enough, to merit rate cuts

·         Further progress on inflation not assured: Further progress on inflation is not assured and its path is uncertain; The Fed is highly attentive to inflation risks--data on inflation this year so far, has been higher than expected

·         Fed remains committed to its goals and added that there will be no interest rate cuts until there is certainty that inflation is moving sustainably to the 2% target

·         Powell warned that the central bank might need more time than previously thought when it comes to gaining this confidence that starting to loosen monetary policy is the right move; We can be patient

·         But an unexpected weakening in the labor market would have to be significant, a couple of tenths in the unemployment rate probably wouldn't do it

·         I was around for stagflation, this ain't stagflation. I don't see the ‘stag’ or the ‘flation’

Overall, on Wednesday Fed Chair Powell declined to estimate how likely it is there will be cuts this year, and added that policy needs more time to work; the Fed will not move even after a small uptick in the unemployment rate (say 1-2 months of above 4% redline); Fed will consider at least average 6M rolling average of economic data.

Conclusions:

Looking ahead, the Fed may keep B/S size around $6.60-6.50T, around pre-COVID levels and 22% of estimated CY25 nominal GDP $30T to ensure financial/Wall Street stability along with Main Street stability; i.e. price and employment stability. Fed’s B/S size is now around $7.40T and by May’24, it should be around $7.30T. At around the projected QT rate of $0.04T/M, it may take 18 months from June’24 to reach the targeted Fed B/S size of around $6.60T; i.e. by Dec’25, Fed’s QT may end with the B/S size around $6.60-6.50T.

 Also, rate cuts along with QT (even with a slower pace/tapering) should be less hawkish.

Ahead of the Nov’23 U.S. Presidential election, White House/Biden/Fed/Powell is more concerned about elevated inflation rather than the labor market; prices of essential goods & services are still significantly higher (around +20%) than pre-COVID levels, which is creating some anti-incumbency wave (dissatisfaction) among general voters against Biden admin (Democrats) on some economic issues (higher cost of living).

Thus Fed is now giving more priority to price stability than employment (which is still hovering below the 4% red line) and is not ready to cut rates early as it may again cause higher inflation just ahead of the November election. Fed may cut only from Septenber’24, which will ensure no inflation spike just ahead of the Nov’24 election (as any rate action usually takes 6-12 months to transmit in the real economy, while boosting up both Wall Street and also Main Street (investors/traders/voters). Fed hiked rate last on 26th July’23 and may continue to be on hold till at least July’24; i.e. around 12 months for full/proper transmission of its +5.25% cumulative rate hikes effect into the real economy.

Overall, the Fed’s mandate is to ensure price stability (2% core inflation), and maximum employment (below 4% unemployment rate) along with financial/Wall Street stability as well as lower borrowing costs for the government. As the US is now paying almost 15% of its tax revenue as interest on debt, the Fed will now not allow the 10Y US bond yield above 5.00% at any cost (against present levels of average core CPI around +4.0%).

But the Fed may also blink on rate cuts in H2CY24 just before the US election to keep itself politically independent/impartial/neutral:

Ahead of Nov’24 US Presidential election, as seen in the Mar’24 Congressional testimony, Fed/Powell is under huge pressure from opposition Republican lawmakers (Trump & Co) to support Biden & Co (Democrats) in boosting the election prospect by facilitating rate cuts just before the Nov’24 election. Thus Fed may not go for any rate cuts till Nov’24 or even Dec’24 to show that it’s politically independent/neutral.

The most logical step would be Fed to close the QT completely before going for a rate cuts cycle and then go for any QE, if required to counter another economic crisis down the years. Fed has to prepare its B/S for the next round of QQE to face another cycle of financial crisis and thus has to normalize the B/S first. Presently, it seems that the Fed is not so confident about the QT pace, which may trigger another QT tantrum, as we have seen in late 2019.

Fed is ‘extremely’ worried about the pace of slower disinflation. Fed is also apparently confused about the dual combination of QT, even at a slower pace (QT taper) and rate cuts in the months ahead as these two instruments (tools) are contradictory/opposite (like if Fed goes for QE and rate hikes at the same time). Ideally, the Fed should finish the QT first for a proper B/S size (bank reserve) to ensure ample liquidity for the US funding/money/REPO market.

But the Fed may continue QT (even at a slower pace) and go for a rate cut cycle at the same time despite these two policy actions being contradictory. Bank of Canada (BOC), recently clarified as long as the policy rate remains within the sufficiently restrictive zone, BOC may go for limited rate cuts, along with QT (even at a reduced pace) as QT is itself equivalent to rate hikes to some extent (tighter banking/funding/money market liquidity). If the real policy rate falls into the stimulative zone, then BOC may go for more rate cuts and completely close or at least temporarily close the QT. BOC is the smaller proxy of the Fed and may have more academic clarity regarding its policy actions.

Thus the Fed may go for rate cuts of -75 bps cumulatively in September, November, and December’24 for +4.75% repo rates from the present +5.50%. But after Powell’s remarks, it seems that the Fed may not cut thrice in 2024 from Sep’24 and may cut only once (symbolic) in Dec’24 or may not cut at all in 2024.

The market is now expecting 3-1 rate cuts (75-50 bps) in 2024, while some Fed policymakers are now arguing for lesser rate cuts of 1-2 rate cuts or even no rate cuts at all. Looking ahead, the Fed may not cut rates at all in 2024 considering the slower rate of disinflation, political issues ahead of the Nov’24 election, and the logic that it should not go for any rate cuts while doing QT, which is the opposite. Also, the reduction of B/S from around $8.97T to around $6.60T (projected); i.e. around $2.50T (~$2.37T) reduction over 2.5-3.00 years is equivalent to a rate hike of around +50 bps (higher 2Y bond yield).

In that scenario, if the US core CPI average for 2024 comes down to around +3.00% by Dec’24 from present levels of +3.8%, the Fed may cut rates by -100 bps in 2025 for a repo rate +4.50% (from present +5.50%) for a real restrictive repo rate +1.50% (repo rate 4.50%-3.00% projected average core spi for 2024). Presently, the real restrictive repo rate is also around +2.00% (repo rate 5.50%-3.50% average 6M core inflation).

At present, in its last (Mar’24) SEP/dot-plots, the Fed projected -75 bps rate cuts each in 2024, 2025, and 2026 and -50 bps rate cuts in 2027 for a terminal neutral repo rate +2.75% against pre-COVID neutral repo rate +2.50%. Now various Fed policymakers are arguing for a slightly higher neutral repo rate at +3.00% against projected core CPI of +2.00%; i.e. neutral real rate at +1.00%.

Thus depending upon the actual trajectory of core CPI, the Fed may cut -100 bps each in 2025, 2026, and -50 bps in 2027 for a terminal neutral repo rate of +3.00% from the present +5.50%. Fed had boosted its B/S from around $3.86T in late September’2019 (after the QT tantrum) to around $8.97T in Apr’22; i.e. over $5T in a matter of 32 months (@0.16T/M) to fight previous QT and COVID induced financial crisis.

Although, the Fed’s official QT rate is -$0.095T/M ($90B/M), in reality, the effective average QT rate is already around -$0.073T/M. As the Fed is now managing the funding/money market through ON/RRP, there is a lower risk of a 2019 type of QT tantrum this time.

Fed’s mandate is now 2% price stability (core inflation), below 4% unemployment rate, and below 4.75-5.00% US 10Y bond yield to ensure lower borrowing costs for the government and overall financial stability. Fed, as well as ECB, BOE, and BOC, are now struggling to keep bond yield and inflation at their preferred range despite non-stop jawboning; perhaps they are talking too much too early and thus FX market is not being influenced by them significantly, moving in a narrow range. The BOJ is now trying to talk down the USDJPY desperately, presently hovering around 152 levels, causing higher imported inflation and a higher cost of living back home, although it may be beneficial for exports. However, most of the Japanese are not happy at all due to higher imported inflation in Japan for the devalued currency.

The 6M rolling average of US core inflation (PCE+CPI) is now around +3.5%. Fed may cut 75 bps in H2CY24 if the 6M rolling average of core inflation (PCE+CPI) indeed eased further to +3.0% by H1CY24. The Fed wants to keep the real/neutral rate around +1.0% in the longer term (assuming a +3.0% repo rate and +2.0% core inflation). But in the meantime, till core inflation/headline inflation goes down to around 2.00%  on a sustainable basis, the Fed wants to maintain the real rate at around present restrictive levels of 1.00-2.00% (assuming the present repo rate 5.50% and 2023 average core inflation around 4.50% and present 6M rolling average of core inflation around 3.50%). Fed needs a +2.00% restrictive real rate for 2024 or at least H1CY24 to produce sufficient slack in the economy, so that core inflation falls to +2.0% target on a sustainable basis.

As per Taylor’s rule, for the US:

Recommended policy repo rate (I) = A+B+(C-D)*(E-B)

=1.50+2.00+ (2.60-2.00)*(4.50.00-2.00) =1.00+2+ (0.60*2.50) = 3.00+1.50=4.50% (By Dec’24)

Here:

A=desired real interest rate=1.50; B= inflation target =2.00; C= Actual real GDP growth rate for CY23=2.6; D= Real GDP growth rate target/potential=2.00; E= average core (CPI+PCE) inflation for CY23=4.50%

Less likely: 1st scenario: 75 bps rate cuts each in 2024, 2025, 2026, and -50 bps in 2027 for a neutral repo rate of +2.75%

More likely 2nd scenario: -100 bps rate cuts each in 2025, 2026, and -50 bps in 2027 for terminal neutral reo rate +3.00%

Fed will continue the QT at a reduced rate of around 40B/M till Dec’25 for a B/S size of around $6.60-6.50T. Fed may continue the QT (even at an officially slower pace) and rate cuts at the same time despite being contradictory. Fed may say (like BOC) that as long as the policy rate is in the restrictive zone (say 1.50-2.00% above core inflation), the Fed may continue both rate cuts and QT to reduce overall restrictiveness. When the policy rate moves into a neutral/stimulative zone, say 50 bps above average core inflation, then the Fed may go for more rate cuts and close the QT.

All other major G20 Central Banks including ECB, BOE, BOC, RBI, and even PBOC may be compelled to follow the Fed’s real rate action to keep present policy differential with the Fed. As USD, is the primary global reserve/trade currency, any meaningful negative divergence with the Fed will result in higher imported inflation, everything being equal; for example, if the ECB goes for -75 bps rate cuts in H2CY24, while the Fed goes for hold, then EURUSD may slip further towards parity (1.0000), which will result in higher imported inflation as the EU is dependent quite heavily on imported goods, foods, and fuel/commodities.

In this way, no major G20 Central Bank will take such rate action/cuts alone as there is a routine/regular coordination/consultation between all major central banks for a coordinated/synchronized policy action to avoid disorderly FX movement. The Fed also not seeking a very strong USD as it would eventually affect US export competitiveness. Thus all major central banks are now focusing on maintaining proper balance and coordination with the Fed, whatever may be the domestic inflation/economic narrative/jawboning.

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

Whatever may be the narrative, technically Dow Future (37966), now has to sustain over 37800-600 for any recovery to 38400/38700-38800/39050*-39100/39300-39500/39750 and 40000/40200-40425/40600-40700-42600 levels in the coming days; otherwise, sustaining below 37600, DJ-30 may again fall to 38300/38050-37650/37450*, and further fall to 37300*/37200-37050/36600 and 36300/36300 and even 35700 levels in the coming days.

Similarly, NQ-100 Future (17500) now has to sustain over 17300-17200 for any recovery/rally to 17650/17850-18000/18150* and 18375-18600/18750-18800/18900*-19100/19200-19450/19775 and 20000/20200 in the coming days; otherwise, sustaining below 17200, NQ-100 may again fall to around 16890/16700-16595*-16100/15900 in the coming days.

Also, technically Gold (XAU/USD: 2296) now has to sustain over 2280 for any recovery/rally to 2310/2330*-2350/2355 and 2375/2385-2395 and 2400/2410-2425/2435* to 2455-2475/2500; otherwise sustaining below 2280, Gold may again fall to 2250/2235*, and 2180/2145*, and further to 2120*/2110-2100/2080-2060/2039 and 2020/2010-2015 in the coming days.

Bottom line:

On Wednesday, the Fed goes for a hawkish hold and the effective QT tapering by around $30B/M is also in line with market estimates. Thus after the initial boost, risk assets (Equities, Gold, and UST) stumbled again. Powell also failed to assure 75 bps rate cuts in H2CY24