Dow recovered on hopes of a Fed pause in September

On Thursday, Wall Street, Gold slid, while USD surged as U.S. Jobless Claims were lower than expected, while Labor Costs and productivity were hotter than expected. In any way, Dow Future recovered from the jobless claims panic low around 34363 to 34583 before closing around 34542, up around +100 points amid less hawkish talks from Fed’s influential and Powell’s ‘right-hand man’ Williams (NY Fed President), indicating a pause on 20th September, but Fed is open for November to go for another hike before final pause for 2023 and most probably finally for the current tightening cycle. And Fed may not be in a hurry to cut in H1CY24 as expected by the market.

Additionally, tech-heavy Nasdaq tumbled as Apple slid after reports that China had ordered officials at central government agencies to not use iPhones and other foreign-branded devices for work. Also, the European Commission designated Amazon, Apple, Alphabet, Meta, Microsoft, and China’s ByteDance as “gatekeepers” under its new Digital Markets Act. On Thursday, NQ-100 Future came under more pressure on a report China may ban iPhone and certain other foreign mobile brands further for state/local government officials/firms & agencies (apart from central government) amid the growing tech/trade war with the U.S. and also with some countries of Europe/EU (anti-China sentiment). Also, the present policy divergence between China and the U.S. coupled with subdued Chinese economic data is boosting the USD, especially against commodity currencies, negative for export-heavy U.S. Tech MNCs.

On early Asian Friday, Chicago Fed’s President Goolsbee said:

·         Inflation is above where we want it, monetary policy is working

·         We are very rapidly approaching the time when the argument is not about how high should rates go, but rather how long rates have to stay high

·         The overall level of inflation is above where we want it

Finally on early European Friday, Dallas Fed’s President Logan ‘confirmed’ (just ahead of Fed’s blackout period beginning from Friday U.S. midnight):

·         It could be appropriate to skip an interest-rate increase in September

·         Skipping does not imply stopping rate hikes

·         There is work left to do to get to a sufficiently restrictive policy

·         Skipping does not imply stopping rate hikes

·         Not yet convinced we've extinguished excess inflation

·         Fed needs to calibrate policy carefully and must proceed gradually

·         Significantly lower inflation in recent months is encouraging, but too soon to confidently say on the path to 2% in a timely way

·         Job market strength suggests we have not finished the job of restoring price stability

·         If stronger economic activity continues, could lead to a resurgence of inflation

Overall, the Fed will be on a pause on 20th September, but still open for another +25 bps hike on 1st November for a terminal repo rate of +5.75% (against H1CY23 average core CPI around +5.40%) and then stop finally for the current tightening cycle. Apart from an unusual sticky surge in core CPI in H1CY24, the Fed will not hike further and will debate about the duration of such a restrictive policy rate. Fed may go for some cuts in H2CY24, ahead of Nov’24 U.S. Presidential election to boost Wall Street and also Main Street, if the 3M rolling average of core CPI indeed goes below +4.50% or +4.00% durably. Fed may like to maintain at least a +0.50% real positive repo rate concerning core CPI (restrictive policy stance) to bring down core CPI to/below +2.00% in a sustainable way without causing an all-out recession (hard landing).

Fed thinks another ‘calibrated’ hike of +25 bps in November will not cause a recession, but may help contain excessive demand to some extent for matching with the present supply capacity of the economy so that inflation will come down durably. Thus the focus of the market will now shift to the Fed’s SEP (dot plots) on 20th September as well as 13th December to see the Fed’s rate action plan and core inflation projections for 2024. At present, the Fed projected a -100 bps cut in 2024 and core PCE inflation at +2.6% by Dec’24 and +3.9% by Dec’23 against the actual core PCE inflation average for H1CY23 around +4.50%.

Thus core inflation is still substantially above the Fed’s Dec’23 and Dec’24 targets and the Fed may not be in a position to cut rates, at least in H1CY24. But if core inflation falls dramatically in H1CY24, the Fed may cut rates by -100 bps in H2CY24 (@-25 bps cut in every meeting)-although it will be unlikely as core inflation may remain elevated and sticky due to a renewed surge in oil and no signs of peace between Russia-Ukraine/NATO. This may force the Fed to adopt a hawkish hold strategy and project fewer cuts for 2024 in its September or December SEPs (dot-plots) to control inflation expectations and actual inflation.

Market wrap:

On early Friday European session, Dow Future surged to around 34630 from overnight closing 34542 amid hopes of a Fed pause on 20th September after Fed’s Logan, the last speaker before the blackout period begins- almost confirmed a September pause, although November is still an open question. At the same time, in line with the Fed, the market is now also discounting a similar pause by ECB on 14th September, but another +25 bps hike on 26th October for a policy repo rate (MLF) at +4.75% by Dec’23 against Fed’s probable +5.75%. Thus European as well as Wall Street Futures surged early European session Friday.

But soon both markets (Europe) stumbled on a report China is extending the iPhone ban further for its local government officials; now all Chinese government officials have been banned from using iPhones. China is the 2nd biggest market for Apple after the home (U.S.) and this is also true for almost all other techs/U.S. MNCs/product exporters. The market is now concerned about the growing cold/tech war between the two largest economies (U.S.-China) of the world reminding dark days of the Trump trade war.

Subsequently, Dow/Nasdaq Future stumbled; Dow Future made a panic low around 34442, but eventually recovered, making a high around 34658, and then retraces to around 34520, eventually closing around 34606 (+0.20%) on hopes & hypes of a Fed pause/pivot/rate cuts. The implied probability of a Fed hike on 20th September is now almost nil and no Fed policymakers tried to boost that ahead of the blackout period. Tech-heavy NQ-100 Future and broader SPX-500 Future edged up around +0.24% and +0.19% respectively. USD/US bond yield and Gold al closed almost flat, but Gold also stumbled from around 1930 to 1917 on the concern of a robust U.S. labor market after hotter hotter-than-expected job report from the northern neighbor Canada. Oil surged on renewed hopes of further production cuts/extension of present voluntary cuts by OPEC+ (led by Saudi Arabia and Russia) well into 2024.

On Friday, Wall Street was boosted by energy (higher oil), utilities, communication services, financials, techs, consumer staples, materials, and consumer discretionary to some extent, while dragged by real estate, industrials, and healthcare. Apple recovered on bargain hunting/analyst support (as the China partial ban panic may be overdone). Additionally, Dow was boosted by Amgen, Microsoft, Walt Disney, Goldman Sachs, Merck, Salesforce, Caterpillar, and Chevron, while dragged by Boeing, Verizon, Intel, United Health, P&G and Nike. Less hawkish comments about China at the G20 Summit (New Delhi) also helped overall risk trade.

Conclusion:

The U.S. economy is slowing down, but core service inflation is still quite elevated and sticky; the Fed may hike in November even after a pause in September.

Overall, the YTD (2023) average of underlying core CPI inflation is now around +5.3% and core PCE inflation +4.5%; overall average core inflation (CPI+PCE) is around +4.9% (~5.0%) against the Fed’s current repo rate of +5.50%; i.e., the real repo rate (wrt core inflation) is now around +0.5% (real positive) and at the mid-zone of Fed’s restrictive rate zone (5.00-6.00%).

Although the Fed officially targets core PCE inflation, Fed Chair Powell makes it quite clear that the Fed is now also targeting core CPI inflation to bring it down to +2.0% targets. Also, core service inflation is still quite elevated and sticky, although goods inflation has turned almost negative (deflation). The divergence between core PCE and core CPI inflation continues to be around +1.0% due to differences in constituents and weightage.

In this way, 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 July-September), it will be clear whether the Fed will go for another +25 bps hike in Nov’23 before going for a 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); now average core inflation (CPI+PCE) is around +5.0% for 2023 (YTD); 6M average core inflation (2023) around +4.95%

Fed may go for a pause on 20th September but may hike another +25 bps on 2nd November, if core inflation does not fall significantly. Fed may go for a long pause to assess the underlying core inflation trend and outlook along with the labor market for July-Sep’23 economic data. Fed may project at least another hike in 2023 in its September dot-plots (SEP) depending upon the actual economic data and outlook. If there is no significant easing of core inflation, especially core service inflation, then the Fed may go for another +25 bps hike in Nov’23 and possibly the end of a tightening cycle.

Fed may now go for a long pause, at least till 1st November’23, to assess the underlying core inflation trend and outlook along with the labor market for July-September ’23 economic data. If core CPI inflation indeed eased further to around +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).

At the current run rate/trend, core CPI inflation should be around +4.0% by Dec’23, +3.0% by June’24, and +2.0% by Dec’24; i.e. at target ahead of the Fed’s estimate of Dec’25. But looking at the overall trend, higher oil prices, and core CPI inflation may also spike again in August-September.

Also, oil prices may stay elevated in the coming months between $75-85 instead of the earlier $65-75 despite US efforts to bring more supply from Iran, and Venezuela (by lessening sanctions) as OPEC/Saudi Arabia will not ‘cooperate’ with the U.S. for ‘breach of trust’ in refilling SPR (as agreed ‘verbally’). Elevated oil prices around $80 will continue to boost energy/transportation costs and core inflation. Saudi Arabia/most OPEC producers and even Russia are now seeking $80 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.

In any way, if average U.S. core CPI inflation indeed falls below +4.0% by June’24 (H1CY24) on a sustainable basis, the Fed may go for a +25 bps cut each in July’24 (just ahead of the Nov’24 US Presidential Election) and thereafter every alternate meeting to keep the real repo rate around +1.0% (from 3M/6M average core inflation).

Looking ahead, from March ’24, 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.

Bottom line:

Technical trading levels: DJ-30

Whatever the narrative, technically now, Dow Future (34602) has to sustain above 34850 for a further rally to 35050-35900 levels; otherwise 34350/34200 and 34070/33900-33750/33300 may be on the card.

The market will now watch any real BOJ intervention, and US core inflation data next week, which should influence the Fed decision in September; unless core CPI does not surge unusually, the Fed is going to pause on 20th September but may hike again for the last time in this hiking cycle on 1st November.