Dow surged on hopes of solid earning, soft landing, Fed pivot

Wall Street jumped to a record high Friday on tech/AI boost; upbeat consumer confidence and softer 1Y inflation expectations. In the early European session Monday, Dow Future stumbled from around 38150 to almost 38060 as the Chinese stock market slid on a hawkish hold by PBOC against market consensus of a rate cut; but tech/AI optimism continues to support NQ-100 Future. But eventually, Dow Future recovered and made a fresh life time high around 38301 before closing around 38195 on hopes of a soft landing after better-than-expected Leading Indicators data and hopes of the blockbuster report cards from some blue-chips in the coming days (J&J, Netflix, Verizon, 3M, Tesla, IBM and Intel.

Also, Dow Future was boosted by hopes of an early end of the Gaza war after an Axios report Israel has given Hamas a proposal through Qatari and Egyptian mediators that includes up to two months of a pause in the fighting as part of a multi-phase deal that would include the release of all remaining hostages held in Gaza. The proposal, according to Axios, would involve a multiphase deal that would see the release of more than 130 captives in stages, in return for an up to two-month ceasefire, and the release of an as yet undetermined number of Palestinian prisoners.

The report, citing two Israeli officials, added that Israeli forces would be redeployed out of the main population centers of Gaza, allowing a “gradual return” of Palestinian civilians to Gaza City and the north of the enclave, and the officials said that after the two months are completed, the Israeli military’s operations in Gaza would be “significantly smaller in scope and intensity” than the current fighting. Hamas has previously said that in exchange for the release of the captives held in Gaza, it demands a total end to the war and the release of all Palestinian prisoners. The Israeli government is under pressure from a protest movement led by family members of captives, which is demanding an immediate deal.

But Israeli PM Netanyahu is not much interested in a permanent ceasefire, while the White House NSA spokesperson Kirby said the Biden admin supports pauses in the fighting to allow the release of captives but it still opposes ending the war: “We don’t support a general ceasefire, which is usually put in place in the expectation that you’re going to end a conflict and lead to specific negotiations – no change to our policy there.”

Previously, Netanyahu has repeatedly and unambiguously said he rejects the establishment of a Palestinian state. But the Biden administration, which promotes a two-state solution to the conflict, has been trying to evade addressing the PM’s comments as it maintains unconditional support for Israel. Asked about Netanyahu’s open rejection of a Palestinian state, State Department spokesperson Patel said: “I’m just not going to characterize the prime minister’s remarks.”

Days earlier, Biden had suggested Netanyahu does not oppose the two-state solution, but the PM left no place for doubt, crediting himself this week for thwarting the establishment of a Palestinian state. In the latest comments from the White House, NSA spokesperson Kirby was also reluctant to talk about Netanyahu’s remarks: “They had a very constructive conversation, and I think I just need to leave it at that--- The prime minister should speak to his comments, and I’m sure he has and he will.”

On late Friday, Fed’s Daly said:

·         The economy is in a really good place

·         It would be scarring to ease too quickly, and not reach the 2% goal

·         The job this year is about calibration

·         We don't want to loosen policy too soon or try to squeeze inflation out too fast

·         At this point, risks are more balanced

·         There's no denying that there's a lot of work still to do

·         We can start to be more patient, & see what the Fed needs to do next

·         The policy is in a good place

·         I hear cautious optimism from business contacts

·         The US economy is in a really good place

Fed is now actively discussing rate cuts, which is encouraging market bet on an earlier and deeper rate cut from March. But the Fed may not go for any rate cuts in H1CY24; the Fed may focus on QT tapering from February and close the QT by June’24 without causing any significant move in bond yield (QT tapering is positive for bonds and negative for bond yields). Fed may go for 75-100 bps rate cuts in H2CY24 depending upon actual core inflation trajectory and employment/labor market conditions & outlook thereof. In this way, the market is now gradually reducing bets for the March rate cut and Gold slips.

Conclusions:

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)*(4.50.00-2.00) =0+2+2.50=4.50% (for 2024)

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 for CY23

Fed has to ensure a 2% price stability (core inflation) target keeping the unemployment rate below 4% and also 10Y bond yield below 5.00-4.50% so that borrowing cost for Uncle Sam remains manageable/sustainable to fund +34T debt (never-ending).

In any way, at the current run rate and trend, the average US core PCE inflation should be around +4.0% in 2023, +2.5% in 2024, +2.1% in 2025, and +1.5% in 2026, in line with Fed’s Dec’23 SEP. Similarly, the U.S. core CPI inflation average should be around +4.6% in 2023, +3.2% in 2024, +2.5% in 2025, and +1.8% in 2026.

If US core CPI indeed dips below +3.0% by May-June’24 and if it seems that the 2024 average core inflation will be around +3.2%, then the Fed may start cutting rates from July’24 and may cut cumulatively 75 bps at -0.25% pace till Dec’24 for a repo rate at 4.75%, so that core real rate continues to stand around +1.50%, in line with the present restrictive stance (5.50% repo rate-4.00% average core CPI for last 6M).

Looking ahead, the Fed may try to balance the financial/Wall Street stability and price stability by expressing intentions to cut (dovish jawboning) from Mar’24 (Q1CY24) to ensure a soft landing while bringing down inflation. Also, whatever the narrative, 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 15% of its revenue as interest on public debt against China/EU’s 5.5%.

As a result of higher bond yields around 4.50%-5.00% (for 10Y UST); i.e. lower bond prices, the Fed is now in deep MTM loss for its huge bond holding. Fed is also providing higher interest to banks & financials for reverse repo operation than it getting under repo operation; i.e. Fed’s NIM/NII is now negative and theoretically the Fed is in negative profit to the tune of -$130B. The same is also true for various banks & financials, most of which are now in deep MTM loss for higher bond yields; i.e. lower prices for their HTM bond portfolio holdings due to Fed hikes. The US10Y TSY market price fell from around $140 to $105 from Jan’20 (pre-COVID) to mid-Oct’23; i.e. a fall of almost -33% in around 4 years; it recently recovered to almost $113 levels.

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 & financial stability and soft-landing. Fed has to bring down inflation to +2.0% targets by the  US 10Y bond yield below 4.50-5.00%, and an unemployment rate below 4.0% without triggering an all-out or even a brief recession in the US Presidential election year (Nov’24). The Fed will ensure that the US10Y bond yield is below 4.50-5.00% at any cost for lower borrowing costs for Uncle Sam (U.S.), everything being equal. Thus, overall Fed is methodically jawboning on both sides (hawkish/dovish) from time to time to achieve all its goals at the same time.

Considering all pros & cons, Fed may wait for core inflation data (average for core PCE and core CPI) for at least Dec’23-Mar’24 and if it goes down to around +4.00% from the projected 2023 average of +4.5% (4.80% core CPI and +4.20% core PCE), the Fed may cut rep rates/FFR by -25 bps in July; further if such disinflation trend continues, Fed may cut -25 bps each in September and December for a cumulative -75 bps.

We may see a synchronized global easing from H2CY24. As the Fed is the world’s unofficial central bank because the USD is the ‘King’ (the world’s most preferred FX or global reserve currency), all major G20 central banks are now bound to follow the Fed policy stance to maintain present policy/currency/bond yield parity, everything being equal.

Thus the market is now expecting a synchronized global easing (rate cuts) by major G20 global central banks including ECB, BOE, BOC, PBOC, and even India’s RBI, whatever may be the domestic macro-economic narrative (just like post-COVID synchronized global tightening to bring inflation down to targets).

Fed policymakers will now jawbone the market in a balancing way to keep the US10Y bond yield between the 3.25-5.25% range or around 4.00-4.50% on an average to maintain price/labor market/financial (Wall Street) and also Main Street/White House stability in the election year (2024). As the U.S. labor market is still robust with healthy wage growths, the incumbent Biden admin may prefer price stability and lower inflation in the coming months along with a sub/below 4% unemployment rate; i.e. price stability over GDP growths. As the 10Y bond is the main instrument for raising debt and a benchmark for US/global borrowing costs, the Fed may not allow it to hover above 5.00% for long under any circumstances, everything being equal. Fed needs to lower borrowing costs for the U.S. government from the present 15% to 10-7% over the next few years.

Fed hiked rate last in July’23 for a +5.50% repo rate and in hold mode with a hawkish stance since Aug’23; subsequently, US10Y bond yield gradually surged from around +3.75% to +5.00% by late November. As a result of higher borrowing costs and tighter financial conditions, the demand of the economy was affected to some extent, resulting in lower inflation. Now Fed has to keep on hold (neutral mode) for at least 10-12 months from July’23, so that the impact of higher borrowing costs is gradually transmitted to the real economy in full, resulting in core inflation back to targets.

Thus Fed has to wait till at least July’24 for the expected 1st rate cut; otherwise, its credibility may be at stake. If the US10Y bond yield again falls below +3.0% in the coming days (from the present +3.95%), then it may cause less restrictive financial conditions, resulting in higher core inflation. Thus Fed has to jawbone the market so that the US10Y bond yield hovers around 4.0-4.50% in the coming days so that the Fed can ensure relatively lower borrowing costs and price stability (soft landing).

Market wrap:

On Monday, Wall Street Futures closed at new life time highs on hopes & hypes of solid earnings, soft landings, and a Fed pivot. Blue Chip DJ-30 surged around +0.40%, while tech heavy NQ-100 edged up +0.10%, while broader SPX-500 gained +).20%. Wall Street was boosted by industrials, real estate, banks & financials, techs, healthcare, materials, energy (higher oil due to escalating geopolitical tensions in the Red Sea), and communication services to some extent, while dragged by consumer discretionary, utilities, and consumer staples.

On Monday, Dow Jones was boosted by Walgreens Boots, Walt Disney, United Health, Apple (analyst upgrade), Caterpillar, Travelers, and American Express, while dragged by Home Depot, Nike, McDonald’s, Microsoft, Coca-Cola, JPM and Boeing (737 Max Jet issues).

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

Whatever may be the narrative, technically Dow Future (38150), now has to sustain over 38400 levels for a further rally to 38600-38700/39000-39200/39500 levels in the coming days; otherwise, sustaining below 38350/300-38250/200 levels, may again fall to 38000-37500-37300 levels may further fall to 37200/37000-36850/36650 and 36400/36200-36050/36000-35800*/35500 and may further fall to 35350/35250-35000/34800 and 34650/34120-34000 and 33700/33200-33000/32400 in the coming days.

Similarly, NQ-100 Future (17115) now has to sustain over 17650 for a further rally towards 18000; otherwise, sustaining below 17600/17550, may again fall to 17350-17200/17100-17000/16850 may again fall to 16550/16300-16200/16050 and 15700/15400, and further 15100-14140 in the coming days.

Also, technically Gold (XAU/USD: 2030) now has to sustain over 2045 for a further rally to 2062-2085-2105/2120 and 2130/2152 levels; otherwise sustaining below 2040, may again fall to 2020-2010-2000-1990-1975-1960/1940 in the coming days.