Gold, Dow, and Nasdaq slips on hawkish Fed talks

Wall Street Futures and gold were already under stress, while USD boosted 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. But as USDJPY is now hovering around 150 redlines, expect some ‘serious’ verbal or even actual FX intervention by BOJ this week, which may reverse the overall trend. Also, the USD may stumble and Gold may soar if there is another government shutdown, leading to rating action/warning.

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 Tuesday, Fed’s Kashkari said:

·         Declining inflation next year might justify backing off the Federal Funds Rate to stop it from getting tighter

·         If the government shuts down will do the best we can with private data

·         The yield curve is un-inverting is not necessarily bad news, and it could be good news

·         We can observe progress on inflation over the next several months to figure out which scenario is the dominant one

·         I put a 40% probability on a scenario where the Fed will have to raise rates significantly higher to beat inflation

·         I put a 60% probability of a soft landing

·         I know of no theoretical framework that can tell us how much we will need to tighten long real rates to get inflation back to 2% in a reasonable time frame

Market wrap:

On Tuesday, Dow Future plunged to a multi-month low around 33800 on the concern of another Fed hike in November and higher for a longer policy stance coupled with the threat of another looming government shutdown. But Dow Future also recovered around +100 points from the multi-month low to close around 33920 in hopes of avoiding the government shutdown after the U.S. Senate Majority Leader Schumer said:

·         The Senate stopgap bill can avoid a shutdown

·         We are very close to finishing our work on a stopgap government spending bill

On Tuesday, Wall Street was also buoyed by renewed generative AI optimism as Microsoft may be developing a cheaper version of ChatGPT (OpenAI). Also, mixed home sales data and subdued consumer confidence affected the risk trade sentiment. Tesla slumped after the news that the company, along with other carmakers that export from China to the EU, is set to come under scrutiny by the European Union (EV subsidy investigation). Amazon tumbled after the U.S. FTC filed an antitrust lawsuit amid an allegation of monopoly using an aggressive pricing strategy to wipe off competition.

On Tuesday, blue chip Dow Jones (DJ-30) slumped -1.08%, broader SPX-500 slid -1.37%, while tech-heavy NQ-100 tumbled -1.39% amid surging borrowing costs (bond yields) and the renewed concern of a hard landing after subdued home sales data. Almost all scrips under DJ-30 were in deep to moderate red except Amgen and Travelers. Dow was dragged by Apple, IBM, Boeing, Caterpillar and Intel. On Tuesday, Wall Street was dragged by all the major 11 sectors led by utilities, consumer discretionary, real estate, techs, industrials, materials, financials, communication services, consumer staples, healthcare, and energy.

Also, the Fed is itself in deep loss running into trillions of dollars due to the plunge in bond portfolio (higher bond yields); the same is true for the ECB and other major G10/G20 Central Banks. The Fed has booked $100B in losses in recent months on operations that currently involve paying more in interest to banks on reserve deposits at the Fed than the central bank earns from its roughly $7.5T portfolio of bonds and mortgage-backed securities. Fed is suffering huge losses as it’s paying more interest on reverse repo and other liquidity absorption tools under LAF to ensure sufficient liquidity for the U.S. banking system (monetary tightening).

Unlike other federal agencies that spend tax dollars allocated by Congress, the Fed is self-funding. Its earnings from its asset holdings and fees charged to banks for a range of services are used to pay the roughly $6.3B in annual expenses of a system that employs nearly 24K people across the U.S. In most years the Fed generates a profit that is turned over to the U.S. Treasury. But since the central bank began to increase interest rates to control a surge in inflation, it has been spending more than it earns each year, and in effect gives the Treasury an IOU to be paid later. Most recently, the Fed was paying out over $700 million each day between interests paid on Reverse Repo and Reserves.

On Tuesday, Wall Street slipped more after a report that the Fed is also cutting its employees quite aggressively. The report said, that while the staff cuts are not directly tied to the Fed's losses, the central bank's operations have been under scrutiny among Republicans in Congress who have expressed concern about how deeply the Fed was in red.

A Fed spokesperson said the cuts are focused on the staff of the Fed's 12 regional reserve banks and mainly hit information technology (IT) jobs, including some no longer needed because of the spread of cloud-based computer software, and positions connected to the Fed's various systems for processing payments, which are being consolidated. The staff cuts represented a combination of attrition, including retirements, and layoffs.

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.

In any way, if average U.S. core CPI inflation indeed falls below +3.50% by June’24 (H1CY24) on a sustainable basis, the Fed may go for a +25 bps cut each in Sep’24 (just ahead of the Nov’24 US Presidential Election) and thereafter every quarter end to keep the real repo rate around +1.0% (from 3M/6M average core inflation).

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 +575%.

Bottom line:

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

Whatever may be the narrative, technically Dow Future (33911) now has to sustain above 33750 levels for any recovery to 34300/34555-34600/34825-35070/200-415/850 levels; otherwise, 33475-33240 levels may come soon.

Similarly, NQ-100 Future (14725) 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: 1900) now has to sustain above 1897 for any recovery to 1910/1920-1926/1937 and 1952/1970 levels; otherwise, 1890/1885 may come soon.