Gold surged on softer progress of US core PCE inflation

On Wednesday Wall Street Futures slip on less dovish Fed talks and fading hopes of an imminent Gaza war ceasefire. The CME Fed swaps now price in only -75 basis points of easing in 2024 (in line with the Fed’s dot-plots) against earlier -150 bps a few months ago. The question is now whether the Fed will start cutting rates from June or July’24, although there is no material difference of impact on the overall economy, whether Fed starts easing from June or July.

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 than pre-COVID levels, which is creating some incumbency wave (dissatisfaction) among general voters against Biden admin (Democrats).

Thus Fed is now giving more priority to price stability than employment (which is quite robust) and not ready to cut rates early as it may again cause higher inflation just ahead of the election. Fed may hike only from July’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 and Real/Main Street. Fed may announce a plan for QT tapering in the March meeting and close the same by June before going for rate cuts from July’24. Fed, the world’s most important central bank, may not continue QT and rate cuts at the same time, which are contradictory.

On Thursday, the focus of the market was on U.S. Core PCE inflation for January. The BEA flash data showed U.S. annual (y/y) core PCE inflation (at 2017 constant prices) for January further eased to +2.8% from +2.9% sequentially, in line with the market expectations of +2.8% and lowest since Mar’21.

On a sequential (m/m) basis (seasonally adjusted at 2017 constant prices) the U.S. core PCE inflation surged +0.4% in January from +0.1% in December, in line with market expectations of +0.4%, and the sharpest jump since Feb’23.

In January, the U.S. core PCE service inflation ex Housing/shelter, the current focus of the Fed surged to +3.45% from +3.3% in December and also jumped +0.60% sequentially. Also, PCE service inflation was unchanged at +3.9% in January.

Overall, after the latest revisions, the average core PCE inflation for 2023 is now around +4.1%, while the same for core CPI inflation is +4.8%, and an average of core PCE+ CPI is around +4.5%. The Fed goes by a 6M rolling average of core PCE inflation for any important policy move. As per the new series (2017 constant prices), the 6M rolling average core PCE inflation is now around +3.3%, while the 6M rolling average of U.S. core CPI inflation is now around +4.1%; i.e. 6M rolling average of US core inflation (CPI+PCE) was around +3.7%, still far above Fed’s +2.0% targets.

 

On Thursday, Fed’s Mester said:

·         The January PCE data was not too surprising

·         The January PCE reading does not change the view that inflation is going downward

·         There is a little more work for the Fed to do on inflation

·         Monetary policy is restrictive, demand should cool

·         We can't rely on the pace of disinflation last year to continue this year

·         Demand will moderate; growth this year will not be as strong as last year

·         I expect a slowdown in employment growth

·         Slowing in employment growth is what we need to see to ease policy

·         Right now three rate cuts this year feel about right to me

·         We are in a really good spot, on policy and the US economy

·         There is a little more work for the Fed to do on inflation

On Thursday, Fed’s Bostic said:

·         Inflation came down much faster than I'd expected

·         The last few inflation readings have shown it is going to be a bumpy path back to 2%

·         We have to stay vigilant and attentive.

·         It is probably appropriate to reduce the policy rate in the Summer

·         Inflation came down much faster than he expected

·         The banking sector is sound and strong

·         The degree of risk exposure in the nonbanking sector worries me

·         I don't think super-core inflation is driven by wages

·         I expect things are going to be bumpy on inflation

·         Bostic when asked about today's PCE inflation data: Sometimes different measures point in disparate directions

On Thursday, Fed’s Goolsbee said:

·         Even with January PCE data showing a month of rebound, we should be careful to extrapolate

·         We've had very substantial progress over a long-term basis on inflation

·         The degree of risk exposure in the non-banking sector worries me

·         We should be careful with the argument that the supply chain is now fixed, and shouldn't expect more benefits in 2024

·         The impact of supply shock on inflation takes time, which suggests benefits of the supply chain on disinflation are still to come

·         Lags on supply shock from labor on inflation are probably long

·         The economy is on a good trajectory, it will take time to normalize

·         We had substantial progress over long-term on inflation

·         What I’m watching the most is why hasn't housing inflation improved more than it has

·         If substantial productivity growth continues, that would have an impact on monetary policy

·         There's a risk of betting against the Fed being committed to doing what it says

·         This is a restrictive environment

·         External shocks are the things I worry about most

On Thursday, Fed’s Daly said:

·         I want to avoid holding rates to 2% inflation

·         Risks of persistent inflation and economic downturn are even

·         There is no imminent risk of the economy faltering

·         We have policy in a good place and can cut if needed

·         If we cut too quickly, inflation can get stuck

·         Fed policy is in a good place. Fed can cut if needed

In the early Thursday Asian Session, BOJ’s Takata said:

·         Japan's economy is at the inflection point of shifting 'norms' where wages and prices are not increasing

·         2% inflation target in sight despite uncertain economic outlook

·         Momentum grows in spring wage talks as companies offer higher hikes than 2023

·         Takata suggests considering flexible response, including exit from monetary stimulus

·         A high wage increase would lead to ongoing expectations of rising household income

·         Takata proposes exit measures, including abandoning the yield curve control framework, ending negative rates, and without any overshoot commitment

·         Takata stresses the importance of balancing easing impact and side effects

·         Small businesses struggle to pass costs to prices, but some invest in productivity and human resources

·         Takata sees the economy entering a cycle of increasing wages and prices, moving away from a chronic deflation cycle

·         Takata sees the corporate sector becoming resilient to yield rises at the exit of monetary policy

·         Momentum is rising in spring wage talks

·         The recovery trend remains moderate despite the slowdown in capital expenditure and consumption

·         Monetary policies must align with the real economy and financial environment

·         I'm undecided on the monetary policy decision for ending negative interest rates in March or April

·         I would call for a gear shift in policy, but not one that is going backward

·         Wage increases are expanding more broadly than last year

·         Wage-driven virtuous cycle emerging compared to last year

·         Spring wage negotiations outcome to be monitored after mid-March

·         Takata mentions nimble responses without singling out any policy step

·         No Plans to Increase Interest Rates Sequentially

·         Small Firms Face Mixed Circumstances, Gradual Steps Needed

·         No Automatic Response to Target, on Rate Hikes After Ending Negative Rates

·         Not thinking of raising rates one after another

·         Monetary policy exit does not require a specific order of steps

·         Takata suggests retaining some easing measures

·         Avoid Discontinuity in Monetary Policy Exit

·         Takata emphasizes the importance of a simple exit strategy

On Thursday, BOJ’s Governor Ueda said:

·         The recent recession is a rebound from strong quarters

·         Inflation is easing at a quick pace

·         Wage negotiations will offer a tailwind

·         Japan's economy will continue a gradual recovery

·         There's no change in my view that Japan's economy is to recover moderately

·         I cannot see that the inflation target has been met

·         Japan's economy is not yet in a situation where sustained 2% inflation is foreseeable

·         Annual wage negotiation outcome key in judging the sustained achievement of the 2% inflation target

·         Notes higher wage growth demand from labor unions year on year, big firms show interest in hiking wages

·         Wants to consider the collective outcome of wage talks and conduct firm hearings

·         Japan's GDP was negative in Q4, but the economy likely flattened after strong growth due to reopening from COVID curbs

·         Ueda expects a recovery in Japan’s consumption with solid results from spring wage talks

·         Soft landing in the global economy, particularly in the US, is becoming a baseline view, which aligns with our projection made in January

·         Inflation is dropping back at a rapid pace

In the early Thursday Asian session, BOJ Board Member Takata caused a stampede in USDJPY after hinting at BOJ ‘exit’ from the April BOJ meeting by abandoning selective NIRP (reverse repo rate) and YCC policy, followed by some ‘minor’ rate hikes. Subsequently Gold got some boost. But overall, BOJ exit/normalization is also a risk for the global market as it will cause higher bond yields.

Conclusions:

The 12M average between the US core CPI and core PCE inflation is now around +4.5%, which the Fed may consider as underlying core inflation, the target of which is +2.0% on a durable basis. The 6M rolling average of core inflation (PCE+CPI) is now around +3.7% or around +4.0%. Fed may cut 75-100 bps in H2CY23 if the 6M rolling average of core inflation (PCE+CPI) indeed eased further to +3.0% by H1CY24.

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 (+4.50%)

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).

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).

Fed has to ensure 2% price stability and below 4% unemployment targets along with financial/Wall Street Stability and also keeping public/government borrowing costs at the lowest possible by directly/indirectly controlling bond yield (like YCC by BOJ). Fed is now targeting 2% core inflation with below 4% unemployment and 4.50% bond yield (10Y US) to keep borrowing costs lowest for the Government.

Bottom Line:

Fed, ECB may also cut rates from July’24; i.e. in H2CY24 for a cumulative 75-100 bps (synchronized global rate cuts amid a synchronized easing in core inflation); every major central bank including BOE, BOC, RBI, and also PBOC has to follow ‘King Fed/USD’, whatever may be the narrative.

Market wrap:

On Thursday, Wall Street Futures and gold surged on softer progress of US core PCE inflation, but the overall boost was limited as the Fed’s favorite inflation data is now a lagging indicator; the market already anticipated the inflation data after core CPI and core PPI data published around 2-weeks ago. Wall Street was also boosted by earnings optimism and month-end flow adjustment. Wall Street was boosted by communication services, techs, consumer discretionary, real estate, materials, energy, industrials, and utilities, while dragged by healthcare, consumer staples and banks & financials. Dow Jones was boosted by Salesforce, Intel, Amazon, Microsoft, Caterpillar, Honeywell, JPM and Home Depot, while dragged by Walmart, Boeing, Amgen, Goldman Sachs, Visa and United Health.

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

Whatever may be the narrative, technically Dow Future (39000), now has to sustain over 39500 levels for a further rally to 39700/39900-40200/40500 and even 42600  levels in the coming days; otherwise, sustaining below 39450/39350-39250/39150 may again fall to 39000-38950/38600 and  38400/38200*-38000*/37300 levels in the coming days.

Similarly, NQ-100 Future (18080) now has to sustain over 18400 levels for a further rally towards 18500/18675-18975/19200 and 19450/19775-2000/20200 in the coming days; otherwise, sustaining below 18350/300-18250/200 may fall to and 17300-16830-16750-16550 in the coming days.

Also, technically Gold (XAU/USD: 2043) now has to sustain over 2055 for any further rally to 2067/2085-2100/2125-2130/2175; otherwise sustaining below 2050-2030, may again fall to 2020/2010-2000-1995/1985-1975 and even 1950 may be on the card.