Wall Street, Gold, UST slid on hotter ECI ahead of Fed meet

On Tuesday, Wall Street Futures extended Friday gains by around +0.5% amid selected mega techs rally and mixed core PCE inflation report; Tesla also helped amid Chinese regulatory approval for its driver assistance system. On early Wednesday European session, Gold stumbled from around 2335 to 2315 after Hamas was offered an ‘attractive’ 40-day ceasefire by the US/Israel and other stakeholders. However, it seems that Hamas is not in the mood to accept any temporary Gaza war ceasefire apart from a permanent one.

On the other side, Israel also tried to pressure Hamas by threatening to launch an all-out Rafah attack if no deal soon on a ceasefire. Israeli army radio said that a plan to attack Gaza’s southern Rafah city will be launched if there is no ceasefire deal with Hamas in the coming days; the order will be given to launch an operation in Rafah if progress is not made within three days on negotiations for a deal. Israel also will not send any delegation to Cairo, and wait for Hamas's response to a ceasefire deal, and decide whether to send a delegation or not depending on the response.

Meanwhile, the U.S. Secretary of State Blinken has landed in Israel for talks with PM Netanyahu and Defense Minister (2nd in command) Gallant to push for a hostage and Gaza war ceasefire deal. Blinken stressed that now is the time for Hamas to agree to the proposed ceasefire framework without further delays or excuses. As per reports, Egypt put forward a ceasefire deal that urges Hamas to release 33 hostages that have been kept since 7th October’23 in exchange for a pause in the Gaza war. The US and the UK have said the potential Gaza ceasefire deal is a generous offer of a sustained 40-day ceasefire in Gaza in exchange for the release of captives.

On Tuesday, U.S. President Biden tweeted: “Yesterday, I held a call with President Abdel Fattah Al-Sisi of Egypt and a call with Amir Sheikh Tamim Bin Hamad Al-Thani of Qatar to discuss reaching a deal to secure the release of hostages together with an immediate ceasefire in Gaza.

The United States will work with Egypt and Qatar to ensure the full implementation of the terms of the deal, and exert all efforts to secure the release of hostages held by Hamas which is now the only obstacle to an immediate ceasefire and relief for civilians in Gaza.”

On Tuesday, some focus of the market was also on the latest ECI (Employment Cost Index) data, which the Fed watches closely for wage inflation trajectory, a vital part of non-house core service inflation. The BLS data shows compensation costs for civilian workers in the U.S. increased +1.2% in Q1CY24 from +0.9% sequentially (Q/Q) and higher than the market consensus of +1.0% growth (seasonally adjusted).

In Q1CY24, US employment costs surged the most in one year, as wages and salaries advanced by 1.1% (vs 1.1% in Q4) and benefits increased by 1.1% (vs 0.7%). Compensation costs for private industry workers rose by 1.1% (vs 0.9%), and those for state and local government workers advanced by 1.3% (vs 1%). Wages and salaries which make up about 70% of employment costs rose 1.1% (vs 1.1% in Q3) and benefit costs went up 1.1%, higher than 0.7% in the previous period (QTR). For ECI, the Fed may be looking for at least a +0.6% sequential (Q/Q) rate; i.e. +2.4% annualized rate for its 2% inflation target. In other words, the Fed’s neutral real wage growth rate may be around +0.5% (y/y) on average, which will not create a wage inflation spiral.

The 12-month (yearly) growth of ECI was +4.2% (NSA; current $), while inflation-adjusted (NSA; constant $) ECI grew +0.8% in Mar’24.

Market impact:

On early European Tuesday, Wall Street Futures also got some boost on hopes & hypes of an early Gaza war ceasefire, but stumbled soon after hotter-than-expected ECI (Employment Cost Index) data, indicating elevated wage pressure, which may keep the Fed for another hawkish hold Wednesday; Fed may continue to bat for higher for longer policy. Gold also succumbed to almost 2285 from the 2320 area just before the ECI data Tuesday; USD, US bond yield surged. Wall Street was also under pressure because of the concern of growing US debt and higher estimates by the Treasury for issuing debts in Q2CY24 (higher supplies of bonds/USTs are positive for yields and negative for equities due to higher borrowing costs).

On Tuesday, blue-chip DJ-30 tumbled almost -600 points, tech-heavy NQ-100 slumped around -2.00%, while broader SPX-500 plunged -1.6%. apart from hotter-than-expected ECI data, Wall Street was also undercut by subdued consumer confidence data, lowest at over 18 months. For April’24, SPX-500 and NQ-100 tumbled -3% each, while the DJ-30 plunged around -4.3%, the highest since Sept’22.

On the earnings front, Tuesday was a mixed day after a blockbuster Monday. McDonald's edged down as revenues fell short of estimates due to boycotts in the Middle East. Also, GE Healthcare sank following a Q1 revenue shortfall, while 3M jumped on the upbeat report card and Eli Lilly surged after earnings beat on higher sales of weight loss drugs.  On Tuesday, all major sectors of Wall Street were in deep to moderate red, while 3M and P&G were the only two stocks in DJ-30, closed in deep to moderate green.

Conclusions:

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%

The Fed may go for -75 bps rate cuts in September, November, and December’24. By 18th September (Fed MPC date), the Fed will have complete data for core inflation and also unemployment/real GDP data for H1CY24 and also Aug/July’24 to have the required ‘higher confidence’ to go for rate cuts. Fed may bring down the repo rate to +4.75% by Dec’24 from present +5.50%.

Fed may announce a plan for QT (tapering or trajectory) and also an optimal B/S size in the May meeting. Ideally, the Fed should have closed the QT before going for any rate cuts cycle as these are two contra tools as QT is restrictive and rate cut stimulative. The Fed, the world’s systematically most important central bank may not continue QT (even at a reduced pace) and go for rate cuts at the same time. But Fed/Powell kept that absurd option of simultaneous QT and rate cuts open, at least theoretically.

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 considering BOC’s explanation, the Fed may go for -75 bps rate cuts in H2CY24, most probably from Sep’24 after deciding about the possible B/S size to ensure money market stability.

Looking ahead, the Fed may keep B/S size around $6.60T, around pre-COVID levels 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 $7.43T around 25% of estimated nominal GDP for $30T by Dec’25. Depending upon the actual rate/funding levels in the repo/funding market, the Fed may taper the QT from the present $0.095T/M to 0.050-0.075T/M for 18-12 months from May’24;i.e. Fed may end the QT by May’25-Dec’25 at B/S size around $6.60T. This is lower than the earlier market estimate of $7.00T and thus should be seen as more hawkish. 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 hike 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. In the meantime, the Fed may close the QT at the present pace of around -0.095T/M for the next nine months (April-Dec’24) for the targeted ample B/S size around $6.60T without any QT tapering (@22% of CY25 estimated nominal GDP around $30T, just above 20% minimum requirement of $6.00T).

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.

Now going by various Fed comments in the last few weeks, it seems the 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. 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%. Fed may bring down further its B/S size from present around $7.43T to $6.60-6.50T through QT tapering by May-Dec’25 to keep minimum/ample liquidity for the US funding/money market and also to prepare itself for the next cycle of QE, whatever may be the next recession excuse.

The market is now expecting 3-2 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.

Now Fed may announce a plan for QT tapering from $0.095T/M to $0.075/M around B/S size $6.60T before going for any rate cuts from mid-March’25; the Fed may opt for four QTR rate cuts (-25 bps) each in each quarter in 2025, 2026 and two half yearly rate cuts in 2027 to ensure price/employment/financial stability. 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.

1st scenario: 75 bps rate cuts each in 2024, 2025, 2026, and -50 bps in 2027 for a neutral repo rate of +2.75%; Fed will continue the QT at a reduced rate till Dec’25 for a B/S size around $6.60T. If the rate of disinflation accelerates, the Fed may go for -75 bps rate cuts each in 2024, 2025, and 2026 and -50 bps in 2027. Fed may continue the QT (even at an officially slower pace) and rate cuts at the same time (in 2024) 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.

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 QT at present pace till Mar’25 and close the same at B/S size around $6.60T. Fed may announce a plan for QT tapering from -$0.095T/M to -$0.075T/M from May’24 and close the QT by Mar’25 at B/S size around $6.60T. Then Fed may start the rate cut cycle from Mar’25 with -100 bps rate cuts each in 2025, 2026 (@-25 bps at each QTR), and finally -50 bps in 2027 (@-25 bps in H1 and H2).

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, Fed may go for a hawkish hold, but may also launch QT tapering from the official QT rate of 0.095T/M to 0.075T/M (present effective rate) and close the QT by Feb’25 at B/S around $6.60T (around 22% of estimated nominal GDP around $30T by 2025); Fed may also reduce QT rate to around -0.05T/M and close the QT by Sep-Dec’25