Wall Street stumbled from record high on hawkish Fed talks

·         Gold surged to another record high after the death of Iran’s President in an age-old US helicopter accident; SPX-500 has reached bubble zone PE around 28

On Friday Wall Street Futures closed almost flat near the life time high on hopes & hypes of an early Fed pivot amid softer US inflation and retail sales report, which may prompt the Fed to start the much-awaited rate cut cycle from Sep’24 rather than Dec’24 or Mar’25. Gold also surged. Risk trade got a further boost on talks of an imminent Chinese stimulus for housing/infra; metals led copper, silver, and also gold soared. Gold is also a major beneficiary of lingering geopolitical tension under the Biden admin (Russia-Ukraine, Israel-Hamas Gaza war, Iran tension etc) and steady devaluation (buying power) of USD amid the never-ending cycle of deficit, debt and inflation.

On early Monday European session, Gold jumped to a fresh life time high of almost $2450 from Friday's closing 2415m Friday closing $2415 after confirmed reports about the death of Iran’s President Raisi in a helicopter accident, ( which may be some ‘foul play orchestrated’ by Israel-US). Oil also surged to over $80, while stock futures slipped on the concern of any fresh geopolitical tension over the ‘accidental death’ of Iran’s President Raisi in a helicopter crash after an Iran-Israel friendly duet a few weeks ago; Iran was seen as financier and weapon suppliers (drones, missiles) to various militant groups in the ME including Hamas, Houthi, Hezbollah and even Russia (drones). Iranian President Raisi was considered a front-runner to succeed Supreme Leader Ayatollah Ali Khamenei.

As per reports:

·         Iran’s President Raisi has been confirmed dead after a helicopter carrying him and other officials crashed in a mountainous and forested area of the country in poor weather

·         Also killed in the crash was Foreign Minister Amirabdollahian, an experienced diplomat who helped secure the recent rapprochement between Iran and Saudi Arabia

·         As per some aviation experts, bad weather (dense cloud cover, heavy fog, rain, mist and low temperature) must have contributed to the crash of the aircraft in the Dizmar forest area in Iran’s East Azerbaijan province (near Azerbaijan and Armenia border with Iran); also some mechanical failure in the tail rotor may be responsible for the sad accident 

·         Iran’s President Raisi was using the age-old US-made Bell-212 Helicopter developed in the 1960-the 70s without a modern-day SOS signaling system; even though there was no Mayday call from the pilot during the crash

·         The modified design of the B212 helicopter used two turboshaft engines instead of one, giving it a greater carrying capacity

·         The B212 military craft was originally designed to carry aerial firefighting gear and cargo and to mount weapons

·         This particular helicopter had been reconfigured to carry 15 people, including a pilot

·         But US (Trump) Sanctions have made it difficult for Iran to obtain parts or new aircraft

·         The most recent fatal crash of a Bell 212 helicopter was in September 2023, when a privately operated aircraft crashed off the coast of the UAE

·         Iran’s Raisi was an active and very popular President; in three years, Raisi had visited all Iranian provinces at least two times and some provinces nine times which is in sharp contrast to most of his predecessors who sat in their office mainly

·         Raisi was also very close to Iran’s first current Supreme Leader Khamenei and won the 2021 Presidential election with 62% of the vote

·         Raisi was seen as a hardliner and a harsh critic of Iran’s nuclear deal with Western global powers (US)

·         Raisi also maintained regional foreign policy and stance

·         Although all major global powers including not-so-friendly Saudi Arabia, the US and the EU had expressed condolences, Israel refused and fumed as the UN mourns Raisi: What’s next? A moment of silence for Hitler?’

·         The US also denied any ‘involvement’ in the Iran President's Helicopter crash

·         Iran’s military chief of staff has ordered a probe into the cause of the helicopter crash

·         Former Iranian Foreign Minister Mohammad Javad Zarif has blamed US sanctions for the crash

·         The decades-long sanctions against Iran have likely played a role in the helicopter crash because its fleet is old and deteriorating

·         The helicopter that crashed did not have its signal system turned on or did not possess such a system

On Monday, Fed’s Bostic said:

·         Data for the first part of the year on inflation has been very bumpy

·         Business leaders tell me things are slowing down, but very slowly

·         Momentum in the economy will take a while to play through

·         Pricing power is weakening

·         My outlook is that inflation will continue to fall this year and into 2025

·         Our new steady state on interest rates is likely to be higher than what people have been used to for the past decade

·         On inflation: We've still got a ways to go

·         The Fed is open to all possibilities on the path of the economy

·         Risks are balanced right now

·         Firms tell me that the labor market is weaker than last year, but not soft

·         Our policy stance is restrictive

·         It is going to take a while before we are certain inflation is headed to 2%

On Monday, Fed’s Governor Barr said:

·         Regulators are exploring targeted adjustments to existing liquidity rules

·         Regulators are considering requiring larger banks to hold minimum levels of reserves and pre-positioned collateral at a discount window

·         Larger banks would be required to have available liquidity to cover uninsured deposits

·         Q1 inflation was disappointing; it did not provide the confidence needed to ease monetary policy

·         The Fed will need to allow tight policy to have further time to continue to do its work

·         I am vigilant to the risks to both inflation and employment mandates. The current approach is prudent to manage both sets of risks

·         The Fed is in a good position to hold steady and watch the economy

·         The Fed does not want to get anywhere close to a balance sheet size that would interfere with controlling the federal funds rate

·         Most funds in the private credit market are not from highly levered entities and face no run risk

On Monday, Fed’s Jefferson said:

·         It is too early to tell if the recent slowdown in the disinflationary process will be long-lasting

·         I expect consumer spending growth to slow later this year

·         The US economy growing at a solid pace, and the labor market remains solid

·         I will assess incoming data, evolving outlook, and the balance of risks to set the appropriate stance of policy rate

·         The policy rate is in restrictive territory

·         We continue to see the labor market come into better balance, and inflation decline, though nowhere near as quickly as would have liked

·         The large increase in market rents during the pandemic may keep housing services inflation elevated for a while

·         Market rents take a long time to pass through to the PCE housing services prices

·         Restrictive monetary policy has weighed on the housing market

·         Fed staff estimate Core PCE prices rose at an annual 4.1% in the first four months of 2024, with a 12-month change at 2.75%

·         April's better inflation reading is encouraging

·         The policy rate is in restrictive territory. Inflation still stubborn

·         It is important not to focus on just one data point

·         The labor market has been quite resilient

·         It is possible to have continued job growth while disinflation continues

·         It is appropriate to return to a more normal balance sheet

·         Too early to say April CPI started a new trend

·         Job market resilience gives the Fed space to maintain focus on lowering inflation

·         I am cautiously optimistic we can continue our battle with inflation and keep the economy strong

On Monday, SF Fed’s President Daly said:

·         I am not yet confident inflation will come down sustainably to 2%

·         I expect improvement in shelter inflation, just not rapidly

·         Not yet confident that inflation is coming down to 2%

On Monday, Cleveland Fed’s President Mester said:

·         Monetary policy is restrictive

·         Inflation progress stalled in the first three months

·         The April CPI report was good news, but it is too soon to tell what path inflation is on

·         Restrictive policy has moderated the labor market

·         The rebalancing labor market will put downward pressure on inflation

·         Risks that we're too restrictive have gone down

·         Inflation risks are tilted to the upside

·         I don't think about a potential rate cut in terms of 'when'

·         There's no risk in spending more time gathering data on inflation because the economy is strong

·         Monetary policy is moderating demand, but not as fast as expected

·         I still think inflation will come down

·         The policy is well-positioned for risks on either side

·         If there is unforeseen deterioration on the real side of the economy, we can cut rates

·         We can hold rates, or even raise them, if inflation, against expectations, stalls out or reverses

·         Previously, I expected three rate cuts this year. I do not think that's still appropriate

·         Monetary policies are restrictive. The neutral rate may be higher

Conclusions:

Overall, the Fed is now changing its tone and gradually preparing the market for no rate cuts in 2024, especially from Sep’24 to avoid any political controversy just ahead of Nov’24 US election.

The 6M rolling average of the US unemployment rate is now around +3.8%, while core CPI inflation is around +3.9%; i.e. US core CPI inflation is still substantially above the Fed’s +2.0% targets, while unemployment rate is still below the Fed’s 4.0% red line. Thus theoretically, the Fed has still space for a higher longer policy stance (restrictive) to produce additional slack in the economy, so that underlying demand decreases further to some extent to match the present supply capacity of the economy, bringing inflation down towards +2.0% targets on a sustainable basis. Fed now needs more confidence for the disinflation process, which is now almost stalled after a good pace in H2CY23.

Also, looking ahead, the Fed may keep B/S size around $6.60-6.50T, around pre-COVID levels and 22% of estimated CY26 nominal GDP around $30T to ensure financial/Wall Street stability along with Main Street stability; i.e. price and employment stability. Fed’s B/S size should be around $7.30T by May’24. At around the projected QT tapering rate of $0.04T/M, it may take 18 months from June’24 to reach the targeted Fed B/S size of around $6.60T; i.e. by Dec’25, Fed’s QT may end with the B/S size around $6.60-6.50T.

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 the general public (voters) against Biden admin (Democrats) amid 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 have cut 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 avoid any political controversy:

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.

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 original QT pace, around 0.07T/M which may trigger another QT tantrum, as we have seen in late 2019.

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 the 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. 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 amid a fall in inflation, then the 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 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%. But after recent remarks by various Fed policymakers, it seems that the Fed may not cut thrice in 2024 from Sep’24 and may cut only once (symbolic) in Dec’24 or may not cut at all in 2024.

The market is now expecting 3 to 1 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.

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.

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%

Less likely: 1st scenario: 75 bps rate cuts each in 2024, 2025, 2026, and -50 bps in 2027 for a neutral repo rate of +2.75%; More likely 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 the QT at a reduced rate of around 40B/M till Dec’25 for a B/S size of around $6.60-6.50T. Fed may continue the QT (even at an officially slower pace) and rate cuts at the same time 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.

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.

Market impact:

On Monday, Wall Street Futures got some boost after Iran's tension was subsidized amid conciliatory tones by almost all major stakeholders except Israel; Gold, Oil stumbled; hawkish Fed talks also dragged risk assets as Fed may not cut rates before Nov’24 US Presidential Election. Blue chip DJ-30 slips around -200 points, while tech-heavy NQ-100 surged to a new record high after adding around +0.6% amid tech optimism.

On Monday, Wall Street was boosted by techs (AI chips optimism), communication services, industrials, and materials to some extent, while dragged by banks & financials, consumer discretionary, consumer staples, real estate, energy, healthcare, and utilities. Script-wise, Wall Street was dragged by JPM, Cisco, Travelers, Home Depot, McDonald’s, United Health, J&J, Goldman Sachs, Chevron, Walmart and Amazon. Chipmakers surged on hopes & hypes of a blockbuster report card by Nvidia in the coming days; Nvidia, AMD, Micron, and Intel jumped. Microsoft also surged after introducing copilot plus state of the art PCs; IBM also gained along with Caterpillar and Boeing. Target slid 2.2% after the retailer announced price cuts on roughly 5K frequently bought items (FMCG) to attract cost-conscious consumers amid the increasing cost of living.

At around $192.43 CY23 EPS, and SPX 500 5350 the TTM PE of the S&P 500 is now around 28; at almost Dec’24 (discounting CY25 projected EPS) target around 5400 AND substantially above the mean/fair PE of 20; projected fair range 4300/4800-5400(CY: 24-25)

Fair Valuation: SPX-500 (S&P 500)

S&P 500 reported an actual EPS of 47.79 in Q4CY23 and 192.43 for CY23 against 172.75 in CY22; i.e. yearly growth of around +11.39% against long-term average growth rate around +12.50%. At an average CAGR of around +12% for CY: 24-26 (against the projected growth of nominal GDP of 8% on an average for the US), the estimated EPS would be around 215.52, 241.38, and 270.35. Assuming a fair PE of 20, the estimated fair value of SPX-500 would be around 3849 for CY23, 4310 for CY24, 4828 for CY25 and 5407 for CY26. As the financial market usually discounts at least 12 months of EPS in advance, the fair value of SPX-500 should be around 4828 by CY24 and 5407 by CY25.

The SPX-500 has already scaled around 5348 a few days ago on hopes & hypes of an early Fed pivot and AI chip optimism; i.e. running much ahead of fundamentals. Looking ahead, the S&P 500 should hover around 4800-5400 for CY24 against the present price of around 5333; if there is any unusual bearish event/development, then the S&P 500 may further fall to around 4600-4300 and even 4000 levels (whatever may be the excuses).

Overall, the present PE ratio of DJ-30 (Dow Jones Industrial Average) is now around 27.00 against a mean/fair PE of 20, while Nasdaq-100 (NQ-100) has a present PE of around 30.00 against a median/fair PE of 22 and S&P 500 has present PE around 28 vs mean/fair PE of 20; i.e. Wall Street is now overvalued significantly and may correct again as Fed may shift its rate cuts cycle from late 2024 to early 2025 (Q1) in its June dot-plots.

Weekly-Technical trading levels: DJ-30, NQ-100, SPX-500 and Gold

Whatever may be the narrative, technically Dow Future (40132) has to sustain over 40400 for a further rally to 40500/40600-40700/41000 and even 42000-42700 in the coming days; otherwise, sustaining below 40350-40200 DJ-30 may again fall to 39700/39200-38900/38500 and 39100/37400 in the coming days.

Similarly, NQ-100 Future (18750) has to sustain over 18900 for a further rally to 19100/19200-19450/19775 and 20000/20200 in the coming days; otherwise, sustaining below 18850-18750, may again fall to 18350/18100-18000/17900 and 17800/17700-17600-17500 and further 17400/17300-17100/17000* in the coming days.

Technically, SPX-500 (5330), now has to sustain over 5400 for any further rally in the coming days; otherwise, sustaining below 5375 may fall to 5275/5175-5100/4990 and 4950/4900*-4850/4825 and 4745/4670-4595/4400* in the coming days.

Also, technically Gold (XAU/USD: 2415) has to sustain over 2455 for a further rally to 2475/2500; otherwise sustaining below 2450/2440-2435/2430, may again fall to 2398/2372-2353/2335 and 2310/2300-2290/2370 in the coming days.