Wall Street surged on China, tech and likely Fed pause boost

On Friday Wall Street Futures recovered on hopes of a Fed pause on 20th September. The implied probability of a Fed hike on 20th September is now almost nil and no Fed policymakers tried to boost that ahead of the blackout period; but the market is still expecting another +25 bps hike, most probably the last one in this tightening cycle and then a long pause. The Fed may sit tight and hold the rate till at least H1CY24. On 20th November, the focus of the market will be also on the Fed’s latest SEP/dot plots to assess the Fed’s plan for any rate action in 2024.

Overall, the Fed may not be in a hurry to cut in H1CY24 as expected by the market. The Fed may adopt a hawkish hold stance not only on 20th September but also in several meetings. The same is true for ECB, BOE, BOC and other major G10 central banks. Even BOJ is now talking less dovish and even discussing about ‘exit’ from its NIRP (reverse repo rate above a certain limit) and YCC policy in 2024.

On early European Session Monday USDJPY tumbled after verbal intervention by BOJ over the weekend (as highly expected). The BOJ Governor Ueda said his focus is now on a ‘quit almost the same as his predecessor Kuroda’s ‘loud exit’.

The BOJ Governor Ueda said in a weekend interview: Highlights

·         The Bank of Japan has entered a phase of reducing monetary easing

·         The monetary policy modification decided in July as “a mechanism to change the balance between the effects and side effects” of monetary easing measures

·         The focus will now be on “a quiet exit,” which the BOJ is seeking to avoid a significant impact on the market

·         We may have enough by the end of the year to anticipate (wage hikes next spring)

·         I think the end of the year is a possible time to assess the trend of wage increases, a key factor in setting price increases

·         There are some things we cannot see-- including overseas economies (expressed his cautious approach)

·         Corporate performance improved in a wide range of industries, including automobiles and distribution, due to the depreciation of the yen and the penetration of price increases in the April-June quarter of 2023. The average negotiated amount of summer bonuses at major companies recovered to over ¥900,000 for the first time in three years

·         Although rising interest rates are a burden on households and corporate finances, if the economy improves, the economy will have the strength to absorb the increased burden. The BOJ’s aim of achieving a 2% inflation rate with accompanying wage increases would become a reality

·         Ueda explained the July revision of the upper limit of long-term interest rates as a kind of risk management

·         It was necessary to create room for a response so that things would not go crazy when prices swing upward

·         The BOJ had made the decision based on reflections that it had underestimated the price outlook until now

·         The BOJ’s quarterly announced inflation rate forecast for fiscal 2023 was 1.6% as of October last year, but it was revised upward in April and July, and the outlook as of July was 2.5%

·         Should individuals and firms in Japan come to anticipate a sustained rise in prices, growth expectations would spur consumption and investment, which could lead to higher interest rates

·         The BOJ focuses on data---the degree of data dependency has increased

·         There is currently no imbalance like that of a bubble economy

·         Behind-the-curve (a situation in which monetary policy lags) is not something we are actively allowing while continuing monetary easing.

·         It is not easy to “exit” from the easing measures in an economic environment that was itself created by the exceptional monetary policy

·         The Bank (BOJ) could have enough data by year-end to determine whether it can end negative rates

·         Once we're convinced Japan will see sustained rises in inflation accompanied by wage growth, there are various options we can take

·         If we judge that Japan can achieve its inflation target even after ending negative rates, we'll do so

·         The BoJ will patiently maintain an ultra-loose policy

·         While Japan is showing budding positive signs, achievement of our target isn't in sight yet

·         Wage rises are beginning to push up service prices. The key is whether wages will keep rising next year

·         We can't rule out the possibility we'll get enough information and data by year-end on the timing for ending negative rates

Japan now pays around 11% of its revenue as interest on public debt, improved from the prior 15%, and thus BOJ may now afford to talk ‘tough’ to bring down core CPI back to +2.0% targets, which recently surged to around +4.30% in July, at multi-decade high. Japan’s core CPI was around +23.90% during 1975, which eventually entered into deflation after COVID, but ultimately jumped above +2.0% by mid-2022 amid the Russia-Ukraine war, higher USDJPY, and higher imported inflation as Japan is dependent on both external fuel and food. Although higher USDJPY is beneficial for Japan’s export-heavy economy, it’s also causing a higher cost of living back home and causing public/social unrest. An average Japanese middle-class household now requires at least 0.25-0.50M monthly income in Japanese Yen for a comfortable life.

The Fed will be on a pause on 20th September, but still open for another +25 bps hike on 1st November for a terminal repo rate of +5.75% (against H1CY23 average core CPI around +5.40%) and then stop finally for the current tightening cycle. Apart from an unusual sticky surge in core CPI in H1CY24, the Fed will not hike further and will debate about the duration of such a restrictive policy rate.

Fed may go for some cuts in H2CY24, ahead of Nov’24 U.S. Presidential election to boost Wall Street and also Main Street, if the 3M rolling average of core CPI indeed goes below +4.50% or +4.00% durably. Fed may like to maintain at least a +0.50% real positive repo rate concerning core CPI (restrictive policy stance) to bring down core CPI to/below +2.00% in a sustainable way without causing an all-out recession (hard landing).

Fed thinks another ‘calibrated’ hike of +25 bps in November will not cause a recession, but may help contain excessive demand to some extent for matching with the present supply capacity of the economy so that inflation will come down durably. Thus the focus of the market will now shift to the Fed’s SEP (dot plots) on 20th September as well as 13th December to see the Fed’s rate action plan and core inflation projections for 2024. At present, the Fed projected a -100 bps cut in 2024 and core PCE inflation at +2.6% by Dec’24 and +3.9% by Dec’23 against the actual core PCE inflation average for H1CY23 around +4.50%.

Thus core inflation is still substantially above the Fed’s Dec’23 and Dec’24 targets and the Fed may not be in a position to cut rates, at least in H1CY24. But if core inflation falls dramatically in H1CY24, the Fed may cut rates by -100 bps in H2CY24 (@-25 bps cut in every meeting)-although it will be unlikely as core inflation may remain elevated and sticky due to a renewed surge in oil and no signs of peace between Russia-Ukraine/NATO. This may force the Fed to adopt a hawkish hold strategy and project fewer cuts for 2024 in its September or December SEPs (dot-plots) to control inflation expectations and actual inflation. Fed wants restrictive monetary policy/stance and elevated borrowing costs till at least H1CY24 to bring down demand in line with the present supply capacity of the economy to ensure price stability and inflation around +2.0% targets consistently.

Last week, tech-heavy Nasdaq tumbled as Apple slid after reports that China had ordered officials at central as well as state/local government agencies to not use iPhones and other foreign-branded devices for work amid the growing tech/trade war with the U.S. and also with some countries of Europe/EU (anti-China sentiment). Also, the European Commission designated Amazon, Apple, Alphabet, Meta, Microsoft, and China’s ByteDance as “gatekeepers” under its new Digital Markets Act. The present policy divergence between China (PBOC) and the U.S. (Fed) coupled with subdued Chinese economic data is boosting the USD, especially against commodity currencies, negative for export-heavy U.S. Tech MNCs.

Over the weekend, U.S. President Biden eventually held a presser in Vietnam after the Delhi/India G20 event. Biden said:

·         I hope to see China’s President Xi sooner rather than later

·         I'm not going to sell China material that will increase its capacity to produce weapons

·         I don't think China's economic issues will cause them to invade Taiwan, but it may reduce their capacity

·         China’s President Xi has some economic difficulties now

·         I don't want to contain China

·         China is changing some of the rules of the game

·         I am sincere about getting the relationship with China right

On Monday, Wall Street was also boosted by less hawkish comments Biden against China as the world’s two largest economies are dependent on each other for economic growth and prosperity. This is also true for Europe/EU and China as the Chinese are also the world’s richest consumers, especially for premium goods and services. Also, there was some fiscal stimulus boost from China on the weekend as China will modify minimum capital requirements for insurance companies. China also relaxed rules for insurers to invest in stock markets. China's Fuzhou relaxed home-buying curbs in some of the areas. Chinese Premier Li, also said on China-EU Relations: “I hope the EU provides a non-discriminatory environment for Chinese businesses”.

On the other side, the US Deputy Treasury Sec. Adeyemo said on Monday:

·         CEOs have learned they can't have all supply chains in China

·         The Chinese haven't opened up to the private sector

·         The US has limited exposure to China's economy

·         China's economy is facing headwinds, and structural issues longer-term

·         Americans are still recovering, but seeing Pre-Covid levels

On Monday, Wall Street was also boosted by the ‘confirmation’ of a Fed pause on 20th September, but it may be a hawkish hold as well.  The influential WSJ’s Fed insider/watcher (leaker) Timiraos is acknowledged as an 'insider' when it comes to the Federal Reserve's Federal Open Market Committee (FOMC). Timiraos wrote the Fed is likely to pause rate increases in September, and then take a harder look at whether more are needed.

As per WSJ’s Timiraos: “Some officials still prefer to err on the side of raising rates too much, reasoning that they can cut them later. Now, though, other officials see risks as more balanced. They worry about raising rates and causing a downturn that turns out to be unnecessary or triggering a new bout of financial turmoil. The shift toward a more balanced bias on rates is driven by data showing easing inflation and a less overheated labor market. In addition, the unusually rapid rate increases implemented over the past 1½ years are expected to continue crimping demand in coming months.”

Market wrap:

On early European Monday, Wall Street Futures were boosted by Chinese stimulus, a less hawkish Chinese narrative by U.S. President Biden and also ‘ultra-hawkish’ comments by BOJ’s Governor Ueda. Additionally, tech-heavy Nasdaq Future (NQ-100) was also buoyed by Tesla (analyst/MS upgrade), Qualcomm (deal with Apple to supply 5G modems and phones), and Meta (generative AI optimism), while dragged by Astra Zeneca (reports of exit by the CEO Soriot).

On Monday, the blue-chip DJ-30 Future inched up +0.24% as it was undercut by higher inflation expectations data by the NY Fed (+3.6% vs. 3.5%). Tech-heavy NQ-100 jumped +1.22%, while broader SPX-500 surged +0.67%; Apple, helped, while Boeing dragged. Wall Street was boosted by consumer discretionary, communication services, consumer staples, healthcare, techs, materials, financials, utilities and real estate, while dragged by energy (lower oil) and industrials to some extent. Gold was rangebound around 1930-1920.

Conclusion:

The U.S. economy is slowing down, but core service inflation is still quite elevated and sticky; the Fed may hike in November even after a pause in September.

Overall, the YTD (2023) average of underlying core CPI inflation is now around +5.3% and core PCE inflation +4.5%; overall average core inflation (CPI+PCE) is around +4.9% (~5.0%) against the Fed’s current repo rate of +5.50%; i.e., the real repo rate (wrt core inflation) is now around +0.5% (real positive) and at the mid-zone of Fed’s restrictive rate zone (5.00-6.00%).

Although the Fed officially targets core PCE inflation, Fed Chair Powell makes it quite clear that the Fed is now also targeting core CPI inflation to bring it down to +2.0% targets. Also, core service inflation is still quite elevated and sticky, although goods inflation has turned almost negative (deflation). The divergence between core PCE and core CPI inflation continues to be around +1.0% due to differences in constituents and weightage.

In this way, 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 July-September), it will be clear whether the Fed will go for another +25 bps hike in Nov’23 before going for a 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); now average core inflation (CPI+PCE) is around +5.0% for 2023 (YTD); 6M average core inflation (2023) around +4.95%

Fed may go for a pause on 20th September but may hike another +25 bps on 2nd November, if core inflation does not fall significantly. Fed may go for a long pause to assess the underlying core inflation trend and outlook along with the labor market for July-Sep’23 economic data. Fed may project at least another hike in 2023 in its September dot-plots (SEP) depending upon the actual economic data and outlook. If there is no significant easing of core inflation, especially core service inflation, then the Fed may go for another +25 bps hike in Nov’23 and possibly the end of a tightening cycle.

Fed may now go for a long pause, at least till 1st November’23, to assess the underlying core inflation trend and outlook along with the labor market for July-September ’23 economic data. If core CPI inflation indeed eased further to around +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).

At the current run rate/trend, core CPI inflation should be around +4.0% by Dec’23, +3.0% by June’24, and +2.0% by Dec’24; i.e. at target ahead of the Fed’s estimate of Dec’25. But looking at the overall trend, higher oil prices, and core CPI inflation may also spike again in August-September.

Also, oil prices may stay elevated in the coming months between $75-85 instead of the earlier $65-75 despite US efforts to bring more supply from Iran, and Venezuela (by lessening sanctions) as OPEC/Saudi Arabia will not ‘cooperate’ with the U.S. for ‘breach of trust’ in refilling SPR (as agreed ‘verbally’). Elevated oil prices around $80 will continue to boost energy/transportation costs and core inflation. Saudi Arabia/most OPEC producers and even Russia are now seeking $80 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 +4.0% by June’24 (H1CY24) on a sustainable basis, the Fed may go for a +25 bps cut each in July’24 (just ahead of the Nov’24 US Presidential Election) and thereafter every alternate meeting to keep the real repo rate around +1.0% (from 3M/6M average core inflation).

Looking ahead, from March ’24, 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.

Bottom line:

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

Whatever the narrative, technically Dow Future (35010) now has to sustain above 35200 levels for a further rally to 35425/35450-35700/35850; otherwise sustaining below 35150, may again fall to 34940/34730-34470/34300 and 34100/34050-34000/33950 and 33790/33350 in the coming days.

Similarly, NQ-100 Future (15661) now has to sustain over 15800 levels for a further rally to 16050-100 in the coming days; otherwise, sustaining below 15750 may again fall to 15450/15300 and 15150/15000-14900-14700/14600* and may further fall to 14450/14275/13950 and 13575/13490-12450 levels in the coming days.

The market will now watch any real BOJ intervention, and US core inflation data this week, which should influence the Fed decision in September; unless core CPI does not surge unusually, the Fed is going to pause on 20th September but may hike again for the last time in this hiking cycle on 1st November; the overall stance may be hawkish hold by Fed as-well-as ECB.