So in the last blog I noted how a US recession did not seem imminent and many aspects of inflation were rolling over, while positioning had been pressured lower since mid-July, which I thought may be setting up an inflection point.
An abridged summary on comments:
"Heading into Q4 headline inflation will likely fall heavily due to YoY factors and the economy should continue to slow. So the market will start looking more seriously at rate cuts next year...we could get a soft landing in the US, i.e. the US economy slows but does not go into a real recession...because the US consumer remains fairly strong... and the US fiscal deficit is around 6% of GDP...
...so that argues towards a period of rebalancing and slower growth similar to 2000-2003."
Soft landing all but priced in in Q1
So markets have rallied on a soft landing/ rate cuts outlook. So far that looks to be the right call. But that doesn't anticipate investor positioning around what actually happens. If markets rally further during Q1, with say the S&P pushing for 5000 give or take, positioning will likely have swung full pendulum to stretched and the bears fully wrung out.
The FOMC has its next meetings on the 1st Feb, 22nd March, 3rd May. Then four more into the elections.
I'm not a Fed watcher, but with 3-6 month inflation readings via several measures around 2% +/-50bps, the current Fed funds rate over 5.25% is excessive in real terms in a slowing economy. Per Nickileaks below:
So in an election year the Fed will be under immense pressure to signal in Jan and then start a cutting cycle in March.
But given the Fed's stated concerns about service wage growth being high and service PMIs still being slightly expansionary and the Atlanta Fed still showing relatively high YoY wage growth of circa 5% (down from almost 7% - so wages are slowing and it is a heavily lagging indicator, but is probably not slowing as fast as they would like to 3-3.5%), so the Fed is likely to highlight the recent easing of financing conditions and is unlikely to cut aggressive, instead emphasising caution and a 'measured normalisation pace, whilst remaining vigilant' or something like that.
So assuming they even do 50bps cuts at the March, May and June, the Fed funds rate would only drop to 3.75%-4%, and higher rates if they do 25bps or cut slower into the summer.
Yet 3.75-4% is still fairly tight (contractionary) in a slowing economy with little real inflation problem to talk about...
Slowing inflation and growth dynamics, leading to a market scare
The Atlanta Fed has Q3 GDP of 4.9% slowing to around 2.3% in Q4, with the consumer being most of the growth and inventories back to dragging.
I dont see the Federal deficit either being expanded or contracted a lot into the election - although I am not an expert on executive powers in this area. According to the White House docs they forecast a $2.1Tn increase in Treasury debt in 2024, which equates to almost 8% of 2023 GDP, at a time of full employment.
The consumer savings rate is low, as they run down excess savings from Covid. Yet a sudden rise in savings or liquidation of inventories are the two most likely triggers for a standard recession. Also weakness starting in cyclical areas covered by the Manufacturing PMIs tends to spread out into private sector service areas, despite the massive Fiscal deficit dominating a large part of the service economy.
So by the end of Q1, going into Q2, we could have a situation where inflation is going under the Fed's 2% level, but high rates are biting, GDP slowing, job losses broadening and savings rising while final demand starts to weaken and businesses are starting to cut back on inventories, investment and employment.
That would be a fairly classical set up for an inflation/ growth downside scare or recession. For sometime in Q2 by the data and the markets positioning for it maybe in March or April.
Lets assume a growth scare/ market mini-crash happens going into Q2
And sometime in Q2 the S&P is down meaningfully and 10yr Tsy bonds have a 2% handle yield on them.
The Fed will then have to accelerate rate cuts into the election to try and head off a broader recession and get a new growth cycle going into year end.
-50bps at every meeting from March to November would bring rates down to 2.25-2.5% and a flat/ contango curve should help banks lend.
Back to hiking in 2025?
Question is what happens then. Equities will be rallying into the election and probably year end.
Per the chart below, in the first two recessions wage growth fell at least 2% YoY (orange lines) before the cycle restarted, in 2020 it was a minimal slowdown and we entered the cycle with more or less full employment and still high wage growth that then started rising and was accelerated by the effects of Russia's invasion of Ukraine.
The Fed then scrambled from a behind the curve position to try and get restrictive to get inflation and wage growth down.
One could argue that as the cost of living crisis passed wage growth naturally slowed and the Fed hiking cycle impact has been significantly blunted by other factors (fixed rate debt, $6Tn Fiscal deficit etc).
If YoY wage growth bottoms out in mid-24 at around 4% YoY (yellow line) and the economy starts to recover from either a growth scare or only a shallow recession, then we might expect wage growth to also start moving up again, but from a quite high starting base.
Food and energy prices
I don't have a strong view on food and expect oil broadly to trade with the S&P, so bounce now, sell off in Q2.
Coming out of that though I'm a structural bull on resources in general, which I think have seen undersupply investment levels and demand grows with GDP or government instructed policies such as electrification.
So if energy prices rise in 2025 it might point towards wage growth also rising as the cost of living starts to upshift again - given energy costs filter through everything in the economy, at which point the Fed will be back to hiking, having been caught behind the curve again.
What happens in the election, fiscal deficits, real yields is not so clear to me, but I dont see anything dramatic happening before the election. A Trump re-election is likely to casue a bit of a market/ economic shock same as in 2016.
So in summary the outlook seems fairly analogous to 2000-2003, where depending on the size of sell off and bounce you look at, we had 5-10 major sell offs and bounces, or as I would call them pathways and inflection points, and the market fell overall in nominal terms.
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