SignalPlus Macro Analysis: The Fed is in a Dilemma

Original title: "SignalPlus Macro Analysis Special Edition: Dilemma"

Original source: SignalPlus

The Fed's situation is undoubtedly more difficult.

The market is facing unfriendly inflation data, especially the CPI on Wednesday. Core prices are moving in an unwelcome direction. In March, both the overall CPI and the core CPI rose by 0.4% month-on-month. The annual CPI growth rate rose from 3.2% last month to 3.5%. The annual growth rate of the core CPI remained at 3.8%, of which energy grew by 1.1%, services grew by 0.5%, and rent grew by 0.4%. The super core CPI rose again by 0.65% month-on-month.

This is the third consecutive time that core CPI has exceeded expectations, making the "gradual slowing inflation" narrative used by the Fed to endorse its three rate cuts in the dot plot almost untenable. With the market (outside of stocks) basically giving a vote of no confidence in Powell's dovish turn, the 1 y 1 y rate has jumped +45bps in the past few trading sessions, the probability of a rate cut in June has plummeted to about 22%, and the dollar has rebounded against most currencies.

Fortunately for risk markets, yesterday’s PPI data was milder, with both headline and core PPI rising 0.2% month-on-month in March, following increases of 0.6% and 0.3% respectively in February. However, although the overall annual growth rate has fallen sharply from 11.7% in March 2022, the annual growth rate of 2.1% in March is still moving in the wrong direction compared to 1.6% in February, posing some challenges to the narrative of slowing inflation.

Citi and Cleveland estimate that the Fed's preferred core PCE measure, based on elements of CPI/PPI, will increase 0.26% month-over-month in March, similar to February's pace, with the annual rate still expected to slide from 2.8% to 2.7% due to base effects and index composition, with core services excluding housing expected to rise 0.29% month-over-month, while super core CPI is expected to remain unchanged at 0.65% month-over-month.

As expected, Fed officials were busy walking back earlier comments about slowing inflation, with Boston Fed's Collins saying "it may take more time than expected" and saying "first quarter CPI was higher than I expected."

Richmond Fed’s Barkin said he wants to see more “broader signs of slowing inflation, not just goods inflation,” after super core services inflation significantly exceeded expectations in the first quarter. Finally, New York Fed’s Williams said in a QA that “rate cuts don’t seem imminent,” suggesting that “there are certainly scenarios where we need higher rates, but that’s not the baseline scenario I think.”

The probability of a June rate cut has fallen to 22.5%, with pricing now reflecting less than 2 full-year rate cuts. In addition, things become more tricky given the timing of the Fed’s meetings for the rest of the year.

· June: Low probability of rate cut

· July: No Summary of Economic Projections (less important meeting, likely to keep the same cadence as June)

· September: Last meeting before the election

· November: A few days after the US election

As we have seen, if the Fed skips a rate cut in June (currently only 22% chance of a rate cut), they are unlikely to cut in July (32% chance) either, as the July meeting does not release a Summary of Economic Projections and is generally less important unless the data moves significantly in a favorable direction within a month. The next meeting will be in September, when the US presidential election is in full swing, and the Fed will be under great political pressure not to act too favorably towards any candidate. In addition, the base effect in the second half of this year is less friendly than in the second half of 2023, and inflation may face greater challenges. The last thing left is the November meeting, which will be held a few days after the election. Imagine if the Fed did not do anything all year, but decided to cut interest rates two days after the election (with a chance that Trump won), how would the media and conspiracy theorists discuss it? There is no doubt that the Fed has been caught in a dilemma.

The bond market also expressed more intensely, with the 2-year yield rapidly approaching 5% and the 10-year yield exceeding 4.50%. The 10-year Treasury auction on Wednesday was very bad, with 3.1 basis points in the tail and the bid-to-cover ratio of only 2.34x. The subscription ratio of direct bids also reached the lowest level in 2.5 years, only 14.2%, while the proportion of dealers was much larger.

Yesterday's 30-year auction improved slightly, but still underperformed, with a tail of 1 basis point, weak bid-to-cover ratios, weak direct bid participation, and dealers allocated 17%, higher than the average of 14%.

Bonds have been flat-out lower year-to-date, with the RSI beginning to enter oversold (price) territory, but given high inflation and a troubled Fed, investors are understandably less optimistic about duration exposure.

Despite the gloomy outlook, there is one asset class that has always managed to take it in stride and keep making a comeback. While stocks were initially disappointed with rate cut expectations, attention quickly returned to “good news is good news”, with stocks recovering nearly all of their post-data losses.

The SPX’s outperformance of nearly every asset class (except perhaps cryptocurrencies) has put its implied yield relative to Treasuries at its lowest level in nearly 20 years, but that hasn’t stopped equity investors from piling into the good performers, and there are no signs of systemic risk at this point.

A similar phenomenon is happening in corporate bonds, where expectations of slower quantitative tightening (slower balance sheet reduction) have led to more buying of corporate bonds, keeping high investment grade bond spreads at historical lows.

On the important question of when interest rates will have an impact on stocks, Citi has conducted an analysis, they have looked at previous "hawkish" scenarios and concluded that we are still some distance away (~40–50 basis points) from the current rate changes having a negative impact on the stock market. Investors also think this scenario is highly unlikely, they are sure that the Fed will remain dovish amid strong growth and inflation, so it is unimaginable that they will completely rule out all implied rate cuts, so investors choose to continue to focus on corporate earnings (coming soon), economic growth (strong), and friendly comments from the Fed to support continued high stock market sentiment. From the current situation, it seems that as long as the current economic trajectory remains unchanged, an actual rate cut is just an additional positive.

In terms of cryptocurrencies, BTC prices have been hovering around 70,000, and some bulls have hedged and taken profits as major currencies have failed to break out sharply. With the arrival of the halving, ETF inflows have slowed down, and market sentiment is also relatively depressed. More consolidation is expected.

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