Watch Your Step

“Let’s hope for a low gravity day.”

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And sometimes pass the salt means just that.

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Black and White Dept: I normally don’t follow analysts, strategists, or news opinions, but I noticed numerous headlines following the Federal Open Market Committee (FOMC) meeting that seemed to be at odds with what I perceived as a very clear directive. Therefore, I want to break Wednesday down into its three components: the FOMC statement, the Summary of Economic Projections (SEP), and Chairman Powell’s press conference.

The nexus of the three components is encapsulated in two exchanges during the press conference. Chairman Powell answered the same question asked in two different ways.

·???????? The first question asked why the FOMC did not announce an end to their hiking campaign, given the uncertainty about policy lags and economic headwinds such as the potential government shutdown?

·???????? The second question later in the Q&A session wondered if the FOMC believes inflation has become more persistent because they moved their 2024 fed funds target higher but inflation stayed constant?

His response to both questions was very direct: “I would characterize the situation a little bit differently...rather than pointing to a sense of inflation having become more persistent…It’s more about stronger economic activity.”

This is all you need to know. But I will add some detail:

1.?????? FOMC Statement. Very few words were changed in the Federal Open Market Committee’s statement for September. But there was a sense of major change in its aftermath. Just three words were removed, and six added: economic activity was upgraded from a “moderate” expansion to expanding at a “solid pace”, and employment growth was tempered from “robust” to “slowing but remains strong.”

2.?????? Summary of Economic Projections. There was a 60-40 split at the Fed with the majority going for one hike at either the November or December meeting, and 9 out of 19 participants concluding July is the last hike. As I had mentioned last week, the fireworks came from their 5.1% 2024 forecast. I wrote that “I cannot rule out a 2024 funds target of 5.1%, or only 2 cuts in 2024, but that risks generating a dramatic increase in yields and a drop in equities.” Before I pat myself on the back too hard, I had expected that result based off a higher inflation forecast that reflected concern over high energy costs and sticky non-housing related services inflation. Their inflation forecast was unchanged, as was the key phrase “Inflation remains elevated” in the FOMC statement. Finally, there was media consternation over the central bank’s forecast that inflation was not going to hit their 2% target until 2026. I hasten to point out that the yearend 2025 forecast had been centered at 2.1% since December 2022, so there is virtually no change in the forecast out three years.?

3.?????? Press Conference. Chairman Powell made it clear that the drop in 2024 expectations to two rate cuts from four in the June SEP was not due to fear of persistent inflation, but stronger economic activity. This is a major shift in my opinion, as he is outlining a pivot on a new world goldilocks scenario:

Powell: “Longer term inflation expectations appear to remain well anchored.”

Powell: “We are seeing monetary policies work…seeing inflation coming down in goods and housing services…and beginning to see effects of it in non-housing services as well.”

Powell: While he did say “a soft landing is a primary objective”, his answer to the question “would you call the soft landing now a baseline expectation?” he replied, “No, no. I would not do that.”

The only conclusion I can make from his statements is he believes we are in a no landing scenario where the Committee’s concern is focused more on upside surprises in growth, and whether that growth will reignite inflation:

He has abandoned his previous mantra that we have a narrow path to a soft landing (meaning there is a real risk of recession): “It’s also possible that path [had] narrowed, and its widened apparently.”

Powell: “The question will be, is the heat that we see in GDP, is it really a threat to our ability to get back to 2 percent inflation?”

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Policy Implications—Policy Error on Deck?

I have argued that investors operate on marginal changes in the fed funds outlook, while businesses and consumers deal in a world of absolute rates. Therefore, this tighter rate forecast is bad for investors, businesses, and consumers. Thankfully, there is a silver lining.

First, the bulls could argue that if we are looking at a rate path of high for longer, is it a problem if the economy is strong? For example, they point to Commercial and Residential Real Estate loan balances hitting new highs of $2.83 trillion and $2.55 trillion, respectively. I do not agree with this logic, but if they turn out to be right, then we grow our way out of the problem despite a few more rate hikes.

Second, and more importantly, because there is a new Fed pivot toward stronger growth’s impact on inflation, it implies the FOMC is less worried about sticky inflation (non-interest rate sensitive inflation).

That means,

1)????? As growth slows as I expect, then the Fed is no longer wed to a strategy of tightening into a recession. Crucially,

2)????? As growth slows, the Fed needs to quickly abandon this new economic portrayal of “heat in GDP” and begin to cut rates. If they fail to be responsive in cutting rates, they risk making a major policy mistake. It would be the mirror image of their “transitory” policy error.

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Other potential pitfalls for risk markets

First, if growth continues to surprise on the upside, then “Broadly stronger economic activity means we have to do more with rates.” If GDP sustains a growth rate faster than their 2024 estimate of 1.5%, with unemployment staying under 4.1%, the implication is to expect more rate hikes next year. A second concern is that “it is certainly plausible that the neutral rate is higher than the long-term rate…and that’s part of the explanation for why the economy has been more resilient than expected.” Meaning if supply side improvements stop, it will require higher rates to reduce demand to control inflation.

Finally, while omitted from the FOMC statement, Powell did mention oil price shocks in the press conference, although he downplayed it. “Energy prices…don't tell you much about where inflation is really going…[although] a sustained period of higher energy prices can affect consumer expectations about inflation [and dampen] spending.” It appears that the quick move up in crude oil is not problematic—for now—but higher for longer crude prices will impact monetary policy at some point.

One last note on the SEP. The back of the report contains the forecasting error ranges and, for the 2024 fed funds rate forecast, one standard deviation equals 1.7%. Hence, the 95th percentile confidence range for the December 2024 fed funds target is 1.7%-8.5%, so when the Chairman says the forecast is not a plan, but a compilation of individual forecasts, he is not kidding.

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Update on the Shutdown

Thursday’s Treasury General Account balance was $662 billion, up from $446 billion at the beginning of the month, so the war chest is growing in case House Speaker McCarthy cannot craft a deal by September 30. As far as the Fed is concerned, Powell mentioned in the press conference that “The shutdown has not historically had much of a macroeconomic impact.”

President Trump confirmed the motive that I had feared last week: “What bothers me is court cases get postponed during a shutdown, and I am wondering if that fact will motivate the extreme conservatives to refuse to compromise.” Bloomberg reported that Trump presented the government shutdown “as a way to halt criminal cases against himself and others who tried to overturn the 2020 election.” The problem with that tactic, of course, is there is a possible incentive on the part of the far-right conservatives to extend the shutdown as long as possible. Also, it could create hesitancy to compromise on the part of moderate Republicans for fear of upsetting the likely GOP Presidential candidate.

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Markets

There are two ways to look at this selloff: either as a typical pullback to buy, or the start of an enormous selloff. The second scenario is a clear possibility, so tread carefully.

Pullback to buy: Since the big October 2022 selloff, the December and February/March selloffs averaged a drop of 8.8%, which equates to 4210 in the S&P 500, 100 points from Friday’s close. The percentage of NYSE stocks trading above their 20-day moving average is at an oversold 22%, and we are approaching a seasonal low over the next few weeks. This all adds up to a buying opportunity if this were a normal selloff.

The question is, this may not be a garden variety correction because we do not know the duration and depth of the UAW strike nor for the potential government shutdown. The lack of visibility could leave buyers on the sideline.

The SMH semiconductor ETF channel I included last week was broken, but price closed Friday only 4 cents below my weekly 142 support, and the value weighted average price was 142.4, so the jury is still out on whether we move to the next downside target at 135.

The weekly chart shown below of the Russell 3000 (the broad market index containing micro, small, mid, and large cap stocks) shows both the long opportunity since it is sitting at support and the danger of a breakdown below support that does not quickly reverse. The arrows show the failed breakdown buying opportunities in 2018, 2019 and 2023.

VIX option dealers are not positioned for higher volatility—quite the opposite. So, bulls could take solace in the bullishness of option dealers or could look at the situation as the glass is half empty: dealers will need to aggressively cover in large size if the market continues lower.

Enormous selloff: In addition to an absence of VIX calls from the dealer community, junk bond spreads are still extremely complacent relative to the past year. The JP Morgan options collar is at 4150, so it could act as a magnet, or worse, an accelerant, if the market breaks that level. Additionally, being a few weeks away from a seasonal low is little comfort in a sharp selloff. I had mentioned that moving below the August and June lows is a defensive trigger, and we closed below. If the S&P 500 index cannot recover above 4335 on a weekly basis, then we need to watch our step, because we could see even more dramatic downside action.

Despite this gloom, the opportunity is excellent from a historical perspective. The third year of a presidential cycle contains the biggest returns, and the record is amplified following negative years such as 2022, so we need to be nimble.

Bond Market

Chairman Powell explained the increase in long term yields is “not because of inflation or inflationary expectations but stronger growth, and more concern over upcoming supply.” Most expect that the path of least resistance in 10-year yields is higher, but the 4.50-4.55% region is an enormous pivot from a fundamental, as well as from a technical perspective. Like stocks, it would normally represent a great area of value and positive risk return for purchase. Normally…

The annual growth rate of federal tax receipts turned negative, which has been a good signal to overweight fixed income. Analogous to our current situation, during the second half of 2007, the Fed maintained a high real fed funds rate with the nominal target holding at 5.25%, and it sparked an excellent 18-month rally in long treasury notes.

The 10-year note weekly yield chart met some major model price objectives:

Those objectives were hit on a weekly daily and hourly timeframe, and 10-year yields also hit the top Bollinger band envelope on each of those scales. Hitting resistance is only a trading setup, not a trigger, but this puts us on alert for a reversal.

Looking at the weekly yield curve between the 2-year and the 10-year treasury notes, we have broken out of a long-standing downtrend. The breakout conforms to the typical pattern just before entering a recession and note that it ended the week near the recent highs.

Below we see inverted 10-year yields in blue with the gold/copper ratio overlaid in black. Historically, the two series are highly correlated; under normal circumstances, if copper underperforms gold, it is a sign of economic weakness and yields fall (the blue inverted yield series rises). If Powell is correct in his optimism, the gold/copper ratio will fall as copper rallies on an improved economic outlook.

As it stands currently, when gold outperforms copper as yields rise in a divergent manner, that is literally the picture of stagflation, which is the worst possible condition for central banks to try and solve.

As we mentioned above, investors need to be nimble, but so do central bankers. For investors and central bankers, being nimble only works if you eventually get the direction right.

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Peter Corey

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PavePro Team

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