The Minutes did naught to explain
Why Jay might need raise rates again
But if we all harken
The Fed’s Thomas Barkin
The future seems cloudy with rain
 
So, now it seems Jay’s somewhat miffed
As he and his team try to shift
The views he expressed
That rate cuts were blessed
And markets did act sure and swift

 

Remember the certainty with which market participants determined that the Fed had not only finished raising interest rates, but that they would be cutting them quite soon?  That is so last year!  It seems that after a powerful Santa Claus rally that was inaugurated by Secretary Yellen’s move to issue more T-bills and less coupons, and then seemingly confirmed at the December FOMC meeting, where the dot plot showed no more rate hikes and a median expectation of three cuts this year, and where Chairman Powell, when given a chance to push back on this new narrative in the press conference, went out of his way to embrace the ‘rate cuts coming soon’ narrative, the Fed is no longer happy about the situation.  Instead, now they seem to want the market to ratchet back these expectations for a quick decline in interest rates.  At least, that’s what we heard from Richmond Fed president Tom Barkin yesterday, “The FOMC’s December meeting got a lot of attention. We acknowledged the progress on inflation and explicitly reaffirmed our willingness to hike if necessary.”  [emphasis added].

Meanwhile, the Minutes seemed to lean more hawkish than not, “It was possible that the economy could evolve in a manner that would make further increases in the target rate appropriate.  Several also observed that circumstances might warrant keeping the target range at its current value for longer than they currently anticipated.”  Arguably the best line, though, was “Participants generally perceived a high degree of uncertainty surrounding the economic outlook,” which is likely the most honest statement they have ever made.  In the end, the Minutes didn’t sound very dovish to me, but as I mentioned above, the press conference came across far more dovishly.  One other thing to note is that they mentioned QT for the first time in quite a while.  It seems that they recognize the incongruity of shrinking the balance sheet while cutting interest rates, so they have begun to consider how to message any changes there.

With this new information being absorbed, the market is now in the process of re-evaluating the idea that rate cuts are going to happen as quickly and as substantially as thought just a week ago.  At this time, there is just a 10% probability of a cut at the end of this month (it was nearer 20% last week) and the March probability is down to 70% (it was 79% last week) though the market is still pricing in 6 cuts in 2024.  FWIW, that seems outside the bounds of how things will ultimately play out, and I maintain that while a cut could easily be made by the May meeting, I do not foresee inflation cooperating which will force a lot of rethinking.

To summarize the Fed story, the market has sensed a disturbance in the easing force that had been widely assumed and a key driver of the late 2023 risk rally.  This morning, markets have stabilized after two consecutive negative days to open the year.  As such, let us keep our eyes peeled for more, new and, potentially non-narrative, information going forward. 

Looking at the latest data releases overnight and this morning, they consisted of the Services PMI data as well as German state inflation.  Regarding the former, both Australian and Japanese data were soft although Chinese data was better than expected with the Caixin Services PMI printing at 52.9, continuing its rebound from summer lows.  Across Europe, Italian (49.8), French (45.7), German (49.3) and the Eurozone composite (48.8) all showed contractionary numbers although the UK (53.4) vastly outperformed.  As to the German state-by-state inflation readings, every one of them bounced sharply from last month’s recent lows and the market is looking for a sharp rebound in the national CPI to 3.7% later this morning.  As I have written before, that combination of rising inflation and weak growth is a tough situation for Madame Lagarde.  My money is still on her to address the growth rather than the inflation, although she will likely wait until the Fed moves before doing so in Frankfurt.

With all this in mind, let’s take a look at the overnight market activity.  In Asia, the picture was mixed although there was more red than green on the screen.  While the Nikkei (-0.5%) fell, other Japanese indices held their own, and we saw some strength in Indian shares as well.  However, China remains under pressure, despite the stronger than anticipated PMI reading and that has been weighing on South Korea, Hong Kong and Australia overall.  However, in Europe, we are seeing modest gains this morning, only on the order of 0.1% or 0.2%, but green is more pleasant than the red of the past two days.  As to US futures, they are little changed at this hour, although again, better than their recent performance.

In the bond market, from the time I wrote yesterday morning, yields fell through the rest of the session by nearly 7bps in the 10yr Treasury market, and this morning, they have bounced back from the closing levels by 4bps.  We have seen similar price action throughout Europe where yesterday’s declines to closing lows have been reversed and we are now between 6bps and 9bps higher than the end of Wednesday’s session.  JGB yields, though, remain anchored at 0.60%, unchanged.

Oil (+1.0%) is continuing to rebound as the situation in the Middle East seems to be getting more complex.  The Houthis continue to attack Red Sea shipping, Israel killed a Hezbollah leader in Lebanon, potentially widening the conflict and there was a terrorist bombing in Iran (with the best guess it was internally executed by an unhappy faction) which can only serve to increase the overall tension levels.  While the broader weakness we have seen in this space is likely a response to weaker overall economic activity, especially in China, at some point, that activity will pick up and I expect oil prices to do so as well.  In the metals complex, base metals are under further pressure this morning, with both copper and aluminum down -0.6% or so, although gold (+0.2%) is bucking that trend, perhaps on the back of the dollar’s marginal weakness this morning.

Speaking of the dollar, as measured by the DXY it is -0.2% softer this morning with pretty uniform losses vs the major G10 and EMG currencies.  The one exception is the yen (-0.6%) which continues to suffer based on the idea that the BOJ will not be able to consider interest rate normalization in the wake of the recent earthquake on the country’s west coast.  In truth, the dollar seems to be quite the afterthought in markets right now, with much greater focus on the bond market and central bank actions as the drivers.  While I would carefully watch if the dollar starts to break these correlations, I don’t see it as a key driver right now.

On the data front, we see a few things this morning, starting with ADP Employment (exp 115K) and then Initial (216K) and Continuing (1883K) Claims.  As well the Services PMI data is released later this morning (51.3) and finally we get the EIA oil inventories with another large draw of 3.7 million barrels expected which ought to continue to support the black, sticky stuff.

There are no Fed speakers on the calendar although we must all be watchful for the pop-up CNBC interview if they feel their message, whatever it may currently be, is not getting proper attention.  While the first two sessions of the year were certainly uncomfortable for risk assets, I do not believe that my idea of a solid first half followed by more evident problems in the second half of the year has been dismantled.  Clearly, tomorrow’s NFP data will be critical, and we will discuss it ahead of the release.  Until then…

Good luck

Adf