Said Jay, “it would be premature”

To think we’ve arrived at a cure

For higher inflation

Though there’s a temptation

By some to claim that we are sure



Instead, if we think it’s correct

More rate hikes we will architect

Investors, however,

Think Jay is too clever

By half and this view did reject

As we start a new week that will culminate in the payroll report on Friday, I think it is appropriate to consider how last week finished, notably how Chairman Powell left things leading into the Fed’s quiet period ahead of their next FOMC meeting on the 13^th of this month.  To my ears, the two most important comments were as follows: “The strong actions we have taken have moved our policy rate well into restrictive territory, meaning that tight monetary policy is putting downward pressure on economic activity and inflation.”  A little later he explained, “It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease. We are prepared to tighten policy further if it becomes appropriate to do so.”  

Now, interpretation is a subjective idea already, but FWIW my interpretation is he clearly understands they have tightened policy quite substantially, perhaps enough to achieve their goal of 2% inflation, but in a nod to this nation’s history, and ostensibly his hero, Paul Volcker, he is not going to get fooled by a temporary respite in inflation.  I believe he has made perfectly clear in the past that the Fed, or at least Chairman Powell, is willing to push the economy into a recession if he believes it is necessary to truly end inflation.

Of course, the biggest problem that he has is that the Fed is losing its ability to manage the situation as the Treasury continues to issue extraordinary amounts of new debt to fund spending.  This fiscal dominance results in a situation where the Fed’s actions have a diminishing impact on the macroeconomic variables they are trying to manage.  In fact, as I consider this situation it is actually a viable explanation for the fact that the market is very clearly ‘fighting the Fed’.  

One of the most common refrains from the post GFC period, when the Fed first introduced QE and kept repeating the exercise, driving asset prices substantially higher, although having very limited impact on goods and services inflation, was that investors, ‘don’t fight the Fed.’  The idea was that if the Fed was going to continue to print money, whatever the macroeconomic story was had limited impact on risk asset prices.  The Fed was the dominant factor and would continue to be so going forward. 

And that proved to be sage advice right up until the end of 2022.  The huge rally was supported by their easy money, and the reversal in 2022 was a result of them tightening policy substantially.  However, since then, and especially since the debt ceiling law was suspended until 2025, the Treasury has been able to issue as much debt as they like, and the government has been spending as quickly as possible.  While the Fed’s policy tightening was dramatic throughout 2022, it has slowed dramatically this year, and now it is being eclipsed, at least in a market response sense, by the flood of money entering the economy.  The result is that despite the Fed’s effort to maintain tight monetary policy, they are being overwhelmed by the Treasury’s profligate ways.  Hence, fighting the Fed is making sense.  It has largely worked in 2023 and while higher for longer may be the Fed’s mantra, it is being trumped by Yellen’s mantra of ‘issue another $1 trillion in T-bills just in case.’  

Setting aside, for a moment, the potential negative implications of the surge of Treasury issuance, its ability to crowd out private funding and therefore slow economic activity, from the market’s perspective, all those Federal dollars are being spent somewhere, and between the subsidies for ‘green’ energy, and the reshoring efforts across numerous manufacturing sectors, that money is circulating in the economy quite rapidly.  Since the government doesn’t really care what interest rate they pay (they will just borrow more to pay that interest), there is no financial brake on this activity.  It needs to be political.  And given there is a presidential election next year, the incentive for the incumbent administration to slow spending is not merely zero, it is negative.  

Ultimately, I believe this means that the Fed’s importance with respect to market movements overall is diminishing, although they will still have some impact.  Rather, I think we need to watch the spending plans more carefully.  One other thing to remember, especially for all the dollar bears out there, is that historically, a nation that runs tight monetary and loose fiscal policy winds up with a stronger currency.  This alone implies that news of the dollar’s demise may be greatly exaggerated.

Ok, while last week was all about Fed speak, this week is much more data focused.  Leading into the data dump, a look at markets shows that despite Friday’s strength in US equity markets, the rest of the world has been a little more suspect of things.  Both Japan and China saw weakness even though a court in HK ruled that China Evergrande had another 2 months to try to work things out before liquidation, although some other markets in Asia, notably India’s Sensex, (+2.0%) performed far better.  In Europe this morning, markets are mixed but I would argue are leaning slightly lower as both the FTSE 100 and CAC lower although the DAX and Spain’s IBEX are a touch firmer.  Finally, US futures at this hour (7:30) are pointing lower by about -0.35% across the board.

In the bond market, Treasury yields have backed up 5bps this morning, but are still at just 4.25%.  European sovereigns are also higher, albeit not quite as aggressively as Treasuries with the movement between 1bp and 3bps.  UK gilts are the outlier, also higher by 5bps.  Looking at Asia, while that 5bp rise was the norm Down Under, JGB yields are unchanged at 0.68%.  All this discussion regarding Japanese yields normalizing certainly seems to be premature at this stage.

In the commodity markets, oil (-0.6%) is slipping again as the response to the OPEC+ meeting has been less than impressive.  While production cuts were mooted, there is no clarity on which members will be cutting and by how much and for how long.  As we have been observing for the past months, the commodity market is the one that is truly pricing in a recession.  Equity markets are clearly on a different page although bond markets, given the magnitude of last month’s move, have certainly taken notice that things are slowing down.  In the metals markets, gold is little changed from Friday’s levels this morning, although Friday saw a sharp 1.5% rally.  As well, I would be remiss if I didn’t mention that in the overnight session, gold exploded to a new all-time high of $2135/oz before retracing those gains.  There is a growing interest in the barbarous relic, especially with the market’s growing belief that the Fed and other central banks are going to be cutting rates soon.  The rest of the metals complex, though, is under pressure this morning, once again pointing to concerns over a recession in the near future.

Finally, the dollar, overall, is slightly higher although there has been a mix in the components.  Notably, the yen strengthened sharply on Friday after the Powell comments but the same cannot be said of either the euro or the pound.  In fact, both of those currencies, as well as the rest of the European bloc, are under pressure as there is a growing certainty that Europe is entering, or perhaps already in, a recession, and the central banks there are going to be cutting rates soon.  As to the EMG currencies, today is a broadly dollar strength day and we are seeing virtually all of them under pressure vs. the greenback.  As I mentioned above, tight monetary and loose fiscal policies are a recipe for a currency’s strength.

Ok, let’s turn to the data story.

Source: Tradingeconomics.com

So, a huge amount of new data with ISM to start the week and NFP to finish.  Perhaps there will be a decisive trend that implies either recession is coming soon or not at all but based on everything we have seen over the last 6 months, at least, I imagine there will be both hot and cold data to absorb.  Fortunately, there are no Fed speakers although keep your eyes peeled for a WSJ article from the current Fed whisperer, Nick Timiraos, if things start to point to even more aggressive rate cuts by the Fed next year (5 cuts are already priced starting in March).  

For today, my take is the market seems likely to take a breather after a remarkable risk rally last month.  Absent any real new news today, look for a quiet one.  But we need to watch the data this week carefully for clues as to whether the goldilocks or recession narrative will dominate.  Funnily enough, in either case, I feel like the dollar is likely to hold its own.

Good luck

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