Sive Morten
Special Consultant to the FPA
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Fundamentals
This week the financial world was like a boiling pot - a lot of data, a lot of political events. Although Fed minutes this week have not brought any sensation, but put more foundation on longer term hawkish Fed policy and once again assured markets that if Fed tells something - it shouldn't be ignored. In last two weeks we've warned that market will regret about it and this is wrong idea to ignore Fed comments as it was done after recent Fed meeting. What do we see now? Yes, definitely it was a mistake to run against the Fed... Besides recent data frees Fed's hands in terms of strict policy for even longer. Swap traders already consider 3 more rate hike, 0.5% rate change appears on horizon again, while terminal rate now grows to ~5.45%.
Market overview
U.S. business activity unexpectedly rebounded in February, reaching its highest level in eight months, according to a survey on Tuesday, which also showed inflation subsiding. S&P Global said its flash U.S. Composite PMI Output Index, which tracks the manufacturing and services sectors, increased to 50.2 this month from a final reading of 46.8 in January. The rebound in business activity fits in with recent robust data on retail sales, the labor market and manufacturing production, which have suggested solid momentum in the economy at the start of the year. (we've talked about this, it might be the victim of the same "seasonal adjustments" in January...)
It seems that markets still do not understand what is going on. Just take a look at this comment -
Global equities and U.S. Treasury yields were lower on Wednesday as recent strong economic data had investors worried about aggressive interest rate hikes even though minutes of the Federal Reserve's last meeting showed officials at the Jan. 31 to Feb. 1 meeting favored moderation. A solid majority of Fed policy makers at the meeting agreed it was appropriate for the central bank to raise rates by 25 basis points, even as they reiterated that the inflation outlook would keep driving further rate actions, the minutes showed. Only a few officials supported a rate hike of 50 basis points.
But since then, strong economic data demonstrated the resilience of the U.S. economy and heightened worries of a longer rate-tightening cycle.
St. Louis Fed President James Bullard, a non-voting member of the Fed's rate-setting committee this year, on Wednesday reiterated his view that a Fed policy rate in the range of 5.25% to 5.5% would be adequate to bring inflation toward the central bank's 2% goal.
Bond yields rose following the release of the minutes and the U.S. dollar also advanced against a basket of currencies. A modest rally in U.S. stocks fizzled out. Traders of futures tied to the Fed policy rate added to bets on at least three more quarter-percentage-point rate hikes at upcoming meetings, with contract pricing pointing to a top federal funds rate range of 5.25%-5.50%.
JPMorgan Chase & Co Chief Executive Jamie Dimon expects U.S. interest rates could hit 6%, he said in an interview with CNBC on Thursday. The Federal Reserve quickly caught up to out-of-control inflation and would probably pause interest rates at a little over 5%, but they may need to go higher, Dimon told CNBC.
Data since the last meeting have shown an economy continuing to grow and adding jobs at an unexpectedly rapid pace, while making less progress back towards the Fed's 2% inflation target. What is not been published in Fed's protocol - the new Fed model that we've mentioned in Telegram. This is the reason why Fed is so concerned with high employment. Rising wages push inflation higher. According to new Fed model companies will not include rising wages in the cost of goods sold. It leads to recession, because companies will bear these costs but not compensated in higher price levels. Since job market now stands almost at full capacity - the value of these costs now is astronomic, which means that recession will be stronger as more loss companies will have to care. Thus, Fed wants to chill job market.
Fathom consulting also suggests possible two quarters of decline but in general US should avoid recession by their opinion -
Although we do know that US stands in recession (wrong world) since the late 2021.
Expectations that the U.S. Federal Reserve will need to push interest rates higher and keep them elevated longer than previously projected rose on Friday after data showed a key inflation gauge accelerated last month. The Commerce Department reported that the Personal Consumption Expenditures price index, the metric by which the Fed measures its 2% inflation target, rose 5.4% last month from a year earlier, a pickup from an upwardly revised 5.3% annual pace in December.
Underlying "core" inflation climbed a faster-than-expected 4.7% from a year earlier, compared to December's upwardly revised 4.6% pace.
Implied yields on federal funds futures contracts rose on Friday as traders firmed up expectations for at least three more rate hikes through June, a path that would push the U.S. central bank's benchmark overnight interest rate to the 5.25%-5.50% range, from the current 4.50%-4.75% range. Pricing also now puts about a 40% chance of an even higher stopping point for that rate, up from about 30% prior to the release of the PCE data.
And traders largely erased what had been consistent bets on Fed rate cuts toward the end of the year, pricing in a year-end Fed policy rate of 5.26%.
Revisions to data from prior months in Friday's Commerce Department report showed inflation did not cool in November and December as much as had been thought, and spending in January rose more than expected even as the savings rate increased. All told, the economic readings may throw doubt on Fed Chair Jerome Powell's assessment this month that the "disinflationary process" had begun, a view that seemed to justify the central bank's decision at its Jan. 31-Feb. 1 policy meeting to deliver a quarter-percentage-point rate increase after a string of bigger hikes in 2022.
Goldman said he expects the next round of Fed projections, to be published in March, to signal rates will rise father and stay there longer than previously thought.
U.S. consumer spending increased by the most in nearly two years in January amid a surge in wage gains, while inflation accelerated, adding to financial market fears that the Federal Reserve could continue raising interest rates into summer. Consumer spending, which accounts for more than two-thirds of U.S. economic activity, shot up 1.8% last month. That was the largest increase since March 2021. Data for December was revised higher to show spending dipping 0.1% instead of falling 0.2% as previously reported.
The overall surge in spending came as wages and salaries jumped 0.9%. An 8.7% cost of living adjustment, the biggest increase since 1981, for more than 65 million Social Security beneficiaries offset a drop in government social benefits. The data together with another Commerce Department report showing new home sales vaulting 7.2% in January prompted Goldman Sachs to raise its first-quarter gross domestic product tracking estimate by 0.4 percentage point to a 1.8% annualized rate. The economy grew at a 2.7% pace in the fourth quarter.
Excluding the volatile food and energy components, the PCE price index increased 0.6%. That was the biggest gain since August 2022 and followed a 0.4% rise in December. The so-called core PCE price index increased 4.7% on a year-on-year basis in January after advancing 4.6% in December.
The Fed tracks the PCE price indexes for monetary policy. According economists' calculations, core services prices excluding housing, which are being closely watched by policymakers, increased 0.6% after climbing 0.4% in December. The latest high readings left economists to expect that the road to disinflation would be slow and bumpy, with a survey from the University of Michigan on Friday showing consumers' near-term inflation expectations increased in February.
The average contract rate on a 30-year fixed-rate mortgage jumped by 23 basis points to 6.62% for the week ended Feb. 17 following stronger-than-expected retail sales and labor market data as well as still robust monthly inflation readings, which compelled investors to up their bets that the U.S. central bank will have to keep raising its policy rate through the summer.
Fed funds futures traders are now pricing the Fed funds rate to hit a peak of 5.395% in September, and expect it to stay above 5% for the year.
Some bond managers have started to adjust short-term exposure to Treasuries to avoid losses during the period when the government may exhaust its ability to pay its bills. Making preparations for a potential default is tricky, partly due to uncertainty over how much revenue the Treasury will collect from Americans filing income taxes in April. The Treasury bills yield curve indicates investors are demanding higher returns to hold debt due in August, signaling that it is perceived to be riskier than other maturities.
Next week to watch
Reports on U.S. durable goods orders, home prices as well as manufacturing and consumer confidence threaten to cement expectations of more Fed rate hikes. Tuesday's consumer confidence data may be of particular interest, offering a glimpse into households' views on economic prospects and inflation expectations. Economists polled by Reuters expect a median reading of 109.5 on the index, which unexpectedly fell in January.
It's inflation week in the euro area. Preliminary February data from Germany, France, Spain and Portugal are due on Monday and Tuesday, followed by the bloc-wide flash number on Thursday. Price pressures are abating: headline euro area inflation eased to 8.6% in January from 9.2% a month earlier. Still, Thursday's numbers are unlikely to placate European Central Bank hawks pushing for aggressive rate hikes to continue.
Focus will likely stay on core inflation, stripping out volatile food and energy prices. It's proving stubborn and could still rise from January's 5.3%. Markets have got the message and renewed bets on the ECB 2.5% depo rate moving higher. Deutsche Bank just raised its forecast for the peak in ECB rates to 3.75% from 3.25%.
Goldman Sachs said it was expecting the European Central Bank to raise interest rates thrice this year, taking the terminal rate to 3.5% from 3.25% estimated earlier.Markets currently see ECB rates peaking at around 3.7% by the end of summer.
Deutsche Bank has lifted its forecast for where the European Central Bank's key rate will rise to in this tightening cycle to 3.75% from 3.25%, the German bank said in a note on Wednesday. Deutsche economists now expect the ECB to raise interest rates by 50 basis points (bps) at its March and May meetings, followed by a final hike of 25bp in June. They had previously expected a 50 bps hike in March and a final 25 bps rise in May.
This week the financial world was like a boiling pot - a lot of data, a lot of political events. Although Fed minutes this week have not brought any sensation, but put more foundation on longer term hawkish Fed policy and once again assured markets that if Fed tells something - it shouldn't be ignored. In last two weeks we've warned that market will regret about it and this is wrong idea to ignore Fed comments as it was done after recent Fed meeting. What do we see now? Yes, definitely it was a mistake to run against the Fed... Besides recent data frees Fed's hands in terms of strict policy for even longer. Swap traders already consider 3 more rate hike, 0.5% rate change appears on horizon again, while terminal rate now grows to ~5.45%.
Market overview
U.S. business activity unexpectedly rebounded in February, reaching its highest level in eight months, according to a survey on Tuesday, which also showed inflation subsiding. S&P Global said its flash U.S. Composite PMI Output Index, which tracks the manufacturing and services sectors, increased to 50.2 this month from a final reading of 46.8 in January. The rebound in business activity fits in with recent robust data on retail sales, the labor market and manufacturing production, which have suggested solid momentum in the economy at the start of the year. (we've talked about this, it might be the victim of the same "seasonal adjustments" in January...)
It seems that markets still do not understand what is going on. Just take a look at this comment -
Global equities and U.S. Treasury yields were lower on Wednesday as recent strong economic data had investors worried about aggressive interest rate hikes even though minutes of the Federal Reserve's last meeting showed officials at the Jan. 31 to Feb. 1 meeting favored moderation. A solid majority of Fed policy makers at the meeting agreed it was appropriate for the central bank to raise rates by 25 basis points, even as they reiterated that the inflation outlook would keep driving further rate actions, the minutes showed. Only a few officials supported a rate hike of 50 basis points.
But since then, strong economic data demonstrated the resilience of the U.S. economy and heightened worries of a longer rate-tightening cycle.
St. Louis Fed President James Bullard, a non-voting member of the Fed's rate-setting committee this year, on Wednesday reiterated his view that a Fed policy rate in the range of 5.25% to 5.5% would be adequate to bring inflation toward the central bank's 2% goal.
Bond yields rose following the release of the minutes and the U.S. dollar also advanced against a basket of currencies. A modest rally in U.S. stocks fizzled out. Traders of futures tied to the Fed policy rate added to bets on at least three more quarter-percentage-point rate hikes at upcoming meetings, with contract pricing pointing to a top federal funds rate range of 5.25%-5.50%.
JPMorgan Chase & Co Chief Executive Jamie Dimon expects U.S. interest rates could hit 6%, he said in an interview with CNBC on Thursday. The Federal Reserve quickly caught up to out-of-control inflation and would probably pause interest rates at a little over 5%, but they may need to go higher, Dimon told CNBC.
Data since the last meeting have shown an economy continuing to grow and adding jobs at an unexpectedly rapid pace, while making less progress back towards the Fed's 2% inflation target. What is not been published in Fed's protocol - the new Fed model that we've mentioned in Telegram. This is the reason why Fed is so concerned with high employment. Rising wages push inflation higher. According to new Fed model companies will not include rising wages in the cost of goods sold. It leads to recession, because companies will bear these costs but not compensated in higher price levels. Since job market now stands almost at full capacity - the value of these costs now is astronomic, which means that recession will be stronger as more loss companies will have to care. Thus, Fed wants to chill job market.
- The model has been revised to reduce the potential output gap. The production of goods and services will go into negative territory in the 3rd quarter of 2023.
- The model assumes that core inflation (PCE - personal consumption) is returning to 2% even though wages (employment cost) are growing at a double rate compared to the pre-pandemic trend. It sounds like miracle. We have big doubts about this point.
- The Fed uses the Keynesian Phillips Curve, which assumes wage rigidity. As a result: people will still ask for more money, despite the actual increase in wages.
- How will inflation return to 2% if the wage spiral continues? According to the model, due to a faster decline in price growth in all other areas.
- How can this happen? It's simple - business (in theory) will not pass costs [labor costs] to final products/services, which implies a significant drop in profits = recession.
Fathom consulting also suggests possible two quarters of decline but in general US should avoid recession by their opinion -
Although we do know that US stands in recession (wrong world) since the late 2021.
Expectations that the U.S. Federal Reserve will need to push interest rates higher and keep them elevated longer than previously projected rose on Friday after data showed a key inflation gauge accelerated last month. The Commerce Department reported that the Personal Consumption Expenditures price index, the metric by which the Fed measures its 2% inflation target, rose 5.4% last month from a year earlier, a pickup from an upwardly revised 5.3% annual pace in December.
Underlying "core" inflation climbed a faster-than-expected 4.7% from a year earlier, compared to December's upwardly revised 4.6% pace.
Implied yields on federal funds futures contracts rose on Friday as traders firmed up expectations for at least three more rate hikes through June, a path that would push the U.S. central bank's benchmark overnight interest rate to the 5.25%-5.50% range, from the current 4.50%-4.75% range. Pricing also now puts about a 40% chance of an even higher stopping point for that rate, up from about 30% prior to the release of the PCE data.
And traders largely erased what had been consistent bets on Fed rate cuts toward the end of the year, pricing in a year-end Fed policy rate of 5.26%.
Revisions to data from prior months in Friday's Commerce Department report showed inflation did not cool in November and December as much as had been thought, and spending in January rose more than expected even as the savings rate increased. All told, the economic readings may throw doubt on Fed Chair Jerome Powell's assessment this month that the "disinflationary process" had begun, a view that seemed to justify the central bank's decision at its Jan. 31-Feb. 1 policy meeting to deliver a quarter-percentage-point rate increase after a string of bigger hikes in 2022.
Goldman said he expects the next round of Fed projections, to be published in March, to signal rates will rise father and stay there longer than previously thought.
U.S. consumer spending increased by the most in nearly two years in January amid a surge in wage gains, while inflation accelerated, adding to financial market fears that the Federal Reserve could continue raising interest rates into summer. Consumer spending, which accounts for more than two-thirds of U.S. economic activity, shot up 1.8% last month. That was the largest increase since March 2021. Data for December was revised higher to show spending dipping 0.1% instead of falling 0.2% as previously reported.
The overall surge in spending came as wages and salaries jumped 0.9%. An 8.7% cost of living adjustment, the biggest increase since 1981, for more than 65 million Social Security beneficiaries offset a drop in government social benefits. The data together with another Commerce Department report showing new home sales vaulting 7.2% in January prompted Goldman Sachs to raise its first-quarter gross domestic product tracking estimate by 0.4 percentage point to a 1.8% annualized rate. The economy grew at a 2.7% pace in the fourth quarter.
Excluding the volatile food and energy components, the PCE price index increased 0.6%. That was the biggest gain since August 2022 and followed a 0.4% rise in December. The so-called core PCE price index increased 4.7% on a year-on-year basis in January after advancing 4.6% in December.
The Fed tracks the PCE price indexes for monetary policy. According economists' calculations, core services prices excluding housing, which are being closely watched by policymakers, increased 0.6% after climbing 0.4% in December. The latest high readings left economists to expect that the road to disinflation would be slow and bumpy, with a survey from the University of Michigan on Friday showing consumers' near-term inflation expectations increased in February.
The average contract rate on a 30-year fixed-rate mortgage jumped by 23 basis points to 6.62% for the week ended Feb. 17 following stronger-than-expected retail sales and labor market data as well as still robust monthly inflation readings, which compelled investors to up their bets that the U.S. central bank will have to keep raising its policy rate through the summer.
Fed funds futures traders are now pricing the Fed funds rate to hit a peak of 5.395% in September, and expect it to stay above 5% for the year.
Some bond managers have started to adjust short-term exposure to Treasuries to avoid losses during the period when the government may exhaust its ability to pay its bills. Making preparations for a potential default is tricky, partly due to uncertainty over how much revenue the Treasury will collect from Americans filing income taxes in April. The Treasury bills yield curve indicates investors are demanding higher returns to hold debt due in August, signaling that it is perceived to be riskier than other maturities.
Next week to watch
Reports on U.S. durable goods orders, home prices as well as manufacturing and consumer confidence threaten to cement expectations of more Fed rate hikes. Tuesday's consumer confidence data may be of particular interest, offering a glimpse into households' views on economic prospects and inflation expectations. Economists polled by Reuters expect a median reading of 109.5 on the index, which unexpectedly fell in January.
It's inflation week in the euro area. Preliminary February data from Germany, France, Spain and Portugal are due on Monday and Tuesday, followed by the bloc-wide flash number on Thursday. Price pressures are abating: headline euro area inflation eased to 8.6% in January from 9.2% a month earlier. Still, Thursday's numbers are unlikely to placate European Central Bank hawks pushing for aggressive rate hikes to continue.
Focus will likely stay on core inflation, stripping out volatile food and energy prices. It's proving stubborn and could still rise from January's 5.3%. Markets have got the message and renewed bets on the ECB 2.5% depo rate moving higher. Deutsche Bank just raised its forecast for the peak in ECB rates to 3.75% from 3.25%.
Goldman Sachs said it was expecting the European Central Bank to raise interest rates thrice this year, taking the terminal rate to 3.5% from 3.25% estimated earlier.Markets currently see ECB rates peaking at around 3.7% by the end of summer.
Deutsche Bank has lifted its forecast for where the European Central Bank's key rate will rise to in this tightening cycle to 3.75% from 3.25%, the German bank said in a note on Wednesday. Deutsche economists now expect the ECB to raise interest rates by 50 basis points (bps) at its March and May meetings, followed by a final hike of 25bp in June. They had previously expected a 50 bps hike in March and a final 25 bps rise in May.
