December 13 FOMC meeting key takeaways

Well, I could just say that the dove is back, but that would be too simple.

So, here’s a page or two on what happened on Wednesday night and what might be hiding in the shadows following the dove’s return.

At and after the meeting of governors at Wednesday’s Federal Open Market Committee (FOMC) meeting, Fed Chair Powell said interest rates were well into restrictive territory.

He said the Fed was ‘at or near’ peak rates for this cycle. Even so, he said the Fed will proceed carefully given the full effect of tightening had likely not yet been felt.

As a result, Fed governors wanted to retain the possibility of further rate hikes if needed.

And then he told markets that rate cut discussions had begun, effectively handing out double doses of Rohypnol, and risk markets partied.

Gone the inner Volcker - dispatched to the sidelines with a few cautionary dovish responses like the Fed will move carefully and consider the totality of data, going forward.

And the day after, the Bank of England paused again for the third time at 5.25%, and the ECB paused at 4% for the second month in a row. The Fed is staying pat at 5.25% to 5.5% with the actual rate floating around 5.35%.

The pivot (rate cuts) is no longer a question of if, but when.

Powell’s dove (his natural state) is back with a few reasons to cut rates and guide his flock to his so-called ‘soft landing’.

Or maybe the real reason is to manage down rates for his old boss, Janet Yellen, who will be trying to fund trillions of government over-spending (and refinance trillions of old debts and interest bills) at a lower cost of capital through Treasury auctions.

Regardless of motivation (political, populist, Powell the dove is back, or a mixture of all) we’re now in an asset inflating Santa rally.

And the more difficult question of whether the Fed’s done enough versus an Arthur Burns premature pivot/relaxation and reprisal of inflation is simply relegated into next year. As is the question of lifting and resetting the suspended debt ceiling and coming yield wars.

Here are some thoughts on the Powell pirouette/pre-pivot proclamation.

The new economic projections proclamations from FOMC, Wednesday 13 December 2023

Productivity is expected to halve with GDP growth of 2.5% by the end of this year expected to fall to 1.4% by end of 2025 (which is still twice the EU growth rate as predicted by the ECB yesterday).
Expectations for unemployment of 3.7% by the end of this year to increase to 4.1% by the end of 2024 and a function of demand for workers still being greater than the supply.
Inflation measured by core PCE of 3.1% today expected to be 2.8% by the end of December, 2.4% by the end of 2024 and only arrive at the Fed’s target of 2% by the end of 2026 (whereas the ECB is predicting 2.1% inflation by 2025, a full year earlier).

And now, to rate cuts.

The pace of rate cuts as seen in the dot plot (which Powell reminded everyone was not Fed policy, simply a survey) indicates 10 cuts over three years, namely from a FFR range of 5.25% to 5.5% today (call it, 5.35%) to:

4.6% by the end of 2024 (meaning 3 @ 25bp cuts);
3.6% by the end of 2025 (meaning 4 @ 25bp cuts); and
2.9% in 2026 (meaning 3 more cuts – resulting in a real rate of 0.9% which is higher than what the Fed has said it wants, indicating the different views amongst the Governors).

Where was Paul Volcker? Arthur Burns, that you? Were the lessons of the 1970s forgotten?

Risk markets do not care to ask those questions. They are making up for bond losses.

And overall, risk markets reacted how they should to Powell’s highly dovish guidance – with cuts sometime between March and May next year and in the meantime money will be rotated and reallocated to where it’s treated best.

Plus, the Volcker devil and Burns angel fighting it out on Powell’s shoulders is just a smokescreen, because he doesn’t see it that way.

He was given a populist job to do (eradicate inflation) and is angling to do so with a soft-landing outcome. Investors and traders that have gone against his guidance in the past have suffered greatly – look at the bond capital loss carnage resulting from market luminaries prematurely predicting this Pivot.

But I believe the real fight will be staged between Janet Yellen’s Treasury and the market, when issuance at scale is required for deficits and debt refinancing, and the Fed will be cheering from the lofty heights of its glass box full of Dom and truffle as it contemplates how much more rocket fuel it will have to buy from its sister team.

For me, I think there will soon be a battle royale between official interest rates (the Federal Funds Rate) and U.S. Treasury yields. Not saying it’s a problem, but I am saying that it will again cause rate/yield and risk market dislocations - and opportunity.

So, in one of my corners, we have inflation that’s rolling over and a Fed that needs to cut rates to keep pace.

Why? Now that the Fed thinks inflation is more or less under control (although admittedly still too high) it will want to stop the real rate from rising too high fast and dragging down the economy.

The problem is that if inflation drops at a faster rate than rate cuts, the real rate (which you can think of as a discount rate or required rate of return after accounting for inflation) will rise. To the extent that happens, you’re back to restrictive territory that will further overtighten conditions.

So, the Fed will be backed into cutting rates to the extent inflation falls in order to keep the real rate down. That will put downward pressure on yields.

In my other corner, I have a large quantum of Treasury issuance in the trillions that will be required to cover the government deficit, interest bill and refinancing in 2024. Market participants are likely to demand decent Treasury yields to fund the government. And that (which I’ve been writing about for some time now) will keep upwards pressure on yields.

Which will win? What will the clearing price be? Which end of the curve will be affected?

No one really knows yet, and it’s a question of when the reverse repo and TGA run out, how well supported the note and coupon paying bond auctions will be, whether Japan and China will come back in to buy, and other black swan events that might arise from left field next year.

In other words, it’s just not possible to predict what will happen with that and the debt ceiling deliberations, noting the trillions stacked over the top while the ceiling has been suspended.

But the current price action across risk markets suggests a few things for the short term from a personal investment and business portfolio perspective.

Investment Portfolio effects

Gold and crypto (store of value assets that go up when increasing liquidity and world reserve currency debasement are on the cards) are ripping and if the market expects Powell to follow with cuts at a pace such that the real yield comes down with nominal yields, these should continue well into next year.

Bond prices too, as yields decline. Long duration growth/tech stocks are also feeling the love due to a declining discount rate. And for some, energy companies look cheap.

Business portfolio effects

Falling costs, services still sticky, lower WACC, slightly lower USD, higher commodity prices, and some improvement in access to project financing for resources projects.

There’s also a likelihood of rising energy prices as COP28 and other populist pressures continue to push for a (premature) phasing out of fossil fuels in the absence of sufficient nuclear and renewable energy in place, which will most likely cause supply shortages again.

And the slightly higher AUD means less imported/tradeable inflation, but less AUD back for USD sales of hard and soft commodities.

Key risks

Keep an eye on unemployment, keep an eye on potential for inflation to come back if Powell’s has been premature with his pre-pivot pirouette, or due to a wealth effect from a Santa rally asset bubble if the market parties too hard.

Debt, deficits, and issuance putting upwards pressure on yields (regardless of the policy rate, i.e., Fed’s FFR) with the risk of higher real yields (soon to battle lower official rates once the Fed starts to cut), albeit hiding somewhere in the shadows at the minute.

And watch the comical deckchair restacking from commentators predicting recession. Looking back, a recession has been predicted for every month of 2023! And what of it? Resilience.

Summary of the Fed’s December FOMC meeting?

Six months on pause feels like a rate cycle top. While Powell said it was too early for a victory lap, he took one anyway 🤣. His policy was surprisingly dovish.

The pivot (rate cuts) is no longer a question of if, but when.

Powell’s dove (his natural state) is back with a few reasons to cut rates and guide his flock to his so-called ‘soft landing’.

Maybe the surprise is to do with keeping real rates low as inflation rolls over, or maybe the unsurprising reason is to manage down rates for his old boss, Janet Yellen, who in 2024 will be trying to fund trillions of government over-spending (and refinance trillions of old debts and interest bills) at a lower cost of capital through Treasury auctions.

Regardless of motivation (political, populist, Powell the dove is back, or a mixture of all) we’re now in an asset inflating Santa rally and risk markets are now in control.

Unless something drastic and ugly happens, Powell’s ‘let’s move carefully data dependent’ Pivot is now a question of when, not if.

Essentially, an early Christmas present with sprinkles of ‘no recession to see here’.

Still, there was a smug air about the Fed Chair, almost as though he had threaded the needle that everyone said could not be done. But is it over?

In the near term, it feels like it’s going to be quite bullish for risk assets, hard commodity prices and projects, as well as corporate deals.

Keep an eye on Treasury yields next year ahead of issuance at scale, which are currently hiding in the shadow of the dove, but other than for that and the 1.4% U.S. GDP growth projection next year, roughly double the pace predicted for the EU, those higher for longer risk asset thermals are sure nice!

For businesses, there could be a goldilocks window for M&A before the secular takes off once the rate cycle is done, and as I’ve reminded my clients recently, certain funding markets are starting to crack open in anticipation of the Pivot.

See you in the markets: bonds, stocks, gold or crypto? Take your pick.

Mike

In the shadow of the dove