As regular readers of this blog are aware, I have been advocating for the potential of a softer monetary stance by the US Federal Reserve and Bank of Canada after September. I believe that inflation has likely peaked, or is close to it. Based on evidence posted on my recent blogs, it appears that there will be enough pressure on the economy to suggest the Fed/BOC will be forced to reduce the tightening stance. AND I believe that they will need to accept that 2% inflation isn’t accessible without invoking stagflation or recession. After all, long term inflation numbers are over 3% for both Canada and USA, as noted in my commodities video (which I implore you to watch ). The 2% inflation goal is based on relatively recent averages, which may be a fantasy.
I am convinced that we may have to settle for an inflation number of at least that 3% average, perhaps higher. Please read this blog, particularly the section called “Fed Policy” to understand my reasoning behind higher inflation as a new reality.
It is my opinion that a move to flat monetary policy will occur far quicker than the banks are letting on. If/as/when we see an economic slowdown, we may even witness eventual easing policies in late 2023. However, its always good to hear another argument. One of the institutional research services we utilize, MarketDesk, has a slightly different outlook than ours. While we all agree that the July stock market rally is likely not going to continue over the summer, their outlook is for further rate hikes beyond September. I have highlighted the points you might want to focus on.
Below is the report, courtesy MarketDesk:
The central bank hiked interest rates +0.75% for a second consecutive month, declined to shut the door on another large hike at the September meeting, and otherwise gave no indication rate cuts are coming … and the equity market rallies!? That’s not what the Fed had in mind. What happens next? We expect multiple Fed presidents to hit the press and speaking circuit in August to talk the market back down, and the Jackson Hole meeting is another potential opportunity for the Fed to push back against the market. Minneapolis Fed president Kashkari led off last Friday during an interview. The following are select quotes from his interview (keep in mind Kashkari is considered among the most dovish Fed presidents):
On the market reaction:
“I’m surprised by markets’ interpretation. The committee is united in our determination to get inflation back down to 2 percent, and I think we’re going to continue to do what we need to do until we are convinced that inflation is well on its way back down to 2 percent — and we are a long way away from that.”
On 2023 interest rate cuts:
“I don’t know what the bond market is looking at in reaching that conclusion.” Kashkari added the bar would be “very, very high” to cut rates. Heeding Chair Powell’s advice to look back to the June Summary of Economic Projections (SEP) for forward guidance, the median projected Fed funds rate at the end of 2022 and 2023 was 3.4% and 3.8%, respectively. Based on the current 2.5% target rate, the June SEP implies ~ +1% before year-end, followed by another +0.4% during 2023. Only during 2024 does the projection decline back to 3.4%. The Fed clearly lost credibility during the pandemic.
Economic data is deteriorating, but that doesn’t mean the Fed can or will cut rates.
Why? Pandemic stimulus measures disproportionately benefited higher income individuals that own a business (PPP loans), large investment portfolios (negative real yields boosted asset prices), and/or a house (low mortgage rates spurred housing demand). These higher income individuals are the consumer segment generating inflation pressures, because the pandemic wealth effect leaves them less impacted by rising prices. We expect the Fed to focus intently on this group, which starts with pushing back against the idea of a Fed pivot.
What are the financial market implications?
We would not be surprised to see a reversal of July’s performance trends over the next 1-2 months. Our base case is: (1) yields on the short end of the Treasury curve rise; (2) corporate credit spreads widen and Corp HY underperforms; and (3) equities produce negative returns as real yields rise. The big question is whether the long end of the yield curve will rise or fall. If long yields rise to reflect more hawkish Fed policy, Long Duration and Growth could underperform near-term. Tactical investors should consider positioning for an unwind of the market’s dovish views near-term, while longer-term focused investors are likely better off not trying to time a volatile market.
Macro outlook paper being sent Tuesday August 9th
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As always, any questions on todays blog – post them below.