Fed Embraces Immaculate Disinflation
Doug Nolan
CNBC’s Jeff Cox:
“Just kind of looking to put it all together, you talked about basically the economy looking strong, with 3.3% annualized growth in the fourth quarter.
Does the strength of the economy speak more loudly to you now than any inflation threat might?
You’re in a position, in other words, to keep rates elevated as long as the economy stays strong, and you’re more tilted towards that.
And also, perhaps, are you worried at all that the economy is maybe a little too strong right now and that inflation could come back at some point?”
Chair Powell:
“I’m not so worried about that.
Again, we’ve had inflation come down without a slow economy and without important increases in unemployment, and there’s no reason why we should want to get in the way of that process if it’s going to continue.
So, I think declining inflation - continued declines in inflation - are really the main thing we’re looking at.
Of course, we want the labor market to remain strong, too.
We don’t have a growth mandate.
We’ve got a maximum employment mandate and a price stability mandate, and those are the two things we look at.
Growth only matters to the extent it influences our achievement of those two mandates.”
Powell:
“So, I guess I would just say this: executive summary would be that growth is solid to strong over the course of last year.
The labor market, 3.7% unemployment indicates that the labor market is strong.
We’ve had just about two years now of unemployment under 4%.
That hasn’t happened in 50 years.
So, it’s a good labor market.
And we’ve seen inflation come down…
The outlook, we do expect growth to moderate.
Of course, we have expected it for some time, and it hasn’t happened.
But we do expect that it will moderate as supply chain and labor market normalization runs its course.”
Powell:
“In terms of growth, we’ve had strong growth.
If you take a step back, we’ve had strong growth, very strong growth last year, going right into the fourth quarter.
And yet, we’ve had a very strong labor market, and we’ve had inflation coming down.
So, I think, whereas a year ago, we were thinking that we needed to see some softening in economic activity, that hasn’t been the case.
So, I think we look at stronger growth, we don’t look at it as a problem.
I think, at this point, we want to see strong growth.
We want to see a strong labor market.
We’re not looking for a weaker labor market.
We’re looking for inflation to continue to come down, as it has been coming down for the last six months.”
Powell and FOMC’s thinking has gone through quite an evolution.
Over recent months, the notion of “immaculate disinflation” has supplanted traditional analysis.
The U.S. can have “very strong growth” and we can enjoy “a very strong labor market” without concern for how such a backdrop might impact inflation prospects.
Powell:
“Our strong actions have moved our policy rate well into restrictive territory, and we have been seeing the effects on economic activity and inflation…
We believe that our policy rate is likely at its peak for this tightening cycle and that, if the economy evolves broadly as expected, it will likely be appropriate to begin dialing back policy restraint at some point this year.”
More remarkable even than having grown comfortable with very strong growth and labor markets, the Fed is willing to disregard extremely loose financial conditions and highly speculative financial markets.
It’s the same old asymmetric policy approach.
Tight conditions would attract all kinds of attention, while quite loose conditions don’t receive a mention.
It’s worth remembering that we’re only 19 months past 9.1% y-o-y CPI inflation.
Meanwhile, the Nasdaq100 returned 55% last year, the strongest performance since 1999, with the Semiconductor (SOX) Index returning 67%.
History teaches us that asset inflation and Bubbles pose greater risk to system stability than consumer price inflation.
The so-called “great financial crisis” was the result of a mortgage finance Bubble that inflated spectacularly in a backdrop of low CPI and loose financial conditions.
Catastrophic “Roaring Twenties” excess evolved during a period of well-contained consumer prices.
Japan’s devastating eighties Bubble (still impactful decades later) also inflated in an environment of meager consumer price inflation.
And, more recently, low inflation and loose lending were a hallmark throughout China’s Bubble inflation, with the scope of damage wrought upon system stability increasingly on display.
Others had issues, but I welcomed Powell’s modest pushback against aggressive market rate cut expectations (essentially taking March off the table).
It was the least he could do following his December “dovish pivot” lapse.
I could have lived without, “We believe that our policy rate is likely at its peak for this tightening cycle…”
It was inconsistent with “we’re not declaring victory at all at this point.
We think we have a ways to go.”
Downplaying the “very strong” economy and labor markets is a misjudgment of consequence.
For one, both impact inflationary prospects over time, certainly increasing the risk of an inflationary shock in the event of an unforeseen disruptive event.
Moreover, if the Fed doesn’t care, markets won’t care, with corrosive effects on market function.
Data that would typically lead to rising market yields and tightening conditions are ignored.
Late-cycle speculative Bubbles, already enjoying formidable impunity, become completely unhinged.
Powell again fielded a question on the “neutral rate,” providing an ambiguous response.
Fed officials can repeat it as many times as they like, but that won’t change the reality that their aggressive rate increases have not yet resulted in policy “well into restrictive territory.”
Perhaps to a few specific sectors, but from a systemic perspective – i.e., Credit expansion, economic growth, marketplace liquidity, asset inflation and speculative excess – policy is decidedly unrestrictive.
This has been such a protracted cycle fueled by a historic Bubble at the heart of perceived safe and liquid government debt and central bank Credit.
Late-cycle dynamics today dominate.
Financial innovation has ensured a proliferation of non-traditional lenders, including “private Credit,” DeFi (decentralized finance), and scores of new age finance companies.
The non-banking sector is in a full-fledged boom.
A late-cycle speculative dynamic is also quite dominant.
Everyone knows that stock prices only go higher.
The explosive growth in the ETF complex nurtures huge ongoing speculative flows into the markets.
Moreover, the long cycle has emboldened options and derivatives traders, institutional and retail alike.
Leveraged speculation has infiltrated all market nooks and crannies.
What is more, egregious leverage has accumulated at the heart of the bond market, with a Trillion plus, can’t lose “basis trade” in Treasuries, Agency Securities and MBS.
In the face of weakened bank lending, Money Fund Assets have exploded almost $1.2 TN, or 24.5%, over the past year.
Importantly, the money fund complex has evolved into the critical late-cycle intermediator of speculative Credit financing the “basis trade” and levered speculation more generally.
There is also the critical issue of now deeply rooted massive deficit spending.
Deficits that would have been viewed with alarm early in the cycle are now accepted as routine and innocuous.
Upwards of $2 TN annual deficits have become integral to system Credit growth, inflating incomes, spending, and corporate profits throughout the economy.
Traditionally, such deficits would have evoked market angst and rising yields.
But the Fed's forceful use of its balance sheet for liquidity injections and market bailouts over this cycle momentously transformed how markets view deficit and debt risks.
For now, the current Credit expansion is impervious to Fed rate policy, bolstered instead by loose market conditions.
This powerful dynamic raises the level of interest rates required to restrain overall Credit growth, system financial conditions, and economy-wide demand.
The so-called “neutral rate”, at this stage of the cycle, is so much higher than today’s analysts and Fed officials have ever contemplated.
Of course, the Fed seeks to avoid breaking things.
But tossing the white towel in the face of loose conditions and accompanying runaway speculative Bubbles at this late-cycle phase shirks the Fed’s overarching responsibility for maintaining financial stability.
Today’s systemic propensity for loose conditions ensures a highly elevated “neutral rate.”
Further confounding analysts, this rate will also prove highly unstable and non-linear.
Tightened financial conditions and deflating speculative Bubbles will profoundly impact the stimulative effects of lower policy rates.
Look to the “pushing on a string” dynamic that is laying bare Beijing’s waning control over China’s faltering Bubble economy.
U.S. job openings (JOLTS) were back above nine million in December, 275,000 above estimates.
And while seasonal adjustments tend to be a little messy to begin the year, January’s booming 353,000 gain in Non-Farm Payrolls (along with December’s upwardly revised 333k) is hard to dismiss.
As is the 0.6% (double estimates) jump in Average Hourly Earnings, the biggest increase since January 2022.
An outsized January boosted y-o-y gains to 4.5%.
Powered by Meta and Amazon, the S&P500 gained 1.1% in post-jobs data Friday trading (Nasdaq100 up 1.7%).
Bonds were notably less sanguine.
Ten-year yields rose 14 bps, partially reversing earlier declines to end the week down 12 bps at 4.02%.
Two-year Treasury yields jumped 16 bps Friday to 4.36%.
It was another volatile week for the notably unstable MBS marketplace.
Benchmark MBS yields were down as much as 33 bps at the Thursday low, only for yields to reverse 26 bps higher in Friday trading to end the week a basis point lower at 5.50%.
Despite more strong data and Powell’s comments, the rates market still ended the week pricing a 22% probability of a March rate cut.
The policy rate is expected to decline 24 and 46 bps by the May 1st and June 12th FOMC meetings.
The market is pricing a 4.07% rate (126 bps of cuts) by the December 18th meeting, rising only eight bps this week.
Assuming March is a no go, the market is pricing five rate cuts between May and December.
There is nothing in the economic data suggestive of the need for aggressive cuts, and one would assume the Fed would prefer to avoid slashing rates into such a pivotal election.
This week’s developments and market dynamics corroborate the thesis that the rates market is not pricing typical rate policy dynamics as much as it is discounting the odds of the Federal Reserve forced into aggressive rate cuts.
February 2 – Bloomberg (Subrat Patnaik):
“Meta Platforms Inc. just became Wall Street’s top comeback kid…
The stock rose 20% Friday to close at an all-time high of $474.99 per share.
The gain added $197 billion to its market capitalization, the biggest single-session market value addition, eclipsing the $190 billion gains made by Apple Inc. and Amazon.com Inc. in 2022.”
February 2 – Bloomberg (Kurt Wagner and Spencer Soper):
“Meta Platforms Inc. and Amazon.com Inc. shares soared Friday after delivering quarterly earnings and outlooks that far exceeded Wall Street’s expectations…
Combined, their stocks added $336 billion in market value.”
With speculative melt-up dynamics much in play in U.S. equities this week, it is not unreasonable for the rates market to price odds of an eventual reversal and downside dislocation.
The big tech stocks are one historic “crowded trade,” with the same probably true for global levered speculation.
Bond markets could also be factoring in the possibility of disruptive geopolitical developments (the U.S. fired 135 missiles and bombs into Syria and Iraq this evening).
And it’s reasonable that bond and rate markets have a watchful eye on ominous Chinese developments.
The Shanghai Composite sank 6.2% this week, while other Chinese markets and indices were under even greater pressure.
The Shenzhen A Index was clobbered 11.1%, the small cap CSI 500 9.2%, the CSI Small & Midcap Index 7.9%, and the growth-oriented ChiNext Index 7.9%.
Hong Kong’s Heng Sang Index fell 2.6% (down 8.9% y-t-d), with the China H-Financials Index down 2.7%.
Confidence that Beijing has everything under control is starting to waver.
January 31 – Reuters (Tom Westbrook):
“China’s major state-owned banks were heavy sellers of dollars on Wednesday…, steadying the yuan as it came under pressure in currency trade as the economy remains shaky.
State banks often act on behalf of China's central bank in the foreign exchange market, but they could also trade on their own behalf or execute clients' orders.
One of the people said the selling was ‘very forceful’ to defend the yuan at around 7.1820 per dollar in the onshore spot market.”
Significant firepower is being spent to support China’s vulnerable currency.
Yet the renminbi declined 0.22% (offshore down 0.36%) this week to trade near the low back to mid-November.
It’s worth noting that most of the week’s loss came in post-payrolls Friday trading.
The vulnerable Japanese yen was hit 1.31% Friday.
UK 10-year yields jumped 17 bps Friday, with yields up near double-digits in Canada, France, Germany, Italy, Spain, Netherlands, Poland, Hungary, Turkey, Denmark, and Ireland.
Local currency yields were 32 bps higher in Colombia and 21 bps higher in Mexico.
Dollar-denominated yields were up 17 bps in Panama, 14 bps in Peru, 14 bps in Mexico and 14 bps in Chile.
Global bond markets are highly synchronized, keying closely off U.S. Treasuries.
“Risk on/risk off” is a global phenomenon.
At this point, it’s all just one big speculation, a highly levered one at that.
January 31 – Bloomberg (Alice Gledhill):
“European regulators are closely following a group of hedge funds with exposure to mortgage bonds and average gross leverage in excess of 2,000%, a position so large it risks impacting markets.
The funds predominantly are buyers in rising markets and sellers during a downturn, according to a… report by the European Securities and Markets Authority about the risk posed by leveraged alternative investment funds.
It’s an approach to trading that tends to compound market moves and can be an added source of instability.
The group represents as much as 15% of trading in the local mortgage-backed note market, the regulator said, without identifying which jurisdictions or specific funds.”
With global speculative dynamics in mind, I have no issue with the market pricing odds of “risk off” liquidity issues forcing the Fed (and central bank community) into aggressive rate cuts.
A surprising rise in Treasury yields would be problematic for fragile global markets.
As we witnessed Friday, a jump in Treasury yields can immediately spur a spike in MBS yields, along with outsized moves in vulnerable markets such as the UK (2-yr yields up 19 bps) and EM.
Higher Treasury yields also translate quickly into dollar strength.
The Dollar Index popped 0.9% on the strong payrolls data, immediately pressuring the vulnerable yen and renminbi.
Perhaps it was fear of higher Treasury yields and a stronger dollar triggering global de-risking/deleveraging that played a role in December’s “dovish pivot.”
January 29 – Bloomberg (Caleb Mutua):
“Blue-chip firms have sold $188.57 billion of bonds in the US in January, setting a record for the month, as companies look to take advantage of drops in longer-term borrowing costs.
The sales broke the prior record for January of around $175 billion, set in 2017...
And more sales are probably coming through the end of the month, Wall Street bond syndicate professionals said.
‘We could easily see $200 billion of sales this month,’ said Jonny Fine, head of the investment-grade debt syndicate at Goldman Sachs…”
The risk today is that financial conditions are much too loose and the markets much too speculative, while the U.S. economy enjoys significant momentum.
The Fed and speculative markets can ignore strong data and tight labor markets if they choose, while heightened risk at the fragile global “periphery” (i.e., China) supports lower market yields and looser conditions for us at the “core.”
It’s a problematic backdrop, one that exacerbates “Terminal Phase” Bubble excess, while increasing the likelihood of an inflationary surprise and raising the odds of a global de-risking/deleveraging outbreak.
A singular focus on current inflation readings is regrettably flawed central banking at a most critical juncture.
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