Re: Inflation/USD/Oil - From Ripping Dots to Dipping Dots?
Since the December Rhetorical Pivot, the market has taken the 3 Dovish Dots from the FOMC and extrapolated 6-8 Rate Cuts from it. Is that realistic? I say NO.
Since the December Rhetorical Pivot, the market has taken the 3 Dovish Dots from the FOMC and extrapolated 6-8 Rate Cuts from it — what I call the Ripping Dots (Ripping away from current baseline Fed Funds Rate).
Is that realistic? I don’t think so.
In fact, I think there is a very good chance of the Fed disappointing on the 6-8 Cuts and a decent chance of the Fed disappointing on even the 3 telegraphed cuts as the data force them to retract their prematurely Dovish stance and jawbone Dipping Dots (Dipping back towards the current baseline Fed Funds Rate).
My Macro View: The Next Decade Won’t Be Like The Last Several Decades
We’ve been in a “Low Inflation/Low Unemployment” Utopia since the mid-90’s due to a combination of High Productivity Growth and a once-in-a-lifetime Demographic Dividend from China in terms of exporting its Labor Deflation.
Although I believe that the Deflationary effects of technology-enabled Productivity Growth are likely to continue, I think they will be countered by Intrinsic and Extrinsic Structural Inflation:
Intrinsic Structural Inflation comes from US Demographics that might be contributing to sticky Labor and Shelter Inflation.
Extrinsic Structural Inflation stems from the reversal of China’s once-in-a-lifetime Demographic Dividend.
Both Intrinsic and Extrinsic Structural Inflation are well-covered in this summary of an event I hosted last year, featuring Peter Zeihan as keynote. I don’t agree with many of Peter’s hyperbolic calls, but I do think he has done good Demographic work. Take a look:
If you buy into my arguments that Intrinsic/Extrinsic Structural Inflation will keep Core Inflation much stickier than the Fed expects, then we must be open to considering the possibility of the “Higher Inflation / Higher Unemployment” Dystopia — polar opposites to the “Low Inflation / Low Unemployment” Utopia we are all used to.
Since 2008, we’ve been in this “YOLO” period of very low Real Rates, and now that we’re at a mildly restrictive 1.69%, the markets are clamoring for 6-8 cuts this year even though the Fed has not yet been presented the dilemma of choosing between its dual mandates of Fighting Inflation (what they call Price Stability) vs. maintaining Low Unemployment.
To top that off, the December Rhetorical Pivot has massively eased Financial Conditions, sending markets to all-time highs, and we’re not even talking about the Red Sea shipping disruptions contributing to spiking Freight Rates.
Also notably absent from every FOMC meeting has been a discussion of the longer-term impact of the waves of Labor Strikes spanning multiple industries that have locked in 30-40% wage increases.
Core Inflation is still running at an annualized 3.9% — almost twice the long-term Fed’s long-term target. The last thing the Fed needs to do right now is to embark on an aggressive easing campaign to goose Aggregate Demand into all of these factors.
I’ve written at length about the Four Horseman of US Economic Resilience, and all of these factors are making the US Economy way too strong for the Rest of the World (“RoW”):
This visual shows in stark relief the difference in GDP Growth among the G7. Note in particular Germany’s underperformance — more on this later.
I believe that the Fed’s bogey for easing is much higher than in past periods because to cut means to start an EASING CYCLE — it’s a PACKAGE DEAL.
The post-December euphoria showed that markets expect this, and the Fed knows this. Therefore, I believe the Fed must overcome the inertia of committing to at least 3-4 cuts before starting the cycle.
The Fed does not want to repeat the mistake of the 1970s, and a Stop/Restart would be disastrous:
I don’t buy the arguments that Jay Powell is political. Janet Yellen, being a member of Biden’s Cabinet, certainly is a political animal, but Jay Powell showed his colors during the latest FOMC, when he deflected a question about whether he wants to be reappointed and reemphasized that “they have a job to do, and they’re going to do it”:
What Would Change The Fed’s Mind: Credit Contagion
The main thing that would change my view, but more importantly the Fed’s view, is if we became embroiled in another Credit Contagion. The Fed doesn’t worry so much about rescuing swooning Stock Markets as it does rescuing Credit Markets that are seizing up. So far, there are no signs of either.
Don’t get me wrong. It’s not lost on me that there are pockets of pain, but that brings me up to the Bifurcation of the US Economy into Haves and Have-Nots:
Haves: Generally unlevered owners of Assets
Have-Nots: Highly levered sectors/consumers exposed to floating-rate risk, those in the lower/middle-income tiers who are living hand-to-mouth and still struggling with 3 years of compounding Inflation
On this last note, remember that there is a big difference between Deflation (declining First Derivative of Price) and Disinflation (Declining Second Derivative of Price):
Despite these signs of Credit deterioration in the Have-Not buckets, I see few signs of broad Credit Stress (beyond highly levered CRE players and smaller Regional Banks, for instance).
Here are some sanguine data points on Credit from speaking to the largest manager of CLO Equity:
LTM Default Rates for Senior Secured Leveraged Loans is at 1.5% (roughly half the long-term average), which is a pretty surprising result when Risk-Free Rates have risen so far so fast and dominate the overall Risky Yield of a floating-rate loan.
Private Credit is now a $1.6T market with only $1T deployed, which means that there is $600B of dry powder waiting to refinance — even when Corporate America is already less rate-sensitive than RoW (Horseman #3).
Although there are some signs of slowing growth, borrowers in general have benefited from the same Fiscal Horseman that I’ve written at length about.
The Senior Unsecured High Yield market remains at all-time tights in terms of Credit Spreads, although there are some topping patterns in the HYG ETF:
Remember Horseman #3 from my Four Horsemen of US Economic Resilience — Relative Rate Insensitivity on the part of US Consumers & Corporation? This stunning chart, courtesy of Nicholas Glinsman and Harald Malmgren, really drives this point home. I am certain this has a lot to do with broad US Credit Market ebullience despite the pockets of aforementioned stress.
Finally, the recent SLOOS (Senior Loan Officer Opinion Survey) data show a significant LOOSENING of lending standards:
The Dry Tinder Mental Model
The Fed is in a box because of the Intrinsic/Extrinsic Structural Inflation — another way to think about this is that these factors serve as Structurally Inflationary Dry Tinder.
What are the sparks that could re-ignite that Dry Tinder?
Oil (like what happened in 2021 and early 2022)
Shipping Rates (happening now from Red Sea disruptions)
Labor Strikes (possibly setting off a Wage-Price Spiral)
Premature Easing Cycle (we are already seeing the lagged effects of the loosening of Financial Conditions)
If the Fed does make the mistake of aggressively easing too soon, the Long End of the Yield Curve could lose confidence in the Fed’s ability to contain Inflation —the same way it did in 1982:
Extrinsic Risks Outweigh Intrinsic Risks
There is an even bigger Bifurcation going on when you consider the GLOBAL Economy, and that is the Bifurcation between the Intrinsic Risks within the US Economy vs. the Extrinsic Risks outside of the US Economy.
US Economic Resilience presents a conundrum less for the Fed and more for the CBs of the RoW, whose economies don’t share the same Four Horsemen of Economic Resilience. In other words:
Intrinsic/Extrinsic Structural Inflation + US Economic Resilience → less Intrinsic Economic Risks at home and more Extrinsic Economic Risks for RoW due to a Fed that will likely be trapped into H4L (“High For Longer”) Mode.
I have been saying this for over a year now, but I still believe ECB will blink before the Fed, because of the relative fragility of the EU Economy:
Again, look at the largest component of the EU Economy, Germany:
Implications for the USD Wrecking Ball and Rest of the World (RoW)
This suggests that the USD Wrecking Ball continues to wreak havoc in weaker economies outside of the US.
Stage 1 of the USD Wrecking Ball came from the Fed Out-Hawking RoW in 2022.
Stage 2 of the USD Wrecking Ball potentially comes from the RoW Out-Doving the Fed in 2024-2025.
This is particularly problematic for smaller Emerging Market economies that do not have FX Swap Lines with the Fed. Witness Egypt:
When I tweeted this anecdote from my visit last April, the USDEGP Black Market Rate was around 35:1. It is now 70:1.
It’s also a problem for large economies that happen to be Geopolitical Antagonists to the US that also don’t have FX Swap Lines with the Fed — like Russia and China.
CNY Devaluation is the biggest potentially DEFLATIONARY countervailing force (again, disproportionately to RoW ex-China than to US), which I wrote about last March, even as the world was focused on the more provincial issues of the US Regional Banking Crisis:
With China’s economy in free-fall and its Real-Estate Bust potentially metastasizing into Credit Contagion, China’s financial authorities are truly stuck between the choice of bailing out its economy vs. preventing a disorderly CNY Devaluation:
Oil: The Global Canary in the Coalmine
I have been bearish Oil since April, 2022 and continue to think that its role as the Global Canary in the Coalmine is a TELL that the Extrinsic risks to RoW overshadow Intrinsic risks due to these economic divergences that will force the Fed’s H4L Monetary Policy to be enforced GLOBALLY through a strong USD:
Why doesn’t US Economic Resilience support Oil Demand? It does, but US Oil Demand alone can’t hold up Oil if RoW’s Oil Demand falters. Because Oil is a GLOBAL Commodity, US Economic Strength ironically spells trouble for RoW’s Demand:
It’s important to watch all Global Procyclical Commodities, because they are all similar Tells of US Economic Resilience leading to disproportionate Extrinsic Risks to RoW:
Ripping Dots → Dipping Dots
Due to all of these factors, I think the dovish Ripping Dots as a result of the premature Rhetorical Pivot in December will wind up becoming more hawkish Dipping Dots as the Fed Mixologist contends with way too much Red-Bull in this Vodka/Red-Bull Economic Concoction:
How about this for a shock on a quiet Friday — RBNZ returned to HIKING after a pause. A couple observations:
RBNZ has historically LED the Fed.
New Zealand doesn’t even have the Four Horsemen of US Economic Resilience going for it.
To conclude, here are my Fed Rate Cut Odds for 2024:
10% chance of 6-8+ Cuts
30% 3-5 Cuts
45% 1-2 Cuts
10% chance of 0 Cuts
5% chance of additional HIKES
Barring a Credit Contagion, the economic data will force the Fed to jawbone Dipping Dots of Rate Cut Expectations, in my opinion.
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