US Strategy Weekly: Fed Counterpoint

The CME FedWatch tool suggests there is a 99% chance that the Fed pauses this week and a mere 31% chance for a Fed rate hike in November. This makes sense since the UAW strike does not seem to be ending soon, the writers’ strike has been ongoing since May 1, and although over 800,000 student loan borrowers received forgiveness under the IDR Account Adjustment, for the first time since March 2020, millions of borrowers will soon get a notice to restart student loan payments in October. These three items will dampen economic activity, along with the fact that the impact of fiscal stimulus packages are waning, and a government shutdown looms in the background. A final reason to expect a pause this week is that Federal Reserve Chairman Jerome Powell has never surprised the financial community with a non-consensus rate hike.

Still, we believe the Fed could, or should, raise the fed funds 25 basis points this week since monetary policy has been persistently behind the curve in terms of fighting inflation. Not only did the Fed postpone raising rates in all of 2021, implying that inflation was “transitory”, but the real fed funds rate only became positive, net of inflation, in April 2023, or roughly five months ago. In other words, monetary policy has been easy and feeding an inflationary cycle for a very long time. This is likely to make inflation more difficult to curb.

Is It Different This Time?

Typically, a Fed tightening cycle ends only once the real fed funds rate reaches a positive 400 basis points. See page 3. With the fed funds rate currently only 200 basis points above the PCE index (July) and 170 basis points above the CPI rate (August), the end of this cycle appears to be several rate hikes away unless inflation suddenly falls. A real decline in inflation appears to be a long shot, in our view, particularly with crude oil on the rise. Keep in mind that on a year-over-year basis, WTI crude oil has been negative every month of this year, a factor that has helped headline CPI decline from 6.4% YOY to 3.3% YOY in the same timeframe. See page 4. For example, fuels and utilities were down 1.2% YOY in August. See page 5. But at the current level of $91.66, WTI is up 15% YOY and gasoline futures are up 8% YOY. In other words, the benefit from falling energy prices, which has helped cool inflation this year, is disappearing and this may become much clearer with September inflation data.

It should be obvious to economists and investors that inflation will be difficult to tame, even if energy prices were not rising. A warning was already visible in August data. After 12 months of decelerating inflation in the CPI, and after 8 months of negative YOY pricing in crude oil, both trends are beginning to reverse. The CPI rose 3% YOY in June, 3.2% YOY in July, and 3.7% YOY in August. The PPI for finished goods was 2.2% YOY in August, the first positive YOY gain in four months.

Some economists had been pointing to the fact that the biggest driver of the CPI was owners’ equivalent rent of residences, and that the OER was an outdated and overstated method to measure housing. But as seen on page 5, it is the service sector and not housing that is the current inflation problem. Other goods and services saw prices rise 0.4% MOM and 5.8% YOY. In addition, while fuels and utilities fell 1.2% YOY in August and helped lower headline CPI, it also rose 0.6% month-over-month, which was more than the CPI. This is a negative sign for future CPI reports. Therefore, if the Fed agrees that inflation will be sticky, it would be appropriate to raise the fed funds rate by 25 basis points this week.

Of course, it could be different this time, and the Fed might be able to maneuver a soft landing for the US economy without completing a full monetary tightening cycle and still manage to get inflation to cool back to the 2% level. But the odds seem slim, particularly since the crude oil futures chart shows little resistance between current prices and $100 a barrel. In short, higher energy prices are one item that could upset the consensus, the stock market, and monetary policy.

On the Horizon

It is more likely that other things could upset the market. The Department of Justice’s hearing into Google’s (Alphabet Inc. – $138.83) search engine is the first antitrust case in decades. The results of this could easily impact large capitalization technology companies. China’s property developer, Country Garden Holdings Co. Limited (2007.HK – 1.01 HK), is facing a deadline this week to pay $15 million in interest for an offshore bond. Plus, the long-standing inversion in the yield curve always poses problems to the finance sector, as the series of bankruptcies in March warned.

There are signs of weakening in the economy. August’s retail sales growth was above expectations, but beneath the surface the details were less strong since the excess growth came entirely from gasoline stations, and prior months were revised lower. Consumer spending is shifting back from goods to services, with restaurants being the fastest-growing segment over the last year. Inflation continues to be a problem eating into consumer incomes and higher interest rates make purchasing big-ticket items on credit more expensive than consumers had been accustomed to. When adjusted for inflation, retail sales have been negative on a year-over-year basis for the last seven consecutive months. This is a typical sign of a recession. See page 6.

The University of Michigan consumer sentiment survey fell in August for the second consecutive month. The weakness in the survey continues to be found in present conditions and is likely due to the rise in energy and gasoline prices. Conversely, a separate University of Michigan survey on consumer inflation expectations fell early in September. Neither the Conference Board nor NFIB business surveys have released September data, but both were lower in August. See page 7.

Technical Changes and Review

The market has been in a consolidation phase this week and in all three indices the near-term trend appears indecisive. Perhaps the most important event is that the Russell 2000 index is currently trading below its 200-day moving average. This could be a sign that the other indices will also test their 200-day moving averages in the weeks ahead. However, the longer-term pattern remains unchanged and is characteristic of a long-term neutral trading range. See page 9.

The 25-day up/down volume oscillator is at a negative 0.79 reading this week and relatively unchanged in recent weeks. It is at the lower end of the neutral range, and also indecisive. See page 10.

The 10-day average of daily new highs is 81 and new lows are 123 this week. This combination is now negative since new highs are below 100 and new lows are above 100. The NYSE advance/decline line fell below the June low on September 22 and is 26,543 net advancing issues from its 11/8/21 high. In sum, the trading range, best defined by the Russell 2000 index between support at 1650 and resistance at 2000, remains intact.

Gail Dudack

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