Valetta declared “recent data suggest that inflation may have peaked.” The latest inflation projection shows a gradual decline toward the Fed’s 2% average goal around 2025 or 2026. Valetta cautions that “repeated upside surprises” to inflation mean that “the risks to this forecast [are] weighted to the upside.” In other words, we should expect the Federal Reserve to keep its interest rate higher for longer in order to ensure inflation’s glide path stays pointed downward. The graph below shows the recent peak and successive higher forecasts for inflation since March.

After on-going upside revisions, PCE core price inflation is now expected to approach the 2% target somewhere around 2025. (Source: Federal Reserve Bank of San Francisco)

The cost of peaking inflation is slower growth. Valetta expects “growth to remain well below trend this year and next year before converging back to trend in 2025.” Conveniently, that return to trend occurs just as inflation returns to the Fed’s target. Most importantly, Valetta points to a mere one percentage point increase in unemployment “through 2024.” This expectation means that the onset of a recession next year will create a mild economic slowdown. Today’s unemployment rate is still near the historic low of 3.5%. Unemployment below 5% is surprisingly low for a recessionary environment. The high job vacancy rate softens the economic blow of slowing growth as there is plenty of room to cool off labor demand without disrupting the labor market.

Valetta acknowledged that the inversion of the yield curve suggests that odds are high for a recession: “such yield curve inversions have proven historically to be reliable predictors of recessions over the subsequent 12 months. After some divergence earlier this year, two leading measures of the yield spread have now both become inverted.” However, Valetta does not want readers to decide that a recession is a foregone conclusion: “their predictions come with substantial statistical uncertainty, however, and are not definitive indications that a recession is looming.”

Inverted yield curves have preceded recessions since the late 1980s. (Source: Federal Reserve Bank of San Francisco)

The Fed’s success in fighting inflation has come from a “proxy funds rate” that is much higher than the effective funds rate. According to the SF Fed, “this measure uses public and private borrowing rates and spreads to infer the broader stance of monetary policy.” The gap between the proxy and effective rate is higher than ever. No wonder Fed Chair Jerome Powell can so comfortably reiterate that the Fed can now slow the pace of rate hikes.

With peak inflation finally here, traders and investors should focus on how long the Fed intends to keep a restrictive stance on monetary policy. Given the extended period over which the Fed expects above target inflation, monetary policy should remain restrictive for longer than the market currently expects. In turn, the implication for the stock market of restrictive policy and below trend growth means valuations must come down further and cap upside in market returns for 2023 and perhaps 2024. Time will tell of course.

The S&P 500 (SPY) is out of bear market territory and now trying to fight its way through restrictive monetary policy.

Be careful out there!

The post The Fed Plants A Flag On Peak Inflation and An Economic Soft Landing appeared first on Inflation Watch.

ARK Invest’s Cathie Wood has opposed the Federal Reverse since at least the time the U.S. central bank first hiked rates above zero. Just three weeks after the Fed’s first interest rate hike, with more promised, Wood warned the Fed was making a mistake. On April 2nd, Wood jumped on a market signal from the inversion of the yield curve to underline the point.

The inversion barely lasted 2 days. The yield curve quickly “reverted” for the next 3 months and threw wrenches into the prognostications of a Wall Street looking for a recession to stop the Fed in its tracks. The yield curve inverted again in early July and has yet to look back. Yet, the Fed has become increasingly hawkish even in the face of this traditional signal of a recession. The Fed’s resolution was epitomized by a curt speech at Jackson Hole where Chair Jay Powell stood resolute on the Fed’s inflation fighting mantra.

So it is no surprise that Wood recently opened a new salvo in her campaign against the Fed’s monetary policy by writing an “open letter to the Fed” to extend her latest criticism in her videocast “In the Know.” In this letter, Wood warns that the Fed is overly focused on lagging indicators from inflation and employment and cannot see the “deflationary bust” that awaits the other side of its aggressive monetary tightening. In many ways, a deflationary bust has already occurred in financial markets. For example, Wood’s flagship fund The ARK Innovation ETF (ARKK) is just a “day’s trade” away from returning to its pandemic lows. Those sudden March, 2020 lows came on the heels of an economic and market crash that was full-force deflation until monetary and fiscal stimulus saved the day.

A Deflation Is Already Here

In other words, the deflation that Wood fears has already unfolded in certain financial markets. That pain is felt by anyone invested in the stock market. That pain runs even deeper for those speculating in the companies uncomfortably jostling around in the collection of ARK funds. However, Wood’s letter does not point to prices in her funds. Instead, the letter relies on a series of economic readings showing peak prices and subsequent declines for gold, silver, lumber, iron ore, DRAM, shipping, copper, corn, oil, and container board. The letter points out the ballooning inventories at major U.S. retailers and elements of employment data that show the first signs of a hot labor market finally beginning to cool.

All this complaining across Wall Street and all these data of course beg the question: why is the Fed ignoring it all? However, I think this question is misplaced. For example, Mary Daly, head of the San Francisco Fed, insisted that the Fed is forward looking. She even scolded the market is wrong in expecting rate cuts in 2023. The Fed has hundreds of economists on staff, including the ones who help to curate the charts from the St Louis Fed that I used to show the yield curve inversion. They know everything and more than the economists who get all the attention in the media. So I think it is a stretch to conclude that the Fed has no idea what is going on.

Why the Fed Won’t Read Cathie Wood’s Letter: Speculating on the Fed’s (Unstated) Strategy

Instead, I look to the larger, strategic context. The Fed kept rates too low for too long: the mania in the housing market and stratospheric valuations of profitless companies (again, see the ARK Funds) are sufficient evidence that the Fed should have started the journey toward normalization earlier. Moreover, the Fed has a massive $9 trillion dollar balance sheet that represents a considerable share of the $20 trillion U.S. economy. My guess is the Fed is not hearing the whispers of the famous inflation fighter, former Fed Chair Paul Volcker. Instead, the Fed recognizes the layers of distortions it helped to create in the economy, and it desperately wants to hit the reset button. From the purview of neutral to slightly restrictive policy, it can THEN observe the impact and assess whether the economy can sustain the resulting damage. I also guess that the Fed fully recognizes that the very minute markets sniff a peak in monetary tightening, speculative forces will roar away. Just watch what happens to the ARK Funds in that moment. Indeed, when Wood expected the Fed to cry uncle in July, she anticipated a vindicating resurgence in the ARK Funds.

In this environment where financial markets have become accustomed to easy money and have little experience dealing with inflationary pressures, the Fed is forced to err on the side of being aggressively hawkish as long as it dares possible. The Fed needs to make sure that when the time comes to pause and observe, little to no inflationary embers are left smoldering, ready to reignite with the giddy anticipation of easy money days to come again. As long as employment remains robust and resilient, the Fed can maintain political support for its actions even as support from market participants plummets. The rush to get to neutral or past neutral is likely exactly because the employment window cannot remain open to the Fed for an extended period. The Fed’s actions suggest a strategy for finishing hikes by the time the labor market’s weakness is obvious through an uptrend in the unemployment rate. The Fed has shown itself unmoved by losses in financial markets. So, pundits can throw all the macroeconomic tomatoes they want, the Fed is in over-correction mode for now.

Clinging to the ARK

When the bottom fell out of the ARK Funds, I updated my technical assessment and trading strategy on each of the major funds. I continue to think that the technicals are much more important than the fundamentals here. While the inverse correlation between interest rates and ARK performance is fundamental (surely much to Wood’s chagrin), the technicals of trend-following are sufficient for making trades. At some point, rates WILL peak. I contend the technicals (of trading on extremes) will actually become even MORE important then. Who knows what will be left standing in the ARK funds by that point…

Be careful out there!

Full disclosure: long ARK

The post Why the Fed Won’t Read Cathie Wood’s Open Letter appeared first on Inflation Watch.