For three months, the bond market has flagged stabilizing inflation starting with the Fed’s first rate cut of 50 basis points (bps). The stock market continued to rally along its uptrend lines. In parallel, the Federal Reserve signaled its second thoughts about its benigas n projections for inflation in the September Summary of Economic Projections. The stock market failed to listen and even Fed fund futures insisted on forcing the Fed into a December rate cut. The Fed delivered that rate cut with a major caveat in the December Summary of Economic Projections: hotter forecasts for inflation and economic growth and an incrementally hawkish expectation for future monetary policy rates. Accordingly, the Fed finally got the stock market’s attention as the market essentially plunged from euphoria to oversold in one day.

Long-term yields continued to increase the day of the Fed decision and the following day. The iShares 20+ Year Treasury Bond ETF (TLT) sliced right through presumed support and closed right at the low for the year set in April.

I took profits on my latest round of TLT put options last week. I will not chase TLT down here. Instead, I will wait to fade the next relief rally.

Instructive Projections

The Fed’s changes were significant but consistent with the Fed’s smoke signals and the declines in the long-term bond market.

• 2025 PCE inflation of 2.3-2.6% vs. the 2.1-2.2% September projection
• 2025 federal funds rate of 3.6-4.1% vs. the 3.1-3.6% September projection
• 2025 GDP 1.8-2.2% vs. the September projection of 1.8-2.2%

Fed Chair Jerome Powell’s commentary during the press conference was instructive. Powell left no question that the Fed sees higher inflation ahead: “these median projections are somewhat higher than in September consistent with the firmer inflation projection.” He acknowledged that under-estimating inflation this year was a partial driver of higher 2025 expectations: this year’s projections have “fallen apart as we’ve approached the end of the year”. Yet, Powell also laid the foundation and rationale for keeping a bias toward easing. He pointed reiterated that the labor market is no longer contributing to inflationary pressures and its accompanying cooling has gone far enough. Moreover, activity in the housing sector has been “weak”. Accordingly, Powell claimed that “cuts will certainly help to support economic activity and the labor market while we can still make progress on inflation because policy is still meaningfully restrictive.”

I remain skeptical. Is current policy really “meaningfully restrictive”? In his opening statement, Powell declared “with today’s action we have lowered our policy rate by a full percentage point from its peak and our policy stance is now significantly less restrictive. We can therefore be more cautious as we consider further adjustments to our policy rate.” This claim only weakly translates into “meaningfully restrictive.” Moreover, financial conditions are now almost as loose as they have ever been since the pandemic per the Chicago Fed’s Adjusted National Financial Conditions Index (ANFCI).

Sure, as one reporter in the Q&A pointed out, “we haven’t seen much change in mortgages, auto loan rates, or credit card rates.” Still, the conventional measures of financial conditions are about as good as can be in the post-pandemic era. Thus, the Fed is walking a fine line between the fear of restoking firmer than expected inflation and a labor market that is noticeably cooling. In the middle, the stock market is pricing in a perfect resolution to this dilemma even with the current plunge.

Powell’s Inflation Narrative Still Rests With the Pandemic

At several points during the Q&A portion of the conference call, Powell offered his version of inflation’s recent history, its origins and drivers. I was surprised to hear him claim that the economy is still dealing with pandemic-related disruptions that are propping up inflation. Perhaps this was a thinly veiled attempt to excuse this year’s under-appreciation of inflation’s stickiness. Powell also blamed technical factors for inflation’s stickiness: the way housing rents are calculated, lags in the data, and “temporary factors like fluctuations in used car prices.” As usual, I turned a skeptical ear toward this narrative because Powell, as he consistently does, absolved the Fed of any responsibility in aiding and abetting inflation’s stickiness by keeping rates too low for too long. I reviewed the case for why the Fed should have raised earlier in “Why Monetary Policy Was Late In Responding to the Pandemic-Era Inflation Surge“). At least this year’s experience and the learning response suggests the Fed will be more circumspect. Victory over inflation is not quite at hand yet.

The Fiscal Wildcard

Circumspection and caution should be keywords going into 2025 and beyond given the uncertainties in fiscal policy. A deepening tariff war and significant tax cuts threaten the Federal Reserve’s fragile dance with inflation-fighting. The mix of opinions within the Fed are telling. In describing how individual Fed members incorporated fiscal policy risks into their forecasts, Powell responded that some members chose to try to estimate fiscal impacts, some chose to leave out fiscal impacts, and others chose not to indicate whether they included fiscal policy. That is quite a mix! Powell made it sound like people stubbornly constructed their forecasts. Anyway, this inconsistency means that the reality of fiscal actions could drive inflation estimates even higher and cause even greater caution at the Fed.

King Dollar

The U.S. dollar (DXY) was the big post-Fed winner. Fresh strength in the U.S. dollar drove the Invesco CurrencyShares Euro Currency Trust (FXE) to a new 2-year low. This breakdown sets up FXE to eventually retest the lows from 2022. Accordingly, I am finally fully on the strong dollar bandwagon. I also expect the stock market to struggle to hit new all-time highs while the U.S. dollar makes new highs.

Is the Invesco CurrencyShares Euro Currency Trust (FXE) ready to resume a downtrend that started in earnest during the financial crisis?

YouTube video of the December 18th FOMC Press Conference

Be careful out there!

Full disclosure: long SPY put spread

The post The Federal Reserve’s “Hawkishness” Finally Gets the Stock Market’s Attention appeared first on Inflation Watch.

Nevermind that a read hotter than consensus has little impact on the current trend. The chart below from the U.S. Bureau of Labor Statistics shows that even as core CPI (all items less food and energy) is flattening out a bit (the red line), the “sticky” shelter component of inflation is still hurtling downward (the purple line).

With the trend still favoring the death of inflation, I think of “sticky” as a reference to people’s impatience with an inflation component taking too long to converge with the overall average inflation level. The CPI report highlighted the relative stubbornness of shelter inflation:

“The shelter index increased 0.6 percent in January, and was the largest factor in the monthly increase in the index for all items less food and energy. The index for owners’ equivalent rent rose 0.6 percent over the month, while the index for rent increased 0.4 percent. The lodging away from home index increased 1.8 percent in January…The shelter index increased 6.0 percent over the last year, accounting for over two thirds of the total 12-month increase in the all items less food and energy index.”

The bubble chart below from the U.S. Bureau of Labor Statistics shows the outsized influence of services less energy services on total inflation (the large purple bubble). This major component includes shelter. Its relative importance of 60.9 dwarfs the relative importance of all other major components of inflation.

Given the angst directed at the shelter component of inflation, I looked at what the National Association of Home Builders (NAHB) had to say about this CPI report. The industry group provided a reassuring conclusion: “the NAHB forecast expects to see shelter costs decline further in the coming months.  This is supported by real-time data from private data providers that indicate a cooling in rent growth.” So while the housing price picture is mixed with existing homes on the uptick and new homes on the downtick, overall rents should continue a cooling pace as expected.

Unfortunately for those traders and investors buying stocks and bonds in anticipation of rate cuts, this reminder of inflation’s stickiness pushed out expectations for the first rate cut from the Federal Reserve. Over-eager financial markets pushed out the first rate cut from May to June. This is a bitter pill to swallow for those who started buying stocks and bonds late last year in anticipation of a rate cut in March (because the Fed admitted to inflation’s death of course). The chart from the CME FedWatch Tool shows how the odds favoring a May rate cut immediately evaporated.

The Fizzle and Sizzle in Financial Markets

Interestingly, currency markets and the bond market have been moving counter to the rallies in the S&P 500 (SPY) and the NASDAQ (COMPX). The 2024 rally in the U.S. dollar index (DXY) has taken the index ABOVE the point where currency traders dumped the dollar in the wake of inflation’s death. The chart below from Tradingview.com shows a bullish breakout for the dollar last month above its 50-day moving average (DMA) (the red line) and a successful test of the trend line as support earlier this month.

The dollar’s rally complicates my bullish trades on the Canadian dollar but also provides my latest opportunity to fade USD/CAD (Invesco CurrencyShares Canadian Dollar Trust (FXC)) within the trading range. I am net long the U.S. dollar by being short EUR/USD (Invesco CurrencyShares Euro Currency Trust (FXE)).

Excluding a sharp countertrend rally at the end of January, iShares 20+ Year Treasury Bond ETF (TLT) has sold off most of 2024.

These trends further reinforce the notion and fear that perhaps earlier rate cut expectations were indeed premature. After the market’s pullback (the S&P 500 lost 1.4% and remains in an uptrend) will stocks also concede the point or will they return to ignoring deteriorating market breadth and other signs of caution in the stock market?

The volatility index (VIX) may have already blown off enough steam to soothe the groans of the bulls…for now. Note carefully how the VIX stopped going down this year and thus has an ever so slight uptrend going…

Be careful out there!

Full disclosure: net long U.S. dollar

The post From Inflation Fizzle to Sizzle appeared first on Inflation Watch.