Although markets were more than 90% certain that the Fed was done raising rates, both stock and bond markets were surprised that the hawkish stance that had prevailed for 18 months had completely disappeared. We were surprised too! Chairman Powell's moderate policy statement and demeanor complemented each other. In our opinion, most of the Fed meeting was devoted to the question of what the rate cutting cycle should look like and at what frequency. Apparently the Fed is now reading from the same song as the markets regarding the inflation devil. So officially the inflation war is over and the inflation opponents have been defeated. And as we predicted in our September 22 blog, “Higher for Longer” did indeed prove to be “temporary.”
Interest rate for 10-year government bonds
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The market reacted quickly on both the stock and bond markets. The S&P 500, already near an all-time high, rose 1.4% on Fed Day (Wednesday, December 13) and bonds staged a huge rally, as seen in the 10-year bond chart. Treasury, whose yield reached 5% just two months ago. It closed at 3.915% on Friday (December 15) and is on the way down in our opinion.
Last Tuesday (December 12), a day before the Fed meeting, the probability of a rate cut at its March meeting was 40%. At the close on Friday they were at 70%. The Fed’s Survey of Economic Projections (SEP), better known as the “dot plot,” is published quarterly. The report released after the most recent meeting showed an average Fed funds rate of 4.625% at the end of 2024, a decrease of 75 basis points from current levels (i.e. three rate cuts of 25 basis points each) and a decrease of another 100 basis points ( four reductions). 2025 to 3.625% and then to 2.875% (3 further cuts) by the end of 2026 (see graphic). And that assumes a soft landing for the economy (i.e. no recession). Of course, rate cuts will be faster and likely at the 50 basis point level when the recession comes.
Dot plot (December '23)
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What led to such an unexpected turn of events? We believe the reality of the rapid pace of disinflation has finally set in, as we have discussed in our blogs over the past few months. Additionally, as Rosenberg Research noted, the Fed's “Beige Book,” a quarterly survey of business conditions in each of the Federal Reserve's 12 districts, said that eight of the 12 districts reported either no growth or actual declines, a result that was even worse as Beige Book reports in the run-up to the 2001 or 2008 recessions.
In the post-meeting press conference, Chairman Powell's demeanor was anything but combative. While he left himself and the FOMC out of the way in the event of a spike in inflation, he acknowledged that the Fed's rate-hiking cycle was likely over and that the Fed's next move would be a rate cut. Again, he did not provide any indication of when the first rate cut would occur, but as noted above, market odds show a 70% probability that the first rate cut will occur in March. If history is any guide, the average number of months between the first pause and the first rate cut is nine. March is the eighth forward month (close enough for government work!).
Inflation – CPI
Inflation data played a key role in this. Both CPI and PPI reports were released this week and both supported the view that inflation has been overcome. Although the Consumer Price Index (CPI) is still elevated year-on-year (3.1%), it actually shows some signs of deflation, particularly on the goods side. The table shows the annualized inflation rate for various periods over the past year.
Annualized inflation over recent periods
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Note that inflation has cooled rapidly over the past three months. This is a key factor in the Fed's move toward dovish monetary policy and in the bond market's assessment of when the Fed will cut interest rates for the first time. To show how widespread falling prices are, the next table shows price changes for the month of November for selected goods and services, examples of the disinflationary (deflationary) environment the economy has entered.
Changes in the price of goods and services
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Inflation – PPI
The producer price index, a leading indicator of future CPI results, was at a non-inflationary 0.0% in November. In October the value was -0.4%. Year-on-year, the PPI only grew by +0.9%. If one looks at PPI elements similar to those in the CPI, one would find that the value in November was also 0.0%, after registering a value of -0.6% in October.
Inflation overview
The war against inflation appears to have been won! We even see this in the oil price (left chart), which is currently hovering around $70/bbl. level (closed at $71.79 on Friday). It is well below its $93/bbl. Peak in September-October, with interruptions in Russian oil deliveries to the West and the discussion of further production reductions by OPEC+.
world as a whole)Universal value advisors
One reason the price could fall was that the production losses were partially absorbed by US operators (right chart above). Note that U.S. production has been rising for some time, including during the peak of oil prices in September and October. Based on these factors, it appears that most of the sharp drop in oil prices is due to falling demand.
Even the prices of food and used cars, two poster children of this inflationary plague, are falling.
Food Price and Used Car Index
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The rental price index is gradually declining
Bureau of Labor Statistics, Housing List
Other observations
The rent problem: The CPI was driven up by the problem of declining rents. But the further we get into 2024, the lower rents will be. As mentioned in previous blog posts, accommodation costs are only a third of the CPI, but lag behind by 12 months. In other words, the current CPI is based on rents from a year ago. In the chart above, the purple line shows the true picture of rents (-1.1% in November) and how quickly they fell. The blue line is the rent figure used by the Bureau of Labor Statistics (BLS) in CPI calculations (7.2% in October) and the red line is the resulting CPI (3.2% in October).
By mid-2024, the CPI protection component will approach negative territory. And once it's there, it's likely to stay, if only because of the record supply of new homes coming online.
Almost 1 million apartments are under construction
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According to Rosenberg Research, the flawed shelter methodology used by the BLS increased the overall CPI by 220 basis points. This means the CPI would currently be under 1% if accurate, current rents were used. So it's no wonder the Fed has taken an expansionary stance!
Banks – Lending and Defaults: The US economy thrives on credit. The left side of the chart below shows that banks have stopped lending, meaning commercial and industrial loan balances are the same as a year ago. The right side shows that consumers have run out of gas. Note the steep rise in defaults. No lending; Rising defaults – a formula for banking problems and an economy that comes to a complete standstill without the necessary flow of credit.
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Final thoughts
The Fed has finally realized that inflation is dead. The November CPI and PPI reports summed this up. The speed at which interest rates are lowered depends on the state of the economy. The next Fed meeting will take place in March. Then, in our opinion, the first interest rate cut will occur. We have been in this position for several months; Nice to see that the markets have caught up (70% chance according to Bloomberg).
There are too many companies announcing layoffs – it seems like every day there is another big layoff announced. Challenger, Gray and Christmas data on layoffs and job vacancies were negative. While retail sales surprised slightly positively in November, Johnson Redbook same-store sales were fairly negative, so we expect November retail sales to be revised downward when December sales are announced in mid-January. Additionally, retailers hired far fewer seasonal workers than usual and we believe this is a prelude to disappointing holiday sales.
We still see 2024 as a recession year!
Merry Christmas and Happy New Year to all our readers!
(Joshua Barone and Eugene Hoover contributed to this blog)
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Robert Barone, Ph.D. is a Georgetown-educated economist. He is co-portfolio manager of UVA's Fixed Income ETF (Symbol: FFIU). Robert is also a Managing Director and Financial Advisor at Farther Finance Advisors, LLC (“Go Farther!”). Known nationally for his writings, Robert's storied career includes serving as a professor of finance, CEO of a community bank, director and chairman of the Federal Home Loan Bank of San Francisco, director and chairman of CSAA Insurance Company (the AAA brand), and Director of the AAA Auto Club of Northern California, Nevada and Utah Robert is currently a director of Allied Mineral Products (Columbus, OH), America's leading refractory company.
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