Surface Tension

Current Backdrop

The position of the Federal Open Market Committee (FOMC) impacts the market’s direction. FOMC members two weeks ago struck a hawkish tone, but last week, another group on the committee that determines interest rates sounded dovish, suggesting three interest rate cuts are coming this year. When a Fed official is hawkish, they want tighter monetary policy, which will translate to fewer interest rate cuts this year. Leaning dovish means the central banker is biased toward a loose monetary policy, preferring to lower the federal funds interest rate target more aggressively.

The critical issue for the markets is how the majority of FOMC voters perceive the future path of inflation and their expectations for wage growth, employment and retail spending. Weakness in the majority of those economic factors will create confidence to cut rates sooner. Because investors are counting on those rate cuts, stronger data will paradoxically result in a market selloff. Conversely, weaker data, as we saw on Friday, results in higher stock prices.

Last Week’s Major Stories

Inflation Steady, Spending Weak, Delinquencies High

The Fed’s favored inflation measure, the Personal Consumption Expenditures (PCE) Deflator, reflects changes in the prices of goods and services. Last week, January’s PCE Deflator rose 2.4% for the year, matching expectations and continuing the downward trend in annual inflation readings. However, what most analysts missed was that 20% of the components that are used to compute the inflation number rose by more than 10% and almost 40% rose by more than 5%. The total percentage of goods and services comprising the PCE inflation basket that exceeded 5% was 58%, the highest level in a year. The report also showed that real spending—adjusted for inflation—fell 0.1% last month, and a separate report showed credit card delinquencies hit a 12-year high due to record-high interest rates. Therefore, as the stock market is hitting all-time highs on hopes that the Federal Reserve will cut interest rates due to lower inflation, underneath the surface, inflation pressure is building. Furthermore, the economic data that drives the future consumption that forecasts future corporate profits may be turning in the opposite direction. This adds up to a potential negative surprise in the making for equities.

Fed Speakers This Week Reversed Last Week’s Hawkishness

New York Federal Reserve President John Williams, a permanent Federal Open Market Committee (FOMC) voter, recently gave a speech titled “There and Back Again.” In it, Williams compared inflation’s path (PCE rose to 7% and then fell to 2.5%) to going to the moon and back. He summarized that the case for the Fed’s rate path expectation, three more interest rate cuts, still matches the FOMC’s rate forecast from last December. That forecast will be updated at their March 20 meeting.

William’s tone reversed last week's message from FOMC voters who discussed delaying rate cuts. William’s message was echoed the following day by two more FOMC voters. One of them, Atlanta Fed President Raphael Bostic, summed up this week’s view: he was thinking of delaying rate cuts until December 2024, but “the accelerated decline in inflation” has moved his timetable forward to the June or July Fed meetings. This optimistic talk runs counter to what small businesses are reporting. The National Association of Independent Business survey polls small businesses, and its latest report shows they plan to raise prices over the next three months. When that happens, it usually signals a renewed increase in the official inflation data. If PCE starts to turn up, the Fed is going to have to switch gears, and that would be a major disappointment for bond and stock investors.

Bitcoin Sees Record Inflows, Beating Bonds and Stocks

Bitcoin, which had rallied in anticipation of the first exchange-traded funds (ETFs) based on Bitcoin, continued its rise in the new year. It is now close to the $65,000- $69,000 record high region recorded in 2021. The inflows are enormous. Blackrock’s Bitcoin ETF (called IBIT)  saw stock investors add $520 million last Tuesday, the largest daily inflow across any of the newly launched ETFs. Bank of America reported that for the week ending February 28, crypto funds attracted $39 billion investor inflows, compared to $14 billion for bonds and $10 billion for stocks. That is a major imbalance between Bitcoin and the traditional asset markets. People put that type of money into an asset when they are expecting huge profits in the future. While that doesn't mean they are wrong, this is an overheated market where some caution is warranted.

This Week’s Developing Storylines

1. The chairman of the Federal Reserve, Jerome Powell, speaks to Congress on Wednesday and Thursday, and if he repeats last week’s message expecting three rate cuts sooner than later, he will spark another stock market rally. If he is more cautious, stocks could reverse hard on the downside. Friday March 8th, the nonfarm payroll report will be released. Because the Fed speakers mentioned above said they are focusing on labor strength in general, and wage inflation in particular, any surprises will move the stock, bond, currency, and commodity markets. Wage inflation is measured by Average Hourly Earnings growth. If it rises for the third consecutive month above a 4.8% annual increase, it will introduce anxiety about wage inflation, and quickly change expectations for the Fed cutting interest rates this summer, resulting in lower stock prices. 

2. Congress has another deadline for this Friday in the continuing budget debate. The fact that it passed the first 6 of 12 spending bills last week is an encouraging sign for the remaining negotiations. The markets do not expect a government shutdown, which would occur if this next round of discussions fails to find enough votes in the House of Representatives. If this happens, it could be because many Republicans are upset that, despite their majority, President Biden continues to get his funding initiatives approved. Now that markets don’t expect a shutdown, any negative news out of Washington would generate selling in stocks and be seen as bad news for the bond market.

3. Since oil prices are central to consumers’ inflation expectations, it will be an important development if OPEC (the group of major oil-producing countries besides the biggest producer, the U.S.) extends their production cuts before they expire on March 31. We expect these cuts to be approved, which could happen early this week. Once that happens, oil could rally above $80 a barrel. A break over $80 would increase gas prices, raising consumers’ inflation views, which is yet another potential trigger that could delay Fed rate cuts and negatively impact the stock market. Crude oil prices historically rally from mid-February through June, so the seasonal trend is bullish.