The Art of War

All Talk: Chairman Powell’s speech at Jackson Hole highlights this week's light economic calendar. If Powell downplays the recent unemployment uptick and the potential for a recession, his message for the September Fed meeting and beyond could be the importance of moving gradually. He will be opaque by talking about the dangers of both moving too fast and too slowly, and the difficulties of knowing for sure if the economy is on a direct path to the 2% inflation goal. Watch the market reaction for clues. We are growing concerned about the earnings slowdown as companies are starting to disappoint on their quarterly guidance, and we can see the employment picture rolling over as companies look to reduce costs.

Ukrainian Offensive: Regime Shift 

You need to pay attention to the problems presented by the success of the Ukrainian invasion of Kursk. From a social and military perspective, much is happening below the surface. Two Russian commentators, Alexander Plushev and Vlad Vexler, have an interesting take. Plushev describes Russia’s citizens rationalizing the Kursk invasion as a natural disaster. They view the occupation through a lens of evacuation and relocation, not perceiving the event as a foreign invasion. Meanwhile, Vexler posits that the Russian people are so desensitized to their political situation that they see their own government as an external colonial occupier. Based on their assumptions, we believe that Russian apathy explains the lack of nationalistic furor over being invaded.

Interestingly, the Russian army is not diverting troops back to Russia but is calling up less experienced combat units in Russia. It is as though Putin has made peace with the idea of having Ukrainian forces within his borders for the long haul. If things devolve further for both sides, it increases the chances of Xi becoming directly involved in helping Russia protect its borders. To make matters worse, there is an alarming 2023 YouTube video circulating of Yevgeny Prigozhin, the deceased leader of the Wagner Group’s failed uprising against Putin. In the video, Prigozhin discussed that the Kremlin was open to launching a tactical nuclear strike on Ukrainian troops who are on Russian soil in Belgorod. Belgorod is just south of Kursk.

It is quite plausible that the Kursk offensive was brought on by Zelensky’s concern over being dragged prematurely to the negotiating table. If the fear of a Russian nuclear strike within its own borders pushes the West to schedule emergency negotiations, that will only accelerate the Ukrainian offensive into Russia. This invasion is a regime shift in the purest sense: this new chapter prevents a return to the way things were prior to the event. This is an evolving painting with a host of outcomes, so every development must be followed closely because they also carry the potential to move global risk markets dramatically.

Abandon Ship

Primary Dealers are obligated to be active in all U.S. government bond auctions, but they are getting fat. The Treasury issues bonds to pay for government spending that exceeds tax revenues. The Fed has been buying a big portion of these bonds to keep interest rates low. However, as the Fed has cut their monthly demand, Primary Dealer inventories just hit a record high. The Fed is pulling back as Treasury bond supply keeps increasing as the budget deficit rises. The result of this bloat is that Primary Dealers have a diminished ability to support market prices in the event of a strong bond selloff.

The Fed has been the elephant in the bond room, and since the April 2022 peak, U.S. Treasuries held by the Fed have dropped almost 25%. The $1.4 trillion reduction has come from their decision to no longer replace maturing bonds. From the time the Fed made the decision to begin Quantitative Tightening and trim their portfolio, dealer inventory increased from $90 billion to $230 billion. This huge inventory means dealers’ losses mount if interest rates rise, so they could dial up the intensity of a selloff if they decide to liquidate during a panic. The Fiscal Responsibility Act of 2023 (a misnomer) kicked any tough budget discussion off until after the election. In doing so, the $31.4 trillion debt ceiling was waived, and the budget deficit since then has increased by over 11%. Expect more sloppy auctions and less liquidity in what was considered one of the most liquid markets in the world. This can only result in more concern about waning demand for U.S. Treasury bonds and cause interest rates to drift higher over time.

Jackson Hole: Micro fights Macro

Federal Reserve Chairman Jerome Powell’s speech this week at the Jackson Hole annual economic symposium is destined to disappoint. It will be difficult for him to give investors what they desperately crave: a clear view of a September Fed rate cut. The reason is that the Fed’s stated approach is to be data dependent, meaning that each economic data point can influence their policy decisions. The critical September 6 payroll report looms large and still lies ahead of that speech, which means that until the FOMC sees the August employment numbers, it is impossible for Powell to be decisive. The latest communications from Federal Open Market Committee (FOMC) voters point to an openness for a cut as soon as the next meeting. However, Tom Barkin encapsulated the tone of many FOMC voters when he said on August 8 the “Fed has time to assess the economy before deciding on further action.”

Even though markets want him in the weeds, Powell will speak at a 10,000-foot level. He will probably discuss major topics, such as when the Fed may return to being forward-looking rather than data dependent. Among the other big questions is whether the neutral rate should be recognized as having moved up from 2% to 2.5%. The neutral rate is the long-term equilibrium Fed Funds rate that neither stimulates nor slows down the economy. At last year’s Jackson Hole meeting, only 3 of 19 FOMC participants thought that Fed Funds would not fall below 3% before they hit an equilibrium level. Currently, that number has tripled, with 9 participants who forecast the minimum Funds target at 3% or higher. That is a material change, and Powell should discuss it because a 3% long-term rate translates to two fewer rate cuts before they are done lowering rates. We do not expect any answers from Powell, but he may lay the groundwork for these big topics. The Fed will convene later this year and release any changes to their long-run goals at their January 2025 monetary policy framework review.

What to Look for This Week

1. Wednesday, August 21 at 2:00 p.m. E.S.T. FOMC minutes from their July meeting. Will take on added significance considering Jackson Hole starts the next day. We will look for the tone of the discussion about how open they are to a September cut.

2. Thursday, August 22 at 8:30 a.m. E.S.T. is Initial Claims that has been celebrated by markets disproportionately on downticks for the past two weeks. It will continue to be a market mover.

3. Friday, August 23 at 10 a.m. E.S.T. Federal Reserve Chairman Jerome Powell’s speech at Jackson Hole