The Big Question

Sell the News: The current market move appears to be the quintessential “sell the news” move, as structurally, nothing much has changed from the post-election expected outcome, aside from the Fed opening the door for a December pause. Economic data is maintaining a market friendly trend, and if it continues, it will give the Fed the cover to continue rate reductions. Everything about this current environment suggests that you should maintain a long market stance in the near term.

Inflation is Deflating the Fed

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Is the Fed being level-headed about inflation leveling off? Our favorite inflation indicator within the Producer Price Index is core Final Demand PPI less Trade Services (PPI ex-food and energy, and net of profits). That measure rose to 3.5% in October, drawing a steady path up from the November 2023 low of 2.5%. Additionally, the last three months’ readings for the Consumer Price Index have been robust, with two major components holding firm. Used Cars, a big driver of CPI, has bottomed out after helping push the Index lower over the past two years. Housing inflation has been persistent; the October report showed that the shelter index rose 4.9% over the past year, accounting for over two-thirds of the annual increase in core CPI. Powell did take a step back Thursday, admitting that PPI was “slightly more of an upward bump than we expected” but held tenaciously to his forecast as he quickly added, “but the broader trend over the last 18 months is still intact.”

We expected inflation to be sticky and anticipated that as each month ticks by with no evidence of inflation moving toward 2%, the Fed will be forced to change its narrative. The market is hyper-focused on whether the Federal Open Market Committee (FOMC) will pause or cut 25 basis points on December 18th. It is a coin flip until the November CPI and PPI inflation readings are published on December 11th and 12th, respectively, so it is not worth considering until then. We prefer to look at the bigger picture and ask this important question: when will steady-to-rising inflation reach a tipping point for the FOMC, forcing them to question their forward guidance of 100 basis points of rate cuts next year?

Will the Fed Walk the Talk?

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The Fed better be attentive to any uptick in inflationary expectations. If they are truly data dependent, now is the time for that Fed to show up. Chair Jerome Powell made it clear he was not going to react to any possible policy changes from next year’s administration. However, the markets move immediately on changes in the market’s consensus outlook for 2025. Investor perception decides the direction of the U.S. Dollar, stocks, interest rates, and credit spreads. That set of assets determines financial conditions, which affect economic activity—with a lag. Because there are “long and variable lags of monetary policy” between the Fed’s rate decisions and their impact on the economy, we find fault with the Federal Open Market Committee’s (FOMC) data-dependent monetary policy. Yet, Powell seems proud of it, pronouncing at the November 7 press conference, “We don’t guess, we don’t speculate, and we don’t assume.”

That approach works in a static economic environment. However, he cannot escape thinking about what could unfold next year because markets “guess, speculate, and assume” and are open to the possibility that the environment could see big shifts. The Peterson Institute has estimated that CPI could rise as much as 1% per million immigrants deported. While we do not know the timing or number of deportations, or even their likelihood, that potential inflation surge needs to be part of the conversation at the FOMC.

William Dudley, former President of the New York Fed, said that the Fed’s economic models will not consider deportations or higher tariffs unless they are likely to be put into action. During a Thursday interview, Chair Powell speculated that due to the burdensome legislative process, policy changes could be delayed until 2026 or 2027. Flaws in the FOMC’s reactive process will become glaringly clear if Trump, through executive orders, bolts out of the starting gate with deportations or tariffs. In that case, the FOMC will be woefully behind the curve regarding the inflationary consequences. Consumer inflation expectations will be sensitive to any immediate policy change about tariffs. Therefore, that data is a central investor focus starting now, and there will be a market reaction if the Fed proves to be out of sync.

Lone Star

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Lorie Logan is a bit of a rock star. The President of the Dallas Fed came from the New York Fed where she ran their Open Market Desk, managing the securities portfolio during the pandemic. She will not be an FOMC voter until 2026, but her opinion carries weight, especially about the markets. In a speech last week, she floated a few interesting ideas. Her preferred trimmed mean inflation rate that excludes volatile outliers is sitting at 2.75% over the last 4 months. That consistently high rate concerns her that inflation will fall short of the FOMC’s 2% target, especially if there is an “unexpectedly strong demand shock or a negative supply shock.” The demand shock could come from lower taxes that push income, spending, and investment higher. The supply shock could result from a trade war. While she did not say it explicitly, whether from the demand or supply side, the inflationary shocks would result from Trump rolling out his policies.

She fears tighter financial conditions could push unemployment up. For now, higher stocks and tighter credit spreads are easing financial conditions, but the stronger dollar and higher interest rates are tightening them. She is quite worried that longer-term interest rates are being pressed higher to “compensate investors for bearing the risk of future interest rate fluctuations.” Part of that risk comes from uncertainty over the final Fed funds target. Logan points out that the Fed is equally uncertain:  “Around the FOMC table, participants’ projections for the longer-run fed funds rate now vary by more than 1 percentage point, compared with a spread about half as wide two years ago.”

We are noticing an emerging theme: In what appeared to be a coordinated Fed action, Chicago Fed President Austin Goolsbee said Friday, “If there is a disagreement over the neutral rate, it does make sense to start slowing the pace of rate cuts.” That same day, Richmond Fed President and FOMC voter Tom Barkin referred to the uncertainty within the Committee over the long-term equilibrium funds rate when he said, “It is hard to know if we are very, or somewhat, or a little restrictive.”

Investors will demand higher rates to compensate for the lack of a well-defined vision from a Fed at risk of falling behind the curve. Market concern will grow if Powell maintains his recent stubbornness that he is certain the Fed will achieve its 2% inflation target.

Ironically, the market’s confidence will fall every time Powell’s confidence grows—not a stable situation.

What to Look for This Week

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1. Tuesday, November 19 at 2:00 a.m. E.S.T. October Car Registrations for Germany and France. While seemingly a bit esoteric, we will focus on it because the two series have been in negative territory for months. Any further economic weakness in Germany makes their political stalemate over the budget even more critical.

2. Tuesday, November 19 at 8:30 a.m. E.S.T. October Building Permits. Any drop below 1.40 million will reveal a weakening outlook for housing. Housing Starts are also released at that time, but Permits lend better insight into future trends. Wednesday November 20 at 7:00 a.m. E.S.T. Mortgage Banker Association Purchase Index is out. Early read on post-election home buying.

3. Thursday, November 21 at 8:30 p.m. E.S.T. November Philadelphia Fed Manufacturing Index. Contained in the report is the New Orders Prices Paid and Business Conditions series, which are all threatening to break out higher. At 11:00 a.m. E.S.T. that day, The Kansas City Fed Manufacturing Index is released,  The Composite Index has been negative since September 2022, so a positive reading is something that will get the attention of President Jeffrey Schmid of the Kansas City Fed. Schmid is aligned with Governor Michele Bowman against excessive Fed easing, and he will be a voter on the FOMC starting at the January 28-29 meeting.

Fed Speakers: Light Schedule Monday, November 18 at 10:00 a.m. E.S.T. Fed President Austin Goolsbee speaks. Tuesday, November 19 at 11:00 E.S.T. Fed Governor Lisa Cook gives a speech on the Economic Outlook and Monetary Policy followed by Governor Michele Bowman at 12:15 E.S.T. Cook favors more accommodative policy, so we are looking out for any comments that could indicate that even she is open to a December rate pause.