Wall Street, Gold recovered from hotter core PCE inflation

Wall Street Futures, Gold wobbled Thursday on hotter than expected US core PCE price index for consumption expenditure component in the GDP data, which may be indicating underlying strong consumer spending and elevated inflation. At the same time, a soft reading of GDP growth is an indication of slowing economic activity. Together this may be an indication of stagflation (elevated/higher inflation, higher unemployment, and lower GDP growth). Thus Wall Street Futures slid, while Gold surged to some extent.

Also, lingering geopolitical tensions over the Gaza War helped gold and dragged Wall Street after Israel launched a full-fledged Rafah attack. The US has also recently supplied Ukraine with medium-range (300 km) ballistic missiles for use against Russian targets within Ukraine's territory. But this may be also an indication that the US may supply Ukraine with more long-range ballistic missiles, which Ukraine could use against Russian targets in Russian territory. This would be a red line for Russia and we may see WW like situation amid a lingering warfare in Eastern Europe.

On the Good Friday holiday, some focus of the market was on U.S. Core PCE inflation for March, the Fed’s preferred gauze to measure underlying inflation trends. The BEA flash data showed U.S. annual (y/y) core PCE inflation (at 2017 constant prices; SA) for March was unchanged at +2.8% from +2.8% sequentially, above the market expectations of +2.6% and lowest since Mar’21 (three years).

On a sequential (m/m) basis (seasonally adjusted at 2017 constant prices) the U.S. core PCE inflation was also unchanged at +0.3% in March from +0.5% in February, in line with market expectations of +0.3%; January’s +0.5% sequential rate was highest in last one year (since Feb’23), while the post-COVID sequential rate was +0.6%.

In March, the U.S. core PCE service inflation ex Housing/Shelter, the current focus of the Fed increased to +3.50% from +3.30% in the last two months, while the sequential rate also ticked up to almost +0.4% from the prior +0.2%.

Also, PCE service inflation ticked up to +4.0% in Mar’24 from +3.9% sequentially.

Fed is now also watching Dallas Fed Trimmed Mean Inflation, which was +3.0% in Mar’24 against +3.1% sequentially.

Overall, after the latest revisions, the average core PCE inflation for 2023 was now around +4.1%, while the same for core CPI inflation was +4.8%, and an average of core inflation (PCE+ CPI) is around +4.5%. The Fed usually goes by a 6M rolling average of core PCE + core CPI inflation for any important policy move. As per the new series (2017 constant prices), the 6M rolling average core PCE inflation is now around +3.0%, while the 6M rolling average of U.S. core CPI inflation is now around +3.9%; i.e. 6M rolling average of US core inflation (CPI+PCE) is now around +3.5%, still far above Fed’s +2.0% targets.

Fed needs an average sequential core PCE inflation rate of around +0.15% on a sustainable basis for its +2.0% core PCE inflation targets. But it was still hovering around +0.25% for the last 6 months, while jumped +0.50% even in Jan’24. That’s why Powell repeatedly pointed out Fed is not confident enough still now for the disinflation process. Although there was a rapid disinflation rate in H2CY23, the same may have now stalled in Q1CY24 and thus Fed will look at Q2CY24 data; i.e. overall H1CY24 data for any policy rate cut decision in H2CY24.

Moreover, several US Senators/Congress members, both Democrats and Republicans are now grilling extensively (ahead of the Nov’24 election) about still elevated inflation compared to pre-COVID levels (by at least +20%) and insisting that Fed/Powell should focus on core CPI inflation rather than core PCE inflation, which is around 1% lower most of the times due to composition/weightage issue.

Powell also publicly acknowledged to a Senator in the last hearing/testimony (Mar’24) that US Congress officially mandated the Fed to maintain price stability mandate as +2% headline inflation (CPI), not PCE, which is always the lowest among various inflation gauzes. Powell pointed out that the Fed is now actually targeting core CPI inflation due to lower volatility (ex-food and fuel), which is still higher than headline CPI. Overall, core PCE inflation is now a lagging inflation indicator, and does not impact the market meaningfully as the market already has an idea/estimate about the level after core CPI and PPI data were released almost 2-weeks ago.

Oil is now hovering around $85, meaningfully higher than the $68 area at the start of the year (2024). Looking ahead Russia and also Saudi Arabia may orchestrate some rally to $95-105 in oil to ‘teach a lesson’ Biden ahead of the Nov’24 Presidential election; Putin may prefer Trump as the next US President than 2nd term of Biden. If oil indeed soars to $95-105 areas in the coming days and sustains there for a few months due to lingering geopolitical tensions (Gaza, Red Sea, and Ukraine war) and OPEC+ production cut agreement extension, the Fed may face some real difficulties in cutting rates even in H2CY24.

Conclusions:

The 6M rolling average of US core inflation (PCE+CPI) is now around +3.5%. Fed may cut 75 bps in H2CY24 if the 6M rolling average of core inflation (PCE+CPI) indeed eased further to +3.0% by H1CY24. The Fed wants to keep the real/neutral rate around +1.0% in the longer term (assuming a +3.0% repo rate and +2.0% core inflation). But in the meantime, till core inflation/headline inflation goes down to around 2.00%  on a sustainable basis, the Fed wants to maintain the real rate at around present restrictive levels of 1.00-2.00% (assuming the present repo rate 5.50% and 2023 average core inflation around 4.50% and present 6M rolling average of core inflation around 3.50%). Fed needs a +2.00% restrictive real rate for 2024 or at least H1CY24 to produce sufficient slack in the economy, so that core inflation falls to +2.0% target on a sustainable basis.

As per Taylor’s rule, for the US:

Recommended policy repo rate (I) = A+B+(C-D)*(E-B)

=1.50+2.00+ (2.60-2.00)*(4.50.00-2.00) =1.00+2+ (0.60*2.50) = 3.00+1.50=4.50% (By Dec’24)

Here:

A=desired real interest rate=1.50; B= inflation target =2.00; C= Actual real GDP growth rate for CY23=2.6; D= Real GDP growth rate target/potential=2.00; E= average core (CPI+PCE) inflation for CY23=4.50%

The Fed may go for -75 bps rate cuts in September, November, and December’24. By 18th September (Fed MPC date), the Fed will have complete data for core inflation and also unemployment/real GDP data for H1CY24 and also Aug/July’24 to have the required ‘higher confidence’ to go for rate cuts. Fed may bring down the repo rate to +4.75% by Dec’24 from present +5.50%.

Fed may announce a plan for QT (tapering or trajectory) and also an optimal B/S size in the May meeting. Ideally, the Fed should have closed the QT before going for any rate cuts cycle as these are two contra tools as QT is restrictive and rate cut stimulative. The Fed, the world’s systematically most important central bank may not continue QT (even at a reduced pace) and go for rate cuts at the same time. But Fed/Powell kept that absurd option of simultaneous QT and rate cuts open, at least theoretically.

Bank of Canada (BOC), recently clarified as long as the policy rate remains within the sufficiently restrictive zone, BOC may go for limited rate cuts, along with QT (even at a reduced pace) as QT is itself equivalent to rate hikes to some extent (tighter banking/funding/money market liquidity). If the real policy rate falls into the stimulative zone, then BOC may go for more rate cuts and completely close or at least temporarily close the QT. BOC is the smaller proxy of the Fed and may have more academic clarity regarding its policy actions. Thus considering BOC’s explanation, the Fed may go for -75 bps rate cuts in H2CY24, most probably from Sep’24 after deciding about the possible B/S size to ensure money market stability.

Looking ahead, the Fed may keep B/S size around $6.60T, around pre-COVID levels to ensure financial/Wall Street stability along with Main Street stability; i.e. price and employment stability. Fed’s B/S size is now around $7.43T around 25% of estimated nominal GDP for $30T by Dec’25. Depending upon the actual rate/funding levels in the repo/funding market, the Fed may taper the QT from the present $0.095T/M to 0.050-0.075T/M for 18-12 months from May’24;i.e. Fed may end the QT by May’25-Dec’25 at B/S size around $6.60T. This is lower than the earlier market estimate of $7.00T and thus should be seen as more hawkish. Also, rate cuts along with QT (even with a slower pace/tapering) should be less hawkish.

Ahead of the Nov’23 U.S. Presidential election, White House/Biden/Fed/Powell is more concerned about elevated inflation rather than the labor market; prices of essential goods & services are still significantly higher (around +20%) than pre-COVID levels, which is creating some anti-incumbency wave (dissatisfaction) among general voters against Biden admin (Democrats) on some economic issues (higher cost of living).

Thus Fed is now giving more priority to price stability than employment (which is still hovering below the 4% red line) and is not ready to cut rates early as it may again cause higher inflation just ahead of the November election. Fed may hike only from Septenber’24, which will ensure no inflation spike just ahead of the Nov’24 election (as any rate action usually takes 6-12 months to transmit in the real economy, while boosting up both Wall Street and also Main Street (investors/traders/voters). Fed hiked rate last on 26th July’23 and may continue to be on hold till at least July’24; i.e. around 12 months for full/proper transmission of its +5.25% cumulative rate hikes effect into the real economy.

Overall, the Fed’s mandate is to ensure price stability (2% core inflation), and maximum employment (below 4% unemployment rate) along with financial/Wall Street stability as well as lower borrowing costs for the government. As the US is now paying almost 15% of its tax revenue as interest on debt, the Fed will now not allow the 10Y US bond yield above 5.00% at any cost (against present levels of average core CPI around +4.0%).

But the Fed may also blink on rate cuts in H2CY24 just before the US election to keep itself politically independent/impartial/neutral:

Ahead of Nov’24 US Presidential election, as seen in the Mar’24 Congressional testimony, Fed/Powell is under huge pressure from opposition Republican lawmakers (Trump & Co) to support Biden & Co (Democrats) in boosting the election prospect by facilitating rate cuts just before the Nov’24 election. Thus Fed may not go for any rate cuts till Nov’24 or even Dec’24 to show that it’s politically independent/neutral. In the meantime, the Fed may close the QT at the present pace of around -0.095T/M for the next nine months (April-Dec’24) for the targeted ample B/S size around $6.60T without any QT tapering (@22% of CY25 estimated nominal GDP around $30T, just above 20% minimum requirement of $6.00T).

The most logical step would be Fed to close the QT completely before going for a rate cuts cycle and then go for any QE, if required to counter another economic crisis down the years. Fed has to prepare its B/S for the next round of QQE to face another cycle of financial crisis and thus has to normalize the B/S first. Presently, it seems that the Fed is not so confident about the QT pace, which may trigger another QT tantrum, as we have seen in late 2019.

Now going by various Fed comments in the last few weeks, it seems the Fed is ‘extremely’ worried about the pace of slower disinflation. Fed is also apparently confused about the dual combination of QT, even at a slower pace (QT taper) and rate cuts in the months ahead as these two instruments (tools) are contradictory/opposite (like if Fed goes for QE and rate hikes at the same time). Ideally, the Fed should finish the QT first for a proper B/S size (bank reserve) to ensure ample liquidity for the US funding/money/REPO market.

But the Fed may continue QT (even at a slower pace) and go for a rate cut cycle at the same time despite these two policy actions being contradictory. Thus the Fed may go for rate cuts of -75 bps cumulatively in September, November, and December’24 for +4.75% repo rates from the present +5.50%. Fed may bring down further its B/S size from present around $7.43T to $6.60-6.50T through QT tapering by May-Dec’25 to keep minimum/ample liquidity for the US funding/money market and also to prepare itself for the next cycle of QE, whatever may be the next recession excuse.

The market is now expecting 3-2 rate cuts (75-50 bps) in 2024, while some Fed policymakers are now arguing for lesser rate cuts of 1-2 rate cuts or even no rate cuts at all. Looking ahead, the Fed may not cut rates at all in 2024 considering the slower rate of disinflation, political issues ahead of the Nov’24 election, and the logic that it should not go for any rate cuts while doing QT, which is the opposite. Also, the reduction of B/S from around $8.97T to around $6.60T (projected); i.e. around $2.50T (~$2.37T) reduction over 2.5-3.00 years is equivalent to a rate hike of around +50 bps (higher 2Y bond yield).

In that scenario, if the US core CPI average for 2024 comes down to around +3.00% by Dec’24 from present levels of +3.8%, the Fed may cut rates by -100 bps in 2025 for a repo rate +4.50% (from present +5.50%) for a real restrictive repo rate +1.50% (repo rate 4.50%-3.00% projected average core spi for 2024). Presently, the real restrictive repo rate is also around +2.00% (repo rate 5.50%-3.50% average 6M core inflation).

At present, in its last (Mar’24) SEP/dot-plots, the Fed projected -75 bps rate cuts each in 2024, 2025, and 2026 and -50 bps rate cuts in 2027 for a terminal neutral repo rate +2.75% against pre-COVID neutral repo rate +2.50%. Now various Fed policymakers are arguing for a slightly higher neutral repo rate at +3.00% against projected core CPI of +2.00%; i.e. neutral real rate at +1.00%.

Thus depending upon the actual trajectory of core CPI, the Fed may cut -100 bps each in 2025, 2026, and -50 bps in 2027 for a terminal neutral repo rate of +3.00% from the present +5.50%. Fed had boosted its B/S from around $3.86T in late September’2019 (after the QT tantrum) to around $8.97T in Apr’22; i.e. over $5T in a matter of 32 months (@0.16T/M) to fight previous QT and COVID induced financial crisis.

Now Fed may announce a plan for QT tapering from $0.095T/M to $0.075/M around B/S size $6.60T before going for any rate cuts from mid-March’25; the Fed may opt for four QTR rate cuts (-25 bps) each in each quarter in 2025, 2026 and two half yearly rate cuts in 2027 to ensure price/employment/financial stability. Although, the Fed’s official QT rate is -$0.095T/M ($90B/M), in reality, the effective average QT rate is already around -$0.073T/M. As the Fed is now managing the funding/money market through ON/RRP, there is a lower risk of a 2019 type of QT tantrum this time.

Fed’s mandate is now 2% price stability (core inflation), below 4% unemployment rate, and below 4.75-5.00% US 10Y bond yield to ensure lower borrowing costs for the government and overall financial stability. Fed, as well as ECB, BOE, and BOC, are now struggling to keep bond yield and inflation at their preferred range despite non-stop jawboning; perhaps they are talking too much too early and thus FX market is not being influenced by them significantly, moving in a narrow range. The BOJ is now trying to talk down the USDJPY desperately, presently hovering around 152 levels, causing higher imported inflation and a higher cost of living back home, although it may be beneficial for exports. However, most of the Japanese are not happy at all due to higher imported inflation in Japan for the devalued currency.

1st scenario: 75 bps rate cuts each in 2024, 2025, 2026, and -50 bps in 2027 for a neutral repo rate of +2.75%; Fed will continue the QT at a reduced rate till Dec’25 for a B/S size around $6.60T. If the rate of disinflation accelerates, the Fed may go for -75 bps rate cuts each in 2024, 2025, and 2026 and -50 bps in 2027. Fed may continue the QT (even at an officially slower pace) and rate cuts at the same time (in 2024) despite being contradictory. Fed may say (like BOC) that as long as the policy rate is in the restrictive zone (say 1.50-2.00% above core inflation), the Fed may continue both rate cuts and QT to reduce overall restrictiveness. When the policy rate moves into a neutral/stimulative zone, say 50 bps above average core inflation, then the Fed may go for more rate cuts and close the QT.

2nd scenario: -100 bps rate cuts each in 2025, 2026, and -50 bps in 2027 for terminal neutral reo rate +3.00%; Fed will continue QT at present pace till Mar’25 and close the same at B/S size around $6.60T. Fed may announce a plan for QT tapering from -$0.095T/M to -$0.075T/M from May’24 and close the QT by Mar’25 at B/S size around $6.60T. Then Fed may start the rate cut cycle from Mar’25 with -100 bps rate cuts each in 2025, 2026 (@-25 bps at each QTR), and finally -50 bps in 2027 (@-25 bps in H1 and H2).

All other major G20 Central Banks including ECB, BOE, BOC, RBI, and even PBOC may be compelled to follow the Fed’s real rate action to keep present policy differential with the Fed. As USD, is the primary global reserve/trade currency, any meaningful negative divergence with the Fed will result in higher imported inflation, everything being equal. For example, if the ECB goes for -75 bps rate cuts in H2CY24, while the Fed goes for hold, then EURUSD may slip further towards parity (1.0000), which will result in higher imported inflation as the EU is dependent quite heavily on imported goods, foods and fuel/commodities.

In this way, no major G20 Central Bank will take such rate action/cuts alone as there is a routine/regular coordination/consultation between all major central banks for a coordinated/synchronized policy action to avoid disorderly FX movement. The Fed also not seeking a very strong USD as it would eventually affect US export competitiveness. Thus all major central banks are now focusing on maintaining proper balance and coordination with the Fed, whatever may be the domestic inflation/economic narrative/jawboning.

Market impact:

On Friday, Wall Street Futures and Gold whipsawed after the core PCE inflation data as although the annual rate at +2.8% was higher than the market estimate of +2.6%, the sequential rate of +0.3% was in line with the market consensus, some market participants were also expecting higher sequential rate at +0.5% after Thursday’s hotter core PCE GDP deflator data. Thus after the initial fall to the day low, both Gold and Wall Street Futures recovered and surged to new day highs. Gold tumbled from around 2350 to almost 2326, but recovered later to almost 2342 before closing around 2337. Similarly, Dow Future initially stumbled from around 38500 to almost 38240 and then recovered to around 38530 before closing around 38450.

On Friday, Wall Street Futures were also boosted by upbeat report card/guidance by mega tech companies amid generative AI optimism led by Alphabet and Microsoft; tech-heavy NQ-100 jumped almost +1.65%, blue-chips DJ-30 surged +0.30%, while broad-based SPX-500 soared +1.02%. But Wall Street was also undercut by Intel, Exxon Mobil, and Chevron as it tumbled on subdued guidance/earnings.

Technical trading levels: DJ-30, NQ-100, and Gold

Whatever may be the narrative, technically Dow Future (38450), now has to sustain over 38600 for a further rally to 38900-39000*-39100/39300-39500/39750 and 40000/40200-40425/40600-40700-42600 levels in the coming days; otherwise, sustaining below 38550, DJ-30 may again fall to 38300/38050-37650/37450*, and further fall to 37300*/37200-37050/36600 and 36300/36300 and even 35700 levels in the coming days.

Similarly, NQ-100 Future (17837) now has to sustain over 17950 for a further rally to 18150*/18375 and 18600/18750-18800/18900*-19100/19200-19450/19775 and 20000/20200 in the coming days; otherwise, sustaining below 17900, NQ-100 may again fall to around 17700/17500-17400/17100* and 16800/16595*-16100/15900 in the coming days.

Also, technically Gold (XAU/USD: 2330) now has to sustain over 2360 for a further rally to 2375/2385-2395 and 2400/2410-2425/2435* for any further rally to 2455-2475/2500; otherwise sustaining below 2355-2350, Gold may again fall to 2335/2325-2315/2300 and 2290*/2270-22245/2240, and 2220/2210-2200/2195-2190/2180 and 2175/2145*, and further to 2120/2110-2100/2080-2060/2039 and 2020/2010-2000-1995/1985-1975 and even 1940 may be on the card.

Bottom line:

On Friday, Wall Street, and Gold slipped after hotter-than-expected US core PCE inflation data but recovered later as some influential market participants were also expecting +0.5% sequential core PCE inflation instead of +0.3% after elevated core PCE GDP deflator data Thursday. Wall Street was also boosted by upbeat/mixed report cards by big techs. Fed may go for rate cuts from Sep’24 or Mar’25 for various issues