The Fed Needs to Introduce Two-Sided Risk to Its Next Move to Slay Inflation
I have been saying for several weeks now that I believe risk assets will stop rising when the odds of the Fed’s next move comes more into balance between cutting and hiking. There simply needs to be two sided risk in the rates market to put a damper on volatility selling strategies non-stop behavior. We are moving further along in that direction but more is needed. The Fed continues to show the asymmetrical nature of its bias, as they will be quick to cut rates on weak labor data but they will be very slow to raise rates further to deal with sticky core and potentially re-accelerating inflation.
They continue to say the bar to raise rates further is much higher than the bar to cut, even after we continue to get higher than expected inflation readings including the CPI last week as the initial reactions from Fed speak so far has been that even though inflation data has come in worse than expected, and that they probably don’t need to be cutting rates soon, they are still are not thinking about hiking. Although Powell spoke this week of needing more time to determine when to start rate cuts, he still doesn’t believe a hike is necessary. This is a mistake.
Despite all the uncertainty the Fed has about why growth, labor and inflation have been stronger than expected in this “tightening” cycle than in previous cycles, they remain convinced that the easing cycle is still going to commence this year. It is just a question of when. But don’t worry, they say they are humble and have humility. I say it’s institutional arrogance and political bias. Anyhow.
Last week brought another round of hotter than expected inflation readings and the core PCE for March is going to come in close to 0.28-0.30 mom so we continue to annualize reasonably higher than where inflation needs to be in order to get to the Fed’s 2.6% YE24 target. We have also continued to receive labor market data that should assuage the Fed’s concern about the need to cut rates sooner from a rapid deterioration in the labor market, something that simply doesn’t appear anywhere on the horizon. The market has done more work to remove cuts this year and for the entirety of the cutting cycle but financial conditions are not really tightening yet because the Fed hasn’t properly opened up the door to their next move possibly being a hike.
If we continue to see oil/gasoline prices moving higher, the risk of de-anchoring inflation expectations will rise which should also put the Fed on notice. This started to show up in the Umich survey data from last week and should continue over the course of next couple months as higher gasoline prices typically show up in these surveys and we are already seeing gasoline prices move higher yoy as we head into stronger gasoline demand season. Higher inflation expectations should also help remove the cuts and should help raise the odds of a hike because on various metrics, inflation breakeven yields are back to levels seen last fall when a substantial majority of Fed members still favored hiking one more time in 2023, something they failed to deliver.
The pathway to a risk asset top is thru stagflationary data which pushes the odds of the Fed’s next move being a hike or cut into better balance. Strong wage, core inflation and inflation expectation momentum is the pathway toward a more humbled Fed (I know, don’t laugh) that will need to remove the cuts, introduce hiking potential and truly work on tightening financial conditions again in order to bring inflation back down to 2% in their time horizon.
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Important Disclaimer: This blog is for educational purposes only. I am not a financial advisor and nothing I post is investment advice. The securities I discuss are considered highly risky so do your own due diligence.
