Dow and gold stumbled on hotter US PMI and higher bond yields

Wall Street Futures were already hovering around a fresh life time high on hopes of solid earnings, a soft landing, and a Fed pivot. In the early European session Wednesday, Wall Street Futures were further boosted by Chinese monetary stimulus, upbeat PMIs from Europe, and hopes of solid US corporate earnings, soft landing and Fed pivot. In an early Wednesday European session, China’s Central Bank (PBOC) Governor Pan announced that PBOC will reduce the reserve requirement ratio (RRR) for all banks by -50 bps to 10% starting from February 5th, releasing up to CNY 1T (~$140B) to the market to boost the economic recovery.

The RRR cut announcement followed after just two days when the PBOC disappointed the market by holding rates (LPR) at 3.45% instead of any cut. This would be the lowest RRR level since March 2007 and aligns with the PBOC's ongoing efforts (targeted monetary stimulus) to reinforce an uncertain economic recovery in light of the plummeting stock and real estate markets. The PBOC had previously cut RRR by -25 bps in March and September last year. Additionally, starting January 25th, the PBOC will lower re-lending and re-discount interest rates by -25 basis points, targeting the rural sector and small businesses. PBOC indicated further targeted monetary stimulus.

On Monday (22nd January), Chinese Premier Li chaired a cabinet meeting where officials indicated they would take more forceful and effective measures to stabilize stock market confidence. Policymakers are reportedly seeking to deploy about CNY 2T, mainly from offshore accounts of Chinese state-owned enterprises (SOE), as part of a fund to buy mainland shares and support/boost the plummeting stock market.

On Wednesday, the S&P Global flash data shows US Manufacturing PMI jumped to 50.3 in January from 47.9 sequentially, higher than the market consensus of 47.9 and the highest since Oct’22. The S&P Global said the latest Manufacturing PMI pointed to an improvement in operating conditions at goods producers. Stocks of finished goods saw a renewed expansion, indicating the fastest rise in post-production inventories since November 2022 as companies anticipate greater new orders in the coming months.

Also, purchasing activity declined less. Still, production dropped further and firms noted broadly sufficient availability of materials at suppliers, but challenging trucking conditions due to storms and transportation delays reportedly weighed on vendor performance. Lead times lengthened for the first time in over a year and to the greatest extent since October 2022.

The S&P Global flash data also shows US Services PMI surged to 52.9 in January from 51.4 sequentially, above market expectations of 51.0 and at a 7-month high. The S&P said improved demand conditions were associated with increased client referrals and reports of customers depleting their buffer stocks. However, there was a marginal decline in new export orders. The rise in employment can be attributed to efforts made by service providers to clear backlogs of work, as well as the accumulation of incomplete business in January. In an attempt to compete and attract new orders, service providers have kept the rise in output charges at its slowest pace since June 2020, when the current sequence of inflation began.

The S&P Global flash data shows US Composite PMI surged to 52.3 in January from 50.9 sequentially, above market expectations of 51.0 and the highest since June’23. The U.S. private sector service activity expanded the most in seven months while manufacturing firms continued to experience a moderate drop in output. New business expanded for the third consecutive month at the sharpest pace since June, despite the second consecutive monthly decline in new export orders. Additionally, the pace of job creation eased during this period. On the price front, input cost inflation eased and was the second-lowest since October 2020, while average prices charged for goods and services rose the least since May 2020. Finally, business confidence reached its highest level since May 2022, fueled by hopes of improving demand conditions, investment in new machinery, and the release of new service lines.

On Wednesday, Gold slipped after hotter-than-expected US PMI data for January, which may keep the Fed on a higher for longer policy, but Dow Future got some boost on soft landing optimism. Dow Future made a high around 38252, but soon stumbled to 37951 and closed around 38000 on higher bond yield amid a terrible 5Y bond auction and as Israel Government Spokesperson clarified that there will be no Gaza ceasefire: “Commenting on reported ceasefire agreements, Israel will not give up on the destruction of Hamas, the return of all the hostages, and there will be no security threat from Gaza towards Israel. There will be no ceasefire. In the past, there were pauses for humanitarian purposes. That agreement was breached by Hamas.”

Earlier there was some report of an imminent Gaza war ceasefire for 3-months. Moreover, an Israeli Minister said Iran is now a ‘legitimate target’ for Israeli missile strikes and Israel can afford to keep fighting and that as big as the crisis is, it is also a really big opportunity. Subsequently, Gold also got some boost.

On Wednesday, overall risk trade sentiment was affected by the hawkish hold stance of BOC, indicating higher for longer policy and no possibility of imminent rate cuts; moreover, BOC is keeping another hike probability on the table if core inflation does not cool as expected.

Conclusions:

As per Taylor’s rule, for the US:

Recommended policy repo rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(4.50.00-2.00) =0+2+2.50=4.50% (for 2024)

Here:

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation for CY23

Fed has to ensure a 2% price stability (core inflation) target keeping the unemployment rate below 4% and also 10Y bond yield below 5.00-4.50% so that borrowing cost for Uncle Sam remains manageable/sustainable to fund +34T debt (never-ending).

In any way, at the current run rate and trend, the average US core PCE inflation should be around +4.0% in 2023, +2.5% in 2024, +2.1% in 2025, and +1.5% in 2026, in line with Fed’s Dec’23 SEP. Similarly, the U.S. core CPI inflation average should be around +4.6% in 2023, +3.2% in 2024, +2.5% in 2025, and +1.8% in 2026.

If US core CPI indeed dips below +3.0% by May-June’24 and if it seems that the 2024 average core inflation will be around +3.2%, then the Fed may start cutting rates from July’24 and may cut cumulatively 75 bps at -0.25% pace till Dec’24 for a repo rate at 4.75%, so that core real rate continues to stand around +1.50%, in line with the present restrictive stance (5.50% repo rate-4.00% average core CPI for last 6M).

Looking ahead, the Fed may try to balance the financial/Wall Street stability and price stability by expressing intentions to cut (dovish jawboning) from Mar’24 (Q1CY24) to ensure a soft landing while bringing down inflation. Also, whatever the narrative, the Fed has to ensure lower borrowing costs for the U.S. Government (Treasury) endless deficit spending and mammoth public debt of almost $32T. The U.S. is now paying around 15% of its revenue as interest on public debt against China/EU’s 5.5%.

As a result of higher bond yields around 4.50%-5.00% (for 10Y UST); i.e. lower bond prices, the Fed is now in deep MTM loss for its huge bond holding. Fed is also providing higher interest to banks & financials for reverse repo operation than it getting under repo operation; i.e. Fed’s NIM/NII is now negative and theoretically the Fed is in negative profit to the tune of -$130B. The same is also true for various banks & financials, most of which are now in deep MTM loss for higher bond yields; i.e. lower prices for their HTM bond portfolio holdings due to Fed hikes. The US10Y TSY market price fell from around $140 to $105 from Jan’20 (pre-COVID) to mid-Oct’23; i.e. a fall of almost -33% in around 4 years; it recently recovered to almost $113 levels.

This is a red flag, and thus Fed has to operate in a balancing way while going for calibrated hiking to bring inflation down to target, avoiding an all-out recession; i.e. to ensure both price & financial stability and soft-landing. Fed has to bring down inflation to +2.0% targets by the  US 10Y bond yield below 4.50-5.00%, and an unemployment rate below 4.0% without triggering an all-out or even a brief recession in the US Presidential election year (Nov’24). The Fed will ensure that the US10Y bond yield is below 4.50-5.00% at any cost for lower borrowing costs for Uncle Sam (U.S.), everything being equal. Thus, overall Fed is methodically jawboning on both sides (hawkish/dovish) from time to time to achieve all its goals at the same time.

Considering all pros & cons, Fed may wait for core inflation data (average for core PCE and core CPI) for at least Dec’23-Mar’24 and if it goes down to around +4.00% from the projected 2023 average of +4.5% (4.80% core CPI and +4.20% core PCE), the Fed may cut rep rates/FFR by -25 bps in July; further if such disinflation trend continues, Fed may cut -25 bps each in September and December for a cumulative -75 bps.

We may see a synchronized global easing from H2CY24. As the Fed is the world’s unofficial central bank because the USD is the ‘King’ (the world’s most preferred FX or global reserve currency), all major G20 central banks are now bound to follow the Fed policy stance to maintain present policy/currency/bond yield parity, everything being equal.

Thus the market is now expecting a synchronized global easing (rate cuts) by major G20 global central banks including ECB, BOE, BOC, PBOC, and even India’s RBI, whatever may be the domestic macro-economic narrative (just like post-COVID synchronized global tightening to bring inflation down to targets).

Fed policymakers will now jawbone the market in a balancing way to keep the US10Y bond yield between the 3.25-5.25% range or around 4.00-4.50% on an average to maintain price/labor market/financial (Wall Street) and also Main Street/White House stability in the election year (2024). As the U.S. labor market is still robust with healthy wage growths, the incumbent Biden admin may prefer price stability and lower inflation in the coming months along with a sub/below 4% unemployment rate; i.e. price stability over GDP growths. As the 10Y bond is the main instrument for raising debt and a benchmark for US/global borrowing costs, the Fed may not allow it to hover above 5.00% for long under any circumstances, everything being equal. Fed needs to lower borrowing costs for the U.S. government from the present 15% to 10-7% over the next few years.

Fed hiked rate last in July’23 for a +5.50% repo rate and in hold mode with a hawkish stance since Aug’23; subsequently, US10Y bond yield gradually surged from around +3.75% to +5.00% by late November. As a result of higher borrowing costs and tighter financial conditions, the demand of the economy was affected to some extent, resulting in lower inflation. Now Fed has to keep on hold (neutral mode) for at least 10-12 months from July’23, so that the impact of higher borrowing costs is gradually transmitted to the real economy in full, resulting in core inflation back to targets.

Thus Fed has to wait till at least July’24 for the expected 1st rate cut; otherwise, its credibility may be at stake. If the US10Y bond yield again falls below +3.0% in the coming days (from the present +3.95%), then it may cause less restrictive financial conditions, resulting in higher core inflation. Thus Fed has to jawbone the market so that the US10Y bond yield hovers around 4.0-4.50% in the coming days so that the Fed can ensure relatively lower borrowing costs and price stability (soft landing).

Market wrap:

On Wednesday, DJ-30 lost almost -100 points, while tech-heavy NQ-100 edged up +0.30% and broader S&P-500 edged up. Wall Street Futures were also boosted by Netflix despite earnings/EPS miss as the company's revenue beat forecasts and subscribers increased more than expected. Late Tuesday, Netflix said it signed up 13.1M customers in Q3CY23, the streaming giant’s best quarter of growth since viewers were stuck at home in the early days of the pandemic.

At the same time, chipmakers and tech shares gained after quarterly results from chip-making equipment maker ASML surprised on the upside. ASML said orders more than tripled sequentially as demand for its most-sophisticated chip-making machines soared (primarily out of China which scrambled to beat new US-led chip import sanctions). The surge in orders was underpinned by a comeback in extreme ultraviolet lithography systems, giving confidence for the Dutch firm’s bullish 2025 goals. But AT&T tumbled after earnings miss. NVIDIA, Microsoft and Meta surged.

On Wednesday, Wall Street was boosted by energy. Communication services, techs, and banks & financials, while dragged by materials, utilities, real estate, consumer staples, healthcare, industrials and consumer discretionary. Dow was boosted by Boeing, Chevron, Microsoft, JPM, Caterpillar, and Intel, while dragged by 3M, Verizon, Coca-Cola, Apple and Amgen.

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

Whatever may be the narrative, technically Dow Future (38030), now has to sustain over 38400 levels for a further rally to 38600-38700/39000-39200/39500 levels in the coming days; otherwise, sustaining below 38350/300-38250/200 levels, may again fall to 38000-37500-37300 levels may further fall to 37200/37000-36850/36650 and 36400/36200-36050/36000-35800*/35500 and may further fall to 35350/35250-35000/34800 and 34650/34120-34000 and 33700/33200-33000/32400 in the coming days.

Similarly, NQ-100 Future (17600) now has to sustain over 17650-17850 for a further rally towards 18000; otherwise, sustaining below 17600/17550, may again fall to 17350-17200/17100-17000/16850 may again fall to 16550/16300-16200/16050 and 15700/15400, and further 15100-14140 in the coming days.

Also, technically Gold (XAU/USD: 2013) now has to sustain over 2045 for a further rally to 2062-2085-2105/2120 and 2130/2152 levels; otherwise sustaining below 2040, may again fall to 2020-2010-2000-1990-1975-1960/1940 in the coming days.

 

 

 

 

 

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