Dow, Gold slips on fading hopes of Fed rate cuts in 2024

But Nasdaq continues to get boosted by Nvidia related AI Chip optimism; the Fed is now gradually preparing the market for no rate hike in 2024

On Friday, Wall Street eventually closed mixed ahead of the long weekend; tech-heavy NQ-100 surged to a new life time high amid AI chip optimism (NVIDIA), while broader SPX-500 gained around +0.7% and blue chip DJ-30 was almost flat; Apple and Alphabet also helped. Wall Street was boosted by communication services, techs, utilities, materials, consumer discretionary, banks & financials, industrials, consumer staples, energy, and real estate, while dragged by healthcare. On Thursday, Wall Street Futures and gold plunged on fading hopes of a Fed rate cut from Dec’24 after hotter-than-expected S&P Global Service PMI data for May, well into the expansion zone after a brief dip around the contraction zone in April. Also, hawkish Fed talks dragged the risk trade.

On Friday, the UM final data showed the year-ahead (1Y) US inflation expectations rose to a six-month high of 3.3% in May, from 3.2% sequentially but below the flash estimate of 3.5% (after actual inflation/CPI data dips in April). Also, the five-year (5Y) US/UM inflation expectations stood at a five-month high of 3% in May, unchanged from April and below the flash estimate of 3.1%. Negative revision of US/UM 1Y inflation expectations helped some short covering in both Wall Street Futures and Gold after heavy selling on Thursday and early Friday.

On Monday, Gold, Silver, and also oil got some boost in a holiday-thinned light market on escalated Gaza War tensions but stumbled early Tuesday on hawkish Fed talks and some progress of Gaza war ceasefire talks. Fed’s Kashkari almost poured cold water on any rate cut in 2024, while Hamas was again offered another fresh ceasefire proposal by Israel after the Rafah attack.

On Tuesday, Wall Street Futures and gold were also undercut by upbeat US/CB consumer confidence data; US consumer confidence ticks up after three straight declines but consumers remain anxious about the future. The Conference Board (CB) Consumer Confidence Index rose in May to 102.0 from 97.5 in April (a slight upward revision).

The CB said:

"Confidence improved in May after three consecutive months of decline. Consumers' assessment of current business conditions was slightly less positive than last month. However, the strong labor market continued to bolster consumers' overall assessment of the present situation. Views of current labor market conditions improved in May, as fewer respondents said jobs were 'hard to get,' which outweighed a slight decline in the number who said jobs were 'plentiful.' Looking ahead, fewer consumers expected deterioration in future business conditions, job availability, and income, increasing the Expectation Index. Nonetheless, the overall confidence gauge remained within the relatively narrow range it has been hovering in for more than two years.

Compared to last month, confidence improved among consumers of all age groups. In terms of income, those making over $100K expressed the largest rise in confidence. On a six-month moving average basis, confidence continued to be highest among the youngest (under 35) and wealthiest (making over $100K) consumers.

According to May's write-in responses, consumers cited prices, especially for food and groceries, as having the greatest impact on their view of the U.S. economy. Notably, average 12-month inflation expectations ticked up from 5.3 percent to 5.4 percent. Perhaps as a consequence, the share of consumers expecting higher interest rates over the year ahead also rose, from 55.2 percent to 56.2 percent. Meanwhile, consumers' assessment of their Family's Financial Situation both currently and over the next six months (measures not included in calculating the Consumer Confidence Index) deteriorated slightly.

The survey also revealed a possible resurgence in recession concerns. The Perceived Likelihood of a US Recession over the Next 12 Months rose again in May, with more consumers believing the recession is 'somewhat likely' or 'very likely'. This contrasts with CEO assessments of recession risk: according to our CEO Confidence survey, only 35 percent of CEOs surveyed in April anticipated a recession within the next 12 to 18 months. Consumers were nonetheless upbeat about the stock market, with 48.2 percent expecting stock prices to increase over the year ahead, compared to 25.4 percent expecting a decrease and 26.4 expecting no change."

On a six-month moving average basis, purchasing plans for homes were unchanged in May at their lowest level since August 2012. While still relatively depressed, buying plans for autos rose slightly for a second month, and buying plans for most big-ticket appliances increased for the first time in several months. Meanwhile, buying plans for electronics products were largely unchanged except for smartphones, which saw renewed interest.

Overall, US consumers are now moderately confident amid robust labor and also stock market despite higher cost of living and higher borrowing costs.

On Tuesday, Minneapolis Fed’s President Kashkari said:

·         Inflation has moved sideways recently

·         We need to wait and see and get more confidence in prices

·         We shouldn't rule anything out on the policy path

·         The Fed is in a good position because of a strong labor market

·         The US economy has remained remarkably resilient

·         I don't see a need to hurry and cut rates

·         I want to see many more months of positive inflation data before a rate cut

·         No hurry to cut interest rates

·         The US labor market has softened but remains tight

·         Wage growth is still quite robust relative to the 2% goal

·         I don't think anyone has taken rate increases off the table

·         If surprised by the data, the Fed will do what we need to do

·         The policy is restrictive by most measures, but not all

·         The short-run neutral rate may have gone up temporarily

·         We could stay on hold for an indefinite period of time

·         Commercial real estate is a risk, I expect big losses

·         I don't think that weakness (slack) in the economy is needed to lower inflation

·         I certainly won't pencil in more than two cuts for 2024

On Tuesday, Fed’s Governor Bowman said in an essay on The Federal Reserve's Balance Sheet as a Monetary Policy Tool: Past Lessons and Future Considerations: 

“I would like to thank the Bank of Japan and Governor Ueda for organizing this year's conference and for the invitation to participate in this afternoon's panel.1 The topic of "the effects of conventional and unconventional policy instruments" is an important one given central banks' expanded use of unconventional monetary policy tools to pursue their mandates over the past decade and a half.

My remarks focus on the use of the central bank balance sheet as a monetary policy tool. I will first offer some observations regarding the benefits and costs of large-scale asset purchases (LSAPs) by reflecting on the two episodes of the Federal Reserve's active use of the balance sheet in U.S. monetary policy following the 2008 financial crisis and during the COVID-19 pandemic. I will then discuss some considerations regarding future balance sheet policy as the Federal Open Market Committee (FOMC) seeks to bring inflation back down to its 2 percent target following the post-pandemic inflation surge, and as the FOMC continues to reduce the size of the Federal Reserve's balance sheet.

Lessons Learned from Past Uses of the Federal Reserve's Balance Sheet as a Monetary Policy Tool Post-2008 Financial Crisis Balance Sheet Policy:

A key challenge for the FOMC following the 2008 financial crisis was how to provide additional support to an economy that was experiencing high unemployment and subdued inflation after the FOMC lowered its primary and conventional monetary policy tool—the target range for the federal funds rate—to near zero. Given the importance of longer-term interest rates for broader asset prices and investment and consumption decisions, the FOMC used both forward guidance and LSAPs (QE) to help lower longer-term rates, which had not yet moved to zero. Forward guidance intended to lower longer-term interest rates by shifting expectations of "low-for-long" short-term interest rates in line with a low-for-long federal funds rate.

LSAPs, or quantitative easing (QE), were intended to reduce longer-term interest rates further by lowering the yields of specific longer-dated securities being purchased and by reducing more generally the term premia, the compensation that investors must earn to incentivize investment in a longer-term bond relative to a short-term bond. LSAPs could also reinforce the FOMC's forward guidance of low-for-long short-term interest rates. Such reinforcement of low-for-long forward guidance could be especially powerful if the FOMC communicated that it would not consider raising the target range for the federal funds rate until it stopped actively engaging in asset purchases for the purposes of QE.

The Federal Reserve purchased both Treasury securities and agency mortgage-backed securities (MBS) as part of its QE programs from 2009 to 2014. Figure shows the evolution of the Federal Reserve balance sheet assets and liabilities from before the 2008 financial crisis to the present. The Fed's Treasury and agency securities holdings increased from around half a trillion dollars to around $4.25 trillion by the end of the third round of QE, which ended in 2014.

A range of studies indicate that the Fed's asset purchases were effective in raising the prices of and lowering the yields on the targeted class of securities. Research suggests that these asset purchases also helped lower term and risk premia across other asset classes, including corporate securities. The impact on the MBS pricing and credit flow was significant since securities prices in this asset class were especially impacted during the financial crisis. Financial institutions holding MBS on their balance sheets, including banks, were also significantly affected.

Some studies have documented that the Fed's agency MBS purchases encouraged banks to continue to lend as the prices of their on-balance-sheet MBS holdings rose in response to QE. Overall, the evidence indicates that the Fed's LSAPs following the financial crisis helped support the economic recovery. The progress on the FOMC's dual mandate of maximum employment and price stability was assisted by the further easing of financial conditions after the federal funds rate had reached its effective lower bound. The post-financial crisis period experience showed that securities purchases in a specific asset class could be effective for those asset classes that had experienced stress, as was the case with MBS during that period.

The Federal Reserve concluded its asset purchases (QE) in 2014, after initiating the tapering process in 2013. In 2017, the Fed began to reduce its securities holding, which is often referred to as quantitative tightening (QT). In January 2019, the FOMC voted to operate monetary policy in an "ample reserves" environment. This change in the policy implementation framework had the effect of keeping the size of the balance sheet much larger and providing more liquidity to the banking system in normal times than had been the case before the financial crisis.

The FOMC ended QT in August 2019, and balance sheet growth resumed in October 2019 through the purchase of U.S. Treasury bills and securities following a brief period of stress in money markets in which the interest rates on repurchase agreements and other short-term funding instruments jumped, as noted by the line labeled "Repo Spike" in the figure. This stress was interpreted as an indication that the level of reserves had fallen below ample levels

Overall, one could deem the post–financial crisis use of the Federal Reserve's balance sheet as a monetary policy tool a success. Unemployment fell and inflation remained near 2 percent through the period over which LSAPs were conducted. The FOMC was able to end LSAPs and eventually was able to partially unwind them, though the overall terminal size of the Fed's securities holdings as a share of GDP following the end of QT was much greater than before the financial crisis. This much larger end state was a direct result of the FOMC's decision to implement monetary policy in an ample-reserves operating framework and had the effect of lowering the likelihood of future volatility in short-term funding markets.

COVID-19 pandemic balance sheet policy

Given the effectiveness of the balance sheet as a monetary policy tool over the previous decade, the FOMC rapidly deployed LSAPs in March 2020 as part of its response to the pandemic. These purchases followed the onset of the COVID-19 pandemic at that time, and the FOMC returned the federal funds rate to its effective lower bound. Following an initial higher level of Treasury and agency MBS purchases motivated both by restoring market functioning following a period of severe stress and by providing monetary policy accommodation, the FOMC began to purchase $80 billion of Treasury securities and $40 billion of agency MBS per month.

In its December 2020 post-meeting statement, the FOMC communicated that it intended to continue this pace of asset purchases "until substantial further progress has been made toward the Committee's maximum employment and price stability goals." By the end of the pandemic period asset purchases, total securities held by the Federal Reserve stood at around $8.5 trillion.

The pace of asset purchases during the pandemic period was much greater than in the previous QE episodes. Conditions in the economy and financial system were also different than those that prevailed following the 2008 financial crisis in significant ways. The stabilizing actions taken by the Federal Reserve to restore market functioning and to support financial stability in the first half of 2020, in addition to the much higher capital levels in the banking system relative to 2008, enabled the financial system to remain resilient. Credit continued to be available to households, businesses, and local governments following the pandemic's onset.

The U.S. Congress and the Administration also provided extraordinary fiscal support in response to the pandemic—which included stimulus checks sent to households, expanded unemployment insurance, and the Paycheck Protection Program—that bolstered household and business balance sheets. The housing market—recently recovered from the buildup of poorly underwritten mortgage debt in the lead-up to the 2008 financial crisis and a subsequent steep decline in house prices—remained in sound condition. As households and families sought larger living spaces and amenities as they worked from home during the pandemic, house prices increased sharply.

In hindsight, the sharp contrast between the economic and financial system conditions during the pandemic period and those following the 2008 financial crisis raises questions about the similarities in the response of the Federal Reserve and FOMC to these events. Was such a strong balance sheet policy response during the pandemic appropriate, and to what extent did such a strong balance sheet policy response contribute to the buildup of inflationary pressures and the post-pandemic inflation surge?

Given the underlying strength in the housing market, should the FOMC have conducted such large purchases of agency MBS into late 2021? Given the strong fiscal response to support spending by households and businesses and the large issuance of Treasury debt, should the FOMC have conducted such large purchases of Treasury securities into late 2021? I look forward to our conversation today and future studies on these questions, such as those conducted regarding the effectiveness of balance sheet policies following the 2008 financial crisis.

My view is that the FOMC would likely have benefited from an earlier discussion and decision to begin tapering and subsequently end asset purchases in 2021 given the signs of emerging inflationary pressures. Doing so would have allowed the FOMC the option to begin to tighten monetary policy earlier by raising the target range for the federal funds rate. While a robust and rapid response by the FOMC was appropriate in 2020, I think it is worth asking whether such a robust response for so long was appropriate. The economic and financial system conditions were very different during the pandemic and included a strongly accommodative fiscal backdrop.

Could the FOMC have reduced its pace of asset purchases earlier once it was clear that market turmoil had subsided, just as the 13(3) emergency lending facilities established in 2020 were allowed to expire and exit plans developed for those programs? A thorough discussion of these questions will be a useful reference for the FOMC and other central banks as they consider the future use of QE as a monetary policy tool. This perspective would be helpful for historical reference when formulating appropriate balance sheet policy as a monetary policy response to future episodes when the conventional interest rate tool is near zero.

Another important difference between the FOMC's balance sheet policy following the pandemic and its balance sheet policy following the 2008 financial crisis was the speed and timing of the subsequent reduction in the size of the Federal Reserve's securities holdings during the period of QT. This difference reflects the larger amount of securities purchases compared to the earlier periods of QE as well as the quite different economic conditions facing the FOMC at the start of QT post-pandemic. These conditions included too-high inflation and a desire by the FOMC to tighten monetary policy through both the federal funds rate and the balance sheet tools.

So far, the rapid and sustained pace of the Federal Reserve's securities runoff has proceeded relatively smoothly. A useful question for further inquiry is to what extent during the post-pandemic period has QT served to further tighten financial conditions. With the understanding that QT is a tool employed beyond conventional monetary policy restriction, how does one measure the incremental increase above the FOMC's concurrent increases in the target range for the federal funds rate and related forward guidance regarding its policy rate?

Evidence to date suggests that QT exerts an independent effect on tightening financial conditions, though in some cases it may be asymmetric to the effects of QE. Quantifying the effects of QT as well as QE will be helpful to policymakers in their future deliberations regarding the use of the balance sheet in setting monetary policy.

Future Considerations Regarding the Federal Reserve's Balance Sheet Policy

Looking ahead, the FOMC continues to reduce the size of its balance sheet as it seeks to maintain a sufficiently restrictive stance of monetary policy to bring inflation back down to its 2 percent goal. Recently, the FOMC voted to slow the pace of securities runoff by around half beginning in June. In its Plans for Reducing the Size of the Federal Reserve's Balance Sheet released in May 2022, the FOMC noted that it would eventually slow and then stop securities runoff when reserve balances are somewhat above the levels it judges to be consistent with ample reserves to ensure a smooth transition to ample-reserves levels.

Aggregate reserve levels currently stand at around the levels at the start of the balance sheet runoff in June 2022, and there are still sizable balances in the overnight reverse repurchase agreement (ON RRP) facility. In light of these conditions, I would have supported either waiting to slow the pace of balance sheet runoff to a later point in time or implementing a more tapered slowing in the pace of runoff.

While it is important to slow the pace of balance sheet runoff as reserves approach ample levels, in my view, we are not yet at that point, especially with still sizable take-up at the ON RRP. In my view, it is important to continue to reduce the size of the balance sheet to reach ample reserves as soon as possible while the economy is still strong. Doing so will allow the Federal Reserve to more effectively and credibly use its balance sheet to respond to future economic and financial shocks.

As balance sheet runoff proceeds, however, it will eventually be appropriate to stop runoff as reserves near an ample level. The FOMC will be monitoring money market conditions and related interest rates as it assesses the point at which reserve levels reach ample. It will be important to communicate that any future changes to balance sheet runoff do not reflect a change in the FOMC's monetary policy stance. Not effectively communicating this point might cause the public to interpret the endpoint of QT as a signal that the FOMC would decrease the target range for the federal funds rate, thereby causing financial conditions to inappropriately ease.

Another important issue regarding future balance sheet policy is what the composition of the Federal Reserve's securities holdings should be in the long run. As noted in the FOMC's January 2022 Principles for Reducing the Size of the Federal Reserve's Balance Sheet, the FOMC intends to hold primarily Treasury securities in the longer run to minimize the effects of the Federal Reserve's holdings on the allocation of credit across the economy.

I strongly support this principle. Consistent with this statement, the FOMC will reinvest any principal payments from agency MBS holdings above the current runoff cap into Treasury securities. Once the balance sheet runoff concludes, I expect that proceeds from agency MBS holdings would continue to be reinvested in Treasury securities to facilitate a transition of the Federal Reserve's balance sheet holdings to consist of primarily Treasury securities.

The longer-run maturity structure of the Federal Reserve's Treasury securities holdings is also an important consideration. A benefit of a balance sheet Treasury security maturity structure that mirrors the broader Treasury market is that the Fed's holdings would be "neutral" in the sense that they would not disproportionately affect the pricing of any given maturity of Treasury security or provide incentives for the issuance of any given type of Treasury security.

However, a balance sheet tilted slightly toward shorter-dated Treasury securities would allow some flexibility in approach. For example, the FOMC could reduce its holdings of shorter-dated Treasury securities in favor of longer-dated Treasury securities in a future scenario in which the FOMC wanted to provide monetary policy accommodation via the balance sheet without expanding the size of its securities holdings. This approach would be similar to the FOMC's maturity extension program in 2011 and 2012, sometimes referred to as "operation twist." It will be important to consider such potential costs and benefits to the Federal Reserve's Treasury securities maturity structure and the best ways to achieve the desired maturity structure over time.

It is also important for the FOMC to clearly distinguish when the goal of future asset purchases is restoring market functioning or supporting financial stability. In my view, when the Federal Reserve purchases securities for such purposes, it should communicate that those purchases will be temporary and subsequently unwound when financial market conditions have normalized.

In conclusion, the FOMC's past experiences with using the Federal Reserve's balance sheet as a monetary policy tool have demonstrated that the central bank balance sheet can be an effective way to ease financial conditions and support the economy in periods in which the conventional monetary policy interest rate tool has reached the zero lower bound. Importantly, the U.S. experience shows that the effects of QE and QT can have varying effects depending on the economic and financial system environment, an important consideration for future episodes.

Just as when using the conventional monetary policy interest rate, monetary policymakers must use the balance sheet judiciously when setting monetary policy. Policymakers must also consider the risks of "doing too little" in balance with the risks of "doing too much" as they pursue their monetary policy mandates.”

Fed’s Governor Bowman indicated Fed may have done too much with QE and now also doing too little in QT, which may be one of the primary reasons behind elevated inflation. Bowman may have preferred no QT tapering from mid-June as was announced by the Fed in its May policy statement. In this way, the Fed has already started QT tapering to avoid any late 2019 type of QT tantrum (REPO spike), but in the future, depending on any financial crisis, the Fed may go for any QE in a limited/measured way, so that ‘too much’ QE will not pose inflation problem after the crisis gets over.

Conclusions: Fed may not cut even in Dec’24 and may revise June dot-plots

Overall, the Fed is now changing its tone and gradually preparing the market for no rate cuts in 2024, especially from Sep’24 to avoid any political controversy just ahead of Nov’24 US election.

Also, looking ahead, the Fed may keep B/S size around $6.60-6.50T, around pre-COVID levels and 22% of estimated CY26 nominal GDP around $30T 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 $7.30T (May 24). At around the projected QT tapering rate of $0.04T/M, it may take 18 months from June’24 to reach the targeted Fed B/S size of around $6.60T; i.e. by Dec’25, Fed’s QT may end with the B/S size around $6.60-6.50T.

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 the general public (voters) against Biden admin (Democrats) amid 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 have cut 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 avoid any political controversy:

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.

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 original/effective QT pace, around 0.07T/M which may trigger another QT tantrum, as we have seen in late 2019.

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 the 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.

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 amid a fall in inflation, then the 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 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%. But after recent remarks by various Fed policymakers, it seems that the Fed may not cut thrice in 2024 from Sep’24 and may cut only once (symbolic) in Dec’24 or may not cut at all in 2024.

The market is now expecting 3 to 1 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.

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.

The 6M rolling average of US core inflation (PCE+CPI) is now around +3.5%. Fed may start cutting rates 75 if the 6M rolling average of core inflation (PCE+CPI) indeed eased further to +3.0% by CY24. 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%

Less likely: 1st scenario: 75 bps rate cuts each in 2024, 2025, 2026, and -50 bps in 2027 for a neutral repo rate of +2.75%; More likely 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 the QT at a reduced rate of around 40B/M till Dec’25 for a B/S size of around $6.60-6.50T. Fed may continue the QT (even at an officially slower pace) and rate cuts at the same time 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.

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 Tuesday Dow Future and gold slid after hawkish Fed talks, hotter than expected US/CB consumer confidence data and fading hopes of Fed rate cuts even by Dec’24. But tech heavy NQ-100 edged up +0.3%, supported by Nvidia (AI chip) boost after a report that Musk's AI startup, xAI may utilize Nvidia’s H100 graphics processing units (GPU).

On Tuesday, Wall Street was boosted by techs (AI chip optimism), energy, and communication services, while dragged by industrials, healthcare, banks & financials, consumer staples, real estate, materials, utilities, and consumer discretionary to some extent. Script-wise, Wall Street was boosted by Nvidia, Intel, ARM, AMD (AI Chip makers), Home Depot, Chevron, Amazon, Walt Disney, Boeing and Nike to some extent, while dragged by Merck, Amgen, McDonald’s, J&J, Travelers, Visa, 3M, Verizon, Salesforce, United Health, IBM, Caterpillar, JPM, Walmart, American Express, Cisco, Goldman Sachs, Coca-Cola and Honeywell.

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

Whatever may be the narrative, technically Dow Future (39100) has to sustain over 39000 for any recovery to 39200//39300-39400*/39700 and 39800/40200-40350*/40500 and may further rally to 40600-40700/41000 and even 42000-42700 in the coming days; otherwise, sustaining below 38900 may further fall to 38750/38550-38450/38250 and 38100*/37900-37600/37400 in the coming days.

Similarly, NQ-100 Future (18975) has to sustain over 19100 for a further rally to 19200-19450/19775 and 20000/20200 in the coming days; otherwise, sustaining below 19050/19000 may fall to 18850-18750, may again fall to 18350/18100-18000/17900 and 17800/17700-17600-17500 and further 17400/17300-17100/17000* in the coming days.

Also, technically Gold (XAU/USD: 2340) has to sustain over 2330 for any recovery to 2355/2365*-2375/2385 and further rally to 2400/2425-2435/2455* and 2475-2500; otherwise sustaining below 2325, may further fall to 2315/2300-2290/2275* and further to 2245/2230-2220/2180 and 2155/2115-2085/2045 in the coming days.