Dow surged on soft landing optimism amid mixed US GDP data

Wall Street Futures stumbled to some extent Wednesday after hotter-than-expected PMIs in the U.S., which may prevent the Fed from an early rate cut in Q1/Q2CY24. But Wall Street was also boosted by an upbeat report card by some blue chips, AI/Tech optimism coupled with hopes & hypes of Fed pivot. In the early Thursday European session, Dow Future stumbled from around 38090 to 37900, again recovered to 38200, and again slipped to 37950 amid mixed report cards; but eventually Dow Future jumped again to 38212 before closing around 38200 on mixed US GDP report and upbeat report card by IBM. Risk trade sentiment was also boosted by less hawkish hold by the ECB and a report that Russian President Putin is interested in a ‘final settlement’ talk with Ukraine (for security and territory) to end the war.

On Thursday some focus of the market was also on US GDP data. The BEA 1st estimate data show U.S. real GDP for Q4CY23 was around $22672.90B against $22490.70B sequentially (+0.81%) and $21990.00B yearly (+3.11%); all in 2017 constant prices and at seasonally adjusted annual rates. In other words, the U.S. economy has expanded by around +0.81% sequentially (Q/Q), which is equivalent to +3.3% annually against +4.9% in Q3CY23 and much above market consensus of +2.0% annualized rate.

In Q4CY23, the U.S. real GDP was annually boosted by higher consumer spending, higher inventories, higher exports, and lower imports, (higher net trade), while undercut by lower private CAPEX,  and government spending & capex. Overall, the U.S. real GDP for CY23 is now around $22375.33B vs $21822.04 in CY22 (+2.5%) and $21407.69B in CY21 (+1.9%); i.e. the U.S. real GDP grew +2.5% in CY23 against +1.9% in CY22, below Fed’s estimate of +2.6%. The U.S. real GDP is now growing around +0.8% average sequential rate (q/q); i.e. +3.2% yearly rate, above +2.0% yearly (y/y) trend rate, which is +0.5% sequential (q/q) rate. Also, there is almost a $2T increase in U.S. real GDP as a result of changed calculation methodology from 2012 to 2017 constant prices (chained dollar).

Although the Q4CY23 real GDP growth was higher than expected, overall CY23 real GDP growth at +2.5% was less than the Fed’s estimate of +2.6%. Moreover, the latest GDP data shows the core PCE price index increased by +2.0% sequentially, while the headline index (PCE) was up only +1.7%, the least since Q2CY20 and compared to +2.6% in Q3CY23. The market is now expecting lower core PCE inflation around +2.7% than the market consensus of +3.0%. This Wall Street surged on the soft landing and the Fed pivoted optimism. In any way, core CPI and core PPI data already indicated core PCE inflation around +2.7% in Dec’23.

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 Thursday, Wall Street closed mixed. Although DJ-30 closed +0.50% on mixed GDP data, tech-heavy NQ-100 was almost flat amid a subdued report card by Tesla. Also, softer-than-expected jobless claims boosted risk trade to some extent; Gold recovered on a mixed GDP report but again slipped as bond yield surged briefly after the subdued auction of US bonds.

On Thursday, Wall Street was boosted by energy (higher oil amid escalating tension in the Red Sea), communication services, utilities, real estate, materials, industrials, consumer staples, banks & financials, and techs, while dragged by consumer discretionary and healthcare.

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

Whatever may be the narrative, technically Dow Future (38165), 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 (17550) 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: 2019) now has to sustain over 2045 for a further rally to 2062-2085-2105/2120 and 2130/2152 levels; otherwise sustaining below 2040-2035, may again fall to 2020-2010-2000-1990-1975-1960/1940 in the coming days.