Wall Street, Gold edged down on mixed US core PCE inflation

Wall Street was trading mixed for the last few trading sessions amid mixed report cards, hotter than expected GDP data, soft landing optimism, hopes & hypes of early and deeper Fed rate cuts coupled with Chinese monetary & fiscal stimulus. Overall, the stimulus-addicted Wall Street may be trading far ahead of its fundamentals/valuation. SPX-500 gained around +24% in the last year (2023) and +27% in the last three years (2021-23), but currently may be running far ahead of fair valuation on hopes & hypes of an early & deeper Fed rate cuts and AI /tech optimism. The S&P 500 is now around 4900 and at Q3CY23 TTM EPS is $184.25, the present/TTM PE of the 500 is around 27 against fair/average PE of around 20 and average EPS growths +17.50% (~18%) since 2018.

In Q3CY23, the actual S&P 500 (SPX-500) EPS was around $47.65 vs 48.58 sequentially (-1.91%), 44.41 yearly (+7.30%), and market expectations 52.35. Now considering the current run rate, the Q4CY23 EPS may grow sequentially by around +2.50% to $48.84, which may translate the CY23 EPS to around $193.48 against CY22 EPS of $172.75 (+12.00%).

In CY22, the EPS of the S&P 500 was around $172.75 vs 197.87 in CY21 (-12.70%).  Now, assuming a +15% CAGR in EPS for CY24-25 amid lower borrowing costs (Fed rate cuts), synchronized global reflation/growths, and the uptick in consumer spending, SPX-500 may report an EPS of around $222.50-255.88. Further assuming an average fair PE of 20, the fair value of the S&P 500 may be around 4450-5118. As the financial market usually discounts 1Y earnings in advance, the projected fair value of the S&P500 may be around 4450-5120 by Dec’23-Dec’24, while the present fair value may be around 4450-3870.

But SPX-500 is now trading above 4900 and may be eyeing 5120, the FY25 fair valuation, if EPS indeed comes around 255 by CY25 from present 185 levels; i.e. SPX-500 is now trading almost projected CY25 EPS valuation levels instead of CY24 and may soon correct itself and fall around 4500 levels in the coming days (whatever may be the correction trigger).

On Friday some focus of the market was on U.S. Core PCE inflation for December. On Friday, BEA flash data showed U.S. annual core PCE inflation (at 2017 constant prices) for December further eased to +2.9% from +3.2% sequentially, slightly below the market expectations of +3.0% and lowest since Mar’21, but in line with Goldman Sachs (GS) forecast made soon after core CPI and core PPI data mid-January.

On a sequential (m/m) basis (seasonally adjusted at 2017 constant prices) the U.S. core PCE inflation increased by +0.2% (~0.17%) in December from +0.1% in October, in line with market expectations of +0.2%.

In December, the U.S. core PCE service inflation ex Housing/shelter, the current focus of the Fed also eased to +3.3% from +3.5% sequentially and most notably the prior sticky & elevated zone of around +5.0% in H1CY23. Also, PCE service inflation eased to +3.9% in December from +4.1% sequentially.

 

Overall, the average core PCE inflation for 2023 is now around +4.1%, while the same for core CPI inflation is +4.8% and an average of core PCE+ CPI WAS around +4.5%. The Fed goes by a 6M rolling average of core PCE inflation for any important policy move. As per the new series (2017 constant prices), the 6M rolling average core PCE inflation is now around +3.5%, while the YTD average is +4.1%. Also, the 6M rolling average of U.S. core CPI inflation is now around +4.2%, while the YTD average is +4.8%.

Conclusions:

The 12M average between the US core CPI and core PCE inflation is now around +4.5%, which the Fed may consider as underlying core inflation, the target of which is +2.0% on a durable basis. The 6M rolling average of core inflation (PCE+CPI) is now around +3.9% or around +4.0%.

Fed may cut 75-100 bps in H2CY23 if the 6M rolling average of core inflation (PCE+CPI) indeed eased further to +3.0% by H1CY24.

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 Friday, Wall Street closed mixed amid mixed economic data, report cards, and hopes & hypes of an early and deeper Fed rate cut. The market is now implying the start of 1st rate cuts of -25 bps from May’24 against earlier March’24. Although Fed policymakers are trying their best to convince the market about no rate cuts in H1CY24, the market seems not convinced as after all, the Fed is now actively talking about rate cuts, although emphasizing that it’s premature. On Friday, Wall Street Futures and gold were also undercut by hotter-than-expected personal/consumer spending and pending home sales for December. Blue chip DJ-30 edged up +0.16%, while broader SPX-500 EDGED DOWN -0.07%, while tech-heavy NQ-100 slumped -0.55%.

On the corporate front, American Express soared amid upbeat guidance after the company said it expects revenue in 2024 to increase 9% to 11%. Intel tumbled after issuing disappointing guidance although earnings and revenue topped estimates. Visa slips after providing a tepid outlook/guidance.

On Friday, Wall Street was boosted by energy (higher oil amid escalating Red Sea tensions), healthcare, consumer discretionary, consumer staples, communication services, utilities, and banks & financials, while dragged by techs, real estate, industrials and materials to some extent. US bond yields recovered to some extent as the market is now shifting its rate cut possibility gradually to H2CY24

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

Whatever may be the narrative, technically Dow Future (38240), now has to sustain over 38400-38600 levels for a further rally to 38800/39000-39200/39500 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: 2018) 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.