Wall Street stumbled from AI high on less dovish Fed talks

On Thursday, Wall Street Futures jumped on NVIDIA and others earnings boost, less hawkish Fed talks and softer than expected composite/SERVICE PMI, and hotter than expected continuing jobless claims. Overall the market is now gradually discounting 75-100 bps rate cuts in 2024 from June-July’24 and the Fed is preparing the market for the same. But the Fed most probably will go for rate cuts from July’24 and by 75 bps unless there is an unusual deflation/dis-inflation and some serious concern about the employment situation, which may keep the Fed for another -25 bps rate cut in H2CY34.

Looking ahead, the Fed may announce a plan for QT tapering in the March meeting and close the same by June before going for rate cuts from July’24. Fed, the world’s most important central bank may not continue QT and rate cuts at the same time, which is contradictory. ECB, BOE, BOC and RBI may also cut rates from July/Aug’24; i.e. in H2CY24 for a cumulative 75-100 bps (synchronized global rate cuts amid a synchronized easing in core inflation); every major G20 central bank including PBOC has to follow ‘King Fed/USD’, whatever may be the narrative.

On Friday, Fed’s Williams almost confirmed:

·         Rate cuts are likely later this year

·         Rate hikes are not my base case

·         My view of the economy hasn't changed after the January data, things are moving in the right direction

·         I expect consumer spending growth to slow this year as growing auto loan/credit card/personal loan delinquencies show that at least some households are facing some stress

·         One of the big surprises in 2023 was consumers continuing to spend and spend pretty strongly through the year

Edited/relevant transcript of AXIOS interview of Fed’s Williams:

·         My overall view of the economy hasn't changed based on one month of data. We've all communicated that we expected month-to-month to move up and down. It can be a little bit bumpy on the way

·         Taking a step back, I think we've seen three very important things. One is we've seen signs of imbalances in the labor market, the economy's imbalances between supply and demand have been coming down. Now, many of the indicators that were saying the labor market was red-hot just a year or two ago, look more kind of like where they were before the pandemic. Still looks like a good strong labor market, but not one with a significant imbalance

·         A couple of indicators are still showing that the labor market is quite strong and demand is probably still a little bit above supply. One is the job vacancies; they've come down. That's moving in the right direction but still quite high. And wage growth still is higher than you would expect in [the] longer run. But again, all these things are moving in the right direction. So that part of the story has continued

·         I think the second part of the story that's important is that this is happening in the context of a strong labor market in an economy that's growing. A year ago, the talk was: Are we going to have a recession? Over 3% GDP growth last year and an unemployment rate of 3.7% — that's not where we're at at all. We're seeing — it's coming back into more balance with a still-strong economy, strong labor market, good job growth

·         And the third, of course, that's very important is that we've seen the inflation trends move down quite quickly over the past year. And it's been broad-based. We've seen it in goods. Goods prices inflation has come down the fastest. We've seen it in some of the other commodity areas. But we're also seeing in services, core services, housing and the non-housing components of that

·         I think on the non-housing, just to get you back to your question, some categories were unusually low in the last few months of last year, bringing the inflation rate down. I recognize that there was probably more noise than signal there. Taking a step back, looking at underlying trends, whether you filter it the different ways we like to do with our economic statistical analysis, looking over six- and 12-month changes, the trends were still in the right direction. Inflation's still above 2%, but now below 3%. And I think the signs are consistent with it continuing to come down, trend down going forward

·         Well, I think, as you know, our long-run goal is 2% inflation. And when I think of sustained basis, it's really about the fact that inflation can move up and down for idiosyncratic reasons. It could be energy prices, it could be other things that aren't lasting or durable factors in inflation, but just represent short-term dynamics

·         And given we have a 2% inflation goal — you want inflation of 2% on average, on a sustained basis — it means that we had some good data that brought it right below 2%, but we know that's not likely to last if you're focused on that medium-term kind of inflation

·         So I don't have a specific period, but it's more than an analysis of "what's the underlying inflation trend?"

·         We have our measure that we've come up with, but there's a trimmed mean from the Dallas Fed and some other measures we can look at to see if underlying inflation is consistent with 2%. And look at all those metrics at the same time. And obviously, looking at where inflation expectations are and whether are they consistent with our 2% longer-term objective

·         So we want to see the data continue to move in the right direction. We've seen a lot of progress over the last year or two now—both on the labor market and on the inflation front. And like I said, things are moving [in] the right direction. I just want to see that continue

·         At some point, I think it will be appropriate to pull back on restrictive monetary policy, likely later this year. But it's really about reading that data and looking for consistent signs that inflation is not only coming down but is moving towards that 2% longer-run goal

·         I don't think there's any formula, or one indicator, or something that will tell you that. It's looking at all the information together, including these signs in the labor market and others and extracting the signal

·         Rate hikes are not my base case. But clearly, if fundamentally the economic outlook changes in a material, significant way — either with inflation not showing signs of moving toward the 2% longer-run goal on a sustained basis or other indicators that monetary policy is not having the needed or desired effects to achieve that goal — then you have to rethink that

·         Is monetary policy adding enough? Is it restrictive enough to ensure that we get back to the 2% inflation goal? So it would be looking at the data, looking at all — what is the underlying inflation doing? Is it not continuing to move consistently towards the 2% goal?

·         Again, that's not my base case. It would be a material change in the economic outlook. But from my point of view, we must get inflation back to 2% on a sustained basis and restore price stability. There are scenarios where it may be appropriate to tighten policy further to make sure that happens. But again, that's not my base case

·         2023 was an incredible, incredible supply-side story. If you looked at the forecast that people were writing down at the end of 2022 or early 2023, nobody was seeing the kind of very strong growth that we saw in the economy, the productivity growth, the labor supply growth — and, of course, at a time when the unemployment rate was edging up and the imbalances in the labor market were receding

·         So it was a period of very strong growth, strong spending, strong job growth, but where supply was the big story. I think that if we could have another great year of supply, both in productivity and labor supply that would be terrific. It would be great for the U.S. economy and also bring further disinflationary pressures, help bring inflation back down

·         Productivity growth had been quite slow in parts of the recovery. And labor supply — of course, we know labor force participation, immigration and things were very low during earlier parts of the pandemic

·         I would like to see continued strong supply-side growth for this year. My expectation would be we're going to see more normal growth on the supply side of the economy this year — hopefully continued improvement, but maybe not on the level of what we saw last year

·         So one example: Some of that productivity growth, I think, was cyclical. We had very strong demand growth. We had other factors helping the economy. Productivity tends to be pro-cyclical — meaning productivity growth is fast when the economy is growing fast. And I think that that's not a longer-term trend or a thing; it's more of a cyclical thing

·         I think the issue (QT tapering) that the committee will be analyzing thinking about and discussing will be about carrying out or executing and implementing the plans that we described back in 2022. What we described then was a two-step process.

·         The first step would be slowing the pace of balance sheet reduction —tapering, if you will. The second part of that process is stopping the reduction in the balance sheet at a point that was above that which we thought was consistent with ample reserves — basically making sure that we're carrying out a monetary policy with a significant amount of reserves in the system, that interest rate control is achieved through the administered rates that we have rather than active increases or decreases in reserves through open market operations

·         So I think the question before the committee is this first step in this process that we've laid out. And that is at what point do we want to slow the reduction of the balance sheet? And therefore, presumably, slow reduction in the amount of reserves. And there are two factors that I think of as important for that. And, of course, we're going to have a lot of discussion around this and thinking about this

·         One is right now and for quite some time, we haven't seen the reduction in the balance sheet translate into the reduction in reserves because of the Overnight Reverse Repo Facility, which exceeded by quite a bit to well over $2 trillion in the past and now is somewhere in between $500 [billion] to $600 billion, and it's been coming down quite quickly

·         That has been kind of a cushion that we've seen, the balance sheet reduction showing up in the reduction in the ON RRP. So I think as that continues to decline towards very low levels over coming months, I think that's one of the factors. Once ON RRP runs out, then obviously the reduction in the asset side of our balance sheet will start translating more one-for-one into bank reserves. And so, I think, that one factor is, the ON RRP running down is something that will change the speed at which reserves respond to the change in the balance sheet

·         The second factor is all the analysis we can do over what's happening in the market for reserves and in short-term money markets and understanding where are we in terms of demand for reserves, signs of interest rates responding to different demand and supply shocks, and looking at how the markets are working there

·         In my view, it's really about — when we decide to slow the shrinking of the balance sheet —to make sure that we get a nice, smooth process of continuing to reduce the balance sheet down to the ultimate level that we want to get to and allowing us to monitor and analyze and understand how that reduction in the balance sheet is meeting that test that we set out for ultimately stopping.

·         So slowing the speed of the balance sheet will give us a little bit more time and give us more data to understand better what's happening in the market and make a good decision ultimately about when we want to stop. It doesn't affect that decision; it just gives us more time and data to inform that decision

·         Fed took a lesson from the 2019 (pre-COVID) disruption in the repo market and thus carefully doing the QT process ensuring financial stability

·         Present estimates of neutral rate may be 0.50-1.50%, against earlier 0.50-1.00% amid stronger demand and higher inflation

·         CRE is not a big risk right now, but the Fed is watching closely

Market wrap:

On Friday, Wall Street Futures jumped to a fresh life time high on tech/AI boost but stumbled in late hours trading after Fed’s Williams, an influential FOMC policymaker almost poured cold water on early Fed rate cuts. The market may be also now concerned about elevated valuation, both technically and fundamentally. Blue Chip Dow Jones (DJ-30) stumbled almost -200 points from the session high of 39342 to close around 38151, almost flat, while tech-heavy NQ-100 tumbled -0.52% and broader SPX-500 edged down -0.06%.

On Friday, Wall Street Futures were dragged by energy, consumer discretionary, techs, and communication services, while boosted by utilities, materials, industrials, healthcare, banks & financials, consumer staples, and real estate to some extent. Wall Street was dragged by Apple, Travelers, Chevron, Boeing, Microsoft, Salesforce, and Verizon, while boosted by Amgen, J&J, IBM, Walgreens Boots, McDonald’s and Cisco. For the week, the S&P 500 saw a gain of 1.6%, the Dow Jones and the Nasdaq added 1.3% each.

‘World’s most important/valuable stock’ Nvidia finished 0.4% higher while hitting a fresh all-time high of $805.55 earlier in the day to surpass a $2 trillion valuation. Carvana surged after the used cars e-commerce platform reported a narrower fourth-quarter loss. Conversely, Booking Holdings tumbled after the online travel company reported earnings that surpassed expectations but cautioned that tensions in the Middle East could impact its results in the current quarter. Warner Bros Discovery also slumped following a disappointing fourth-quarter revenue report.

SPX 500 may be far above fair valuation amid hopes & hypes of a blockbuster earnings growth on tech/generative AI and Fed pivot optimism:

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 5100 and at Q3CY23 TTM EPS is $184.25, the present/TTM PE of the 500 is around 28 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 made a life time high round 5122 Friday after consolidating around 5000 for months, 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 4700-4500 levels in the coming days (whatever may be the correction trigger).

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

Whatever may be the narrative, technically Dow Future (39150), now has to sustain over 39400-39500 levels for a further rally to 39700/39900-40200/40500 and even 42600  levels in the coming days; otherwise, sustaining below 39350 may again fall to 39250/200-39150/39000-38950/38600 and  38400/38200*-38000*/37300 levels in the coming days.

Similarly, NQ-100 Future (17085) now has to sustain over 17400 levels for any recovery to 18300-18200 and further towards 18500/18675-18975/19200 and 19450/19775-2000/20200 in the coming days; otherwise, sustaining below 18350/300-18250/200 may fall to and 17300-16830-16750-16550 in the coming days.

Also, technically Gold (XAU/USD: 2035) now has to sustain over 2045-2055 for any further rally to 2067/2085-2100/2125-2130/2175; otherwise sustaining below 2030, may again fall to 2020/2010-2000-1995/1985-1975 and even 1950 may be on the card.