ANDREAS STENO LARSEN: Hi, guys, and welcome to the Real Vision Daily Briefing. I'm Andreas Steno Larsen, sending to your live Monday, September 19th, ahead of a big central bank weekend. That's why we're going to ask the question today, whether the Fed will be able to stick to their guns on Wednesday when we get the conclusion at the FOMC meeting. And with me to discuss this week of central bank action, I've invited maybe the best central bank watcher I know out there, namely Darius Dale, the CEO of 42Macro. Darius, really good to see you again.
DARIUS DALE: I take great offense to that.
ANDREAS STENO LARSEN: My apologies.
DARIUS DALE: I don't know if I'm going to be known as the best central bank watcher, but I appreciate you, brother.
ANDREAS STENO LARSEN: Let's call you the best inflation watcher then. But before we get to the discussion of the Federal Reserve, I wanted to debate the backdrop macro wise heading into this meeting on Wednesday. Of course, inflation is of great importance for the Federal Reserve reaction function. Why don't you give us the overview of the current inflation pressures in the US heading into this meeting?
DARIUS DALE: Yeah, absolutely. I'll start taking that step back. Because you mentioned it's a big week for global central banks, I think we have somewhere on top like 500 basis points of rate hikes program for this week, at least according to what markets are predicting across all the different central banks. Let's isolate the Fed here, because again, I think the Fed's decision tree is becoming increasingly clear, at least with respect to the August CPI report. A couple charts on that, just getting us started here.
Claire, if you put up Slide 73 that we sent you, where we show the core inflation pressures in the US economy on a three-month annualized rate of change basis, where you can see just going across the chart, looking at the different clusters of bars, here, we have core CPI at 6.4% three-month annualized. Again, we're not looking at year-over-year, because again, the year-over-year statistics are noisy, there's a lot of non-information in the year-over-year.
But I think what the Fed and other investors like myself are looking for is to see if the trending momentum and the time series, the sequential momentum can actually get to a level that's at or near 2% well before the year-over-year time series get there. Just looking at a three-month annualized rate of change basis, you have core CPI at 6.4%, you have core goods CPI 5.9%. And then these are August numbers, core services CPI at 6.5%, shelter CPI new high of 7.4%. And then lastly, services CPI less rent of shelter, at 7.4%.
These numbers are ridiculous. We all know the year-over-year numbers are high. But when you're talking about three-month annualized rates of change in the month of August, we're still building a considerable amount of inflationary pressure in the system.
And this is why if you look at Slide 92, Claire, which I think are some of the more most important time series to look at when you're talking about contextualized inflation momentum in the US economy, whether it be trimmed mean CPI, which popped up to 7.7% on a month-over-month annualized basis in August, median CPI which popped up to 8.9% on a month-over-month annualized basis in August, which is a new all-time high, and then sticky CPI, which popped up to 7.7%.
These numbers are all well north of the pre-COVID trends, which are the light blue bars in each of those charts. I think the key takeaway here is there a possibility for a hawkish surprise relative to what is already expected to be quite a hawkish meeting, when you look at a 75-basis point rate hike being priced in and obviously a positive revision to the dot plot that's going to be more in line with market pricing.
ANDREAS STENO LARSEN: We have a little bit more than 75 basis points priced in for this meeting on Wednesday. But if you were Jay Powell, and you wanted to communicate this tighter for longer narrative, what would you say on Wednesday to emphasize that?
DARIUS DALE: Yeah. I think it's less about what he says and more about what the Fed does. Obviously, they can shock it off the 400 basis points. That's neither here nor there from my perspective, because I think what the Fed doesn't want to do, as Jay Powell eloquently put it, succinctly put it going back to Jackson Hole, which is they don't want to do an about face and doing a dovish pivot because again, their data, all of our data shows that part of the reason we had such this elongated inflation episode in the 1970s was because we had these intermittent periods of tightening and easing.
And what the Fed doesn't want to do is be forced into easing because it overdid it in terms of the monetary tightening. I think 100 basis points is probably less of an issue in terms of markets having to react to that. What I think is more of an issue is the Fed taking its dot plot terminal Fed funds rate expectation amongst its committee members, and again, this is not a Fed deciding this. This is individual committee members voting and putting their own median forecasts, median estimate in there.
If that dot plot gets to a level that is A, in line with market pricing and B, if you look at the longer run projections of neutral and the longer run projections for the dot plot, i.e., where are we going to be in in 2024, et cetera. If those numbers are still sticky and elevated to me, I think that represents a very tacit admission of the Fed acknowledging that we are in this Phase 5 of global liquidity cycle downturn, which we talked about last week, which is acceptance.
Let's just accept the fact that we're going to get rates really high, and we're going to keep them there for a long period of time, which I would argue and our data would show is that outcome is not adequately priced in and across financial markets.
ANDREAS STENO LARSEN: Darius, as investors, we tend to miss the forest for the trees if we're stuck in a debate on whether it will be a 75 basis points or 100 basis point hike on Wednesday. It doesn't really matter for the medium-term trajectory for the Federal Reserve. In terms of the medium-term signals, and the consequences for asset allocation, what will you be watching on Wednesday in relation to that?
DARIUS DALE: Yeah. Look, it's about the Fed. Jay Powell using his words, and the Fed officials using their dotplot votes to effectively tell us that, look, we're not cutting rates next year. Get out of here. We might not even cut rates in 2024. If you look at Slide 79, Claire, what I sent you, I just show the Eurodollar calendar spreads for 2023 and 2024.
And we're still somewhere around minus 32 basis points for 2023, minus 66 basis points for 2024. Right now, the markets are pricing in effectively from the terminal Fed funds rate, we're going to cut rates right around 100 basis points from basically starting in second half or first half of 2023 through the end of 2024. I think that has to be. In my opinion, that has to be median expectation, because the reality is, if the Fed does wind up cutting rates, they're going to cut rates a whole hell of a lot more than 100 basis points.
This is a Fed that panics when it, especially this Jay Powell Fed, this is the Fed that is predetermined to panic when it comes to the economy if they deem that the economic growth outlook and the unemployment outlook, and that becomes more important than currently their [?] on inflation. That tells me that, hey, look, what if we don't get that really deleterious economic outcome, then it's probably that's 100 basis points of tightening that is very unlikely to happen.
I think there's a lot of investors out there that are anchored on this concept of a recession. And I hear a lot of discussions and debates across Wall Street institutional investors that's like, well, in a recession... or when there's a recession, you got to do XYZ or ABC. But that's all wrong from my perspective, because right now, we still have yet to see an inversion in the yield curve that matters for predicting recessions. We talked about this last week, the 10Y 3M has not only not inverted, but it's actually nearly doubled in terms of its level since the early part of August.
So from my perspective, I don't think a recession is the modal outcome here. It may become the modal outcome as we continue to see incremental tightening priced in, but for the current, right now, it is not. And as a function of that, there's a real undertone to the bull market in yields, the bear market in bonds that should continue. And as a function of that, obviously, we're going to continue to see that continue to weigh on asset prices.
ANDREAS STENO LARSEN: We got a great question in relation to this exact spread between the 10Y point and the 3M point on the dollar yield curve earlier today on Twitter. And we got the question specifically on whether we should expect this spread to invert during the fall. If the Federal Reserve delivers a 75-basis point hike this week, and signals further hikes down the road. What's your take on when this spread will actually invert?
DARIUS DALE: Yeah. I think if it's going to invert, it's going to invert probably sometime in November, December if it's going to revert. Because right now, if you look at it on a three-month forward basis, you were more or less-- we are now, including the December Fed Funds meeting or Fed December 14th meeting in the three-month Treasury yield. That's now inclusive of it.
We need to see something incremental in this next three and a half months to cause the thing to invert, either through the lens of investors really starting to increase their duration risk, because they're getting incrementally concerned about the economic outlook, or investors getting equally concerned about the Fed having to do more from a policy rate standpoint.
Again, we all know that this-- at the least history has shown, the Fed has had to get policy rates into real territory relative to realized and observed CPI in order for the Fed to effectively do what it needs to do in terms of slowing demand and slowing the economy. That may not be the case this cycle but I would argue all indications suggest that that is likely to be the case, just given the information I just shared with respect to core inflation pressures and with respect to trimmed mean, median and sticky inflation pressure.
ANDREAS STENO LARSEN: Even if we can postpone this recession discussion, say another quarter or two from no, it's not necessarily a signal to buy risk assets with a nominal lag, also given the communication from the Federal Reserve already now. If you look at the developments in the inflation-adjusted interest rate in the US, we've seen a clear pickup in the real interest rate over the past six eight weeks. To me, that's usually a signal that we should expect spillovers to other asset classes. Talk to this point of the real rate being the thing to watch and markets right now, Darius.
DARIUS DALE: Yeah, 100%. And I think, speaking of spillovers, one thing we track is dispersion within the equity market in terms of trying to monitor changes in flows. Now, we're trying to isolate a shorter-term flows between sectors and style factors that front run, or at least at the bare minimum, observe what "pod shops" are doing. These are the big multi manager, hedge funds, they control a decent amount of the market activity on any given trading day upwards of 75%, 80%, 90% pick your day.
One thing we see in our dispersion analysis on Slide 19, Claire, where we show just on a month-over-month Sharpe ratio basis as a proxy for real time flows, it's been persistently procyclical throughout the summer and into the early part, we're not quite in the fall yet, but we'll be in the fall in a couple of days. That, to me, it's very inconsistent, at least historically with the slowing economy. What that tells me is that investors are taking, they're extrapolating, they're bearish bets on duration in the fixed income market, and they're pushing that into the equity market.
If you look at it on a one-year Z score basis in terms of tracking dispersion from a time series, which is shown on the right, when you get a positive value or a positive Z score in that chart, it's telling you that the procyclical sectors and style actors are leading the equity market in a negative value, shows you that defensive sectors and style factors are leading and not lagging more importantly.
What we're seeing is a consistent push to procyclicality. Now, it's not the push to procyclicality that you typically see in a new bull market. We have not observed that level of procyclicality but it's been consistently procyclical. To answer your question on spillovers, I think this real rate move has been very clear and very evident. If you think of some of the drivers of the real rate move, namely decline in global liquidity and the strong dollar, it's likely to continue at least through the fall.
ANDREAS STENO LARSEN: Yeah, I would tend to agree. And I guess the Federal Reserve has been crystal clear on this topic as well. They want to see real rates at positive levels throughout the yield curve and they want to contain them there for a prolonged period as well until they see a reaction in the economy and then in asset markets. And in relation to that, I wanted to read out loud the tweet of the day for you.
It's a quote from Steven Blitz, an economist at TS Lombard, a great macro shop as well. He said earlier this week that Powell's eight-minute talk at Jackson Hole reminded him of how he learned to speak to his sons when they were teenagers. In short, declarative sentences to get his point across. Would you expect Powell to be this explicit again on Wednesday to really emphasize his point here?
DARIUS DALE: Yes, of course, I do at least in the prepared remarks. But the problem with Powell, and we've seen this many times, is that when you get him into these Q&A sessions, he just starts elaborating too much, which is ironic, because his background is as a lawyer, and these people tend to be very buttoned up with their words.
But in his press conferences, he always winds up shooting himself in the foot. I think he's probably going to be really focused on just hammering home the point, which is, we're nowhere near done with this tightening cycle, we need to get everyone to understand that, hey, we're not coming to the rescue next year with rate cuts and QE unless something really breaks. And obviously, something really breaks is not, in my opinion, at least according to our analysis, has not really occurred yet in financial markets.
Obviously, we've seen some pain across asset classes, but nothing's really broken yet, especially if you look at the labor market, which continues to grow at a very rapid pace. I mean aggregate private sector labor income growth is at 7.6% on a three-month annualized basis, which compares to a pre-COVID trend of 4.4%. We're nearly double in terms of how quickly the labor market is growing if you factor in income, total jobs and hours worked.
I think Powell is going to be very resolute in his commentary, and this just happens to see how much he does or does not shoot himself in the foot in the Q&A section.
ANDREAS STENO LARSEN: Darius, we hosted Thomas Hoenig, the former president of the Kansas Fed earlier this week at Real Vision. And I wanted to play a soundbite for you from his discussion with Harry Melandri in terms of whether the Fed can actually do anything but fail, given the outlook that they have ahead of them with inflation running way beyond target, and the trickiness in terms of bringing this inflation back to target without harming the economy. Let's listen to Thomas and get back to this discussion.
THOMAS HOENIG: I don't know that the Fed has been set up for failure but it is being set up for a huge challenge. Because if the Federal Reserve acts independently, refuses to compromise on buying all the new debt, that means interest rates have to go up even more, because someone has to pay for it and to get them to do it, get the private sector to do it, you have to pay more interest, because they're competing for those available funds.
If the Federal Reserve says, yes, fiscal authority, you're spending, but that's your decision, we are not going to have inflation back up to 5%, and 6%, 8%, 9%, 10%, and so you have to make some decisions yourself. That will bring animus towards the Federal Reserve as it did Paul Volcker, as it did Paul Volcker. And that's when I say, keep saying that's when the test of the FOMC will really take place. Right now, they can do it because unemployment is low. And wages, even though they're falling behind, at least they're increasing to some degree, and people want inflation brought back down.
But if the unemployment rate starts to rise significantly, and if the economy does slow into a recession, even if inflation is still above 6% or 7%, there'll be enormous pressure on the Federal Reserve to reverse itself. And that's when we'll know whether they're going to stick to the plan.
ANDREAS STENO LARSEN: The entire interview with the former head of the Kansas Fed is already available at the Real Vision platform for subscribers today. But back to you, Darius, I have to admit that I'm personally almost grateful that I'm not on the committee voting this year, because it is a tricky task to get inflation back to say 2% to 2.5% without harming the economy. Do you think the Fed is stuck between a rock and a hard place in this debate?
DARIUS DALE: No. I think it's only a tricky task if you don't want to harm the economy. But we know how to get rid of inflation. It's been long documented that if you ameliorate some of these supply/demand imbalances, i.e. by whacking demand, you can get inflation under control. The alternative, obviously, is increasing supply. But we know how difficult and challenging that's going to be in terms of getting expeditious responses in inflation.
If we go the supply route, it could take us three, four or five years before we see any really meaningful developments on the inflation front. I'm not sure how many people really want to stomach 8%, 9%, 7% to 9% inflation for three, four or five years. I think by the end of that process, a lot of people on Twitter who keep screaming it's only supply will be quite sick of that. But that's neither here nor there.
One thing I would bring up with respect to Dr. Hoenig's discussion, in terms of the Fed being destined-- not quite destined to fail but seem to be on this path that make it destined to fail, you and I've talked about this