MAGGIE LAKE: Hey there, welcome to the Daily Briefing. It's Wednesday, May 4th, 2022. I'm Maggie Lake, and here with me today is Darius Dale, founder of 42Macro. And wow, Darius, this is a move we are seeing after the Fed.
DARIUS DALE: There's a lot of stuff to unpack. I think it's a very, very important meeting in terms of the next six to nine months of that market activity.
MAGGIE LAKE: Certainly. Well, let's catch everybody up if you haven't been glued to your screens. Today, big Fed day. End of the two-day meeting, they hiked 50 basis points as expected, but then Fed Chair Jay Powell came out and basically ruled out any aggressive-- so they're not actively considering more aggressive rate hikes, basically taking a 75-basis point rate hike for June off the table, which completely surprised the market. The reaction was swift. And as you said, Darius, straight up.
Let's just walk through the numbers. They're notable. The major US stock markets were just closing here, rallied 3% across the board, the Dow up nearly 1000 points, the NASDAQ 3.19%, the S&P 500 at 3%, its best gain I think, since May 2020. If that holds, the yields on the 10Y Treasury bond moving in the opposite direction back down to 2.92, backing all the way down from 3%. That's a big move.
Cryptocurrencies rallying, risk on and the VIX falling 13%. And again, we'll have to see if this holds. But just what did you make of the press conference? Because that seems to be what really led this thing going.
DARIUS DALE: Yeah, absolutely. Anytime we have one of these off schedule FOMC meetings where we do not get a revised dotplot, in summary, economic projections, really the whole market, the whole world's global financial markets are hinging on one man's mouth. And he's made a couple of comments. Obviously, you alluded to the 75-basis point rate hike being something they're not actively considering, that got things going.
You remember that for the first little part of the press conference, markets are unchanged, they were on edge looking for the signal. And that was the first aspect of the signal. But the bigger aspect of the signal why we've seen the market push itself higher up about just shy of 3% today, just basically where we were last Thursday's highs, by the way, I think the comment he made about unintended-- I don't think it was intentional or not, but he said that he felt neutral was somewhere between 2.5% to 3%.
And if you would think about it, most investors and market participants don't really understand where neutral is, no one knows where neutral is. It's a wonky academic framework, if you will, but he threw out the Fed's target on that on accident. It didn't seem like he meant to do it, but that's what really catalyzed the markets because market pricing, if you look at Eurodollars, overnight index swaps or Fed Funds Futures, had already gotten there.
The market's like oh, no, wait, we've already overpriced this relative to our inflation forecasts, the consensus inflation forecasts call for it to come down alongside the Fed's. Now, that's the end of the dovishness. You think about the whole outcome for this meeting, we can unpack this because it's a loaded statement, this is a very bullish statement in the short term. But everything else he said, and we can go down the list, is extremely bearish from the medium-term perspective, particularly in the context of inflation may not-- to say that inflation does not get under control.
MAGGIE LAKE: Yeah. Let's go through, what jumped out at you? And let's start with maybe why do you think he felt the need to rule out that 75 basis point hike? Was he trying to tell the markets that they'd overdone it? And sitting with the juxtaposition of some of the other stuff that he talked about, what do you think was going on there? Because that part did not seem accidental.
DARIUS DALE: Yeah. I think, again, I think that as an institution, this is a Federal Reserve that wants to be measured and data driven. That's the legacy of the Jay Powell Fed, right. Its pivots are data driven, as opposed to wonky academic models and forecasts and operating monetary policy based on those tools. Taking off 75 basis points out of the equation, it gives them more flexibility either to stick at 750 basis points, which they effectively confirmed for the next several meetings is very much on the table.
He said several, by the way, this is more than what the markets are pricing in. And then in terms of the economy, he didn't make any statements that will suggest that the Fed is concerned about the economy. In fact, I would argue he made one in particular that tells me they don't care about the economy. He didn't say we're trying to enact a soft landing. He said soft-ish landing.
And this is the first admission, this is a tacit admission that this is an FOMC that is willing to push the economy into a mild recession in order to tame the inflation drag. It's the first indication we've gotten from them on that.
MAGGIE LAKE: Is it that, Darius, or is it just that they know that have an awful track record at achieving a soft landing, like terrible, right?
DARIUS DALE: Yeah. Well, there have only been two soft landings in the last, really, of significance. One in 1984, one in 1994. And the reason I think those are very much off the table in this particular juncture, because we had a lot more organic growth potential in the economy back in those instances. In 1984, when they started the tightening cycle, the unemployment rate was north of 10%. In 1994, when they started the tightening cycle, the unemployment rate was north of 6.5%.
Today, we have an unemployment rate of 3.6%, that can actually go lower if we start to pull people back into the labor market. The concept of a soft landing from this point in the economic cycle, labor being as tight as it is, inflation being as high as it is, consumers having spent as much as they've already have, to me, it seems like a moot point.
MAGGIE LAKE: Yeah. There's so much to talk about today. I'm going to try to bounce back and forth between the really important discussion about the fundamentals and it is a really important time to have that. And then also some of the price action that I know people want to get to too. Let's just keep it short-term for a moment because we're concentrating on today, let's get this question in right off the bat.
We've got awesome ones coming in. You know I try to get to as many as I can, so keep them coming. But James Lieberman from the exchange asking, Darius, is this a good time to short FB, Facebook? I don't know if you're going to talk individual, but as well as the QQQ. Talk to me a little bit about the fact that we saw this massive rally today, what are you going to be looking at to see whether this has any legs?
DARIUS DALE: Oh, so the number one thing you got to look at to see if any rally, any short covering rally has legs, is there enough ammunition left from a Vana flow perspective? That's a third derivative Greek, so we won't have to-- we don't have time to get into that now. But that just means is there a fuel for the rally to continue in terms of dealers having to unwind the hedges associated with the buy side and investors putting on put positions, particularly short-dated positions, which is the setup that we experienced coming into today.
To answer the question, and I want to answer Facebook, we don't cover single stocks, but they will present itself an opportunity to get back short or increase the size of your short on something like the NASDAQ. I just wouldn't do it today, you got to let the market breathe. And you have to assess the data, particularly from the volatility positioning side of the trade, because I think in the very immediate term, that's what's driving the boat. But again, as I mentioned, from a medium-term perspective, even a couple of weeks from now, I think the story around this press conference is very much likely to change.
MAGGIE LAKE: Yeah. And James, we're also laughing with you, James put in there after the question, how excited folks with a promise not to move up 75 basis points. Crazy, right? Yes, this is where we're at in terms of trying to figure this out. Darius, let's shift back to the fundamentals again. When you look at your dashboard, and I know you track all this, what market regime are we in? Are we in an inflationary regime, which seems to be what the Fed is still making the case for? What are you seeing?
DARIUS DALE: Yeah, we've been in what we call-- we have a framework where we segment market regimes and economic regimes on the four different buckets at 42Macro, Goldilocks, reflation, inflation, and deflation. We've been in what we call inflation for the most part since going back to early November. It's been a trending inflation or stagflation, as many of you guys would recognize it. That hasn't changed. And I don't anticipate that changing anytime soon.
We are very much likely to transition to deflation at some point in the next three to four months here as the momentum in inflation starts to break down. As a matter of fact, we're actually starting to see some of that data, Brian, if you don't mind putting up the chart, core PCE momentum, and I got a bunch of charts for everyone today, the first chart would be core PCE momentum, where we show the seasonally adjusted level of core PCE, the year-over-year rate of change and the second panel and on the third panel, we show the three-month annualized rate of change.
The three-month annualized rate of change is important, particularly important in this timeframe, because we all know that core PCE is not going to get anywhere near their 2% inflation target anytime soon. What folks like myself in the institutional finance community are looking at is the sequential momentum in the time series to give us an indication, okay, we're finally starting to get inflation under control.
We're still not at that point yet, but we are seeing if you look at that third panel, a dissipation in the sequential momentum and the trending momentum of the time series, which is supportive of base effects driven forecasts that the time series would be lower over the medium term. It's just not going to get to where it needs to be anytime soon. In fact, if you look at our forecast for core PCE specifically, we don't have an under 4% until you get to March of 2023. Or sorry, yeah, under 3%.
MAGGIE LAKE: What does that say, or where are you in terms of the underlying economy? How strong or weak is the underlying economy?
DARIUS DALE: Yeah, so the underlying economy on a backward-looking basis is quite strong. If you look at-- the internals in the Q1 GDP report were rock solid from a consumer spending and business perspective. We got the ISM data this week, it's mostly slowing across the board, both US and global economy. But when you take a step back and look at the levels of the ISM, it is consistent with above potential GDP growth.
55.4 in headline ISM for manufacturing, 57.1 on headline for services, this is an economy that is still growing at a really robust paste. Now, the problem with that, and this is why we're in such an awkward position from a market timing perspective, it's very likely-- this is according to our models and our forecasts at 42Macro, we're going to transition from going in and above potential pace, above trend pace, to a below trend pace by the end of Q3.
Between now and let's call it October in terms of receiving all that data, there's going to be a realization amongst market participants, that one, whatever the Fed thinks neutral is might actually be lower, and two the market, the markets have to now price in a much more significant shock to economic activity, corporate profits, etc, etc. And on those points, another couple charts for you today. Yeah, Brian, throw up the chart forward guidance, mortgage rates.
There are two charts about for guidance, and this is something I tweeted about prior to the show, we are in uncharted territory on a lot of metrics. And I hate to say this time is different. But this is a very unique time in terms of as far back as we can pull back a lot of time series, relative to the policy setup, relative to the growth setup, relative to the inflation setup.
Particularly right now, what's new in this particular juncture is the forward guidance function out of the Fed. And Jay Powell actually talked to this. He spoke specifically, said, monetary policy is working through expectations now, consumers and businesses are already feeling the effects of our tighter policy. Going back to this chart, the top panel shows manufacturing PMI in the red and mortgage rates of the 30-year National Average fixed rate mortgage in the blue line.
The second panel just shows the trailing three-year Z score of the blue line of the mortgage rate. And as you can see on a trailing three-year Z score basis, this is the biggest shock in mortgage rates we have in the data going all the way back to 1988 as far as we can get the data. And as you can see, every time we've had a shock in mortgage rates, we've seen a significant slowdown in the manufacturing economy, obviously housing is a big component of that.
Put up the second chart there, Brian, forward guidance, corporate borrowing costs, same analysis. Instead of mortgage rates in the blue line in the upper panel, we're showing the Bloomberg Barclays average corporate yield to worse so the average yield on corporate debt outstanding of which, by the way, there's 12 trillion total. It's a lot more than we have in previous tightening cycles, so that's going to be a problem.
Now, we have a near three-sigma shock in corporate borrowing costs as well. As you can see in that chart, the panel's lined up in terms of the drawdowns we've seen, that's the bottom panel in these charts in the manufacturing PMI index. That's my long-winded data driven way of telling you, look, this economy's about to have a significant slowdown, we are on the precipice of a significant slowdown in growth. That has not been realized yet.
This is what I've been saying on every daily briefing for the past, I don't know, four months, five months, there's going to come a point in time in the middle of the year, where the Fed is doing this with the policy rate tightening, and the economy is doing this. And guess what happens to financial market multiples and credit spreads when that happens?
MAGGIE LAKE: It's ugly. Let me understand where inflation fits in this view. The economy's weakening, is inflation also going to come down, or is this where the stagflation comes in, slow growth, high inflation?
DARIUS DALE: Yeah. Our models have both core inflation and core PCE having peaked alongside headline CPI. I don't think that's the real story here. Because I don't think there was a human being in finance that has any chops on forecasting that thinks inflation hasn't peaked already. It doesn't matter if the year-over-year rate of change peaks, what matters is if, in terms of the base effects, we all know the base effects are going to kick in and drag the time series lower.
What matters is the momentum and the time series and what we're likely to be a year from now when the base effects fall out of the equation. We can't just rely on base effects to take inflation back to 2%. Because it's not going to, it's going to take us back to something like 5% on headline, 3.5% on core, and we're going to be stuck at levels that are significantly higher than the Fed's mandate, which is why they're tightening ahead of time.
This is why they're tightening into an inflation deceleration because they understand that base effects aren't going to do enough of the work for them. On the inflation side, one thing I think the Fed is particularly concerned about, Brian, if you put up the chart ECI versus quits rate, and Powell talked about this today as well. He started talking about this a couple of months ago prior to the March FOMC, which is this supply/demand imbalance in the labor market.
We can see it through the JOLTS data we got yesterday, all-time high in job openings relative to the total number of unemployed workers. That's an all-time high as a ratio as well. But this ECI versus quits spread dynamic is really interesting because one, we have an all-time high in employment cost index. That's in terms of the year-over-year rate of change at 4.5%.
The reason that matters is because that's the broadest measure of wages in the economy. Wages, salaries, benefits, etc. And you see, the quits rate is just shy of an all-time high. That's telling us, that's telling the Fed, that's telling the financial markets, that there is a secondary wave of inflation building, an underlying inflation building that this Fed is trying to get out in front of and cut off at the head.
Now, they have a choice on that. They could favor financial market's stability and financial conditions. And we'll keep the S&P 500-- he said in the press conference, which is he wants to let the American public know that we work for them, not Wall Street. And I think this is a Jay Powell-led Fed that is very, very keen on sacrificing Wall Street for the time being to meet the demands of the American public.
MAGGIE LAKE: It's important that we take the time to talk about that, because the macro framework is critical and there's a lot of disagreement on it, right? That's why we've rolled out this series of amazing conversations on the topic this week, interviews all week long, kicking off with Raoul laying out his base case, and then challenging others to push against it, and see if they can change his mind.
Juliette Declercq was one of the people that he sat down with this week, founder of JDI Research. And this is what she had to say about the risk of recession, let's have a listen.
JULIETTE DECLERCQ: You and me have never actually had to analyze an economy where there is inflation. But when there is inflation, the first thing is actually inventory costs are down dramatically. In fact, you might make money on high inventory beyond the fact that you actually want to guarantee your production.
The same thing is actually true for unemployment, because as we well know, employment can drop down really quickly when there's a shock on the economy and no inflation, because you have to cut your labor cost by actually laying off people. In an inflationary environment, you can just basically free salaries and actually cut your labor cost without firing anyone. It's much more difficult to bring an economy where there is inflation down, and that's really what I'm seeing in the US where the credit impulse has turned, obviously, but it's still at a