Technical rebound continues
The “textbook technical rebound” in US equities that I wrote about in the last edition of Big Money continued last week.
Indeed, it gathered momentum, and could continue higher this coming week on renewed hopes of an early Federal Reserve (Fed) pivot. The S&P 500 Index ended the week up 4.7%.
So, is the Fed wimping out on rate hikes, even before the going gets tough? How many times have we heard talk of a pivot before and seen the market disappointed? Too many.
But this time, the talk in the market is the Fed might be encouraging this speculation, via a report from the Wall Street Journal reporter nicknamed the “Fed Whisperer”.
The report by Nick Timiraos, who has a reputation for accurately predicting Fed rate moves, said the FOMC was “likely to debate” a smaller rate hike in December.
The dominant bet in the Fed Funds futures market had been for 75-basis point (bp) hikes at both the November and December FOMC meetings.
But by end of the week, the dominant bet had shifted towards only 50 basis points in December.
Prepare for a re-run of 1969-1980
If the Fed weakens in its resolve to crush inflation, it will likely store bigger problems for 2023, much as it did from 1969 to 1980.
That was when the Fed flip-flopped between rate hikes and cuts and hikes, repeatedly, with inflation pushing higher and higher.
Meanwhile, the economic arguments are very one-sided at the moment, in favour of continuing super-sized rate hikes.
This suggestion of a slowing of the pace of rate hikes is coming at a time when there are no obvious reasons for it to slow.
Core inflation is still rising; the jobs market remains over heated; there are credible concerns over the oil supply and demand balance going into the northern winter; there is little credit stress; and the economy has at least around half a year before a recession hits.
In short, it has a window of opportunity to defeat inflation. But the implication from the WSJ report, if it is correct, is the Fed is considering squandering that opportunity.
Risks of inflationary pressures
The September FOMC minutes contained a warning from Fed staff that their estimate of potential output had been:
“Revised down significantly in response to continued disappointing productivity growth and the sluggish gains in labor force participation seen so far this year; moreover, this lower trajectory for potential output was expected to persist throughout the forecast period.”
“As a result, the staff’s estimate of the output gap was revised up considerably this year, and while the staff projection still had the output gap closing in coming years, the level of output was expected to be slightly above potential at the end of 2025.
Likewise, the unemployment rate was expected to rise more slowly than in the July projection and to be slightly below the staff’s estimate of its natural rate at the end of 2025.”
In short, the US economy has become even more vulnerable to inflation from its own internal capacity constraints.
Indeed, the output gap – the difference between the actual GDP and the potential GDP – was, on its latest data point, already running at its highest level in post-War history.
This latest downward revision of the potential output will push the gap yet higher, raising inflationary pressures.
The most moderate Taylor Rule Model methodology on the Atlanta Fed’s utility suggests the Fed should be targeting a rate of 5.8% on the current output gap.
Even on the existing output gap, the Fed’s own Taylor Rule Utility is suggesting an appropriate rate of 5.8% to 7.7%, depending on the methodology.
Technical supports to help drive risk-on sentiment
In my thinking, it would be weak and irresponsible for the Fed to start easing the pace of rate hikes so soon.
But that is the speculation in the market now and that may continue to drive the technical rebound in the coming week.
And the technicals supporting the rebound include:
- The US Dollar Index bumping its head on a long-term technical resistance – this is the top of the uptrend channel from 2009.
- USD/JPY looking like it may break below a rising wedge formation from July of this year. This is usually a signal of a pause or even breakdown of an uptrend. It comes amid reports of Bank of Japan intervention to bring down the USD/JPY.
- Both the S&P 500 and the Nasdaq 100 indices are rebounding off key Fibonacci retracement supports. The S&P 500 is rebounding off the 50% retracement of the bull market from March 2020 to January 2022. The Nasdaq 100 is bouncing off the 38.2% retracement of the entire move from the 2009 low to the 2022 high. It is also right on its 50-month moving average (see five charts below).
But poor fundamentals haven’t changed
Our view is that failure to contain this inflationary challenge could damage the US economy even more, and cause it to struggle for decades to come.
So, even if the Fed triggers a bigger rebound by wimping out on rate hikes, those poor economic fundamentals will likely return again, with a vengeance. But that is an analysis for another time.