Weekly Signal & Noise Filter

Will They or Won’t They?

Pinebrook’s money shot from this summer (June CPI Preview on July 9, 2024) was to prepare for a more aggressive cutting cycle commencing in September, with either an initial 50-basis point cut or 100 basis points in cuts by calendar year-end.

Last week’s note ended with the statement that the Powell Fed would likely be forced to cut more than what is currently priced by markets.

It seems we have reached this fork in the road, with the probability of 50 now exceeding that of 25.  This however is the noise, as markets have priced in these probabilities and the results are bound in price.  The signal is in the Fed’s dot placement and forward view.

The U3 dot will reveal the Fed’s policy preferences for a tighter or more lose labor market, and it will be the key driver of the Fed’s forward view and subsequent reaction function.

The current inflationary state is one of continued disinflation, consistent with the soft-landing thesis.  We have enough information from the August CPI and PPI releases to have continued confidence in this path, which resumed in late spring of this year after a seasonal inflation scare.

The state of the labor market is far more uncertain.  July showed significant second order (deceleration) slowing in the labor market.  The unrounded unwinding of this deterioration in the August report (from a 4.2553% U3 rate to 4.221%) widened the wedge between Fed rhetoric and market pricing.

Sahm Rule aside, there is now a consensus that the Fed is behind the curve. 

• Recall the 2-standard deviation spread between the 2-year Treasury note and the Fed Funds policy rate that was discussed last week.

• With the unemployment rate currently 22-basis point above the Fed’s 4% year-end target, a year-end overshoot in the U3 rate is not a non-trivial possibility.

On the surface, the Fed’s job is to play catch-up, as Chair Powell made an explicit commitment at Jackson Hole to keeping the labor market anchored. 

The labor market slowdown, however, cannot be seen in isolation and needs to be contextualized versus the broader macro reality.

• Core PCE is on track for a lower print versus the June SEP projection.

• GDP is on track for a higher print versus the June SEP projection.

The Fed’s catch-up commitment is further constrained by bureaucratic inertia that is informed by institutional memory.

Since 1990, the Fed has made three initial 25-basis point cuts at the initiation of a cutting cycle.

• July 1995 => A mid cycle adjustment after raising rates by 300bps between 1994 and 1995.

• September 1998 => LTCM.

• July 2019 => The Powell pivot in January of 2019, after the market through a tantrum in December 2018, set the stage for a July 2019 cut.

Here is the list of 50-basis point cuts at the initiation of a rate cutting cycle.

• January 2001 => It was clear as day the Fed had over played its hand with rate hikes in 2000 given the dot-com implosion.

• September 2007 => This one is a no brainer given the housing market collapse and distress in financial markets prior to the GFC.

If the Fed is treating the initiation of this cutting cycle as a mid-cycle adjustment to a slowing economy, then history argues for a 25-basis point cut with a dovish forward guidance and dot placement.

The problem with this kind of sequencing is that 25 now plus more later, if need be, means that any future aggressive easing is an admission of distress and failure at not initially catching-up.

On the other hand, a 50-basis point cut at the September meeting is an admission that not cutting in July was a policy whiff.

If there is one thing Pinebrook has learned in over 30-years of studying markets, it is that policy makers do not like to admit to being wrong.

Thus, the dilemma for the Powell Fed is to catch-up without admitting they were ever behind in the first place.

This contradiction is the equivalent of admitting an affair to a spouse while professing emotional loyalty.  It is hard thing to do.  But not impossible.