Merry Christmas to All!
This week was a wild one on Wall Street. The main event was a Wednesday bomb-drop by Jay Powell and the Federal Open Market Committee (FOMC). The explosive ordinance? While, the FOMC cut the Fed funds rate by an expected 25 basis points, they also said that “The balance of risks around inflation shifted in a hawkish direction” since previous meetings. Greater concern over elevated inflation means a higher-for-longer interest rate policy setting is back on the menu after Powell had seemingly removed it at his Jackson Hole speech in August. At that time, markets rejoiced when Powell announced that “the direction of travel is clear” for lower interest rates.
Given this latest update from the Fed, the further rate reductions the market had previously expected now apparently hinge on further progress in lowering stubbornly high inflation. How alarming was the tone change from the Fed?
While inflation was still ripping near peak levels in 2022, the number of FOMC members that indicated they were concerned about an upside to the inflation outlook peaked at 17. Since that time, the number of members concerned over upside inflation surprises had steadily shrunk to three by October 2024. As of the Wednesday meeting, that number sprang back to a whopping 15 committee members now worried about upside inflation risks.
That polar shift clearly demonstrates that the FOMC is getting just a little concerned with higher-for-longer inflation remaining so sticky and notably above target. Importantly, it may also indicate that policymakers could be finally starting to grapple with the prospects for sweeping economic changes under a Trump administration.
The interpretation by the market was clear. Until FOMC concern about inflation drops again, Santa may not have a bundle of 2025 rate cuts in the back of the sleigh after all. Without those cuts, our relative goldilocks economic conditions could come under the threat of a dollar that’s too strong, yields that are too high, an interest component on the debt that spikes instead of shrinks, and inflation that keeps our trusty Federal Reserve firefighters trapped at the station.
The combination of a strong dollar and higher yields will likely slow economic growth, and slowing growth will likely send the stock market down. A slowing economy (lower income tax revenues) and a falling stock market (lower capital gains tax revenues) means less income to the government, while higher rates and a strong dollar mean government outlays will increase. The combo of lower receipts on greater outlays means we have an accelerated deficit problem until the Fed decides to change its stance back to dovish.
Going into this Fed meeting, U.S. “true interest expense” (entitlements + interest expense) was already 103% of tax receipts for the past four months. If the Fed just initiated a new round of dollar up, rates up, stocks down, then it’s likely to drive true interest expense up rapidly going forward. That in turn is likely to put further upward pressure on the dollar and Treasury yields while applying further downward pressure on stocks. In a vicious cycle, these dynamics are likely to drive a further tightening of financial conditions and devastating debt spiral dynamics.
In HAI’s view, Powell and the Fed now appear to be playing a game of chicken with the market over their own credibility. It’s a game they can’t win. In response to the Fed’s hawkishness, the S&P 500 had the worst Fed day loss since 2001 as both the dollar and yields surged. Too much more of that, and it won’t be long before the market starts to loosen financial conditions again. It knows that unless the Fed wants to bankrupt the government, crash the market, and blow up the system, the clock is ticking before the Fed is back to apply every tool it has to ease policy, stimulate, and stabilize the situation—at least temporarily.
The Fed’s bark was big this week, but will its bite match the bark? HAI doubts it. Either way, gold continues to look like the best possible bet over the widest distribution of potential scenarios. Santa is already making final preparations for his annual present drop. In 2025, it still looks like the greatest of gifts are likely to be had by holders of the yellow metal. In the alleged words of jolly Saint Nick, “Merry Christmas to all, and to all a good night.” Merry Christmas everybody!
Weekly performance: The S&P 500 was down 1.99%. Gold was off 1.15%, silver lost 3.45%. Platinum was up 1.31%, and palladium was down 4.42%%. The HUI gold miners index was off 5.96%. The IFRA iShares US Infrastructure ETF was off 4.52%. Energy commodities were volatile and higher on the week. WTI crude oil was off 2.57%, while natural gas surged 14.57%. The CRB Commodity Index was off 0.60%. Copper was down 2.30%. The Dow Jones US Specialty Real Estate Investment Trust Index was off 5.23%. The Vanguard Utilities ETF was down 1.73%. The dollar index was up 0.63%, to close the week at 107.35. The yield on the 10-yr U.S. Treasury gained 12 bps to close at 4.52%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
