Something is Rotten in the State of Denmark
This week was all about the Federal Reserve FOMC decision to initiate the new rate cutting cycle with an aggressive 50 basis point jumbo cut. Historically, such aggressive cuts (25 basis points is the standard) have been reserved solely for widely acknowledged crises, recessions, and panics. This meeting, however, curiously, the jumbo cut came along with an uncharacteristically rosy Summary of Economic Projections (SEP).
As Harvard economics professor Jason Furman put it on Wednesday, “The FOMC’s new Summary of Economic Projections is just about the closest thing to a ‘Mission Accomplished’ banner you can imagine them unfurling; 2% inflation going forward with no slowdown in economic growth and the unemployment rate staying low and falling.”
Post Powell presser, economist Mohamad El-Erian framed the monumental moment quite well. Speaking on Bloomberg television, El-Erian said, “I think it’s too early to declare mission accomplished. There are inherent contradictions that still have to be sorted… This was historic. We’re going to look back on this day not only as the beginning of the cutting cycle, but also as having recalibrated what we mean by a 50 basis point start to a cutting cycle. This is a fundamental change in the reaction function.” HAI couldn’t say it better. Wednesday was indeed a day of contradictions and a historic change in the Fed’s typical reaction function.
As Senior US Strategist at Rabobank Philip Marey put it, “the 50 basis point jumbo cut didn’t resonate with the Fed’s assessment that the economy is still ‘strong’… The whole press conference could have come straight from Orwell’s 1984: ‘War is peace; Freedom is slavery; Ignorance is strength.’” Certainly, the combo of a crisis-style jumbo cut paired with an “everything is wonderful” message in both the SEP and the press conference was cause for plenty of head scratching.
Typical monetary policy orthodoxy regarding the Fed’s reaction function is described by the Taylor rule, which prescribes how central banks should set interest rates. According to this rule, the Federal Reserve should increase interest rates when inflation exceeds targets or when output growth is overheating. When inflation falls short of targets or when output growth is below potential, it urges central bank policymakers to lower interest rates.
Describing the historic change in the Fed’s reaction function, Vincent Deluard, Global Macro Strategist at financial services company StoneX, noted that despite a 50 basis point jumbo cut, “the Taylor rule estimate of the neutral policy rate calls for a 25 basis point HIKE.” Furthermore, according to Goldman Sachs’ US Financial Conditions Index, ahead of the Fed meeting, US private sector financial conditions were the loosest since just after the Fed began tightening policy in May of 2022. That’s right, times are certainly changing, and we are not in Kansas anymore. Not only did the Fed deliver a 50 basis point cut, but it also arranged the Fed’s SEP dot plot forward guidance to suggest that another 50 basis point cut is right around the corner—coming by year-end 2024.
So, what’s going on? Why is Jay Powell so seemingly anxious to declare mission accomplished and pronounce that everything is great while simultaneously abandoning the Taylor rule and aggressively cutting interest rates in a fashion historically reserved for emergencies?
In HAI’s view, the likely answer isn’t what most on Wall Street are debating. The likely answer is the US fiscal problem. In the context of a new global reality in which foreign held US debt is near a 25-year low as a total percent of reserves, it’s a major dilemma that US government “True Interest Expense” (entitlements + interest expense) is already pushing past 98% of tax receipts on a trailing twelve-month basis after accelerating to 120% in July and 150% in August. Furthermore, that 98% is mathematically certain to go higher given US entitlement obligations, US demographics, and interest rates that will remain higher than in the preceding zero-interest-rate-policy (ZIRP) era unless the Fed starts cutting fast and cutting hard regardless of Taylor rule circumstances.
Jay Powell’s recent inflation-fighting rate-hike blitzkrieg seems to have demonstrated one thing. US monetary policy cannot raise rates to combat inflation on a sustained basis without risking debt-spiral dynamics that threaten the bond market—and by extension, ultimately, the US government’s means of funding.
The new reality of a runaway fiscal problem compromising monetary policy means that the traditional monetary inflation brake is effectively broken. One of the most under-discussed and yet crucial developments this week supports the idea that monetary policy is gravely compromised and that we remain critically vulnerable to a new secular trend of higher inflation. Despite the fact that the Fed cut by a jumbo 50 basis points on Wednesday, the entire Treasury yield curve from 2s to 5s to 10s to 30s all closed higher on the week. One week does not a trend make, but US policymakers must have been quaking in their collective boots at close on Friday when, at least for one week, the monetary maestros lost control over the bond market and the yield curve. Whether the bond market is signaling policy error, a coming re-acceleration of inflation, or beginning to rebel over a Fed seemingly ready to capitulate and facilitate runaway fiscal largess, only time will tell. But higher Treasury yields (despite a jumbo Fed cut) and new record highs for gold amid this “historic” week of trashing the Taylor rule leaves HAI further convinced of a deeply unsettling truth—to quote the Bard, “Something is rotten in the state of Denmark.”
Weekly performance: The S&P 500 was up 1.36%. Gold was up 1.36%, silver was up by 1.39%. Platinum lost 2.47%, and palladium gained 0.66%. The HUI gold miners index was nearly flat, up 0.03%. The IFRA iShares US Infrastructure ETF was up 2.54%. Energy commodities were volatile and higher on the week. WTI crude oil was up 3.42%, while natural gas surged 17.96%. The CRB Commodity Index was up 3.12%. Copper gained 2.53%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 1.13%. The Vanguard Utilities ETF was up 1.89%. The dollar index was down 0.36% to close the week at 100.42. The yield on the 10-yr U.S. Treasury was up 9 bps to close at 3.74%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
