We Are In It Now
Since inflation data began picking up again in the first three months of the year, the drumbeat of higher-for-longer interest rate policy has once again increased. That rhythmic drumbeat has steadily permeated market expectations. The market kicked off 2024 expecting six to seven rate cuts beginning in March. Presently, however, closing in on the start of May, we have yet to see any rate cuts. Expectations have now plummeted to one expected cut in all of 2024. Additionally, that one lonely cut has been pushed out—first from September to November, now, after even more recent stagflationary data, to December.
The market’s collective calculus is that as inflation data heads higher, rate cut expectations should drop. That analysis is clean, straightforward, simple, and historically correct. It accurately accounts for decades of Fed policy orthodoxy. However, the soft underbelly of the higher rates for longer expectation is that the reasoning is backward looking and unidimensional. The correlation between inflation data and Fed rate policy expectations has been tight as long as policymakers could afford to keep it simple and set rates based solely on inflation data.
However, times are changing. The rate cut calculus is no longer simple. After “the great moderation” helped convince market participants that debt and deficits don’t actually matter, a new era of inflation and the resulting higher interest rate environment is changing the game. Much higher interest expenses are the showstopper.
Unsustainable debt and deficits are now beginning to matter again. To put it plainly, the U.S. managed to accumulate $11 trillion of debt in its first 220 years, but debt spirals accelerate. We’ve managed to add the latest $11 trillion over just the last four years. Now, with a chain reaction of inflation leading to higher rates and then to much higher interest expenses, that accelerating debt spiral is at grave risk of spinning completely out of control. Monetary policy must now be viewed through the prism of a much more complex multidimensional set of variables.
As policymakers have walked ever further down the plank of unsustainability, policy optionality has collapsed around them. We’re not in Kansas anymore, and markets are just beginning to adapt to a new set of rules in which Fed-conjured Goldilocks conditions are no longer an option.
To underscore the new reality of policy complexity, trade offs, and lose/lose optionality, consider the extreme contradictions now swirling around Wall Street. Former Treasury Secretary Larry Summers correctly says that rate cuts would be a “dangerous and egregious error” because they would pour gasoline on an already simmering inflationary fire. BofA Chief Investment Strategist Michael Hartnett, on the other hand, points out that without 150 basis points of rate cuts by the end of the year, government interest expense on the now nearly $35 trillion of debt will reach a crushing $1.6 trillion and trigger a debt spiral-turned-crisis. For a Fed that’s essentially promised to restore Goldilocks economic conditions, where do you go when you’ve got nowhere to run?
The days of a “relatively” sustainable fiscal situation and low inflation appear to be over. Powell can’t cut rates because of inflation, but he can’t not cut rates because of a debt spiral. His situation is dire, and it worsens by the week.
Most recently, it was the International Monetary Fund (IMF) highlighting the problem of unsustainable and untenable policy in the U.S. Last week, the IMF warned that American economic exceptionalism (when compared to weaker economies seen globally) is primarily due to “unsustainable spending for growth” that’s creating the “conditions for financial instability.” The always-understated IMF went so far as to describe U.S. policy as “a fiscal stance that is out of line with long-term fiscal sustainability” and “risks reigniting inflation.” The IMF’s bottom line: “something will have to give.”
This week, in a Bloomberg op-ed, noted author Niall Ferguson penned an article titled, “The Second Cold War Is Escalating Faster Than the First.” While tying the vulnerability of a U.S. fiscal crisis into the larger context of the greater East/West divide, Ferguson makes some especially pertinent observations. He states what is increasingly obvious: suddenly, concern is growing. The mainstream is waking up to the reality that U.S. debt and deficits matter again in a very big way.
As Ferguson said, “US fiscal policy is on a completely unsustainable path. To run a 7% deficit at a time of full employment is, to put it mildly, not what the macroeconomics textbooks recommend… An inexorably rising share of revenues will have to go on servicing the debt.”
Now recall Michael Hartnett’s recent claim that without rate cuts interest expense on the debt will surpass all other government line items to become the government’s largest and fastest growing outlay. Keep Hartnett’s point fresh in mind when considering Ferguson’s next observation:
“My sole contribution to the statute book of historiography—what I call Ferguson’s Law—states that any great power that spends more on debt service (interest payments on the national debt) than on defense will not stay great for very long. True of Hapsburg Spain, true of ancien régime France, true of the Ottoman Empire, true of the British Empire, this law is about to be put to the test by the US beginning this very year.”
Regardless of exactly when, evidence is building that the Fed’s next major move will be to cut rates to reduce the interest burden on Federal debt despite inflation. When, not if, is increasingly the question at hand.
The Fed meets again next week. Over the last month, since the Fed’s last gathering, the evidence of reaccelerating inflation has become so overwhelming that Powell and other Fed members have since attempted to retake the high ground on the inflation fight, push back on rate cut expectations, and recapture the narrative of a hawkish Fed ready to stay higher for longer and even raise rates again if necessary to ultimately quash inflation. HAI isn’t buying it.
While HAI expects an impressive hawkish facade at the FOMC, this author believes the Fed has already tipped its pitch. They are eager to cut rates. They just need a credible face-saving excuse to do so.
In HAI‘s view, even if inflation data doesn’t significantly moderate, fresh signs of a weakening economy may give the Fed all the excuse it needs to cut rates.
The latest NFIB small business optimism survey just hit its lowest level since 2012 after recently accelerating a decline that’s seen 27 consecutive months of sentiment readings below the 50-year average.
The latest S&P Global PMI data out this week badly missed estimates for both manufacturing and services activity. Services came in at 50.9 (a five-month low) vs. 52 expected, down from 51.7 last month. Manufacturing, after recent talk of green shoots, slipped back into outright contraction with a reading of 49.9 vs. 52 expected and 51.9 prior.
Most importantly, the PMI employment data is suddenly showing notable cracks. As S&P Global Chief Economist Chris Williamson commented, “the U.S. economic upturn lost momentum at the start of the second quarter… Further pace may be lost in the coming months, as April saw inflows of new business fall for the first time in six months and firms’ future output expectations slipped to a five-month low amid heightened concern about the outlook… The more challenging business environment prompted companies to cut payroll numbers at a rate not seen since the global financial crisis if the early pandemic lockdown months are excluded.” Read that last bit again; it needs emphasis—companies cut payroll numbers at a rate not seen since the global financial crisis.
As has been the consistent trend of late, despite the weakened economic data, the prices paid component of the PMI came in hot again. After the March U.S. PMIs definitively exposed the end of the disinflation narrative, April saw an “accelerated increases in input costs… Most notable was an especially steep rise in prices charged for consumer goods, which rose at a pace not seen for 16 months.”
So prices were up notably while economic activity and payrolls softened meaningfully. Overall, PMI data left a distinct stagflationary taste in the mouth, along with a disconcerting pit in the stomach.
That same disturbing stagflationary signature was also manifest later in the week when Q1 GDP was released. It came in at 1.6%, significantly below the 2.5% expected and far lower than the 3.4% in the prior quarter. It was the lowest GDP print in two years, and even came in below the lowest Wall Street estimate. At the same time, the GDP price component came in hotter than expected. The price index registered 3.1%, hotter than the 3.0% expected, and almost double the 1.6% in Q4. Even worse, the all-important core price index soared to 3.7% from 2.0% in Q4, blowing away the estimates for 3.4%.
This week we also saw signs of a weakening consumer. University of Michigan U.S. consumer sentiment fell in April on dimmer views of personal finances and the economy, while inflation expectations increased. The UMich final April sentiment reading fell to 77.2 vs 77.9 expected, and down substantially from 79.4 in March. At the same time, consumers expect prices will climb at an annual rate of 3.2% over the next year, the highest since November and up from 2.9% in March. The survey revealed consumers now see costs rising 3% over the next five to 10 years, also a five-month high. Furthermore, the number of consumers reporting that high prices were weighing down their living standards jumped by a hefty 5% over last month while consumers’ perceptions of their current financial situation and the economic outlook over the next year both slid to four-month lows.
Additionally, in another cautionary footnote to the “strong consumer” narrative, this week Discover Financial, the nation’s 6th largest credit card company, offered a sobering update. According to Discover, delinquency rates on credit cards are now spiking. Delinquency rates are now up 4X off the lows of two years ago. After bottoming at a historically low level of 1.5% in 2022, the delinquency rate surged to 4.7% in Q4 of last year. Now, in Q1, that rate has punched up to 5.7%. For context and perspective, Discover’s credit card delinquency rate was lower than at present (5.6%) three quarters into the great recession of 2008! If nothing else, we need to be on high alert for a seriously rapid unwind of the “strong consumer” narrative.
Again, the week’s data was good for an increasingly stagflationary outlook, but, regrettably, good for little else. It affirmed what we already knew about rising prices and stubborn inflation, but it also pointed towards a significant slowing of economic momentum. It’s HAI‘s suspicion that those signs of a weakening economy will be what the Federal Reserve latches onto for an excuse to discount inflation and administer the rate cuts they’re anxious to deliver.
What’s largely underappreciated by the market majority, in HAI‘s view, is the unequivocal message being sent by the price of golden financial insurance. Of late, regardless of whether the wind is blowing toward higher rates for longer or imminent rate cuts, gold’s unrelenting upward bias has remained intact. In short, the surge in the price of financial insurance is speaking volumes. It’s saying, Houston, we’ve got a big problem on our hands either way the Fed goes.
In other words, gold is hoisting the red flag and parroting Winston Churchill’s epic speech to the House of Commons in November of 1936. On that date, the British Bulldog warned colleagues that, “We have entered upon a period of danger… The era of procrastination, of half measures, of soothing and baffling expedients, of delays, is coming to its close. In its place we are entering a period of consequences… We cannot avoid this period; we are in it now.”
As the policy imperative shifts from “strict inflation targeting” toward a compromised, practical, de facto tolerance of higher inflation for longer, HAI expects a consequence of higher gold for longer.
Now, nothing goes up in a straight line, and gold has made a historic surge from $1,823/oz in October to a local high of $2,448 on the continuous contract in April. At this point, pullbacks and even a full back test of the roughly $2,100 breakout zone should be considered possible, if not probable. Pullbacks are a healthy component of all bull markets. Similarly, a full back test of $2,100 would be no surprise at all. Such a move would be completely normal. In fact, no major price breakout in the era of freely traded gold has ever failed to retest its primary breakout zone. That said, given the bullish evolution of the macro fundamentals now driving gold, we can no longer take for granted that past will prove prologue. In HAI‘s view, despite the real risk of correction, the dominant longer-term trend has been established. It’s higher. The yellow metal train has left the station, its ultimate destination is a much higher gold price.
Critically, this week also introduced the first Q1 reporting from a few key gold producers. Initial results were very encouraging. Even though the bulk of the move higher in the gold price was confined to the late quarter-end period, mining companies are now beginning to demonstrate their ability to translate higher gold prices into significant margin expansion. Indications are mounting that, after being derailed and stuck in station for years, the gold mining train is now back on track, whistling and preparing for departure. Like physical gold, we may not have to wait long now for that leveraged gold mining train to leave the station as well. In HAI‘s view, it is as Churchill said, “We cannot avoid this period; we are in it now.”
Weekly performance: The S&P 500 was up 2.67%. Gold was off 2.76%, silver was down 5.51%, platinum was off 2.30%, and palladium dropped 6.63%. The HUI gold miners index actually bucked the correction on physical precious metals with a gain of 2.43%. The IFRA iShares US Infrastructure ETF was up 1.89%. Energy commodities were volatile and higher on the week. WTI crude oil gained 1.98%, while natural gas surged 9.59%. The CRB Commodity Index was lower by 0.44%. Copper was up 1.70%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 0.61%. The Vanguard Utilities ETF was up 1.35%. The dollar index was off 0.17% to close the week at 105.80. The yield on the 10-yr U.S. Treasury was up 5 bps to close at 4.67%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
