Coming down the mountain – Don’t look down!
- It is the general consensus among mountain climbers and hikers that going up is relatively safer or easier than coming down. When descending, it is hard to be sure footed when distracted by the height and the fear of missteps and falling and it places high demands on your body.
- When inflation is high, the main central bank combative tool is to raise short-term interest rates. It dampens credit creation (lowering leverage), slows down animal sprits, and curtails demand. However, knowing when to stop and pivot before choking off the general economy (i.e., hard landing) is as much an art as it is a science. When the descent from the top of the rate mountain begins, the pace (how often) and depth (how many basis points cut per meeting) of each step are unknown. The FOMC “calibrates” each rate cut decision based on economic data and circumstances in real time. Due to massive uncertainties, the FOMC is maintaining a no “forward guidance” stance (i.e. unanchored) in exchange for optionality to respond to changing inflation, employment, market liquidity, exogenous shocks, and general economic conditions. The Fed remains in a meeting-by-meeting, data dependent, policy making mode; expect more rate volatility from here.
- The market is constantly anticipating and pricing when and how much future rate cuts will be. Intra-meetings, the market often goes from one scenario (bigger rate cut) to the other (no cut or a smaller cut) depending on how the incoming (backward looking) data are compared to expectations. The constant shifts from good news for the economy is bad news for rates (i.e., no to small rate cuts) or good news on rates when it is bad news for the economy (i.e., rate cut or larger cut). These kinds of speculative steps when coming down the mountain certainly add to market uncertainty and “injury”.
- The FOMC has started its descent from the top of the rate mountain. The path forward is not linear, and it is unclear if inflation will continue its current steady disinflationary trajectory to the 2% target. At the same time unemployment has moved up. Under normal circumstances this should indicate a weakening economy and likely further contain inflation, but the rise is likely caused by increased migration (more workers seeking jobs) rather than mass layoffs. The second quarter U.S. GDP was growing at 3% – a reacceleration. The Personal Consumption Expenditure (PCE) for August on an annualized basis is down from 2.5% in July to 2.2%, but the preferred inflation gauge, core PCE (i.e., ex. food and energy), is up from 2.6% to 2.7%. At the same time, the mortgage rate has dropped to 6.08% in late September with mortgage applications hitting a 19-month high in August. Combining these with the wealth effect, financial conditions seem not so restrictive, and yet, the Fed has started the rate cutting cycle with a 50bp cut, a big first step down this mountain. Could this be the tail wagging the dog?
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