Is the Fed Done Hiking? With Darius Dale and Andreas Steno Larsen

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1:24And now to the top analysis of today's markets.

1:41Is the Fed done hiking rates? Hi, everyone. Welcome to the Real Vision Daily Briefing. With me today is Andreas Denno-Larsen, founder of Steno Research and senior markets editor here at Real Vision, and Darius Dale, founder of 42 Macro. Hi, gentlemen. Hey, Maggie. What's up, Andreas? I've got a dream team here today. Just a reminder to everybody before we jump in. This is an extended daily briefing. Lucky us. So we're going to go for an hour today. If you want to stay with us for the entire time and participate in the questions in the second half, you need to be a member. So scan that QR code and jump on the trials we have going.

2:18So we had Federal Reserve raised Fed funds rate, another 25 voices points as expected. I mean, not a lot of fireworks out of this one. But Darius, what did you make of the press, what we heard from Jerome Powell, the chairman in the press conference. Yeah, that was a lot of waiting around to hear a lot of nothing, unfortunately. I mean, I think the only thing we actually learned as investors from the press conference and the statement was that September is live and that there's a possibility that they can continue quantitative tightening while cutting interest rates next year. But I don't think we really need to worry about that as market participants today.

2:50Yeah, patient as well as resolute, right? It's the same message they've been banging on about. Andreas, anything catch your eye? And we should point out, it's not just the Fed this week. We also have the ECB. We had Canada. They hiked. We have the ECB and the BOJ coming up as well. Yeah, I mean, if you look at the press release, first of all, I think they changed one sentence and one sentence only. They changed the wording on the growth outlook from a modest growth pace to a moderate growth pace. And I simply had to look that up in the dictionary since I'm not a native speaker. And apparently, moderate is a slightly more optimistic word than modest.

3:28That's about as much detail as we got from the Federal Reserve today. But I guess on the margin, you could argue that they are slightly more upbeat than in June. And therefore, I'm not overly convinced that this was the last rate hike. OK, what about either of you expecting anything more interesting from the ECB or the BOJ? Yeah, well, from my perspective, the data in Europe has soured pretty significantly in the last sort of, you know, intermediary period between the ECB's last rate hike. So I really want to see how Lagarde's tone might change. Recall the last few times we've heard from her, she's been extremely hawkish, much more hawkish than Powell has been.

4:08I want to see if the growth data really starts to change her mind or if they're narrowly focused on inflation still. I tend to agree with that, Darius. First of all, if we look at the growth data in Europe, we are now clearly in contraction territory for a couple of the big countries, France and Germany, to mention a few. And that is a game changer relative to just a few months ago. And on top of that, if you look at the preferred recession model of the European Central Bank, a model that uses the growth of money in real terms, so the growth of euros adjusted for inflation and so-called term spreads or a yield curve measure, the probability of a recession is now as close to 100 % as it gets, meaning that we are probably already in a recession in Europe.

4:59So I'm more convinced that the European Central Bank is close to pausing compared to the Federal Reserve here. And the question is whether they dare saying so tomorrow. We need to remember that it is one of those in-between meetings where they don't update their staff projections, meaning that they have less confidence in the outlook. And typically, they kick the can down the road on such a meeting. But they may decide not to tomorrow, because I think the outlook in Europe is deteriorating in a pace that will essentially warrant another stance from the European Central Bank very soon. Yeah. And one final thing I'd say, you also mentioned the BOJ on Friday, Maggie.

5:44This is also going to be another snooze fest from the perspective of financial markets. But from our perspective, they're going to revise up their inflation targets. They have to. But the reality is, I think the meeting that's most likely to be live over the next, let's call it, 36 months for the BOJ will be the October 31st meeting. At the end, in September, their price subsidies for fuel and energy and certain food items, they actually lapse. And so if they decide to let them lapse completely, we're going to see another surge higher in Japanese inflation. So it may be the case that in addition to an additional rise in their inflation forecast in October, they might actually have to tweak yield curve control.

6:24If they don't do it, then they're probably not going to do it at all. Interesting. All right. Mark your calendars, everyone, October, because this is a thing we've all been waiting for and it hasn't happened. OK, so somebody put in the chat nothing burger from the Fed today. That probably sums it up. But let's talk about something that is more consequential. And that is, it really sounds like inflation is going to be key here. And there is a lot of disagreement about the outlook, about what's happening. I would say for inflation, for the economy, right? We're back to soft landing, no landing, hard landing.

6:59And everyone's all over the map. So Andreas, I'd like both of you to kind of give us your macro outlooks. I know you both have some awesome charts, too. But Andreas, give us your setup. What are you thinking about in terms of those really important conversations about growth and about inflation? I think the interesting thing here right now is that we get more and more signs that the cyclical part of the economy is picking up right now in the US. At least that's what the market is telling us. You should not always trust the market, but the market seems like it has sniffed out something here when it comes to the cycle in the US.

7:40If we look at commodities, they try to rally higher here, which is typically a sign of a cyclical upturn or a positive mood in the cyclical part of the economy. If you look at the US dollar, it's weakening. That's also typically something that you will experience amidst a positive rebound in the economy. cyclical equities are starting to move as well, everything from industrials to materials, etc. So it's kind of an interesting backdrop if you look at the economy from a market perspective. And I think it's the big question for the Fed right now, whether this cyclical part of the economy, everything that is very interest rate sensitive, so energy, industrials, materials, If we see a pickup in that part of the economy, it may end up in a very tricky situation for the Fed in a few months from now, because it also means that goods inflation will start rising again.

8:38And if we look at headline inflation right now, we just got below 3 % in the June report. But we have some extremely harsh base effects to combat over the next couple of months here. And I actually have a great chart showing that. I think it's chart number five, Brian. If we look at headline inflation from here and until the meeting in September, it is very likely that we get above 3 % again unless we get some major surprises on the low side in the core inflation measure because energy is moving upwards. And the inflation in July last year printed at 0%. So if the monthly pace of inflation is just 0.1 % through July, I think it's very likely that it is.

9:26Then we will get a pickup in the yearly inflation measure ahead of the September meeting and likely be back above 3%. And I think the Fed can very well use that as an excuse to hike again if they want to. And the latest set of dot plots basically showed that they had a willingness to hike another 25 basis points this year on top of what we saw today. So I think that this is really the key question right now. Is there a cyclical upswing brewing here as a consequence of lower energy prices, as a consequence of the weaker dollar? And I wouldn't rule it out. And that would certainly lead to a completely different macro landscape than the one that we've been discussing over the past couple of quarters here.

10:09Yeah, agreed. Darius, is that how you see it setting up as well? And my question, of course, is going to be, is this priced in? Yeah. So is a surge higher in inflation? Surge is probably too strong of a word. But is a rebound in inflation and, more importantly, a firming of inflation relative to consensus expectations priced in? Absolutely not. If you think about what's been priced in asset markets, and we run a pretty sophisticated dynamic factor model to identify what the market's pricing in from a regime perspective and the probability of that regime dissipating or inflecting. And what's been driving asset markets from the perspective of that system is this sort of concept that immaculate disinflation is inflating soft landing expectations.

10:51So you have what we call transitory Goldilocks. We're in this sort of multi-month period of where it feels like the economy can do no wrong. We get soft landing. We get inflation going down. So that's great. And so going back to your question of whether or not that's priced in, clearly, if we start to see something, the narrative around immaculate disinflation shift, we're going to actually lose the ability for the market to say, well, I can roll that forward into rising soft landing expectations. Brian, if you throw up our chart five, where we show several measures of underlying inflation, so we have median CPI, trim mean CPI, median PC deflator, trim mean PCE, and then we have core PC and super core PCE.

11:30And one thing I call out in the context of this chart is that the blue bars show the three-month annualized growth rates, the red lines show the year-over-year. The year-over-year rate of changes on all of these statistics are going to continue heading lower in the next few months just to catch down to where the sequential readings are. But what's concerning about the sequential readings, particularly if you look at median CPI, trim mean CPI, we're no longer really making progress. Now, it's like one month of no longer really making progress. But if we start to stall out at levels of somewhere between 3 % and 4 % in terms of these more core underlying measures of inflation, that's going to be a big problem.

12:06And the reality is, that's the highest probability outcome at some point over the next, let's call it, three to six months. If you think about our view that the US economy is unlikely to enter recession until we get into Q4 or Q1 of next year, and that's what I mean, enter recession. So obviously, we won't be deeply in the recession until maybe let's call it second quarter of next year. If you go to slide four, Brian, where we show our HOPE plus side framework on business cycle dynamics, it's very likely that between now and let's call it second quarter of next year, at some point we're going to see inflation kind of bottom out and become sticky again.

12:40And the reason for that is that it's very unusual to have observed as much immaculate disinflation in the economy as we've seen to date. And so what this chart shows is the delta adjusted Z score of a basket of indicators that represent each of these cycles. And so we have the housing cycle, which tends to break down right around 18 months ahead of a recession. We have the order cycle, which tends to break down right around 8 to 10 months ahead of a recession. Production and profit somewhere around 4 to 6 months ahead of a recession. Employment tends to break down right on the doorstep of a recession, which makes a lot of sense given the NBER's process.

13:10But what we tend to see is that inflation is the most lagging indicator of the business cycle. And so this is a long-winded way of saying we've gotten a lot of immaculate disinflation. It's likely been because of the transitory elements of inflation have dissipated or disinflated. And we're going to be left with a structurally higher level of inflation that is inconsistent with 2%, which means we actually are going to have to go through the inflation process to get it back down to and potentially through 2%. So that is going to be an issue for the market. It's not an issue for the market yet. It'll probably be an issue for the market.

13:39Let's call it fourth quarter, first quarter of next year. So we have some time to wait and kind of see this play out. Hey, everyone. We're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

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14:58Yeah. So, Andreas, I mean, at the risk of oversimplifying this, why is everyone getting this wrong? Or why are people, maybe the better question is, why are people so married and so quick to return to that soft landing, Goldilocks, you know, some of the terms that Darius threw out? But why is everyone so quick to assume that that's how it's going again? But to be honest, Maggie, I think I'm the perfect subject matter expert here because this is the first time in my adulthood that I experience inflation. And therefore, my sort of equilibrium scenario or the scenario that I've known throughout my adulthood is a scenario with no inflation or at least low inflation.

15:41So you've not really known an inflationary environment. No, exactly. And that is why my sort of equilibrium state is a state of no inflation. That's the only thing I've known. And I think a lot of participants in global markets kind of look at the past, say, 10 to 15 years for a playbook when stuff like this happens, and you don't have a playbook. And that's the big issue here. And I guess the overarching discussion now is whether something has changed for good as a consequence of the pandemic. I'm not overly convinced myself that we will enter, say, a decade of higher inflation than usual. But it remains to be seen.

16:26I mean, if we look at, for example, the broad supply of money right now, both in US dollars and euros and sterling, it is essentially down versus a year ago. So there are fewer dollars around. There are fewer euros around. And at least if you look at it from a textbook perspective, that should lead to much less inflation, maybe even negative inflation down the road. And on my most pessimistic indicators, we will actually enter deflation next year. But I think it's still too early to call it. And I agree with Darius that there are some signs of the cycle of inflation picking up into 2024 again.

17:05So I'm caught between a rock and a hard place. And I'm very, very short term in all of my trading right now as a consequence of it. Yeah, interesting. I mean, you could also say it's recency bias, right? I mean, some people have never known it. And some people, it's just been so long that that's the trade. Darius, do you buy into that idea that things are different and that the way we measure inflation is flawed? Because you hear that as well. Or do you think that this is just the time needed, the time lags are just longer maybe this time around? I think the time lags are longer this time around.

17:41We've done a bunch of work on that, why the time lags are longer. Let me just, before we even unpack that particular aspect of the question, let me say something on the measurement of inflation. I think we talked about this last time I was on, but it doesn't matter what inflation is. It matters where it's going. It's the rate of change of inflation that matters to financial markets, the speed of which it's changing. It's not the actual level. The only institution that cares about the level is the Fed, and we have to react to what they're doing. And obviously, we front run what they're doing by monitoring the rate of change, the magnitude, et cetera.

18:13So it's apples to apples in the time series. So it doesn't matter if Truflation is right or the BLS is right or some other organization is right. It's just what does it matter to the Fed? And shifting back to the second half of your question, which is, have the long and variable lags of monetary policy sort of gotten longer in this particular cycle? I think they have. There's a few reasons why I think they have. We'll list everything we talked about last time I was on, or a couple times ago I was on, where we had a bunch of factors that were contributing to our resilient US economy theme. Recall that almost a year ago, to this day, we identified that the US economy, that lag would be longer in this particular business cycle and that the U.S.

18:54economy would remain resilient well into 2023. It's looking like 2024 now. So I'll just list those things real quickly and add one chart to that, which is, one, we had near-record cash on household balance sheets. We had near-record cash on corporate balance sheets, both from a nominal perspective and also as a share of total assets on both of those sectors. Private sector income and wealth have outpaced inflation since the start of the pandemic. So as much as inflation has risen, we've seen income and wealth rise faster than inflation on a cumulative basis. We have limited credit cycle vulnerabilities.

19:27We don't have the kind of capital misallocation in this business cycle that we've historically had ahead of recessions, which obviously means the recession is going to be delayed and or it's going to be mild or both. We have limited exposure to the volatile manufacturing sector, which on a medium basis accounts for 98 % of the net job loss in a business cycle downturn. We also have labor hoarding, which is a complicated topic, but we can unpack that. And we also have Bidenomics, which we have this record non-war, non-recession budget deficit in the U.S. economy that's obviously contributing to the resiliency of nominal GDP.

19:58And so one final thing I'll add to that, Bliss, I'll go to slide two, Brian, if you can throw that chart up. So this is a pretty wonky chart. I'm fancying myself and pretty schooled at making complicated charts, but I'll take some time to explain this. So what this chart shows, the blue line in the top panel shows the basis point spread between the yield on the U.S. Corporate Credit Aggregate Index and minus the coupon. And so right now, the yield is 157 basis points wider than the coupon. The last time we had such a large spread in this indicator, the red line, which is the Lubbock-Williams estimate of R-star, which is the neutral interest rate, was somewhere around, let's call it 2 ,5%.

20:41The next panel on this chart shows that same corporate credit index, U.S. corporate credit index, and we show the duration of that index at right around 7.4 years. And the last time we've had it this high, it was the late 70s, when the R-star was somewhere around 4 % to 5%. You go down to the third panel on this chart, so we're showing the same analysis as we showed in the top panel relative to the mortgage-backed securities. So we're going from corporate tech credit to, let's call it, household credit here. and the spread between the yield and the coupon on the mortgage index is 192 basis points.

21:11It hasn't been that wide since the 80s. So going back to the R-Star discussion, R-Star was somewhere around 3.5 % to 4 % back then. And then finally, the duration on the mortgage-backed security index is right around 6.4%, and R-Star was somewhere around 3 % to 4%. And so that's the long-winded way of saying two things. One, both the private sector, both consumers and corporates, have termed out their liabilities and so that the tightening of monetary policy that we've experienced thus far hasn't really affected them because they have these longer-term loans and then leases, et cetera. And secondarily, because of that spread is so wide, it's probably causing a lot of stasis in terms of the issuance of new credit and the financing of new home purchases.

21:54And so it's like a double whammy of why monetary policy from an interest rate perspective has been so ineffective. It'll eventually become effective. Eventually, these loans will come due, and they have to refinance at higher rates. It just means the process is taking longer and it's allowing all those resilient economy factors that we just listed to, you know, kind of fester and contribute to economic resilience. Yeah, which is not a bad thing necessarily. I mean, this is what you could argue is part of the soft landing, because if that rolling process is spread out and the rug isn't pulled from everyone at the same time, it's a lot more manageable, right?

22:27100 percent. Yeah, you're absolutely right. That's why the probability of a soft landing, in my opinion, is higher than the probability of having a recession in the very near term. I still think a recession is the modal outcome, but a probability of having a soft landing is higher than the probability of waking up tomorrow and a U.S. economy being in a recession. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

22:55Andres, this is probably why it speaks to your meme of the day, right? Should we roll that out? Yeah, let's do it. Paul has apparently landed on the moon. At least it was, I think he tried to convey that message today. And let me just find the exact phrasing here, because I think the Fed basically went from saying that they needed a recession to lower inflation, to saying today, Paul admitted to no longer forecasting a recession. It was no longer the base case of the Fed. and they've went from one scenario to the other in under a year here. And to me, that is a consequence of the Fed being much more upbeat today on bringing inflation down without having to completely kill the labor market to get there.

23:44And I actually think that the most recent data suggests that there is a chance, to quote Jim Carrey here, and I honestly think that the probability has risen for such a scenario over the course of the past two or three months here. And that is probably also why the Fed is starting to acknowledge this scenario to a larger extent and started to sound more upbeat on the actual possibility of creating a soft landing. It is not the standard scenario to expect, given what we see in the yield curve right now, but you shouldn't rule it out. But I actually have one thing to add on the leads and lags and inflation, And I'd like your take on it as well, Darius, since you're one of the best followers of US inflation I know out there.

24:31If we look at inflation right now, it is basically mostly made up by the rent of shelter cost. If we leave the rent of shelter aside or we set it aside, inflation is already gone. And if we use various live gauges of the cost of rent, we probably get to levels close to zero in inflation, maybe even below zero if you use some of the online versions of the rent of shelter cost. So the big question is whether the Federal Reserve is constantly late as a consequence of the rent of shelter category. I don't really have a strong opinion on it myself. as a client of mine repeated on the chat when I shared the chart of Powell's favorite inflation measure, so services x shelter, thank God I'm homeless was his response to that, because obviously, you need to take the cost of living into account also when it comes to the rental shelter, right?

25:31So what do you make of it, Darius? Do you think the Fed is late to the party, both on the way up and on the way down as a consequence of this category? Yes, 100%. Great. But one, phenomenal kind of setting up that question. I think you are also one of the world's best at this as well, so I appreciate the compliment. I will say, yes, and I think it's on purpose. Because the reality is, as much as Zillow can tell you what home prices are doing based on their metrics or these other private sector entities, The reality is just because Zillow tells you what a home price is doing doesn't mean that we all have new different rents or we have all new different mortgage payments.