The Fed's Real Boss

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Does the Fed serve the people or the banks? … the case against another rate cut … why banks would like one … expect another quarter-point cut on Wednesday

Who does the Fed serve?

That’s the question posed by veteran trader Jeff Clark, the latest addition to our corporate family.

It came last week when I was in Baltimore at an investment conference featuring some of InvestorPlace’s and TradeSmith’s top analysts. I was at a dinner including InvestorPlace’s CEO Brian Hunt, the Chief Investment Officer of The Freeport Society, Charles Sizemore, and Jeff.

Charles was highlighting Federal Reserve Chairman Jerome Powell’s missteps in recent years. After he finished, Jeff thought a moment then posed the question above. He followed it up with (paraphrasing):

If the Fed serves the people, sure, there have been missteps. But if they serve the Big Banks, it’s business as usual.

We’ll circle back to this in a moment.

This Wednesday, the Fed will conclude its December FOMC meeting and release the latest interest rate policy

As I write Monday morning, the CME Group’s FedWatch Tool puts a 95.4% probability on another quarter-point cut.

For a Fed that has repeated ad nauseam that it’s “data dependent,” another cut raises questions.

Now, before I make my case for why, let’s be fair: The Fed has a challenging job. It must walk a tightrope between keeping rates loose enough to prevent damage to the labor market, yet tight enough to prevent a resurgence of inflation.

But from where I stand, inflation is the much greater danger at the moment. And that means another quarter-point cut on Wednesday is a bad move – unless there’s something else at play here…

Service to the Fed’s real boss: the banks (and to some extent, Wall Street).

To explore this possibility, let’s start with the Fed’s preferred inflation gauge, the core personal consumption expenditures (PCE) index

The following data don’t exactly make a compelling case for a “data dependent” Fed that we’ve conquered inflation and can now focus on the labor market.

We’re looking at month-over-month core PCE inflation over the last six months (November’s report comes out this Friday):

May: 0.1%

June: 0.2%

July: 0.2%

August: 0.2%

September: 0.3%.

October: 0.3%.

I’m not suggesting we raise rates, but do we really need to cut them given this upward trajectory?

If you respond “yes,” let’s move to exhibit #2.

Last week’s Consumer Price Index and Producer Price Index inflation didn’t show any victories over inflation

CPI data came as forecasted and the financial media cheered – but what was the forecast?

A month-to-month increase of 0.3%, which was the fastest growth since April.

Meanwhile, on a year-over-year basis, CPI jumped 2.7%, 35% higher than the Fed’s 2% target.

This is cheer-worthy data?

Apparently so, because the market shrugged it off and climbed last Wednesday. But it didn’t shrug off Thursday’s Producer Price Index (PPI) report.

It rose 3.0% year-over-year, up from the 2.4% in October, and coming in well above the 2.6% rate that economists projected. Meanwhile, core PPI came in at 3.4% year-over-year, easily topping October’s 3.1%.

Again, is a rate cut on Wednesday a smart move given inflation’s current trajectory?

“Yes,” you reply?

Bold answer!

Okay, well, here’s my next pitch…

“Truflation is going the wrong direction – fast

Truflation is one of the best real-time indicators of inflation. And as I write Monday morning, it pegs inflation at 3.00% – 50% above the Fed’s target rate.

Bond expert/analyst Jim Bianco pointed toward this same chart/reading and asked:

What is going on here?

And should it concern us that the markets are pricing a 99% probability the Fed will cut rates again?

Well, circling back to Jeff Clark’s question at dinner, is it possible that what’s “going on here” is the Fed serving its true boss?

Why banks have an interest in lower rates

During the pandemic shutdowns, without many profitable lending opportunities, banks dumped more than $2 trillion into investment securities as they scavenged for returns. That was an increase of more than 50%.

Enter the Fed and one of the most aggressive rate-hiking campaigns in history, which then crippled the market value of these long-dated investments. Today, banks are sitting on a mindboggling amount of unrealized losses.

The chart below provides a visual. Dating back to 2006, the chart shows the unrealized losses on available-for-sale securities (in tan) and unrealized losses on held-to-maturity securities (in blue).

Enjoy…

In the second quarter of 2024, U.S. banks reported $512.9 billion in unrealized losses on investment securities.

Is that a lot?

Well, it’s seven times higher than the peak of the 2008 Financial Crisis. So… yes.

By the way, Q2 marked the 11th consecutive quarter of unrealized losses for banks.

Now, if a bank is well-capitalized with strong cash flows, it can simply hold these securities on its balance sheet until maturity. That way, it never has to “realize” the loss. For this reason, some investors brush off this chart, believing it’s all bark, no bite…

But lower rates aren’t just about these balance sheet losses

While high interest rates help banks by increasing their net interest margins, those same high rates often result in a decline in loan originations, higher deposit costs to banks, and concerns about credit quality.

This is part of the reason why a few months ago, Bank of America’s CEO, Brian Moynihan was vocal about his desire for the Fed to cut rates. Here’s Disruption Banking:

Brian Moynihan, has been outspoken about his desire to see the Federal Reserve cut interest rates. This call to action has stirred up quite the conversation in the financial world, with many wondering whether Moynihan’s plea is a carefully calculated strategy or a sign that the banking giant is feeling the pressure from an increasingly volatile economic environment…

Moynihan has argued that lower interest rates would give banks the breathing room they need to stabilize their earnings in what he calls a “softening economy.” In his view, cutting rates could create more favorable conditions for consumers, who may be struggling with loans, and for businesses, which might otherwise pull back investments…

Though Moynihan’s arguments for a rate cut have merit, the move also raises questions about the bank’s underlying health. After all, if BofA’s business is truly on solid ground, why the sudden urgency for lower rates?

Bank of America has about $85.7 billion in unrealized bond losses – the most in the banking industry.

To be clear, we’re not predicting bank failures from this (although some analysts believe that smaller and regional banks aren’t out of the woods yet due to their commercial real estate exposure). But our goal here isn’t to analyze bank solvency, it’s to explain a potential motivation for the Fed cutting rates again despite a climate in which a rate cut seems unnecessary.

“It’s not unnecessary, Jeff, and it’s not about the banks – the labor market is cracking”

If that’s your perspective, don’t tell it to Jerome Powell and his merry band of Fed presidents.

Here’s Powell when speaking at an event earlier this month hosted by the New York Times:

The U.S. economy is in remarkably good shape… We can afford to be a little bit more cautious as we find neutral.

And here’s CNN Business with some of the Federal Reserve presidents who sound rather unconcerned about the economy/labor market:

“It can be dangerous to focus too much on one release because it may be subject to revisions and reflect idiosyncratic factors like the impact of hurricanes and strikes,” Cleveland Fed President Beth Hammack said Friday at an event hosted by The City Club of Cleveland. Overall, she said recent trends indicate the labor market is getting into better balance from the pandemic, when employers had to contend with shortages.

Chicago Fed President Austan Goolsbee said last month’s job gains were higher than he anticipated, but said he’s not reading too much into it. Instead, he said he’s taking into account recent averages of monthly job gains. In that regard, the labor market is at a level of “sustainable full employment,” Goolsbee said Friday at a conference…

Fed Governor Michele Bowman said the labor market’s strength continues to outperform her expectations. In her view, the rise in the unemployment rate over the past year “largely reflects weaker hiring as the layoffs continue to remain low,” she said Friday at an event hosted by the Missouri Bankers Association.

Powell and these presidents are not exactly painting the picture of an economy in dire need of rate cuts.

Finally, let’s throw anticipated economic growth into the mix

As we’ve detailed here in the Digest, Trump appears poised to slash taxes and eliminate regulations in hopes of turbocharging the economy. The business community is salivating.

Here’s Axios:

Confidence among America’s top chief executives is soaring after President-elect Trump’s re-election, with high hopes the former president will usher in an era of low taxes and regulations…

Cisco CEO Chuck Robbins, who chairs the Business Roundtable, said in a statement that top executives feel “energized” by Washington set to “consider measures that can protect and strengthen tax reform, enable a sensible regulatory environment, and drive investment and job creation” …

Nearly 80% of the lobbying group’s CEO members expect higher sales in the next six months, up from 71% who expected the same last quarter.

Now more than 40% plan to increase capital spending, an increase from the 35% who previously said so.

It’s not just big businesses that are more optimistic. An index measuring sentiment among small business owners also surged after the election — notching the single largest one-month gain in the survey’s 40-year history, according to the National Federation of Independent Business.

Now, all this spending/investment is likely to increase the velocity of money and create upward pressure on inflation. The hope is that the related economic productivity will be so robust that it will offset higher nominal prices, netting out to a “felt” economic improvement for Main Street America and family budgets.

Still, the risk of reinflation is quite real.

Actually, we’re already seeing reinflation. The risk of a marked acceleration of inflation in 2025 is quite real.

And yet, if traders are right, the Fed will deliver another quarter-point rate cut on Wednesday – exactly what the banks (and Wall Street) want to see.

I’m not sure it’s what your wallet wants to see at the grocery store.

Speaking of Wall Street…

While we’re concerned about how all this eventually ends, for now, lower interest rates, surging corporate confidence and capex spending planning, and climbing investor FOMO appears to be more than enough to keep the market partying as we enter 2025.

So, mind your stop losses… use wise position sizing… and keep your portfolio balanced and diversified… but with those steps in place, keep riding this bull market.

Circling back to the question of “who does the Fed serve?” I’m curious what you think. Email us your thoughts at Digest@InvestorPlace.com where we’d love to begin posting a back-and-forth from readers. In any case, if the Fed is going to cut rates – for whatever reason – let’s position ourselves accordingly.

Have a good evening,

Jeff Remsburg

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