Necessary And Sufficient

Data Dependent Risk-On Rally

The data cooperated this week, though a literal reading of the constant stream of FOMC participants speeches and media appearances would lead one to conclude they were unimpressed. Nevertheless, the market skated to where the Fed is heading even if they (the Fed) don’t know it yet, by reducing the probability of a final hike to zero, assigning a 75% chance of the first cut by May, and restoring a fourth hike to the market implied policy path in 2024. While this is close to our forecast — we received three inflation reports this week that restarted the disinflationary trend that stalled in 3Q — as we will detail in this week’s note, disinflation is only the necessary, but not sufficient, condition for the Fed policy path to take the final step from policy put, to pause, and then a full pivot.

The sufficient condition is deterioration in the Fed’s employment mandate, beyond the modest increase in unemployment they expect. Unlike the FOMC, we do not view policy as sufficiently restrictive. For the banking system to play its necessary role in financing the growing federal debt and deficits, small businesses, real estate, leveraged loans and high yield in 2024, the FOMC will need to cut rates more than their September policy rate forecasts imply. In other words, policy is excessively restrictive due to three hikes after it became abundantly clear the policy rate was above r**, the financial instability rate, when there were a series of bank failures in March. In essence, they were wrong to address the massive losses on bank securities holdings with macro prudential policy. A suboptimal monetary tightening process, passive unwinding of asset purchases and aggressive rate hikes, together caused the third deepest inversion of the 3-month bill/10-year Treasury curve in history and the additional 75bp of hikes made an — at best — very marginal contribution to 2023 disinflation.

From a tactical perspective, cooler inflation, a coming negative revision to 3Q services consumption and another month of soft labor market data should be enough to keep the risk-on rally going through year-end. However, the combination of fixed income supply across a range of sectors, a growth scare, the gap between the market implied monetary policy path and FOMC participants forecasts, stretched valuation for Treasuries, credit and technology and related sectors, points to a difficult start to 2024. We don’t want to jump the gun, but everywhere we turned this week we got pressed on our 2024 outlook. We don’t know why the street insists on publishing outlook notes in November, we are still targeting early December.

Figure 1: The markets got pretty excited about a 12bp drop in the expected YE24 policy rate.