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September 28, 2023

We get the Fed’s favored inflation gauge tomorrow.

As you can see in the chart below, it has been moving the right direction, but well shy of the Fed’s target of 2%.

The expectation for tomorrow’s numbers (for the month of August), is 3.9% on this year-over-year number.  On the monthly number, which Jerome Powell referenced in his recent Fed meeting, it’s expected to come in at 0.2%.  

If the year-over-year number does indeed come in below 4%, it will be the lowest since inflation peaked in February of last year (the month before the Fed started the tightening cycle).  

If the monthly change comes in at 0.2%, that would be three consecutive months at that low level, which if annualized the Fed is looking at inflation running less than 2.5%.

This is in line with the cpi data we talked about earlier in the month.

Remember, we looked at this chart …

If both core and headline inflation were to grow at around the average of the past three months (monthly rate of change), the paths would cross by the end of the year, and the core (what the Fed cares most about) would be in the mid-2s by the mid-2024, which happens to be when the market has been expecting rate cuts

Of course, the Fed tried to disabuse the market of that expectation in the communications from their September 20 meeting, by removing two rate cuts from their projections for 2024.

They want us thinking “higher rates for longer,” which is intended to suppress demand (despite the sustained disinflationary trend, driven by a crash in money supply growth).

Just like they wanted us thinking inflation was “transitory” back in 2021, which we can only assume was intended to keep the consumption fire burning (in the face of a textbook inflation boom, driven by the explosion in money supply growth).

Are they just prone to mistakes, or are they purposely managing to an outcome?

Let’s hope they aren’t manipulating toward a return of the post-GFC era of sluggish growth and ultra-low inflation, with the threat of deflation.

That would leave us with trillions-of-dollars of fiscal bullets fired, with no growth to show for it (a massive increase in debt, with no growth offset).

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September 27, 2023

Yields continued to climb today.
With record global government indebtedness, these are high stress levels for the global economy. 
With that, let's revisit the events of June and October of last year.
In June of last year, the mere plan of the European Central Bank ending QE resulted in a blow-out of sovereign bond yields in Europe.  The global tightening cycle was just getting started, and yet Europe was already flashing warning signals of another sovereign debt crisis.  An implosion of European sovereign debt would mean an implosion of the euro (the second most widely held currency in the world), and therefore an implosion in the global economy. 
The ECB called an emergency meeting to plan a response.  They responded with a new plan (same as the old) to buy bonds of the weaker euro zone constituents to defend against "fragmentation" (i.e. an implosion of the euro zone).
That turned the interest rate market, on a dime (and bottomed global stock markets).
The ECB's new plan, aptly named the "Transmission Protection Instrument," was a public acknowledgement that they would rotely exit emergency level policy (raise rates, reduce the size of the balance sheet), while simultaneously manipulating markets to cancel the negative or destabilizing consequences (namely, uncomfortably high sovereign debt yields).
With the above in mind, the sovereign debt market in Europe has now returned to historically vulnerable levels
We should expect the ECB to execute on their plan.
Speaking of vulnerable levels, the Bank of Japan is once again looking at 150 USD/JPY.  This is the level of yen weakness, that proved to be intolerant to the Bank of Japan last October.  
Responsible for this yen weakness was the increasingly divergent monetary policies of Japan relative to the rest of the world (mainly, relative to the U.S.).  And related to that, by late October of last year, yields in Europe and the U.S. were trading at new highs of this tightening cycle — creating stress not only for the Japanese currency, but for the global financial system.  
The Bank of Japan intervened in the currency markets, to defend the value of the yen.  That relieved the pressure in markets.
The intervention event turned the interest rate markets (yields fell sharply) and it fueled stock market rallies. 






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September 26, 2023

We looked at this chart on Thursday …

The technical break-down in stocks has been driven by the pain of a sharp 25 basis point rise in the U.S. 10-year yield, in response to the Fed’s meeting last week.  That pain has spread to stock and bond markets in Asia and Europe, as well.

And you don’t have to look too hard to find bad news to compound what looks like vulnerable levels in key financial markets.

But that’s not unusual, especially in the recent history of the past 15-years — in the post-Global Financial Crisis world.

Speaking of history, let’s take a look back to late September of 2021 — two years ago.  This was another rough September, which left the S&P down 5%.

This is what stocks were doing at the time…

This chart is from my September 28, 2021 note.  The “pain” catalyst was mostly driven by a move UP in interest rates (the 10-year yield).

The Fed had turned hawkish, finally telegraphing a change in the direction of monetary policy, from easing to tightening, which is historically bad for stocks.  

Add to that, there were two other negatives weighing on stocks back in September of 2021:  1) concern about the Chinese financial system, namely a default by its biggest real estate developer, and 2) a potential U.S. government shutdown.

Sounds very familiar. 
The trendline in the 2021 chart represented the 40% climb from election day, on anticipation of a massive fiscal spend.  The break of that line turned out to be a minor technical correction, lasting a little less than a month.

Stocks rallied 12% in the fourth quarter of 2021, finishing on the highs.

Let’s turn attention back to the current chart (the first chart in this note) …

First, you’ll notice the level of the S&P 500 is right where we were two years ago (low 4300s).  So, after two years of rate hikes and (indirect and direct) demand suppression by the Fed, the global risk proxy (the S&P 500) is nearly unchanged.  

The factors weighing on stocks are similar to that of September 2021 (rising rates, a threat of government shutdown, problems in the Chinese property market). 

But now we have a Fed that is, at worst, one more rate hike away from telegraphing a change in policy direction (from tightening to easing).  At best, they are already there.

With all of the above in mind, going back through almost 80 years of data, we have a 10% decline in stocks, on average, about once a year. We’ve yet to have one this year.  If we test the 200-day moving average (the purple line in the top chart), that comes in at 9% below the July lows.  That’s just 2.3% lower than today’s close.

This puts us on the path toward Q3 earnings in a couple of weeks, where expectations have, again, been dialed down — which sets up for positive surprises. 






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September 25, 2023

We get the Fed's favored inflation gauge on Friday.  The August core PCE reading is expected to come in under 4% (year-over-year) for the first time in two years.  This measures the change in prices of goods and services that people have actually paid — not just a selling price. "Core," means excluding food and energy prices. 
So, the expectation is for a break of the 4% level.  The Fed wants to see this number at 2%.
What would it take to get there?  And what would it take to get there by the time the market is pricing in the probability of a first rate cut?
It would take an average monthly change in core PCE (month-over-month) of just under 0.17% through the first half of next year.
That would bring the annual change in core PCE to 2% by July.
This seems unlikely unless there are deflationary pressures coming down the pike.  
This view would argue that the Fed will probably do what they've told us they will do (i.e. raise one more time).  At this point, with a tight job market, and an economy running around a 5% annualized pace, and the expectation (of another raise) already built-in, they don't have a lot of risk in pressing the brake a bit harder.  Of course, this assumes they continue to clean up any mess that may reveal itself in the financial system, due to climbing market interest rates (i.e. intervention).
On that note, let's take a look at a couple of charts …
Here's the U.S. 10-year yield, trading above 4.5% today, and into the top of this channel …
More concerning than the level of U.S. rates, is the influence on the Euro zone interest rate market.  Today, German yields traded to the highest levels since 2011 (when the European sovereign debt crisis was escalating).  Spanish yields traded to nine-year highs.  And the chart on Italian yields looks like this (a potential breakout) …
With the above in mind, given the recent history of central bank manipulation in these markets, we should expect them to maintain control of these extremely important (to global financial stability) government bond markets.





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September 22, 2023

In late June, the four most important central bankers in the world sat on a stage in Portugal, and fielded questions spanning from the inflation outlook and rate path, to geopolitical concerns, fiscal policy, digital currencies, and AI.
Three central bankers on the stage, from the U.S., eurozone and UK, were all well into the process of normalizing interest rates.  And then there was the new governor of the Bank of Japan, Kazuo Ueda.
In my June 28th note, I called him the most important person in the room that day.  He was the only one in the room that has been trying to get inflation UP, and therefore, he was the only one in the room with negative rates and running full bore QE — buying both domestic and global assets each month with no limits
And running that policy, simultaneously, as the rest of the world tightened, is the only way his central bank counterparts were able to raise rates to combat inflation, without losing control of their respective government bond markets (i.e. runaway yields). 
How?  The Bank of Japan became the liquidity offset to the Western world's attempt to extract liquidity.  As importantly, if not more, they have been buyers of foreign government bonds (largely U.S. Treasuries) via freshly printed yen. 
All of this to say, perhaps the most interesting thing said that day:  Ueda said he imagined rates would go up by a large margin in Japan, "IF they GET to normalize policy."
With Western central banks now on pause, and holding rates "higher for longer," as they say in unison, it doesn't appear that Ueda will GET that chance any time soon.  
Indeed, the Bank of Japan stuck with their ultra-easy policy overnight. 
And they added, they will patiently continue with easing, while "nimbly responding to developments in economic activity and prices as well as financial conditions."
This sounds a lot like (head of the European Central Bank) Christine Lagarde's comment at Jackson Hole.  Just as everyone has been hoping the central bankers would step away from manipulating the economy and markets, Lagarde says we need even more "robust policymaking in an age of shifts and breaks."


"Robust policymaking" in this post-pandemic era, seems to translate into breaking things in the financial system, and then simultaneously intervening in markets to fix what they break (as the ECB did with its sovereign bond market, as the UK did with its sovereign bond market, and as the Fed did with its banking system).





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September 21, 2023

With some time to digest the message from the Fed yesterday, the 10-year yield surged and finished on the highs today.  We are now revisiting a 4.5% 10-year yield, for the first time since November of 2007.
With that, stocks finished on the lows of the day.  
And we have some charts that look concerning…  
As you can see in this chart above, this trendline from the March lows has been broken.  And this trend, importantly, was driven by a Fed response to the confidence shock in the banking system.  They stepped in to provide liquidity to depository institutions to backstop deposits.  And the bottom was in.
So, this line has been broken.  And we have similar charts across the stock indices (the Dow, Nasdaq) — all trend breaks.
With this break, the money management community piled into hedges.  The VIX spiked, albeit from very subdued levels.
Even oil, which has been on a tear the past three months, traded down as much as 4% from yesterday's highs.
This, all because the Fed projected two less rate cuts for next year?
Remember, many economists and much of Wall Street have been expecting recession for the better part of the past year.  Why?  The dreaded "inverted yield curve," which has historically been a predictor of recession.
That said, we had a technical recession, already — in anticipation of the tightening cycle. It was the first half of 2022.
Is the Fed hell-bent on inducing another one?  That seems to be the belief, based on the initial response from markets.
But remember, as Jerome Powell ended the press conference yesterday, he had this to say about the economy:
I think overall households are in good shape. Surveys are a different thing. So surveys are showing dissatisfaction, and I think a lot of that is just people hate inflation, hate it. And that causes people to say the economy is terrible, but at the same time they're spending money. Their behavior is not exactly what you would expect from the surveys. That's kind of a guess at what the answer might be. But I think there's a lot of good things happening on household balance sheets, and certainly in the labor market and with wages. The biggest wage increases having gone to relatively low-wage jobs, and now inflation coming down, you're seeing real wages, which is a good thing.
With this assessment, and an economy that is running at a near 5% annual growth rate, the Fed still seems more concerned with throttling a strong economy, rather than tipping a weak economy into recession.
My view:  At this point, they don't want to give the "all clear" signal to markets, which would provide fuel to markets and the economy.





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September 20, 2023

The Fed left rates unchanged today.  
The key takeaways were in the projections on policy and the economy made by Federal Reserve board members and Federal Reserve Bank presidents (the "Summary of Economic Projections").
As we discussed yesterday, the economy has been running at a pace three-times what the Fed was estimating in June.  
So today, they doubled their forecast, from 1% to 2.1% economic growth for 2023 (still looks too low).
Add to that, they lowered their estimate on unemployment on the year, and on core inflation (their favored inflation gauge).
So, the Fed has said we will need to see higher job losses, and below trend growth "for a period of time" to get inflation where they want it.  They've been wrong.  Inflation is going their way (lower).  And yet the job market remains tight, and growth has been hot.
On the inflation front, as we've discussed here in my daily notes, we had a growth shock in money supply, from the 2020-2021 policy response to the pandemic.  That was the inflation catalyst.
We've since had the disinflationary effect (falling inflation) from the contraction in money supply.
And now, money supply growth is normalizing.  The monthly change in money supply has been growing (modestly) for three consecutive months.   A low and stable rate of money supply growth is good for economic growth and price stability.  That's what we're getting.  And that's good! 
With that, what does the Fed really think about the economy?
In a parting comment, Jerome Powell admitted today that the government handouts from pandemic packages were "very meaningful" and have "left housholds in good shape" — still!  That's despite the headwind of increasing interest rates by 525 basis points.
And he said "people hate inflation" … "and that causes people to say the economy is terrible" in surveys … "but at the same time, they are spending money."   





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September 19, 2023

The Fed will decide on rates tomorrow.
Remember, they told us after the July meeting that they would be completely "data dependent" in determining the path forward for monetary policy.
And while the July hike was a unanimous decision (among the 11 voting members), we later found in the minutes from that meeting, that there was indeed some dissension"Almost" all participants agreed to raising rates at the July meeting.  "A couple" (assumably non-voters) favored leaving rates unchanged.
A week later or so, we heard from Jerome Powell at Jackson Hole, and he said the Fed was currently in restrictive territory, putting "downward pressure on inflation," and he reiterated that the Fed is data dependent.  
So, since late July, the Fed has been looking for softening data to validate a pause, if not the end of the tightening cycle.
They've gotten it.  With that, the Fed will leave rates unchanged tomorrow.  The question:  What will the new forecasts look like (the "summary of economic projections")? 
This is from July …
If we step through the July projections, the data point that stands out is economic growth.  The Fed has dramatically (to this point) underestimated the impact of the fiscal spend on real GDP growth.  Through three quarters, actual growth is running about three times higher than the Fed's forecast.  However, the employment and inflation data are closing in on the Fed's targets. 





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September 18, 2023

In my last note, we revisited the mid-term election analogue for stocks. 
The 12-month period following the past eighteen mid-term elections, of the past seventy years, has been positive for stocks — to the tune of a 16% return, on average.
Indeed, stocks are tracking that analogue this year.  
Today, let's revisit another big analogue we discussed coming into 2023.  It has to do with the trusty 60% equity/40% bond portfolio.  
As you might recall, at one-point last year, this portfolio mix was down as much as 30%.  That was tracking to be the worst on record, even worse than 1931 (the depths of the Great Depression). 
This 60/40 portfolio finished last year, down 18%.
Now, it's not rare for this portfolio to be down on the year.  It's happened about a quarter of the time.  But it is rare for both stocks AND bonds to be down on the year. 
It's only happened four times going back to 1928.  And it happened last year. Stocks were down 18% (S&P 500, total return) and bonds were down 18% (10-year bond, total return).
So, let's revisit how stocks performed in the year following these four rare occurrences, that shared the features of a negative 60/40 portfolio return, driven by a negative annual return for both stocks and bonds.
It happened in 1931.  That was followed by a negative return year for stocks (down 9%) and a positive return year for bonds (up 9%).  
It happened in 1941.  That was followed by a positive year for stocks (up 19%) and a positive year for bonds (up 2%).  
It happened in 1969.  That was followed by a positive year for stocks (up 4%) and a positive year for bonds (up 16%).  
It happened in 2018.  That was followed by a positive year for stocks (up 31%) and a positive year for bonds (up 10%).
Now we've had the fifth occurrence, in 2022. And more than eight months into the year, stocks are up 17%.  Bonds are down 1%.
As you can see, this year's performance in the bond market is deviating from history.  This is thanks to the sledgehammer of rate hikes, and threats of more (by the Fed), which have weighed steadily on bond prices throughout the year (prices down, yields up).   
On that note, we head into a Fed meeting this week, with the benchmark 10-year bond yield having printed a new 16-year high overnight — now hanging around the 4.30% yield mark, a level that has marked a high, and a turning point, on two other occasions over the past year.
With this setup, speculators are net short treasury futures (i.e. short bond prices) at record levels
What does that mean?  They are leaning heavily in the direction of a break higher in yields (lower in bond prices).  These extreme positions tend to be contrarian indicators.
The last time the market was positioned near this extreme of a short (against bond prices) was September-October of 2018.  Those bets were wrong.  It was was the turning point, and those levels weren't seen for another four years.
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September 14, 2023

As we discussed yesterday, going into the August inflation report, we’ve had a 30% rise in oil prices and a 55 basis point move in the 10-year yield, all since the end of the first half (the end of June).

Meanwhile, stocks (Nasdaq, S&P 500, DJIA) are left virtually unchanged over the same period.

With the inflation data now behind us, is it time for stocks to make a strong run into the end of the year?  Maybe. 

Stocks are trading at 18.6 times next year’s earnings (forward twelve months).  That’s more expensive than the long-term average of around 16 times.  But it’s cheaper than the average trailing twelve month P/E of the past 30 years (which is north of 20 — even if we exclude the high multiple years following recession).

If we apply a P/E of 20x for earnings expected over the next twelve months, we get a price target on the S&P 500 that implies another 7-8% higher (from current levels). 

With that in mind, let’s revisit the midterm election year analogue we’ve talked about since last November …

Going back to 1950, there has never been a 12-month period, following a midterm election, in which stocks were down.

And the average 12-month return, following the eighteen midterm-elections of the past seventy years, was +16.3% (about double the long-term average return of the S&P 500).

This phenomenon has been playing out.  The S&P 500 opened at 3,750 on November 8th, 2022 (election day).  Today it trades 4,510.  That’s a rise of 20% over the past ten months.

What was the best 12-month period following a midterm election (over the past eighteen periods observed)?  It was under Kennedy.  Stocks rose 31% in the 12-months following the 1962 midterm election.

And interestingly, the worse stocks did in the 12-months prior to the midterm elections (over the 70-year period observed), the better they did after.  In the current case, stocks were down 22% prior to last year’s election.