STUBBORN INFLATION PRESSURES DELAYING FED PIVOT

Weakening Inflation is not sticking to the script by coming down relatively quickly. Instead it is universally stubbornly coming in higher than expectations and actually increasing on a M-o-M basis. This isn’t just a US problem as was seen this week, as EU Core CPI surged, with German CPI coming in at 9.3%. over the last four weeks the markets have being caught off guard and are reacting in three ways:

1. 1. Increasing the Fed Funds Terminal Rate to a 5.5% high,
   2. Increasing Duration Term Risk Premiums on Treasury Debt,
   3. By pushing out the timing of projected Fed rate cuts and the fully expected “Fed Pivot”.

As a result Cash is quickly becoming King with better risk adjusted returns than equities. As a consequence money has begun leaking from equities into Money Market Assets. There is increasing concern that this may become a flood when compounded by both stock buybacks and insider buying weakening! We explore this possibility in this newsletter.

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WHAT YOU NEED TO KNOW

A near term “Fed Pivot” is now off the table as inflation is not subsiding as expected. This was confirmed as still a global problem as Spanish, German and overall EU CPI surged above expectations. During the week, the Terminal rate topped 5.50% and any expectation of a rate-cut in H2 2023 is gone. Does this push the Recession call out? We also consider this in this week’s newsletter.

2Y TREASURY NOTE REACTS AND TELLS FED TO DELAY PIVOT!

• • The Fed Funds Rate has historically always followed the 2Y UST Bill,
  • Inflation expectations best represented by 1Y Inflation Swaps soared back to life in February pushing the 2Y UST Bill to nearly 5%.
  • February releases were effectively the death toll for the Fed Pivot narrative as expectations for an H2 2023 rate-cut collapsed and the terminal rate outlook priced in rose significantly,
  • This has resulted in a complete reversal in the previously worrying Financial Conditions Index and making the buying of US short term treasuries more attractive than S&P Equity Dividend yields. Treasury bills (2Y Note) are the cheapest to stocks since the very peak in 2007.

EQUITY MARKETS ARE FOLLOWING RATE VOLATILITY (THE ‘MOVE INDEX’)

• • Throughout the last 5 years equity markets have closely followed central bank liquidity levels. This has changed and is now tracking treasury Bond Volatility (MOVE Index),
  • The importance of the MOVE Index aligns with what the LEI is signaling. Anything more than a -1% YoY decline in US Leading Economic Indicator (LEI) has always led to a US recession within a few months. We’re are now at -6% YoY which increases speculation of a shift in Fed Policy and hence bond yields and value.

TERM PREMIUMS BEGINNING TO BE PRICED IN

• • If bond holders are worrying that inflation is becoming embedded, then we should expect:

1. 1. 1. Most immediately, yields would be biased structurally higher.
      2. Yields would likely decline less when the Fed cuts rates.
      3. This would lower the control the central bank have over longer-term borrowing costs.

CONCLUSION

• • With interest rates now at levels that many investment professionals have not seen in their young careers, the timing is right for money to quickly shift towards safer, less volatile and an increasingly more attractive alternative of Money Market Assets

We fully expect an overdue recessionary deflationary scare to arrive in H2 2023.

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2 YEAR US TREASURY NOTE REACTS AND TELLS FED TO DELAY PIVOT!

THE FED ALWAYS FOLLOWS!

We have pointed out on numerous occasions that it is important to understand that the Federal Reserve actually follows the 2T Treasury Note. The easiest way to appreciate this is to appreciate that the Primary Dealers and Money Center Banks actually own the Federal Reserve, which operates under quasi government regulations, guidelines and controls with position appointments limited to the FOMC and not the regional bank governors who are the heads of the major banks. The real power has historically been held by the NY Federal Reserve centered on Wall Street. Effectively the 2 Year yield is determined by the trading actions of these Primary Dealers and Money Center Banks which the FOMC then uses as a key input for official monetary policy.

This reality can be seen by the historical illustration below, where the black 2T UST always leads the Fed Funds Rate in orange.

A SHOCKER TO EXPECTATIONS

2Y UST BREAKS OUT VIOLENTLY!

With the shocking 517K new jobs release of the January Labor Non-Farm Payrolls (NFP) on February 3rd the 2Y UST Yield exploded upward breaking key overhead resistance. This was followed by surges from the CPI, PPI and PCE releases, which all signaled hotter than expected inflation.

February also saw the largest absolute jump in the Citi US Economic Surprise Index since July 2020.

The 2Y yield broke back above its November highs to its highest yield since July 2007

… prior to pre-Financial Crisis levels

These February releases were effectively the death toll for the Fed Pivot narrative, as expectations for an H2 2023 rate-cut collapsed and the terminal rate outlook priced in rose significantly

Inflation expectations best represented by 1Y Inflation Swaps soared back to life in February