Peak Fed Dovishness

Damir Tokic |

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At the March FOMC meeting, the Fed re-confirmed its intention to cut interest rates three times in 2024, despite rising inflation expectations and boosting growth expectations. This moment could signal the Fed's peak dovishness. In other words, the Fed cannot possibly get more dovish than it already is, and this is usually a turning point for the stock market as well. There are two key issues to consider: First, the monthly core CPI increased well above expectations and above the Fed's target in January and February. The Fed views this increase as a "bump" and thus it does not want to "overreact". This is dovish. Second, there's growth and the job market. The January and February jobs data showed that the new job creation also accelerated, which is likely to keep the GDP growth above potential - and inflation elevated and sticky as well. Accordingly, the Fed boosted the GDP prediction for 2024 from 1.4% to 2.1% and the core PCE inflation to 2.6% from 2.4% - and still signaled that it intends to cut interest rates three times. That's very dovish. In fact, it would be hard to imagine how the Fed could get more dovish (other than sharply cut due to a recession). That's the peak dovishness. What comes next? Now, the Fed has to actually signal that first cut in June and then actually cut the Federal Funds rate in June. In order to cut in June, the Fed has to get enough evidence to support the January/February "inflation bump" thesis, which means that March core CPI has to come at 0.1-0.2% MoM range, and then it needs to be supported with equally tame inflation in April. But even if this happens - it's already priced-in. The Fed would have to signal 4 cuts in 2024 at the June FOMC meeting to get "more dovish". But what's more likely to happen is that the core CPI comes at 0.3% MoM either for March or April, which would invalidate the "inflation bump" thesis and further delay the first interest rate cut, possibly to November after the election. In fact, the December 24 Federal Funds futures are already starting to price less than 3 cuts in 2024 after the FOMC repricing on March 20th. However, the delayed normalization to November would be a huge problem for the stock market. Specifically, the yield curve has been inverted now for the record time - and the inverted yield curve causes a recession with the lag. This means, the longer the yield curve stays inverted, the higher the probability of a recession. Thus, if the Fed is forced to delay the interest rate cuts to November, it is very likely that by that time the lagged effects of monetary policy easing will cause a recession. More importantly, the market will get hit with the maturity wall in 2025, this is when leveraged loans and junk bonds will have to be refinanced - at a much higher rate. The Fed is aware of what happens if interest rates stay higher until November - a deep recession. So, the Fed is aware that it needs to lower interest rates in advance. But it needs to provide the supporting evidence for the "inflation bump thesis". If the March and April core CPIs disprove the "inflation bump thesis", and the Fed still cuts in June, and signals more cuts in 2024, the market could interpret this as the signal that the Fed abandoned the 2% inflation target. As a result, the inflation expectations could de-anchor which could result in sharply higher long-term interest rates, with 10Y Treasury yields rising well above 5%. In addition, the US Dollar (UUP) could start depreciating, boosting the price of oil (USO), gold (GLD), as well as other commodities, which would only add to the inflationary pressures, and further push interest rates higher. This would be a disaster scenario for the bond market, especially in combination with the US debt issues. Obviously, this would also be a very bad scenario for the stock market as well. Thus, the Fed is unlikely to cut in June, unless there is sufficient evidence for the "inflation bump thesis." Thus, we are likely past the peak dovishness, which means that the Fed will be forced to make a hawkish turn, and further delay the interest rate cuts - possibly until a recession.