As investors go all in on a false narrative, will their bets go bust in the months ahead?
With the white metal jumping by more than 2% on Jan. 6, silver ignored the hawkish payrolls print. However, with Fed officials reiterating their commitment, an epic battle is unfolding.
For example, Fed officials have been steadfast in supporting a higher FFR, and have even stated that the metric may need to rise much more than the ~5% expected. On top of that, they also warned that whenever a pause ensues, rate cuts are out of the question, as a rise-and-hold strategy is the prudent response to ~40-year high inflation.
Yet, market participants do not believe the Fed, and they assume the central bank will cut rates, pause QT and continue its post-GFC trend of dovish pivots. So, the fundamentals boil down to a single question: do you believe the Fed or the consensus?
Now, the question is somewhat misleading because we do neither. Instead, we follow the data and let it guide our expectations. But, with employment outperformance, resilient GDP, and continued consumer spending, the data supports the Fed’s conclusions, and we believe the consensus has it wrong.
For context, when the Fed and the crowd were aligned in their “transitory” expectations in 2021, we warned that both parties missed the forest through the trees. We wrote on Dec. 23, 2021.
When the Fed called inflation “transitory,” we wrote for months that officials were misreading the data. As a result, we don’t have a horse in this race. However, now, they likely have it right. Thus, if investors assume that the Fed won’t tighten, their bets will likely go bust in 2022.
Likewise, when the crowd was pricing in a dovish pivot in the summer of 2022, we warned again that their expectations were out of touch with reality. We wrote on Aug. 1:
While the consensus assumes the Fed is near the end of its rate hike cycle, the CPI is on the fast track to 2% and a 3% FFR will be enough to capsize inflation, market participants are living in fantasy land.
For example, we’ve warned on numerous occasions that demand is much stronger than the consensus realizes. With Americans’ checking account balances at unprecedented all-time highs and the Atlanta Fed’s wage growth tracker hitting an all-time high in June, the FFR needs to go meaningfully above 3%. To explain, we wrote on Jul. 25:
With more earnings calls showcasing how the situation continues to worsen, market participants don’t realize that the FFR needs to hit ~4.5% or more for the Fed to materially reduce inflation. For context, the consensus expects a figure in the 2.5% to 3.5% range.
Therefore, while the predictions proved prescient, the crowd assumes that because the Fed was wrong about inflation and the FFR in 2021, they’re wrong about both now. In contrast, we believe the Fed has the right read on the U.S. economy, and the pivot predictors should suffer mightily in the months ahead.
For example, while the crowd celebrated the mild slowdown in wage inflation, Atlanta Fed President Raphael Bostic said on Jan. 6:
“It doesn’t really change my outlook at all. I’ve been looking for the economy to continually slow from the strong position it was at in the summertime. This is just the next step in that.”
He added:
“What I think is the important [point] is just to hold [the FFR] there and stay there and let that policy stance really grip the economy and just make sure that the [inflation] momentum is fully arrested, so that we get to a place where demand and supply start to become more interbalanced and we start to see those pressures on inflation really start to come down.”
As such, while it sounds like a broken record, the fundamentals remain consistent with our expectations.
Please see below:
Source: CNBC
Moreover, St. Louis Fed President James Bullard said on Jan. 5:
“This is a great time to fight inflation,” as the FOMC should “get it under control, get it back to 2% while you've got the resilient labor market.”
Furthermore, he added in a CFA Society presentation:
“The policy rate is not yet in a zone that may be considered sufficiently restrictive, but it is getting closer.”
Please see below:
To explain, the blue line above tracks the FFR, while the gray shaded area above represents the lower and upper bounds of what is considered a “sufficiently restrictive” FFR. For context, it’s essentially what is required to normalize inflation.
As you can see, the blue line has not yet reached the lower bound and is still far from the upper bound. As a result, while Bullard believes that a ~5% to ~7% FFR could materialize in 2023, the crowd expects rate cuts.
Remember, the FFR has eclipsed the peak YoY core CPI in every inflation fight since 1961; and since the YoY core CPI peaked (for now) at 6.66% in September 2022, the historically-implied peak FFR is at least 6.67%.
So, while investors position for the exact opposite, we see a profound difference between what’s priced in and what’s likely to occur.
Making three of a kind, Kansas City Fed President Esther George said on Jan. 5:
“I’m not forecasting a recession. But I’m quite realistic that when you see below-trend growth and the idea that [the FFR is] going to work on demand, bringing that down, it doesn’t leave a lot of margin there. Any shock could come, any risk to the outlook could send the economy in that direction. So it’s not my forecast, but I do understand that bringing demand down creates that sort of possibility.”
Thus, while we warned for many months that resilient demand would spur the Fed into action, George said that she expects the FFR to remain high into at least 2024.
Please see below:
Source: CNBC
Overall, Fed officials are as hawkish as they’ve ever been, but investors don’t care because they don’t believe them. However, we’ve seen this movie before, and the Fed is now on the right side of the fundamentals. Consequently, history has made corpses out of those that doubted inflation’s capabilities, and we see this iteration as no different.
Do you agree? Or, how do you see the Fed’s inflation fight unfolding? When could the FOMC buckle under the pressure from investors? We always welcome your feedback.
Alex Demolitor
Precious Metals Strategist