When the Fed Pauses

We are very close to the end of the tightening cycle.  The LEIs and PMIs are both showing an economy that is at the beginning of an economic downturn.  While the labor market still hasn't cracked, its not as strong as the nonfarm payrolls have shown, due to inaccuracies and double counting part-time jobs held by one person.  The divergence between the household survey and the establishment survey is huge, which tells you that 2nd jobs have been a big part of the strength in the nonfarm payrolls number.  Also, the birth-death model underestimates job losses when the economy suddenly starts to weaken, as businesses unlikely to respond when they are about to go out of business or are out of business.  

Inflation is trending lower but people are still spooked by the trauma of higher than expected CPI prints for most of 2022.  On the housing side, the end of eviction moratoriums and the increase in supply in 2023 will ensure that rent inflation is subdued.  If layoffs blowup like I expect it to next year, a lot of Millenials will be moving back to their parents' basement rather than staying in an apartment.  The only fly in the ointment to my disinflation thesis for 2023 are commodities.  Commodity prices could go back up again as China comes back on to the market for their "reopening".  I don't think it will be as big as people expect, but the anticipation of it could boost energy prices in the first half of 2023.  But overall, even if oil prices go back up, the year over year comparisons will be favorable, so higher oil prices won't feed too much into the CPI.  

I know they say that Powell doesn't want to stop hiking and then start hiking again if inflation stays sticky, like they did in the 1970s, but he's deluding himself if he thinks this economy is anything like that of the 1970s.  You have to remember that in the early 1970s, the US went off the gold standard, and that ushered in an inflationary wave, exacerbated by the oil embargo.  You had a fast growing younger population, with a much higher demand for goods, while not having the mass globalization as you do now to be able to meet the demand.  The money supply was growing faster than it is now.  And there was much less household debt.  The household debt to gdp ratio is almost double that of the 1970s.  

Households cannot handle high interest rates when they hold so much more debt.  Not only that, the wages adjusted for inflation were much higher in the 1970s than they are now.  A lot of people are buying into the sticky inflation/deglobalization/1970s theme but the data just doesn't support it.  

I don't know what Powell is thinking, although many are saying that he wants to be revered like Paul Volcker.  But Volcker was just a person who was in the right place at the right time.  He wasn't the one who killed inflation.  Commodity deflation, productivity growth from technology leading to deflationary forces, and the dollar going on a massive appreciation cycle as it became the clear global reserve currency were the inflation killers.  

The bond market is the biggest beneficiary of a Fed that finishes its rate hiking cycle.  In the last 4 rate hiking cycles (1994, 1999-2000, 2004-2006, 2017-2018), 10 year yields fell rapidly after the last rate hike.  While stocks also did well right after the Fed finished hiking, the strength was temporary in 2 of 4 cases, as stocks dropped bigly in 2000-2002, and in 2007-2008.  But all 4 cases saw bond yields trend lower for years after the final hike.  

Here is what happened to 10 year yields after the last rate hike and during the subsequent pause in 1994, 2000, 2006, and 2018-2019.  

Here is what typically happens after the last rate hike by the Fed.  They never signal a future rate cut, they either signal more rate hikes which they can't execute due to economic weakness, or they signal that they will keep rates at current levels for an extended period.  They NEVER signal a rate cut right after their last rate hike.  So don't expect one.  Just expect the bond market to start rallying after the dark cloud of future rate hikes is lifted and the sunny skies of future rate cuts is on the horizon.  

People like to look in the rear view mirrow when forecasting, which is why you see a lot of fears of another bond market liquidity squeeze like you saw in September/October or hawkish central banks.  Central banks ALWAYS fight the last battle.  They have no foresight.  They are always in CYA mode (cover your ass), which means they take the politically safe route, which is to fight the last battle.  The last battle was inflation.  The next battle will be a deep recession.  I don't buy the shallow recession reasoning at all.  When you have secular stagnation and central banks still fighting the last battle and not coming to the rescue, you will get a deep recession and lots of job losses.  They are the firemen who always come an hour late, when the house is already burned down.  Expect the same result this time.  The house is burning now, and they are just adding more gasoline to the fire.  When they figure out their policy error, they'll act like nothing bad happened, they will just push their mistakes under the rug, and go back to what they always do: fight the last battle.  

Neutral on the stock market.  After this dip, leaning bullish on bonds.   The BOJ yield curve control tweak scared some weak hands, but it doesn't change anything.  Japan isn't really that relevant anymore in the big scheme of things, the big current account surpluses from their heyday are over.  The yield differentials are still huge so their won't be much repatriation unless they follow the ECB and get really aggressive.  Doubtful that happens before the global economy is in a deep recession, at which point they will stop whatever minor tightening they have done.  It appears that too many are jumping on the weak dollar bandwagon as the ECB and BOJ have suprised on the hawkish side.  Fundamentally, the dollar is still the cleanest dirty shirt out there.  Europe's energy policy is terrible.  Japan just isn't printing enough money to sustain big inflation numbers.  And after a big dip, I expect a return to a strong dollar in early 2023 as fundamentals reassert themselves.