Upcoming July Rate Cut May Trigger Biggest Market Shock of the Year
Biden's tendency to distort economic data to make it appear stronger than it is in order to gain more votes has turned the analysis of nearly everything into a nightmare. We have now reached a point where any further data manipulations are as evident as Biden's dementia, something even the White House press corps can't hide anymore – just look at California. Despite Biden's handlers' efforts to conceal the true state of the economy, the situation is unraveling. This means that the Fed's remaining credibility depends on when and how much it cuts rates if it hopes to steer the economy into at least a non-catastrophic hard landing, if a soft landing is impossible.
According to TS Lombard's chief economist Steven Blitz, we are just days away from the biggest market shock of the year: a July rate cut announcement.
Blitz notes in his latest report that "the economy is probably the least important issue on Americans' minds these days, and the Fed aims to keep it that way." While Blitz might be catastrophically wrong about the first point, he is correct that the Fed wants to avoid another economic disaster in the next few months, the second in four years. This means it's time to ease financial conditions (unless there's a surprising 300,000+ jobs report on Friday).
Blitz explains that "data continue to lower the rules-based funds rate, and the Fed is likely to comply – assuming June employment data cooperates." The TSL strategists add that the Fed has reasons to be cautious about the current low inflation, as it echoes last year's slowdown in growth.
The economy picked up in the second half of last year, suggesting that current inflation rates might be at a low point rather than a stop on the way to a pre-COVID inflation profile. Real growth has continued, and the equity market has gained despite real rate levels that would have crippled the economy and markets pre-COVID.
Blitz points out that the economy's dynamics have changed, with a significant liquidity overhang ready to be released with a sharp drop in short-term interest rates (not to mention over $6 trillion still in money market funds waiting to buy during a recession dip). However, he notes that recession is not an option, given an inverted real yield curve and negative real growth in bank lending, both indicating slower growth ahead.
Blitz uses Core PCE as the inflation rate, which was 2.6% in May. His adjusted Taylor Rule model suggests a funds rate of 4.2% (with CPI placing the funds rate where it currently stands). According to the Fed's inertia model, aiming for 15% moves at each meeting barring a crisis, a 25bp cut in September announced in July is recommended. Interestingly, the unemployment rate rose from 3.7% to 4.0% within five months once the prescribed funds rate fell below the effective rate.
Furthermore, the PCE-Taylor rule dipped below the actual rate when the real yield curve inverted, indicating a recession-inducing event in 9-to-12 months if the Fed doesn't cut now and leaves rates unchanged. Additionally, the nominal inversion of the 3M-3Y yield curve tends to dampen bank lending growth, which it certainly has in this cycle. Both yield structures suggest lower real growth ahead.
Regarding inflation, Blitz says the "story is more mixed than headlines suggest." While PCE prices excluding food, energy, and housing are up only 2.2% Y/Y, good deflation (-1.2% Y/Y) drives this result. Service inflation (excluding housing and energy) remains above 3%, though it has decelerated in the past two months. The pace of goods deflation is no longer as strong.
Inflation expectations vary, but prices will likely soften due to technical reasons and the clear economic slowdown in response to high real rates, especially in housing, where US recessions often start. If housing costs reflected the true market, core CPI would be flat or negative.
Blitz warns that "the Fed would be complicit in any recessionary outcome if it failed to adjust the funds rate sooner rather than later." The real economy, particularly the labor market, is now a mess with slowing hiring rates and real discretionary spending also slowing (though still positive). Real discretionary goods consumption is returning to its 2012-19 trendline after a flat past year. Even worse, spending on real discretionary services (excluding housing and energy) never returned to trend and is now at levels seen between 2012 and 2019.
Blitz concludes that if the current real rate structure remains, "a recession later this year or early next is likely," especially as "early next year" is when Trump is expected to take over, and the deep state might attempt to crash the economy. However, Blitz doubts the Fed will let this happen and expects them to use "rules" to justify a cut if Friday's employment report signals a weaker economy.
While the announcement might come at the end of July, the actual cut can wait. It's "better to lower coupon yields with communication to boost housing and equities than lower actual short rates and let loose stored liquidity."