Jay Powell's Pivot, U.S Debt Default?
Yields Are Soaring, The Dollar Is Soaring- Here's What's Going On
Hey guys,
It’s a beautiful Friday in London, the sun’s out.
I’m planning my birthday.
It’s in June and I’ve been wanting to travel for a while, so we’ll see what’s on the playing cards.
As you’ve probably seen, Fed Chair Powell held a speech at 4 pm BST which added volatility to all markets pushing equities into the red.
We heard from a few FOMC members this week but of course, the debt ceiling took most of the headlines with a halt in debt ceilings also adding to the sour mood to end markets for the week.
As always, lend me your attention:
The Fed Pivot ‘Soft Launched’
Earlier today Jay Powell gave a speech where he signalled to markets that there will not be any rate hikes for the upcoming June 14th meeting. Instead, he pointed towards a” tightening in credit conditions” as being sufficient enough to continue bringing down the inflation rate.
“Having come this far, we can afford to look at the data and the evolving outlook to make careful assessments,” — Jay Powell, Fed Chair
In essence, what Jay is saying here is this. We have raised rates by 500bps in under 18 months since March 2022 without ever pausing to see if we’ve gone too far. Now is the time. That’s my interpretation, now more than the top headline that the Fed is set to pause interest rate hikes, what’s really important is what’s happening under the hood of the economy.
The financial conditions index below shows how the banking frenzy forced conditions to loosen ever so slightly due to the immediate accommodative actions taken by the Fed, but overall the index does show the path in tightening the Fed has guided markets too.
First-order thinking of this particular situation would be: “Ok, the Fed has stopped hiking, I guess that means the U.S is vulnerable and may be headed for a recession”
Second-order thinking would look like this: “The U.S has halted hikes, what is the reason behind this, what risks may be evolving underneath the surface? And what implication does this have on global economics and the future actions of global central banks?
You see the difference right? First-order thinking is where 90% of traders and investors lie, looking at the immediate effect of certain economic outputs. Second-order thinking is where the real ideas start and are born, you can go much deeper and much further down into the ripple effects certain decisions have on the economy and markets. This is edge, the thought level that goes into building a macro bias, trade ideas from delving beyond the surface of what we see in the headlines is what helps build your edge in understanding and turning releases into probable trade ideas/scenarios. Something I’ve been working on and will continue to refine.
In his speech, Jay Powell mentioned that “labour market slack is likely to be an increasingly important factor in inflation going forward”. He then pointed towards inflation in “non-housing services” being persistent which is a major contributor to the Fed’s no.1 inflation reading, personal consumption expenditure (PCE).
If you were wondering how tight the U.S labour market is, the number of unemployed people per job opening is less than 1. The tightest in over a decade. So a rise to 2, 3 even 4 may be what the Fed needs to see as a confirmation that the tightness in the labour market is starting to normalise to economic conditions.
Leading Inflation Indicator
I find myself often observing and analysing the M2 supply growth change to determine where inflation is headed as M2 supply leads inflation.
For those who aren’t aware of M2, this simply stands for money supply within the economy, with M2 being hard currency in circulation, liquid deposits, and money in money market funds (mutual funds etc).
We can see that when M2 peaks, as shown in 2021 inflation begins to follow the trend with a lag of 6 months in this example, but usually 12months+ in normal conditions. June 2022 was the month inflation peaked but by then M2 was declining at an incredible rate.
Observing the current M2 growth rate is a great indicator that inflation in the U.S will continue to fall back towards the 2% target, the risk at hand however, is that the Fed would have done too much damage to the economy forcing the Fed to pivot and cut rates towards the end of Q4 ‘23/Q1 ‘24.
Debt Ceiling & The Treasury Yield Curve
The debt ceiling has been on the lips of every single analyst, writer and macro person I know.
I could go into the nitty gritty numbers of how the State government’s debt becomes increasingly more unsustainable when you have to make interest payments on $31.4t at c5.00% p/y. Those numbers start to reach increasingly high amounts when considering the U.S government’s fiscal budget for 2023 is $6.4tr, a $426b increase from 2022’s budget.
It’s expected that the U.S government’s payment on their interest bill for the fiscal year 2023 will total $633b, ramping up to $1.4tr in 2033. Their annual budget is $6.4tr, by 2033 the interest payments on U.S debt would be 21% of their budget, on the lower end!
Now do you see the issue?
Let’s see what the US Treasury curve is doing vs 1 week ago.
Vs last week.
Focusing on the front end of the curve you can see that the 1-month and 3-month are little changed, but from the 2-year yield, the treasury curve has steepened.
As a rule of thumb, the longer the maturity of the treasury bond, the higher the yield should be, as the bonds with a higher maturity have to compensate the investors taking on interest rate risk, price volatility and inflation risk. Right now the yield curve is inverted with the front end of the curve offering higher yields than the long end of the curve.
Meaning?
Investors are betting on the economic climate within the U.S to worsen as they’re pricing in future interest rate cuts which would only come around due to a weakening U.S economy.
Up until the U.S finalise their debt ceiling I believe the market will continue to run in circles; there’s only one thing the market hates more than bad news, uncertainty.
If you’re reading this you’re a champ, Friday night and you’re learning, growing and building.
I respect that.
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