Entrenched inflation may push rate cut to September or December; US Economy shows sign of slowing

Austin Or, CFA

Highlights

Hotter than expected March NFP and inflation dialed back June rate cuts odds, and one or no rate cut instead of two cuts come under debate.

Slowing sign of US economy pokes through with plodding Q1 GDP and proliferating PMI stress.

At May FOMC, Fed continued to freeze rate at 5.25% to 5.5% and decided to slow Treasury securities reduction to $25 billion monthly, a more gradual pace than anticipated.

Fed Chairman Powell expected lower inflation over the year, pushed back rate hike as the next policy rate move, and reiterated rate cut as premature when the inflation battle is not over.

Exuberance in NFP is inflated by part-time job increase against slumping full-time openings.

Entrenched inflation is muddled by transient auto insurance cost spike and obselete shelter data.

Inflation will claw its way back to the cooling path due to slowing economy, crimping labor market demand and consumer spending.

We maintin our S&P 500 forecast up at 4700-5200 at year end, convicted by the softening inflation trend, robust S&P earnings growth propelled by the Magnificent Seven (2024Q1: 4.7% YoY, 2024: 8% YoY, 2025: 14% YoY) and rate cut imperative for a plethora of maturing treasury, corporate loan and commerical property debt in 2024.

Hong Kong Hang Seng Index (HSI) breached over 18000 due to the Fed’s Dovish stance but the
daily turnover kept hovering between HK$110 billion to HK$140 billion.

Blowing NFP uptick with slipping unemployment rate

The seasonally adjusted non-farm payrolls in the US increased by 0.3 million in March, significantly exceeding expectations of 0.2 million, and the average monthly increase in the past 12 month of 0.23 million, making it the largest increase since May 2023. According to Bureau of Labor Statistics, the job growth was concentrated in health care, government and construction. Unemployment dropped slightly to 3.8% in March, below the previous value of 3.9%. Since August 2023, it has ensared in a narrow range of 3.7% to 3.9%. The average monthly wage growth rate in March inched up to 0.3% from the previous value of 0.1%.

Upswing of CPI and PCE boost by higher gasoline and housing prices

The annual CPI inflation rate surged from 3.2% in February to 3.5% in March, marking the second consecutive month of increase and exceeding expectations of a 3.4% surge. On a monthly basis, the CPI advanced at a pace of 0.4%, maintaining the momentum from the previous month and surpassing forecasts of 0.3%. Excluding food and energy costs, the core CPI inflation rate came in at 3.7% yearon-year, slightly easing from the 3.8% rate in February, in line with expectations.The gasoline and the shelter remain the culprits for the entreched CPI and core CPI. The index for gasoline spiked by 1.7% MoM and 1.3% YoY, while the shelter component increased by 0.4% MoM and 5.7% YoY in March, driving up core services inflation. Commodity inflation has essentially disappeared. The commodity inflation rate in March was approximately 0.6%, below 1% for six consecutive months.

The market apprehension on stagflation was compounded by the Supercore CPI (excludes housing) and PCE (Fed’s favorite inflation gauge). In March, Supercore CPI rose by 0.7% MoM and 4.8% YoY, the fastest YoY pace since May 2023. This rebound was largely driven by a rise in transportation services, as
car-insurance premiums rose by 2.6% MoM. Headline PCE rose to 2.7% YoY, beating the expected 2%, while core PCE held at 2.8% YoY, defying expectations of a decline. Probing into the PCE components, transportation services prices were up 1.6%, while the housing and utilities cost registered a 0.5% gain.

GDP flywheel starts sputtering

Due to reductions in consumer spending expectations, net exports and government spending, the U.S. real GDP in the first quarter of 2024 increased at 1.6%YoY, which is lower than market expectations of 2.4% and lower than the 3.4% in the fourth quarter of last year. Consumer spending increased 2.5% in the period, down from a 3.3% gain in the fourth quarter and below the 2.5% economist consensus. Fixed investment and government spending at the state and local level helped keep GDP positive on the quarter, while a decline in private inventory investment and an increase in imports. Net exports subtracted 0.86 percentage points from the growth rate while consumer spending contributed 1.68 percentage points.

Slide in PMI heralds dented econonmic growth momemtum ahead

The U.S. Composite PMI decelerated from 52.1 to 50.9, marking a four-month low. Nevertheless, April signaled the 15th consecutive month of output increase. The U.S. Services PMI fell from 51.7 to 50.9, missing expectations of a rise to 52, marking a five-month low. The U.S. Manufacturing PMI fell from 51.9 to 49.9, falling short of the 52 forecasted, hitting a four-month low. Companies reduced employment for the first time in nearly four years. Tougher business conditions led companies to reduce their workforce for the first time in nearly four years. As companies see April inflows of new business fall for the first time in six months and firms’ future output expectations slipped to a five-month low amid heightened concern about the outlook, further pace may be lost in the coming months.

Fed keeps rate unchanged and slows QT at May FOMC, negating either a rate cut or a rate hike as the next imminent option

In May’s FOMC meeting, the Fed decided to keep the federal funds rate steady at a range of 5.25% to 5.5%, as widely anticipated. This decision reinforces the Fed’s commitment to steering the economy towards sustainable growth and controlling inflation. Fed Chairman Powell acknowledged that there has been limited progress in achieving the 2% inflation target, but emphasized that the current situation does not warrant an immediate rate cut or hike, while his faith that inflation will move back down over the year is unfazed.

Powell reiterated that if inflation consistently decreases to 2% and there are unexpected signs of weakness in the labor market, the Fed may consider reducing interest rates. He dismissed the rate hike speculation as the next policy rate move, stating that the Fed requires convincing evidence that its current policy stance is not sufficiently restrictive to bring inflation down to 2% in the long term.

In addition to maintaining the interest rate, starting in June, the Fed will decrease the monthly redemption limit on Treasury securities from $60 billion to $25 billion. However, it will maintain the limit on agency debt and mortgage-backed securities at $35 billion. This adjustment aims to facilitate a smoother transition and mitigate potential strains in money markets, and does not mean that the balance sheet will ultimately shrink by less than it would otherwise.

Prediction

1. Exuberance in NFP is undurable.

In contrast to NFP which is based on corporate survey, another job report based on household survey, unveiled that the U.S. labor market is predominantly driven by part-time jobs rather than full-time jobs, faltering the robustness of the labor market as the nonfarm payrolls data suggests. The number of workers working part-time in March increased by 0.69 million, 1.9 million more than a year ago, whereas the number of workers reporting full-time employment fell by 6,000 in March, 1.35 million fewer than a year ago. Significant downward revision to March may occur later like January and February.

2. Elevated inflation is biased and will claw its way back to the cooling path.

The primary cause of inflation in March was an increase in auto insurance prices, a residual effect of the pandemic induced surge in auto prices, which is not structural. Tenacious inflation owing to OER (5.91% YoY) and rent (5.68% YoY) are also misleading. As government’s shelter cost data is based on a monthly survey of thousands of rental units, only conducted once every six months, it trails the real rental market condition. Rents have remained sticky even as the supply of apartments has increased and independent measures showed a decline in rent demands. In reality, the latest Zillow Housing Rent Index (3.57%
YoY) and the New Tenant Rent Index (0.42% YoY) that investigate the rent levels of new tenants, depicted that the rental market is ticking down. Thus, the wedge between government shelter cost private shelter will close off at some point this year.

3.Hamstrung in tapering inflation prompt for higher and longer rate.

As CPI and PCE showed outright exceedance over market expectation, market-implied probabilities for a June rate cut have plummeted from 54.5% prior to the CPI release to a mere 20%, according to the CME Group Fed Watch tool. In respect of stalling inflation, only one rate cut instead of two are more convinced by the market. Some Federal Reserve even claimed that rate cut should be abandoned in 2024 and did not rule out the possibility of rate hike if inflation flares up further. After May FOMC, market participants interpreted Powell’s remarks as cautious but less hawkish, raised their bets on a rate cut by September, indicating expectations that a cut is more likely than not. There are still calls from bulge bracket firms such as Citigroup and Goldman Sachs looking for rate cuts as early as July.

As oil price jumped due to the heat-up of geopolitical tension in the Middle East and OPEC’s persistent production cut in 1H2024, we assert that US will avoid rate cut in 1H2024 to stanch inflation from rallying and await more compelling evidence of cooling of inflation. A “good rule” is that it will take at least three months of better data to be observed before considering rate cut by Fed. That said, we still believe the logjam to resume the downfall of inflation will be broken with the graudal cooling of job market and exhaustion of excess savings, alongside with the deceleration of economy mirrored by the PMI headwind. We contend that the ongoing depreciation of Japene Yen will be conducive to strengthening US dollar and help mitigating import inflation further.

In light of substantial amount of treasury debt (US$ 7.6 trillion), commercial real estate loan (US$544 billion) and corporate debt (US$790 billion) that will be mature in 2024, we assume a 0 bp-25 bp rate cuts projection in 2024.

Disclaimer

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