Is The Fed Late? This Time Is Different (SPX)

Thesis Summary

The Federal Reserve left rates unchanged in the last FOMC meeting, and odds are we won’t get a rate cut in March either.

The Federal Reserve is being weary of cutting too soon since the economy has remained very strong, and there is a fear inflation could return.

But what if deflation is the real threat? Plenty of evidence suggests that disinflation may be much stronger than the headline numbers suggest.

If this is true, then the Fed may already be late in cutting rates. Let’s not forget that monetary policy works with a lag.

Under normal circumstances, I would agree with this thesis. However, the unprecedented amount of fiscal stimulus being delivered by the US Treasury, could likely “balance things out”.

I remain neutral on the S&P500, as I see higher prices in the future, but believe a poll-back is now due.

The Fed Has Been Late Before

Jerome Powell spoke last week and then gave an interview on 60 minutes on Sunday, making it quite clear that rate cuts won’t happen for a couple of months. This is certainly what markets are pricing in now.

Odds of the Fed maintaining rates unchanged in March are now over 83%.

However, the odds of a rate cut in May now sit at 55%, according to the data from CMEWatch.

In any case, this is much in line with the Fed’s guidance, so it shouldn’t come as a big surprise. We have also seen continued strong macro data from the US, giving the Fed even more reason to be cautious.

But could the Fed be late to the game again? Let’s not forget that their last big call, “transitory inflation” definitely didn’t pan out as they expected.

Back in 2021, as inflation rose, the Fed assured markets that it was transitory. Only in 2022, once core CPI had reached over 6%, did the Fed actually begin to admit the mistake and raise rates.

Interestingly, inflation actually peaked very shortly after the Fed began to raise. One could even make the argument that the Fed already overtightened by continuing to raise as inflation began to clearly come down.

And now the Fed may still be too tight, given the fact that many measures suggest inflation could fall below target soon.

Deflation Rears Its Ugly Head

While official inflation numbers would suggest inflation is still above 3%, Truflation’s alternate measure of inflation claims we are already below 2%.

Truflation uses a wide array of sources and has up-to-date data. If this measure is to be believed, then inflation is already below the Fed target, with a Fed Funds rate of 5.5%.

Another chart that shows not only a risk of low inflation but even deflation is the New Tenant Rent Index.

The most recent release shows a huge drop in the fourth quarter, entering into negative territory, something which we really hadn’t seen since the 2008 housing crisis.

Rents are a very big component of the CPI and even more the Core CPI, and this is a very strong indication that we could get some surprises to the downside in the coming months.

Lastly, if we look at the growth of M2 and the trend in bank credit, it becomes quite clear that deflationary forces are building.

M2 YoY change has traditionally been a great way of forecasting changes in inflation, as changes in M2 tend to lead changes in inflation. During 2022-2023, we saw one of the largest declines in M2 over the course of US history. We have seen a reversal in the last few months, but that doesn’t mean that inflation might still need to catch up by coming down even more.

If we look at the YoY change in bank credit, we entered negative territory towards the end of 2023. This doesn’t bode well for M2 growth.

Is this time different?

We have a lot of evidence mounting that shows that deflation could become a real problem in the next few months. However, there is also one very strong force at play right now that is helping bolster liquidity, markets, economic output and inflation.

That is, of course, unprecedented amounts of fiscal spending.

As we can see, never before have we had such high levels of spending when unemployment was at historic lows.

We have seen a fundamental shift since the COVID pandemic. This time is indeed very different.

No doubt, this dynamic will also see itself reinforced as we approach the November elections.

Statistically speaking, election years have seen outperformance in markets, no matter the result. This has a lot to do with the fact that fiscal spending tends to ramp up in those 12 months.

What does this mean for markets?

Overall, I think markets will end the year higher and perhaps keep rallying into 2025. A couple of things to note.

Firstly, while a deflation risk exists, this will likely take still a few months to materialize. Furthermore, to the extent that deflation can justify further monetary easing, markets could even cheer on the news.

A deflation would only become problematic if it led to a recession. This might eventually happen, but I think we are not there yet. In order to assess this, we will have to keep an eye on consumer spending trends, productivity levels and employment.

Secondly, this deflationary pressure will no doubt be counteracted by the fiscal side, and this will also contribute towards aiding overall liquidity and lifting markets.

The way I see it, the Treasury may continue to fill up the TGA for the next 2-3 months, and will then proceed to slowly release this into the end of the year. This will be quite bullish for markets.

Technical Outlook

As I’ve said, I expect the market to turn higher, but I also think, more immediately, that the market should pull-back from these levels.

As we can see, we are now nearing the top of the channel we have formed since the October lows. We are also right at the 1.618 ext of wave I, measured from the bottom of wave II. And, to top things off, the weekly RSI is now the most overbought we have seen in this rally.

The way I see it, the market should give us a slight pull-back in the coming months, re-testing the 4500 level before continuing much higher.

Final Thoughts

In conclusion, while I do believe the Fed is cutting rates late, this will be compensated by the aggressive fiscal stimulus.

All in all, we have a recipe for higher stock prices, and I will remain bullish until a more clear risk of recession materializes.