The Fed Meeting Preview: Expect A Hawkish Turn, Possibly A ‘Higher-Until-Recession’

The December SEP projections

The FOMC is set to meet next week and will likely decide to leave the Federal Funds unchanged at the 5.25-5.50% range.

However, the market is starting to price the Fed’s hawkish turn – or a signal from the Fed that it plans to cut interest rates less than 3 times in 2024, which is likely to be reflected in the revised Summary of Economic Projections SEP.

The last SEP projections from the December 2023 FOMC meeting are as follows:

• The FOMC signaled in December of 2023 that it plans to cut interest rates three times (from 5.33% to 4.6%) in 2024.
• However, the FOMC also expected that 1) nominal GDP growth would slow to 1.4% in 2024, and 2) the unemployment rate would increase to 4.1%.
• Thus, the FOMC was confident in December that these macro conditions would ensure that the core PCE inflation continues to gradually (sustainably) fall towards the 2% target, reaching the 2.4% mark in 2024.

The FOMC statement following the December meeting included the sentence:

In determining the extent of any additional policy firming that may be appropriate to return inflation to 2 percent over time…

The sentence above still reflected a possible tightening bias by mentioning “additional policy firming”, however the revision of the projected appropriate policy path from 5.1% to 4.6% was a major dovish turn from the September FOMC meeting.

What happened since the December 2023 meeting?

The FOMC met in January 2024, but it did not release the SEP projections. However, the FOMC statement deleted the reference to “policy firming” and included the following sentence:

The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.

The sentence above confirms that the Fed’s next move is the interest rate cut. However, the timing of the eventual cut appears to be data-dependent – the Fed needs “greater confidence” that inflation is moving towards the 2% target.

This is essentially a “higher-for-little-longer” policy, so no immediate cuts were signaled.

However, the economic data since the December meeting does not support the policy easing – on the contrary, it suggests additional policy firming might be more appropriate. Here is why:

• Inflation is accelerating

First of all, inflation is actually accelerating. The core CPI for January and February increased by 0.4% month-over-month, which led to an increase in the quarterly annualized core CPI inflation to 4.16%. The core PCE also increased by 0.4% MoM in January.

The graph below tells it all, monthly core CPI inflation has been increasing since June 2023, and once the base effects fade in June, the annual core CPI will start to increase.

• The labor market is still very robust

The labor market has been very strong based on the initial weekly claims for unemployment, which are still just above the 200K – and that’s very low based on the historical standards.

The payroll data has been very robust, and despite the revisions to the January data, the new job creation actually accelerated over the last three months, as the graph below shows.

• GDP growth is still well above the prediction

Thus, given the strong labor market, the real GDP growth seems to be around 2.3-2.5% for Q1 2024 based on the GDPNow measure, which is slower than the growth in Q4 2023, but still well above the Fed’s 1.4% projection.

• Financial markets have been under speculative mania

Since the Fed’s dovish turn in December 2023, which was signaled in November, the financial conditions have loosened significantly, with the interest rates falling, USD depreciating, and the stock market soaring. In addition, the most speculative assets such as Bitcoin also soared. Here is the chart of AI-themed Super Micro Computer (SMCI), which is up 276% in 2024, and over 1000% since late 2023.

The expected hawkish turn at the March meeting

At the next meeting, the FOMC will evaluate the data since the last meeting in January, and since the last SEP projections in December, and make the necessary adjustments.

• Obviously, the FOMC will notice that inflation is not falling towards the 2% target as expected, and it’s possibly accelerating.
• Further, the FOMC will discuss the possibility that the neutral rate is much higher than initially estimated, and thus, the current policy rate is not as restrictive as initially expected.
• Thus, the FOMC will reevaluate the projected appropriate policy path.
• The obvious implication would be that the premature policy easing in December is loosening the financial conditions, which is boosting the inflationary pressures.
• As a result, the FOMC should conclude that further monetary policy tightening is needed to tame the speculative fever and to broadly tighten the financial conditions.
• However, the FOMC seems to be under political pressure to cut interest rates leading to the elections, based on Powell’s testimony to Congress and admission that the Fed is “not too far from cutting interest rates” – despite the “hot” inflationary data.
• Thus, the FOMC is likely to revise the SEP projections and signal 1-2 cuts in 2024, and keep the statement “The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.”
• Even this slight adjustment is likely to be interpreted as a hawkish turn.
• The December Federal Funds futures are currently implying a 4.7% policy rate by the end of 2024, above the Fed’s 4.6% prediction.

The big picture

In the big picture, it is all about whether the Fed needs to induce a recession to bring inflation sustainably towards the 2% target.

The Fed’s dovish turn in December signaled that the Fed does not need to induce a recession, and that a soft-landing” would be sufficient for inflation to return to the 2% target.

However, the longer the yield curve stays inverted, the higher the probability of a recession. The yield curve is currently inverted for the longest time ever. That means that the probability of a recession is already very high, and the delayed normalization only increased the chance that the economy slips into a deep recession.

Thus, even a modest hawkish turn where the Fed further delays normalization is essentially a “higher-for-longer policy”, or a “higher-until-recession” policy. In other words, the Fed could be becoming aware that it might have to induce a “hard landing” – similarly to all other hiking cycles, except in 1995.

Implications

The S&P 500 (SP500) PE ratio is currently above 23, while the expected 2024 earnings growth is around 10%. Thus, SP500 is overvalued by historical standards, while the expected earnings growth does not assume even a modest slowdown. Both of these metrics are irrational, given the current macro situation.

As a result, the S&P500 is likely to significantly correct over the near term, and the intermediate term.

• First, the expected hawkish turn by the Fed (SEP revision) is likely to cause the reversal of the speculative fever since the premature dovish turn in December, and thus, the PE multiple contraction
• Second, the probability of a recession is increasing with the delayed cuts, and thus, the earnings growth expectations for 2024 are likely to be downgraded, which is likely to culminate with a major recessionary bear market.

Thus, I am downgrading my outlook for S&P 500 (SPY) (SPX) from Neutral to Sell.

Obviously, the key risk to the outlook is if the Fed actually signals a cut in June, by stating that it’s getting “more confident” that inflation is falling sustainably towards the 2% target – ignoring the data, and succumbing to political pressure. The signal of a politically influenced Fed could light the fire under the current speculative bubbles, in which case I will quickly revise my recommendation accordingly.