Consensus calls for cuts, confidently

Good morning. GameStop, which has been falling steadily for two years, rose 20 per cent yesterday, and is up 36 per cent over two days. This could be a short squeeze ahead of the company’s earnings report next week, or something to do with options hedging. In any case, higher rates and quantitative tightening have not quite wrung all the speculative hysteria out of the system. If you see others signs of persistent irrationality, email us: robert.armstrong@ft.com and ethan.wu@ft.com.  

Rate cuts

This comment, delivered by Federal Reserve governor Christopher Waller at a think-tank event on Tuesday, generated a fair amount of attention:

If we see disinflation continuing for several more months — I don’t know how long that might be, three months, four months, five months . . . you could then start lowering the policy rate just because inflation’s lower . . . It has nothing to do with trying to save the economy.

Waller’s comment spurred an immediate reaction in the two-year Treasury yield and the dollar, two markets highly sensitive to the path of policy rates. Both fell.

It’s not an unreasonable reaction. Of course, Waller doesn’t set monetary policy by his lonesome. But as Neil Dutta of Renaissance Macro Research notes, he “has been at the front-edge of numerous monetary policy pivots during this tenure at the Fed”. His view is bolstered by the increasing plausibility of a soft-landing scenario.

Many investors link cuts and recession — the Fed lowers rates, either proactively or reactively, to support a faltering economy. But as Waller laid out in his speech, there is another path to cuts. Real rates, not nominal policy rates, determine the stance of monetary policy. This implies that as inflation falls, monetary policy will automatically tighten if the Fed holds rates steady. Therefore, rate cuts would serve to keep policy stable, rather than representing a move towards monetary loosening.

Waller’s general outlook — that gently falling inflation make rate cuts feasible at some point midway through next year — is catching on. The OECD’s latest economic outlook has the Fed cutting in the second half of 2024. Markets, too, have priced in cuts as early as May. By year-end, they expect rates to fall nearly 100 basis points:

This view rests on continued inflation progress, of course. And this is precisely where Fed officials still differ. Most agree that a period of “below-trend growth” is needed to curb inflation, but are we getting that yet? Waller said he was “encouraged” by the slowing pace of growth, which he thinks will come in at about 1-2 per cent in the fourth quarter. But he noted that “just a couple of months ago, inflation and economic activity bounced back up, and the future was looking less certain”.

Such caution is shared by other Fed members. One danger is pricing behaviour. Stable inflation discourages price increases, which can lead to loss of market share. But once inflation is elevated, it acts as a co-ordinating mechanism allowing companies to raise prices together. What stops that process is pushback from consumers, making companies worry again about losing market share. But as Richmond Fed president Thomas Barkin told CNBC yesterday:

I’m sceptical that price setters at this point are going back to pre-Covid . . . I just don’t know if people are going to give up that power unless they have to . . . I don’t think [recently revised third quarter] 5.2 per cent GDP growth [is] what convinces people they no longer have pricing power.

Atlanta Fed president Raphael Bostic, in a comment published yesterday, took the opposite line:

My staff and I are picking up clear signals that companies’ pricing power is diminishing. That is, it is no longer easy to raise prices without resistance from customers. In that context, we’re hearing reports of more and more companies sacrificing some profit margin to maintain market share. Firms are increasingly offering discounts and price promotions or otherwise swallowing cost increases rather than risk chasing away customers.

It isn’t obvious who is right, looking at third-quarter corporate results. Pricing talk was very mixed. Walmart is talking about the possibility of a deflationary environment, for example; Coke is continuing to increase prices aggressively. Overall, S&P 500 net income margins rose in the third quarter, and consensus forecasts suggest that will continue in the fourth. But big business isn’t the whole economy. The Fed’s Beige Book of economic anecdata, also published yesterday, was stuffed with examples of activity slowing and lower-end consumers pulling back or trading down. The debate is live.

All this is to say that despite the soft landing mood in markets, the Fed remains data-dependent. Waller’s cautious case for rate cuts that have “nothing to do with trying to save the economy” is contingent on inflation co-operating, without too much of a slowdown. Markets are betting heavily on that outcome.

Against the liquidity theory of the rally

On Tuesday, we considered the possibility that an increase in financial system liquidity might explain November’s rally. On Wednesday, the macro data analytics shop Quant Insight published a piece arguing that we were barking up the wrong tree. It was bluntly titled “US equity rally — it’s not liquidity”. 

QI has a factor model that calculates a fair value level for the S&P 500, by applying a statistical technique called principal component analysis to macro inputs including economic growth, Fed posture, the dollar, credit spreads, and so on. PCA is designed to tease out the independent relationships between each explanatory factor and the explanatory target (in the case, the S&P). As of yesterday, the model put fair value for the index at 4,492, 1.4 per cent away from the actual value. The model’s confidence — that is, the amount of the variation in the index that the macro factors are currently able to explain — was 85 per cent.   

But QI also has a model of the S&P that includes all those macro factors plus Fed liquidity, and they measure Fed liquidity the same way we measured it in Tuesday’s piece. Using that model, the difference between estimated fair value and the actual value of the S&P was 0.61 per cent, and confidence was 86 per cent. Adding liquidity to the model didn’t add much, in other words. As Huw Roberts of QI sums up: “The improvement in the model’s goodness of fit is marginal . . . Fed liquidity is a positive driver [of the index] but the relationship is modest.”

My question, on reading the QI piece, was whether liquidity might be influencing the model covertly, seeping in by influencing other factors such as bond volatility or credit spreads. The central idea of the liquidity theory, after all, is portfolio balance: the notion that changes in liquidity alter investor propensity to pay up for risk. Roberts wrote in an email that the PCA approach, by pulling apart the influence of different factors, helps sniff out this sort of connection, but leaves open the possibility of liquidity influence “leaking” into stock prices through other channels. “To measure that we’d need for example to build a custom model for say US high yield spreads and see whether Fed liquidity features as a prominent driver”.

If there are readers out there willing to speak up for the liquidity model, we’d like to hear from you. 

One good read

“It’s got to be one of the deals of the decade.”

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