November 20, 2023
Last week’s cooler-than-expected CPI print increased conviction that the Fed is done with its hiking cycle, resulting in equity upside that triggered CTA moving average buy signals into a strong seasonal period.
The drag from tight monetary policy will continue despite an increased likelihood that the Fed is done with its hiking cycle. One-year real yields remain highly restrictive at +315bp, the Fed continues to shrink its balance sheet and fiscal supports will fade further in 2024. The consumer is slowing but has yet to turn outright weak and labor market activity has also been slowing with the Unemployment Rate on a recent upward trend. Slowing job growth should allow wage inflation to moderate further, which should allow core PCE (Fed’s preferred inflation measure) to slip below 3%. Unfortunately, core PCE that sits below 3% but above the Fed’s 2% target will likely result in continued tight monetary policy. In this scenario, the Fed doesn’t hike but waits for a supply shock or recession to ‘do its work’ by pulling core PCE to its target. While, it’s difficult to distinguish a normal slowdown from the early stages of recession, we expect markets would begin to reflect the increased probability of a recession when monthly payroll growth slips below +50,000. Increased probability for a recession would likely result in lower bond yields and lower stock prices. This is the opportunistic Fed/hard landing scenario that played out in the mid-1990s. In our view, the hard landing scenario has a 70% probability, while the soft-landing scenario has a 30% probability. The hard landing scenario comes with a tactically bearish near-term equity outlook, and bullish longer-term outlook. If it begins to develop, we’d expect to see equity downside until the 5/10 yield curve signals an imminent Fed pivot. We think that happens with the 5/10 curve steepens above +19bp. For now, the soft landing scenario is the predominant narrative with near-term performance chasing likely to continue until mid-December.