The U.S. Economic Engine Is Running Too Hot

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MARKETS

On Monday, US stocks faced a retreat, with rising yields casting a long shadow despite robust earnings reports. Investors were initially buoyed by hopes that the conflict in the Middle East would not escalate further but continued to exercise caution, waiting for the dust to settle and for the short-term volatility, often associated with geopolitical risk, to subside completely.

The recent surge in the US economy indicates that the neutral rate may be higher than the current Fed policy suggests, especially after nominal spending significantly surpassed expectations in this week's primary release from the world's largest economy.

The headline figure of 0.7% far exceeded the consensus estimate of 0.4%. Moreover, March marked the second consecutive month of MoM gains, with the previous month's increase revised substantially upward to reflect a 0.9% rise.

Furthermore, the control group witnessed a remarkable 1.1% increase, nearly quadrupling the expected gain. This robust performance is poised to strengthen Q1 GDP estimates before next week's forthcoming advance read on overall economic growth. Notably, February's control group reading was also revised upward to reflect a 0.3% gain, contrary to the initially reported flat figure.

Taken together with the overshoots on both payrolls and CPI for March, this release underscores the resilience of US consumers in the face of higher interest rates. It suggests that the Fed's policy stance may not be as restrictive as previously thought. And strongly hinting that the Federal Reserve will neither be inclined nor warranted to hasten rate cuts.

In summary, the US economy is firing on all cylinders. Needless to say, this is not the stuff of rate cuts, and the market reacted accordingly with higher yields and lower stocks.

The Federal Reserve's monetary policy has been in a holding pattern akin to a space launch since last July, awaiting concrete evidence that the economy is cooling and inflation is on a sustainable path back to target before initiating rate cuts. However, with the latest data painting a much hotter picture, there's a risk that the Fed's easing mission could be shelved altogether.

Once more, macroeconomists find themselves entangled in fervent discussions concerning the genuine magnitude of the neutral federal funds rate. Is it persisting around 2.6%, as suggested by the latest dot-plot, or could it soar to significantly loftier levels, nearing 4.0% or 4.5%? Should the neutral rate surpass the Federal Open Market Committee's (FOMC) current estimation, it prompts inquiries into the effectiveness of ongoing monetary policy strategies in tackling inflation.

As the inflation challenge persists and the US economy remains scorching hot, the pivotal query revolves around the Federal Reserve's tolerance for patience as a data-driven institution. The spotlight falls on how long the Fed can wait before its credibility faces scrutiny, especially in light of the skepticism it encountered in late 2021 when it dismissed the inflation surge as "transitory."

If the overheating economy isn't enough to unsettle your policy considerations, the current equity valuations add another layer of concern. With inflation on the rise and the potential absence of rate cuts in 2024, the outlook for equity valuations appears increasingly precarious.

As investors increasingly interpret the landscape as signalling no cuts in 2024, markets are losing one of their key stabilizers. Fortunately, the concept of rate hikes has yet to permeate the market lexicon.

However, the recent spike in Treasury yields serves as a wake-up call, shattering the Goldilocks illusion that has characterized market sentiment. As yields climb to levels reminiscent of the "higher for longer" era last seen in September, before the inflationary downturn, fixed-income markets are signalling a pragmatic shift towards a more hawkish stance.

This increase in yields has significant repercussions, notably pushing 30-year mortgage rates above the critical threshold of 7.0%. This development poses a tangible threat to both home sales and housing affordability, amplifying concerns about the broader economic outlook.

The latest market turbulence reflects a more profound concern about the trajectory of interest rates against the backdrop of an evolving economic landscape. While stocks have shown resilience recently, the surge in Treasury yields has rattled investors, prompting a reassessment of risk dynamics.

This divergence between equities and rates, which emerged earlier this year, is now reaching a critical juncture. Investors are increasingly grappling with the implications of potentially higher rates in the absence of anticipated cuts, particularly against the backdrop of persistent inflationary pressures and a far too-hot economy.

The current market dynamics suggest that a resolution between equities and rates may be on the horizon, potentially leading to lower stock prices and adjustments in valuation multiples.


OIL MARKETS

Oil traders are now closely scrutinizing whether the recent Iran attack represents a "one-and-done" scenario, a determination that will wield significant influence over financial markets. According to an unnamed White House official, the US has declared it would not endorse an Israeli counter-attack, a stance that has thus far helped stabilize oil prices.

However, this escalation underscores a broader conflict in the Middle East, exposing the crude oil market to further price hikes. Crude oil prices had already surged by 4%-5% following Israel's April 1st attack, with some degree of risk already priced in. The contained nature of the recent attack and the absence of immediate retaliation should help mitigate financial repercussions for the time being. As a result, crude oil prices have since seen a decline.


FOREX MARKETS

The packed schedule of Fed speaking engagements throughout the week offers a window into how last week's CPI data may have influenced Fed officials' viewpoints.

Given the recent adjustments in the FOMC dot plot and the diminished emphasis on multiple rate cuts this year, hawkish messages from Fed officials might have a muted impact on the US dollar. Especially considering OIS pricing, it suggests a full 25bp cut is not anticipated until September. The dollar may experience some consolidation at current levels as it might be premature for the market to heavily discount September rate cuts, given the significant amount of important data to be released between now and then.


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