Will Stock Markets Sink If Fed Rate Cuts Are Delayed?

Macro Money - Market Analysis & Outlook (January 26, 2024)

Key Concepts:

• PMI (Purchasing Managers' Index): An indicator of economic health, with 50 representing neutral, above 50 indicating expansion, and below 50 indicating contraction.
• Term Premium: The extra compensation investors demand for holding longer-term bonds due to the increased risk associated with duration.
• Dovish Adjustment: A shift in monetary policy towards easing, typically involving lower interest rates.
• ISM (Institute of Supply Management): Organization providing economic data, particularly the PMI reports.
• Duration Risk: The risk that changes in interest rates will affect the value of a bond portfolio.
• IBIT: iShares Bitcoin Trust - an ETF tracking the price of Bitcoin.
• IWM: iShares Russell 2000 ETF - tracking small-cap US stocks.
• Q's: QQQ ETF - tracking the Nasdaq 100 index.
• SPY: SPDR S&P 500 ETF Trust - tracking the S&P 500 index.

I. Market Overview & Recent Price Action

The markets remain largely unconcerned with the situation in Venezuela, while continuing to favor precious metals. Stock markets experienced modest gains, but failed to reach new highs. The S&P and NASDAQ are holding October highs, while the Russell 2000, though briefly surpassing December highs, remains in a choppy range. Yields are oscillating within narrow ranges established since December, with little movement on the long and front ends of the yield curve. Crude oil saw a reversal of yesterday’s bounce, falling 2.35%, while gold continued its upward trend, increasing by 1.98-2%. Bitcoin experienced a pullback from its recent range high, entering consolidation. The dollar strengthened slightly.

II. Geopolitical Impact – Venezuela & Regional Markets

Despite the capture of Maduro, regional markets show minimal reaction. The iShares MSCI Latin America ETF, representing the top 40 Latin American stocks, showed positive movement over the past two trading days. Brazil and Colombia ETFs also demonstrated resilience, with Colombia even experiencing gains. Venezuela’s own stock exchange (Borsa de Caracas) saw a significant surge, up 62%, though liquidity concerns remain. Crude oil’s reaction was muted, with yesterday’s rally quickly reversing. This suggests the market does not perceive the Venezuelan situation as a significant threat.

III. Upcoming Economic Data & Fed Expectations

The primary focus is now shifting to upcoming US economic data, specifically the Institute of Supply Management’s (ISM) service sector activity index. Services contribute a larger share to the US economy than manufacturing, making this a crucial indicator. The manufacturing PMI came in slightly below expectations at 47.9, indicating a faster rate of contraction. The service sector is expected to cool to 52, still indicating growth. A composite index, weighting services at 70% and manufacturing at 30%, suggests overall growth will be in line with the average of the past 11 months (around 50.7-50.8), providing little impetus for the Federal Reserve to alter its course.

IV. Fed Policy & Market Sentiment

The Fed’s argument for focusing on the jobs market, given cooling inflation, is supported by recent data. Markets are pricing in 56 basis points of rate cuts for the year, centered on 2026, while the Fed anticipates only two cuts over the same period. This discrepancy highlights the market’s desire for more aggressive easing. Stock market consolidation coincides with this standoff in Fed policy expectations. Markets are largely unconcerned about a policy change at the January 31st Fed announcement (82% probability of no change). Current expectations point to a rate cut in July and another in April, clashing with the Fed’s more cautious outlook.

V. Internal Dynamics of ISM Numbers & Economic Health

ISM data generally supports the Fed’s narrative: employment in contraction mode, and moderating inflation. Q3 GDP numbers were relatively strong, driven by a rebound in consumption. While the Q4 government shutdown introduces uncertainty, preliminary S&P Global PMI data suggests the economy remained resilient, albeit at a slower growth rate than the post-COVID surge. The shutdown appears to have merely shifted the economy towards a more “normal” growth trajectory.

VI. Global Trade, AI Supply Chain & Risk Premium

The markets’ desire for rate cuts is attributed to uncertainty and a desire for a “kevlar” of cheap money to insulate against various risks. The trade policy uncertainty index, while down from its April 2023 peak, remains volatile. Global trade volumes declined in 2023, the first drop since 2023 (excluding the COVID blip) and comparable to the 2008-2009 financial crisis. This poses a risk to the AI sector, which relies on a globally distributed supply chain (26% in Asia, 24% in Europe). The term premium on the 10-year Treasury yield is at its highest level since 2014, indicating significant market jitters and a demand for compensation for duration risk. This is driven by uncertainty, not necessarily inflationary concerns.

VII. Trading Strategy & Positioning

Pback maintains a short risk position, anticipating market disappointment with upcoming data. This is implemented through put verticals on IBIT, IWM, Q's, and SPY. He has extended duration on Brazilian stock holdings and remains long gold. He is short the dollar against the pound and Canadian dollar, with some reservations about the Canadian dollar position, and has flipped to a short position on the euro.

Notable Quote:

“...the problem is uncertainty and the desire for rate cuts reflects essentially a push for the markets to become insulated in the kevlar of cheap money as all of the various uncertainties wash over investors…” – Pback, explaining the market’s demand for rate cuts.

Conclusion:

The market is currently in a state of cautious anticipation, awaiting key economic data releases. While the situation in Venezuela has had minimal impact, underlying uncertainties surrounding global trade, the AI supply chain, and geopolitical risks are driving demand for a more dovish Federal Reserve policy. The upcoming ISM data will be crucial in determining whether the Fed will respond to market pressure or maintain its current course, potentially leading to further market volatility. Pback’s positioning reflects a belief that the market is overestimating the likelihood of aggressive easing and is vulnerable to disappointment.