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A September to Remember: The FED Won’t Tell Until It’s Done

June 10, 2021, 8:52 AM Przemysław Radomski , CFA

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With inflation risk growing at an unprecedented pace, the FED already knows it has to put its dovish policy back in Pandora’s box. The question is: when?

A Growing Problem

Another day and another all-time high for the U.S. Federal Reserve’s (FED) daily reverse repurchase agreements. While investors haven’t clued in on the meaningful implications, on May 17 the FED sold $209 billion worth of daily reverse repos. On Jun. 9 that figure ballooned to $503 billion.

Please see below:

A reverse repurchase agreement (repo) occurs when an institution offloads cash to the FED in exchange for a Treasury security (on an overnight or short-term basis). And with U.S. financial institutions currently flooded with excess liquidity, they’re shipping cash to the FED at an alarming rate.

The green line above tracks the daily reverse repo transactions executed by the FED, while the red line above tracks the U.S. federal funds rate. Moreover, notice what happened the last time reverse repos moved above 400 billion? If you focus your attention on the red line, you can see that after the $400 billion level was breached in December 2015, the FED’s rate-hike cycle began. Thus, with current inflation dwarfing 2015 levels and U.S. banks practically throwing cash at the FED, is this time really different?

Moreover, with market participants eagerly awaiting today’s release of the Consumer Price Index (CPI), the U.S. 10-Year Treasury yield’s recent slide signals that bond investors are all-in on the FED’s “transitory” narrative. However, with historical imbalances (I can’t stress this enough) reaching new heights, investors’ faith in the FED is at extreme levels. For one, with the core Personal Consumption Expenditures (PCE) Index (released on May 28), recording its highest year-over-year (YoY) percentage increase since 1992, the spread between the U.S. 10-Year Treasury yield and the core PCE Index is now at its lowest level since 1975.

Please see below:

To explain, the green line above subtracts the YoY percentage change in the core PCE Index from the U.S. 10-Year Treasury yield. And because it’s prudent to analyze the latter’s performance relative to realized inflation, the spread reveals that the U.S. 10-Year Treasury yield is pushing the limits of historical precedent.

Furthermore, research from Scotiabank emphasizes that bond market investors’ compliancy is at an all-time high.

Please see below:

To explain, the blue dots above depict the U.S. 10-Year Treasury yield during various YoY percentage changes in the core PCE Index. If you analyze the relationship, you can see that when the core CPI increases, the U.S. 10-Year Treasury yield often follows suit. However, if you analyze the red dot near the bottom of the chart, you can see that the U.S. 10-Year Treasury yield has completely decoupled from fundamental reality. To that point, since 1978, every time the YoY percentage change in the core PCE Index exceeded 3%, the U.S. 10-Year Treasury yield was north of 6%. Thus, with inflation still surging, a reversion to the mean could light plenty of fireworks across Wall Street.

If that wasn’t enough, not only is the bond market out of touch with reality but also the stock market is blindly following the “transitory” narrative. Case in point: with the core CPI’s 3% rise in April, on a relative basis, the S&P 500’s trailing price-to-earnings (P/E) ratio is currently the second-highest on record.

Please see below:

To explain, the red dots above depict the S&P 500’s trailing P/E ratio during various YoY percentage changes in the core CPI. If you analyze the dot labeled “current,” you can see that with the YoY percentage change in the core CPI at 3%, the S&P 500’s trailing P/E ratio has exceeded 40 only one other time in history. As a result, the FED has convinced investors to throw all caution to the wind.

However, with the Commodity Producer Price Index (PPI) signaling further inflationary pressures ahead, I warned on May 14 that the latest print implies another ~5.50% YoY percentage increase in the headline CPI. For context, the consensus estimate is 4.70%.

I wrote:

The commodity PPI surged by 17.25% YoY in April. And if you exclude the 17.36% YoY jump in July 2008, it was the largest YoY percentage increase since December 1974. For context, the commodity PPI often leads the headline CPI and that’s why tracking the former’s movement is so important. Moreover, reconnecting with the green line implies a ~5.50% YoY percentage increase in the headline CPI.

Please see below:

The Tapering Climax Is Near

In addition, while I’ve mentioned on several occasions that FED officials already know they have to taper (they just don’t want to disclose it publicly and cause a sell-off in the stock and bond markets), their divergent messaging is another sign that a climax is approaching.

Please see below:

To explain, Arbor Data Science tracked FED officials’ “words of agreement” during various speaking arrangements. When the purple line is rising, it means that FED officials all support the same narrative. Conversely, when the purple line is falling, it means that FED officials are sending conflicting signals. If you focus your attention on the right side of the chart, you can see that divergent rhetoric is now at its highest level since the taper tantrum in 2013 and when the FED reversed course in 2019 following a barrage of interest rate hikes (depicted by the purple lines being extremely low). The bottom line? With the group now splintered, it has become increasingly clear that QE is nearing a meaningful reversal.

But when should we expect an announcement?

Well, with the Jun. 15/16 policy meeting not leaving enough time for FED officials to “communicate very early, very often what we’re going to do” (swords of Philadelphia FED President Patrick Harker) and the Jul. 27/28 policy meeting excluding a summary of the FED’s economic projections either, the Jackson Hole Economic Symposium (late August) or the Sep. 21/22 policy meeting is when the fireworks will likely begin. For a visual representation of the expected timeline, please see below:

To explain, with market participants still loyal followers, the FED’s omniscience currently reigns supreme. Moreover, with YoY inflation surges likely to decline in July/August, FED officials will cite base effects as reasons for the initial trepidation. For context, though, it’s important to remember that the core PCE Index surged by 0.66% month-over-month (MoM), the highest MoM percentage increase since 1983, while the core CPI surged by 0.92% MoM, the highest MoM percentage increase since 1981. As a result, the concept of base effects is largely a distraction. More importantly, though, with the Shelter CPI accounting for more than 30% of the movement of the headline CPI and often lagging Apartment List data by three months, we could be in for a September to remember.

Further supporting the timeline, with the U.S. Bureau of Labor Statistics (BLS) job openings completely decoupling from U.S. nonfarm payrolls, the FED has a cover until September.

With the U.S. Bureau of Labor Statistics (BLS) revealing on Jun. 8 that U.S. job openings surged to an all-time high of 9.286 million – and came in well above the consensus estimate of 8.300 million – the only thing depressing the U.S. labor market are ill-advised enhanced unemployment benefits.

Please see below:

To explain, the red line above tracks U.S. nonfarm payrolls, while the green line above tracks U.S. job openings. If you analyze the relationship, you can see that the latter is often a strong predictor of the former. However, with enhanced unemployment benefits still in effect until mid-to-late June or early July (across ~25 states) – and nationwide until Sep. 6 (expected) – the shift likely won’t occur overnight. But once the benefits expire, U.S. nonfarm payrolls will likely spike in August (reflecting July’s data) and September (reflecting August’s data) and lift the U.S. 10-Year Treasury yield and the USD Index in the process.

The bottom line? With a potential spike in the Shelter CPI likely to coincide with a major resurgence in the U.S. labor force, September has all of the necessary ingredients to force the FED’s hand.

Forecasts Are Soaring

As further evidence, the World Bank released its Global Economic Prospects report on Jun. 8. And with the group increasing its 2021 U.S. real GDP growth forecast from 3.5% (in January) to 6.8%, the FED is already playing with fire.

An excerpt from the report read:

“The U.S. economy is recovering more quickly than its peers from the pandemic shock, supported by greater amounts of fiscal relief. Surging personal income has boosted consumption, which is expected to firm as households reduce their savings rate from historically high levels.”

Source: the World Bank

On top of that, The National Retail Federation (NRF) projected on Jun. 9 that “retail sales will now grow between 10.5% and 13.5% ” (an increase from the 6.5% projected previously) and for “full-year GDP growth to approach 7%, compared with the 4.4% and 5% forecasted earlier this year.”

Please see below:

Source: NRF

More importantly, though, the last time the U.S. economy reached this level of real GDP growth (1984), the USD Index and the U.S. 10-Year Treasury yield hit highs of 151 and 11% respectively. And while that level of strength is unlikely to emerge this time around, it’s simply a reminder of how low the current readings are relative to prospective GDP growth.

On the opposite end of the spectrum, the European Central Bank (ECB) holds its June policy meeting today. And with both realized inflation and economic growth significantly underperforming the U.S., I wrote on Apr. 27 that hawkish rhetoric is likely more semblance than substance.

Recent whispers of the ECB tapering its bond-buying program are extremely premature. With the European economy still drastically underperforming the U.S., it’s actually more likely that the ECB increases the pace of its bond-buying program.

To that point, ECB President Christine Lagarde said the following on May 21:

Source: Reuters

Furthermore, Societe Generale economist Anatoli Annenkov said on Jun. 9 that “Given the markets' nervousness about taper talk and the ECB's firm wish to distance itself from the taper preparations in the U.S. over the summer, the ECB is likely to signal unchanged purchases until September.” However, with Eurozone inflation rising by only 1.60% YoY in April (the red bar below) compared with 4.20% YoY in the U.S., even September seems optimistic.

In conclusion, the FED has opened up Pandora's box, and it could come back to haunt the central bank over the medium term. With inflation surging and pent-up demand yet to be unleashed in a meaningful way, the longer the FED pours on the gasoline, the larger the fire grows. Moreover, with the USD Index and the U.S. 10-Year Treasury yield historically undervalued relative to realized inflation and GDP growth expectations, it’s all just as the former New York FED President William Dudley said in 1999, “too much of a good thing can be a bad thing." The bottom line? With the PMs enjoying a fundamental environment that we may never see again, once sanity prevails, the metals are unlikely to enjoy the dose of reality.

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Przemyslaw Radomski, CFA
Founder, Editor-in-chief

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