Growth is too strong, inflation too sticky and the labor market softer but not crashing

As we detail below, growth is too strong, inflation too sticky and the labor market softer but not crashing, all factors that will prevent the Fed from cutting rates for some time.

Yesterday the Atlanta Fed added to the weight with Q4 GDPNow at 2.7%, up from 2.4% last week. Real personal consumption and better exports get the credit, with a smaller negative investment. We get another forecast on Thursday.

But the big factor supporting the dollar anew is likely the rise in US Treasury yields across the board. The elegant explanation comes from Reuters' Dolan:

"Dragging up government borrowing costs across the world, the new year spike in long-term U.S. Treasury yields is flashing red as a long-absent risk premium in debt markets re-builds alarmingly amid fiscal policy and interest rate fears.

"The New York Federal Reserve's estimate of the 10-year 'term premium' - seen as the compensation investors seek for holding long-term Treasuries to maturity instead of rolling over short-term debt holdings - topped 50 basis points this week for the first time since 2014.

"Partly reflecting uncertainty about long-term inflation expectations and debt supply and an incoming U.S. administration intent on tax cuts, immigration curbs and tariff rises, the 30-year Treasury yield hit its highest since 2023 on Tuesday and 10-year yields hit their highest in almost 9 months.

"At almost 64bps, the 2-to-30 year yield curve gap on Wednesday reached its widest since the Fed started raising interest rates in March 2022. With this week's latest heavy Treasury debt sales frontloaded due to Thursday's market holiday and high seasonal corporate bond issuance in the background, $22 billion of 30-year 'long bonds' go under the hammer later today.

"The more immediate cause of bond market anxiety - which sideswiped stock markets again on Tuesday - comes from the week's persistently 'hot' economic releases - adding concern about future Fed rate cuts as President-elect Donald Trump's economic policies are parsed."

Forecast

We wrote that the dollar's downward correction was due to its big overbought condition and despite the yield differentials, which don’t always work every minute to serve as the top FX influence. Well, that changes when the US yields go to historic highs as we saw yesterday and overnight. The implication is that the bond vigilantes are out in force and roaming the countryside looking for something to spear (including, perhaps, the stock market). 

It’s rare for a brand-new correction to flop after only two or three days, but that may well be what is happening now. Possible targets include the B band bottom at 1.0258, the previous low at 1.0223 and (eek) the linreg channel bottom at 1.0188. We doubt it will go that far and as New York is just now coming in, we see some respite on the hourly chart. 

Long-term musing: As many have suspected for some time, nowhere is inflation coming down to central bank targets of 2%. As some analysts say, the central banks can live with it because recession is worse. That means the “last mile” may never get covered, at least not in this cycle.

In the US, the Fed’s sticky price index less food, energy and shelter has hardly ever gone to 2% from the peak high at 7.33% in June 2022. See the chart from FRED.

It goes without saying that the concept of “sticky” is a reference to the tremendous lag inflation displays, but it’s critical to note at the same time that interest rates are only a small part of the total factors determining inflation. The Fed would like to name labor as the other big factor alongside rates and supply issues, and in practice labor costs are 20-35% of total costs, with more in the services industry.

This gives the Fed two massive problems. First is acknowledging that inflation isn’t going to 2% even in the best of circumstances. This is due mostly to labor costs the stickiest of all—cutting wages during a labpor shortage is well-nigh impossible, and that applies to sectors where the labor supply of undocumented immigrants is high—meat-pakcing, agriculture, construction.

And circumstances are getting worse, not better, under Trump. Supply chain costs will go up even in goods not affected by tariffs, as we complained during Covid. Those that are affected by tariffs can fall right out of the picture, including luxury goods, especially when the domestic production doesn’t even exist and would take years to develop.

So the question becomes “when does the Fed acknowledge these conditions?” Despite its unreliability, the CME FedWatch tool is instructive. It’s only in June that the majority of Fed funds bets goes over 50% for a single rate cut. Those betting on no change are 90.9% for Jan, 56.4% for March, and 46.4% for May. Even in May, 54% vote for no cut. ING Economics writes that “Only 35bp is priced with the first rate cut not fully discounted until July. The risk is that a stronger jobs number and yet another 0.3% month-on-month core CPI print next week sees that being scaled back even more.”

ECR Research has a splendid chart showing the evolution of Fed rate cut expectations. This it top-drawer economics that is not from the US perspective.

Higher for longer, indeed. Meanwhile, economists are sticking to four rate cuts by the ECB. Before the release of eurozone inflation yesterday, the FT survey of 72 European economists showed nearly half (46%) said the ECB was behind the curve—to slow to cut.
This is despite the ECB cutting 4 times since June from 4% to 3%.

With eurozone growth expected far less than in the US, “Analysts expect the divergence in growth will mean Eurozone interest rates end the year far lower than US borrowing costs.”  One roadblock is a slower process than at the Fed, but even so, “the majority of economists believe that the ECB will continue on its current rate-lowering trajectory in 2025, lowering the deposit rate by another percentage point to 2 per cent. Only 19 per cent of all polled economists expect that the ECB will continue to lower rates in 2026.”

The FT had better run another survey now that eurozone inflation rose to 2.4% from 2.2% and uneployment remains a steady 6.3% (= labor shortage). If we assume the ECB sticks to the expected rate cut schedule, if backloaded to later in the year, it will suggest an acceptance of 3% inflation rather than 2% as pointed out above. 

There is only one deduction to be made here—dollar bulls are coming back. In droves.

And how long will that last? After mid-year, we will start to see the consequences of whatever foolish policies Trump and his lackeys put in place. The consensus is that these will initally drive the economy into high gear (tax cuts, subsdies) but then drive the US economy into slow growth/near-recession by (say) Q3, so that bond yields come down as the probability of those Fed rate cuts becomes more certain. So, after getting at high as 5%, the 10-year can fall back to 3.5-4% while the more sensitive 2-year can go to 3%. This will put a dent in the dollar, again.

In one of those weird outcomes we sometimes get, the relative stability of fiscal policy in the eurozone could be to its benefit. Treaty rules does not permit any more deficit spending and more than one country (France) is on notice it has to cut back on spending. While this may seem a negative in terms of goosing growth, it’s a positive to long-term investors who seek respite from splashy up/down moves that we will see in the US. THst does not exclude the possibility of a big, fat stock market correction, too.

Bottom line, we will see the peak in US yields by March-June, then a lousy summer as stagflation seems the verdict (Larry Summers will be right, like the stopped clock), and we start getting Fed rate cuts in Aug/Sept. The peak is in sight. 

Think twice: On another note, realistically, geopolitical risk is the top risk these days, and rising. Trump seems to be the generator of the most risk, threatening to invade and take over the Panama Canal and Greenland, but that is just hot air. Elsewhere, Germany, France and Canada have real issues. So does S. Korea. Taiwan is at the mercy of the Chinese and the US. Ukraine is at the mercy of Trump, or so he thinks. Diplomacy is going nowhere in Israel/non-Israeli sects and countries.

And it’s a new world in which guns and tanks are no longer the weapons but rather cyber-attacks. Having lived through so many power outages in Connecticut (the second richest state), our big fear is a series of cyber-attacks taking down the US power grid. Fortunately, it’s not all interconnected, but it’s amazing that enemies can infect social media and have left the power grid alone (so far). Generac stock is up 30%, so we are not alone in this worry. 

It's interesting that fear of oil and gas shortages has vanished off the stage, even though we saw quite a rise recently (from $69.10 on Sept 10 to $77.07 yesterday). We read the oil reports fairly regularly but the “reasons” for price changes are, honestly, not credible. We suspect the oil traders don’t know unless they get hot news from OPEC or the US Petroleum Institute. Today the US WTI hit the highest since July after the API reported crude supplies fell last week and supplies from Russia and OPEC fell a bit..

In the big picture for oil, we can name slow growth in many economies, especially Europe, plus vast increases in US output that stymied OPEC’s effort to cut production.

Then there’s China. Ever since Evergrande and the overall blowup of the property sector, China has struggled to regain growth, not to mention domestic confidence. But it’s unwise to bet against China. Not only is too big to fail, the Chinese understand capitalism better than most Westerners. They will find a way. Having seen that monetary stimulus isn’t working to change minds, the other approach is on its way—fiscal. Getting the Chinese consumer to stop saving so much and start spending at least a little more is the right idea. Having seen savings dissolve in the property market, the average Joe and Josephine are fearful. A government that shows concern for their plight might fix it.

Note that this approach did not work in Japan in the 1990’s. The government handed out cash and most of it was saved--it didn’t get spent. This is what Keynes called “pushing on string.”

A resurgent domestic consumer would help take away the curse of export-dependence in a world slapping tariffs on Chinese goods.

Keeper tibdit: US nonfarm payroills rose by 227,009 in Nov after the diastrous 36,000 in Oct (Boeing stike, hurricanes). The current consensus for Dec is 150,000, although Trading Economics has 200,000. Both forecasts will change upon receipt of the ADP number on Wednesday.

Keeper tidbit: The St. Louis Fed has the schedule for 2025 release dates of the PCE data. 

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