The Fed did exactly what every sensible observer had predicted

Outlook

The Fed did exactly what every sensible observer had predicted—a 25 bp rate cut and a warning that 2025 may bring only two cuts, not the four that the Fed September dot-plot had shown and Wishful Thinkers were clinging to for dear life. Inflation has stalled and the Fed needs to see better progress.

Two cuts next year, two more in 2026 and one in 2027 adds up to a total of six additional cuts by end 2027, or exactly 3%. We would bet ten dollars we do not see 3%. Note we haven’t seen the neutral rate at 3% since 2018.

Mr. Powell used that word again—“cautious”—and said “From here, it’s a new phase.” You can take that as a happy thing or ominous. We say ominous, but then, we have been listening to cable TV for three straight days and find the future after Jan 20 to be very, very scary.

What the Fed needs to see: “For additional cuts, we’re going to be looking for further progress on inflation.” Notice that when speaking to the press, he tap-danced around the “softer” labor market but declined to commit to any rate cut solely to shore up the labor market.

In other words, he didn’t say anything to offend Trump. He did say the economy is doing remarkably well. And sure enough, the Atlanta Fed GDPNow model has Q4 at 3.2%, from 3.1% the day before. The driver--real residential fixed investment growth up from 4.7% to 5.3%.

But the official Fed forecast for inflation next year is higher by 0.3% to 2.5%--but the forecast for the GDP is higher by only 0.1% to 2.1%. 

This is not necessarily a warning of stagflation, but just wait.

The Fed decision is no surprise at all. The economy (the consumer) and stock market have overheated. It will take a giant Shock or a series of small shocks for the consumer to pull in his horns and the equity speculators to switch from greed to fear.  The economy during the first six to nine months of the Trump administration may be quite good because these movements have some serious momentum. Then, depending on policy announcements, the frog in the pot will start to boil, a nicer way of saying the sh** will hit the fan.

By then the cost of food will go up, way up, because migrant farm workers will be gone. Roofs and other constructions will cost twice as much for the same reason. Toys, electronics, appliances and our proverbial socks will cost some 20-50% more, because retailers learned from the pandemic-induced supply chain inflation, made a bundle and know how to do it again. Remember that even stuff entirely domestically made, like kitty litter, doubled in price and has stayed there. Our biggest worry today is what is going to happen to US-Canadian relations (and the price of toilet paper). 

That’s just a sliver of the economics. In other matters, like national security, health and education, we don’t know what to expect from the wildly inappropriate and unqualified department leaders, but it can’t be good and might be downright dangerous. At what point does the consumer take notice and stop spending/start saving a whole lot more? Now add in the risk of another pandemic or natural disaster.

The core problem is that hardly anyone knows how to judge risk. Just one risk, like a tariff of 20% on a single country like Canada. Now add simultaneous concurrent hazards and even if the effect of each on inflation, growth and consumer/business confidence is small, you suddenly have a Catastrophe. If you have a mind for math, check out https://lumivero.com/resources/blog/modeling-the-compound-effect-of-concurrent-occurrences-of-risk-events-with-risk/.

Pimco is one manager who believes every word of intended new policies and will eschew the longer Treasury tenors mostly because the fiscal deficit is not going to get fixed. It will go for paper from UK, Canada and Australia instead. Pimco lost quite a lot of luster when it lost the noisy top spokesman (Bill Gross), but it’s still a big name, and perhaps only the first of many. That means prices down, yields up. That means, overall, dollar up.

As a Reuters headline puts it, “Trump, not yet in office, looms over global economy.” Both the BoJ and BoE rate decisions were accompanied by mention of “heightened uncertainty.” Reuters had a survey last week of Japanese businesses that “showed nearly three-quarters expect Trump to have a negative effect on their operating environment, something BOJ officials may have to reckon with as the world's lone developed central bank still trying to tighten policy.”

“Norway's central bank held its policy interest rate unchanged at a 16-year high of 4.50% and highlighted the risk of a trade war between the United States and China. ‘Higher tariffs will likely dampen global growth, but the implications for price prospects in Norway are uncertain,’ the bank said. Sweden's central bank cut its key interest rate by a quarter percentage point to 2.50% as expected, but said it now saw reasons to be more cautious about cutting rates in early 2025.”

It's arguably worse in Canada, where FinMin Freeland quit after disagreeing with PM Trudeau on managing the promised US tariffs. Reuters reports “Freeland said the threat of new U.S. tariffs represented a grave danger… ‘That means keeping our fiscal powder dry today, so we have the reserves we may need for a tariff war. That means eschewing costly political gimmicks, which we can ill afford,’ she wrote in a letter to Trudeau posted on X.”

Brazil has its own internal issues, together with the dollar rise driving the real by the most in over 2 years r two years to record low yesterday. Reuters reports “stocks and bonds were pressured as financial markets put the Brazilian government's spending plans and widening deficit to the test. The alarming sight of the currency falling after such steep central bank interest rate rises this week and with bond yields climbing is seen by many as a red flag.”

Other emerging market currencies also fell, as did commodities.  We get inflation reports from Brazil and Mexico today.

On the wider Big Picture level, ECR Research points out that the Fed having curt rates at all yesterday is out of step with the economy already running at near capacity. As we wrote periodically leading up to the decision yesterday, the Fed could have decided on no cut on the grounds of the data. So if the Fed cut anyway, “This is probably because the Fed expects economic growth to slow for some reason. However, caution is needed here, as this slowdown has been predicted for a long time without coming to fruition.”

… “The Fed has clearly indicated that, at this point, its rate forecasts have hardly factored in various measures that Trump intends to implement, such as cutting tax rates, reducing immigration, and imposing import tariffs. Additionally, no account has been taken of the increased attractiveness of oil and gas drilling. These measures will likely further stimulate growth and drive up inflation. The Fed is still too uncertain to incorporate these factors into its forecasts. This also applies to other proposals Trump has made, such as shrinking the civil service and making the government more efficient.

“The question is, how quickly can all this happen? The introduction of import tariffs and limiting immigration could occur quite quickly. The rest will need Congressional approval, where the Republicans hold a thin majority. This wouldn't be so problematic if they all agreed on these issues, but this is certainly not the case. It is therefore likely that many of Trump's proposals will remain stalled in Congress for some time.

“This creates a situation where the proposed measures to stimulate growth will likely be adopted quickly, but the measures needed to finance them will take considerably longer. Therefore, we expect that if the Fed lowers rates again in the near future, the next step might well be a rate hike.”

Tidbit: Canada is the biggest worry today. ING writes the CAD can go to 1.50 (or worse) when it’s already down 7.5% since the start of 2024. “The floor seems to be shifting under the Canadian dollar as risks of a US-Canada trade war, large Bank of Canada cuts, a soft outlook for oil prices, and now political turmoil have seriously dented the loonie’s long-held status as the safer option in the high-beta commodity currency space.

“The clearest symptom of this change in sentiment is the rise in CAD’s implied volatility relative to historical volatility, a measure of the market-perceived risk of wider FX moves in the future. As shown below, that ratio is higher for CAD (1.39) than for any other G10 currency now when taking the six-month tenor. This is in sharp contrast to the generally low volatility character of CAD. If we exclude the February-March Covid shock, we have to go back 10 years (October 2014) to see CAD implied /historical volatility ratio at or above 1.40.”

Sorry, Canada.

Forecast

The markets are just starting to digest the idea that the two cuts expected for next year might not come until June—if then. We will have to listen carefully for Fed comments that indicate postponement. The Fed does prefer to speak of possible changes based on actual data, but cannot honestly pretend to ignore the inflationary effect of tariffs, even if only announced and not yet having an effect on CPI. In addition, the probability of the Trump administration reducing the federal deficit is nearly zero.

US yields are likely to keep rising and European yields are likely to keep falling, each in line with growth and inflation. The world has still not punished the dollar for extraordinary privilege, first voiced by the French over 50 years ago, and so the widening differential favors the dollar. There is some small possibility of Europe getting back on track late in H2 with growth recovering, allowing for a respite. But before then, euro/dollar parity is very much in the cards.

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