19th Dec 2024 - Mid Week Insights

The Japanese yen breaching past 156 on Thursday, a one month low, as the Bank of Japan kept interest rates unchanged in a nearly unanimous decision on Thursday, as policymakers remained cautious over Japan’s economic outlook and the path of inflation. BOJ member Naoki Tamura was the sole dissenter, calling for a 25 basis point hike on concerns over rising inflation. Additionally, the yen faced pressure from a strengthening US dollar after forward cuts were repriced higher.

NQ trading flat on BoJ no change announcement while Nikkei tracking in lockstep with Yen weakness. The yen is down more than 8% in 2024 against the dollar and is set for a fourth straight year of decline. For now, Hawkish Fed and less hawkish BoJ means Dollar yen have the freedom to run higher. December's FOMC was the “last catalyst for the calendar year for most systematic flows.

The FOMC performed the widely expected 25bps cut to fed funds range of 4.25% to 4.50% and indicated just 2 cuts in 2025, down from previous 4 cuts projected in September meeting. Markets were pricing in close to 3 cuts in 2025 prior to FOMC meeting. Powell came out incredible hawkish and the dot plot reflected the view that inflation won’t make any progress in 2025.

Fed was dovish with a 50bps cut in Sept and now has flipped hawkish. The fact that the Fed is shifting its stance after multiple cuts and softening labor market data indicates that it intentionally wants to take an even more aggressive stance toward inflation at the expense of growth, this could potentially be due to the new trump administration.

Fed voter Beth Hammack dissented in Favor of no cut. Both headline and core PCE projections for 2025 were all higher (2.5 vs 2.1 for PCE, 2.5 vs 2.2 for Core PCE). Funny part about this was that sept projections were all off, not surprisingly. Latest projections all breached mean distributions laid out for PCE inflation in Sept.

Also, Fed funds rate projections showed 3.9% (2 cuts in 2025), 3.4% (1 cut in 2026) and 3.1% (1 cut in 2027). Fed Chair Jerome Powell said twice at his press conference, "We're significantly closer to the neutral rate." We have previously explained our issues with this mythical interest rate that keeps inflation subdued at full employment. However, Powell's declaration is a shift from September when he said several times that the committee is moving gradually down towards neutral. Nonetheless, Long run FFR rate also increased from 2.9% to 3% which is FOMC’s approximation of the neutral rate.

Growth: Growth continues to surprise to the upside, 2024 end target was up 50bps to 2.5% from 2% while projections for 2025 was at 2.1% vs 2% in September. If real GDP growth continues to surprise in fed expectations in 2025, we would expect neutral rate to be revised higher than 3%.

Overnight reverse repo facility (ONRRP) was lowered by 30bps, 5bps more than bottom range of FFR at 4.25%. This will likely help ease off pressure on overnight market rates and possible extend how long the fed can run down its balance sheet.

Unemployment: Numbers were broadly revised lower versus September’s projection but higher than 2024 at 4.3% vs 4.2%. Additionally, 3m10y spread have recently flipped positive last week after being inverted for more than 700 days. Historically, the dis inversion of the yield curve will tend to drag unemployment rates up as the economy tops out. However, this time might be different as productivity scenario remains strong and manufacturing sector seems to be bottoming out. Higher productivity tends to be disinflationary and likely increase unemployment as companies become more efficient and produce more output with fewer workers, they may require less labor overall, potentially leading to job losses and a higher unemployment rate. On the other hand, increased productivity can also stimulate economic growth and create new job opportunities in other sectors.

Overall, The fed is walking on a thin thread and possibly of holding rates too restrictive for too long impeding growth vs cutting rates to fast that lead to reflation. Continued economic strength and potentially inflationary fiscal policies in 2025 may even make the pace of rate cuts slower and far from a done deal. In his post-meeting press conference this afternoon, Fed Chairman Jerome Powell likened the coming slowdown in rate moves to driving a car on an unfamiliar road on a foggy night—the driver will naturally decelerate to remain on track.

Given the extended positioning and valuation within equities and deteriorating market breadth concentrated towards large cap tech, its no surprise that every slight misalignment in expectations will trigger a sell-off in equities, S&P 500 and NASDAQ lost around 3% while small caps closed 4.5% lower.

All 11 S&P 500 sectors closed lower, with Consumer Discretionary hit hardest at over 4%, and Real Estate, Technology, and Financials each down around 3%. This broad selloff indicates increased risk aversion amid uncertainty about the Fed's policies. The economic outlook remains concerning as investors prepare for potential growth and earnings challenges. More of a combination of extended positioning, lofty valuations and expectations that higher rates for longer will reduce growth on the margin.

Bond markets also sold off in tantum over higher growth, inflation expectations and likely pro-growth regimes under Trump. Bond yields pop 13bps to 4.51%, highest since May. Similarly, King dollar broke through 108 intraday, a 2 year high.