Fed Pivot Math Seen Wildly Implausible

According to one popular sell-side strategist, a string of “very hot” US economic data could catalyze a “rip lower” for recently buoyant equities.

For the summer rebound in stocks to be remembered as anything other than a bear market rally built on systematic flows and short covering, the macro data needs to be cool enough to dissuade the Fed from incremental hawkish escalations, but warm enough to dispel recession concerns.

While elaborating on what would count as the kind of “very hot” data which might compel the Fed to lean further into the most aggressive tightening campaign in decades, BofA’s Michael Hartnett cited a July payrolls print in excess of 400,000 and a drop in the unemployment rate to 3.5% or below.

Friday’s jobs report gave us both. The US economy added 528,000 jobs last month and the unemployment rate matched February 2020 for the lowest since 1969. It was indeed a “very hot” report.

Whether it’s enough to catalyze a “rip lower” (as Hartnett put it) in equities is an open question. Certainly, the read-through was hawkish for an already hawkish group of policymakers who spent the days leading up to the jobs report reiterating plans to hike rates into restrictive territory. Friday’s data made the case better than they ever could.

Of course, a cooler-than-expected read on July CPI could offset the scorching payrolls print. But in addition to being the furthest thing from a foregone conclusion, the problem is that we don’t just need one “cool” CPI report. Rather, we need multiple benign inflation prints in succession.

In the simplest terms: The path to anything like price stability goes through a string of implausibly low MoM inflation readings. The figures (below) are from this week’s installment of Hartnett’s popular weekly “Flow Show” series.

“Even assuming 0.3% MoM prints for the next 6-9 months, both core CPI and PCE will be around 5% YoY in Q1 2023,” Hartnett wrote.

A similar assessment of headline CPI suggests that in order for headline inflation (which, as Jerome Powell will be happy to remind you, is the only kind of inflation that matters on Main Street when food and fuel prices are elevated) to recede below 5% during Q1 of 2023, monthly inflation prints would need to drop to between 0.1-0.2% (figure below).

Getting to 3% would entail flat monthly prints. Getting to target would, I can only assume, require negative prints.

Admittedly, I haven’t checked Hartnett’s math, but I assume it’s accurate.

Is any of that possible? Well, I suppose. Is it likely? I doubt it, although it’s certainly the case that a sustained decline in commodity prices could produce welcome relief on the headline readings.

The overarching point is that even under an optimistic scenario where monthly inflation prints fall by half (or even a little more than half), inflation, both headline and core, will still be at least 5% in Q1 of 2023.

It’s difficult to imagine the labor market deteriorating enough to override 5% or 6% inflation in the eyes of the Fed. Seen in that context, market pricing for Fed cuts commencing midway through next year seems far-fetched.

On the other hand, maybe I’m missing the point. Maybe STIRs and, more importantly, the yield curve, are correct about the path of policy and the economy, respectively. If that’s the case, I suppose I should be pondering a truly terrifying about-face in the labor market. Because, again, that’s what it’s going to take to compel the Fed to cut rates with inflation still several percentage points above target.