The top question now for markets is whether traders and investors are jumping the gun by extrapolating a run of soft US macro data into a Fed easing cycle commencing from late Q1 2024.

To be sure, the combination of i) softer payrolls and retail sales, ii) cool CPI and PPI, iii) lackluster consumer sentiment and iv) ISM misses, argues strongly in favor of the notion that monetary policy is finally working its “magic” on a lag, and that this time isn’t different after all.

Jerome Powell introduced “head fakes” into the lexicon last week while promising not to be “misled” by false dawn inflation reports, but this week’s updates felt like the real deal. Core and supercore prices undershot, and headline producer prices posted the largest MoM decline since April of 2020.

BMO’s Ian Lyngen and Ben Jeffery described the price action in rates following the CPI report as “a wholesale rethink of the trajectory of inflation.” Some of that move reversed on Wednesday despite the favorable PPI print, but as Lyngen put it, “it appears that in fact, monetary policy still works and it continues to require a lag before its impact is evident in the realized data.”

The concern, though, is that markets are now overestimating the chances of full-on Fed accommodation. As discussed here on several occasions over the past week, “insurance cuts” in 2024 are probably a foregone conclusion given the number of times officials have alluded to the mechanical effect of receding inflation on the real policy rate.

The rationale is straightforward: As inflation falls, you “have” to cut rates unless you intend to countenance “passive” policy tightening.

But that’s something different from rate cuts aimed at removing restrictive policy settings. In the “insurance cuts” envisioned by so many market participants, the Fed is simply preventing the real policy rate from rising — cutting to stand still, if you like. Cutting to actively provide support for the economy is something different altogether, and for now, the Fed has to pretend it’s completely far-fetched lest they should end up with too many sessions like Tuesday’s frolic, which engendered the single largest one-day financial conditions easing impulse of 2023.

At least one bank (UBS) expects growth to slow dramatically next year while inflation drops below target and the unemployment rate rises a full percentage point. In such a scenario, the Fed would indeed have a rationale for deep rate cuts like those UBS envisions. Morgan Stanley has a bear case for the economy in which the Fed cuts even more than the 275bps UBS sees in their baseline.

But we may be getting ahead of ourselves, and the price action earlier this week (i.e., following the CPI report) was indicative of just how far behind positioning really was vis-à-vis the rapidly shifting rates zeitgeist.

“Despite a constructive tone-shift on bonds from customers, investors nevertheless remain extremely under-positioned in duration and still over-positioned in legacy ‘high for longer’ views in a world that is now violently capitulating past a 2024 Fed ‘insurance cuts’ scenario and wildly into a hypothetical full-fledged Fed cutting cycle instead,” Nomura’s Charlie McElligott wrote Wednesday, noting that some now appear convinced that policy is running “‘too tight’ versus the trajectory of the short-term trailing disinflationary trend.”

Again, the market’s assumption is that the Fed’s driving in the rear view mirror (as is their wont) and the evidence is piling up that the bottom is about to fall out for previously stubborn inflation. After this week, it’s not just M2 and bank lending that point in that direction, but the actual, realized inflation data too.

While it’s certainly true that the Fed’s risking a counterproductive scenario with market-based financial conditions ease rapidly in the face of lower yields, a weaker dollar and higher stock prices, we may be well enough along in the cycle that the “animal spirits” risk is trumped by the multifaceted, real-world disinflation process. If that’s the case, the Fed’s avowed determination to hold terminal until they see the whites of the recession’s eyes could be a mistake. 

But remember: There are no Paul Volckers at this Fed. And 2024’s an election year. Given that, traders may not be irrational at all to believe the pivot’s coming, and that when it does, it won’t stop at a couple of 25bps “insurance cuts.”

“Perhaps this is too much wishful thinking — near-linear projection of something that’s proven unforecastable — but the worst-case ‘hard landing’ / ‘over-tightening accident’ left-tail lost delta [early this week], while the ‘softest landing’ scenario picked up delta,” McElligott went on. “If inflation were to continue to decline precipitously, the Fed is almost forced to cut nominal rates just to maintain levels of real yields. So yeah, cross-asset euphoria versus expectations and under-positioning.”