The Breakdown - Powell Inches Towards Rate Cuts

Episode Date: July 11, 2024

NLW does a macro roundup, including recent comments from Fed Chair Jerome Powell and Treasury Secretary Janet Yellen on the possibility of increased unemployment and the need to move towards rate cuts. Plus a check in on politics in France, the UK and Argentina. Sign up for Permissionless here: https://blockworks.co/event/permissionless-iii Use code BREAKDOWN10 to get 10% off Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribe to the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on Macro, Bitcoin, and the Big Picture Power Shifts remaking our world. What's going on, guys? It is Wednesday, July 10th, and today we are going macro. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Well, friends, surprisingly for a summer in some ways, there has been enough going on in the

crypto space, particularly with regard to the whole political overlap, that we haven't actually had a chance to check in on the larger macro environment for some time. While there hasn't been anything hugely new or different, there have been some new notes from Powell, a Janet Yellen hearing, and some global events that are worth digging into just a little bit. We kick off with Fed Chair Jerome Powell, who appeared before the Senate on Tuesday for the first of two days of congressional hearings. These routine hearings are held twice a year and serve to keep lawmakers updated on the state of monetary policy.

The last time these hearings were held in March, the clear focus was on the inflation fight after an uptick in first quarter data. At yesterday's hearing, Powell emphasized a growing concern over the potential for an economic slowdown. He framed the situation as the risk of inflation and the risk of rising unemployment coming into closer balance. During prepared remarks, Powell said, In light of the progress made both in lowering inflation and in cooling the labor market over the past two years, elevated inflation is not the only risk we face. Reducing policy restraint too late or too little could unduly weaken economic activity and employment. We're very much aware that we have two-sided risks now.

Yesterday's hearing was held one year after the Fed ended their hiking cycle, making this one of the longest periods of holding elevated rates in Fed history. All eyes are now on the timing for the first rate cut, but Powell wasn't keen to nail down a timeline. He leaned on the idea that further confidence is needed before committing to the first cut and noted that the most recent inflation data had only showed modest further progress. Powell added, More good data would strengthen our confidence that inflation is moving sustainably towards 2%. One of the unique things about these hearings is that they allow lawmakers an opportunity to question the central bank and push their own views on where monetary policy should be

headed. That political maneuvering is only heightened during an election year. Several Democrat senators urged Powell to get on with the rate cuts with committee chairman Sherrod Browns, dating, I'm concerned that if the Fed waits too long to lower rates, the Fed could undo the progress we've made on creating good-paying jobs. If unemployment trends upward, you must act immediately to protect Americans' jobs. Workers have too much to lose if the Fed overshoots its inflation target and causes a completely unnecessary recession. Powell acknowledged the risk of an excessive slowdown, but was loathed to get involved in political grandstanding. During his opening remarks, he had emphasized the, quote, operational independence required to fulfill the Fed's mandate.

The rhetoric was no less incendiary from Republicans. Ranking member Tim Scott had a simple message in his opening statement. Joe Biden broke our economy and it is very very very important. difficult for anyone to fix it. Republican talking points focused on wages failing to keep up with inflation during the earlier part of Biden's term. Scott said that the vast majority of families are in an absolute crisis with, quote, too much month at the end of the money. Other Republicans were more focused on the impotence of the Fed to solve remaining issues in the economy. Mike Round suggested the remaining inflation is really a story of constrained supply, particularly in the energy sector. Still, aside from the political posturing, the hearing really was about incoming rate cuts.

Powell repeatedly avoided questions about precise timing, saying, I'm not going to be sending any signals about the timing of future actions. However, his commentary implied that it was now a matter of when, not if, the Fed would begin to cut rates. And indeed, by all indications, we are in the final few months before the start of the cutting cycle. Markets are pricing in basically zero chance of a surprise rate cut when the Fed meets at the end of this month. However, according to the CME Fed Watch tool, the September meeting has a 70% chance to see the first cut and two cuts are expected by the end of the year. The hearing barely moved the needle on these odds, but served to confirm the rate path that markets are pricing in. Nick Timmeros of the Wall Street Journal, who notoriously has excellent sourcing at the Fed, thought that Powell had inched the Fed closer to cutting rates. He tweeted,

there were some subtle but meaningful observations from Powell today. Quote, the labor market appears to be fully back in balance. It's not a source of broad inflationary pressures for the economy now, end quote. The whole focus by the Fed starting in late 2022 on core services ex-housing tied back to a concern that wage growth was too strong and the labor market too hot, notwithstanding likely goods deflation and shelter disinflation. Declaring that labor market imbalances have been resolved and that they are no longer a source of broad inflationary pressures seems important in that context. Timrose concluded. This view is backed up by the June Jobs Report, which was delivered last Friday. Headline job growth was above expectations,

but still a massive reduction from the prior month. However, this was another jobs report that showed a lot of weakness below the headline number. Unemployment had increased slightly for the third month in a row, ticking up to 4.1%. This is the level the Fed had forecast for the end of the year during their most recent summary of economic projections. The report also featured large downward revisions from the previous two months, suggesting that a lot of labor market strength from the second quarter had been illusory. The Fed is now expressly balancing the risks of inflation against labor market. They're seeing stable but slightly high inflation data compared against the labor market that Prince Weaker reports month after month. In fact, many believed

Powell was only paying lip service to inflation fears and that his emphasis has entirely shifted. Derek Tang, an economist at policy analysis firm LH Meyer said, his focus is squarely on the labor market. Further softening in the labor market, even if further disinflation is not delivered, is enough to spur action. Bloomberg economist Anna Wong wrote, Powell's remarks to lawmakers are rife with references to labor market risks.

The Fed now appears to be placing equal weight on the employment leg of its dual mandate, in contrast to the past two years when it explicitly prioritized price stability. Given our forecast for the unemployment rate to climb to 4.5% in Q4, we expect that by year end the Fed will prioritize the employment leg of its mandate. Claudia Somm, former Fed economist and creator of the so-called

SOM rule, said, it is very clear the labor market has cooled considerably. The alarm bells aren't sounding right now, but you are certainly pointed in that direction. So what is the SOM rule? According to the St. Louis Fed, the SOM rule identifies signals related to the start of a recession when the three-month moving average of the national unemployment rate rises by 0.5 percentage points or more relative to its low during the previous 12 months. Many have pointed out that the SOM rule is close to triggering as unemployment rises significantly above its low point. It is unclear whether this recession indicator will be accurate due to unemployment being abnormally low during this cycle. However, we do know that the Fed uses the SOM rule to gauge the risk of runaway unemployment. So, as she said,

those alarm bells could soon be sounding. At this stage, rate cuts are basically a given for this year, so the speculation is mostly around how Powell will choose to signal them. Jason Ruchel of Options Hawk thinks it will be a slow burn, tweeting, really think the Fed will cut in September and maybe hint at that during the July FOMC meeting, then confirm it more at Jackson Hole. Based on recent uptick and jobless claims and softer labor market plus early signs of housing slowing, these guys are always too slow with monetary policy and likely should be cutting rates this month in July. Inflation has been dead for a year plus and they are still worried about easing too soon, since they look at backward-focused data showing rent prices from mid-20203. Meanwhile, lumber

prices are tanking and home builder stocks peaked three months ago and are now down 15% from highs and are negative year-to-date. Housing and real estate leads everything in this economy. They know it and will do plenty to spur activity into next year, in my opinion. Now, Jackson Hall is the annual central banking symposium held in August and is traditionally used to discuss and communicate monetary policy plans for the next year. In other words, it's a chance to zoom out a little bit more than the average FOMC meeting. The theme for this year's symposium is reassessing the effectiveness and transmission of monetary policy. Powell has used this conference in the past to deliver impactful guidance. In 2022, he famously shortened his speech at the last minute to deliver the simple message

that higher interest rates will bring some pain to households and businesses. This speech set the stage for a further nine rate hikes across three meetings to close out that year, making for the fastest hiking cycle in history. On the margin host, Felix Javan, argued that these hearings were not the time for forward guidance, tweeting, no reason for him to jump the gun now when he can use Jackson Hole in August as a place to formalize cuts if he decides to ensure he retains the optionality he got himself in June, traditionally a much more commonplace for Fed to discuss major policy shifts, not in a testimony environment. And with rate cuts now just a matter of time, analysis has turned to their historical impact.

The rubric is pretty simple. Rate cuts are historically bad for the stock market as they almost always come alongside a recession. The one counter example is the series of fine-tuning cuts throughout the mid-90s, which added fuel to the dot-com boom. It seems as though the lesson is that rate cuts are only bullish in the short term if the economy remains healthy. We're not seeing the panicked recession calls as we saw last year, but still some analysts are urging caution. Mark Dow tweeted, for example, rate cuts, be careful what you wish for. Hello, friends. Before we get back to the rest of the show, I want to implore you to join me at Permissionless. Permissionless is the conference for crypto-natives by crypto-natives, and the reason

it's so important this year is that despite regulators' best attempts to push industry founders, devs, and executives out of the U.S., the United States remains the beating heart of crypto. Today, the tide is turning. Policymakers have pivoted from fighting crypto to embracing it. Literally now we are in a major political party's platform, which we are in a major political party's platform, which will lead ultimately to the creation of new financial products, new applications, and ultimately new adoption. Permissionless is the conference for those using and building on-chain products. It's home to the power users, the devs, and the builders, and perhaps more importantly, I will be there. The location is Salt Lake City, the dates are October 9th to the 11th, and tickets

are just $499. If you want to get 10% off, use code breakdown 10. Go to the Blockworks website, blockworks.com. There will be links to register for the conference, and again, you can use code Breakdown 10 to get 10% off. Treasury Secretary Janet Yellen echoed Powell's views of a cooling labor market during a separate hearing in the House. Yellen said that coming out of the pandemic, labor market conditions were initially very tight, but that now, quote, we have a strong labor market, one with few pressures that would create inflationary concern, so inflation is coming down.

More generally, Yellen added, I believe that it will continue to come down over time. Rents and housing costs continue to leave it higher than we would ideally like. This seems to be the view that a weakening labor market and a lag in shelter disinflation make it structurally difficult to see another spike in inflation. The hearing was supposed to be on the state of the international financial system, and there were a few periods that stayed on topic. Democrats and Republicans dueled over the use of the World Bank and the IMF to promote renewable energy and developing nations. There were also several questions about how to deal with the debt burden in emerging market economies, stemming from loans from the IMF and China's Belt and Road

initiative. The biggest headline grabber was a brief discussion about the mental acuity of the president. Mike Lawler asked Yellen whether she had, quote, noticed any mental or cognitive decline during recent meetings with Biden. Yellen Stonewalled the line of questioning, responding, the president is extremely effective in the meetings I've been in him with. That includes many international meetings that are multi-hour, like his meetings with President Xi. The hearing descended into disorder at that point, with Democrats objecting across the chamber. Loller followed up by asking whether there had been any discussion among cabinet members to remove the president using the 25th amendment. Yellen simply responded, no. To the extent that Yellen had relevant views on monetary

policy, she seemed to agree with Powell. That inflation was still declining and the labor market is starting to present more of a problem. It wasn't anywhere close to an endorsement of rate cuts, but Yellen seems to agree that the state of the economy makes it appropriate to begin the cutting cycle soon. Although Powell was reluctant to commit to rate cuts, bond traders are nowhere near as shy. Open interest on 10-year treasury notes has surged so far this month with traders flocking to position for falling rates. Yields have already dropped by 20 basis points, but traders continue to pile in. J.P. Morgan positioning reports disclose that clients have increased their outright long positions by 5% over the past two weeks. Similar dynamics were also observed in the market for

two and five-year bonds. Meanwhile, the biggest topic over on FinTwit is the continued narrowing of breadth in the stock market. Charts are being splashed around showing that market concentration has hit historic highs. The three-month correlation between S&P 500 index gains and the number of stocks gaining value has fallen below the dot-com bubble low. The divergence between the cap-weighted and equal-weighted indices is now higher than it was prior to the 2008 crash. While market breadth it's at the extremes, there's no mechanism that would force it to revert, so theoretically it can always keep going. At this point, increased concentration in large-cap stocks has gone on so long that it's become a meme rather than a sign to panic. The market dog lampoon the situation, tweeting,

at any point in time, there's always someone with a gfc or dot-com chart, changed my mind. In a Monday research note, Jonathan Krinsky of BTIG suggested that narrowing breadth was a sign of fear of an economic slowdown. The thesis is that investors crowd into the biggest and most resilient companies in hopes of writing out a drawdown. Krinskii liken the situation to the late 1990s when market breadth peaked in the spring of 1998. The top in the S&P 500 took another two years to arrive, the problems had already bubbled to the surface by late 1998. Krinzki noted that breadth and individual stock gains has already peaked in May. Overall, he suggested that, quote, the market is sniffing out economic weakness that will overpower the implied rate cuts.

Another weird sign is that despite the S&P 500 reaching fresh all-time highs, short-sellers had a fantastic quarter. Data from S3 partners suggested that short-selling firms amassed 10 billion in paper gains by identifying the many-week companies littering the market. The Q2 story of narrowing breadth was mainly about Nvidia. The AI chip company put in a 37% quarterly gain to briefly become the largest company in the world. Although Nvidia has slowed down over the recent weeks, we're seeing the momentum rotate rather than being extinguished. This has allowed the indices to continue to grind higher despite a change in leadership. Tesla has become the new momentum, darling, while Apple and Amazon have also seen an outsized benefit.

Now, a couple international stories to round up, a pair of European elections look set to shake up the continent. Results of the French election gave a broad coalition of leftist parties the most parliamentary seats, but not enough to form a government. The coalition had been thrown together in a rush to contest the snap election, which was called with just a few weeks to campaign and register for ballots. The rapid organization was viewed as a necessity to block the rise of the far-right national rally party and their leader, Marine Le Pen. A snap election had been viewed as a desperate gambit from President Emmanuel Macron. The political calculation was that his center-left coalition could defeat Le Pen now, but might not be able to hold back the tide for much longer. This

calculation seems to have backfired, with Macron's coalition losing seats to the left and the right. Macron's prime minister has offered his resignation, but it's entirely unclear who would take over. None of the three major factions are anywhere close to holding a majority in the 577-seat National Assembly, each fall short by at least 200 seats. Sylvain Mayard, an MP for Macron's Renaissance Party, pointed out that coalition governments are tricky at the best of times, stating, It's not possible to govern France if you don't have 240 to 250 lawmakers. I was president of the resistance group with a coalition of 250 members of parliament,

and it was already very complicated. This is an unprecedented situation in French politics, so there's no playbook on how to move forward without a sitting government. Despite resigning, the previous prime minister has put his name forward to lead a caretaker government while the political crisis is resolved. Meanwhile, Paris is set to host the Olympics next month, and a budget will need to be passed by the fall. The French bond market has already freaked out.

Beyond the immediate chaos, the outperformance of the leftist coalition suggests large fiscal deficits on the horizon. If the decline of Macron's party was about anything other than ideological upheaval, it was about fiscal policy. Macron had promised pension and benefit reform on a massive scale to deal with projected shortfalls over the coming decade. This was unpopular with the French public to say the least. It now seems that even if the political crisis is resolved, France could become mired in an ongoing fiscal crisis. Economist Philip Pilkington noted that bonds are already settling down, tweeting, pay close attention to the market reaction in France. Bonds are recovering, stocks are not.

Markets know gridlock or Marxist influence will be terrible for the economy, but they also know that the ECB will back the far left in the bond markets to squeeze out the right. The other major election was resolved in the UK, with the Conservative Party handed their largest defeat in decades. The Tories had presided over the British Parliament since 2010, despite a never-ending string of scandals and missteps. Kierstammer will take over his prime minister, forming a labor government with a massive majority but a shaky mandate. The UK election was marred by extremely low turnout, the lowest since 2001. Labor will inherit an economy that has grown only 1.9% over the eight years since Brexit. Infrastructure is crumbling, public services are in disarray,

standards have been declining for more than a decade. The fiscal situation will also be extremely tight. The UK famously already had their bond revolt in 2022 when Liz Trust proposed tax cuts in a budget that caused her to be the shortest serving Prime Minister in the nation's history. With little room to propose spending in public service renewal, Labor might find themselves constrained to governing on cheaper culture war issues. Rochon Kishore, the political economy editor of the Hindustan Times, wrote Kirstarmers' economic challenge is perhaps the toughest in the UK's history. High levels of inequality made worse by falling growth in Brexit's self-destructive economic impact must be reversed to prevent fiscal crisis. Lastly, in Argentina, President Miele seems to be making

headway on inflation with his radical reform agenda. The libertarian economist was elected late last year on the back of a bold platform to bring an end to one of the worst inflation crises in the world. Last year, Argentine inflation came in at 211.4%. Miele planned to gut the government, firing a huge amount of bureaucrats and shutting down half of government departments. He called this his chainsaw plan and literally campaigned while wielding a chainsaw. Six months later, this deep austerity seems to be working. Food inflation was at zero during the third week in June and has been consistently below 2% since mid-March. This was the first week of zero food inflation in over 30 years. Overall inflation hit a 4.2% month-on-month rate in May and is seen consistent decline since

Miele took office. Analyzed inflation is still at 276%, but the progress seems clear. The costs have also been fairly dramatic. The peso has been devalued by 50% and continues to slide lower. Official growth numbers have not been calculated for the first half of this year, but analysts expect to see a massive contraction in the economy as evidenced by a huge drop-off in consumer spending. More than half of citizens still live in poverty with no sign that trend is reversing. There's also no progress on dollarization and the central bank has not yet been abolished, which were some of Miele's more ambitious promises. A reduced version of Muley's omnibus bill was finally passed in June, granting the president extraordinary powers for one year and enabling many of his agenda items.

This could allow him to continue with more radical reforms, such as the privatization of two dozen state-owned utilities. The IMF seems to approve the progress so far, stating that Miele's performance was, quote, better than expected, and that Argentina's economic program was, quote, firmly back on track. Still, Kimberly's perfecter, emerging markets economists at capital economics, noted how big the lift is, stating that Miele has to overcome, quote, years and years of economic mismanagement. She thinks the economic slowdown might begin to slow progress, adding, with Argentina, you never really know. But I think the shine is coming off.

The optimism is going to fade and the economy is going to struggle. Here is hoping that's wrong. But for now, that is going to do it for this macro roundup. Appreciate you listening as always. and until next time, be safe and take care of each other. Peace.