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Ignore rates, focus on liquidity

There is a reason Fed officials and MSM want you to focus on rates - it works to their advantage. The Fed gets to say it is doing its job in controlling inflation by keeping rates higher for longer. MSM reports rates are restrictive, hoping that repeating the message will lower inflation expectations.

This is the magician's trick - getting people to look one way while the science-y stuff behind the trick happens elsewhere.

I wrote about this in my December macro outlook. Time for an update.

First off, banks are lending again. Note how borrowing started to take off just after the Nov FOMC, when the Fed hinted at changes to the SEP.

Non-farm payrolls never even blipped. Labor conditions are tight. Higher rates are hurting a lot of people but that doesn't show up in the payroll numbers.

Meanwhile, the Treasury keeps draining the RRPs to fund the runaway deficit. Federal debt now stands at $34.65 trillion. That's $103k per US citizen. Maybe less if you count all the illegal immigrants who will magically become citizens in time for the polls.

Stimulus checks sent to ordinary Americans increased their purchasing power and caused price inflation. Interest payments sent to wealthy asset owners increased their asset purchasing power and caused asset price inflation.

With the Treasury insisting on financing itself via T-bills, this is only set to continue.

When the bond market threw a fit ahead of SVB's bankruptcy, the Fed calmed the market with the "temporary" Bank Term Funding program. The sharp move in rates inflicted a lot of pain on bond investors, causing bank credit to contract (see my December 2023 macro outlook).

Bonds are throwing a similar fit following the release of the CPI.

In March 2023, the Fed undid 5 months worth of QT in two weeks to calm the bond market.

While the FDIC broke precedent and bailed out Silly-con Valley bank depositors at a cost of $16.1 billion - to be borne by more prudent banks, and by extension, depositors who stayed far away from the Silicon Valley bubble economy.

(Incidentally, the Nasdaq/AI/crypto bubble kicked off just after the SVB bailout. Give a bunch of VCs and tech start-ups free government money, and naturally that money goes into feeding a tech bubble. It is so obvious in hindsight).

However, mere jawboning isn't going to be enough to stop the bond sell-off this time. After promising rate cuts for a long time, and exhausting pretty much all other tricks, the Fed is going to cut rates to save the bond market.

As early as next month. This is my non-consensus view.

I believe investors are too trusting of the Fed when they say they care about high inflation.

"You want to be reducing rates well before inflation gets to 2% so you do not overshoot". - Jerome Burns, December 2023 FOMC

But, they need a ruse. My guess is we are going to see a lot of articles on how high rates are causing shelter inflation.

Because rates trend, the first cut will instantly lower mortgage rates. Homeowners who feel trapped because they locked in a 2.5% mortgage rate will finally be free to move, unlocking supply.

Lower rates => lower rental yields => lower owner's equivalent rent.

And just like that, shelter inflation will come down.

Surging gasoline prices will be blamed on Iran and Russia, not the Federal Reserve.

Or the focus will be shifted to core CPI.

Or Paul Krugman's CPI.

I have painted a neat little narrative, but there's a fly in the ointment.

The consensus opinion is that the dollar is strong because rates are going to be higher for longer. Never mind that high commodity prices is bearish the dollar - they are two sides of the same coin.

My explanation is that the dollar's move is influenced by the ECB's dovishness and the BoJ's willingness to allow USDJPY to move up to 155.

It has nothing to do with the ever changing narrative on rate cuts.

To sum up, liquidity measures have turned up. Lending has turned up. Asset prices have turned up.

Commodity prices have turned up. The Fed is going to follow through on lowering rates and ending QT.

Rates don't matter, liquidity does.

This week's moves are a reaction to tax receipts draining liquidity, a little bit of FUD over the CPI, and not much else.

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” - Citigroup CEO in July 2007.

The Fed is about to spike the punch bowl and leave a bag of crack by the door. The inflation party is about to get heated up.

This ends when WIN buttons make a comeback as a fashion accessory.

Good Trading!

Kashyap Sriram

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