Dec 18 / Victor Arduin

Macroeconomics Weekly Report - 2023 12 18

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"It wasn't easy, but after a campaign initiated in March 2022 with 11 interest rate hikes, the monetary authorities of the United States finally begin to signal victory over inflation."

Fed's communication indicates an anticipation of monetary policy easing

  • The inflation in the US has been falling more or less steadily since peaking in June of 2022 when it reached 9.1%. With prices at more comfortable levels, the discussion for interest rate cuts in the world's largest economy is increasingly advancing.
  • One of the main consequences of a less restrictive interest rate environment is the decline in yields of American Treasuries. However, the country's financing needs for 2024 may provide support for yields, even with the decline in interest rates.
  • Energy, one of the most volatile inflationary components, is increasingly posing less risk to price increases. Therefore, inflation is expected to continue improving in the coming months.

Introduction

It wasn't easy, but after a campaign initiated in March 2022 with 11 interest rate hikes, the monetary authorities of the United States finally begin to signal victory over inflation. Jerome Powell's , the Fed's chairman, made a much more dovish speech, and brought a bullish sentiment to risky markets, with the S&P rising 2.49% last week, while the DXY fell 1.4%.

However, the consequences of restrictive interest rates may still come from the world's largest economy. The market's greatest fear is whether the American economy will be able to avoid a recession or not, which, even if mild, would have bearish repercussions, especially in the commodities markets.

Image 1: Major US Stock Indexes

Source: Refinitiv

Image 2: US Dollar Index (DXY)

Source: Refinitiv

With controlled prices, the focus is on interest rate cuts in 2024

Once again, the Fed announced that it is holding interest rates steady, maintaining the federal funds rate between 5.25 and 5.5 percent. With the probability of further hikes nearly non-existent, Jerome Powell's dovish speech suggests that US’s monetary policy is rapidly moving towards an interest rate-cutting cycle in the first semester of 2024.

An interest rate-cut scenario unfolding sooner than anticipated is creating a more risk-on environment, impacting major stock exchanges worldwide. Additionally, the two-year Treasury yields have declined by 25 basis points, settling around 4.5%. However, is the optimism seen thus far perhaps a bit exaggerated?

Image 3: Treasuries Bond Yields - US (%)

Source: Refinitiv

Some signs from the American economy show that it is still necessary to be cautious if interest rates are at a sufficiently restrictive level to bring inflation to the target of 2%. An example is that the labor market in the US remains quite heated, with job growth accelerating in November and the unemployment rate falling to 3.7%. While, on one hand, it dispels the fear of a recession on the horizon, on the other hand, it could indicate that inflation will persist longer than wished.

Furthermore, other risks present challenges for the commodities markets. The American federal budget forecasts a $1.7 trillion deficit for 2024. These high fiscal deficits will require more issuance of short-term Treasury bonds (T-Bills), increasing the already substantial American debt of around $34 trillion. As a result, the yields paid for Treasuries could be higher than expected in a scenario of interest rate cuts, as the US Treasury will seek to allure investors with a more attractive premium for their securities, leading to a valuation of the dollar.

Image 4: Federal Debt by Type in the United States

Source: Bloomberg

Energy costs are no longer a threat

Inflation is heading towards the Fed's 2% target. Energy costs, which were responsible for a significant inflationary shock in 2022, have become a concern for authorities from August to October, a consequence of OPEC+ cuts that have put pressure on the price per barrel of oil.

However, for now, they seem to not pose risks, given the significant losses observed in the energy complex in recent weeks. The deficit of oil in the market appears to be much smaller than anticipated. Therefore, it is expected that inflation will continue to improve in the world's largest economy.

Image 5: Contributions to U.S. CPI YoY (%)

Source: Bloomberg

In Summary

It cannot be denied that there is a substantial improvement in the prices in the American economy. The worst inflation in the last 30 years continues to converge towards its target, and each new FOMC meeting that reinforces this optimistic view of inflation is opening up more space for discussion about interest rate cuts, something eagerly awaited by the market.

However, there are still some important macroeconomic risks to be observed, as the American debt continues to grow, requiring an increasing issuance of Treasuries to finance the expenses of the US’s government. Even if the long-awaited interest rate cut arrives next year, yields may not fall with as much intensity, which will still provide some support for American Treasuries.

Furthermore, it is always important to exercise caution. While improvements in inflation are visible in the economy, the US job market remains resilient, posing a potential risk to inflation at any time. Despite it not being the most likely scenario, the possibility of inflation rising again,  is something to pay attention.

Weekly Report — Macro

Written by Victor Arduin
[email protected]
Reviewed by Alef Dias
[email protected]
www.hedgepointglobal.com

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