The Fed Will Pivot Now

And markets will rally

The news on the inflation front is very encouraging. It will allow the Fed to pivot now. But markets are yet to price in the good news.

The Fed cares very strongly about two things. First, the technocrats want to see through temporary fluctuations and focus their attention on the pace of underlying inflation. That’s why they pay so much attention to core and supercore measures. Second, they want to be certain that inflation expectations are anchored on target. So they pay great attention to market-based measures of inflation compensation, survey-based measures of expected inflation, and wherever they can find an expectations signal.

Core CPI strips out food and energy, while supercore strips out food, shelter, energy, and used cars and trucks. Powell recently highlighted services less shelter as a barometer of underlying inflation. The lowest volatility quintile is our signal for the inflation expectations of the slowest moving price setters. We report 3-month annualized rates for these measures.

Core CPI is running at 3.1%; supercore at 1.8%, and services at just 1.2% per annum. The lowest volatility quintile — which we believe contains the strongest predictive signal for the future path of inflation — tempered from 5.2% to 4.2% in December. The FOMC will look at the numbers and reckon that the time has come to pause the hiking cycle. There’ll be much discussion of monetary policy working with a lag et cetera. The upshot is that we’re looking at the sudden death of this hiking cycle.

Risk assets have rallied a bit so far this year. The SPY is up 3.7% year to date. We expect a much bigger rally as the good news is impounded into asset prices.

It is not out of the realm of possibility that inflation will revive. The next few prints may yet yield a nasty surprise. But that is now decidedly a risk scenario. The baseline scenario is that this hiking cycle is over.

Let it rip.