I expect to see the Federal Reserve cut interest rates before it hikes! That view got some solid support with last Friday’s job numbers, which we discussed on TheStreet Pro.

I continue to believe that chair Kevin Warsh is being a “magician” on inflation:

• Convince everyone you are very focused on inflation (check)
• Wait for inflation to come down naturally (it was declining before the resumption of attacks in Iran and will like go lower again after any sort of resolution that re-opens the Strait of Hormuz)
• Find credible, possibly even more accurate data to use for policy decisions (which, at the moment, are providing a better inflation reading)

While not part of his play, we need more discussions on the problem of affordability versus inflation. Affordability is the sum of inflation over time, and I strongly believe that the official data understated inflation post-COVID, which means that inflation didn’t tie in with what people were experiencing at the register — the problem was less the “official” inflation numbers but the real-world inflation numbers, which were much greater. These errors led to policy mistakes and to politicians misreading the atmosphere.

I also believe that the “official” data is “catching up” and is now overstating inflation.

Building a Case Not to Hike Interest Rates in September

According to the Bloomberg WIRP function, the market went from pricing in a full hike in September, as recently as July 24, and is now back below a 50% chance (which I think is still too high).

JOLTS was mixed. The employment component of ISM Services was below 50. ADP was better than NFP but left a lot to be desired (44,000 jobs). It is reasonable for the Fed to question the strength of the job market.

Let’s examine truflation a bit more closely:

We include “frozen,” which is the time series as originally published with no attempt to revise it as more information is available. The “unfrozen” version is effectively a “revised” time series.

The pink line is 2.49%, because 2.49% rounds down to 2% if we are using only whole numbers (that may seem like “cheating” but I think Warsh, in particular, thinks more “in the vicinity” of 2% rather than 2.0%). The beauty of this data is that it makes sense to me. Just a quick glance at this data seems to “jive” with what we’ve been experiencing (and notice it is all below 2.49%):

In this chart we explore the difference between truflation and CPI. Truflation was much higher for 2021 and 2022 than CPI. Honestly, that seems correct!

While the barbaric way in which shelter is calculated for CPI played a big part, it is not entirely to blame. Now CPI is higher than truflation. Why? Because maybe it is just catching up? Imagine if the Fed was focused on truflation rather than CPI in 2021 and 2022. Would it have hiked sooner? Would it have continued with QE as long as it did? We will never know, but treating CPI as a “gold” standard and dismissing metrics like truflation seems nonsensical to me.

This is also why I’d argue that we have an “affordability” issue more than an “inflation” issue. The problem isn’t so much in today’s price moves, it is that the price moves we were hit with back in 2021 and 2022 were not properly reflected in the data! (Yes, this is a hill I’m prepared to defend.) I’m not saying truflation is perfect by any stretch of the imagination, but it is pretty easy to see a policy path that is very different than the one we’ve taken if they looked at more types of data.

I’ve always thought the Fed liked core PCE as its favorite metric, because it was almost always below 2%! It was “convenient” that its “preferred” metric was never above 2%. Literally, from 2008 to 2020, it was almost never above 2%. Maybe I’m being a bit too cynical, but I think the Fed liked to point to this measure because it gave it the flexibility to be more dovish, rather than because it was so much more useful, relevant and accurate than other bits of inflation data we get.

If you can agree that other data might tell a good story and that this pedestal that Core PCE has been set upon doesn’t make sense, then maybe we should be cutting?

It isn’t like truflation core is “always” below PCE (which is why we put in the nice green oval), but it is certainly much lower now! And the rate of decline (inflation) actually makes more sense to me than the PCE numbers. The large price shocks are behind us in the real world, but unfortunately they are still appearing in the data world that the “old Fed” looked at. I am pretty sure I still have a 12C lying around (anyone on Wall Street from the last century knows how ubiquitous they were on trading desks), but I cannot remember the last time I thought about using it!

Warsh was basically put in charge to cut. He will deal with the hand he has been dealt (the renewed conflict in Iran isn’t helping), but his bias is to cut, not hike.

While it is unclear where we stand in Iran at the moment, it seems like we are on the verge of getting some sort of agreement between Oman and Iran to re-open the strait in some capacity. It seems as though they are negotiating something that will be agreed to by the U.S.? It all seems a bit weird, and goes against the military successes, but it seems to be headed in that direction. If the Strait is opened and the U.S. encourages Iranian oil sales (like we did at the start of the memorandum of understanding) then Warsh’s job of steering the Fed to a cut gets a lot easier (and the hawks may have to change their tune rapidly).

Bottom Line

The long end of the yield curve is likely to remain under some pressure as the global supply of sovereign and corporate debt continues to soar.

The front end will start pricing out fewer hikes. It’s probably far too early to price in cuts, but the hiking story is crowded, and I think wrong. It will require more people to break years of tradition and base decisions on the same set of data, regardless of being aware of the inherent flaws in the data!

Credit spreads should do well, though I like the AI and data center plays even more on an all-in yield basis than just the spread. It is cheap and positioning has corrected itself to where the move to tighter spreads and lower yields seems to be the more likely path.

(GPZ) is an ETF I own that should do well if I’m correct on many of my credit and rate views as it is correlated to private credit.