Understanding the market | The US stock market has taken on the script of a "crazy bull"! How will the future play out?

Last week, NVIDIA released its earnings report, with better-than-expected performance and future outlook, causing NVIDIA's stock price to soar, boosting the Nasdaq 100 index by about 3% and erasing the previous week's decline. Fueled by the further push of the artificial intelligence trend, last week saw all three major U.S. stock indices hitting historic highs. However, judging from the positioning and implied trends in the options market, the extent of the surge may not be as surprising.

Nevertheless, the news last week that may have the most significant impact on long-term trends is perhaps the speech by Federal Reserve Governor Chris Waller, who outlined the issues investors should pay attention to in order to understand when and whether the Fed will cut interest rates in 2024.

Zhitong App learned that Waller delivered a speech on February 22, pointing out that economic data such as GDP, employment, and inflation in January were hotter than expected, reinforcing his view: "We need to verify that the progress in inflation seen in the second half of 2023 will continue, which means there is no rush to start cutting interest rates for monetary policy normalization."

The Fed may proceed cautiously with interest rate cuts, as Waller continued to state: "I still expect rate cuts to take place this year, but strong output and employment growth suggest that loose policy is not urgently needed."

He sharply pointed out: "Allow me to pause here for a moment. The FOMC usually only considers loose policy when there are clear signs that the economy may be entering or approaching a recession."

Data Shows Strong Economy

From the data perspective, the U.S. is clearly not heading towards or nearing a recession. The U.S. a year ago seemed closer to an economic downturn than it is now. With the economy picking up speed again in the second half of 2023, as of February 16, the Atlanta Fed's GDPNow model predicts a 2.9% growth in the first quarter.

Waller still expects rate cuts to happen later this year, but for now, the data indicates that the Fed can maintain great patience.

In his speech, Waller pointed out that in the next two weeks, we will receive several key data points that will tell him whether the economic conditions in January were just a fluke or if the slowdown in inflation progress achieved in the second half of 2023 is reversing.

Among them, the most crucial data point may be the PCE report to be released on February 29; Waller noted that the core PCE in January is estimated at 2.8%, lower than December's 2.9%. Analysts also expect the core PCE to increase by 0.4% month-on-month. Additionally, the overall PCE is expected to increase by 0.3% month-on-month and by 2.4% year-on-year.

Waller also mentioned the ISM Services and Manufacturing Purchasing Managers' Index, both of which improved in January. The February ISM Manufacturing report is expected to be released on March 1 (Friday), with analysts predicting further improvement from January. Analysts expect the February ISM Manufacturing Index to rise from 49.1 to 49.5, and the ISM Price Index to increase from 52.9 to 54.5. Waller also discussed wages, compensation, and the Atlanta Fed's wage tracker. However, the key point raised by Waller is the breakdown of inflation and how he views the inflation components in different categories. If the market-based inflation expectations are correct, based on market-based inflation swaps and expectations, Waller is likely to be dissatisfied with the inflation data for February, March, and possibly April.

Higher inflation rate pricing for inflation swaps

The pricing of inflation swaps shows a month-on-month increase of 0.43% in the CPI for February, which may round up to 0.4% or 0.5%. For March, the swap contracts suggest a 0.25% increase in CPI, rounded to 0.3%. In April, the swaps anticipate a month-on-month CPI decrease to 0.14%, rounded to 0.1% or 0.2%. In all these scenarios, the data between February and March does not meet the 2% inflation rate, indicating that the Fed may need to wait longer to confirm policy normalization.

The swap market expects a year-on-year inflation rate of 3.14% for February, 3.28% for March, and 3.04% for April. This means that inflation is expected to run above 3% since June 2023.

The one-year breakeven inflation expectation is rapidly rising and has returned to the levels before the Silicon Valley Bank incident in March 2023. Meanwhile, the two-year and three-year breakeven inflation expectations are also on the rise.

Reasons for rising inflation expectations

Part of the reason driving the increase in inflation expectations may be the rise in gasoline and freight costs. The average daily gasoline price in February increased by over 4% compared to January. At the same time, since the end of 2023, sea freight rates in Shanghai, China have surged by over 80% year-on-year, and long-term changes in sea freight rates often lead to an increase in the consumer price index.

Moreover, according to NFIB's calculations, small businesses have shown an intention to raise prices in the next three months. This index has been steadily increasing since hitting a bottom in April 2023, diverging from the year-on-year change in the CPI. This may be a sign of an upcoming increase in the CPI.

Additionally, if the ISM Manufacturing Paying Prices released this week meets expectations, it will continue the trend of accelerating price increases over the past few months, further confirming the intention of businesses to raise prices in the future as indicated by the NFIB survey.

Higher neutral interest rate

If we further extrapolate the implications of the speech, we will find that it begins to lay the groundwork for the possibility of no rate cuts in 2024. The data may not continue to support rate cuts, or the number of rate cuts may be fewer than the three times expected at the December FOMC meeting.

This implies that when the FOMC Economic Projections Summary for March is released, the expected number of rate cuts in 2024 may no longer be three, but fewer. If the market and survey data, along with the trend of sticky inflation, are correct, the likelihood of fewer rate cuts in 2024 seems significant. Of course, this leads to the next point of discussion: Are current policies tight enough? The longer the time period in which inflation exceeds the target and growth exceeds the trend, the more it can prove that the neutral interest rate in the economy is higher. Perhaps it is simply that the degree of policy tightening is not sufficient to achieve the goal.