Looming Mistakes

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PPI: Too Late but Not Too Little

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Soundbite: The July PPI report contained a significant increase in headline core inflation, but the details were even more troubling for future monetary policy. Trade Services PPI jumped 2% in one month, to a 6.9% annual rate, suggesting firms were able to pass through tariff increases. This jump is a precursor to wholesale price inflation, which will lead to consumer price inflation, but that may not happen fast enough before the next Fed meeting to prevent what could prove to be a mistaken rate cut.

We can infer from the July PPI data that companies were comfortable paying higher prices for goods that were placed into inventories for sale to consumers. It can be argued that this increase in margins was driven by high-ticket items and may not affect lower-income consumers’ inflation expectations, but we will need more data to be certain.

Because of the need for further clarification from future inflation reports, the Fed should stay on hold.

However, the fact that traders have priced in a September cut in addition to pressure from the administration makes it unlikely that rates remain on hold on September 17. We expect the Fed will cut rates unless the PCE report at the end of the month is shockingly higher, either in Governor Waller’s favored market-based core PCE (which just hit a one-year high in June), or in the percentage of items that are inflating by more than 5% (already at a high level of 30%). Alternatively, the unemployment rate would have to spike from 4.2% to 4.4% in the September 5 August payroll report, or the August CPI on September 11 surges by as much as July PPI to turn the momentum away from a 25-basis point cut.

The Fed is in danger of making a policy mistake because there may not be enough evidence before the September meeting to have sufficient visibility on the impact of tariffs. Given the current trend, we agree with Goldman Sachs that consumers could bear up to 70% of the entire tariff increase. If correct, the rise in consumer inflation could spill into higher inflation expectations, eventually weighing on stocks, either through fears of far fewer rate cuts or by a marked slowing in consumer spending.

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Crypto Demand Shift: Trading Mechanics

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Soundbite: President Trump’s announcement that the $12 trillion in 401 (k) accounts are no longer restricted from buying crypto put gasoline on this year’s speculative fire. Ethereum rose almost 30% this month, approaching its 2021 highs before pulling back late last week. The rally is explained by these new potential buyers shifting the entire demand curve for crypto higher. However, in the short term, we may have entered a dynamic where higher prices are simply feeding further increases in demand. Under normal trading conditions, water seeks its own level and generates an equilibrium condition, but when taken to an extreme, that is when you drown.

Because we fear investors are beginning to forget about the fundamentals of markets, it is time to go over basic market rules. Prices move up because there is higher volume at the current price than the amount offered by willing sellers. Prices continue to move higher until they reach a level where there are enough sellers to satisfy that demand. Typically, prices extend beyond equilibrium levels, motivating buyers to take partial profits by closing long positions, and short sellers perceive value and begin to open new short positions. It is at that time that sellers become the dominant volume factor, and a selloff ensues. 

In the current hyper-speculative environment, as buyers chase prices higher, sellers back off and continually raise their offers. That can put recent buyers in danger because they have entered at very high prices compared to the previous equilibrium price. In the case of Ethereum, the price with the highest acceptance in July, before the 401 (k) announcement, was $3,725. Any break below that support would be problematic for longer-term bulls.

The expectation of an upward shift in the demand curve is rational, as new buyers are entering this market, because if 10% of the 401 (k) market buys a 3% crypto position, that is an additional $360 billion in buying power. The question is whether buyers at today’s price are being rational. Before the announcement, we wrote on August 4:

“Watch cryptos and especially follow Ethereum, which has been the focus of recent speculative flows. Use $3400 as a sentiment barometer…if it keeps a bid above that price, it is a signal of optimism that could help the major equity indices bounce.”

It is no surprise to us that on the day of the August 7 announcement, price accelerated above $3,725 and never looked back, in search of a new equilibrium level. There was a jump to a higher range last week, so a move below the prior week’s $3900 level would be a sign that last week’s buyers were overly exuberant. Shorter term traders would turn to sellers below $4175 versus last Friday’s $4425 close. Corresponding levels in the S&P 500 Index are 6440, 6415 in the near term, and a break of major support at 6200 would constitute a trend reversal. The Index closed at 6450 on Friday.

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DOGEing the Fed Balance Sheet

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Soundbite: President Trump’s expanding the list of potential Fed Chair candidates has unleashed the financial equivalent of Pamplona’s Running of the Bulls. There has been discussion about shrinking the Fed balance sheet even further than its 25% drop since the Q2 2022 peak to allow for a series of rate cuts. Doing so could hamstring policymakers by removing their ability to be a lender of last resort if a liquidity crisis arises. This would be a classic case of “be careful what you wish for” on the part of the administration.

The world changed in a lot of ways during the 2008 financial crisis, and Fed policy was one of them. The extreme liquidity situation sparked a move by the Fed to begin paying interest on reserves that the bank had on deposit with the central bank. That severed the impact the size of the Fed balance sheet had on the economy and credit creation. Credit growth was now a function of its price, not the size of reserves.

The dynamic is as follows: when the Fed engages in Quantitative Tightening, it reduces its balance sheet by selling its Treasuries and Mortgage-Backed Securities, and investors buy those bonds, taking deposits out of the banking system. Banks are left with fewer deposits and fewer reserves at the Fed. That reduction of reserves sitting at the Fed does not constrict lending activity. For that to happen, the Fed would need to raise rates on reserves that the banks keep at the Fed, attracting bank capital out of the system and into the Fed. As former NY Fed Governor Bill Dudley explains it, that interest rate sets a floor for all short rates, and longer-term yields are priced off investors’ forecast for short-term rates over the next two years.

Suppose the Fed were to continue to cut its balance sheet much further from here as some Fed Chair candidates have proposed. In that case, it risks a repeat of the 2019 liquidity crisis when the pool of reserves from the Fed dropped below the minimum level banks needed to satisfy customer transactions. The result was that short rates spiked higher. If that were to happen again, the central bank would have to inject reserves, thereby increasing its balance sheet, the opposite of what was intended. Instead of leading to higher investor confidence and a pathway to lower longer-term rates, the stampede to capture the top slot at the Fed has led to faulty logic that could lead to negative unintended consequences.

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What to Look for This Week

(All times E.S.T.)

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1. Wednesday, August 20, at 2:00 p.m. FOMC Minutes from the July 29-30 meeting are released. We know that Governors Waller and Bowman dissented, preferring to cut 25 basis points at that meeting, rather than the consensus unchanged rate decision. We will look for how often the word “couple” appears in relation to dovish language. If there are infrequent references to “couple” associated with comments on weak growth/capped inflation would mean that there is a more significant contingent of FOMC members who are leaning similarly to Waller and Bowman, increasing the chances of a September cut at the September 16-17 meeting.

2. Tuesday August 19 at 8:30 a.m., July Housing Permits. May and June were very weak, hitting levels not seen since the pandemic. Despite this, housing stocks have reversed their strong underperformance from September until mid-June when these weak housing numbers first came out. A third weak number could see housing stocks pull back. Existing home sales also come out this week, on Thursday August 21 at 10:00 a.m.

3. Thursday August 21 at 8:30 a.m. Initial Jobless Claims and Continuing Claims. The 4-week moving average of Initial Claims had fallen for 6 weeks before basing and ticking up last week. Continuing Claims moved back toward its multi-week highs in the first two weeks of August. There is one employment number out before the next Fed meeting, and they will also consider claims heavily due to the payroll distortions.

FOMC Voters Speaking: Big event is Jackson Hole and Jerome Powell kicks it off on Friday August 22 at 10:00 a.m. with his Economic Outlook and Framework Review. The two FOMC dissenters also are featured this week at a Blockchain Symposium: Governor Bowman on Tuesday August 19 at 2:10 p.m. and Governor Waller on Wednesday August 20 at 11:00 a.m.

Earnings: Focus on Consumer. Home Depot reports before market open on Tuesday August 19, we will look for any view on increased cost of goods sold and any insight on passing through costs as well as further insight into consumer sentiment. We will compare HD to Lowe’s, which reports before market open on Wednesday August 19, as well as Target. Walmart reports before market open on Thursday August 20.

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