12/14/23 09:25 AM EST

The Fed's "Broken Landing Gear"

Below is a chart and brief excerpt from today’s Market Situation Report written by Tier 1 Alpha. If you’re interested in learning more about the Hedgeye-Tier 1 Alpha partnership, there’s more information here.

We are living in the twilight zone. Let’s take a moment to think this through because the Fed is trying to afford themselves maximum optionality. After Chair Powell acknowledged the Fed will entertain cuts next year, Jim Cramer called it a “celebration for the bulls.” The 2-year treasury yield celebrated by dropping 9% in 24 hours. We’ve touted being long of the short end in size, so it doesn’t break our hearts, but it gives an unambiguous message.

This will come as a surprise to some, but rate cuts are not necessarily a good sign. Since the Fed refuses to offer a clear framework for rate cuts, we must assume the fire department/the Fed will only be coming to our house when we have a fire, AKA a recession. House fires can be contained in the basement, but sometimes they burn down the whole house. Let us explain.

Envision a scenario where U.S. economic expansion eases toward stagnation, narrowly sidestepping an outright recession, with joblessness capping at 4%. Picture core PCE inflation, now ticking at an annual 3.5%, easing into the headline rate at 3%. As economic vitality stirs anew, what unfolds? A sticky services inflation at 3% could signal that as a floor, not the soaring heights of the 70s, yet a noticeable distance from subdued inflation.

It's a concerning picture, suggesting the Federal Reserve may need to return to the fray, risking a harsh economic downturn and increased joblessness.

Now, ponder a different trajectory. Suppose higher for longer in 2024 triggers a sharp recession, spiking unemployment to 7%. We'd likely see a dive in commodities and broader pricing pressures due to weakened demand, potentially slicing inflation below 2%. The Fed's response? Aggressive cuts – surpassing the anticipated 125 basis points – though stopping short of zero. Once the economy regains momentum, it will be from a low inflationary baseline, alleviating inflation concerns but at a steep human cost.

Neither scenario is appealing. The latter may spare the Fed from reentering the fray, but it's precisely the disaster they aim to sidestep going into an election.

The Fed's September unemployment predictions have already proven too conservative. A spike to 4.5% next year might not just hint at a recession but guarantee it. Even in the most mild recession we could anticipate unemployment climbing to at least 6%.

The upshot: The "just-right" scenario seems improbable. Even a gentle landing is improbable, and broken landing gear very probable, given the risk of overheating with current inflation and employment figures. We try to be accurate and politically agnostic, but ladies and gentlemen, we give you your central planners.

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