Weekly Monologue
Economists and market watchers everywhere celebrated the first major official data release in almost a month. Friday saw the release of the September Consumer Price Index (CPI), which had been surveyed but not compiled when the government shut down on October 1.
If the release was exciting, the numbers themselves were not. Headline inflation rose to 3.0% YoY, but was a hair below the consensus expectation. Markets have now converged on a consensus of 50 basis points of further easing by year-end, starting with 25 basis points at this week's meeting.
While I remain skeptical that so much easing is needed, it's now hard to see the Fed diverging from that view. Granted, there is a lot of data before that December 10 meeting. But it would take substantial upside surprises on both inflation and employment to knock them off course now.
The Macro Monitor digs a little deeper into the inflation numbers, because it wasn't an immaculate print. The two price categories I'm most concerned about – durable goods and food – are establishing a durable upward trend after spending most of the past 18 months deflating. I can only hope the Fed flags this in Wednesday's press conference, but I'm not betting on it.
We trace out the consequences of the Fed cutting too far in this week's Memo. This easing cycle with inflation above target is happening against a backdrop of already easy financial conditions. It's not at all clear that the economy needs monetary easing, and the Fed risks creating an inflation problem at the same time that forces outside of their control (tariffs, immigration policy) continue to slow economic growth.
We're nearly ready to publish our Q4 Scenario update. Needless to say, this stagflationary dynamic constitutes one of our three scenarios, and we will assign a meaningful tail-risk probability to this outcome.
Last week's monologue was mostly about what I perceived as a sentiment shift on equity markets and the AI theme, which I dismissed as having no fundamental backing. And indeed, we haven't heard much more about it this week. Gold is down and stocks are up.
We did get one major warning about systemic risk this week, and it should be taken seriously. Bank of England governor Andrew Bailey said in testimony to Parliament that "alarm bells" are ringing over private credit markets because of similarities to the opaque and multi-layered products that transformed the 2008 housing bust into a deep financial crisis. The BoE is leading major global regulators in terms of attempting to properly understand how private markets plug into the rest of the financial system and monitoring risks and leverage.
As I've written before, more blowups from the 2020-2025 credit cycle are inevitable, but the structure of private funds is better at limiting contagion.
The more important question is what happens if allocations to private credit funds continue to sag, as Blackstone President Jonathan Gray said would be the case. Well, Gray himself has the answer: private equity is looking more appealing for institutional investors: “Directionally healthier markets, more liquid markets, better credit markets, better IPO markets; that’s healthier for realizations."
Starting this week, we're adding a new regular section to the weekly monologue: My Reads of the Week. In it, I'll highlight longer reads on macro, markets, and related issues that I found enlightening.
Reads of the Week
- Who Pays for Tariffs Along the Supply Chain? Evidence from European Wine Tariffs: A very smart research paper that uses the wine industry to understand how tariffs affect margins along the value chain. Conclusions: importers get hurt, but retailers can actually benefit.
- Is Japan private equity’s next frontier? : An outdated headline, but a great piece. I'm a big believer in the role that PE can play in supporting domestically focused mid-market Japanese firms and in financing the much-needed reorganization of bloated corporate structures.
- Investing in Everything Everywhere, All at Once: My old colleagues in Goldman Sachs' Global Investment Research are brilliant as always, this time taking a clear-eyed view of global portfolio dynamics and spotting ways to improve risk/return balance.
Market Monitor
A reversal in two of the key commodity themes that have been playing out this year was the most interesting dynamic at play this week.
Gold prices ended the week down -3.7%, having endured a -6% tumble on Tuesday (the largest one-day drop since 2013). As physical retail and ETF demand rises, institutional investors have taken profits. Pictures of lineups outside gold brokers smack of a market top.
Meanwhile, oil prices rose sharply (WTI crude up +5.2%) as the Trump administration imposed harsher sanctions on Russian exports, prompting Indian and Chinese refiners to halt buying (at least for now).
In neither case has the big picture changed—the fundamental drivers behind the gold rally remain in place and the yellow metal has appreciated by +57.3% this year. Crude oil remains oversupplied and its price has fallen by around 10 dollars per barrel over the same period. Still, both moves have shown that we were probably stretching the respective narratives, and we may be in for sideways moves or partial corrections into year-end.
Elsewhere, stocks rallied on Friday after CPI data all but locked in further Fed easing. The S&P 500 closed the week up +2.5%, the Nasdaq up +2.8% and the Russell 2000 small-cap index up +1.9%. Corporate spreads narrowed, and the only corner of the market not participating in the bullish action (aside from gold) was sovereign fixed income, where yields on US, European, and Chinese 10-year rates all rose between +3 and +10 basis points.
Macro Monitor
The key U.S. and global data and events this past week:
- CPI (United States): +3.0% YoY (previous: +2.9%; consensus: +3.1%)
- CPI ex. food and energy ("core"): +3.0% YoY (previous: +3.1%; consensus: +3.1%)
For the first time in a long time, we got some official data regarding the Fed's dual mandate. The bottom line is that prices rose a little less than expected in September, and the labor market has been broadly stable.
The inflation print was good in that it did not provide any reason for the Fed to deviate from the easing path that Chairman Powell has been communicating since September.
But it was not a perfect print. The two sectors I'm most worried about in relation to tariff pass-through and immigration restrictions -- food and core durable goods prices -- both picked up and are becoming meaningful contributors to price growth (see charts below).
On the labor market front, despite the pause in nationwide statistics, we're still getting state-level unemployment claims data. Although these have a slight lag and need to be aggregated, they're an excellent labor market indicator even when we have all the usual data. As expected, we're seeing a big surge of claims from furloughed federal government employees. But if these are stripped out, claims look essentially flat through September and the first half of October. If we were seeing a broader surge, we would have to be considering a 50-point Fed cut this week, but that's not the case.
Another data point that caught my eye this week was the Chicago Fed's Survey of Economic Conditions, which saw a big swing from -14 to +15. That implies robust above-trend growth and is the strongest print since 2022. Take that with a pinch of salt; it's a regional index, and it can be volatile. Still, it's an interesting and somewhat contrary indication.
What we'll be watching next week
- Argentina parliamentary elections. Argentines will elect a new parliament this weekend, with polling indicating that President Milei will receive a blow that could derail his austerity agenda. Global investors have been betting heavily on a debasement of the Argentine Peso, U.S. Treasury Secretary Scott Bessent's $20bn swap lifeline notwithstanding. This makes these elections a U.S. domestic issue, and the Trump administration will need to evaluate the optics of providing further financial support while its own government is shut down.
- FOMC interest rate decision (Wednesday): A 25-basis point cut looks like a slam dunk, so the focus will be on forward guidance in the statement and press conference.
- Global central bank decisions: The Bank of Canada (Wednesday), Bank of Japan (Wednesday), and European Central Bank (Thursday) will also announce policy rate decisions this week.
Memo: The U.S. Financial System is not Asking for Lower Interest Rates
Bottom line: The Fed is set to cut rates against a backdrop of easy (not restrictive) financial conditions. At best, they're setting themselves up for a complex communication challenge. At worst, they may be sowing the seeds for a period of stagflation
This week's benign CPI and labor market data have given futures markets enough comfort not only to lock in a further 50-basis points of easing this year, but also to raise the odds of another 25 basis points by the end of January above 50%.
This is entirely logical within the context of Fed Chair Jay Powell's comments since the September Jackson Hole Conference, but there is a niggling inconsistency at the heart of the interest rate outlook that we're finding difficult to shake.
Powell has described the Fed's easing path as moving from "mildly restrictive" to a more neutral stance. He means something particular and technical when he uses this language. Specifically, that the current Fed Funds Rate is above the Fed's internal estimates of the "neutral" rate ("r-star") that would be consistent with long-term 2% inflation and full employment.
Hence, their stance is "restrictive."
R-star is a famously slippery concept. It's a theoretical construct that's not directly observable, and attempts to estimate it quickly run into serious statistical issues. But we can sense-check Powell's logic quite easily by looking at the world around us. What we see is plenty of evidence that financial conditions writ large are actually quite loose.
Our proprietary Financial Factor is more than a standard deviation above the long-run mean, signaling that financing is easy to access by historical standards.
A big part of this is down to the equity market, which is up around 15% this year. Elevated valuations are encouraging a rebound in IPOs and secondary financing in public markets, as well as improving collateral for other financing mechanisms. Torsten Slok this week pointed out an interesting manifestation of how equity markets can drive financial conditions: because major tech firms are internally financing AI-related investments, data center outlays are linked to stock prices, not interest rates (at least not directly).
Looking at other parts of the financial system, we see similar signals. Credit spreads are almost as tight as they were during the 2020-2022 financing bonanza. That's true in publicly traded corporate credit and in leveraged loans. Additionally, the U.S. dollar has depreciated by 8.8% this year, providing another boost to financing conditions.
The upshot is that, contrary to what r-star analysis says, further cuts to the Federal Funds Rate will amplify already easy financial conditions by reducing absolute interest rates on lending, raising equity prices via the discount rate, and further making dollar-denominated assets even less appealing to foreign buyers.
Unless we're in a much more rapid deterioration in economic activity than current labor market and real indicators suggest, the Fed may be creating a big problem for itself. At best, this will mean a tricky communication problem around the January meeting when a pause will be necessary, contrary to market pricing.
At worst, they are underestimating R-Star and inflating segments of the economy even as activity growth gradually slows, setting up a stagflationary scenario for 2026.