At turning points, I like to compare GDI to GDP. GDP has trade, inventories and large revisions. GDI is income.

If GDI is falling relative to GDP, bad things tend to happen. This is pre-COVID. This is post COVID.

GDI printed 5.34% nominal in Q2.
Tax Receipts are 7% YoY.
Redbook sales are 6.6% YoY now.

My base case is people are really struggling to digest the collapse in supply side potential for the economy and it's a strange adjustment.

I have been heavily focused on the impacts financial conditions have on the economy since mid 2022.

I identified The Loop pattern that has transpired and routinely exploited it in my trading. I described The Loop last year in a detailed note.

https://x.com/DannyDayan5/status/1805254002814132259

The dynamics have changed this year. We have policies that are creating impulses on growth and inflation in opposite directions. We have also seen the correlations between assets change regularly.

It is time to refresh the financial conditions framework.

Financial conditions are extremely loose. Equities are back to the highs, the dollar is weakened substantially, yields are off their highs and credit spreads are very tight.

Let's recap why this is important. March 2023, the Fed hiked to 5%. The market priced year end 2023 at 3.5%.

July 2023, the Fed hiked to 5.5%. The market priced year end 2024 at 4.1%.

December 2023, Fed held at 5.5%. The market priced year end 2024 at 3.7%.

The Fed had two pathways after 2021:

1) Volcker, by nuking the economy and causing a recession to remove inflationary pressures.

2) Soft Landing. This involves hiking to "restrictive" levels, sitting there for disinflation and then gradually removing restraint. It's a hard choice to willingly cause unemployment, so I don't blame them for choosing #2. The consequence with soft landing is they didn't get restrictive enough, ignored easing FCI for a material amount of time, which allowed inflation to persist at levels above the target.

My rough read on things:

Uncertainty remains high in the PMIs, but expected output yr ahead higher. New admin, very new policies has made uncertainty very high, but not in a way that they want to divest from their business. They just want clarity and will wait for it. Germany/China stimmies are material developments.

Market is interpreting this as end to US exceptionalism. To me, it's more like: End of US being only good economy. Stronger global economy doesn't hurt US, it helps it. FX moves reflect this but also calling bluff on tariffs.

There is a lot of confusion over the rise in rates of late.

As someone who wrote to clients ahead of the September FOMC's first cut "I am uncomfortably short SOFR Z5 and 10y going into the meeting", which I rode for 110 and 80 bps respectively, let me try and explain. Since the 50 bps cut, the 10y rate is 80 bps higher.

We can break that down to real yields + breakeven inflation.

The former is up 50 bps, while the latter is up 30 bps.
How do we make sense of these moves?

Supply shocks are temporary forces on inflation. We have had massive volatility in supply, from the negative supply shocks once the economy re-opened, to a recovery as supply chains adapted, to sharp positive supply shocks in labor and productivity Sticky inflation is ultimately a function of demand. Real private sales remain quite strong at 2.9% in Q2 and are tracking very strong in Q3.

Remember when we looked at supercore as a proxy for this? We just passed the low seasonal period, and it remains sticky at 4.5%

The challenge to assessing how far the Fed should cut rates is that it requires a firm conclusion on R*. I researched this in May and estimated that R* is much higher than the prior cycle.

https://x.com/DannyDayan5/status/1795469428710105150

However, since the Fed has not come to such a conclusion on R*, we need to look at this another way. A simple way is to look at how effective monetary policy has been in achieving its objectives thus far that puts them in a place to cut rates.

The 1990s have an incredible amount of parallels and lessons for today. In both 1995 and 1998, the Fed did 75-100 bps of adjustment cuts. There were notable differences in the economy and labor markets at the time, so it is instructive to look at the responses to these cuts. Notably, the starting point for the unemployment rate was quite different between the two periods. Cutting in 1995 was reasonable due to some labor market slack, and as such, there were no material negative consequences.

When people are hyperventilating about the chance of a U.S. recession, I tend to do international comparisons.

Sweden is an economy far more vulnerable to higher rates. Household debt to income is very elevated and mortgages reset every 6 months, for fast pass thru of policy Like the rest of the world, it had a surge in inflation that peaked at 12% in late 2022.

As a result, policy rates were jacked up by 400 bps in a year, and they've now cut them by 50 bps.

Last week was about fading extremes. This week I am mostly content to sit on my hands and wait for the next extreme. I'll briefly explain. My detailed work tells me that the unemployment rate is overstating the softness in labor market. There is some softness, and I think the Fed will put a floor underneath that quickly. This leaves me thinking bonds are rich and too many cuts priced. But to fade, we need next NFP

NFP caused quite the scare. It forced me to both change my big picture macro views, but also to investigate the vary strange dynamics in the labor market. I sent the below to clients Sunday evening, and I will make it public for now.

dannydayan.substack.com/p/the-state-of… There is clear slowing that wasn't apparent earlier in year, and though June activity data improved, NFP did not bounce as in other FCI episodes.

UR has gone up for 5 months. Headline growth and private sector jobs have slowed. Job openings as well. Healthy levels but slowing.

Most people expect the Fed to tee up a September cut this week. It would be ideal if good journalists like @steveliesman or @NickTimiraos ask Chair Powell what economic objectives they are actually trying to achieve?

Thread. Since taking policy rates above 5%, nominal GDP has consistently averaged 5.85% for 5 quarters (almost 2% above potential). Final demand has been strong throughout.

Is the goal thus 7%? Higher? How does growth pick up from here without excess demand leading to inflation?

The data is softening more than I expected, so this naturally causes an update to views. I would note that softening is not recessionary, but this is what the Fed wanted to see and they are seeing it. They will need 2-3 more months of confirmation to cut, which seems likely. Where I come out is this is more complicated than people appreciate. Cutting at 5% UR and CPI 2% or below would be easy as there would be a lot of slack in the economy and they would be able to do a full cutting cycle to wherever neutral is.

"The Loop" is a deep dive note into financial conditions and the role they are playing in either reinforcing or undermining monetary policy.

The economy has become financialized, especially since the GFC when the QE era began, with household wealth rising to almost 6x GDP. In the last 18 months, we have often had very large market movements without an economic catalyst, due to Fed speeches, dot plots and general obsession over rate cuts. These market movements have thus driven marginal change in the economy and often undermined policy makers.

There's two plausible eco scenarios right now.
1) Soft patch due to liquidity drain, tax payments.
2) Growth slowdown

In #1 stocks are fine, bonds are offsides.
In #2 bonds are reasonably priced, cuts will come but later. Stocks way offsides. I am leaning #1 but the data will need to reverse to prove me right.

I am increasingly seeing consumers/corps complain about inflation, not high interest payments. As inflation fell last year, nominal GDP was static, but real GDP surged. That feels amazing!

If the Feb inflation prints are strong, coupled with strong growth, I expect the market to price hikes as much as ~50% probability, even if delivery of them is still lower likelihood than that.

Base effect for CPI get really easy to beat after February. More importantly, March FOMC will test Fed credibility.
They will have to either raise neutral rate substantially, or at least mention they are studying it. They would need to remove rate cuts in aggregate from pricing to tighten conditions.

This is my 1970's roadmap. The Burns mistake was cutting Fed Funds below inflation prematurely, and we can see the Volcker solution on the right. The Fed thinks they are following Volcker by cutting alongside the falling inflation level.

BUT... Their mistake is ignoring this key lesson. Inflation falling without economic weakness, namely job losses or credit events, simply leads to economic re-acceleration. This is exactly why I expected the economy to reaccelerate in 2023. The Fed has seemingly missed this.

The market is boxing the Fed into a corner.

They wanted to indicate adjustment cuts based on a real rate framework. This means if they cut less than priced, it won’t loosen conditions.

If the economy reaccelerates, they are unable to tighten conditions credibly. If a mild slowdown ensues, the only way to loosen conditions is to cut more than priced which risks major inflation revival. Imagine they cut but less than priced; in this scenario conditions may actually tighten from stocks, credit. They’d be forced to cut more than they want.

As a result of the dovish pivot, there are a very wide range of outcomes for 2024. Not all of these are realistic, each should be probability weighted. Please let me know which scenario you see most likely and why, and I will then let you know my view 1) Nirvana. Inflation is solved. Cuts stimulate economy and we settle at 2% real GDP. Stocks rally all year, and experience no real drawdown. Bonds rally as they cut, then move sideways for a long time. Dollar weakens, commods rally. Investors sing Koombaya all year long.

Macro is a puzzle. It's always important to respond to new information that could change your view.

I had strong conviction that we would see re-accelerating growth this year, but I expected it to also reignite inflationary pressures. Recent data has been encouraging in that we have had really strong growth and it has been led by the supply side of the economy (labor force, capex, and productivity).