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Arch Indices Weekly Thoughts: December 18, 2023

Recapping our current income portfolios: 

DFMAP (Dividend Focused Multi-Asset Portfolio) 
TAC (Treasuries Across the Curve)
VWI (Volatility Weighted Income)

Please reach out if you would like to learn more about them.

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This Fed pivot was surprising given recent speeches and the Timiraos preview last Sunday. We were certainly not expecting this and are left asking “Did the Fed get Spooked?”

Let’s review December:

12/1 Powell Speech: “It would be premature to .. speculate when policy might ease”

12/8 Nonfarm Payrolls: 199k jobs added and unemployment decreases to 3.7%

12/10 Timiraos FOMC Preview: Highlights debate shifting to cutting nominal rate to keep real rate from increasing, no signs inflation is stalling at 3%, and rent weakness could drive PCE to 2.1% by end of 24  

12/12 CPI: Core CPI increased 4.0% y/y and remains sticky

12/13 FOMC Press Conference: Rate cuts are something that “begins to come into view” and “clearly a topic of discussion”

12/15 Williams on CNBC: We aren’t really talking about rate cuts right now

Given the strong payroll report and stubborn CPI data along with the Fed having little faith in their models the last few years and fearful of having to re-hike, wouldn’t it have made sense to wait on a pivot? Or is there some reason the Fed suddenly gained confidence in inflation decreasing?

The Fed alluded to this with the comments on rent weakness driving inflation down in the Timiraos preview. The Fed seems to fully subscribe to shelter inflation coming down. This is largely driven by increases in multi-family supply (construction has been strong) and the technical calculation of owner’s equivalent rent and lag effects on rent calculations. Housing makes up ~18% of core PCE and ~42% of CPI. This is a technical difference: PCE includes costs not borne by the consumer, mainly medical costs, while CPI does not. This article from the WSJ provides a good background read: LINK

We think what is happening in Commercial Real Estate and the potential impact on the banking sector may have driven the pivot. There have been numerous reports of CRE financing issues becoming widespread as highlighted in a Muddy Water’s report on BXMT (a REIT that finances CRE loans) and our research from a month ago (LINK). It is quite likely the bank examiners are highlighting the solvency issue of banks with the securities portfolio underwater and CRE loan write-downs coming. Rate cuts would fix both issues if lower inflation allows for it.

However, rate cuts won't fix the underlying supply/demand imbalance of the housing market. 

With this in mind, choosing to cut rates earlier would be the easier fix relative to the Treasury recapitalizing banks and a big monetary easing program in a hard landing. While the market is fully on board with the soft landing scenario, a spooked Fed would imply there are a lot of potential headwinds ahead.

As always your thoughts and feedback are very much appreciated!


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