Only One More Fed Rate Increase Likely

We are forecasting a maximum of one more Fed rate increase despite the fact that Fed Funds futures have over 3 increases priced in. It is important to note that futures prices are not empirically an accurate predictor of future cash prices. More importantly, the hawkish Fed only has one more hike implicit in the dot plot. The 10-year treasury is also currently only pricing one more hike in as it normally trades at 100bp over the terminal rate, which implies a 4% Fed Funds rate and one more hike.

The last rate increase was clearly politically motivated and was completely unjustified by any data with CPI core plunging .5% over the last 4 months with a four-month annualized rate of only 1.8%. PCE core is heavily distorted by the miscalculated software and portfolio management components with both tracking over 20% despite market prices being down.  PCE core normally is 40bp below CPI core, implying it is dislocated due to miscalculation by 1.4%. We forecast that CPI core will approach 2% by year end as the delayed shelter component starts to reflect market rents.  Moreover, excluding energy related airline fares inflation and marking shelter to market results in only a 1% CPI core inflation rate. We also forecast that the housing industry will enter into a deep recession which will impact employment over time.

With a maximum of one more rate hike likely, we remain bullish on both stocks and bonds.  A multiple of 20x earnings is consistent with a treasury rate in the 4.75-5.0% level resulting in an 8,300 S&P target. We are also bullish on bonds, as the inflation data as measured by CPI core will continue to improve as shelter reflects market prices and as other volatile components such as airline fares and lodging normalize. In addition, the labor market is likely to soften as the housing market enters a deep recession. We expect the Fed to be forced to cut rates 3-4x over the next 18 months due to steadily moderating inflation and declining employment.

We expect oil to trade in the $80-100 range as long as the Yanbu pipeline remains open.  We expect a steady decline in the global oil price over the next year as the world economy adjusts to the new political situation in the Middle East. Declining oil prices will be a tailwind for declining inflation and force a hawkish Fed to cut.