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All About The Fed, The Economy & Inflation
In a scant three months, FOMC members moved from a unanimous hold to a unanimous hike, raising the federal funds rate by 25bps and suggesting more of the same to come. President Trump, preferring rates be slashed, blamed everyone on the FOMC except Fed Chair Kevin Warsh. Today, Ed and Elias examine what motivated the September decision and Warsh’s role in it. He had argued all summer that conditions were ripe for a rate hike: The economy was resilient, with a full-employment labor market and financial conditions not restrictive, while inflation was a problem. By September, the Committee at large concurred. … We expect one or two more rate hikes this year. … Also: Dr Ed reviews “The Whisper Man” (+).
ECONOMIC WEEK AHEAD: September 21 - 25
The Federal Reserve raised the federal funds rate (FFR) by 25bps on Wednesday, lifting the target range to 3.75%-4.00%. The vote was unanimous. Fed Chair Kevin Warsh cited stronger growth, insufficient progress on inflation, and rising geopolitical risk as reasons for the move. The Fed's updated projections show inflation not returning fully to target until 2029, while growth and employment forecasts improved. Global bond yields eased a bit. President Trump hosts Chinese President Xi Jinping in Washington this week, with markets watching for progress on the export-control truce, the countries' new trade and investment boards, and the long-delayed Taiwan arms package. Attention also turns to Fedspeak, with nine officials set to hit the tape. Goolsbee, Williams, Jefferson, Barkin, Barr, Hammack, Paulson, Bowman, and Schmid are all on the calendar. It's a light week for economic data. Unemployment claims (Thu) and regional business surveys from Richmond (Tue) and Kansas City (Thu) round out the domestic calendar. Flash PMIs (Wed) will offer an early read on September activity, both domestically and overseas. Overseas, the Swiss National Bank meets Thursday. Here's more: (1) FedSpeak. Fed funds futures now imply 3.1 rate increases over the next 12 months and 1.8 over the next six (chart). The odds of an October hike stand at roughly 58%, against 42% for a hold. The odds of hikes at both the October and December meetings are at 44%. With October hike odds still close to a coin flip, this week's remarks by the various talking Fed heads carry real weight for a potential revision of those numbers. Kansas City Fed President Jeffrey Schmid, speaking Friday, supported this week's hike, saying elevated inflation reflects more than just oil prices, with a broad range of goods and services also running hot. He described the labor market as balanced and growth as solid. He is not a voter on the FOMC this year. The 2-year Treasury yield climbed to 4.75% by Friday's close, up from 4.67% a day earlier, and remains well above the FFR (chart). (2) Unemployment Claims. Initial jobless claims (Thu), covering the week ended September 18, follow last week's 196,000 print, the lowest since July and a break from five straight weeks above the 200,000 mark. That reading came in below the four-week average of 203,200 (chart). Continuing claims eased to 1,730,000 for the week ended September 4, with the four-week average at 1,774,000 (chart). (3) Regional Business Surveys. The Federal Reserve banks of Richmond and Kansas City release their districts’ September business surveys this week. The regional M-PMI business activity index continues to track the national M-PMI, which eased to 54.6 in August from July's 55.6 (chart). (4) Flash PMIs. According to S&P Global's survey, August's final manufacturing PMI came in at 53.9, up from a flash reading of 53.2. Services eased to a final 56.5, down from its flash print of 56.8 (chart). September's flash PMIs (Wed) are expected to ease slightly from those levels. Global flash and final manufacturing readings tracked closely in August. Japan's flash reading led at 55.1, while France's lagged at 48.0 (chart). (5) Durable Goods Orders. August's new orders for durable goods (Fri) likely rose to yet another record high as a result of the AI capital spending boom. Most of the major durable goods industries are benefiting from the AI buildout (chart). (6) Global Interest Rates. The Swiss National Bank (Thu) is expected to hold its policy rate at 0.00% (chart).
US MARKET CALL: Investors Curbing Their Enthusiasm As Less FOMO Offsets More FEMO
I. Curbing Our Enthusiasm Last week on Tuesday, we pushed our 8,400 year-end target for the S&P 500 to mid-2027. Our new year-end target is 7,900. We remain confident in the resilience of both the economy and S&P 500 companies’ earnings per share (EPS). On the other hand, we think recent developments may weigh on their stocks’ valuation multiples for the rest of the year. The recent re-escalation of the war in the Middle East increases the chances of higher-for-longer oil prices and stickier inflation. As a result, the FOMC voted unanimously to hike the federal funds rate (FFR) last week, and the Committee seems set to tighten some more in the coming months. Bond yields remain on an uptrend worldwide. A growing backlash against the proliferation of AI is also weighing on valuation multiples. It is becoming a political issue during midterm congressional campaigns, and the election results are likely to exacerbate the partisan divide in the US. Then again, perhaps President Donald Trump will soon find a way to end the war, causing oil prices to drop. Perhaps China will convince Iran's IRGC to stop their Houthi friends in Yemen from disrupting shipping through the Red Sea. Perhaps bond yields will stop rising. Perhaps. In any event, our base-case scenario remains a continuation of our Roaring 2020s scenario, which has been underway for almost seven years. It posits that rapid, noninflationary economic growth will result from tech-led productivity growth. We give it 70% odds of continuing. So far, so good: Three more years to go. Nevertheless, we'll keep updating our worry list of unhappy scenarios, which currently has a subjective probability of 30%. For now, let's review the recent developments in the financial markets. II. Earnings Exuberance S&P 500 companies’ forward EPS rose to a record $404.84 last week (chart). The analysts' consensus 2027 EPS estimate is up to $419.93. We expect it to keep climbing to $425 by year-end, which would put forward EPS at $425 too. Multiplying that forward EPS target by a forward P/E of 18.6 yields our year-end target of 7,900. To get to 8,400 by year-end, the forward P/E would have to rise to 19.8. The current forward P/E is 18.9. The Q3-2026 earnings season starts in early October. Analysts project 23.7% y/y growth for Q3 and 28.2% for Q4 (chart). Both estimates continue to rise. Q2's 50.8% jump included huge mark-to-market capital gains; excluding those gains, EPS growth was about half that. Analysts’ estimates for the second half of the year carry no such distortion. Forward earnings rose to record highs for the S&P 500, S&P 400, and S&P 600 last week (chart). Fabulous earnings momentum (FEMO) isn't just a LargeCap story. III. Valuation Compression The S&P 500’s forward P/E is down to 18.9, with the Magnificent-7’s at 22.7, the S&P 400’s at 15.1, and the S&P 600’s at 14.3 (chart). As earnings have soared this year, forward P/Es have declined. FEMO has been partly offset by less FOMO (fear of missing out). While analysts have been increasingly exuberant about earnings, investors have been curbing their exuberance. Investors want a valuation discount for the known unknowns: How far will the Fed tighten from here? How long will the war last? How high will oil prices and bond yields go? What will the midterm elections deliver? Will the AI labs' push to slow frontier development slow the capital-spending boom driving earnings? By how much? The Fed's Stock Valuation Model (named as such by Dr. Ed in 1997) is working again (chart). The S&P 500 earnings yield and the 10-year Treasury bond yield are moving in tandem. Rising bond yields are depressing the forward P/E, which is the reciprocal of the forward earnings yield. Analysts' consensus long-term annual earnings growth (LTEG) expectation is up to 26.6%, as analysts have kept raising what they think their companies will earn over the next five years. That’s well above the 18.9 to which the S&P 500 forward P/E has fallen (chart). During the 1999 Tech Bubble, both LTEG and the forward P/E moved higher together and then fell together during the Tech Wreck. Their disconnect now shows that investors aren’t completely buying what analysts are selling. IV. Investor Sentiment Mixed The Investors Intelligence Bull/Bear Ratio eased to 2.88 last week, close to its 2.60 average, while the AAII ratio fell to 0.54, well below its 1.18 average (chart). Institutional bullishness has come off its summer extreme, and retail remains washed out, which is constructive on a contrarian read. V. Bond Yields On 5% Fence Following Wednesday's FOMC decision, the 2-year Treasury yield is at 4.67% and 12-month FFR futures is at 4.66% (chart). They both imply roughly two and a half more 25bps FFR hikes over the coming year. The 10-year Treasury yield is at 5.00%, the top of the 4.00%-5.00% "old normal" range that we have argued is the right one for this business cycle (chart). A sustained Fed tightening cycle could push yields into abnormal territory. The good news is that breakeven inflation rates dropped sharply after the Fed raised the FFR on Wednesday (chart).
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