The Uncertainty Bends™ Continue...

Although the first thought after a military strike is the classic “flight to safety”, I think the markets might view the US attack on Iranian nuclear sites as a one and done (assuming they were successful).

• We are the only country with the bombing capabilities to reach deep underground bunkers, so coming to the aid of one of our closest allies doesn’t feel like a commitment of troops.
• I believe every political leader’s primary obsession is to remain in power. If Iran attacks the US, it risks an overwhelming response that results in the loss of power.
• Attacks on US soil are likely limited to random acts of violence rather than a coordinated Iranian response. While tragic, not necessarily market moving.
• Iran has been substantially weakened over the last two weeks and I’m not sure it is even capable of a retaliation that would spook markets.
• Russia hasn’t been able to defeat Ukraine in three years and has also suffered considerable losses, so I don’t see Putin risking his own regime by committing resources to Iran

If I am right, then markets will instead turn its attention to the potential inflationary impact of disruptions to oil supply chains. I think fears around this could outweigh escalation fears with rates actually ending the week higher. With oil in the mid $70s, we do have some cushion before getting back to the peak two years ago at $90/barrel.

Good luck to the US servicepeople in the Middle East and the Israelis that seem more likely to bear the brunt of any retaliation.

 Last Week This Morning

• 10T: 4.38%
• 2T: 3.91%
• SOFR: 4.28%
• Term SOFR: 4.32%
• Retail Sales: -0.9% actual vs -0.6% expected
• FOMC Meeting: The Fed continued their wait-and-see approach with half of the Fed members projecting at least 2 cuts this year.
• Fed Commentary:
  • Fed Powell: “For the time being, we are well positioned to wait to learn more about the likely course of the economy before considering any adjustments to our policies.” 

FOMC Recap

Nothing to report – pretty boring meeting overall. Perhaps the biggest takeaway is the incredible disagreement between Committee members. Seven expect no cuts this year, while nine expect 2 cuts. San Francisco Fed Senior Researcher Andrew Foerster noted the extreme diversion of SEP projections for Fed Funds. 

Prior to the attacks over the weekend, the market had a 65% chance of a cut in September and similar odds that Fed Funds is below 4% at year end. I don’t think these change much this week.

On Friday morning, Federal Reserve Board of Governor member Christopher Waller threw his hat in the Fed Chair replacement ring by calling for a rate cut next month.

• “If you’re starting to worry about the downside risk [to the] labor market, move now, don’t wait,” he said. “Why do we want to wait until we actually see a crash before we start cutting rates? So I’m all in favor of saying maybe we should start thinking about cutting the policy rate at the next meeting, because we don’t want to wait till the job market tanks before we start cutting the policy rate.”

SF Fed President Daly, apparently disinterested in the position, later in the day said she preferred to wait until the fall.

• “Businesses are telling me that’s what they’re going to look to for some resolution to some of the uncertainty,” added Daly, who does not vote this year on the FOMC. “So I think unless we saw a faltering in the labor market that was meaningful, and we thought it would be persistent, then I would say the fall looks more appropriate to me.”

I agree with Waller, but I think Daly’s outcome is far more likely to materialize. With seven members seeing no cuts this year, I can’t see a scenario where they suddenly cut in four weeks. But I do still believe cuts are coming this year, in part because the impact of inflation could very well be less than feared.

New Century Advisors Chief Economist Claudia Sahm noted last week that, “the inflation data through May have been weaker than expected, with limited signs of a tariff pass-through to consumer prices. The most likely explanation is that it’s too early to see the price effects of tariffs, but it could also be a sign of weaker demand limiting the pass-through to consumer prices. The smaller the boost to consumer inflation from tariffs, the more likely the Fed is to cut rates this year.”

1yr inflation swaps on Friday were at 3.2%, well below Fed Funds of 4.3%. That means even if inflation linked indices are correct, the Fed still has positive real rates and can ease off the brakes as soon as inflation crests. 

Sahm also pointed out that, “Spending on apparel accounts for only 2.5% of the CPI so that it won’t settle the debate about tariff-related inflation risks. However, it provides some counter to the worst-case scenarios.”

I still think the Fed cuts 0.75% by year end, but inflationary fears may cause the Fed to move later and push those cuts into next year.

The Week Ahead

I mean…pick your thing. The Uncertainty Bends™ continues…