Opinions

Historically, oil price spikes represented a significant negative shock to the US economy. Prior to the emergence of shale in the US, the impact was primarily one sided. Higher oil prices drove up energy costs for households and businesses, exerting a clear negative impact on economic output. However, with the emergence of shale energy in the US, the impact of oil price movements on economic activity has become more balanced. Although higher oil prices continue to represent a cost shock for households and most businesses, there is now a more meaningful offset from benefits to energy producers and through the export channel. Due to these offsetting channels, the growth impact of oil price shocks is fairly modest. A $20 oil price shock, similar to that observed recently, would have a small impact on growth. The peak effect is only about a one-tenth drag on the level of output one year ahead. The impact on the unemployment rate is about half. A $60 oil price shock would have larger effects – given the linear nature of the model the impact is three times the $20 oil shock scenario. With oil prices around $120 per barrel, real GDP would be depressed by about 0.2 percentage points over a year and the unemployment rate would rise by a tenth. Unlike real GDP and the unemployment rate, an oil price shock has a significant effect on headline inflation. Conversely, given the muted impact on activity, the pass-through of an energy price shock to core inflation is generally small. A $20 oil price shock initially lifts headline PCE inflation by about 70bps in the quarter of the shock, though the impact dissipates materially with only an 11bps increase for the year following the shock. The $60 oil price shock impact scales by a magnitude of three – initially headline PCE inflation is 2ppt higher, with the impact moderating to 35bps over the year. Simulations show that oil price shocks similar to those outlined above are initially a modest dovish impulse for the Fed. With growth adversely affected and the unemployment rate pushed modestly higher, while core inflation is mostly unaffected, the Fed can focus on the labor side of the dual mandate. That said, the calculus could be somewhat different in the current environment, where supply-side shocks (i.e., tariffs) have already kept inflation well above the Fed’s target. Which bias is correct – the dovish bias implied by the Fed’s model or the market’s belief in a more hawkish impact on Fed policy? The market appears to have agreed with the “wait-and-see” bias from the Fed, with the 2-year Treasury yield rising about 19bps since last Friday – down from a peak rise of nearly 20bps. Consistent with this move, the market removed about 17bps of easing from 2026 and now only anticipates about 44bps of reductions. This is in spite of a super weak Feb Non-Farm Payroll no. Taken together, we think this historical perspective reinforces a Fed on hold for the time being until clear evidence emerges that they should adjust policy. We continue to expect the Fed to cut rates twice this year (in June & Sep) once Kevin Warsh takes over as Fed Chair. We see brent in the range of 80-100 now unless there is an off ramp by either Iran or Trump. We see this off ramp as a low probability event as both parties do not see much losses in current scenario. Iran has already lost it’s supreme leader and seen the worst of aerial attacks. Their missile and drone capabilities are impacted but still enough to create nuisance value for civilian life in middle east. As long as they can ensure this sustained low intensity warfare continues with Strait of Hormuz effectively closed for transits, pressure is on surrounding gulf countries to put pressure on Trump to pull back. But Trump does not see many losses in his calculations as long as US equities are relatively unharmed. Only if S&P500 goes below 6500, Trump might start thinking of off ramps. Till then we can expect the current standoff to continue. This implies further downside to risk assets specially equities. US rates can remain elevated and DXY strong. Precious metals have seen their best days, and we see scope for large fall there in either scenario of a sustained war (stronger DXY leads to lower Gold/Silver prices) or a ceasefire (geopolitical risk premium vanishes leading to fall in Gold/Silver prices).

Friday morning President Trump announced Kevin Warsh as his nominee to replace Jay Powell as Chair of the Federal Reserve. This will be a four-year term set to begin in late May this year. We expect him to be confirmed on time, despite the current Tillis roadblock relating to the subpoenas. We do not anticipate any great change in monetary policy from his appointment alone. The FOMC’s process of rate setting is deeply embedded into the FOMC and will take more than a new Chair to upend. Warsh himself is of impeccable credentials. He is till date the youngest Fed governor. He became Fed governor in 2006 at the age of 35. He resigned in 2011 because of his well justified views on the efficacy of QE-2 unleased by then Fed. However, he never once dissented from an FOMC vote, although he did often publish an opinion in the Wall Street Journal a day or so after FOMC meetings, lamenting the need for the Committee’s actions. His discomfort was due to his genuinely hawkish views and his scepticism about the need for QE, the size and composition of the balance sheet it generated and the collateral some of the lending facilities accepted. When he was a Governor, Warsh said, “the Chair owns the room” in reference to the relative influence of the Chair and other policymakers. We believe the current FOMC might be slightly more cmplex than Bernanke's era. But eventually we expect Warsh to be a deft manager of the FOMC debate, it will take time and careful cultivation for him to get to the status his predecessors enjoyed. As the next Fed Chair, we expect him to not accept the status quo at the Fed and to bring fundamental changes to the Fed’s frameworks and the Alt-Keynesian mindset. The use of excessive force by the Fed will probably be behind us, and the Fed could strike a better balance of prudence and restraint. On the question of Warsh being a hawk or a dove, we believe deep inside Warsh is a genuine monetary policy hawk. His view has been that AI increases productivity and therefore potential growth but then it may not lower the neutral rate. Indeed, the nominal neutral rate could be higher, although the composition would shift to lower inflation and a higher real rate. Since the stance of policy is loosely based on comparing current rates to the neutral rate, the scope for cutting rates on the basis of AI may be quite limited. However, AI may as well offer a reason to cut rates in the short run, because it could weaken labor demand and so cut consumer spending, among other immediate effects. Hence, we expect only two cuts of 25 bps each in June’26 & Sep’26 and then a long pause till March’27. US long end yields might not like Warsh as he does not support QE but Dollar swoons on Warsh as seen in Gold & Silver correction since Thursday when news broke out about Warsh being the next Fed chair.

The FOMC is likely to keep rates on hold at its 29th January meeting, with guidance continuing to signal a higher threshold for future rate cuts. It might also signal that there is no expectation of action at the March meeting. Fed Chair Powell will likely reiterate that policy is “in a good place” to respond to future developments and that rates are currently “within a range of plausible estimates of neutral.” On the economic outlook, the policy statement & press conference might present a somewhat more upbeat view about the economy. The statement is likely to upgrade the growth assessment to “solid”, note tentative evidence that unemployment has stabilized, and hint at an improving balance of risks to the outlook. Powell press conference might have more questions on Fed's independence than macro economic data. Powell will likely be asked about the DOJ investigation into his Senate testimony as well as the recent Supreme Court arguments around President Trump’s attempt to fire Governor Cook. We expect Powell to largely avoid these questions, referring back to his 11 January video message without further comments. Our own expectations is on a long hold till May when Powell leaves as Chair & two cuts of 25 bps each in June & Sep as a new Fed Chair takes office. Currently the inflation employment dynamics are in a stable orbit implying no rush for cuts. We do see recent legal actions as raising the potential for Powell to stay on as a governor. Indeed, if the administration insists on following through with a criminal prosecution of Chair Powell, and Senate Republicans stand firm in not advancing nominees to the Federal Reserve Board, it is likely the FOMC would choose Powell to remain on as chair. But this is not our base case. We currently do not have any strong views on UST yields seeing the 10yr UST between 4.20-4.40 for short term. On DXY, the continuous erosion of policy stability from Trump administration has led to DXY weakness below 98 levels this week. Currently at 97.6 levels, we expect it to retest the Sep’25 lows of 96.5 levels. Markets will be more focused on the announcement of new Fed Chair. Our own view is Rick Rieder has the strongest chance of clearing senate confirmation. He is also a market friendly face and should be seen as +ve for Fed’s credibility as an independent central bank. Rieder also is an avid golf player which provides him a special bonding with Trump. Polymarket ranked the probability of a Rieder chairmanship at just 3% till last week. But on Friday afternoon, those odds jumped past 40%, putting him above former Fed Gov. Kevin Warsh as the leading contender.

We expect the policy rate to be left unchanged in the 23rd Jan BOJ MPM. BOJ will use this meeting to assess the impact of its latest rate hike on the economy, prices, and financial conditions. BOJ's outlook report will reflect yen depreciation since October 2025 and the government's economic stimulus package. We expect upward revisions to GDP forecasts, particularly for FY26. While we expect the BOJ to lower its CPI forecast for FY26 due to policy effects, we do not expect it to change its underlying inflation outlook. BOJ Governor Kazuo Ueda's post-meeting press conference will be closely watched for any hints on future hikes trajectory. We believe he will continue to avoid taking a hawkish stance in the sense of clarifying the terminal rate or the pace of rate hikes. We believe BOJ is significantly behind the curve and is now caught in a spiral of depreciating JPY, higher fiscal deficits & a still nascent economic revival. JPY depreciation is not only about the Takaichi trade. It is also about how BOJ has missed the bus and how significantly -ve real rates are in Japan. We are bearish on JPY for few months now and expect it to breach 160 sooner than later. Any MoF intervention might give only a brief respite. Eventually we won’t be surprised to see JPY test 185 too (chart below) if BoJ keeps on delaying the rate hikes which we believe is a real possibility. We don’t see the next hike coming before Dec’26 whereas the market is currently pricing in the next hike almost by June’26. On 10yr JGBs, we believe it is eventually headed towards 2.5% by June’26. Currently it is trading at 2.18%. From a political point of view, a general election is widely anticipated in early or mid-February. Campaign issues should crystallize once Prime Minister Takaichi officially calls the election, an announcement that could come as early as next week. Such pre poll promises as well as opinion polls might soon start pushing JPY above 160. There has been some new prepoll alliance formation against Takaichi but her approval ratings are way too high for her to lose the election in our view. Hence the fiscally expansionary policies are likely to remain in place pushing JPY to depreciate further.

We now expect the Fed to close out 2025 with a final 25bps cut. Our earlier call of a Dec hold in absence of macro data had to change after New York Fed Williams comments on 21st Nov which tilted the market pricing in favour of a Dec cut. But this decision will not be unanimous and is likely to feature dissents in both a hawkish and dovish direction. We expect five out of the twelve FOMC members to dissent, with four hawkish dissents against the decision to cut rates (Schmid, Musalem, Goolsbee, and Collins). We also expect Governor Miran to dissent dovishly in favor of a 50bp cut. Powell & a handful of close allies will likely be the swing votes at this meeting. There has been no clear pushback from Powell against the likelihood of a cut raising the probability that he supports additional easing next week. To forge as much consensus for the 25bp rate cut, and thus minimize dissents, we anticipate the statement and Chair Powell’s press conference will signal that the hurdle is relatively high for another cut in early 2026. We believe the December cut will be the final cut with Powell as Fed chair. We now see cuts in June and September 2026 under the next chair. The dot plot is likely to show even greater “tacit dissent,” with 8-9 officials likely to submit a 2025 dot of 3.875% (signalling they preferred no cut at this meeting). The dot plot and economic projections are unlikely to change significantly. We expect the median dot to show one cut per year in 2026 and 2027, with the terminal rate unchanged at 3.125%. On the state of US economy it has been a mixed bag. While UR increased to 4.4% in Sep NFP & ADP private employment contracted 32k in November, weekly initial jobless claims have been subdued. In economic conditions, business surveys have been solid seen in above average PMIs. To summarise, the meeting statement will likely adjust its forward guidance language to imply future cuts are not a given or that the pace of easing is likely to slow. From a market perspective, we expect DXY to strengthen post FOMC on 10th Dec as well as US yield curve to shift higher before the NFP data release on 16th Dec and CPI release on 18th Dec. Our trade reco published on 9th Nov on 10yr UST yield is still active and we are expecting 4.3 levels from the reco yield level of 4.08. Current yield is 4.13. https://macro-spectrum.com/trade-recommendation/sell-10yr-ust US equities might still rise as FOMC description of US economy might remain solid which do not require rate cuts in short term. We are expecting 7000 on S&P 500 by year end as our below trade reco published on 8th Nov: https://macro-spectrum.com/trade-recommendation/buy-sp-500

We have been consistent in our view that US employment is worsening due to AI led productivity growth in US corporates & tariff uncertainties in small & medium business. Our own view on employment is that Oct NFP is it were to be released on 5th Nov as scheduled might have shown UR (Unemployment Ratio) at 4.5% with headline NFP at -25k. But as long as there is no data, we have to agree to Powell’s logic of driving slow in foggy conditions. As long as data is not there, FOMC won’t see the weakness in employment and hence not be motivated for a cut when inflation is still elevated. Hence we now see a December pause as the most likely outcome in absence of US employment data. We continue to expect 3 more consecutive cuts of 25 bps each when ever the employment data resumes. Hence in short term, we are bullish on DXY expecting to test 100.50 & 10yr UST testing 4.20. It was interesting to see the group dynamics at play in Oct FOMC. It appears to us that Powell has no more control on any fraction in the FOMC, whether pro cuts or status quo. The discussion around neutral rates also implies that without employment data at hand, the status quo group wont be agreeing to any further cuts. Powell himself sounded dovish on inflation when he said that tariff-driven inflation would be short-lived, and suggested that tariffs were contributing 50-60bp to current y-o-y inflation. Powell went further to say “inflation away from tariffs is actually not so far from our 2% goal,” echoing dovish remarks from officials like Governors Waller and Bowman. So it is not inflation but employment data which would be needed to bring in more cuts. Moving on to QT, the Committee announced that it will conclude balance sheet runoff on December 1, broadly in line with our expectations. Thereafter the Fed will roll over maturing Treasury securities via non-competitive bids at Treasury auctions, proportional to announced offering amounts, and reinvest MBS principal payments into Treasury bills. The end of quantitative tightening via runoff of the Federal Reserve's assets beginning in December will start the clock ticking toward a resumption of asset purchases in 2026 as Fed liabilities naturally increase. Demand for bank reserves and currency in circulation could force the central bank to begin buying Treasuries as soon as from Jan’26. More Fed bill purchases pave the way for upcoming shift in Treasury funding strategy. Although the Fed’s decision this week to reinvest MBS proceeds exclusively into bills from December onward was modest, it nonetheless aligns with the notion of transitioning towards a shorter maturity SOMA portfolio. We estimate the Fed will purchase $360bn of bills in 2026, with roughly 2/3 of that due to MBS reinvestments and 1/3 due to reserve management purchases.