JPow’s J-Hole and other Macro Musings

It’s time to refresh my list of ideas, so if you have a stock that you think I should look into, please post it in the comments. A lot of messages got lost while I was on vacation, and my organization system is in need of an update. Thank you all.

Jerome Powell finally changed his rhetoric and the market now believes that we will have a rate cut at this upcoming September meeting. He is a lawyer by trade, he chooses his words carefully, and he left himself wiggle room to change his mind. If the next CPI report comes in hot, Jerome Powell might not cut, but since Trump’s tariff uncertainty has frozen the business community from deploying capital for new projects, odds are good that CPI will stay cool for a month. For now, the market believes a rate cut is coming, and that is enough.

If CPI does come in hot, the choice of the Fed to cut or not will tell us how effective Trump’s persuasion has been. The following was posted by the 47th President of the United States on Truth Social:

The above image generated a lot of hand-wringing about Fed independence, which is a legitimate concern in a world where unfortunately partisanship washes away most legitimate concerns. Fed independence is important, but so is electing leadership that doesn’t engage in criminality, such as the former head of the nuclear program who was stealing designer luggage from airports, or Saule Omarova who was very close to becoming the comptroller of the currency, until her past shoplifting episodes became public. The raid on John Bolton gives some veneer that the prosecution of criminality within the governing class will be bipartisan, what a fantastic litmus test.

But I don’t want to get too bogged down in politics. Between the assault on Fed independence and JPow’s J-Hole speech, which both occurred on Friday, the bond market reaction was that the 10-year Treasury yield fell by 0.076%. This would indicate that cutting the overnight rate, as long as it is still above the 2-year Treasury rate, is not perceived by the market to be a mistake, and neither is prosecuting Lisa Cook.

There has been an overwhelming consensus that rate cuts would cause the long end of the yield curve to rise. This would be true if the market believed that the Fed was committing a policy error. With the housing market frozen and the labor market weak, the market believes there is room to cut. Things become harder to predict after the first 0.50%.

Treasury Secretary Bessent has claimed that SOFR could come down by 1.50% to 1.75%. That is a very large cutting cycle, and might be large enough to run the risk of policy error. But there is a strange feedback loop where cuts decrease the interest expense on the Federal debt, which improves the US fiscal position, which takes fear out of the Treasury market. So again, this strange consensus that yields will rise on rate cuts is far from certain.

If cuts of that degree were to happen, small cap stocks which are barely profitable but have a lot of SOFR denominated debt, such as Sleep Number, for example, would suddenly be massively profitable. Sleep Number would save about $8.5 million a year on interest, which comes out to $0.36 per share. The consensus forecast is only for $0.15 EPS next quarter. Interest rate cuts of that extent would increase SNBR’s EPS by over 50%. I still like Purple over Sleep Number, but that is exactly the type of stock that would benefit disproportionately from rate cuts. Thank you to Covexititties for bringing it to my attention.

The July budget deficit came in at $47 billion worse than 2024. In a previous writeup, I had pointed out that the deficit is about $250 billion better than last year and nobody is talking about it. Well, now that deficit is only $192 billion better than 2024. I will still be watching to see how the deficit unfolds. I wouldn’t thumb my nose at a deficit that annualizes to $400 billion better than the year before, it would still be a step in the right direction, but the thing about action is spectators always demand more of it. The comps get easier in November, so there is room for positive surprises.

I did stumble upon another $150 billion that Trump will almost certainly try to shake out of the couch cushions. In normal times the Fed remits interest payments back to the treasury. However, when the Fed raised interest rates, it caused mark to market losses on long dated bonds. The Fed has been keeping the interest payments from the Treasury to repair their balance sheet. This has been ongoing since 2023, and isn’t projected to stop until 2027. I don’t want to get too bogged down in monetary theory, and I certainly don’t want to be accused of being part of the Modern Monetary Theory crowd, but I hope everyone realizes that fiat currency is just made up, and there is something strange about having an extra $750 billion of Federal debt because the central bank wants to cover mark to market losses which they themselves caused. Would it be inflationary if the Fed didn’t stop remitting the interest payments back? Yes, probably a bit. I anticipate that after May of 2026, the new Fed chair will remit those payments and the deficit will shrink by that $150 billion, as well as by however much the government can save on interest expense at lower rates, if rates do actually fall and the market doesn’t perceive it to be a policy error.

Have you heard the joke about Stalin asking for a one-armed economist? He was tired of hearing the expression, “on the other hand.”

The stock market reaction was that everything rallied, especially small cap value. On my recent post, “green stocks on red days,” I mentioned that there could be a rotation into the real economy, and that is exactly what we are seeing. This rotation started and failed twice before, each of the last two Januaries after stocks were repurchased after tax loss harvesting in December. Both times, the rotation to small value looked like a sure thing, but after a month, returned to the penalty box. The thing that killed the small cap value rally these past two years was NVIDIA’s earnings. If NVIDIA reports earnings that are good, but not amazing, the rotation will likely continue, and at the speed the market moves these days, it might be pretty quick.

The valuation gap between growth and value has extended to its widest range in modern history. If it is true that AI will become a commodity and the benefits of AI will be captured by the user, then the value stocks will be the ones who enjoy improved earnings while the growth stocks spend enormous capex. Could the trend reversal have already started last week? Or is it still a couple of years away? We live in interesting times.

Take a few moments and listen to Tom Lee of Fundstrat talk about a large firm who recently became a client of Palantir. It starts at 29:50 and runs until 33:07. He speaks about enormous profit gains that accrue to Palantir’s corporate clients, even those commodity suppliers whose business is in the real economy. Again, if AI becomes a commodity, the lion’s share of that increased profitability will accrue to value stocks and not to tech stocks.

Thank you for being a subscriber. I will try to keep the macro musings infrequent.