Two central banks managed to shock The market by walking the walk The Old Lady jacked By fifteen, in fact Banxico then doubled the talk So, now that it’s all said and done C bankers, a new tale have spun The virus no longer Is such a fearmonger Inflation’s now job number one Talk, as we all know, is cheap, but from the two largest central banks, that’s mostly what we got. While Chairman Powell got a positive market response from his erstwhile hawkish comments initially, yesterday investors started to rethink the benefits of tighter monetary policy and decided equity markets might not be the best place to hold their assets. This is especially true of those invested in the mega-cap tech companies as those are the ones that most closely approximate an extremely long-duration bond. So, the NASDAQ’s -2.5% performance has been followed by weakness around the globe and NASDAQ futures pointing down -0.9% this morning. As many have said (present company included) the idea that the Fed will be aggressively tightening monetary policy in the face of a sharp sell-off in the stock market is pure fantasy. The only question is exactly how far stocks need to fall before they blink. My money is on somewhere between 10% and 20%. Meanwhile, Madame Lagarde continues to pitch her view that inflation remains transitory and that while it is higher than the target right now, by next year, it will be back below target and the ECB’s concerns will focus on deflation again. So, while the PEPP will indeed be wound down, it will not disappear as it is always available for a reappearance should they deem it necessary. And in the meantime, they will increase the APP by €40 billion/month while still accepting Greek junk paper as part of the mix. Even though inflation is running at 4.9% (2.6% core) as confirmed this morning, they espouse no concern that it is a problem. Perhaps the most confusing part of this tale is that the EURUSD exchange rate rallied on the back of a more hawkish Fed / more dovish ECB combination. One has to believe that is a pure sell the news result and the euro will slowly return to recent lows and make new ones to boot. One final word about the major central banks as the BOJ concluded its meeting last night and…left policy unchanged as universally expected. There is no indication they are going to do anything different for a long time to come. However, when you step away from the Big 3 central banks, there was far more action in the mix, some of it quite surprising. First, the BOE did raise the base rate by 15 basis points to 0.25% and indicated that it will be rising all throughout next year, with expectations that by September it will be 1.00%. The MPC’s evaluation that omicron would not derail the economy and price pressures, especially from the labor market, were reaching dangerous levels led to the move and the surprise helped the pound rally as much as 0.7% at one point. Earlier yesterday, the Norges Bank raised rates 25bps, up to 0.50%, and essentially promised another 25bp rise by March. Then, in the afternoon, Banco de Mexico stepped in and raised their overnight rate by 0.50%, twice the expected hike and the largest move since they began this tightening cycle back in June. It seems they are concerned about “the magnitude and diversity” of price pressures and do not want to allow inflation expectations to get unanchored, as central bankers are wont to say. Summing up central bank week, the adjustment has been significant from the last round of meetings with inflation clearly now the main focus for every one of them, perhaps except for Turkey, where they cut the one-week repo rate by 100 basis points to 14.0% and continue to watch the TRY (-7.0%) collapse. It is almost as if President Erdogan is trying to recreate the Weimar hyperinflation of the 1920’s without the war reparations. Will they be able to maintain this inflation fighting stance if global equity markets decline? That, of course, is the big question, and one which history does not show favorably. At least not the current crop of central bankers. Barring the resurrection of Paul Volcker, I think we know the path this will take. This poet is seeking his muse To help him define next year’s views Thus, til New Year’s passed Do not be aghast My note, you’ll not have, to peruse Ok, for my final note of the year, let’s recap what has happened overnight. As mentioned above, risk is under pressure after a poor performance by equity markets in the US. So, the Nikkei (-1.8%), Hang Seng (-1.2%) and Shanghai (-1.2%) all fell pretty sharply overnight. This morning, Europe has also been generally weak, but not quite as badly off as Asia with the DAX (-0.65%) and CAC (-0.7%) both lower although the FTSE 100 (+0.3%) is bucking the trend after stronger than expected Retail Sales data (+1.4%). Meanwhile, Germany has been dealing with soaring inflation (PPI 19.2%, a new historic high) and weakening growth expectations as the IFO (92.6) fell to its lowest level since January and is trending sharply lower. US futures are also pointing lower at this hour. Bond markets, meanwhile, are generally firmer although Treasury yields are unchanged at this time. Europe, though, has seen declining yields across the board led by French OATs (-2.6bps) and Bunds (-1.8bps) with the peripherals also doing well. Gilts are bucking this trend as well, with yields unchanged this morning. In the commodity space, oil (-1.75%) is leading the energy sector lower along with NatGas (-1.9%), but metals markets are going the other way. Gold (+0.5%, and back above $1800/oz) and silver (+0.7%) feel more like inflation hedges this morning, and we are seeing strength in the industrial space with copper (+0.45%), aluminum (+2.1%) and tin (+1.8%) all rallying. Lastly, looking at the dollar, on this broad risk-off day, it is generally stronger vs. its G10 counterparts with only the yen (+0.2%) showing its haven status. Otherwise, NZD (-0.5%) and AUD (-0.4%) are leading the way lower with the entire commodity bloc under pressure. As to the single currency, it is currently slightly softer (-0.1%) but I believe it has much further to run by year end. In the EMG bloc, excluding TRY’s collapse, the biggest mover has actually been ZAR (+0.6%) after it reported that the hospitalization rate during the omicron outbreak has collapsed to just 1.7% of cases being admitted. This speaks to the variant’s less pernicious symptoms despite its rapid spread. Other than that, on the plus side KRW (+0.25%) benefitted from central bank comments that they would continue to support the economy but raise rates if necessary. On the downside, CLP (-0.4%) is opening poorly as traders brace for this weekend’s runoff presidential election between a hard left and hard right candidate with no middle ground to be found. However, beyond those moves, there has been much less activity. There is no economic data today and only one Fed speaker, Governor Waller at 1:00pm. So, the FX market will once again be seeking its catalysts from other markets or the tape. At this point, if risk continues to be shed, I expect the dollar to continue to recoup its recent losses and eventually make new highs. As I mention above, this will be the last daily note for 2021 but the FX Poet will return with his forecasts on January 3rd, 2022, and the daily will follow afterwards. To everyone who continues to read, thank you for your support and I hope everyone has a happy and healthy holiday season. Good luck, good weekend and stay safe Adf
Apparently, Powell has learned
Why everyone’s been so concerned
With prices exploding
The sense of foreboding
‘Bout ‘flation seemed very well earned
So, Jay and his friends at the Fed
Said by March, that they would stop dead
The buying of bonds
Til ‘flation responds
(Or til stocks fall deep in the red)
By now you are all aware that the FOMC will be reducing QE twice as rapidly as their earlier pace, meaning that by March 2022, QE should have ended. Chairman Powell was clear that inflation has not only been more persistent than they had reason to believe last year but has also moved much higher than they thought possible, and so they are now forced to respond. Interestingly, when asked during the press conference why they will take even as long as they are to taper policy rather than simply stop buying more assets now if that is the appropriate policy, Powell let slip what I, and many others, have been saying all along; by reducing QE gradually, it will have a lesser impact on markets. In other words, the Fed is more concerned with Wall Street (i.e. the stock market) than it is with Main Street. Arguably, despite a more hawkish dot plot than had been anticipated, with the median expectation of 3 rate hikes in 2022 and 3 more in 2023, the stock market rallied sharply in the wake of the press conference. If one is seeking an explanation, I would offer that Chairman Powell has just confirmed that the Fed put remains alive and well and is likely struck far closer to the market than had previously been imagined, maybe just 10% away.
One other thing of note was that Powell referred to the speed with which this economic cycle has been unfolding, much more rapidly than the post-GFC cycle, and also hinted that the Fed would consider reducing the size of its balance sheet as well going forward. Recall, however, what happened last time, when the Fed was both raising the Fed funds rate and allowing the balance sheet to run off by $50 billion/month back in 2018; stocks fell 20% in Q4 and the Powell Pivot was born. FWIW my sense is that the Fed will not be able to raise rates as much as the dot plot forecasts. Rather, the terminal rate will be, at most, 2.00% (last time it was 2.50%), and that any shrinkage of the balance sheet will be minimal. The last decade of monetary policy has permanently changed the role of central banks and defined their behavior in a new manner. While not described as such by those “independent” central banks, debt monetization (buying government bonds) is now a critical role required to keep most economies functioning as debt/GDP ratios continue to climb. In other words, MMT is the reality and it will require a much more dramatic, and long-lasting, negative shock for that to change.
One last thing on this; the bond market has heard what Powell said and immediately rallied. The charitable explanation is that bond investors are now comforted by the Fed’s recognition that inflation is a problem and will be addressed. Powell’s explanation about foreign demand seems unlikely, at least according to the statistics showing foreign net sales of bonds. Of more concern would be the explanation that bond investors are concerned about a policy mistake here, where the Fed is tightening too late and will drive the economy into a recession, as they always have done when they tighten policy.
With Jay and the Fed finally past
The market will get to contrast
The Fed’s hawkish sounds
With Europe’s shutdowns
And watch Christine hold rates steadfast
But beyond the Fed, this has been central bank policy week with so many other central bank decisions today. Last night the Philippines left policy on hold at 1.50%, as did Indonesia at 3.50%, both as expected. Then, this morning the Swiss National Bank (-0.75%) left rates on hold and explained the franc remains “highly valued”. Hungary raised their Deposit rate by 0.30% as expected and Norges Bank raised by 0.25%, also as expected, while promising another 0.25% in March. Taiwan left rates unchanged at 1.125%, as expected and Turkey continue their unique inflation fighting policy by cutting the one-week repo rate by 1.00%, down to 14.00% although did indicate they may be done cutting for now. As to the Turkish lira, if you were wondering, it has fallen another 3.8% as I type and is now well through 15.00 to the dollar. YTD, TRY has fallen more than 51% vs. the dollar and quite frankly, given the more hawkish turn at the Fed, seems like it has further to go!
Which of course, brings us to the final two meetings today, the ECB and the BOE. Madame Lagarde and most of her minions have been very clear that they are not about to change policy, meaning they will continue both the PEPP and APP and are right now simply considering how they are going to manage policy once the PEPP expires in March. That is another way of saying they are trying to figure out how to continue to buy as many bonds as they are now, while losing one of their programs. I’m not worried about them finding a way to continue QE ad infinitum, but the form that takes is the question at hand. While European inflation pressures have certainly lagged those in the US, they are still well above their 2.0% target, and currently show no signs of abating. If anything, the fact that electricity prices on the continent continue to skyrocket, I would expect overall prices to only go higher. But Madame Lagarde is all-in on MMT and will drag the few monetary hawks in the Eurozone down with her. Do not be surprised if the ECB sounds dovish today and the euro suffers accordingly.
As to the BOE, that is much tougher to discern as inflation pressures there are far more prevalent and members of the MPC have been more vocal with respect to discussing how they need to respond by beginning to raise the base rate. But with the UK flipping out over the omicron variant and set to
cancel Christmas impose more lockdowns, it is not clear the BOE will feel comfortable starting their tightening cycle into slower economic activity. Ahead of the meeting, the futures market is pricing in just a 25% probability of a 0.15% rate hike. My money is on nothing happening, but we shall see shortly.
Oh yeah, tonight we hear from the BOJ, but that is so anticlimactic it is remarkable. There will be no policy shifts there and the yen will remain hostage to everything else that is ongoing. Quite frankly, given the yen has been sliding lately, I expect Kuroda-san must be quite happy with the way things are.
And that’s really the story today. Powell managed to pull off a hawkish turn and get markets to embrace risk, truly an impressive feat. However, over time, I expect that equity markets will decide that tighter monetary policy, especially if central bank balance sheets begin to shrink, is not really a benefit and will start to buckle. But right now, all screens are green and FOMO is the dominant driver.
In the near term, I think the dollar has further to run higher, but over time, especially when equity markets reverse course, I expect the dollar will fall victim to the impossible trilemma, where the Fed can only prop up stocks and bonds simultaneously, while the dollar’s decline will be the outlet valve required for the economy. But that is many months away. For now, buy dollars and buy stocks, I guess.
Good luck and stay safe
Apparently, Powell has learned Why everyone’s been so concerned With prices exploding The sense of foreboding ‘Bout ‘flation seemed very well earned So, Jay and his friends at the Fed Said by March, that they would stop dead The buying of bonds Til ‘flation responds (Or til stocks fall deep in the red) By now you are all aware that the FOMC will be reducing QE twice as rapidly as their earlier pace, meaning that by March 2022, QE should have ended. Chairman Powell was clear that inflation has not only been more persistent than they had reason to believe last year but has also moved much higher than they thought possible, and so they are now forced to respond. Interestingly, when asked during the press conference why they will take even as long as they are to taper policy rather than simply stop buying more assets now if that is the appropriate policy, Powell let slip what I, and many others, have been saying all along; by reducing QE gradually, it will have a lesser impact on markets. In other words, the Fed is more concerned with Wall Street (i.e. the stock market) than it is with Main Street. Arguably, despite a more hawkish dot plot than had been anticipated, with the median expectation of 3 rate hikes in 2022 and 3 more in 2023, the stock market rallied sharply in the wake of the press conference. If one is seeking an explanation, I would offer that Chairman Powell has just confirmed that the Fed put remains alive and well and is likely struck far closer to the market than had previously been imagined, maybe just 10% away. One other thing of note was that Powell referred to the speed with which this economic cycle has been unfolding, much more rapidly than the post-GFC cycle, and also hinted that the Fed would consider reducing the size of its balance sheet as well going forward. Recall, however, what happened last time, when the Fed was both raising the Fed funds rate and allowing the balance sheet to run off by $50 billion/month back in 2018; stocks fell 20% in Q4 and the Powell Pivot was born. FWIW my sense is that the Fed will not be able to raise rates as much as the dot plot forecasts. Rather, the terminal rate will be, at most, 2.00% (last time it was 2.50%), and that any shrinkage of the balance sheet will be minimal. The last decade of monetary policy has permanently changed the role of central banks and defined their behavior in a new manner. While not described as such by those “independent” central banks, debt monetization (buying government bonds) is now a critical role required to keep most economies functioning as debt/GDP ratios continue to climb. In other words, MMT is the reality and it will require a much more dramatic, and long-lasting, negative shock for that to change. One last thing on this; the bond market has heard what Powell said and immediately rallied. The charitable explanation is that bond investors are now comforted by the Fed’s recognition that inflation is a problem and will be addressed. Powell’s explanation about foreign demand seems unlikely, at least according to the statistics showing foreign net sales of bonds. Of more concern would be the explanation that bond investors are concerned about a policy mistake here, where the Fed is tightening too late and will drive the economy into a recession, as they always have done when they tighten policy. With Jay and the Fed finally past The market will get to contrast The Fed’s hawkish sounds With Europe’s shutdowns And watch Christine hold rates steadfast But beyond the Fed, this has been central bank policy week with so many other central bank decisions today. Last night the Philippines left policy on hold at 1.50%, as did Indonesia at 3.50%, both as expected. Then, this morning the Swiss National Bank (-0.75%) left rates on hold and explained the franc remains “highly valued”. Hungary raised their Deposit rate by 0.30% as expected and Norges Bank raised by 0.25%, also as expected, while promising another 0.25% in March. Taiwan left rates unchanged at 1.125%, as expected and Turkey continue their unique inflation fighting policy by cutting the one-week repo rate by 1.00%, down to 14.00% although did indicate they may be done cutting for now. As to the Turkish lira, if you were wondering, it has fallen another 3.8% as I type and is now well through 15.00 to the dollar. YTD, TRY has fallen more than 51% vs. the dollar and quite frankly, given the more hawkish turn at the Fed, seems like it has further to go! Which of course, brings us to the final two meetings today, the ECB and the BOE. Madame Lagarde and most of her minions have been very clear that they are not about to change policy, meaning they will continue both the PEPP and APP and are right now simply considering how they are going to manage policy once the PEPP expires in March. That is another way of saying they are trying to figure out how to continue to buy as many bonds as they are now, while losing one of their programs. I’m not worried about them finding a way to continue QE ad infinitum, but the form that takes is the question at hand. While European inflation pressures have certainly lagged those in the US, they are still well above their 2.0% target, and currently show no signs of abating. If anything, the fact that electricity prices on the continent continue to skyrocket, I would expect overall prices to only go higher. But Madame Lagarde is all-in on MMT and will drag the few monetary hawks in the Eurozone down with her. Do not be surprised if the ECB sounds dovish today and the euro suffers accordingly. As to the BOE, that is much tougher to discern as inflation pressures there are far more prevalent and members of the MPC have been more vocal with respect to discussing how they need to respond by beginning to raise the base rate. But with the UK flipping out over the omicron variant and set to
cancel Christmasimpose more lockdowns, it is not clear the BOE will feel comfortable starting their tightening cycle into slower economic activity. Ahead of the meeting, the futures market is pricing in just a 25% probability of a 0.15% rate hike. My money is on nothing happening, but we shall see shortly. Oh yeah, tonight we hear from the BOJ, but that is so anticlimactic it is remarkable. There will be no policy shifts there and the yen will remain hostage to everything else that is ongoing. Quite frankly, given the yen has been sliding lately, I expect Kuroda-san must be quite happy with the way things are. And that’s really the story today. Powell managed to pull off a hawkish turn and get markets to embrace risk, truly an impressive feat. However, over time, I expect that equity markets will decide that tighter monetary policy, especially if central bank balance sheets begin to shrink, is not really a benefit and will start to buckle. But right now, all screens are green and FOMO is the dominant driver. In the near term, I think the dollar has further to run higher, but over time, especially when equity markets reverse course, I expect the dollar will fall victim to the impossible trilemma, where the Fed can only prop up stocks and bonds simultaneously, while the dollar’s decline will be the outlet valve required for the economy. But that is many months away. For now, buy dollars and buy stocks, I guess. Good luck and stay safe Adf
The data from China last night
Could, President Xi, give a fright
While IP was fine
Show’s everything there’s not quite right
Now, turning our focus back home
The question that’s facing Jerome
Is should he increase
The speed that they cease
QE? Or just leave it alone?
Clearly, the big news today is the FOMC meeting with the statement to be released at 2:00 and Chair Powell to face the press 30 minutes later. As has been discussed ad nauseum since Powell’s Congressional testimony two weeks ago, expectations are for the Fed to reduce QE purchases more quickly than the previously outlined $15 billion/month with many looking for that pace to double. If that does occur, QE will have concluded by the end of March. This timing is important because the Fed has consistently maintained that they would not raise the Fed funds rate while QE was ongoing. Hence, doubling the pace of reduction opens the door for the first interest rate hike as soon as April.
And let’s face it, the Fed has fallen a long way behind the curve with the latest evidence yesterday’s PPI data (9.6%, 7.7% core) printing much higher than expected and at its highest level since the series was renamed the PPI from its previous Wholesale Price Index in 2010. Prior to that, it was in the 1970’s that last saw prices rising at this rate. So, ahead of the meeting results, investors are trying to analyze just how quickly US monetary policy will be changing. Recall, yesterday I made a case for a slower reduction than currently assumed, but as of now, nobody really knows.
What we do know, however, is that the economic situation in China is not playing out in the manner President Xi would like. Last night China released its monthly growth data which showed Retail Sales (3.9% Y/Y) Fixed Asset Investment (5.2% Y/Y) and Property Investment (6.0% Y/Y) all rising more slowly than forecast and more slowly than last month. Only IP (3.8% Y/Y) managed to grow. As well, Measured Unemployment rose to 5.0%, higher than expected and clearly not the goal. For the past several years China has been ostensibly attempting to evolve its economy from the current mercantilist state, where production for export drives growth, to a more domestically focused consumer-led economy like the West. Alas, they have been unable to make the progress they would have liked and now have to deal with not only Covid, but the ongoing meltdown in the property sector which will only serve to hold the consumer back further. Interestingly, the PBOC did not adjust the Medium-term Lending Rate as some pundits had expected, keeping it at 2.95%, and so, it should not be that surprising that the renminbi has maintained its strength, although has appeared to stop rising. A 2.95% coupon in today’s world remains quite attractive, at least for now, and continues to draw international investment.
Aside from these stories, the other headline of note was UK inflation printing at 5.1%, its highest level since 2011 and clearly well above the BOE’s 2.0% target. Remember, the BOE (and ECB) meet tomorrow and there remains a great deal of uncertainty surrounding their actions given the imminent lockdown in the UK as the omicron variant spreads rapidly. Can the BOE really tighten into a situation where growth will clearly be impaired? It is this uncertainty that has pushed the timing of the first interest rate hike by the BOE back to February, at least according to futures markets. But as you can see, the BOE is in the same position as the Fed, inflation is roaring but there are other concerns that prevent it from acting to stem the problem. In sum, the betting right now is the Fed doubles the pace of taper and the BOE holds off on raising rates until February, but either, or both, of those remain far less than certain. Expect some more market volatility across all asset classes today and tomorrow.
With all that in mind, here’s a quick look at markets overnight. Equities in Asia (Nikkei +0.1%, Hang Seng -0.9%, Shanghai -0.4%) mostly followed the US declines of yesterday, although Japan did manage to eke out a small gain and stop its recent trend lower. Europe, on the other hand, is having a better go of it with the DAX (+0.3%) and CAC (+0.6%) both performing well as inflation data there was largely in line with expectations, albeit far higher than targets, and there is little concern the ECB is going to do anything tomorrow to rock the boat. In the UK, however, that higher inflation print is weighing on equities with the FTSE 100 (-0.2%) underperforming the rest of Europe. Ahead of the open, and the FOMC, US futures are little changed in general, although NASDAQ futures continue to slide, down (-0.25%) as I type.
The rally in European stocks has encouraged a risk-on attitude and so bond markets are selling off a bit with yields edging higher. Well, edging except in the UK, where Gilts (+3.7bps) are clearly showing their concern over the inflation print. But in the US (Treasuries +0.3bps), Germany (Bunds +1.2bps) and France (OATs +0.9bps) things are far less dramatic. Given the imminent rate decisions, I expect that there is a chance for more movement later and most traders are simply biding their time for now.
The commodity picture is a little gloomier this morning with oil (-1.2%) leading the way lower and weakness in metals (Cu -1.5%, Ag -0.5%, Al -1.4%) widespread. Gold is little changed on the day and only NatGas (+2.1%) is showing any life. These markets are looking for a sign to help define the next big trend and so are also awaiting the FOMC outcome today.
Finally, the dollar continues to consolidate its recent gains but has been range trading for the past month. The trend remains higher, but we will need confirmation from the FOMC today to really help it break out I believe. In the G10, the biggest gainer has been AUD (+0.4%), but that appears to be positional, as Aussie has been sliding for the past week and seems to be taking a breather. Otherwise, in this bloc there are an equal number of gainers and laggards with none moving more than 0.2%, so essentially trendless.
In the emerging markets, TRY (-2.1%) continues its decline toward oblivion with no end in sight. Elsewhere, ZAR (-0.6%) has suffered on continue high inflation and the SARB’s unwillingness to fight it more aggressively. INR (-0.5%) suffered on the back of a record high trade deficit and concerns that if the Fed does tighten, funding their C/A gap will get that much more expensive. Beyond those, though, there has been far less movement and far less interest overall.
We do have some important data this morning led by Empire Mfg (exp 25.0) and Retail Sales (0.8%, 0.9% ex autos) at 8:30 and then Business Inventories (1.1%) at 10:00 before the FOMC at 2:00. The inventory data bears watching as an indication of whether companies are beginning to stockpile more and more product given the supply chain issues that remain front and center across most industries.
And that’s really what we have at this point in time. A truly hawkish Fed should help support the dollar further, while anything else is likely to see the dollar back up as hawkish is the default setting right now.
Good luck and stay safe
Investors seem somewhat concerned
That risk, in all forms, has returned
Thus, stocks are backsliding
While Jay is deciding
If QE should soon be adjourned
With the FOMC beginning its two-day meeting this morning, and PPI data due at 8:30am, it is clear that investors are taking a more precautionary view of the world today. Certainly, yesterday’s US equity market price action, where the major indices all closed on their session lows, has not helped sentiment, nor has the current market narrative of imminently tighter policy from the Fed. As such, it should be no great surprise that risk assets across the board are under pressure while more traditional havens have found some support.
But let us ask ourselves, is this current market (not Fed) narrative realistic? Again, I would contend the market expectations for tomorrow are that the Fed will double the pace of its QE tapering come January, which will have them finish QE by the end of March. And it is easy to see the merits of the argument given the persistence and magnitude of price gains seen over the past twelve to fifteen months. This is especially so given there is no obvious reason to believe prices will decline other than the economists’ mantra that supply will be created to fill the demand. (While this is certainly true in the long run, as Keynes pointed out back in 1923, in the long run we are all dead, so timing matters here.)
However, there are counterarguments also being made that will carry weight, especially with the political bent of the current administration. Specifically, the maximum employment piece of the Fed mandate, which Mr Powell highlighted last year when announcing the Fed’s new policy initiatives, remains an open question. It appears that the current Fed view is that NAIRU (full employment) is reached when the Unemployment Rate reaches 3.8%. The November NFP report showed Unemployment has declined to 4.2%, as measured, and recall that pre-pandemic, the Unemployment Rate had fallen to 3.5%, its lowest point in half a century. Thus, the new view is that full employment will only be reached at near historic lows. Yet, is that maximum employment in the current vernacular?
The Fed’s policy review used the terms “broad-based and inclusive” to describe maximum employment, by which they were considering not merely the statistical headline, but the makeup of the data when broken down by various subcategories, notably race. That November report indicated that the Unemployment rate for minorities was 6.7%, considerably higher than for the white cohort which saw Unemployment of just 3.7%. That disparity is at the heart of the question as to whether the Fed believes its employment mandate has been fulfilled.
You will not be surprised to know that there is vocal advocacy by some that the ratio that currently exists reflects bias and the Fed must do more to alleviate the problem, even at the expense of higher inflation. Nor would you be surprised that others make the case that rising inflation is a greater burden on the lower and middle classes, so seeking those last few jobs results in a significantly worse outcome for all, especially those for whom the policies are intended to help.
The point is it is not a slam-dunk that the Fed is going to be as aggressively hawkish as the current market narrative claims. While Chairman Powell clearly indicated that the pace of tapering would increase, do not be surprised if it rises from $15B/month to $20B or $25B/month rather than the baseline market assumption of $30B/month. If that is the case, then another repricing in markets will be coming, with risk assets getting a reprieve while the dollar is likely to suffer. While this is not my base case, I would ascribe at least a 30% probability to the idea that tomorrow’s FOMC is less hawkish than currently priced. Stay on your toes.
In the meantime, here is what has been happening since you all went home last evening. As mentioned, risk is under pressure with Asian equity markets (Nikkei -0.7%, Hang Seng -1.3%, Shanghai -0.5%) all following the US markets lower while European markets opened in a similar vein. However, it appears that recent omicron news regarding the efficacy of current vaccinations with respect to moderating illness has begun to turn sentiment around and we now see both the DAX and CAC flat on the day while the FTSE 100 (+0.4%) has risen, embracing the new omicron news along with better than expected employment data from the UK (Unemployment fell to 4.2% with Weekly Earnings rising 4.9%). Alas, US futures remain lower despite that Covid news, led by the NASDAQ (-0.6%).
Bond markets, which had earlier been modestly firmer (yields lower) have reversed course on the omicron news and we now see Treasury yields (+1.9bps) rising alongside the European sovereign market (Bunds +1.5bps, OATs +1.2bps, Gilts +2.3bps). It seems market participants continue to be whipsawed between concerns over tighter policy and positive omicron news.
Commodity prices, too, have begun to reverse course as early session declines have now been erased with oil (0.0%) back to flat on the day from a nearly 1% decline a few hours ago. While NatGas (-2.6%) in the US remains stable and under $4/mmBTU, the situation in Europe remains dire with prices rising another 3.6% as ongoing concerns over Nordstream 2 pressure the situation. In the metals’ markets, there is mostly red with precious (Au -0.1%) softer and base (Cu -0.1%, Al -0.7%) also under pressure. Agricultural products are falling as well today.
The dollar is on its back foot this morning as positivity permeates the markets with only NOK (-0.15%) softer in the G10, still feeling the lingering pain of oil while we see CHF (+0.35%) and EUR (+0.3%) lead the way higher. Much of this movement, I believe, is position related as there has been little data or commentary to drive things, and the broader dollar gains that we have seen over the past months are seeing some profit-taking ahead of the FOMC and ECB meetings in the event that my case above for a more dovish outcome occurs. Remember, too, given the market’s long dollar positioning, even a hawkish Fed could see a ‘sell the news’ result.
EMG currencies are showing similar trends with TRY (-3.3%) the true outlier as the lira quickly melts on ongoing policy concerns. But elsewhere, HUF (+0.8%) has gained as the central bank reduced its QE purchases and expectations of further rate hikes are rampant. CZK (+0.5%) is also benefitting from hawkish central bank news as the head there explained he saw rates closer to 4.0% than 3.0% next year (current 2.75%). After those stories, there is much less movement overall.
Data this morning showed the NFIB Small Business Optimism Index edge slightly higher to 98.4 while PPI (exp 9.2%, 7.2% ex food & energy) is due at 8:30. If the market takes hold of the latest omicron news, I would expect the equity market to turn around, but also the dollar as less Covid worries allows the Fed to be more hawkish. But really, all eyes are on tomorrow afternoon, so don’t look for too much movement in either direction today.
Good luck and stay safe
In Europe, the UK, and States
The central banks face dire straits
But omicron’s trending
So, what should they do about rates?
First Jay will most certainly say
More tapering is on the way
But Andrew is stuck
With Covid amok
While Christine, a choice, will delay
It is central bank week and all eyes are on the decisions and statements to be made by the Fed on Wednesday and the BOE and ECB on Thursday. In fact, the BOJ will be meeting Friday, but by that time, given the fact that markets are likely to be exhausted from whatever occurs earlier in the week and the assumption nothing there will change, that news seems unlikely to matter much.
By this time, the market narrative (as opposed to the Fed’s preferred narrative) has evolved to the Fed must taper QE even more rapidly with doubling that rate seen as the bare minimum. You may recall that in November, the Fed announced it would be reducing its QE purchases by $15 billion / month until such time as QE ended. At that point, they would then consider the idea about raising interest rates assuming inflation remained a concern. Of course, since then, no matter how you measure inflation, (CPI, core PCE, Trimmed Mean, Sticky) it has risen to levels not seen since the early 1980’s. This has resulted in a near hysterical call by the punditry for much faster tapering and nearly immediate interest rate hikes. The longer the Fed delays the process, the fact that rising inflation forces real yields lower means that monetary conditions are easing during a period of extraordinary fiscal policy led demand. This simply exacerbates the inflation situation feeding this self-reinforcing loop. Quite frankly, I believe the punditry is correct on this issue, but also expect that the Fed will do less than has become widely believed is necessary because inaction is their default setting.
The dollar, which is largely firmer across the board this morning, continues to benefit from the anticipated hawkishness that this new narrative has evoked. Arguably, that sets up the opportunity for a sell-off in the greenback if Powell doesn’t deliver the goods, and realistically, even if he does on a ‘sell the news’ outcome.
Turning to the Old Lady of Threadneedle Street, Governor Andrew Bailey has already drawn the ire of financial markets (and some members of Parliament) with his comments from October that many took as a ‘promise’ to raise the base rate then in an effort to address rising inflation in the UK. But he didn’t do so, and blamed market participants for hearing what he said as such a promise. That led to investors and traders assuming the rate hike would be coming this week, with more to follow, and that the base rate, currently at 0.10%, would be raised to 1.25% by the end of 2022. However, omicron has thrown a wrench into the works as the Johnson government is now considering Plan B, or C or D (I lose count) as their newest lockdown strictures to prevent the spread of the latest variant. Arguably, raising interest rates into a period where the economy is shutting down would be categorized as a policy mistake, and one easily avoided. Thus, the BOE finds itself in a difficult spot, wait to find out more about omicron despite inflation’s rapid and persistent rise, or address inflation at the risk of tightening into a slowing economy.
The pound, despite expectations which had been focused on the BOE leading the interest rate cycle amongst the big four central banks, has traded back down to its lowest level in a year, although realistically to its average over the past five years. The trend, though, is clearly lower and any reasonable hawkishness by the Fed is likely to see Sterling test, and break below, 1.30, in my view. At this point, I feel like the pound is completely beholden to Powell, not Bailey.
Finally, the ECB also announces their policy decisions on Thursday, just 45 minutes after the BOE. Here the discussion has been around what happens when the PEPP, which is due to expire in March 2022, ends and what type of additional support will they be pumping into the economy. It has already become clear that the original QE program, the APP, will be expanded in some form, but one of the things about that was the requirement that the ECB stick to the capital key with respect to its purchases, and the inability of that program to purchase non-IG debt. The problem there is that Greece remains junk credit, but also the Greek government bond market remains entirely dependent on the ECB’s purchases to continue to function. At the same time, Germany, where inflation is running the hottest (Wholesale Prices rose 16.6% in November, the highest level ever in the series back to June 1968) is where the largest proportion of bonds is purchased, easing local financial conditions even further thus exacerbating the inflation story there. In many ways, it is understandable as to why there is less clarity on the ECB’s potential actions. As many problems as the Fed has created for themselves, the ECB probably has more, and Madame Lagarde is not a central banker by trade, but rather a politician. As such, she is far more likely to push for a politically comfortable solution than an economically sound one.
The euro had been trending steadily lower until Thanksgiving when we saw a bounce and it has been consolidating ever since. However, my take is the ECB is likely to be more dovish, rather than less, and in the wake of a Fed that is clearly tightening policy and will be seen to have to tighten further going forward, the euro is likely to feel more pressure to decline going forward. Look for a test of 1.10 sometime early in Q1.
OK, now that we’ve set the stage for the week ahead, let’s quickly tour the overnight activity. After yet another rally in the NY afternoon, Asia was mostly higher (Nikkei +0.7%, Hang Seng -0.2%, Shanghai +0.4%) with Europe showing a similar type of performance (DAX +0.9%, CAC +0.15%, FTSE 100 -0.1%). US futures are all pointing a bit higher, but only about 0.2%. Net, risk appetite seems to be modest today ahead of the meetings this week.
Interestingly, despite decent equity market performance, and despite no end in sight for inflation pressures, bond markets have generally rallied today with yields edging lower. Treasury yields have slipped by 1.4bps, while Bunds (-1.0bps), OATs (-1.5bps) and Gilts (-1.7bps) all show similar yield declines. This seems a little odd given the inflation narrative remains strong, but perhaps is a response to concerns over a policy mistake, or three, amongst the central banks.
Commodity prices are mixed this morning with oil (-0.7%) under pressure while NatGas (+1.5%) is making gains based on colder weather. (PS, European NatGas is up 9.3% this morning to $38.33/mmBTU, compared to US NatGas at $3.98/mmBTU). That is NOT a typo, almost 10x the price. It seems that colder weather and the ongoing Russia/Ukraine/Belarus issues are having a big impact. Metals prices are generally firmer with precious (Au +0.4%, Ag +0.4%) looking solid while industrial (Cu +0.3%, Al +1.2%) also perform well although some of the lesser metals like Ni (-0.6%) and Sn (-0.2%) are underperforming.
As to the dollar, it is universally stronger vs. the G10 with NOK (-0.6%) and AUD (-0.5%) the laggards although CAD (-0.3%) is also under the gun. It seems oil is an issue as well as the Chinese economy with respect to the Aussie. EMG currencies are broadly softer, but other than TRY (-2.0%) which continues to trade to new historic lows amid policy blunders, the movement has not been excessive. MYR (-0.4%) is the next worst performer, consolidating recent gains as traders await presumed hawkish news from the Fed, with most other currencies showing similar types of losses on the same story. The exceptions to this rule are ZAR (+0.5%) which rallied on the strength of the metals complex and IDR (+0.2%) which benefitted based on a reduced borrowing plan for the government.
On the data front, ahead of the Fed we see PPI and Retail Sales plus a bit more stuff later in the week.
|Tuesday||NFIB Small Biz Optimism||98.4|
|PPI||0.5% (9.2% Y/Y)|
|-ex food & energy||0.4% (7.2% Y/Y)|
The demand story certainly seems robust based on Retail Sales, and that has to continue to influence the Fed. I find the inventories data interesting as firms evolve from just-in-time to just-in-case models, another inflationary process. But in the end, this week is all about the Fed (and BOE and ECB) so until we know more from there, look for choppy markets with no real direction.
Good luck and stay safe
For months the Fed had been mendacious
In calling inflation fugacious
But that view’s expired
And Jay has retired
The word that had been so fallacious
So, later this morning we’ll see
The reason that transitory
Is out on its ear
As it will be clear
Inflation’s not hyperbole
Chairman Powell must be chomping at the bit this morning as he awaits, along with the rest of us, the release of the November CPI data. For us, it will be the latest data point to which the inflationistas will point and say, ‘see? I told you so.’ But, given the timing of the release, just days before the FOMC is scheduled to meet and therefore during the Fed’s self-imposed quiet period, whether the print is higher than the expected (0.7% M/M, 6.8% Y/Y) number or lower, no Fed speaker will be able to try to shape the discussion. Instead, they will be left to the mercy of the punditry and the markets, something with which they have never been comfortable, at least not since Paul Volcker retired from the Fed.
Of course, they are not completely without capabilities as you can be sure the WSJ is going to run an article later this morning by Nick Timiraos, the current Fed Whisperer, which will be designed to explain the Chairman’s views without attribution. However, given the recent history of the median forecast, which have consistently underestimated the rise in CPI (and PCE for that matter), it seems likely the official narrative will fall further behind the curve. Speaking of the curve, looking at the Fed funds futures markets, expectations are for the first rate hike to come in either May or June of next year, which means if the Fed truly wants to finish QE before raising rates, current expectations for a doubling of the speed of tapering may be underestimating the pace.
We have also heard recently from former Fed officials, who clearly remain in contact with the current group, and virtually every one of these has forecast that the dot plot will show a median of two rate hikes next year with a chance of three and then another four in 2023 with the eventual neutral rate still anchored at 2.50%. And yet, this quasi-official view remains at odds with all the other information we have regarding inflation expectations. For instance, later today we see the University of Michigan stack of data which last month showed 1-year inflation expectations at 4.9% and the 5-10-year figure at 3.0%. Since the Fed is one of the greatest champions of the inflation expectations theory (i.e. inflation can be self-fulfilling, so higher expectations lead to higher actual inflation), it would seem that if the dot plot does indicate long-term rates ought be centered around 2.50%, the Fed believes the neutral rate is negative in real terms. Either that, or they are willing to dismiss data that doesn’t suit the narrative. However, it is more difficult to understand how they are willing to dismiss the data they themselves compile, like the NY Fed’s Consumer Expectations survey which indicates 1-year inflation is expected at 5.7% and 3-year at 4.2%.
Ultimately, there is nothing that we have seen of late that indicates either inflation or inflation expectations are peaking. In addition, inflation continues to be a major topic on Capitol Hill, so for now, it seems clear the Fed will continue to preen its hawkish feathers. This speaks to the dollar resuming its upward trend and calls into question the ability of the equity markets to maintain their euphoria. In fact, a reversal in equity markets will pose a very real conundrum for the Fed as to how to behave going forward; fight inflation or save the stock market. You already know my view is they will opt for the latter.
Anyway, with all eyes set to be on the tape at 8:30, here’s what we have seen overnight. After a late sell-off in the US, equity markets in Asia (Nikkei-1.0%, Hang Seng -1.1%, Shanghai -0.2%) all suffered although European bourses have managed to recoup early weakness and are essentially unchanged across the board as I type. The only data of note has come from the UK, where October GDP rose a less than expected 0.1% pouring some more cold water on the BOE rate hike thesis for next week. US futures, however, are trading higher at this hour, with all three major indices looking at gains of 0.3% or so.
The bond market is under modest pressure this morning, with yields edging higher in the US (+1.4bps) as well as Europe (Bunds +2.4bps, OATs +1.9bps, Gilts +2.8bps) as investors around the world continue to prepare for a higher interest rate environment. Remember, just because the G10 central banks have been slow to tighten policy doesn’t mean that is true everywhere in the world. For instance, Brazil just hiked rates by 150 bps to 9.25% and strongly hinted they would be raising them another 150bps in February given inflation there just printed at 10.74% this morning. Mexico, too, has been steadily raising rates with another 25bps expected next week, and throughout Eastern Europe that has been the norm. The point is that bond markets have every chance of remaining under pressure as long as inflation runs rampant. In fact, that is exactly what should happen.
In the commodity world, early weakness in the oil price has been reversed with WTI (+1.1%) now firmly higher on the day. NatGas (+1.3%) is also firmer although we are seeing much less movement from the metals and agricultural spaces with virtually all of these products withing 0.1% or so of yesterday’s closing levels.
As to the dollar, it is broadly firmer again this morning, albeit not by very much. NZD (-0.25%) and JPY (-0.25%) are the laggards in the G10, although one is hard-pressed to come up with a rationale other than position adjustments ahead of the data release this morning. In fact, that is true with all the G10 currencies, with movements other than those two of less than 0.2%.
The same cannot be said for the EMG space, where TRY (-1.05%) continues to slide as the combination of rampant inflation and a leadership that is seeking to cut interest rates as a means to fight it is likely to undermine the lira for the foreseeable future. Thus far, TRY has not quite reached 14.00 to the dollar, up from 9.00 in mid-October. But there is nothing to prevent USDTRY from trading up to 20 or higher as long as this policy mix continues. Elsewhere, KRW (-0.6%) fell on the news that Covid infections grew at their fastest pace in a year and concerns over potential government actions to slow its spread. Otherwise, weakness in PLN (-0.4%), INR (-0.35%) and CLP (-0.3%), for instance, all seem to revolve around expectations for tighter US monetary policy rather than local weakness.
In addition to the headline CPI discussed above, expectations are for core (+0.5% M/M, +4.9% Y/Y) and Michigan Sentiment is expected at 68.0. Until the data is released, there should be very little in the way of movement. Afterwards, though, I would look for the dollar to rally on higher than expected data and vice versa. We shall see.
Good luck, good weekend and stay safe
When most of us think of an APP
It’s something on phones that we tap
But Madame Christine,
The ECB queen,
Fears PEPP’s end would be a mishap
So, word is next week when they meet
Expansion of APP they’ll complete
Thus, PEPP they’ll retire
But still, heading higher
Are PIGS debt on their balance sheet
Over the next seven days we will hear from the FOMC, ECB and BOE with respect to their policies as each meets next week. Expectations are for the Fed to increase the speed at which they are tapering their QE purchases, with most pundits looking for that to double, thus reducing QE by $30 billion/month until it is over. Rate hikes are assumed to follow shortly thereafter. However, if they sound quite hawkish, do not be surprised if the equity market sells off and all of our recent experience shows that the Fed will not allow too large a decline in stock prices before blinking. Do not be envious of Chairman Powell’s job at this point, it will be uncomfortable regardless of what the Fed does.
As to the ECB, recent commentary has been mixed with some members indicating they believe continued support for the economy is necessary once the PEPP expires in March, and that despite internal rules prohibiting the ECB from buying non IG debt, they should continue to support Greece via the Asset Purchase Program. The APP is their original QE tool, and has been running alongside the PEPP throughout the crisis. Both the doves on the ECB and the punditry believe that any unused capacity from the PEPP will simply be transferred to the APP so there is more buying power, and by extension more support for the PIGS. However, we are hearing more from the hawks recently about the fact that QE has been inflating asset prices and inflation, and perhaps it needs to be reined in. When considering ECB activity, though, one has to look at who is running the show, just like with the Fed. And Madame Christine Lagarde has never given any indication that she is considering reducing the amount of support the ECB is providing to the Eurozone economy. Rather, just last week she explained that inflation’s path is likely to be a “hump” which will fall back down to, and below, their 2.0% target in the near future, so there is no need to be concerned over recent data.
Finally, the BOE finds itself in a sticky situation because of the relatively larger impact of the omicron variant in the UK versus elsewhere. While Governor Bailey had indicated back in October that higher rates were on the way, the BOE’s failure to act last month was a shock to the markets and futures traders are now far less certain that UK interest rates will be rising in order to fight rapidly rising prices there. Instead, there is increased discussion of the negative impact of omicron and the fact that the Johnson government appears to be setting up for yet another nationwide lockdown, something that will clearly reduce demand pressure. So, there is now only a 20% probability priced into the BOE raising rates to 0.25% next week from the current 0.10% level. This is not helping the pound’s performance at all.
And lastly, the PBOC
Adjusted a rare policy
Was raised to a bar
Two points o’er its prior degree
One last piece of news this morning was the PBOC announcement that they were raising the FX Reserve Ratio Requirement from 7% to 9% effective the same day the RRR for bank capital is being cut. This little-known ratio is designed to help the PBOC in its currency management efforts by forcing banks to increase their FX liquidity. This is accomplished by local banks buying dollars and selling renminbi. It is a clear sign that the PBOC was getting uncomfortable with the renminbi’s recent strength. Today is the second time they have raised the FX RRR this year with the first occurring at the end of May. Prior to that, this tool had not been used since 2007! Also, if you look at the chart, following this move in May, USDCNH rose 2.25% in the ensuing three weeks. Since the announcement at 6:10 this morning, USDCNH is higher by 0.5% already. It can be no surprise that the Chinese are fighting the strength of the yuan as it remains a key outlet valve for economic pressures. And while Evergrande is officially in default, as well as several other Chinese property developers, the PBOC maintains that is not a problem. But it is a problem and they are trying to figure out how to resolve it without flooding the economy with additional liquidity and without losing face.
With all that in mind, let’s see how markets have behaved. Yesterday’s ongoing rebound in US equity markets only partially carried over to Asia with the Nikkei (-0.5%) failing to be inspired although the Hang Seng (+1.1%) and Shanghai (+1.0%) both benefitted from PBOC comments regarding the resolution of Evergrande. European bourses are in the red, but generally not by that much (DAX -0.35%, CAC -0.2%, FTSE 100 -0.2%). There was little in the way of data released in the Eurozone or UK, but Schnabel’s comments about PEPP purchases inflating assets have put a damper on things. US futures, too, are sliding this morning with all three major indices lower by about -0.4% or so.
One cannot be surprised that bonds are rallying a bit, between the large declines seen yesterday and the growing risk-off sentiment, so Treasuries (-2.2bps) are actually lagging the move in Europe (Bunds -3.6bps, OATs -3.8bps, Gilts -4.7bps) and even PIGS bond yields have slipped. Clearly bonds feel like a better investment this morning.
After a 1-week rally of real significance, oil (-0.7%) is consolidating some of those gains and a bit softer on the day. NatGas (-0.7%) is also lower and we are seeing weakness in metals prices, both precious (Au -0.2%. Ag -0.7%) and industrial (Cu -1.4%). Foodstuffs are also under pressure this morning, but at this time of year that is far more weather related than anything else.
As to the dollar, it is broadly stronger this morning with the only G10 currency to gain being the yen (+0.1%) and the rest of the bloc under pressure led by NOK (-1.0%) and AUD (-0.45%) feeling the heat of weaker commodity prices. I must mention the euro (-0.3%) which seems to be adjusting based on the slight change in tone of the relative views of FOMC and ECB policies, with the ECB dovishness back to the fore.
EMG currencies are also mostly softer although there are a few outliers the other way. The laggards are ZAR (-1.0%) on the back of softer commodity prices and TRY (-0.9%) which continues to suffer from its current monetary policy stance and should continue to do so until that changes. We’ve already discussed CNY/CNH and see HUF (-0.5%) also under pressure as the 0.2% rise in the deposit rate was not seen as sufficient by the market to fight ongoing inflation pressures. On the plus side, the noteworthy gainer is CLP (+0.5%) which seems to be responding to the latest polls showing strength in the conservative candidate’s showing. Also, I would be remiss if I did not highlight BRL’s 1.5% gain since yesterday as the BCB raised rates by the expected 1.50% and hawkish commentary indicating another 1.50% rate rise in February.
On the data front, Initial (exp 220K) and Continuing (1910K) Claims are really all we see this morning, neither of which seem likely to have an FX impact. Tomorrow’s CPI data, on the other hand, will be closely watched.
The current narrative remains the Fed is quickening the pace of tapering QE in order to give themselves the flexibility to raise rates sooner given inflation’s intractable rise. As long as that remains the story, the dollar should remain well supported, and I think that can be the case right up until the equity markets respond negatively. Any sharp decline will be met with a dovish Fed response and the dollar will suffer at that point. Be prepared.
Good luck and stay safe
It turns out the internet can
Stop working, though that’s not the plan
Thus, to be succinct
The people who linked
Their lives to it found nothing ran
Under the heading, ‘It’s amusing today but could be much worse’, it seems there is a downside to all the conveniences we were promised if we just linked all the mundane features of life to the internet so the IoT could work its magic. When the IoT stops working, so do all those mundane features, like door locks using Ring, and Roomba® vacuums and smart refrigerators and washing machines. And so, yesterday, when Amazon Web Services crashed for upwards of 9 hours along the East Coast, many people and businesses learned just how reliant they were on a single private company (albeit a big one) for maintaining the status quo of their lives. Do not be surprised if the question arises as to whether the ‘cloud’ has become too important for the private sector to manage by itself and needs to be regulated as a utility going forward.
With omicron somewhat less feared
The bulls feel the way has been cleared
To add to positions
Which led to conditions
Where price rises were engineered
Markets, however, were completely unconcerned with any hiccups regarding the cloud and bulled ahead with spectacular gains yesterday as the NASDAQ led the way rising more than 3.0%. While this author’s view is risk appetite is more closely correlated to views on / concerns over the tapering of QE and tighter Fed policy, the narrative has been very focused on omicron and the news that it seems to be more widespread but far less virulent and therefore will have a lesser impact on the recovering economy. At least, that’s what the punditry is saying this morning as an explanation for yesterday’s massive risk-on rally.
And perhaps, that is an accurate viewpoint. Perhaps last week’s selloff was entirely due to the uncertainty over just how impactful omicron would be on the global economy. The problem is that doesn’t pass the smell test. Consider that if omicron was really going to result in another wave of economic closures, the central bank response would likely be adding still more liquidity to the global system, much of which would find its way into equities. In contrast, tighter monetary policy that reduces overall liquidity would have the opposite effect. As such, it seems to me that sharp declines are more likely on fear of less liquidity than fear of the latest virus variant. So, while markets are still pricing rate hikes for next year, they have clearly come to grips with the current expected pace of those hikes. Now, if inflation continues to rip higher, and we see the latest CPI print on Friday, the sanguinity over the pace of rate hikes could well disappear. Remember that there are many ‘fingers of instability’ weaving throughout the market construct, among them massive leverage and extremely high equity valuations. Risk is a funny thing, it often isn’t a concern until, suddenly, it is the only concern. Risk asset markets, while continuing to ascend, are also doing so on less and less breadth. Again, I would contend that hedging remains a critical activity for the corporate set.
Looking around markets today, yesterday’s euphoria, while evident in Asia overnight, has not made its way to Europe. Japan’s Nikkei (+1.4%) led the way in Asia despite GDP data printing at a much lower than expected -3.6% in Q3. It seems to me any idea that the BOJ will consider reducing its support for the economy is misplaced. If anything, I would anticipate increased support as the nation tries to dig itself out of its latest economic hole. As to the rest of Asia, the Hang Seng (+0.1%) lagged as its tech sector continues to be undermined by Xi’s ongoing crackdown on Chinese tech behemoths, but Shanghai (+1.1%) with far less tech exposure, did fine.
Europe, on the other hand, is under a bit of pressure this morning with the DAX (-0.6%) leading things lower followed by the CAC (-0.3%) while the FTSE 100 is little changed on the day. The big news in Germany is that Angela Merkel is officially out as Chancellor and Olaf Scholz was sworn in as the new leader of the nation. I don’t envy his situation as energy prices are rising sharply and Germany is entirely reliant on Russia and Vladimir Putin for the natural gas necessary to stay warm this winter, while their export-led economy is so tightly tied to China’s performance, that the ongoing slowdown there will soften growth prospects. But then again, as a Social Democrat, maybe that is exactly the position Scholz relishes.
Finally, US markets remain in euphoria mode with futures all pointing higher by another 0.4% at this hour with the S&P 500 less than 1% from its all-time high.
The bond market, this morning, is showing no clarity whatsoever. Treasury yields, after backing up 5bps yesterday, are actually lower by 0.8bps despite the positive look from equities. Bunds and OATs are little changed while Gilts (-1.4bps) are showing the most strength. Perhaps of more interest are the PIGS, where yields are rising sharply (Italy +3.2bps, Greece +4.9bps) after comments from Latvian ECB member, Martin Kazaks, that there was little reason to continue with additional QE once PEPP expires in March. I suspect the Greeks and Italians would have a different opinion!
Last week, commodity prices were under huge pressure, led by oil, which cratered in the wake of the Thanksgiving holiday. This morning, WTI (+0.75%) and Brent (+1.0%) are continuing their strong rebound with both grades more than 12% off their recent lows. NatGas (+3.9%), too, is rebounding but has much further to go to reach the peaks seen in October. Metals market, on the other hand, are having a less interesting day with gold (+0.1%) and copper (+0.1%) just edging up a bit.
Turning to the dollar, it is broadly, but not universally weaker this morning with NOK (+0.6%) leading the way on the back of oil’s rebound, although the rest of the G10 gainers are far less impressive (AUD +0.2%, CAD +0.1%). There are some laggards as well with GBP (-0.35%) falling after news that PM Johnson is about to impose new travel restrictions in the country. Now, if the UK combines tightening monetary policy, at which the BOE has hinted, with omicron inspired restrictions, that is clearly a recipe for slowing growth, and a weaker pound and FTSE. In fact, the pound has fallen to its lowest level in almost exactly 12 months this morning. In the EMG space, only TRY (-1.3%) is really falling and that story is consistent. On the plus side, though is THB (+0.6%), RUB (+0.4%) and ZAR and MXN (both +0.35%) as the commodity sector continues to perform well while Thailand powered ahead on reduced omicron fears. So, the UK is reacting one way while the Thai government is going in the opposite direction!
On the data front, yesterday’s productivity and labor cost data were even more awful than forecast and Consumer Credit rose far less than anticipated and barely 56% as quickly as September. This morning brings only the JOLTs report (exp 10469K) which means that with the lack of Fed speakers, the FX market will look elsewhere for drivers. As long as risk remains in vogue, I expect the dollar to remain under some pressure, but if the European equity impulse comes here, look for the dollar to recoup its losses before the day is over.
Good luck and stay safe
The omicron variant seems
No longer to haunt people’s dreams
Thus, stocks are advancing
And markets financing
The craziest, wildest schemes
So, risk is no longer taboo
As narrative changes ensue
Chair Powell’s regained
Control, and contained
The fallout from his last miscue
Risk appetite is remarkably resilient these days as evidenced not only by yesterday’s US equity rally, but by the follow-on price action in Asia last night as well as Europe this morning. In fact, it seems the rare market that has not rallied at least 2% this morning. Naturally, this raises the question as to what is driving this sudden return to bullishness? Is it a widening view that the omicron variant is not going to result in more draconian government lockdowns? Well, based on the news that NYC has imposed new restrictions on people, requiring vaccinations for everyone aged 5 and older to enter any public building, that may not be the case. Perhaps the news that Austria has established fines of €600 for the first time someone is found not to be vaccinated with an increasing scale and jail time in that person’s future if they do not correct the situation, is what is easing concern.
At this point, arguably, it is too early to truly understand the nature of the omicron variant and its level of virulence, although it is clearly highly transmissible. Early indications are that it is not as deadly but also that none of the currently approved vaccines does much with respect to preventing either infection or transmission of this variant. However, global equity investors have clearly spoken and decided that any potential issues are either likely to be extremely short-term or extremely mild.
Perhaps this renewed risk appetite has been whetted by the idea that the Fed’s tapering will be a net positive for the market. On the surface, of course, that doesn’t seem to accord with the idea that it has been the Fed’s (and ECB’s) largesse of adding constant liquidity to the system that has been the major support for the equity rally. I’m sure you all have seen the graph that shows the growth in the Fed’s balance sheet overlain on the price action in the S&P 500, where the two lines are essentially the same. So, if more central bank liquidity has been the key driver of higher stock prices, how can reduced liquidity and threats(?) or indications of higher interest rates coming sooner help support stocks. That seems to run contra to both that thesis as well as the idea that inflation is good for stocks, with the second idea suffering from the concept that tighter monetary policy is designed to fight inflation.
But maybe, that is the key. For the cognitive dissonant equity bull, loose policy and high inflation are good for equity markets because loose policy will keep the economy growing faster than inflation can reduce real returns. On the other hand, tighter policy will fight inflation thus allowing lower nominal returns to remain competitive on a real basis. Or something like that. Frankly, it has become extremely difficult to understand the ever-changing rationales of equity bulls. But that doesn’t mean they haven’t been right for a long time now, despite changes in underlying macroeconomic trends.
From its peak on November 22, to its bottom Friday, the S&P 500 fell about 5.25%, not even a correction, as defined in the current vernacular. That requires a 10% pullback. So, for all intents and purposes, this bull market has done nothing more than pause for a few days and is apparently trying to regain all its lost ground as quickly as possible. Remember this, though, trees do not grow to the sky, nor do markets rally forever. There continue to be numerous red flags as to the performance of equities; notably potentially tighter monetary policy, extremely high valuations, narrowing breadth of index performance and questions over future earnings growth amongst others. And any of these, as well as the many potential issues that are not even currently considered, can be a catalyst for a more significant risk-off event. In fact, the situation in the Treasury market, the curve is flattening quite rapidly, seems to be one clear warning that the future may not be as rosy as currently priced by the stock market. Do not take for granted that risk appetite will remain this robust indefinitely and plan accordingly.
But today that is not a concern! Risk is ON and in a big way. After yesterday’s US rally, we saw all green in Asia (Nikkei +1.9%, Hang Seng +2.7%, Shanghai +0.2%) and Europe (DAX +2.1%, CAC +2.2%, FTSE 100 +1.2%) with US futures all higher between 1.0% (DOW) and 1.8% (NASDAQ). In other words, all is right with the world! Interestingly, one of the stories making the rounds today is about yesterday’s Chinese reduction in the RRR, but that was literally yesterday’s news, well known throughout the entire session. I feel like there is something else driving things.
As to the bond market, while prices have fallen slightly, the movement is a lot less than would be expected given the strength of the equity rally. Treasury yields are higher by just 0.2bps while Bunds (+1.5bps), OATs (+0.9bps) and Gilts (+2.4bps) are all responding a little more in line with what would normally be expected. Data from Europe was slightly better than forecast with German IP (2.8%) and ZEW Expectations (29.9) both showing the economy there holding up better despite the ongoing lockdowns. Asian bonds also saw yields climb a bit making the process nearly universal.
Commodity prices are following the risk narrative with oil (+2.8%) rallying sharply for the second consecutive day and now trading nearly 15% off the lows seen Thursday! NatGas (+2.2%) is rebounding but still well below its highs seen in early October, while metals prices are all higher as well led by Cu (+0.7%) and Al (+1.2%) although both gold (+0.25%) and silver (+0.3%) are a bit firmer as well.
It will come as no surprise that the dollar is somewhat softer this morning given the environment as we see AUD (+0.7%), CAD (+0.5%) and NOK (+0.4%) all benefit from firmer commodity prices while the euro (-0.25%) is actually the laggard on the day, despite the rally in equities there. Perhaps the single currency is gaining some haven characteristics. In the emerging markets, TRY (+0.7%) is the leading gainer followed by THB (+0.6%) and BRL (+0.5%). One can simply recognize the extreme volatility in the lira given the ongoing policy missteps, so a periodic rally should be no surprise. As to the baht, it seems buyers are looking for China’s RRR cut to support the Chinese economy and by extension the Thai economy as well. Brazil is a more straightforward commodity story I believe. On the downside, CZK (-0.4%) and HUF (-0.3%) are the laggards as traders express mild concern that the central banks there may not keep up with rising inflation when they meet this week and next.
On the US data front, Nonfarm Productivity (exp -4.9%) and Unit Labor Costs (+8.3%) lead along with the Trade Balance (-$66.8B) at 8:30. One cannot help but look at the productivity and labor cost data and wonder how equity markets can continue to rally. Those seem to point to the worst of all worlds. As to the Fed, they are in their quiet period ahead of next Wednesday’s meeting, so nothing to report there.
While I may not agree with its underpinnings, risk is clearly in vogue this morning and I don’t see any reason for that to change today. In general, I would look for the dollar to continue to soften slightly, but also see limited scope for a large move. All eyes have turned to the Fed next week and will be anxiously awaiting Chair Powell’s explanations for whatever moves they make.
Good luck and stay safe