It seems the transition’s complete
As every Fed dove’s in retreat
From Powell to Daly,
And like Andrew Bailey,
They want to end QE tout de suite
Regarding the Fed’s hawks, Mester, George, Bostic and Bullard, we already knew they were ready to end QE. They have been saying so since much earlier this year, before two of their kettle were forced to resign
in disgrace (you remember Rosengren and Kaplan). Just yesterday, Cleveland’s Loretta Mester reiterated she was “very open” to quickening the tapering process in order to give the Fed the option to raise rates early next year if they deem it necessary. But of more interest has been the transition of the erstwhile dovish contingent with Mary Daly’s apparent desire to quicken the taper amongst the most surprising given her consistently dovish leanings. In fact, the only holdout that I can determine is Neel Kashkari from Minneapolis, who has yet to agree inflation is a problem. However, no one is more important than Chairman Powell, who over the past two days, in testimony to Congress, made it clear that come the FOMC meeting on December 15th, the pace of tapering will be increased.
At least, that is the view to which the market is turning. Equity market weakness, a flattening yield curve and rising volatility all demonstrate that investors and traders are beginning to adjust the strategies they have been following since QE1 in the wake of the GFC. This helps explain how the stock market could decline more than 1% two days in a row (!) and why it has fallen, already, nearly 5% from its all-time-high set back on November 22. While I am being somewhat facetious with respect to dramatizing the recent declines, there are many in the market who seem to believe these are unprecedented moves.
And it is this last issue which is likely to become a major concern for the Fed going forward. More than a decade of Fed easy money has taught people to buy every dip in asset prices. Post Covid Fed policy has encouraged people to lever up when they buy those dips and so margin debt has reached historic highs on both a nominal ($581 billion) and percentage of GDP (2.5%) basis. The problem here arises
if when stock prices decline, and margin calls are made. Just like the Fed is a price insensitive buyer of Treasuries, and index funds are price insensitive buyers of equities, margin calls result in price insensitive selling of equities. When this happens, equity prices can decline VERY quickly. Know, too, that exchanges can raise margin requirements intra-day, so if a decline starts at the open, they can raise margin requirements by lunchtime to protect their members. All this matters because the sudden hawkish tilt by the Fed could cause a very severe reaction in the financial markets. And if there is one thing about which we should all be sure, it is that a very sharp decline, anything over 10% in a short period, will be met with a change in behavior by those very same Fed hawks. Talk is cheap. Sticking to their guns because they are trying to address rampant inflation will make them all very unpopular, something which the current denizens of the Marriner Eccles building seem unlikely to be able to handle very well.
Is this the beginning of the end? I don’t believe so, especially as nothing has actually changed yet. However, when it comes to sentiment shifts, they can occur in a heartbeat, so do not rule anything out. Of more importance, though, is what we can expect if the shift comes.
In a classic risk-off scenario, where margin selling is rampant and equity prices are falling sharply, there is very likely to be contagion, so equities worldwide will decline. We are very likely to see Treasuries, Bunds and Gilts in demand, with yields there declining sharply. However, I would expect that the sovereign debt of the PIGS nations will more likely follow the equity market than Bunds, so spreads will widen. Commodity prices will come under severe pressure as this will be seen as a precursor to a recession. And the dollar will rise sharply vs. its EMG counterparts as well as the commodity bloc of the G10. JPY and CHF are both likely to do very well while the enigma is the euro, although my sense is the single currency would decline, just not as aggressively as, say, SEK. We are not at that point but be aware that the current market setup is such that the opportunity for a move of that nature is quite real. If you read Mark Buchanan’s terrific book, Ubiquity, you will recognize the “fingers of instability” described there as being present in every market. It just seems that those fingers are more prevalent currently. (If you haven’t read the book, I cannot recommend it highly enough.)
Ok, let’s take a tour of markets today. Yesterday’s late day US equity decline saw a continuation in Tokyo (Nikkei -0.65%) although the Hang Seng (+0.55%) managed to rally while Shanghai (-0.1%) was roughly flat. I believe HK benefitted from the word that China was going to force the tech companies listed in the US to delist likely driving them to the HK market. Europe, too, has been following that late day sell-off with the DAX (-1.3%) leading the major exchanges lower, followed by the CAC (-1.0%) and FTSE 100 (-0.8%). However, US futures are all pointing higher led by the DOW (+0.9%) as it seems two down days in a row are enough.
Perhaps not surprisingly, the bond market is behaving in a split fashion as well, with Treasury yields (+3.4bps) rising while European sovereigns (Bunds -1.2bps, OATs -2.0bps, Gilts -1.4bps) all slipping as risk is shed on the Continent.
The rebound thesis is alive and well in oil markets with WTI (+0.4%) edging higher, although it is off its early session highs. NatGas (+0.15%) is a touch firmer while precious metals are mixed (Au -0.3%, Ag +0.4%). Mixed also defines the industrial space with copper (+0.5%) doing well while aluminum (-0.6%) is under a bit of pressure. One thing that is universal today, though is the ags, all of which are higher by between 0.5% and 1.5%.
Finally, mixed describes the dollar as well, with half the G10 rising and the other half falling on the session. NOK (-0.35%) is the laggard, while GBP (+0.3%) is the leader. However, given the relatively modest movement, and the lack of news or data, there can be many things leading to these movements. In the EMG bloc, ZAR (+1.1%) is the leader despite (because of?) the omicron variant spreading so rapidly there. Information on the issue of omicron’s impact remains very difficult to come by, but the market appears to be taking the stance that it will not be a very big deal as the rand has rallied 3.5% from its lows seen last week when the news first hit. Away from that, RUB (+0.7%) and MXN (+0.7%) are the next best performers although both are outperforming their key export, oil. On the downside, TRY (-1.2%) continues to fall with no end in sight. Yesterday, President Erdogan sacked his FinMin and replaced him with a new, more pliant deputy, in order to be certain the central bank will continue cutting interest rates in the face of quickly rising inflation. This currency has much further to fall. Away from this, the decliners have been far less impressive led by THB (-0.4%) as local traders see concerns over the impact of the omicron variant.
On the data front, Initial (exp 240K) and Continuing (2003K) Claims are on the docket as all eyes turn to tomorrow’s NFP report. Yesterday’s ADP data was right on expectations which will give comfort to those looking for 545K in the NFP tomorrow.
Bostic, Quarles, Daly and Barkin take the stage today on behalf of the Fed and I would expect to hear more about a faster taper from all of them as this is clearly the new message. Looking at the dollar with all this in mind, it still appears to be following the 10-year trade more than the 2-year trade. As such, if the curve continues to flatten, I would look for the dollar to continue to consolidate its recent gains.
One last thing, I will be out tomorrow so there will be no poetry. However, my take is the NFP data is likely to be in line with expectations so not have much impact overall.
Good luck, good weekend and stay safe