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