As central banks worldwide prepare
To raise rates investors don’t dare
Buy bonds, bunds or gilts
While confidence wilts
Defining Jay Powell’s nightmare
The upshot is negative rates
Are no longer apt for long dates
But we’re still a ways
From NIRP’s end of days
While Christine and friends have debates
Whatever else you thought mattered to markets (e.g. Russia/Ukraine, oil prices, omicron) you were wrong. Right now, there is a single issue that has every pundit’s tongue wagging; the speed at which the Fed tightens policy. Don’t get me wrong, oil’s impressive ongoing rally feeds into that discussion, but is clearly not the driver. So too, omicron’s impact as it spreads rapidly, but seems clearly to be far less dangerous to the vast majority of people who contract the disease. As to Russia and the widespread concerns that it will invade the Ukraine shortly, that would certainly have a short-term market impact, with risk appetite likely reduced, but it won’t have the staying power of the Fed tightening discussion.
So, coming full circle, let’s get back to the Fed. The last official news we had was that tapering of asset purchases was due to end in March with the Fed funds rate beginning to rise sometime after that. Based on the dot plot, expectations at the Eccles Building were for three 0.25% rate increases this year (Jun, Sep and Dec). Finally, regarding the balance sheet, expectations were that process would begin at a modest level before the end of 2022 and its impact would be minimal, you remember, as exciting as watching paint dry. However, while the cat’s away (Fed quiet period) the mice will play (punditry usurp the narrative).
As of this morning, the best I can figure is that current market expectations are something along the following lines: QE will still end in March but the first of at least four 0.25% rate hikes will occur at the March FOMC meeting as well. In fact, at this point, the futures market is pricing in a 12.5% probability that the Fed will raise rates by 0.50% in March! In addition, regarding the balance sheet, you may recall that in 2017, the last time the Fed tried to reduce the size of the balance sheet, they started at $10 billion/month and slowly expanded that to $50 billion/month right up until the stock market tanked and they reversed course. This time, the punditry has interpreted Powell’s comments that the runoff will be happening more quickly than in 2017 as a starting point of between $40 billion and $50 billion per month and rising quickly to $100 billion/month as they strive to reach their target size, whatever that may be.
The arguments for this type of action are the economy is much stronger now than it was in 2017 and, more importantly, inflation is MUCH higher than it was in 2017, as well as the fact that the balance sheet is more than twice the size, so bigger steps are needed. Now, don’t get me wrong, I am a strong proponent of the Fed disentangling itself as much as possible from the markets and economy, however, I can’t help but wonder if the Fed moves according to the evolving Street narrative, just how big an impact that will have on asset markets. Consider that since the S&P 500 traded to its most recent high on January 4th, just 2 weeks ago, it has fallen 5.0%. The NASDAQ 100 has fallen 10.5% from its pre-Thanksgiving high and 8.5% from its level on January 4th. Ask yourself if you believe that Jay Powell will sit by and watch as a much deeper correction unfolds in equity markets. I cannot help but feel that the narrative has run well ahead of reality, and that next week’s FOMC meeting is going to be significantly more dovish than currently considered. We have seen quite substantial market movement in the past several weeks, and if there is one thing that we know for sure it is that central banks abhor sharp, quick movement in markets, whether higher (irrational exuberance anyone?) or lower (Powell pivot, “whatever it takes”.)
The argument for higher interest rates is clear with inflation around the world (ex Japan) soaring, but central bankers are unlikely, in my view, to tighten as rapidly as the market now seems to believe. They simply cannot stand the pain and more importantly, fear the onset of a recession for which they will be blamed. For now, though, this is the only story that matters, so we have another week of speculation until the FOMC reveals their latest moves.
Ok, so yesterday was a massive risk-off day, with equities getting clobbered while bonds sold off sharply on fears of central bank actions. In fact, the only things that performed well were oil, which rose 2.7% (and another 1.5% this morning) and the dollar, which rallied against virtually all its G10 and EMG counterparts. Overnight saw the Nikkei (-2.8%) follow in the footsteps of the US markets although the Hang Seng (+0.1%) and Shanghai (-0.3%) were far more sanguine. Interestingly, European bourses are mostly green today (DAX +0.25%, CAC +0.55%, FTSE 100 +0.25%) despite further data showing inflation is showing no sign of abating either on the continent (German CPI 5.7%) or in the UK (CPI 5.4%, RPI 7.5%). As to US futures, +0.2% describes them well at this hour.
Bond markets remain under severe pressure with yields higher everywhere except China and South Korea. Treasuries (+1.4bps) continue their breakout and seem likely to trade to 2.0% sooner rather than later. Bunds (+2.6bps and yielding +0.003%) have traded back to a positive yield for the first time since May 2019. Of course, with inflation running at 5.7%, that seems small consolation. OATs (+2.4bps) and the rest of the continental bonds are showing similar yield rises while Gilts (+5.2bps) are leading the way lower in price as investors respond to the higher than already high expectations for inflation this morning. Remember, the BOE is tipped to raise the base rate as well next week, but the global impact will be far less than whatever the Fed does.
Oil prices continue to soar as the supply/demand situation continues to indicate insufficient supply for growing demand. This morning, the IEA released an update showing they expect demand to grow by an additional 200K barrels/day in 2022 while OPEC+ members have been unable to meet their pumping quotas and are actually short by over 700K barrels/day. I don’t believe it is a question of IF oil is going to trade back over $100/bbl, it is a question of HOW SOON. Remember, with NatGas (-0.5% today) still incredibly expensive in Europe, utilities there are now substituting oil for gas as they try to generate electricity, adding more demand to the oil market. And remember, none of this pricing includes the potential ramifications if Russia does invade the Ukraine and the pipelines that run through Ukraine get shut down.
Finally, the dollar is retracing some of yesterday’s substantial rally, falling against all its G10 brethren (NOK +0.45%, AUD +0.4%, CAD +0.3%) led by the commodity currencies, and falling against most of its EMG counterparts with RUB (+1.4%) and ZAR (+1.05%) leading the way. The former is clearly benefitting from oil’s sharp rally, but also from rising interest rates there. Meanwhile, a higher than expected CPI print in South Africa, (5.9%) has analysts calling for more rate hikes there this year and next with as much as 250bps expected now.
On the data front, yesterday saw a horrific Empire Manufacturing outcome (-0.7 vs. exp 25.0), clearly not a positive sign for the economic outlook. This morning brings only Housing Starts (exp 1650K) and Building Permits (1703K), neither of which seem likely to move the needle.
With the Fed silent, the narrative continues to run amok (an interesting visual) but that is what is driving markets right now. This is beginning to feel like an over reaction to the news we have seen, so I would be wary of expecting a continuation of yesterday’s risk-off sentiment. While we will almost certainly see some more volatility before the FOMC announcements next week, it seems to me that we are likely to remain within recent trading ranges in the dollar rather than break out for now.
Good luck and stay safe