Selling Aggression

There once was a time when the dip
Was what people bought ere the rip
As equity prices
Would brush off all crises
And FAANGs showed incredible zip
 
But this year there is a new theme
That’s more like a nightmare than dream
The end of each session
Sees selling aggression
As bearishness moves to mainstream
 
There has been an evolution in the market narrative recently that is growing in strength.  After a very long period where BTFD (buy the f***ing dip) was the mantra of algorithms and day traders alike, backed up with don’t fight the Fed, it seems that market price action has turned around to sell every rally you see.  While there is not yet an acronym in place (and I’m sure there will be one soon, perhaps AS for Abandon Ship), what has become abundantly clear is that the sentiment that inflated the broad asset bubble in which we have been living is starting to change.
 
Arguably, the Fed is the cause of this change, which is to be expected as it was their monetary policies that inflated the everything bubble in the first place.  Consider that since the GFC, the Fed has increased the size of its balance sheet by $8 trillion, and the US economy has expanded by another $7.3 trillion (already a problem that the balance sheet grew faster than the economy), while the S&P500 has grown by $28.2 trillion, nearly twice as fast again.  It is certainly difficult to continue to justify the valuation premiums attributed to the equity market if there are any concerns about future growth rates.  And there are plenty of concerns about future growth rates, especially if the Fed is true to its word and actually tightens monetary policy.   
 
The upshot is that investors have been paying an increasing premium for the same dollar of earnings during the past 14 years and we appear to be reaching the breaking point.  The key thing to remember about markets is that their behavior in a rally and in a decline tend to be very different.  Rallies are made of steady, albeit sometimes sharp, moves higher with much buying at the end of each session to insure that asset allocators have their proper proportions in various sectors.  Declines are characterized by mayhem, where sellers often seek to sell anything that is liquid and as quickly as possible.  So, in the vernacular, stocks ride the escalator up and fall down the elevator shaft.  And quite frankly, having witnessed some of the biggest market declines in history (Oct 1987 anyone?) price action recently has started to take on those negative characteristics. 
 
Just think, too, this is happening before the Fed has actually even begun to tighten.  In fact, this week, their balance sheet rose to a new record high!  How will things perform when they actually raise rates, let alone start to allow the balance sheet to shrink.  For those of you who disagree with my thesis that any Fed tightening will be small and short-lived, this market reaction function is exactly how I have arrived at my conclusions.
 
Earlier this week I explained that I believe we are at peak Fed hawkishness, where market expectations have moved to the first (of four) rate(s) hike in March (some calling for 50bps) while balance sheet reduction (QT) will start this summer and proceed to the tune of $40-$60 billion per month thereafter.  Arguably, QT will be much more damaging to the equity markets than a 50-basis point rise in Fed funds, but neither will help.  Many analysts believe that next week’s FOMC meeting will result in a clear timetable for the Fed’s future actions, but I disagree.  Between the recent equity decline and the softening data, the Fed will not want to lock itself into a tightening schedule.  As I wrote earlier, look for Wednesday’s meeting to appear dovish compared to current expectations.  However, that is unlikely to help change risk attitudes that much.
 
Risk is off and has further to go.  Yesterday’s US price action was abysmal as equity markets were higher all day until the last hour and then turned around and fell between 1.5%-2.0% to close with sharp losses.  Asia generally followed that line of reasoning with both the Nikkei (-0.9%) and Shanghai (-0.9%) falling although the Hang Seng was unchanged on the day.  In fact, the Hang Seng was the only bright spot around.  Europe is much softer (DAX -1.6%, CAC -1.4%, FTSE 100 -0.9%) with the only data being weaker than expected Retail Sales in the UK (-3.7%, exp -0.6%).  It can be no surprise that US futures are also under pressure, with the NASDAQ (-0.7%) leading the way at this hour, but all in the red.
 
Remember when the bond bears were certain that the 10-year was getting set to trade through 2.0%?  Yeah, me too. Except, that is not what is going on as this morning, the 10-year Treasury has seen yields decline by another 1.6bps, taking it more than 10bps from its recent high yield.  European bonds are rallying as well with Bunds (-3.0bps), OATs (-2.2bps) and Gilts (-2.4bps) all behaving as havens this morning, and even the PIGS’ bonds performing well.  It is abundantly clear that heading into the weekend, the marginal investor does not want to own risky assets.
 
Today’s risk-off theme is alive and well in commodities too with oil (-1.9%) leading the way lower but weakness in precious metals (Au -0.3%, Ag -0.4%) and industrials (Cu -1.8%, Al -0.8%).  The only outlier is NatGas (+2.8%) which based on the 13-degree temperature at my house this morning seems driven by the weather and not risk.
 
Finally, looking at the dollar this morning it is difficult to discern a strong theme.  In the G10, gainers and losers are split 5:5 with the commodity currencies (AUD -0.4%, NZD -0.4%) leading the way lower while the financials (CHF (+0.4%, SEK +0.35%) are rising.  Given commodity price weakness, this should not be that surprising.  As to the financial side, with Treasury yields declining, those suddenly seem more attractive.
 
However, that same thesis does not appear to be valid for the EMG bloc where the leading gainers (ZAR +0.5%, CLP +0.4%, MXN +0.3%) are all commodity focused while the laggards, aside from TRY which has its own meshugas (look it up), are all commodity importers (TWD -0.25%, THB -0.25%, HUF -0.2%).  In other words, it is difficult to tell a coherent story about the FX markets right now although the one thing that is very clear is that volatility across virtually all currencies has been moving higher.  Old correlations seem to be breaking down, which is leading to the increased volatility we are observing.
 
On the data front, only Leading Indicators (exp +0.8%) are due this morning at 10:00.  Yesterday’s US data was kind of awful with Initial and Continuing Claims both printing far higher than forecast (although attributed to omicron’s impacts) while Existing Home Sales also fell far more than expected which was attributed to a lack of inventory.  However, I would contend that the US growth trajectory is definitely pointing lower as evidenced by the Atlanta Fed’s GDPNow Forecast which is currently at 5.14%, down from 9.7% just one month ago. 
 
As we all await next week’s FOMC meeting, the dollar’s cues are likely to continue to come from the equity markets, and given how poor they currently look, if nothing else, I expect the haven currencies to continue to perform reasonably well.
 
Good luck, good weekend and stay safe
Adf
 
 
 

Every Reason

While prices in Europe are leaping
According to Christine’s bookkeeping
She’s got “every reason”
To keep on appeasin’
The ECB doves who are sleeping

So, rather than look to the Fed
She’s focused on China instead
Where they just cut rates
As growth there stagnates
And Covid continues to spread

One has to wonder exactly what Christine Lagarde is looking at when she makes comments like she did this morning.  Specifically, she said the following in a radio interview in France, [emphasis added] “We have every reason to not react as quickly and as abruptly as we could imagine the Fed might, but we have started to respond and we, of course, stand ready to respond with monetary policy if figures, data, facts, require it.”  Remember, the ECB has a single mandate, achieving price stability which they define as 2% inflation over the medium term.  With this in mind, let me recount this morning’s data, which clearly has Madame Lagarde nonplussed: German Dec PPI +5.0% M/M and +24.2% Y/Y, the highest figures ever in the history of German record keeping back to 1949.  Eurozone Dec CPI +0.4% M/M and 5.0% Y/Y, also the highest since the creation of the Eurozone.  I realize I am a simple FX salesman, but to my uneducated eye, those indications of inflation seem somewhat above 2.0%.  Perhaps mathematics in France is different than here in the US, but I would challenge Madame Lagarde to explain a bit more carefully why, despite all evidence to the contrary, she thinks the ECB is acting in accordance with their mandate.  I suspect there are about 83 million people in Germany who may be wondering the same thing.

Certainly, traders do not believe her or her colleagues when they say, as Pablo Hernandez de Cos did “an increase in interest rates is not expected in 2022.”   De Cos is the head of the Spanish central bank and a Governing Council member and clearly not a hawk.  Yet, the OIS market in Europe is pricing in 0.20% of rate hikes by the end of 2022 (the ECB has been moving in 10 basis point increments), so two rate hikes.  I also realize that there appear to be many econometric models around that are forecasting a return to much lower inflation within the next twelve months, certainly those are the models the central banks themselves are using.  It seems that the real question is at what point will the central banks, specifically the Fed and ECB, recognize that their models may not be a very accurate representation of reality?  And I fear the answer is, never!

Perhaps Madame Lagarde was channeling Yi Gang, the PBOC’s Governor, although the situation on the ground in China is clearly different than that in Europe.  For instance, after cutting two important interest rates last Friday, the PBOC cut two different interest rates last night, the 1-year loan prime rate by 0.10% down to 3.70%, and the 5-year rate was cut by 5 basis points to 4.60%.  China continues to struggle with their zero covid policy.  They continue to fall behind the curve there as the omicron variant is so incredibly transmissible.  But what is clear is that China is growing increasingly concerned over the pace of growth in the economy and so the PBOC has begun to act even more aggressively.  While 5 and 10 basis point moves may not seem like a lot, given how infrequently the PBOC has been willing to cut interest rates, they are an important signal to market participants that support is at hand.  This was made clear by the equity markets last night where the Hang Seng, home to so many property companies, exploded higher by 3.4% although Shanghai’s market was quite subdued, actually slipping 0.1%.

In the end, it is clear that global synchronicity is not an appropriate way to think about the current macroeconomic situation.  Given the dramatically different ways that different nations approached the Covid pandemic, it should be no surprise that there are huge differences in rates of growth and inflation around the world.  The hedging implications of this outcome are that it will require more specific analysis of each country in which there is an exposure to determine the best way to mitigate risks there.

With that in mind, let us take a look at markets this morning.  Despite Shanghai’s lackluster performance, the rest of Asia was actually quite solid with the Nikkei (+1.1%) rounding out the top markets.  Europe, on the other hand, has been less positive with the DAX (+0.1%) edging higher while both the CAC (-0.1%) and FTSE 100 (-0.1%) are slipping a bit.  I guess more promises of ongoing policy ease were not enough to overcome the soaring inflation story on the continent.  US futures are all pointing higher at this hour, with NASDAQ (+0.9%) leading the way although that index has fallen by 10% from its highs, so has more room to catch up.

Looking at the bond market, I can’t help but wonder if we have seen peak hawkishness earlier this week, at least for the Fed.  After the long weekend, we saw the 10-year Treasury yield trade up to 1.88%, but since then it has slipped back with today’s price action seeing yields fall an additional 2.7 basis points and placing us 4bps off those highs.  Now, this could simply be a short-term correction, but with the Fed announcement next week, it really does feel like the market has gotten way ahead of itself.  At this point, the only way next week’s FOMC could be seen as hawkish would be if they actually raised rates, something to which I ascribe a zero probability.  One other thing to recall is that recent surveys continue to show a large contingent of fund managers believe that inflation is transitory which implies that they are likely to take advantage of the current rise in yields and prevent things from running away.

On the commodity front, oil (-0.4%) has stopped running higher, although this pause seems much more like a consolidation than a change in views.  NatGas (-1.5%) is also a bit softer today in both the US and Europe as seasonal or higher temperatures continue to reduce marginal demand.  Turning to metals markets, gold (-0.2%) is slightly softer this morning, but overall, despite rising interest rates, has held up quite well lately and remains well above the $1800/oz level.  Interestingly, silver (0.0% today +4.6% this week) seems to be having a much better time of things and technically looks to have broken out higher.  Arguably, this information blends well with the thought that bond yields may have peaked, but we shall see.

As to the dollar, it is mixed this morning with both gainers and losers in both the G10 and EMG spaces.  The funny thing is, other than RUB (-0.6%) which is leading the way lower today on the back of threats of more substantial sanctions in the event Russia does invade the Ukraine, the rest of the story is much harder to pin down.  For instance, from a news perspective Bank Indonesia met last night and left rates on hold, as expected, but indicated that it would begin normalizing monetary policy in March, returning its RRR to its pre-covid levels, but the rupiah only rose 0.2%.  In fact, today’s leading gainer is ZAR (+0.75%), but given the dearth of either data or news, the best bet here seems to be a response to precious metals strength.  One other thing to remember is that despite easing by the PBOC, the renminbi continues to edge higher.  Frankly, I see no reason for it to weaken anytime soon, especially with my view the dollar will be suffering going forward.

On the data front, Initial Claims (exp 225K), Continuing Claims (1563K), Philly Fed (19.0) and Existing Home Sales (6.43M) are on the calendar.  Remember, Empire Manufacturing was a huge bust earlier this week, so watch the Philly Fed number for any indication of weakness and slowing growth here at home.  In fact, it is that scenario that will allow the Fed to remain on the dovish side, although I fear it will not slow down the inflation train.

If there are any inklings that the Fed is not going to be as hawkish as had seemed to be believed just a few days ago, I expect that the dollar will come under further pressure.  In fact, in order to change that view we will need to see a very hawkish outcome from next Wednesday’s FOMC, something I do not anticipate.  Payables hedgers, I fear the dollar may be near its peak, so don’t miss out.

Good luck and stay safe
Adf

Confidence Wilts

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
Adf

Bears are All Thrilled

Kuroda explained
The future is like the past
Ergo, rates unchanged

The BOJ concluded their latest policy meeting last night and the results were…nothing changed.  Well, that’s not strictly true.  Their economic and inflation forecasts were tweaked to arrive at a revised path to the same outcome.  So, instead of faster growth this year, they decided it would be delayed a year before falling back to its long-term 1.0% trend while inflation is now forecast to jump up to… 1.1% for the next two years, from a previous expectation of 1.0%. Now that’s precision!  Kuroda-san’s term expires in April 2023 and despite 12 years of extraordinarily easy money, with QE, YCC and NIRP all employed to drive inflation higher, at this time it seems likely that he will have failed dismally in his only task.  (As an aside, I would wager if you surveyed the Japanese population, there would be scant few demands for higher prices in their purchases.  Just sayin’.)  As to the yen, it is essentially unchanged on the day and when asked about the currency, Kuroda explained it should move stably (whatever that means), but that a weaker yen would ultimately be desired.  Plus ça change.

Excitement has started to build
And bond market bears are all thrilled
With One point Eight breached
The story they’ve preached
Is finally being fulfilled

Arguably, however, the biggest story today is that the US 10-year yield has finally traded above 1.80% (as I type it is +3.2bps at 1.816%) for the first time since before the pandemic in February 2020.  For those market participants who have been preaching that rising inflation would lead to higher yields, this is a clear milestone.  Regarding the transitory vs. persistent inflation narrative, this also indicates a growing number of investors are moving toward the persistent side of the argument.  The key question, of course, is why has this happened today?  Are there specific catalysts or was it simply time?

Perhaps the first place to look is the oil market, where WTI (+1.2%) has rallied more than $1.00/bbl and is trading back above $85/bbl for the first time since October 2014.  We all know that higher oil prices tend to have a very clear impact on both actual prices and price expectations.  Today’s oil rally seems to be the result of a few different issues.  First has been the news that there was a drone attack on oil facilities in the UAE raising the specter of market disruptions from the Middle East.  A background story there is that the amount of spare capacity available in OPEC+ members may also be somewhat overstated as evidenced by the fact that OPEC’s last production increase of 400K barrels per day fell short because several members simply couldn’t pump enough to meet their quotas.  Meanwhile, demand seems pretty robust as 1) the omicron variant is quickly becoming seen as akin to the common cold and so not too disruptive; and 2) with NatGas prices so high in Europe and Asia, utilities are turning to both oil and coal to power their countries adding to oil demand.

Of course, the other key feature of the US interest rate market is forecasting what the Fed is going to do this year and how that will impact things.  It is worth noting that while 10-year yields have jumped 3+ basis points this morning, 2-year yields are higher by more than 6 basis points and back above 1.0% for the first time since before the pandemic as well.  But that means that the yield curve continues to flatten, a harbinger of slower future growth.  Now, one might expect that slower future growth would help reduce inflationary fears and ordinarily that would be a good thought.  However, there is nothing ordinary about the current policy settings nor their recent history and it is those features that are likely to drive market sentiment for at least a little longer.

Remember, monetary policy works with “long and variable lags” which historically has been calculated as somewhere between 24 and 30 months.  This implies that whatever action the Fed takes next week will not start to impact the economy until 2024.  It also means that the actions they took at the beginning of the pandemic, about 22 months ago, are likely starting to be felt in the real economy.  Money supply rose >35% for many months throughout 2020 and the early part of 2021, and it is fair to expect that the impact of all that extra cash floating around has not yet completely been seen.  The point is that inflation remains built up in the system and is likely to be with us for quite some time to come.  With this in mind, it is easy to see why yields are rising.

And there is one more thing to add to the puzzle, QT.  Remember, too, comments from a number of FOMC members hinted at an increasing desire to start reducing the size of their balance sheet.  If they do follow through with that process, it seems likely that Treasury yields will move even higher across the curve as the only price insensitive buyer leaves the market.  The question then becomes, at what point do yields rise enough to make the Treasury uncomfortable when it comes to refinancing the current debt?  I make no claims that I know where that level lies, but I remain confident that as soon as carrying costs for debt start to climb as a percentage of GDP, QT is going to end.  Summing up, there is a lot happening and it feels like we may be at the beginning of some significant trend changes.

How has all this activity impacted markets today?  You will not be surprised to know that risk has been significantly reduced across the board.  Looking at equity markets, red is the predominant color on screens this morning with only one exception, Shanghai (+0.8%) as traders react to easing monetary policy and support for property markets in China.  Otherwise, it is not pretty (Nikkei -0.3%, Hang Seng -0.4%, DAX -1.0%, CAC -1.0%, FTSE 100 -0.6%).  US futures are also under severe pressure led by the NASDAQ (-1.8%) although both the DOW and SPX are lower by -1.0% at this hour.  It seems that rising yields are pretty bad for growth stocks and I believe that story has legs.

Global bond markets had all been much softer earlier in the session but have since recouped their losses so that European sovereigns are essentially unchanged at this hour.  The one outlier, again, in Asia was China, where CGB’s saw yields decline 4.4bps last night as investors pile in looking for further policy ease.

On the commodity front, we have already discussed oil, which is by far the most interesting thing out there.  NatGas in the US is little changed on the day and actually slightly lower in Europe.  Gold (-0.3%) has fallen which should be no surprise given the rise in yields across the curve, and copper (-0.85%) is also under pressure as the flatter curve and declining stocks hint at weaker future growth.

As to the dollar, it is generally firmer this morning although not universally so.  SEK (-0.5%) is the laggard in the G10 on a combination of residual belief the Riksbank will remain relatively dovish and the beginnings of concern over election outcomes when the Swedes go to the polls in September.  After that, AUD (-0.4%) and NZD (-0.4%) are next in line, both suffering from weakness in metals and agricultural markets.  The rest of the bloc is softer by about 0.2% or so save CAD (+0.1%) which is benefitting from oil’s rise.

In the emerging markets, TRY (-0.8%) volatility continues to dominate, but INR (-0.45%), PHP (-0.45%) and HUF (-0.45%) are all under pressure as well.  The first two are feeling the effects of higher Treasury yields as well as concerns over potential CNY weakness after PBOC comments about preventing one-way trading (meaning continued strength).  As to HUF, it and the rest of the CE4 look simply to be displaying their relatively high betas with respect to the euro (-0.2%).

On the data front, Empire Manufacturing (exp 25.0) is today’s only number of note and we will need a big surprise in either direction to have a market impact.  Rather, today’s trend seems pretty clear, higher yields, weaker stocks and a stronger dollar.  Will it continue much longer?  That, of course, is the key question.

Good luck and stay safe
Adf

Lest Things Implode

The central banks all through the West
Are trying to figure how best
To, policy, tighten
But not scare or frighten
Investors and so they are stressed

Meanwhile from Beijing data showed
That Chinese growth actually slowed
With prospects now dimmed
The central bank trimmed
Two interest rates, lest things implode

There is a new contest amongst the punditry to see who can call for the most shocking rate policy by the Fed this year.  With the FOMC in their quiet period, they cannot respond to comments by the likes of JPM Chair Jamie Dimon (the Fed could raise rates 7 times this year!) or hedge fund manager and noted short seller Bill Ackman (the Fed should raise rates by 50 basis points in March to shock the market), and so those comments get to filter through the market discussion and creep into the narrative.  A quick look at Fed funds futures shows that the market is now pricing in not only a 25bp rate hike, but a probability of slightly more at the March meeting.

Now, don’t get me wrong, I think the Fed is hugely behind the curve, as evidenced by the fact they are still purchasing assets despite raging inflation, and think an immediate end to asset purchases would be appropriate policy, as well as raising rates in 0.5% increments or more until they start to make a dent in the depth of negative real yields, but I also know that is not going to happen.  Time and again they have effectively explained to us all that while inflation is certainly not a good thing, the worst possible outcome would be a decline in the stock market.  Their deference to investors rather than to Main Street has become a glaring issue, and one that does not reflect well on their reputation.  And yet, Chairman Powell has never given us a reason to believe that he will simply focus on inflation, which is currently by far the biggest problem in the economy.

However, with the market having already priced in a 0.25% rate hike for March, it is entirely realistic they will raise rates at that meeting.  The key question, though, is will they be able to continue to tighten policy when equity markets start to respond more negatively?  For the past 35 years (since Black Monday in 1987) the answer has been a resounding NO.  Why does anybody think this time is different?

Interestingly, at the same time virtually every Western central bank is trying to figure out the best way to fight the rapidly rising inflation seen throughout the world, the Middle Kingdom has their own, unique, issues, namely disappointing economic growth and expanding omicron growth leading up to the Winter Olympics.  Of course, the last thing that President Xi can allow is any inkling that things in China are not running smoothly, and so after the release of weaker than expected IP, Fixed Asset, Retail Sales and GDP data for Q4, the PBOC cut both its Medium-Term Lending and 7-day Reverse Repo rates by 0.10% last night.  In addition to the weaker data came the news that yet another property developer, Logan Group, may have made guarantees that do not appear on their balance sheet to the tune of $812 million.  I have lost count of the number of property developers in China that are now under growing pressure ever since the initial stories about China Evergrande.  But that is the point, the entire property sector is under huge pressure of imploding and property development has been somewhere between 25%-30% of the Chinese GDP growth.  This does not bode well for Chinese GDP growth going forward, which does not bode well for global growth.  PS, one last thing to mention here is the Chinese birth rate fell to its lowest level since 1950!  Only 10.62 million babies were born in 2021, despite significant efforts by the government to encourage family growth.  As demographics is destiny, unless the Chinese change their immigration policies, the nation is going to find itself in some very difficult straits as the population there ages rapidly and the working population shrinks.  Just sayin’.

Ok, with that out of the way, a look around today’s holiday markets shows that risk is on!  Aside from the Hang Seng (-0.7%) overnight, which is where so many property firms are listed, every other major market is in the green.  The Nikkei (+0.75%) and Shanghai (+0.6%) were both solid performers as that PBOC rate cut was seen as encouraging.  In Europe, the DAX (+0.4%), CAC (+0.6%) and FTSE 100 (+0.6%) are all firmer as are the peripheral markets.  Even US futures (+0.1% across the board) are firmer although there is no trading here today due to the MLK holiday.

Bond markets, on the other hand, are under pressure everywhere as Treasury futures are down 13 ticks or about 3 basis points higher, while European sovereigns (Bunds +1.7bps, OATs +2.0bps, Gilts +2.8bps) are all seeing higher yields as well.  In fact, 10-year Bunds are approaching 0.0% for the first time since May 2019.  Asia was no different with only China (-0.8bps) seeing a yield decline and sharp rises in Australia (+6.7bps) and South Korea (+9.7bps).

In the commodity markets, WTI (0.0%) is flat although Brent (-0.3%) is edging down from its multi-year highs.  NatGas (-0.6%) is also edging lower and European gas prices are falling even more significantly as a combination of LNG cargoes and warmer weather eases some pressure on that market.  Gold (+0.2%) is firmer, despite what appears to be a risk-on day, although copper (-0.7%) is under a bit of pressure.  In other words, the noise is overwhelming the signal here.

As to the dollar this morning, mixed is the best description as there are gainers and losers in both G10 and EMG blocs.  Interestingly, despite oil’s lackluster trading, both NOK (+0.3%) and CAD (+0.2%) are the leading gainers in the G10 while JPY (-0.25%) is following its risk history, selling off as equities gain.  In the emerging markets, RUB (-0.55%) is the worst performer as there seems to be growing concern over the imposition of tighter sanctions in the event Russia does invade the Ukraine.  KRW (-0.45%) is next in line after North Korea launched yet two more ballistic missiles, raising tension on the peninsula.  On the plus side, THB (+0.4%) has been continuing its recent gains as the nation opens up more completely from Covid lockdowns.

It is a relatively light data week with Housing the main focus, and with the Fed in their quiet period, we won’t be getting help there either.

Tuesday Empire Manufacturing 25.0
Wednesday Housing Starts 1650K
Building Permits 1700K
Thursday Initial Claims 220K
Continuing Claims 1521K
Philly Fed 19.8
Existing Home Sales 6.41M
Friday Leading Indicators 0.8%

Source: Bloomberg

In truth, it is shaping up to be a quiet week.  Next week brings the central bank onslaught with the Fed, BOJ and BOC, but until then, we will need to take our cues from equities and geopolitical tensions to see if anything occurs that may inspire the jettisoning of risk assets in a hurry.  My gut tells me we will not be seeing anything of that nature, and so a range bound week for the dollar seems in store.

Good luck and stay safe
Adf

Buying Will Stop

It seems nearly every day now
Some Fed members make the same vow
First buying will stop
Next Fed funds will pop
Then asset run-off we’ll allow

Thus far markets have been subdued
Though some players now have construed
That buying the dip
Has lost all its zip
While selling all rallies is shrewd

Another day, another series of Fed speakers explaining that inflation is the primary focus, that when QE stops in March it may (read will) be appropriate to raise the Fed Funds rate by 0.25% and that the Fed has powerful tools to prevent inflation from getting out of hand.  While it is encouraging that they have finally figured out inflation is a problem, the fact that they still don’t understand it is a problem of their own making is somewhat disconcerting.  However, moving in the right direction is clearly a positive.

So, after Brainerd, Waller, Barkin and Evans all basically said the same thing, here is what we know.  It seems a virtual certainty that the Fed Funds rate will be raised at the March meeting with a very high likelihood of at least two more hikes as the year progresses.  Mr Waller even suggested more than four total this year, although that is clearly a minority view, right now, on the FOMC.  The problem is that 25 basis point increments every 12 weeks is not going to make much of a dent in inflation running at 7.0%.  And, even if inflation falls back down to 4.0%, it will still take more than three years for the Fed to even reach a point where real yields are back to 0.0%.   Not only that, when Waller was asked about 0.50% increments, he dismissed the idea as being destabilizing for markets.  (Yet again we can read between the lines and recognize that preventing an equity market decline remains the Fed’s primary focus regardless of recent comments on inflation.)

But back to the real yield story.  It is important to understand that negative real yields are not a bug in their plans, they are the feature.  Negative real yields are the only way for the US (and every overly indebted nation) to reduce the value of their debt without a technical default.  The Fed knows this playbook from their actions in the wake of WWII, where they capped yields at 2.50% and inflation ran at 10.0%.  A few years later, the debt/GDP ratio had fallen from 125% to 35% and the country’s finances were back in order.  That process worked then because the US economy dominated the global economy and essentially everything was manufactured here.  Given the dramatic changes that have taken place in the ensuing 80 years, it is not clear that the citizenry in the US will be quite as patient this time, but that is almost certainly the Fed’s plan.

If we assume that real yields are set to remain negative for a long time into the future, what are the likely impacts going to be?  First and foremost, real assets like commodities and real estate should perform well and maintain their value if not appreciate.  Bonds, on the other hand, will have a tougher time, although there are many things which may help support them, not least of which would be a reversal of policy by central banks.  Equities are going to find themselves segregated into companies that have businesses and are profitable and those that have benefitted from the ongoing monetary largesse of the central banks and may find that funding their businesses will get more difficult.  In other words, credit is going to matter going forward in this environment.  Finally, the dollar’s behavior will be contingent on just how other nations approach the real yield question.  For those countries that follow sound money policies, and seek to end financial repression, their currencies should benefit.  However, all signs are pointing, at this time, to the fact the US will not be considering sound money policies as they are short-term politically unpalatable, and the dollar will underperform going forward.  I apologize for the dour message on a Friday, but the constant Fed blather becomes difficult to tune out after a while.

Ok, here’s what we have seen overnight.  Yesterday’s tech rout in the US took equity markets lower across the board and that was followed in Asia as well (Nikkei -1.3%, Hang Seng -0.2%, Shanghai -1.0%).  Europe, too, is in the red with fairly solid declines in the DAX (-0.6%) and CAC (-0.6%) although the FTSE 100 (-0.1%) is outperforming after November GDP data showed surprisingly strong growth in the UK across both manufacturing and services. Meanwhile, US futures are hovering either side of unchanged although NASDAQ futures have recently turned down a bit more aggressively.

An interesting feature of today’s price action is that not only are stocks being sold, but so are bonds, and everywhere.  Treasury yields are higher by 3.0bps, although that is simply unwinding yesterday’s rally where yields fell a similar amount.  European sovereigns are also selling off with yields higher across the board (Bunds +2.4bps, OATs +2.4bps, Gilts +2.8bps).  While the positive news from the UK seems a rationale for the Gilt market, German GDP actually fell in Q4 bringing their Y/Y number down to 2.7% and one would have thought that might support Bunds.

Where, you may ask, are investors hiding if they are selling both stocks and bonds?  Commodities are looking better this morning with oil (+0.7%) continuing its recent rally although NatGas (-2.6%) remains beholden to the winter weather.  A warmer day here in the Northeast is undermining the price.  Precious metals (Au +0.1%, Ag +0.2%) are both on the right side of unchanged and most industrial metals are doing well (Cu -0.7%, Zn +1.9%, Sn +2.3%).  Agricultural prices are also beholden to the weather so are seeing a mixed bag this morning.

Finally, the dollar is mixed this morning, with an equal set of gainers and losers in both the G10 and EMG blocs.  JPY (+0.3%) is the leader in the clubhouse as the very obvious risk-off sentiment is encouraging repatriation of funds while AUD (-0.3%) is the laggard, seemingly on the back of the hawkish Fed comments (or perhaps on the fact that Novak Djokovic will not be playing in the Australian Open after all!)  In the emerging markets RUB (-0.6%) is the worst performer on the back of fears of further sanctions as the Ukraine situation continues to escalate, while INR (-0.35%) has also suffered overnight, this more on the talk of Fed hawkishness.  However, after those two, decliners have moved very little, certainly not enough to make a case about anything in particular.  On the plus side, CLP (+0.5%) and ZAR (+0.4%) are the leaders.  The peso is following yesterday’s strength with more as traders anticipate more hawkishness from the central bank while the rand is trading on the back of some key technical levels having been breached and pointing to yet more strength short-term.

Data this morning brings Retail Sales (exp -0.1%, +0.1% ex autos) as well as IP (0.2%), Capacity Utilization (77.0%) and Michigan Sentiment (70.0).  Yesterday’s PPI data did nothing to dispel the idea that inflation is well entrenched in the US economy regardless of what Fed members say in testimony or commentary.

Using the dollar index (DXY) as a proxy, the dollar has fallen 1.5% since this time last week.  Heading into this year, dollar bullishness was rampant as expectations for much tighter Fed policy were seen as likely to push the dollar higher.  However, the early price action is beginning to dispel that notion.  I have a feeling that we are going to see investors sell dollar rallies at the same time they sell equity rallies.  This is a huge sentiment change from the previous “buy the dip” mentality that had been prevalent since Ben Bernanke first introduced QE all those years ago.  Caveat emptor is the new watchword, for both stocks and the dollar.

Good luck, good weekend and stay safe
Adf

Policy, Tighter

Apparently, seven percent
Defined for Chair Jay the extent
Of just how high prices
Can rise in this crisis
Ere hawkishness starts to foment

But is it too little too late?
As he’s not yet out of the gate
Toward, policy, tighter
Despite a speechwriter
That claims he won’t fail his mandate

There is no shame in being confused by the current market situation because, damn, it is really confusing!  On the one hand we see inflation not merely rising, but fairly streaking higher as yesterday’s 7.04% Y/Y CPI reading was the highest since June 1982.  With that as a backdrop, and harking back to our Economics 101 textbooks, arguably we would expect to see interest rates at much higher levels than we are currently experiencing.  After all, in its simplest form, real interest rates, which are what drive investment decisions, are simply the nominal interest rate less inflation. As of today, with effective Fed Funds at +0.08% and the 10-year Treasury at 1.75%, the calculated real interest rates are -6.96% in the front end and -5.29% in the 10-year, both of which are the lowest levels in the post WWII era.  The conclusion would be that investment should be climbing rapidly to take advantage.  Alas, most of the investment we have seen has been funneled into share repurchases rather than capacity expansion.

With this in mind, it makes sense that dollar priced assets are rising in value, so stocks and commodities would be expected to climb, as would the value of other currencies with respect to the dollar.  However, the confusion comes when looking at the bond market, where not only are real yields at historically depressed levels, but there is no indication that investors are selling bonds and seeking to exit the space.

Our economics textbook would have us believe that negative real yields of this magnitude are unsustainable with two possible pathways to adjustment.  The first pathway would be nominal yields climbing as investors would no longer be willing to hold paper with such a steep negative yield.  Back in the 1990’s, the term bond vigilantes was coined to describe how the bond market would not tolerate this type of activity and investors would sell bonds aggressively thus raising the cost of debt for the government.  So far, that has not been evident.  The second pathway is that the inflation would lead to significant demand destruction and ultimately a recession which would slow inflation and allow bondholders to get back to a positive real yield outcome.  Not only would that be hugely painful for the economy, it will take quite a while to complete.

The problem is, neither of those situations appear to be manifest.  The question of note is, is the bond market looking at the current situation and pricing in much slower growth ahead?  Certainly, the punditry is not looking for that type of outcome, but then, the punditry is often wrong.  Neither is the Fed looking for that type of outcome, at least not based on their latest economic projections which are looking for GDP growth of 3.6%-4.5% this year and 2.0%-2.5% next with nary a recession in sight in the long run.

This brings us back to the $64 trillion question, why aren’t bonds selling off more aggressively?  And the answer is…nobody really knows.  It is possible that investors are still willing to believe that this inflationary spike is temporary, and we will soon see CPI readings falling and the Fed declaring victory, so bond ownership remains logical.  It is also possible that given the fact that the BBB bill was pulled and seems unlikely to pass into legislation, that Treasury issuance this year will decline such that the fact the Fed will no longer be purchasing new debt will not upset the supply/demand balance and upward pressure on yields will remain absent.  At least from a supply perspective.  The problem with this idea is that pesky inflation reading, which, not only remains at extremely high levels, but is unlikely to decline very much at all going forward.

Ultimately, something seems amiss in the bond market which is disconcerting as bond investors are typically the segment that pays closest attention to the reality on the ground.  While the hawkish cries from Fed members are increasing in number and tone (just yesterday both Harker and Daly said they expected raising rates in March made sense and 4 rate hikes this year would be appropriate), that implies Fed Funds will be 1.0% at the end of the year, still far below inflation and not nearly sufficient to slow those rising prices.

It seems to me there are three possible outcomes here; 1) bond investors get wise and sell long-dated Treasuries steepening the yield curve significantly; 2) the Fed gets far more aggressive, raising rates more than 100 basis points this year and pushes to invert the yield curve and drive a recession; or 3) as option 1) starts to play out, and both stocks and bonds start to decline sharply, the Fed decides that YCC is the proper course of action and caps Treasury yields while letting inflation run much hotter.  My greatest fear is that 3) is the answer at which they will arrive.

With all that cheeriness to consider, let’s look at how markets are behaving today.  Despite a modest equity rally in the US yesterday, risk has been less in demand since.  Asia (Nikkei -1.0%, Shanghai -1.2%, Hang Seng +0.1%) was generally lower and Europe (DAX 0.0%, CAC -0.5%, FTSE 100 -0.1%) is also uninspiring.  There has been virtually no data in either time zone, so this price action is likely based on growing concerns over the inflationary outlook.  US futures at this hour are basically unchanged.

As to the bond market, no major market has seen a move of even 0.5 basis points today with inflation concerns seeming to balance risk mitigation for now.

Commodity markets are mixed with oil (-0.1%) edging lower albeit still at its highest levels since 2014, while NatGas (-4.5%) has fallen as temperatures in the NorthEast have reverted back to seasonal norms.  Gold (-0.1%) has held most of its recent gains while copper (-0.7%) seems to have found a short-term ceiling after a nice rally over the past few sessions.

Finally, turning to the dollar, it is somewhat softer vs. most of its G10 brethren with NZD (+0.35%) leading the way, followed by CHF (+0.3%) and CAD (+0.2%) as demand for any other currency than the dollar begins to show up.  In EMG currencies, excluding TRY (-2.5%) which remains in its own policy driven world, the picture is more mixed.  RUB (-0.75%) has fallen in the wake of the news from Geneva that there was no progress between Russia, the US and NATO regarding the escalating situation in the Ukraine with the threat of economic sanctions growing.  BRL (-0.55%) is also under some pressure although this looks more like profit taking after a nearly 3% rally in the past two sessions.  On the plus side, THB (+0.5%) and PHP (+0.3%) are leading the way as they respond to the broadly weaker dollar sentiment.

Data today brings Initial (exp 200K) and Continuing (1733K) Claims as well as PPI (9.8%, 8.0% ex food & energy), but the latter would have to be much higher than expected to increase the pressure on the inflation narrative at this point. From the Fed we hear from Governor Brainerd as she testifies in her vice-chair nomination hearing, as well as from Barkin and Evans.  Given the commentary we have been getting, I expect that the idea of 4 rate hikes this year is really going to be cemented.

The dollar has really underperformed lately and quite frankly, it feels like it is getting overdone for now.  While I had always looked for the dollar to eventually decline this year, I did expect strength in Q1 at least.  However, given positioning seemed to be overloaded dollar longs, and with the Treasury market not participating in terms of driving yields higher, it is beginning to feel like a modest correction higher in the dollar is viable, but that the downtrend has begun.

Good luck and stay safe
Adf

Quite a Surprise

This morning’s report on inflation
Is forecast as verification
The Fed is behind
The curve and must find
The will to cease accommodation

While last night from China we learned
The trend in inflation has turned
In quite a surprise
It fell from its highs
A positive for all concerned

Ahead of this morning’s CPI report (exp 7.0%, 5.4% ex food & energy) investors around the world have been feeling positively giddy about the current situation.  Sure, China’s growth forecasts have been cut due to omicron infection outbreaks and the Chinese response of further lockdowns, but that just means that combined with the first downtick in PPI there since February 2020 (10.3%, exp 11.3%, prev 12.9%), talk has turned to the PBOC cutting interest rates next week by between 5 and 10 basis points.  So, while many other nations are aggressively fighting inflation (Brazil, Mexico, Hungary) or at least beginning to tighten policy (UK, Sweden, Canada), the market addiction to ever increasing liquidity may now be satisfied by China.  While it is still too early to know if lower interest rates are coming from Beijing, what is clear is that the credit impulse in China (the amount of lending) seems to have bottomed and is starting to reverse higher.  That alone augers well for future global growth; so, buy Stonks!

Meanwhile, I think it is valuable to consider what we heard from Chairman Powell yesterday at his renomination hearings, as well as what the two erstwhile hawks, Esther George and Loretta Mester, had to say about things.  Mr Powell, when asked why the Fed was continuing to purchase assets with inflation well above target and unemployment near historic lows inadvertently let the cat out of the bag as to the most important thing for the Fed, that if they were to move at a more aggressive pace, it could upset markets and there could be declines in both the stock and bond markets.  Apparently, the unwritten portion of the Fed’s mandate, prevent markets from falling, remains the most important goal.  While Powell paid lip service to the idea that the Fed would seek to prevent the inflationary mindset from becoming “entrenched”, he certainly didn’t indicate any sense of urgency that the Fed’s glacial pace of change was a problem.

Perhaps more surprisingly, neither Mester nor George were particularly hawkish, with both explaining that the Dot Plot from December was a good guide and there was no reason to consider a rate hike as soon as March.  Regarding QT, neither was anxious to get that started either although both wanted to see it eventually occur.  Finally, this morning, former NY Fed President (and current Fed mouthpiece) Bill Dudley explained in a Bloomberg column that there was no hurry to reduce the size of the balance sheet and that when it begins, the impact would be “like watching paint dry.”  Now, where have we heard that before?  Oh yeah, I remember.  Then Fed Chair Yellen used those exact same words to describe the last attempt to shrink the balance sheet right up until Powell was forced to pivot after the equity market’s sharp decline in 2018.  Apparently, the dynamics of drying paint are more interesting than we have been led to believe.

For those seeking proof that investors welcomed yesterday’s comments, one need only look at market behavior in their wake.  US equity markets rallied after the testimony and never looked back all day.  Treasury bonds did very little, with the sharp trend higher in yields having hit a key resistance and unable to find the will to push through.  Finally, the dollar took it on the chin, declining vs virtually every major and emerging market currency yesterday with many of those moves continuing overnight.  Recapping: higher stocks, unchanged bonds and a weaker dollar are not a sign that the market expects much tighter policy from the Fed.

Ok, so how are things looking this morning?  Well, in the equity market, the screen is entirely green. Last night, Asia followed the US lead  with gains across the board (Nikkei +1.9%, Hang Seng +2.8%, Shanghai +0.8%), and European bourses are also higher (DAX +0.35%, CAC +0.5%, FTSE 100 +0.7%) as data from the continent showed much better than expected Eurozone IP growth (2.3% vs 0.2% exp) as well as the first indication that inflation might be peaking in Germany with PPI there “only” printing at 16.1%, down from last month’s record 16.6%.  As to US futures, they are modestly higher ahead of the data, between 0.1%-0.2%.

In the bond market, while 10-year Treasury yields have edged higher by 0.7bps at this hour, they remain just below 1.75% and have shown no inclination, thus far, of breaking out much higher.  Arguably this implies that market participants are not yet full believers in the Fed tightening policy aggressively, and after yesterday’s performances, I think that is a good bet.  Meanwhile, European sovereign bonds are all rallying with yields falling nicely (Bunds -1.8bps, OATs -1.7bps, BTPs -1.3bps) as it remains clear that there is not going to be any tightening of note by the ECB this year.

On the commodity front, we continue to see strength in energy (WTI +0.5%, NatGas +5.2%) as well as industrial metals (Cu +2.9%, Zn +2.2%) although both gold -0.2%, and silver -0.2% are consolidating after strong moves higher yesterday.

Looking at FX markets, I would say the dollar is modestly weaker overall, albeit only in a few segments.  In the G10, NOK (+0.7%) and CAD (+0.2%) are the largest movers, by far, with both benefitting from oil’s continued rise.  The rest of the bloc, quite frankly, is tantamount to unchanged this morning.  In emerging markets, the picture is a bit more mixed with both gainers and losers about evenly split.  However, only 3 currencies have shown any real movement, BRL (-0.4%), KRW (+0.4%) and CLP (+0.3%).  The real seems to be consolidating some of its massive gains from yesterday, when it rallied 1.7% on the back of central bank comments implying that though inflation would fall back in 2022, it would require continued tight policy to achieve that outcome.  On the flip side, the won benefitted from a better than expected employment report showing more than 770K jobs added in the last year and indicating better economic growth going forward.  Finally, the Chilean peso seems to be benefitting from copper’s strong rally today.

Aside from this morning’s CPI report, we also see the Fed’s Beige Book at 2:00pm which has, in the past, been able to move markets if the narrative was strong enough.  Only one Fed speaker is on the docket, Kashkari, and even he, an uber-dove, is calling for 2 rate hikes this year as per his last comments.

The Fed tightening narrative is definitely having some difficulty these days which implies to me that the market has fully priced in its expectations and those expectations are that the Fed will not be able to tighten policy very much.  If the Fed is restrained, and tighter policy continues to get pushed further out in time, the dollar will suffer much sooner than I anticipated.  For those with opex and capex needs, perhaps moving up the timetable to execute makes some sense.

Good luck and stay safe
Adf

A New T#heme

The news yesterday from the Fed
Was Vice-Chair Clarida has fled
While later today
Chair Jay seeks to sway
The Senate to keep him Fed head

But in the meantime, it would seem
The narrative has a new theme
It seems pretty clear
Four rate hikes this year
Have gone from the fringe to mainstream

As we walk in this morning, there seems to be a lot of movement with respect to market expectations regarding the Fed’s actions going forward and exactly how those actions are going to impact the various markets.  Today’s headline event is Chairman Powell’s renomination testimony in the Senate as everyone is waiting to see just how much effort Senator Elizabeth Warren puts into trying to derail the process.  It is widely known that the Senator does not care for Mr Powell going so far as to calling him “dangerous” in his recent semi-annual testimony to the Senate.  Yesterday, she also wrote a letter demanding to see all the personal trading records of all Fed officers which probably was part of the impetus for vice-Chair, Richard Clarida, to step down early from his post.  So, on the one hand, we will be treated(?) to the scene of some Senators trying to play gotcha with the Fed Chair today with the ever-present possibility that some comment is made with a real market impact.

On the other hand, the tightening train has not merely pulled away from the station but is starting to gather serious speed.  Earlier this morning, Atlanta Fed President Bostic commented that he sees 3 rate hikes this year and that the Fed “will act to ensure inflation doesn’t run away from us.”  Futures markets are now pricing in a more than 60% probability of a fourth rate hike in 2022 with an increasing number of Fed speakers explaining a rate hike in March would be appropriate.  We are also hearing the 4-hike scenario from an increasing number of pundits with Goldman Sachs economists publishing that view yesterday while JPMorgan Chairman Jamie Dimon explained that “four rate hikes of 0.25% each would not have an enormous effect on the economy.”  And that is likely correct, a Fed Funds rate of 1.0% doesn’t seem that onerous for businesses.  Of course, what impact would four interest rate hikes have on financial asset prices, especially if they were joined with a reduction in the size of the Fed’s balance sheet?  And it is this latter question that seems likely to be the key as we continue to hear from more and more Fed speakers that the idea of allowing the balance sheet to ‘run-off’ is appropriate.

For those of you with shorter memories, the last time the Fed tried to reduce the size of its balance sheet, from 2017-2018, they were also raising interest rates, albeit far more slowly.  Of course, CPI had peaked below 3.0% in that cycle, GDP was running at 2.4% and wages were growing at 2.5% while the balance sheet was less than half its current size.  The point is conditions were clearly very different.  However, not only did the equity market’s 20% decline inspire the Powell Pivot on Boxing Day 2018, but nine months later, the repo market blew up forcing the Fed to take dramatic action to ensure that sufficient liquidity was made available to the banking system.  I assure you, neither of those outcomes were part of the carefully described plans the Fed had made to ‘normalize’ monetary policy.

Will this time be different?  While starting conditions certainly are different, the one thing of which we can be sure is that the complexities of the international money markets remain opaque even to the central banks charged with their oversight.  While there is no way to anticipate exactly what will happen to derail the current plans, one can almost be certain that things will not work out the way they are currently planned.  Personally, I remain convinced that markets will have a very difficult time handling any reductions in the excess liquidity that has been the dominant feature of the post Covid-19 global financial markets, and that despite a lot of tough talk now, the Fed, at least, will be walking back that hawkishness before too long.

And perhaps, markets are beginning to agree with me.  After all, hawkish monetary policy is rarely the backdrop for a risk-on attitude.  Yet that is a pretty fair description of today’s price action.  Equities are rebounding along with commodities; bonds are benign, and the dollar is softening.

While yesterday saw US equity markets in the red most of the day, the NASDAQ staged a furious late day rally to close flat although market breadth was awful (1205 gainers vs. 2201 losers).  And while Asia was still under pressure (Nikkei -0.9%, Hang Seng 0.05, Shanghai -0.7%), Europe has taken heart from something as we are seeing solid gains across the board there (DAX +1.15%, CAC +1.35%, FTSE 100 +0.7%) despite a complete lack of news.  US futures, too, have turned green with all three main indices up about 0.3% at this hour.

The Treasury rout is on hold with yields essentially unchanged this morning and the 10-year right at the key level of 1.75%.  In Europe, Bunds (-0.9bps) and Gilts (-2.3bps) are both trading well while the rest of the sovereign market is virtually unchanged.  Again, there has been essentially no news of note.

Oil prices are rallying (WTI +1.4%) while NatGas (-0.9%) has consolidated some of yesterday’s gains despite the fact it is 14 degrees here in NJ this morning.  Gold (+0.3%) and silver (+0.6%) are both firmer, as are industrial metals (Cu +0.6%, Al +0.1%, Zn +2.4%) and the ags are strong as well.

Finally, the dollar is under modest pressure with NOK (+0.4%) leading the G10 revival on the strength of oil’s rally, while CAD (+0.3%) follows closely behind.  JPY (-0.25%) is the only laggard here, again pointing to the risk characteristics in today’s price action.  EMG markets have seen similar price action with THB (+0.6%) the leading gainer followed by HUF (+0.4%) and KRW (+0.35%), all benefitting from the pause in the US yield rally and generally better risk appetite.

Today’s only data point has been released, NFIB Small Business Optimism (98.9, slightly better than 98.7 expected) and has had virtually no impact on the market.  This brings us back to the Fed as today’s most likely catalyst, as not only will we hear from Chair Powell starting at 10:00, but also from two of the most hawkish regional bank presidents, Mester and George between 9:00 and 9:30.

With risk in vogue for the session, I expect the dollar will have difficulty gaining any ground, but nothing has changed my short-term view that the Fed’s hawkishness is going to be the key driver of a stronger dollar…right up until they reverse course!

Good luck and stay safe
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No Delay

Investors have not yet digested
The truth of what Jay has suggested
There’ll be no delay
QT’s on the way
(Unless the Dow Jones is molested)

Given the change in tone from the Fed and a number of other central banks, where suddenly hawkishness is in vogue, the fact that risky assets (read stocks) have only given back a small proportion of their year-long gains is actually quite remarkable.  The implication is that equity investors are completely comfortable with the transition to positive real interest rates and that valuations at current nosebleed levels are appropriate.  The problem with this thesis is that one of the key arguments made by equity bulls during the past two years has been that negative real interest rates are a crucial support to the market, and as long as they remain in place, then stocks should only go higher.

But consider how high the Fed will have to raise interest rates to get back to real ZIRP, let alone positive real rates.  If CPI remains at its current level of 6.8% (the December data is to be released on Wednesday and is expected to print at 7.0%), that implies twenty-seven 0.25% rate hikes going forward!  That’s more than four years of rate rises assuming they act at every meeting.  Ask yourself how the equity market will perform during a four-year rate hiking cycle.  My take is there would be at least a few hiccups along the way, and some probably pretty large.  Consider, too, that looking at the Fed funds futures curve, the implied Fed funds rate in January 2026 is a shade under 2.0%.  In other words, despite the fact that we saw some pretty sharp movement across the interest rate markets last week, with 10-year yields rising 25 basis points and 2-year yields rising 13 basis points, those moves would just be the beginning if there was truly belief that the Fed was going to address inflation.

Rather, the evidence at this stage indicates that the market does not believe the Fed’s tough talk, at least not that they will do “whatever it takes” to address rising inflation.  Instead, market pricing indicates that the Fed will try to show they mean business but have no appetite to allow the equity market to decline any substantial amount.  If (when) stocks do start to fall, the current belief is the Fed will come to the rescue and halt any tightening in its tracks.  As I have written previously, Powell and his committee are caught in a trap of their own design, and will need to make a decision to either allow inflation to keep running hot to try to prevent an equity meltdown, or take a real stand on inflation and let the (blue) chips fall where they may.  The similarities between Jay Powell and Paul Volcker, the last Fed chair willing to take the latter stand, stop at the fact neither man had an economics PhD.  But Jay Powell is no Paul Volcker, and it seems incredibly unlikely that he will have the fortitude to continue the inflation fight in the face of sharply declining asset markets.

What does this mean for markets going forward?  As we remain in the early stages (after all, the Fed is still executing QE purchases, albeit fewer than they had been doing previously) tough talk and modest policy changes are likely to continue for now.  Equity markets are likely to continue their performance from the year’s first week and continue to slide, and I would expect that bond markets will remain under pressure as well.  And with the Fed leading the way vis-à-vis the ECB and BOJ, I expect the dollar should continue to perform fairly well against those currencies.

However, there will come a point when investors begin to grow wary of the short- and medium-term outlooks for risk assets amid a rising rate environment.  This will be highlighted by the fact that inflation will remain well above the interest rate levels, and in order to contain the psychology of inflation, the Fed will need to continue its tough talk.  Already, when looking at the S&P 500, despite being just 3% below its all-time highs, more that 50% of its components are trading below their 50-day moving averages (i.e. are in a down-trend) which tells you just how crucial the FAANG stocks are.  And none of those mega cap stocks will benefit from higher interest rates.  In the end, there is significant room for equity (and all risk asset) declines if the Fed toes the tightening line.

Looking at markets this morning shows that no new decisions have been taken as both equity and bond markets are little changed since Friday.  Perhaps investors are awaiting Wednesday’s CPI data to determine the likely path going forward.  Or perhaps they are awaiting the comments from both Powell and Brainerd, both of whom will be facing the Senate this week for confirmation hearings for their new terms.  However, we do continue to hear hawkish comments with Richmond Fed President Barkin explaining that a March rate hike would suit him, and ex-Fed member Bill Dudley explaining that there is MUCH more work to be done raising rates.

So, after Friday’s late sell-off in the US, equities in Asia rebounded a bit (Hang Seng +1.1%, Shanghai +0.4%, Nikkei closed) although European bourses are all modestly in the red (DAX -0.3%, CAC -0.4%, FTSE 100 -0.1%). US futures are also turning red with NASDAQ futures (-0.35%) leading the way down.

Meanwhile, bond markets are mixed this morning with Treasury yields edging higher by just 0.4bps as I type, albeit remaining at its highest levels since before the pandemic, while we are seeing modest yield declines in Europe (Bunds -1.0bps, OATS -1.5bps, Gilts -0.3bps).  The biggest mover though are Italian BTPs (-5.3bps) as they retrace some of their past two-week underperformance.

On the commodity front, oil (-0.2%) has edged back down a few cents although remains much closer to recent highs than lows, while NatGas (+4.4%) has jumped on the back of much colder weather forecasts in the US Northeast and Midwest areas.  Gold (+0.3%) continues to trade either side of $1800/oz, although copper (-0.2%) is under a bit of pressure this morning.

As to the dollar, it is mixed today with SEK (-0.4%), CHF (-0.35%) and EUR (-0.3%) all under pressure while JPY (+0.25%) is showing its haven bona fides.  This definitely feels like a risk move as there was virtually no data or commentary out overnight.  In the EMG space, RUB (+0.9%) is the leading gainer as traders continue to look for further tightening by the central bank despite the fact that real rates there are actually back to positive already.  INR (+0.35%) and IDR (+0.35%) also gained with the rupee benefitting from equity market inflows while the rupiah responded to word that the government would soon lift the coal export ban.  On the downside, the CE4 are in the worst shape, but those are merely following the euro’s decline.

There is a decent amount of data coming up this week as follows:

Tuesday NFIB Small Biz Optimism 98.5
Wednesday CPI 0.4% (7.0% Y/Y)
-ex food & energy 0.5% (5.4% Y/Y)
Fed’s Beige Book
Thursday Initial Claims 200K
Continuing Claims 1760K
PPI 0.4% (9.8% Y/Y)
-ex food & energy 0.5% (8.0% Y/Y)
Friday Retail Sales -0.1%
-ex autos 0.2%
IP 0.2%
Capacity Utilization 77.0%
Michigan Sentiment 70.0

Source: Bloomberg

In addition to the data, we hear from seven Fed speakers and have the nomination hearings for Powell (Tuesday) and Brainerd (Thursday), so plenty of opportunity for more hawk-talk.

For now, I continue to like the dollar for as long as the Fed maintains the hawkish vibe.  However, I also expect that if risk assets start to really underperform, that talk will soften in a hurry.

Good luck and stay safe
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