The holiday season has passed
And this year the reigning forecast
Is for higher rates
Right here in the States
Thus, dollars will soon be amassed
But frequently, as is the case
Consensus is, here, out of place
Though some nations will
Raise rates, like Brazil
The Fed soon will turn about-face
Reading the many forecasts that are published this time of year, the consensus certainly appears to be that the Fed is going to continue to tighten policy and the only question is how soon they will begin raising interest rates; March, May or June? The Fed narrative has evolved from there is no inflation, to inflation is transitory to inflation is persistent and we will address it with our tools. But will they? Since Paul Volcker retired as Fed Chair (1979-1987) we have had a steady run of people in that seat who like to talk tough, but when there is any hiccup in the market, are instantly prepared to add more liquidity to the system. Starting with the Maestro himself, in the wake of the October 1987 stock market crash, to Bennie the Beard, the diminutive Ms Yellen and on up to today’s Chair Powell, history has shown that there is always a reason NOT to tighten policy because the consequences of doing so are worse than those of letting things run hotter. Ultimately, I see no reason for this time to be any different than the past 35 years and expect that as interest rates begin to climb here, and equity markets reprice assumptions, the Fed will not be able to withstand the pain.
But for now, the higher US interest rate story remains front and center. This was made clear yesterday when 10-year yields rallied 12 basis points in a thin session, trading back to levels last seen in November. Perhaps not surprisingly, the dollar reversed its late year losses as well, rallying vs. almost all its counterparts with the yen (-0.7%) by far the worst performer in the G10. It seems that the Japanese investor community has decided that a 155 basis point spread in the10-year, in an environment where expectations for a stronger dollar are rampant is a sufficient reason to sell yen and buy dollars.
And the truth is that given inflation is a global phenomenon these days, there are only a handful of nations where expectations don’t include higher interest rates. For instance, Japan, though they have stopped QE are not even contemplating higher interest rates. The ECB has indicated QE will be reduced to some extent (they claim cut in half, but I will believe that when I see it) but is certainly not considering higher interest rates. Turkey is kind of a special case as President Erdogan continues to try his unorthodox inflation fighting methodology, but if the currency reprises the late 2021 collapse, which is entirely realistic, if not probable, that is subject to change.
However, there is one more nation of note that is almost certainly going to be working against the grain of higher interest rates this year, China. President Xi has a growing list of economic problems that will result in further policy ease regardless of any inflationary consequences at this time. The fundamental flaw is the Chinese property market, which has obviously been under severe pressure since the problems at China Evergrande came to light. This is fundamental because it represents more than 30% of the Chinese economy and has been THE key reason that Chinese GDP has been growing as rapidly as it has over the past two decades. With Evergrande and several (many?) other property developers going to the wall, the property sector is going to have a much slower growth trajectory, if it is positive at all, and that is going to drag on the entire economy. After all, if they are not going to build ghost cities (Evergrande’s specialty), they don’t need as much concrete, steel, copper, etc., and the whole support framework that has been created for the industry will slow down as well. The upshot is that the PBOC seems highly likely to continue to ease policy in various ways including RRR cuts, as well as reductions in interest rates.
On the surface, one would expect that to work against CNY strength and fit smoothly with the stronger dollar thesis. However, the competing view is that President Xi is more focused on the long-term viability of the renminbi as a stable store of value and strong currency, and I expect that imperative will dominate this year and in the future. Thus, while your textbooks would explain the renminbi should fall, I beg to differ this year. We shall see as things evolve.
Ok, starting the year, there is clearly a solid risk appetite. Yesterday saw strong gains in the US equity market which was followed by the Nikkei (+1.8%) last night, although Shanghai (-0.2%) and the Hang Seng (0.0%) failed to follow suit. Europe (DAX +0.7%, CAC +1.4%, FTSE 100 +1.4%) are all bullish this morning as are US futures (+0.35% across the board). Record Covid infections are clearly not seen as a problem anymore.
After yesterday’s dramatic sell-off in Treasuries, this morning yields there have consolidated and are essentially unchanged. In Europe, though, there has been a mixed picture with Gilts (+8.3bps) following the US lead, while the continent (Bunds -1.5bps, OATs -2.5bps) are clearly more comfortable that interest rates have no reason to rise sharply there anytime soon.
In the commodity markets, oil (+0.3%) is continuing its run higher from last year and, quite frankly, shows no sign of stopping. This is a simple supply demand imbalance with not nearly enough supply for ongoing demand. NatGas (+1.8%) continues to trade well as cold weather in the NorthEast and much of Europe and a lack of Russian deliveries to the continent continue to demonstrate the supply demand imbalance there as well. Gold (+0.25%) has bounced after getting roasted yesterday, although it spent the last weeks of the year grinding higher, so we remain around $1800/oz. Industrial metals, though, are mixed with copper (-0.8%) under some pressure while aluminum (+1.4%) and zinc (+2.4%) are both having good days.
As to the dollar, aside from the yen’s sharp decline, the rest of the G10 is +/- 0.15% or less, not enough to consider for a story rather than position adjustments at the beginning of the year. In the EMG space, though, the dollar has had a bit more positivity with ZAR (-0.9%) and RUB (-0.8%) the worst performers (I need to ignore TRY given the insanity ongoing there). In both cases, rapidly rising inflation continues to outpace the central bank efforts to rein it in and the currency is weakening accordingly. In fact, that is largely what we are seeing throughout this bloc, with central banks throughout lagging the rise in prices. In the EMG space, this trend has room to run.
On the data front, we get a decent amount of stuff this week, culminating in the payroll report:
|ISM Prices Paid||79.3|
|JOLTS Job Openings||11,100K|
|Average Hourly Earnings||0.4% (4.2% Y/Y)|
|Average Weekly Hours||34.8|
In addition to the data, we start to hear from FOMC members again with Kashkari, Bullard, Daly and Bostic all on the calendar this week. My impression is that investors and traders will be looking for hints as to the timing of rates liftoff. But we are a long way from that happening yet.
For now, though, the narrative is clear, and a firmer dollar seems the most likely outcome in the near term.
Good luck and stay safe