Tag Archives: #Powell

The Battle’s Been Won

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‘Bout Jay and the FOMC
The market has come to agree
The battle’s been won
And hiking is done
So, buy stocks with verve and with glee

In Europe, though, Madame Lagarde
Is finding that things are still hard
Inflation’s not tamed
And she will be blamed
If prices, she cannot retard

Meanwhile on the world’s other side
Where growth has begun to backslide
The PBOC
More cash will set free
As Xi tries to hold back the tide

When looking at the market activity yesterday, it is easy to conclude that the market believes the Fed has instituted their last hike.  This was evident in the equity market’s performance where all three major indices rallied more than 1% and it was evident in the FX market where the dollar was pummeled, falling by 1% or more against 7 of its G10 counterparts as well as about half the EMG bloc.  In addition, Treasury yields fell sharply as the idea that the Fed is going to continue hiking, as implied by Chairman Powell in his comments on Wednesday, seems to have faded from memory. 

 

But that’s not all!  While key markets are beginning to discount any further Fed activity, the ECB not only raised their rate structure by 25bps as expected, but Madame Lagarde essentially promised another hike in July and this morning the ECB’s hawks are circling and hinting that a September rate hike is quite possible as well. 

 

Now, we already know that the Fed’s dot plot is calling for 2 more rate hikes this year, but the Fed funds futures market is not in accord with that view.  Rather, it is pricing a 70% probability of a July hike as the final move.  But, will they hike again?  Clearly, between now and the end of July we will all have seen a great deal more data, including both an NFP and CPI report, and that will have a major impact on the Fed.  But after yesterday’s US data dump, which showed Retail Sales holding up far better than expected while both the Import and Export Price Indices showed price declines, there has been a significant increase in the chatter of the Fed pulling off a soft landing after all.  And, if the landing is soft, do they need to hike more?

 

Although the manufacturing side of the economy remains lackluster, Services have been killing it.  There is one other reason to believe the Fed will remain on hold as well, and that is the employment situation.  While we have seen a much hotter than forecast NFP print basically each month for the past year, we are starting to see Initial Claims data tick higher.  Yesterday’s 262K was both higher than expected and the highest print since October 2021 when claims were tumbling during the post-pandemic recovery.  More ominously, the 4-week and 13-week moving averages (analyzed to seek a trend and remove the weekly choppiness) are both clearly trending higher.  If that number continues to rise, the Fed’s confidence in the economic recovery continuing is likely to be impaired.  In fact, I think this is the feature that is most likely to cause the Fed to stop hiking.

 

If we pivot to Asia for a moment, we see a completely different set of concerns in both China and Japan.  Starting with China, after cutting their lending rates earlier this week, the PBOC is still struggling to figure out how to support what is a clearly softening economy.  Although there has been much lip service paid to the fact that China will no longer prop up the property market and investment and is instead seeking to generate more domestic consumption, the fact that the youth unemployment rate is at a record 20.8% and that the only playbook the Chinese really understand is infrastructure spending and leveraged property speculation, they are falling back into that trap.  Rumors abound that the government is going to put forth a CNY1 trillion (~$140B) spending package and that the PBOC is going to ease restrictions on property lending, removing the ban on second home purchases in small cities.  Remember, property speculation was a critical part of China’s rapid growth as people there have little confidence in a social safety net and were using those second homes as an investment to secure their nest egg.  Alas, with China’s population shrinking, that may no longer be an interesting investment for the middle class.  So, while China’s problems are different, they are no less severe than those in the West.

 

Uncertainty is
“Extremely high” over both
Wages and prices

So, Ueda-san
Will keep liquidity flows
Like flooding rivers

As to Japan, I’m old enough to remember when there was a growing belief that once Kuroda-san stepped down as BOJ head, his replacement would have free rein to tighten policy. Boy, were we ever wrong about that.  After last night, while there was no policy adjustment as expected, Ueda-san’s comments can only be construed as strongly dovish and the market got the message.  JGB yields slid a few basis points and are back below 0.40% while the yen is the only currency that is underperforming the dollar.  Meanwhile, the Nikkei (+0.65%) continues its recent strong performance as the second best major index after only the NASDAQ.

The one thing that we know is that things do not seem to be evolving as per much of the consensus from earlier this year.  While there is still a long way to go before this cycle ends, and I still expect a more significant economic slowdown globally, the possibility that Chairman Powell pulls off a soft landing cannot be dismissed.  And as I saw on Twitter yesterday, if he does so, he will be hailed as the greatest Fed chair ever, even more so than Paul Volcker.  Alas, I fear things will not work out that way.  Remember that monetary policy works with long and variable lags, and I would contend that the economy is likely just beginning to feel the true impacts of tighter policy.  Now, this may only happen in the manufacturing sector, where the cost of capital is such a critical input, but history has shown if that sector stumbles, it drags the economy down with it.  Remember that so much of the service economy exists to service manufacturing, so the two are quite intertwined.

Remember, too, there are potential exogenous shocks, both positive and negative, that can have a big impact.  What if the Ukraine war ended?  What if China invaded Taiwan?  What if there was an escalation of fighting in the Middle East with a dramatic reduction in oil production?  All I am pointing out is that myopically focusing on just the economic data is not sufficient for a risk manager.  Sh*t happens and it can matter a lot.

Ok, as to today, we already know that risk is on.  The data coming out this morning is Michigan Sentiment (exp 60.0) and of the three Fed speakers, two have already commented with Governor Waller not talking economics or policy, but rather bank regulation and Bullard was more theoretical than policy focused, so really there has been nothing new there either.  In a little while, Richmond’s Barkin will discuss inflation, so that could be interesting.  But for right now, the market has made up its mind.  Everything is right as rain so add risk.  That means the dollar is likely to remain under pressure with a test of its lows (EUR 1.11, DXY 102) coming soon to a screen near you.

Heading into a bank holiday weekend, I expect positions to be lightened but the recent dollar weakening trend to remain intact.

Good luck and good weekend

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Which One Means More?

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The question is, which one means more?
The headline inflation? Or core?
The former declined
But please bear in mind 
The latter rose more than before

Which brings us today to the Fed
Where skipping a rate hike is said
To be what they’ll try
Then come late July
Will hike ere more water they tread

By now you are all aware that CPI’s release yesterday was a bit of a mixed bag with the headline number falling slightly more than expected to 4.0% while the core (ex food & energy) fell slightly less than expected to 5.3%.  As always, my go-to source on inflation is @inflation_guy, who in yesterdays’ post clearly laid out that there is very limited evidence that core inflation is going to decline sharply from these levels anytime soon.  In a nutshell, the key issue is that the housing portion of the index remains robust and that represents slightly more than one-third of the entire reading. 

 

Ask yourself the following question; why would a landlord reduce his asking rents if his costs are rising (taxes and maintenance) and his potential customers are all seeing wages rise healthily, at least as per measured by the BLS and the Fed?  Of course, the answer is that landlord is unlikely to reduce rents, but rather raise them, and that is not going to feed into lower inflation.  One other thing to note is the price of energy, which was the key driver of the decline in headline CPI, has the earmarks of a bottom here.  Not only have we seen production cuts from OPEC+, but it appears the Biden administration is beginning the process of finally refilling the SPR which means they have likely mapped the bottom of oil prices which have rebounded more than 5% from the lows seen Monday after the news broke.

 

As expected, the equity market took this news as a huge positive and continued its recent rally as it is almost certain that the Fed will be holding rates unchanged when they announce their policy update this afternoon.  The Fed funds futures market has reduced its pricing for a rate hike to just 9% this morning although the implied probability of a hike in July has risen to 71% now.  As an aside, the futures market is still pricing in the first rate cut by December or January 2024, although I suspect we will need to see a more significant decline in economic activity with much higher Unemployment for that to come to fruition.

 

This afternoon’s FOMC statement, and more importantly Chairman Powell’s press conference are the next critical features for the market.  There is much talk of this being a ‘hawkish pause’ where they will not change rates but really play up the still hot core inflation data to make sure that everyone knows they are not going soft on inflation.  As I have repeatedly explained, I continue to look at NFP as the most critical data point these days because as long as that number keeps printing solidly and beating expectations, the Fed will not be overly concerned a recession is coming and will feel comfortable tightening further if inflation starts to tick higher again.  And so, at this time, all we can do is wait for the outcome at 2pm.

 

Ahead of that, here’s what’s been happening:  risk has largely been in favor as yesterday’s US equity rally was followed by strength in Japan (+1.5%) and Australia (+0.3%) although many other APAC markets, notably China and South Korea, fell.  The China situation is quite interesting as there is news that the Chinese government has convened several meetings with business leaders to get ideas as to how to improve the economy there.  Not surprisingly, according to a Bloomberg story, the discussions focused on more market-oriented actions and less state planning as well as better coordinated fiscal and monetary policy stimulus.  My guess is that President Xi is not keen to let the market do the work as he will not control that, so it will be interesting to see how things there progress.  Meanwhile, European bourses are all much stronger this morning, even the FTSE 100 (+0.6%) despite a modestly weaker than expected set of GDP and IP data being released.  And of course, US futures continue to edge higher, at least NASDAQ futures do, although it would be quite surprising to see any large movement ahead of the FOMC this afternoon.

 

Of much greater interest to me is that bond yields rose so sharply yesterday with 10yr Treasuries rising 7 bps yesterday and another 1.5bps this morning, despite (because of?) the CPI data being soft.  The curve inversion remained essentially unchanged at -85bps, so I guess the story I saw that might have been the driver was when Treasury secretary Yellen was asked in Congressional testimony about the Fed and Treasury being prepared if China were to liquidate their entire portfolio of Treasuries, which is ~$875 billion.  That seems highly unlikely to me, but I guess anything is possible.  European sovereign yields are also rising after gains yesterday, which seems at odds with the equity markets that clearly believe in lower inflation.  Things are quite confusing these days.  As well, there will be much attention paid to China tonight to see if the PBOC follows through with a 10bp rate cut in the 1yr lending facility, or perhaps, if they are concerned about economic weakness, opts for more.

 

As mentioned, oil prices continue to rebound, pushing back to $70/bbl while gold got crushed yesterday seemingly in response to the rise in Treasury yields.  This morning the barbarous relic is ever so slightly firmer but in a bigger picture view, remains relatively unchanged over the past month.  Copper has continued its recent countertrend rally, but I expect that we will need to see real signs of an economic rebound for the red metal to get back to levels seen earlier this year above $4.00/pound.

 

Finally, the dollar remains under modest pressure overall, sliding about 0.25% against most of its G10 counterparts and a bit further against several EMG currencies.  Notably, ZAR (+1.0%) is the best performer today, after a solid Retail Sales print this morning.  As well, we see PLN (+0.7%) rising on rising zloty yields after the government increased the budget deficit on increased spending.  On the downside, KRW (-0.55%) is the laggard, falling after several days of a sharp rally has led to profit-taking.

 

Ahead of the Fed, we see PPI this morning (exp 1.5%, 2.9% ex food & energy) although that seems anti-climactic after yesterday’s CPI.  Add to that the Fed is coming and I cannot believe it will have any impact at all.

 

So, it is all about the Fed and how they sound since it seems pretty clear that they will not be adjusting rates today.  Look carefully at the dot plot as well, for clues to their forward-looking beliefs.  As to the dollar’s response, nothing has changed my big picture view that higher rates here will continue to support the greenback.

 

Good luck

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Widened the Spread

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Twixt ceilings for debt and the Fed

The market has widened the spread

Of rates here at home

Despite what Jerome

Last weekend ostensibly said

Thus, dollars remain to the fore

As traders want so many more

The megacaps rise

But in a surprise

There’s less and less talk of the war

The debt ceiling negotiations remain at the top of the market’s list of concerns as the ostensible X-date of June 1stapproaches.  Certainly, the positive aspect is that both sides are talking as opposed to merely grandstanding, but as is always the case in a political standoff with a non-political impact, it is clear no deal will be reached until the Nth hour.  The other thing to remember is that the June 1st date is not a hard deadline, it is the current estimate by Secretary Yellen and subject to change.  In the end, nothing has changed my view that a deal will be reached as both sides desperately want one, but also, no deal will be reached until both sides can explain to their supporters that they did everything possible to achieve their agendas.

However, this process is clearly having an impact on the markets, especially in the interest rate space as we have seen 10-year Treasury yields, which are higher today by 3.3bps, rise 36 basis points in the past two weeks.  In addition, the yield curve inversion, which at one point had fallen to as low as -41bps, is back to a -64bp difference.  Not only that, but the 4-week T-bill, the nearest expiry past the X-date, is now yielding 5.47%, far above Fed funds and the highest spot on the yield curve.  That is clearly a direct response to fears over a possible default.  My sense is this process will go on right through Memorial Day and US interest rates may well have further to rise between now and then.

But this begs the question, are US rates dragging up rates around the world?  I would argue the answer is yes.  Looking at European sovereigns, which have all seen yields rise by around 3bps-4bps today (Gilts are actually +8bps), they have all risen in concert with Treasury yields.  During the same time frame that Treasuries rose 36bps, Bunds are +28bps, OATS +25bps and Gilts +43bps.  Yet during that period, the dollar has gained more than 1% vs. both the euro and the pound (and all the other G10 currencies as well). 

Perhaps what we are seeing is a new safe haven asset being born, the US megacap tech stock.  The likes of Apple, Microsoft and Alphabet have seen steady strength, helping to drive the NASDAQ 100 Index up nearly 5% during this same two-week period.  In fact, a quick look at YTD performance in US equity markets shows that the Dow Jones Industrials are +0.4% YTD while the NASDAQ is up 21.5%.  In the past, there was a concept during bouts of USD strength that investors were buying dollars to buy Treasuries.  I think right now investors are buying dollars to buy Apple!  In fairness, one can see the premise as regardless of the debt ceiling outcome or timing, the belief that Apple (or Microsoft or Alphabet) shares will react to that news rather than their own positive stories generates no concerns.

Of course, those names are the exceptions to the rule as the bulk of the rest of the market has been under pressure recently on the back of all the catastrophic predictions if the debt ceiling isn’t raised and the US defaults on its debt.  This can be seen in the fact that the other major indices have seen almost no movement, just sideways trading, during the recent period in question.

Turning to the Fed, it appears that we are reaching an inflection point in the tightening process, or at least in the rate hiking cycle.  While prior to the last FOMC meeting, virtually every speaker was on the same message, we are starting to see some differences.  Most importantly, Powell, last weekend, hinted that there was some concern that the continued rate hikes were starting to impact financial stability (seriously, after 4 major bank failures it is now a concern?). But the implication is that while inflation remains job number one, there are other issues on the agenda.  That seems to be the dovishness that was attributed to Powell over the weekend.

Meanwhile, yesterday we heard from two regional Fed presidents.  James Bullard from St Louis, who said that he saw at least two more rate hikes (50bps total) as necessary to be certain they have slain the inflation dragon.  As per Bloomberg news, “I think we’re going to have to grind higher with the policy rate in order to put enough downward pressure on inflation and to return inflation to target in a timely manner,” Bullard said at an event in Florida on Monday.  “I’m thinking two more moves this year — exactly where those would be this year I don’t know — but I’ve often advocated sooner rather than later.”

However, we also heard from Minneapolis President Neel Kashkari with a different message, “I think right now it’s a close call, either way, versus raising another time in June or skipping.  What’s important to me is not signaling that we’re done.”  I guess the Eccles Building will be rocking in June when they next meet.

As it stands currently, at least according to the Fed funds futures market, the market is pricing in a 23% probability of a 25bp rate hike on June 14th.  Remember, though, between now and then we see a lot of critical data including this week’s Core PCE release, next week’s NFP data and finally the May CPI data, scheduled to be released the day before the FOMC announcement.  In the meantime, all eyes seem to be on the debt ceiling negotiations, and reasonably so, given the fallout could begin before the big data comes. 

Looking at today, the big movers overnight were the bond markets with equity markets mildly in the red in both Asia and Europe.  US futures are also edging lower, but barely -0.1% at this hour (7:45).  As to commodities, oil (+0.5%) is edging higher on word that the Saudis are going to push for another production cut, while gold (-0.5%) is sliding on the back of the strong dollar and the base metals are falling again, clearly anticipating a recession.

As to the dollar, it remains king of the hill, continuing to rally vs. virtually all its G10 counterparts with only the yen (+0.1%) managing to hold its own.  In the emerging market space, the story is similar with HUF (-1.0%) the laggard on expectations of a rate cut today and the bulk of the bloc lower.  The one outlier seems to be KRW (+0.4%) which saw substantial equity inflows as the driver.  I would be remiss if I didn’t mention that CNY has rallied substantially in my absence and is now well above 7.0500 as there is a growing belief the PBOC will continue to ease policy to support the Chinese economy.

On the data front today, we see preliminary PMI data (exp 50.0 Mfg, 52.5 Services) and New Home Sales (665K).  The European flash PMI data was slightly soft, but pretty close to expectations.  Meanwhile, only Dallas Fed President Lorie Logan is on the docket today, but don’t be surprised to hear from others on CNBC or BBG as they basically cannot shut up.

In the wake of the Silicon Valley Bank failure, I was convinced the Fed was going to be finished and accordingly, changed my views on the dollar.  I had been bullish until a clear pivot was seen and I thought that was the case.  However, it increasingly appears that no pivot is coming and that higher for longer is the future.  In that case, I have to revert to my original stance and look for continued dollar strength until we get that signal.

Good luck

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Ready to Pop

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Investors are having some trouble
Determining if the stock bubble
Is ready to pop
Or if Jay will prop
It up, ere it all turns to rubble

So, volatile markets are here
Most likely the rest of this year
Then, add to this fact
A Russian attack
On Ukraine.  I’d forecast more fear

One has to be impressed with yesterday’s equity markets in the US, where the morning appeared to be Armageddon, while the afternoon evolved into euphoria.  Did anything actually change with respect to information during the day?  I would argue, no, there was nothing new of note.  The proximate cause of the stock market’s decline appeared to be fear over escalating tensions in the Ukraine.  Certainly, that has not changed.  Russia continues to mass troops on its border and is proceeding with live fire drills off the coast of Ireland.  The Pentagon issued an order for troops to be ready for rapid deployment, which Russia claimed was fanning the flames of this issue.  While the key protagonists continue to talk, as of yet, there has been no indication that a negotiated solution is imminent.  With that in mind, though, today’s market reactions indicate somewhat less concern over a kinetic war.  European equity markets are all nicely higher (DAX +0.6%, CAC +0.8%, FTSE 100 +0.75%) and NatGas in Europe (-2.4%) has retraced a bit of yesterday’s surge.  Granted, these reversals are only a fraction of yesterday’s movement, but at least markets are calmer this morning.

However, one day of calm is not nearly enough to claim that the worst is behind us.  And, of course, none of this even considers the FOMC meeting which begins this morning and from which we will learn the Fed’s latest views tomorrow afternoon.  The punditry is virtually unanimous in their view that the first Fed funds hike will come in March and there will be one each quarter thereafter.  In fact, if there are any outliers, they expect a faster pace of rate hikes with five or more this year as the Fed makes a more concerted effort to temper rising prices.

Now, we have not heard from a Fed speaker since January 13th, nearly two weeks ago, although at that time there was a growing consensus that tighter policy needed to come sooner and via both rate hikes and balance sheet reduction.  But let’s take a look at the data we have seen since then.  Retail Sales were awful, -1.9%; IP -0.1% and Capacity Utilization (76.5%) both disappointed as did the Michigan Sentiment indicator at 68.8, its lowest print since 2011.  While the housing market continues to perform well, Claims data was much higher than anticipated and the Chicago Fed Activity Index fell sharply to -0.15, where any negative reading is seen as a harbinger of future economic weakness.  Finally, the Atlanta Fed’s GDPNow indicator has fallen to 5.14%, down from nearly 10% in December.  The point is, the data story is not one of unadulterated growth, but rather of an economy that is struggling somewhat.  It is this issue that informs my decision that the Fed is likely to sound far more dovish than market expectations tomorrow,  The policy error that has been discussed by the punditry is the Fed tightening policy into an economic slowdown and exacerbating the situation.  I think they are keenly aware of this and will move far more slowly to tackle inflation, especially given their underlying view that inflation is going to return to its previous trend on its own once supply chains are rebuilt.

For now, barring live fire in Ukraine, it seems the market is quite likely to remain rangebound until we hear from Mr Powell tomorrow afternoon.  As such, it is reasonable to expect a bit less market volatility than we saw yesterday.  But, do not discount the fact that markets remain highly leveraged in all spaces and that the reduction of high leverage has been a key driver of every market correction in history.  Add that to the fact that a Fed that is tightening policy may push rates to a point where levered accounts are forced to respond, and you have the makings of increased market volatility going forward.  While greed remains a powerful emotion, nothing trumps fear as a driver of market activity.  Yesterday was just an inkling of how things may play out.  Keep that in mind as we go forward.

Touring the markets this morning, while Europe is bouncing from yesterday’s movement as mentioned above, Asia saw no respite with sharp declines across the board (Nikkei -1.7%, Hang Seng -1.7%, Shanghai -2.6%).  US futures, too, are under pressure at this hour with NASDAQ (-1.7%) leading the way, but the other main indices much lower as well.

Looking at bond markets, European sovereigns are all softer with yields backing up as risk is re-embraced (Bunds +2.1bps, OATs +1.4bps, Gilts +4.4bps) as are Treasury markets (+0.7bps), despite the weakness in equity futures.  Bond investors are having a hard time determining if they should respond to ongoing high inflation prints or risk reduction metrics.  In the end, I continue to believe the latter will be the driving force and yields will not rise very high despite rising inflation.  The Fed, and most central banks, are willing to live with rising prices if it means they can stabilize bond yields at relatively low levels.

In the commodity markets, oil (+0.1%), after falling sharply from its recent highs yesterday has rebounded slightly.  NatGas (-1.4%) in the US is also dipping although remains right around $4/mmBTU in the US and $30/mmBTU in Europe.  Gold (-0.25%) and Copper (-0.3%) continue to consolidate as prospects for weaker growth hamper gains of the latter while uncertainty over inflation continue to bedevil the former.

As to the dollar, it is stronger for a second day in a row today, with substantial gains against both G10 (NOK -0.7%, CHF -0.7%, SEK -0.6%) and EMG (PLN -0.75%, RON -0.5%, MXN -0.45%) currencies.  Clearly, the Ukraine situation remains a problem for those countries in proximity to the geography, while Mexico responds to slightly disappointing GDP growth data just released.  But in the end, the dollar remains the haven of choice during this crisis and is likely to remain well bid for now.  However, if, as I suspect, the Fed comes across as less hawkish tomorrow, look for the greenback to give up some of its recent gains.

This morning brings only second tier data; Case Shiller Home Prices (exp 18.0%) and Consumer Confidence (111.1).  So, odds are that the FX market will continue to take its cues from equities, and if the sell-off resumes in stocks, I would expect the dollar to remain firm.  For payables hedgers, consider taking advantage of this strong dollar as I foresee weakness in its future as the year progresses.

Good luck and stay safe
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Confidence Wilts

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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

Policy, Tighter

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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
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Quite a Surprise

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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

Posted on by

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
Adf

No Delay

Posted on by

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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On the Brink

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Most pundits worldwide seem to think
The Fed is now right on the brink
Of both raising rates
And having debates
On how soon the BS should shrink

And so, today’s Minutes are key
To see if the FOMC
Has made up its mind
That they’re now behind
The curve, and need hurry QT

I am old enough to remember the last time the Fed decided that they wanted to shrink their balance sheet and normalize policy, way back in 2018.  As I recall, when first mooted, then Fed Chair Janet Yellen (she of Treasury Secretary fame) described the process of the gradual reduction as ‘like watching paint dry.’  Who knew drying paint was so exciting!  Of course, she couldn’t bring herself to even start the process.  Ultimately, the combination of slowly raising the Fed Funds rate and simultaneously reducing the size of the balance sheet (which all occurred on Powell’s watch) led to a declining stock market throughout Q4 2018 with the largest Christmas Eve sell-off ever seen in stocks as the culmination of the events.  Two days later, Chairman Powell explained he was just kidding, and tighter monetary policy was a thing of the past.

But that was then.  It’s different this time!

Actually, it’s not.  In fact, what we have learned from observing markets for many years is that it is never different.  While the catalysts may change, market responses remain pretty much the same time and again.  So, here we are three years later with the Fed’s balance sheet having more than doubled in the intervening period, equity markets having made 70 record highs in the past twelve months and the 10-year bond yielding half what it was back then. Inflation is raging, as opposed to the situation back then, and GDP, while higher than back then, has clearly peaked and is reversing some of the pandemic-induced policy giddiness.  But human nature is still the same.  Greed and fear remain the constants and investor and trader responses to policy decisions are pretty cut and dried.  You can be confident that if longer date interest rates rise, whether in a steepening or flattening yield curve, the rationale for the mega cap stocks to maintain their value is going to diminish quickly.  And as they are the ‘generals’ of the equity market rally, when they start to fall, so will everything else, including the indices.  Ask yourself how long the Fed, whose members are virtually all multi-millionaires and hold large equity portfolios, are going to sit by and allow the stock market to correct just because some Austrian school monetary hawks believe in sound money.  Exactly.

However, we have not yet reached the point where the markets have started to decline substantially, as, of course, the Fed has not yet started to even raise interest rates, let alone shrink the balance sheet.  But that is the growing consensus view amongst the punditry, that today’s FOMC Minutes from the December meeting are going to reveal the level of interest to begin that part of policy normalization.  Many analysts continue to highlight the fact that inflation is becoming such a problem that the Fed will be forced to stay the course this time.  I wish it were so, but strongly believe that history has shown they will not.  Rather, they will change the inflation calculations and continue to explain that the alternative is worse.

Yesterday, Minneapolis Fed President Neel Kashkari, the most dovish of all FOMC members, explained that he believes the Fed Funds rate needs to rise 0.50% this year as, “…inflation has been higher and more persistent than I had expected.”   It is comments such as this that have the analyst community convinced the Fed is really going to tighten this time.  But we have heard these before as well.  This is not to say that the Minutes won’t hint at QT, they very well could do so.  However, when the rubber meets the road and risk assets are falling sharply in price, the Fed will exhibit its underlying Blepharospasm, and tighter policy will be a thing of the past (as will a stronger dollar!)

Now, leading up to the Minutes, let’s take a look at what happened last night.  In the wake of a bit of equity market schizophrenia in the US, we have seen a mixed picture.  Yesterday saw the NASDAQ fall sharply (there’s that concern over higher rates) while the Dow managed to rally.  Overnight saw the Nikkei (+0.1%) bide its time but the Hang Seng (-1.6%) and Shangahi (-1.0%) both suffer on a combination of the ongoing property sector problems as well as more lockdowns in country.  Europe, on the other hand, has managed to stay in the green (DAX +0.6%, CAC +0.5%, FTSE 100 +0.2%) after PMI Services data was released a little bit softer than forecast, but still seen as quite positive.  In a way, this was a ‘bad news is good’ idea as softening growth means the ECB doesn’t need to respond to Europe’s very high inflation readings so dramatically.  Alas, US futures are flat except for NASDAQ futures, which are lower by -0.4%.

In the bond market, while yesterday saw an early sell off in Treasuries, it was mostly unwound by the end of the day and this morning yields are little changed at 1.645%.  As to Europe, yesterday also saw Gilt yields rally sharply, 12.5 bps, but they have consolidated today, falling 1bp while the rest of the continent has seen much less movement.  Clearly, there is far less concern over ECB activity than either Fed or BOE.

As to the commodity space, oil (+0.3%) is edging higher and NatGas (+2.3%) is firming on the cold weather in the Northeast.  (Of course, compared to what happened in Kazakhastan, where the government was kicked out by the president because of high energy prices, this seems rather tame!)  Metals prices are mixed with gold (+0.2%) still hanging around $1800, while copper (-0.6%) is clearly less enamored of the current economic situation.

Finally, the dollar is under modest pressure this morning, with SEK (+0.5%) the leading G10 gainer after printing the strongest PMI data around, while JPY (+0.4%) has simply rebounded from its very sharp decline yesterday, although it remains in a very clear downtrend for now.  the rest of the G10 is modestly firmer vs. the dollar at this hour, but nothing to write home about.

In the EMG space, ZAR (+0.9%) is the leader, also seeming to benefit on the back of last week’s liquidity induced decline and seeing a rebound.  We are also seeing strength in PHP (+0.7%) and CZK (+0.6%) with the latter benefitting from expectations for further rate hikes while the former benefitted from a much lower than expected CPI print of just 3.6%.  Meanwhile, on the downside, IDR (-0.4%) was the worst performer as the infection rate rose sharply and KRW (-0.25%) fell after North Korea launched another ballistic missile and rejected further talks with the US.

On the data front, ADP Employment (exp 410K) leads this morning and then the Minutes are released at 2:00pm.  Aside from the Minutes, there are no speakers scheduled, so the dollar will need to take its cues from other markets.  Keep an eye on the 10-year as a continued rally in yields should see further dollar strength.

Good luck and stay safe
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