Tag Archives: #QT

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
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No Delay

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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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Somewhat Bizarre

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Apparently, no one expected
The Fed, when they last met, detected
Their actions thus far
Were somewhat bizarre
And so, a new stance was erected

Not only would they halt QE
But also, a shrinkage they see
In balance sheet sizing
So, it’s not surprising
The bond market filled bears with glee

“…it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.”
“… participants judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience.”
“Many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode.”

These were the words from the FOMC Minutes of the December meeting that roiled markets yesterday afternoon.  Arguably there were more as well, but these give the gist of the issue.  Suddenly, the Fed sounds so much more serious about their willingness to not only taper QE quickly, and not only begin to raise the Fed Funds rate, but also to actually shrink their balance sheet.  If the Fed does follow through on this, and finishes QE by March, starts raising the Fed Funds rate and also begins to reduce the size of the balance sheet, then you can expect that the global risk appetite is going to be pretty significantly reduced.  In fact, I would contend it is the last of these steps that is going to undermine risk assets, as balance sheet reduction will likely result in higher long-term bond yields and less liquidity available to flow into risky assets.  As I have highlighted in the past, in 2018, the last time the Fed was both raising interest rates and shrinking the balance sheet, the resulting 20% equity market decline proved too much to withstand.  Are they made of sterner stuff this time?

One other thing to note was that while omicron was mentioned in the Minutes, it was clearly not seen as a major impediment to economic growth in the economy.   The fact that, at least in the US, there doesn’t appear to be any appetite/willingness for complete lockdowns implies that the nation is beginning to move beyond the pandemic fear to a more relaxed attitude on the issue.  Granted there are still several city and state governments that are unwilling to live and let live, but for the nation writ large, that does not seem to be the case.  From an economic perspective, this means less demand interruptions but also, likely, less supply interruptions.  The inflationary impact on this change in attitude remains uncertain, but the underlying inflationary trends remain quite strong, especially housing.  Do not be surprised to see CPI and PCE peak in Q1, but also do not be looking for a return to 2.0% levels anytime soon, that is just not in the cards.

And really, that was the driving force in yesterday’s market activity and is likely to be the key feature going forward for a while.  We will certainly need to pay close attention to Fed comments to try to gauge just how quickly these changes will be coming, and we will need to pay attention to the data to insure that nothing has changed in the collective view of a strong employment situation, but in the US, at least, this is the story.

The question now is how did other markets respond to the Minutes and what might we expect there?  Looking at equities, the picture was not pretty.  Following the release, US equity markets sold off sharply with the NASDAQ falling 3.3% on the day and both the Dow (-1.1%) and S&P500 (-1.9%) also suffering.  Activity in Asia was also broadly weaker with the Nikkei (-2.9%) and Australia’s ASX (-2.75%) both sharply lower although Chinese stocks were less impacted (Hang Seng +0.7%, Shanghai -0.25%).  The story there continues to revolve around the property sector and tech crackdowns, but recall, both of those markets had been massively underperforming prior to this Fed news.  As to Europe this morning, red is the color of the day (DAX -1.0%, CAC -1.2%, FTSE 100 -0.5%) as the data mix showed continued high inflation in Germany with every Lander having reported thus far printing above 5.1%.  As to US futures, they are not buying the bounce just yet in the NASDAQ (-0.5%), but the other two indices are faring a bit better, essentially unchanged on the day.

It can be no surprise that the bond market is under further pressure this morning as the Fed has clearly indicated they are biased to not only stop new purchases but allow old ones to mature and not be replaced.  (There is no indication they are considering actually selling bonds from the portfolio.  That would be truly groundbreaking!)  At any rate, after the Minutes, yields jumped an additional 3bps and have risen another 2.8bps this morning.  This takes the move in 10-year yields to 23 basis points since the beginning of the week/year.  Technically, we are pushing very significant resistance levels in yields as these were the highs from last March.  If we do break higher, there is some room to run.  As well, the rise in Treasury yields is driving markets worldwide with European sovereigns all selling off (Bunds +3.5bps, OATs +4.2bps, Gilts +5.5bps) and similar price action in Asia, where even JGB’s (+2.0bps) saw yields rise. Real yields have risen here, although as we have not seen an inflation print in the US since last month, that is subject to change soon.

On the commodity front, the picture is mixed today with oil (+1.2%) higher while NatGas (-1.2%) continues to slide on milder weather.  Uranium (+3.9%) has responded to the fact that Kazakhastan is the largest producer and given the growing unrest in the country, concerns have grown about its ability to deliver on contracts.  With yields higher, gold (-0.6%) and silver (-2.2%) are both softer as are copper (-1.4%) and aluminum (-0.5%).  Clearly there are growing concerns that higher interest rates are going to undermine economic growth.

Finally, in the FX markets, the broader risk-off tone is manifesting itself as a generally stronger dollar (AUD -0.7%, NZD -0.6%, NOK -0.35%) with only the yen (+0.25%) showing strength in the G10.  In the EMG bloc, the picture is a bit more mixed with laggards (THB -0.9%, CLP -0.7%, MYR -0.5%) and some gainers (ZAR +0.8%, RUB +0.7%, HUF +0.5%).  Rand is the confusing one here as the ruble is clearly benefitting from oil’s rise and the forint from bets on even more aggressive monetary policy.  However, I can find no clear rationale for the rand’s strength though I will keep looking.  On the downside, THB is suffering from an increase in the lockdown levels while MYR appears to be entirely dollar driven (higher US rates driving dollar demand) while the peso seems to be suffering from concerns over fiscal changes regarding the pension system.

On the data front, this morning brings Initial Claims (exp 195K), Continuing Claims (1680K) and the Trade Balance (-$81.0B) at 8:30 then ISM Services (67.0) and Factory Orders (1.5%, 1.1% ex transport) at 10:00.  But tomorrow’s payroll report is likely to have far more impact.  And the Fed calendar starts to fill out again with Daly and Bullard both on the slate for today and seven more speakers over the next week plus the Brainerd vice-chair hearings.

I’m a bit surprised the dollar isn’t stronger in the wake of the new Fed attitude, but perhaps that is a testimony to the fact there are many who still don’t believe they will follow through.  However, for now, I expect the dollar will continue to benefit from this thesis, albeit more gradually than previously believed, but if we do see risk appetite diminish sharply, look for a little less tightening enthusiasm from Mr Powell and friends, and that will change sentiment again.

Good luck and stay safe
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