by Marc Chandler
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At the risk of over-simplifying, there seem to be three sources of dynamism in the investment climate: Covid, the Federal Reserve, and market positioning. The last of these is often not given its due in narratives in the press and market commentary, so let's begin there.
The anthropologist Clifford Gertz once posed the question about distinguishing between someone winking and someone with a twitch in their eye, and a person mimicking the wink or twitch. Context matters. All buying is not going long. Sometimes it is short-covering. Nor is all the buying and selling done as an active response to what preceded it. Sometimes it is passive, as stop losses are triggered.
There still is a bias in the currency market of talking about the Japanese yen or Swiss franc as safe-havens. There may be a self-fulfilling element here. One thinks the yen is a safe haven, so they devise a formal or informal rule to buy the yen when the S&P 500, for example, falls sharply or, alternatively, sell the yen when into an equity market rally. While there is no doubt a kernel of truth, it seems exaggerated and tends to make further analysis superfluous.
If pressed, some argue the franc and yen are safe havens because they have current account surpluses. But draws attention back to trade, and yet the daily turnover of the foreign exchange market in a week is more than covers world trade in a year. When North Korea lobs missiles toward Japan, does the fact that Japan has a current account surplus truly relevant?
The conventional narratives typically focus on the spot market, but more activity in the foreign exchange market is in forwards and swaps. Liquidity is easily shifted between the major currencies in unstressed times. Currencies of traditionally low-interest rates, like Japan and Switzerland, perhaps partly because they do have current account surpluses (surplus savings), are used to structure financial transactions. The yen is borrowed and sold and the proceeds are used to buy higher-yielding or more volatile assets. When those assets go south, and they invariable do, they are liquidated and the funding currency has to be bought back and returned.
Redenomination risk (i.e., the chances that a country leaves the European Monetary Union) is low, so if the periphery-core spread widens, why is the franc often bought against the euro? Safe haven? Maybe the franc is used to fund the structure and when the spread widens the structure is unwound. The euro-swiss exchange rate is not dollar-neutral. The euro frequently trends in the same direction against the dollar and Swiss franc.
II
The 6.2% headline US October CPI print was a game-changer. We recognized it immediately as such and quickly anticipated that the Fed would have to accelerate the pace of tapering. It follows from two considerations. First, because of the high degree of uncertainty, the Fed needs to have maximum flexibility to respond to a wide range of probable outcomes. Second, the Fed is committed to the logical sequencing of finishing liquidity provisions (bond-buying) before beginning to remove accommodation (raising rates). At the current pace of tapering, the Fed could not raise rates until June 2022 at the earliest.
This is no longer acceptable. It is not just that the headline CPI is above 6%, but that has not peaked. Of course, the Fed does not target CPI but the PCE deflator, and it too has not peaked. The deflator stood at 5% in October. The base effect alone warns of another sharp rise last month. Recall that in November 2020, the PCE deflator was unchanged and when this drops out of the 12-month comparison, the year-over-year pace will accelerate. At an annualized rate, the PCE deflator rose by a little more than 5.6% in the three months through October, the same as in the three months through July.
The headline CPI has risen at an annualized pace of a little more than 6.4% in the three months through October. The headline US CPI rose by 0.2% in November and December last year. These will drop out and be replaced by higher numbers. Consider that the average monthly increase this year is 0.6%. The median forecast in Bloomberg's survey calls for a 0.7% increase in last month's CPI following a 0.9% increase in October. If accurate, the year-over-year pace will rise toward 6.7%.
The core rate is also likely to trend higher through Q1 22. Consider that after a 0.2% increase in November, the core CPI was flat in December 2020 and January 2021. It rose by 0.1% in February. As these dropout, the core rate of CPI will accelerate. It has risen by an average of 0.4% a month this year and the median forecast (Bloomberg survey) is for a 0.5% increase in November. This will lift the core CPI close to 5.0%.
The rhetoric of many Fed officials had shifted but it wasn't until Chair Powell's pivot in his prepared remarks for his testimony before the Senate on November 30 did the market recognize it en masse. The two-year note yield jumped eight basis points, recouping the Omicron-linked 14 bp decline on November 26. The Federal Reserve meets in mid-March 2022, and if the Fed would finish its tapering that month, it could ostensibly raise rates at its next meeting, which is on May 4.
There is no meeting in April. The fact that the April Fed funds contract implies an effective average for Fed funds of 15.5 bp when the current average effective rate is eight basis points means that the market is pricing in about a 1 in 3 chance that the Fed hikes at the March meeting. This does not seem particularly realistic. The May or June meetings are more likely. If the Fed hikes in May, fair value would be about 30 bp for the May FF contract. It settled around 21 bp, which translates to about a 50% probability. The June contract has almost an 87% probability of the first hike then.
A day before the October CPI print on November 10, the implied yield of the May Fed funds futures contract settled at 13.5 bp, implying about a 20% chance of a hike had been discounted. On November 24, the day before the US holiday and 24-36 hours before South Africa announced the sequencing of the Omicron variant, the implied yield had risen to almost 25 bp, or about a 68% probability of a hike. The new variant undermined the growing confidence, and the implied yield fell back to 14 bp (~25%) before Powell's prepared remarks hit the wires.
Although the market had done much of the heavy lifting for the Fed, Powell's comments were significant. They signaled that despite the unknowns surrounding the mutating virus, for which the Delta variant was already on the rise in the US, even if slower than Europe, the Fed was committed to preventing elevated inflation from becoming embedded into households', businesses, and investors' expectations. To put it another way, in the first instance, the emergence of the Omicron variant adds color (and uncertainty) to the Covid wave that was already taking place.
Powell acknowledged that uncertainty and the benefit of not holding the FOMC meeting now. By the time it meets on December 15, more information about Omicron will be available. It is not just negative risks associated with the new variant, though of course, deserves the initial focus. There are some upside risks. It may help accelerate the take-up of the vaccine. If it has limited economic impact, that might boost the confidence of consumers and businesses. It could signal the end of the pandemic and the beginning of a more chronic phase. In any event, the point is that the Omicron variant increases the range of probable outcomes and the Federal Reserve will still see it necessary to secure greater flexibility. At this juncture, it can only be done by ending its bond-buying sooner.
Even though the first hike is still at least a few months away, it is not too early to think about the terminal rate. Of course, any such conclusions are tentative by their very nature. It appears the market is favoring the peak to be in late 2023 around 1.50%. This has important implications for businesses and investors in discounting future earning streams, managing pension funds and endowments, and returns on investment. It very well may turn out that this cap on rates may be a more formidable cap on long-term yields than QE itself.
Powell sought to explain why inflation is higher than he expected. To be sure, he did not cite the neoliberal argument that March's $1.9 trillion stimulus was a multiple of the estimated output gap, leading to the classic too much money chasing too few goods. Instead, he said that the supply disruptions were not fully appreciated. Fair enough, and although he has stopped calling the inflation "transitory," like Yellen and many economists, Powell still expects price pressures to ease in H2 22. The base effect goes into reverse. Big jumps in prices drop out of the 12-month comparisons. The median forecast in Bloomberg's survey sees the year-over-year rate in CPI peaking now and falling sharply in Q2 22. The same general pattern is true of the PCE deflator. It peaks now and is halved by be the end of next year.
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