All Bets Are Off!

For anyone thinking that markets had already fully priced aggressive Federal Reserve and European Central Bank (ECB) rate hikes, last week’s message from the US May CPI inflation report as well the ECB meeting was crystal clear.  All bets are off!  The US CPI report destroyed any hopes that US inflation had peaked with headline CPI surging 1% on the month and the annual rate hitting a new post-COVID high of 8.6%.  If there was ever any doubt, the data not only seals the case for at least a 50 basis point (1/2 %) hike at this Wednesday’s Fed FOMC meeting but increases the risk of a 75bp move though the latter still seems unlikely.  More likely, the Fed embarks on a series of 50bps hikes. . 

Separately, the ECB shifted away from its long held dovish stance and announced an expected end to its bond purchase plan (APP) at the beginning of July, effectively pre-announced a 25bp policy rate hike in July and 25-50bp hikes in September, with the central bank expecting to maintain a tightening cycle beyond September.  Many other central banks are scrambling to catch up the curve as inflation pressures end up being much higher than many of them previously anticipated.  There are exceptions of course such as Japan (see below), Russia recently cut its policy rate by 150bp and China which may still cut policy rates in the weeks ahead (watch this week’s 1y Medium Term Lending Facility decision, with a small 5-10bp cut possible), but these exceptions are few and far between.

The jump in US inflation will also further support the US dollar, keeping it on the front in the days ahead against most other currencies.  Already at the start of the week, most currencies were hurt in the face of a resurgent US dollar, especially high beta emerging market currencies. Separately, market volatility measures (e.g. MOVE and VIX) are likely to rise while liquidity is likely to remain poor.  Risk assets overall are likely to struggle against this background. Overall, it’s hard to see sentiment turn around quickly.

This week the main focus will be on the Federal Reserve FOMC meeting (Wed) but there are also several other central bank decisions of interest including the BCB in Brazil (Wed) where consensus expects the pace of hikes to slow to 50bp.  Additionally, 25bp rate hikes from the Bank of England and CBC in Taiwan (both Thu) are expected while the Bank of Japan (Fri) meeting is likely to be uneventful as BoJ governor Kuroda has doubled down on his aggressive stimulus stance while noting that a weaker Japanese yen benefits the economy.  Key data this week includes likely yet more weak Chinese activity data in May (Wed), jobs data the UK (Tue) and Australia (Thu) and a likely stronger than consensus increase in May  US retail sales (Wed).  

The Week Ahead

Of course the main focus for markets will continue to be the war in Ukraine. The risk of Nato being dragged into the war has risen after Russian warnings that military conveys to Ukraine will be considered legitimate targets and a military training facility near Poland’s border was attacked.  Russia has reportedly intensified its attacks on key Ukrainian cities while peace talks are reportedly making some progress though nothing concrete has yet been achieved.  The US and China will also gold high-level talks in Rome today while there has been no traction towards a no-fly zone over Ukraine. 

Illiquidity and volatility are likely to continue to characterise market activity in the days ahead while risks of a Russian default grow. Stagflation risks will likely continue to sound louder in the weeks ahead too, leaving central banks in a bind.  As it was, economic growth was slowing and inflation was highly elevated ahead of the crisis in Ukraine.  Now it’s going to look a whole lot worse, implying a still tense environment for risk assets.  The US dollar looks firm going into this week against this background. 

This week’s key central bank events include Bank Indonesia (Tue), Federal Reserve FOMC decision (Wed), Bank of England (Thu), European Central Bank (ECB) Watchers Conference (Thu), CBC in Taiwan, CBRT in Turkey (Thu), BCB in Brazil, Bank of Japan (Fri), and CBR (Fri) in Russia.  Most focus will of course be on the Fed where a 25 basis points hike in interest rates is highly likely.  Any clues to the pace of tightening and details of quantitative tightening will also be in focus.  Similarly, the BoE is likely to hike by 25bp.  The ECB Conference will be watched for discussion on the speed of policy withdrawal. 

Meanwhile, the BoJ is likely to downgrade its growth outlook while no change in policy is expected in Indonesia, Turkey and Russia.  In contrast, Brazil is expected to hike rates by 100bp.  There will also be attention on China’s 1 year medium term lending facility where a cut amid slowing activity, would presage a potential easing in the policy Loan Prime Rate (LPR) next week.  Data in focus will be China activity data (Tue) where a further slowing in both industrial production and retail sales is likely while US February retail sales (Wed) are likely to gain momentum.  Last but not least, Australian jobs data (Thu) are likely to reveal a strong print for February.   

Debate Over Fed Tightening Rages On

After receiving a major beating over recent weeks this week has seen a ‘risk on’ tone permeate through markets as dip buyers emerge.  COVID is increasingly taking a back seat though risks from simmering geopolitical tensions over Russia/Ukraine continue to act as a threat to markets.  Nonetheless, equity volatility has fallen, with the VIX ‘fear gauge’ dropping sharply over recent sessions.  In contrast, interest rate volatility remains elevated as debate over a potential 50 basis point hike from the Federal Reserve and/or policy hikes at successive FOMC meetings continues.  Fed speakers this week including St. Louis Fed President Bullard and Philadelphia Fed President Harker in comments yesterday appear to have dampened expectations of a 50 basis point hike, but this has unlikely put an end to such speculation.

Overall market uncertainty is likely to persist in the weeks ahead setting the scene for renewed bouts of volatility.  The debate over Fed rate hikes both in terms of magnitude and timing is far from over, with analysts ramping up expectations of multiple hikes this year.  There is a strong chance that the Fed will announce tightening at each of the next three meetings including beginning quantitative tightening (QT).  Markets are pricing in five quarter point hikes in the next year and there may be scope for even more aggressive tightening.  Given likely persistently high inflation readings in the months ahead it is not likely the time to push back against markets tightening expectations. 

Much of Asia has been closed for part or all of this week though China’s purchasing managers index (PMI) data for January released last weekend highlighted a loss of economic momentum.  Although official stimulus measures will likely help to avoid a sharp slowing in economic growth, sentiment is unlikely to get back to pre-COVID levels anytime soon. China’s zero-tolerance approach to COVID means that even small outbreaks will lead to lockdowns, likely dampening services sentiment and travel. Meanwhile, manufacturing pressure may find some support from fiscal policy measures as policy is front loaded, and likely further monetary easing ahead, with at least another 10 basis point easing in the Loan Prime Rate and 50bp cut in the RRR likely in the weeks ahead. However, the overall trajectory of activity remains downwards.

Monetary policy decisions in the Euro area (Thu) and UK (Thu) will be among the highlights this week in addition to US Jan jobs (Fri).  The Reserve Bank of Australia (RBA) left policy unchanged as expected but revealed a relatively dovish statement even as it formally announced an end to quantitative easing (QE). There is likely to be a contrasting stance between the Bank of England (BoE) and European Central Bank (ECB), with the former likely to hike by 25 basis point on concerns about rising inflation expectations while we the latter is likely in cruise control for H1 2022. In the US there are risks of a worse than consensus outcome for US non-farm payrolls due to a surge in Omicron cases (consensus 175k).  Separately, in emerging markets, focus will be on Brazil, where the central bank, BCB is expected to hike rates by 150bp (Thu).

Setting Up For A More Volatile Q4

After a disappointing September for risk assets, markets at least found some relief at the end of last week, with the S&P 500 ending up over a 1% while US Treasury yields fell and the US dollar also lost ground.  However, sentiment in Asia to kick of the week has been poor, with Evergrande concerns coming back to the forefront.

There was positive news on the US data front, with the Institute of Supply Management (ISM) manufacturing index surprising to the upside in September, rising modestly to 61.1 from an already strong level at 59.9 in August (consensus: 59.5) though the details were less positive.  In particular, the rise in supplier delivery times and prices paid reflects a re-emergence of supply chain issues. 

Separately, the infrastructure can was kicked down the road as infighting within the Democratic party on the passage of the bipartisan $1.2 trillion infrastructure bill and larger $3.5tn package, led to a further delay of up to one more month. It is likely that the eventual size of the proposed $3.5tn spending plan will end up being smaller, but there still seems to be some distance between the progressives in the Democratic party want and what the moderates want. Separately, the debt ceiling issue is likely to go down to the wire too.

China’s Evergrande remains in focus, with the company reportedly suspended from trading in Hong Kong pending “information on a major transaction”. According to China’s Cailian news platform another developer plans to acquire a 51% stake in the property services unit. The sale is likely a further step towards restructuring the entity and preventing a wider contagion to China’s property sector and economy.

Over the rest of the week attention will turn to the US September jobs report, which will as usual likely be closely eyed by Federal Reserve policymakers.   A pickup in hiring relative to the 235,000 rise in August is expected, with the consensus looking for a 470,000 increase. It would likely take a very poor outcome to derail the Federal Reserve’s tapering plans in my view.  

Several central banks including in Australia (Tue), New Zealand (Wed), Poland (Wed) and India (Fri) will deliberate on policy.  Among these the most eventful will likely be the RBNZ, with a 25 basis points rate hike likely while the others are all set to remain on hold.  Other data includes the European Central bank (ECB) meeting accounts of the September meeting (Thu), US ISM Sep services index (Tue) and Turkey September CPI (today). 

Overall, going into the fourth quarter investors will have to contend with host of concerns including weakening global activity especially in the US and China, supply chain pressures, persistent inflation risks, Evergrande contagion and related China property developer woes, China’s regulatory crackdown, raising the debt ceiling, difficulties in passing the US infrastructure bills, Fed tapering, and ongoing COVID concerns.  This may set up for a much rockier and more volatile quarter ahead for markets especially amid a growing wave of more hawkish G10 central banks.

Busy Week Ahead For Central Banks

US equities came under more pressure at the end of last week, with the S&P 500 falling to its lowest in four weeks, down around 2% month to data.  The drop will test the buy on dips mentality as the S&P is once again resting just above its pivotal 55-day moving average, a level that has seen strong buying interest in the past. 

Economic data gave little help to market sentiment, with the University of Michigan confidence index improving a little to 71.0 in early September but falling slightly below consensus expectations at 72.0.  Separately, the inflation expectations measures were broadly unchanged, with the most relevant series for Fed officials (the 5-10y) remaining steady at 2.9%, which is still consistent with the Fed’s 2% goal.

This week is all about central bank meetings, with an array of policy meetings including in Indonesia (Tue), Sweden (Tue), Hungary (Tue), China (Wed), Japan (Wed), US (Wed), Brazil (Thu), Philippines (Thu), UK (Thu), Norway (Thu), Switzerland (Thu), South Africa (Thu), and Taiwan (Fri), all on tap. 

Most focus will obviously be on the Federal Reserve FOMC meeting, during which officials will likely signal that they are almost ready to taper. A formal announcement is likely in December or possibly November.  Most other central banks are likely to stay on hold except a likely 25bp hike in Norway, 25bp in Hungary, and 100bp in Brazil.

Politics will also be in focus, with Canada’s Federal election and the results of Russia’s parliamentary elections today.  Polls suggest the incumbent Liberals ahead though the most likely outcome is a minority government in Canada while in Russia the ruling pro Kremlin United Russia party is likely to renew its supermajority. 

Other issues in focus this week are frictions over the US debt ceiling, with the House voting soon on raising the ceiling.  US Treasury Secretary Yellen renewed her calls for Congress to raise of suspend the debt ceiling stating in a Wall Street Journal op-ed that failing to do so “would produce widespread economic catastrophe”. 

In China, Evergrande’s travails will be in the spotlight on Thursday when interest payments on two of its notes come due amid growing default risks.  Indeed, China related stocks slid on Monday morning as Evergrande concerns spread through the market.  Property developer stocks are under most pressure and whether there is wider contagion will depend on events on Thursday.

The US dollar has continued to strengthen, edging towards its 20 Aug high around 92.729 (DXY) and looks likely to remain firm heading into the Fed FOMC meeting especially as it will hard for Fed Chair Powell to sound too dovish and given risks of a hawkish shift in the dot plot.  Positioning data is showing increasingly positive sentiment towards the dollar, with speculative positioning (CFTC IMM net non-commercial futures) data showing the highest net long DXY position since May 2020. 

Conversely, speculative positioning in Australian dollar has hit a record low likely undermined by weaker iron ore prices.  Similarly, positioning in Canadian dollar is at its lowest since Dec 2020 while Swiss franc positioning is at its lowest since Dec 2019. Asian currencies have been hit, with the ADXY sliding over recent days.  The Chinese currency, CNY has been undermined by weaker data and concerns over Evergrande while high virus cases in some countries are hurting the likes of Thai baht. 

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