Central Banks Deliver Hawkish Surprises – What Will The Fed Do?

Following a series of more hawkish central bank action recently, 50 basis points (bp) hikes have become the new 25bp.  Several central banks surprised last week including a 100bp hike in Canada, 75bp hike in the Philippines and an inter-meeting tightening in Singapore. 

Meanwhile, while the upward surprise in US June CPI inflation (1.3% m/m) increased the chance of a 100bp hike from the Fed this month the University of Michigan sentiment survey revealed a decline in inflation expectations, with consumer sentiment languishing near all-time lows, dampening expectations of a larger move. 

While a 100bp hike at the 26/27 July FOMC meeting is quite possible after the Fed raised rates by 75bp last month, some Fed officials have dampened expectations of such a large move.  Officials such as Atlanta Fed President Bostic and Kansas City President George, have highlighted the risks that more aggressive rate increases would hurt the economy at a time when recessions risks have intensified. 

As we go into the Fed blackout period, with no Fed speakers ahead of the FOMC meeting and with the key June CPI print out of the way, there will be limited new news for markets to chew on.  Markets have fully priced in a little more than 75bp of Fed tightening this month, which seems reasonable, with a 75bp hike the most likely outcome.

This week has kicked off with another outsize increase in CPI inflation, this time in New Zealand where the Q2 CPI reading came in at 7.3% y/y (consensus. 7.1%, last 6.9%) reinforcing expectations of a 50bp hike by the RBNZ at its August meeting. 

There are several central bank decisions on tap in the euro area, Japan, China, Turkey, South Africa, Indonesia, and Russia.  The outcomes will differ.  The European Central Bank is primed to hike by a tepid 25bp, with focus on the likely announcement of an anti-fragmentation tool.  Not surprises are expected in Japan (Thu), China (Wed), Indonesia (Thu) and Russia (Fri), with policy likely on hold in all four cases. 

In contrast a 50bp rate hike from the SARB in South Africa (Thu) is likely while Russia is expected to cut policy rates by as much 100bp.   Aside from central bank decisions earnings releases gain momentum this week while Italian politics will remain in focus.  

The US dollar has kicked off this week on a weak footing after ending last week on a softer note. USD positioning remains heavily long though its notable that speculative positioning in the USD index (DXY) has slipped over recent weeks (according to the CFTC IMM data). 

Still stretched positioning and lower yields as markets pull back from aggressive Fed tightening expectations will likely cap the USD in the short term.   However, it’s hard to see the currency losing much ground, with EURUSD parity continuing to act as a magnet.  

Action Shifting To Currencies as Rates Volatility Eases

US stocks barely closed higher at the end of last week and flirted with bear market territory. US consumer and retail stocks remain under pressure alongside industrials as recession fears intensify.  Indeed while inflation concern remain elevated, recession fears are increasing. US Treasury yields are finally coming off the boil amid such fears, with May seeing a significant pull back in yields; the biggest decline has been in the 3-10 year part of the yield curve over recent weeks.  This has been met with a decline in interest rate volatility unlike equity and implied currency volatility measures, which have pushed higher.   For instance, major currency implied volatility measures have reached their highest since around March 2020. Emerging markets volatility breached its March 2020 high in March 2022 and after a brief fall is moving back higher.  

Action is shifting to currencies and the drop in the US dollar from its highs, with the currency increasingly undermined by lower US yields.  In Asia, the 3 most sensitive currencies to yield differentials (US 10 year yield minus 10 year local currency bond yields) are the Thai baht, Indonesian rupiah and Korean won.  As such, Korean won is likely to rally the most in Asia should US yields fall further.   The Chinese yuan has strengthened amid US dollar weakness though underperformance of the Chinese currency is likely versus its peers as the authorities likely aim to weaken it on a trade weighted (CFETS) basis. 

In China, the surprisingly large 15 basis point cut in 5-year loan prime rate last week will be seen as a boon for China’s property market.  However, while support for the property market has increased there does not seem to be much more stimulus ready to be unleashed despite various pledges.  China’s April data slate was weak highlighting the risks of a contraction in GDP this quarter and providing evidence that the “around 5.5%” official growth target looks increasingly out of reach.  COVID restrictions across the country are easing gradually pointing to some pick up in activity though consumption and the service sector are likely to remain under pressure for months to come as mass testing, quarantines and border controls continue to restrict mobility.  

There was relief for China’s markets today as President Biden highlighted the potential for a reduction/removal of tariffs implemented by President Trump, stating that he will discuss tariffs with Treasury Secretary Yellen when he returns from his Asia trip.  Removing tariffs is by no means a done deal given there will be plenty of pressure to maintain some level of US tariffs on China. A reduction in tariffs would be beneficial for the US in that it would help reduce imported inflation pressures while it would also help to support Chinese exports at a time when they are slowing down and adding pressure on China’s current account position.  However, some of this impact would likely be mitigated by a relatively stronger yuan, which would undoubtedly benefit as tariffs were cut.  

Key data and events highlight this week include monetary policy decisions in Indonesia (Tue), New Zealand (Wed), South Korea and Turkey (both Thu).  Federal Reserve FOMC meeting minutes will also be released (Wed). Although not expected by the consensus there is a good chance that Indonesia hikes policy rates by 25 basis points. In New Zealand a 50bp hike is likely while a 25bp hike in South Korea is expected.  In contrast despite pressure on the Turkish lira and very elevated inflation no change in monetary policy is expected in Turkey this week.  Meanwhile the Federal Reserve FOMC minutes will provide further detail on how quickly the Fed wants to get to neutral rates and beyond and on its quantitative tightening policy. 

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.   

State Of Shock

Equity markets are in a state of shock.  After a stellar year last year equities have started the year in terrible shape. The rout extended further at the end of last week, capping off the worst week in over a year for US stocks.  Tech continued to lead losses, with the Nasdaq down 7.6% over the week.  Notably global equities were impacted less than the US, reflecting the fact that most equity markets outside of the US are less tech orientated.  Anything with leverage and consisting of highly speculative investment such as Crypto are bearing the brunt of the pressure.  Volumes of equity put options on the S&P 500 have also risen sharply as investors try to hedge further losses on US stocks. 

The main cause of market pressure remains the build-up of expectations of Fed tightening, with Fed officials sounding increasingly hawkish and speculation growing of a 50 basis point Fed rate hike in March as well as several more hikes over the course of this year, with four hikes already priced in for this year.   It’s hard to see such pressure abating soon. Indeed, technical indicators on the S&P 500 look poor, with the index having closed below its 200 day moving average level.  However, with market pricing for US rate hikes already so aggressive, a lot of the pain may already have been inflicted unless the Fed really does hike at every meeting this year.  

Wednesday’s Federal Reserve FOMC meeting will give further clues US interest rate policy, with the Fed likely to give signals that a March rate hike is in the offing.  However, this should not be surprising given that Fed officials have over recent weeks already strongly hinted at a March rate hike.  What will be scrutinised is any clues on Fed balance sheet reduction (quantitative tightening) as well as the path of the funds rate after March.  It’s unlikely that the Fed provides any firm indications, but nonetheless the press conference could prove more interesting.

Other policy meetings this week include the Bank of Canada meeting (Wednesday). It’s a close call but strong domestic data points to a 25-basis points policy rate hike, kicking off a likely cycle of hikes in the months ahead.  Separately, rate hikes in Hungary (tomorrow) and South Africa (Thursday) are also likely.   Following unchanged outcomes from Malaysia and Indonesia and a policy cut in China last week, there is little on the data and events front in Asia this week.  

Political and geopolitical developments will garner plenty of attention this week.  In the UK the Sue Gray report on “Partygate” will be released.  In Italy, the path for Draghi to be elected President appears to have become easier, with Berlusconi pulling out of the running though it is by no means a clear cut process.  Meanwhile, the situation with regard to Ukraine is on tenterhooks, with Russia reportedly continuing to build up troops on the border, and risks of “significant military action” rising.

Currency markets have been largely spared the carnage seen in equity markets. Speculative positioning data suggests the market remains heavily long the dollar index (DXY). Higher US real rates and continued tightening of Fed rate expectations suggests any pull back in the USD will be limited and the currency remains a buy on dips. Notably, GBP positioning has remained firm, ignoring the potential for a no-confidence motion on Prime Minister Boris Johnson. Asian currencies also remain relatively resilient, with the Chinese currency likely to continue outperforming.

Testing The Fed’s Resolve, China Data Gives Some Relief

In the aftermath of the surge in US consumer prices in October which reached the highest since 1990 at 6.2% year-on-year, the Fed’s stance is under intense scrutiny.  While tapering is beginning soon, the biggest question mark is on the timing of interest rate hikes, with markets having increasingly brought forward expectations of the first Fed hike to mid next year even as Chair Powell & Co keep telling us that inflation pressures are “transitory”.  Front end rates have reacted sharply and the US dollar is following rates US rates higher.  The flatter yield curve also suggests the market is struggling to believe the Fed.  Meanwhile, liquidity in interest rates market remains thin, and smaller Fed purchases going forward will not help.  In contrast, equities are hardly flinching, with the FOMO rally persisting. US equities closed the week higher despite a drop in the Michigan sentiment index, which fell to a new 10-year low of 66.8 in early November (consensus 72.5), with inflation being largely to blame. 

There was a bit of relief for markets on the China data front today.  The October data slate revealed less sharp softening compared to the previous month, but momentum continues to be downwards. Industrial production increased by 3.5% (consensus 3.0% y/y). A host of regulatory, and environmental pressures are leading to policy led weakness in manufacturing.  While there has been some easing in such pressures, there is unlikely to be much of a let up in the months ahead.  While retail sales also increased by more than expected up 4.9% (consensus 3.7% y/y) sales have been impacted by China’s “zero-tolerance” COVID policy, which has led to lockdowns across many provinces.  Fixed assets and property investment slowed more than expected reflect the growing pressure on the property sector. Also, in focus today will be the virtual summit between President’s Biden and Xi. I don’t expect any easing in tariffs from the US side.  

Over the rest of the week, US retail sales data will be take prominence (Tue). Sales likely rose by a strong 1.3% month on month in October, but the data are nominal and goods prices rose 1.5% in the October CPI, implying real good spending was far more restrained.  Central bank decisions among a number of emerging markets including in Hungary (Tue), South Africa (Thu), Turkey (Thu), Indonesia (Thu) and Philippines (Thu) will also be in focus.  The divergence between most Asian central banks and elsewhere is becoming increasingly apparent, with expectations for policy rate hikes in Hungary and South Africa, and a likely cut in Turkey contrasting with likely no changes from Indonesia and Philippines.   Also watch for any traction on the passage of the $1.75bn “build back better” fiscal package in the US, with a possible House vote this week.  Separately, markets are still awaiting news on whether Fed Chair Powell will remain for another term or whether Brainard takes his seat, with a decision possible this week.

As noted, sharply higher than expected inflation readings in the US and China will play havoc with the narrative that inflation pressures are “transitory” while highlighting the depth of supply side pressures.  Higher US market rates, with the US yield curve shifting higher in the wake of the CPI, bodes badly for emerging market carry trades in the near term as it reduces the relative yield gap.  At the same time a tightening in global liquidity conditions via Fed tapering may also raise some obstacles for EM carry.  That said, there is still plenty of juice left in carry trades in the months ahead.  Markets are already aggressively pricing in Fed rates hikes and there is limited room for a further hawkish shift i.e a lot is already in the price.  Meanwhile FX volatility remains relatively low even as volatility in rate markets is elevated.  Many EM central banks are also hiking rates. As such carry and volatility adjusted expected returns in most EM FX remain positive.

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