Hawkish Central Banks

It was a soft end to the week for global equities, while the US dollar (USD) rallied further as US Treasury yields pushed higher.  Neither the move in Treasuries or the USD shows any sign of slowing, and if anything, US inflation data will keep the upward pressure on yields and USD intact this week.  Clearly, most currencies, expect notably the Russian rouble are suffering at the hands of a strong USD though Asian currencies have been less pressured of late compared to other currencies. 

The surge in US Treasury yields has been particularly stark and fuelled pressure across many other markets.  The USD (DXY) has been a key beneficiary of the rise in US yields, with the currency propelled to its highest level since May 2020.  USDJPY remains one of the most highly correlated currency pairs to yield differentials and with Japan persisting in its defence of Yield Curve Control (YCC) it looks like USDJPY will continue to move higher, with 130 moving into sight. 

There’s plenty of central bank action this week and much of it likely in a hawkish direction, including in New Zealand (Wed), Canada (Wed), Singapore, Korea, Euro area, and Turkey (all Thu).  Tightening is expected from several of these central banks.  The consensus is expecting a 25-basis point (bp) hike in policy rates in New Zealand, but a significant minority is looking for a 50bp hike

In Korea, the consensus is split between no change and a 25bp hike, with the risks skewed towards the latter amid strong inflation pressures and high household debt, even though the new central bank governor may not be installed at this meeting. Similarly, a hawkish outturn from the Monetary Authority of Singapore is likely, with a steepening, re-centering and possible widening of the Singapore dollar nominal effective exchange rate band expected.  Note that Singapore’s monetary policy is carried out via its exchange rate.

In Canada, a 50bp hike in policy rates is likely, while the Bank may announce balance-sheet run off in a likely hawkish statement in the wake of stronger readings both on the growth and inflation front. Last but not least, the European Central Bank (ECB) may announce an early end to its quantitative easing and prepare markets for rate hikes, possibly as early as June.  In contrast, Turkey is likely to continue to maintain its monetary policy on hold amid some stability in its currency. 

On the data front, US March CPI inflation data will be among the key releases this week.  Another high reading is likely, with the consensus expectation at 8.4% year-on-year, from 7.9% previously.  The data will not make for pleasant reading, with headlines likely to highlight that US inflation is back at over 40- year highs.  While the data will likely keep up the pressure on interest rate markets, I would caution that a lot is in the price.       

Will The Fed Hike By 50bp? Asia Singing To Its Own Tune

The outsized gain in the US January CPI inflation rate has firmly put a 50 basis points (bp) Federal Reserve rate hike on the table as well as reinforcing expectations of a series of consecutive rate hikes while St Louis Fed President Bullard even raised the prospect of an inter-meeting hike in the wake of the CPI data.  Markets are now pricing close to 7 hikes in 2022 and 80% odds of a 50bp hike in March. 

US CPI inflation jumped to 7.5% y/y, a 40-year high, with prices rising by 0.6% m/m and core CPI rising to 6% y/y, all above consensus.  In the wake of the data Bullard strengthened his hawkish rhetoric by saying that he would like to see 100bp of hikes by July 1 2022.  Markets have quickly ramped up their expectations for Fed tightening, with a growing chorus expecting a series of consecutive hikes.

Markets are reacting badly, with equities under renewed pressure, bond yields moving higher and the US dollar firming.  It’s hard to see such pressure easing anytime soon.  Historically the bulk of market pressure takes place as the market prices in / discounts rate hikes rather than after the Fed actually hikes.  This suggests that markets will remain highly nervous at least until the March Federal Reserve FOMC meeting. 

It is clear that the data is killing off any chance of a more tepid pace of US monetary tightening. The Fed alongside other major central banks are frantically trying to regain credibility in the wake of much stronger inflation readings than they had anticipated by espousing increasingly hawkish rhetoric, which will likely soon be followed with action as policy rates increase and central bank balance sheets start to shrink. 

There is now a growing probability that the Fed will kick off its monetary tightening with a 50bp rate hike followed by consecutive hikes in the months ahead as well as quantitative tightening in the second quarter.  It’s not quite a done deal but another strong US inflation print for February will seal the case for a 50bp hike in March.

In contrast, Asia monetary policy is singing to its own tune.  Unlike in past tightening cycles when Asian central banks were forced to tighten to avoid pressure on their markets, especially to avoid currency weakness, there is limited signs of such pressures at present.  Some in Asia such as the Bank of Korea and Monetary Authority of Singapore have tightened already, but this is largely due to domestic factors rather than the Fed.

The stark difference in stance between Asian central banks and what is being priced in for the Fed has been particularly apparent by the recent dovish policy decisions in India, Indonesia, and Thailand, with all three central banks showing no urgency to tighten.  Similarly, the Bank of Japan acting to defend its yield curve policy by conducting unlimited fixed-rate JGB purchases, was clearly a dovish move.  Last but not least, the PBoC, China’s central bank has already cut its policy Loan Prime Rate and is likely to do so again in the next few months.  

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.

Inflation Angst

US equities fell for a fifth straight day on Friday enduring their worst week since June.  Asian markets faced a tough start to the week after US losses and amid further Chinese regulatory measures, with Alipay in focus as regulators are reportedly (FT) looking to break it up while the Biden administration is reported to be looking at starting a new probe into Chinese industrial subsidies.  Worries about the persistent impact of the Delta variant on the services and tourism sector globally are adding to the sense of malaise in markets. 

Data wise, US Aug Producer Price Index (PPI) data dented confidence following a bigger than expected 0.7% m/m, 8.3% y/y increase, with yet more evidence of the impact of supply pressures impacting the data even as the core measure slowed.  It is worth noting that China’s outsized increase in PPI inflation in August released last week sent a similar message.  Such fears may have been attributable to the move in bonds, with US Treasury yields rising on Friday, giving back the gains in the wake of the strong 30- year auction, despite the fall in equities. 

Following the US PPI, there will be a number of other releases this week which could potentially add to nervousness over lingering inflation pressures.  The plethora of inflation data kicks off with India’s August consumer price index (CPI) today for which a 5.6% y/y increase is expected, a level which will likely continue to make India’s central bank (RBI) uncomfortable.  US August CPI scheduled for tomorrow is likely to show another strong rise in food and energy prices though core CPI likely rose at its slowest pace since February.  Canada August CPI (Wed) is likely to drift higher while UK August inflation (Wed) is likely to reveal a jump after a sharp decline last month.  On balance, the inflation releases this week will do little to calm market’s inflation fears.

Other key data this week will likely show weakening activity.  The slate includes US August retail sales (Thu). The data is likely to add to evidence that the boost to goods spending in the US from fiscal stimulus has peaked.  China activity data including August retail sales and industrial production (Wed) will likely show further moderation especially to retail sales which was likely impacted by lockdowns in various provinces.  Australia employment data (Thu) is likely to have revealed a decline while NZ GDP (Thu) is likely to show firmer economic momentum than the RBNZ’s forecast.

Market Cross-Currents

There are many cross currents afflicting markets at present.  Equity valuations look high but US earnings have been strong so far, with close to 90% of S&P 500 earnings coming in above expectations. This has helped to buoy equity markets despite concerns over the spreading of the Delta COVID variant and its negative impact on recovery.  Yet the market doesn’t appear entirely convinced on the recovery trade, with small caps continuing to lag mega caps. 

The USD index (DXY) remained supported at the end of last week even as US yields remain capped, but the USD does appear to be losing momentum. Positioning has now turned long according to the CFTC IMM data indicating that the short covering rally is largely exhausted; aggregate net USD positioning vs. major currencies (EUR, JPY, GBP, AUD, NZD, CAD & CHF as a percent of open interest) turned positive for the first time in over a year. 

Inflation fears have not dissipated especially after recent above consensus consumer price index (CPI) readings, for example in the US and UK.  Reflecting such uncertainty, interest rate market volatility remains high as seen in the ICE BofA MOVE index while inflation gauges such as 5y5y swaps have pushed higher in July.  There was some better news on the inflationary front at the end of last week, with the Markit US July purchasing managers indices (PMIs) revealing an easing in both input and selling prices for a second straight month, albeit remaining at an elevated level. 

This week we will get more information on inflation trends, with the June Personal Consumption Expenditures (PCE) report in the US (Fri), Eurozone July CPI (Fri), Australia Q2 CPI (Wed) and Canada June CPI (Wed), on tap this week.  We will also get to see whether the Fed is more concerned about inflation risks at the Federal Open Markets Committee (FOMC) meeting (Wed).  The Fed is likely to continue to downplay the surge in inflation, arguing that it is transitory, while the standard of “substantial further progress” remains a “ways off”.   Nonetheless, it may not be long before the Fed is more explicit in announcing that is formally moving towards tapering. 

An emerging markets central bank policy decision in focus this week is the National Bank of Hungary (NBH) where a 15bp hike in the base rate is expected.  Central banks in emerging markets are taking differing stances, with for example Russia hiking interest rates by 100 basis points at the end of the week while China left its Loan Prime Rate unchanged.  The July German IFO business climate survey later today will be in focus too (consensus 102.5).  Overall, amid thinner summer trading conditions market activity is likely to be light this week.

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