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).  

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).

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.

Geopolitical Risks Rise

Last week ended on a positive note for risk assets, with equities rallying to record highs. In particular tech stocks are back in lead this quarter. The biggest surprise was the ability of US Treasuries to rally at the same time, particularly in the wake of a strong slate of economic data. The rally may be attributable to strong foreign and pension buying amid short market positioning.  Indeed, CFTC data show that Treasury bearish positions had increased as of April 13th.  The pull back in US Treasury yields points to some relief for emerging market assets. Similarly, commodity positions had also been cut, with gold, copper and oil positioning liquidation taking place. The risk rally and lower US yields have put the US dollar on the back foot, extending its decline over the week.  As such, the USD “exceptionalism” story appears to be fading somewhat.

Last week finished off with another set of firm US data; Housing starts surged 19.4% m/m to 1,739k, well-above the 1,613k consensus, from 1,457k (revised from 1,421k) in February. Similarly, consumer sentiment continued to improve in April, according to the preliminary release of the University of Michigan survey, with the index rising to a new post-COVID high of 86.5.  This week’s highlights include central bank decisions in China (Tue), Indonesia (Tue), Canada (Wed), Euro area (Thu) and Russia (Fri).  Russia’s central bank CBR is expected to hike by 25bp while no changes are expected from the other central banks.  Canada’s Federal Budget today and CPI (Wed) will also be in focus.  Data wise, Australia March retail sales (Wed), New Zealand Q1 CPI and Euro area flash purchasing managers indices PMIs (Fri) will garner attention.  

On Friday, the US Treasury released its semi-annual FX report and found that once again Vietnam and Switzerland met all three criteria under the 2015 Act. over 2020.  Taiwan was also found to breach the Treasury criteria.  The outcome means that there will be ‘enhanced analysis’ of these countries.  However, the {US} US Treasury declined to name any of these countries as currency manipulators, citing insufficient evidence under the 1988 Act.  The other interesting development is that the Treasury questioned the foreign exchange activities of Chinese state banks given that it appears that China’s official FX intervention was very limited.  Separately, Ireland and Mexico were added to the US Treasury Monitoring List.

Geopolitical risks are rising once again and could act as a threat to markets in the day and weeks ahead. Last week the US levied sanctions on Russia including targeting Russian government debt. Russia responded with counter sanctions. However, the US administration did hold out an olive branch in the form of a potential joint summit. Focus is also on growing tensions between Ukraine and Russia Similarly, US and Japanese leaders voiced concerns over Chinese policies, which were subsequently rejected by China’s foreign ministry. Despite the US criticism of China the US and China appear to be moving ahead with cooperate on climate change. US-China over Taiwan remain elevated however.

Going “The Extra Mile”

Risk assets ended last week on a soft note as Brexit uncertainties intensified amid a lack of progress towards a transition deal.  However, news overnight was a little more promising, as PM Johnson and EC President von der Leyen agreed to “go the extra mile” to try to agree up on a deal.  “Incremental” progress has reportedly been made and talks could now continue up to Christmas.  Sterling (GBP) rallied on the news and further gains are likely on any deal.  However, gains may prove short lived, with markets likely to focus on the economic difficulties ahead of the UK economy.  A no deal outcome is likely to result in a much sharper decline in GBP, however.

Progress towards fresh US fiscal stimulus progress faltered leaving US equity markets on shaky ground.  As it is, US stocks have struggled to extend gains over December after a stellar month in November and in recent days momentum has faded further.  Last week 9 out of 11 S&P sectors fell, suggesting broad based pressure.  Whether it is just a case of exhaustion/profit taking after solid year-to-date gains – for example, Nasdaq is up almost 38% and S&P up 13.4%, ytd – or something more alarming is debatable.  The massive amount of liquidity sloshing around and likely more dovishness from the Fed this week, would suggest the former.  

At the same time the US dollar (DXY) and broader BDXY are down almost 6% and 5% respectively, this year and most forecasts including our own look for more USD weakness next year.  Some of this is likely priced in as reflected in 27 straight weeks of negative aggregate USD (vs major currencies) positioning as a % of open interest (CFTC). The USD looks a little firmer this month, but gains are tentative and like equities this could simply reflect profit taking.  For example, in Asian currencies that have performed well this year such as the offshore Chinese yuan (CNH) and Korean won (KRW), fell most last week, partly due to increased central bank resistance. 

This week is a heavy one for events and data.  The main event on the calendar is the Federal Reserve FOMC meeting (Wed).  The Fed could include new forward guidance stating that quantitative easing (QE) will continue until there is clear-cut progress toward the employment and inflation goals.  The Fed may also lengthen the average maturity of asset purchases. Central bank decisions in Hungary (Tue), UK, Norway, Indonesia, Taiwan, Philippines (all on Thu), Russia, Japan and Mexico (all on Fri) will also be in focus though no changes in policy are likely from any of them.   On the data front China activity data (Tue), Canada CPI (Wed), US retail sales (Wed), and Australian employment (Thu) will be main highlights.

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