The market has changed: It’s no longer about inflation, it’s about growth
The US dollar is at the highest levels since the dawn of the pandemic and has surged higher today.
In short, the market is no longer convinced that global central banks can tame inflation without a major hit to growth. Maybe that’s not a recession but it’s a much slower growth paradigm than assumed.
Eight months from now, the Fed funds futures market is priced for 2.75-3.00% overnight rates after a series of at least three 50 bps hikes to start. The overnight rate hasn’t been that high since 2007 and we just don’t know what the economy will look like when it gets there.
The market is saying that global central banks are behind the curve and will need to over-tighten to halt inflation.
“We are walking a very tight line between tackling inflation and the output effects of the real income shock, and the risk that could create a recession,” said Bank of England Governor Andrew Bailey today.
Yesterday, Powell had this to say:
Our goal is to use our tools to get demand and supply back in synch…and
do so without a slowdown that amounts to a recession,” he said. “It
is going to be very challenging.”
Not just inflation
Previously, the market was convinced that central banks had plenty of latitude to hike rates at a gradual pace to cool inflation but two things have changed in 2022.
1) The Ukraine war catalyzed commodity inflation
2) China is on lockdown, snarling supply chains again
The market put on the rose-coloured glasses on both fronts for a time but it’s now clear that both aren’t going anywhere. Plus, with inflation continuing to ramp up and central banks now taking a more-hawkish tilt, the risks have hit a point that’s intolerable for the bulls.
Combine that with the irrational exuberance in stay-at-home tech stocks during the pandemic and the resulting bubble burst and it’s a minefield out there.
Ultimately, what’s made me have a rethink is the performance of commodity producers this week. Commodity prices have largely held up this week but producers are being rocked.
Alcoa reported good earnings this week and the commentary in the conference call was overwhelmingly upbeat. Yet here’s the chart:
That’s a 23% fall this week.
It’s not an isolated case either. Freeport McMoran is down 18% and others to a less extent.
If I had to name the watershed it would be the latest IMF global growth forecasts released this week. Those sets of numbers generally tell people what they already know but this time the report seemed to galvanize sentiment. The 2022 global GDP forecast was ratcheted down to 3.6% from 4.4%.
If you look at those forecasts as more of a snapshot of the consensus a month ago, then layer in faster rate hike scenarios since then — you can easily get below 3%. For instance, China was only lowered to 4.4% from 4.8%. Given the covid state-of-play, that’s optimistic.
In addition, here’s a look at 2023 forecasts. If you’re concerned about higher rates and a deeper slowdown, there isn’t much room for error:
- UK +1.2%
- Italy +1.7%
- Eurozone +2.3%
- US +2.4%
What does it mean for the currency market?
The pictures tell the story. GBP/USD has clung to 1.30 as important support since mid-March. It crashed through today to the lowest since October 2020.
The New Zealand dollar chart (which looks an awful lot like the Nasdaq) also crashed through the 61.8% retracement of the March rally. It still has some breathing room before the January low but today’s price action is a sign of things to come unless the market mood reverses.
There is still plenty to like with commodity currencies: I think this will be a bullish decade for natural resources due to underinvestment and the green transition. But the rallies are likely to go ‘on pause’ until we see global central bank hawkishness dialed back.
When will central banks get off the brakes?
That’s the big question.
I can make a compelling case that we’ve already priced in maximum hawkishness. A 2.71% return in two-year Treasury is a decent yield in a time of uncertainty.
I think the Fed also underestimates just how much leverage is out there. We saw it at the start of the pandemic when bonds imploded before the Fed started buying in unlimited amounts. Financial markets are built on a shaky foundation of wildly over-leveraged trades.
The basket of things that work at a 3% overnight rate compared to 0.1% is infinitely smaller. To get there will require some heavy unwinds and no one knows what that looks like. I fear that it isn’t pretty.
The Fed is going to announce an unwind of its balance sheet on May 4. They’ve already stopped net purchases.
It’s a good bet that Powell will see some turmoil in markets along with growth fears and try to dial back aggressive rate hike expectations so maybe that’s when the coast is clear. The Fed has been a great friend to markets for many years.
At the same time, inflation is a real problem and Fed comments suggest they’re running scared. Powell yesterday said the jobs market was ‘unsustainably hot’ and that taming inflation was ‘absolutely essential’.
“We have had an expectation that inflation would peak around this time
and come down over the course of the rest of the year and then further,”
Powell said. “These expectations have been disappointed in the
past…We are not going to count on help from supply side healing. We
are going to be raising rates.”
Watch the Canadian dollar
One currency that I’m particularly worried about in the context of higher rates is the Canadian dollar.
The Canadian housing bubble is in the process of popping and the decline will be dramatic. At this point the bull case is that prices fall 20% and Canadians shrug it off because it was all found money anyway.
What’s important to remember is that the Canadian and US housing markets have fundamentally diverged. Canadian prices are much higher but structurally, the housing market is also much more vulnerable. That’s because variable rate mortgages are highly popular and have grown even moreso as rates have risen. That means that the freshest money that bought homes at the highest prices is also most vulnerable to higher rates. There’s no room for error there.
In addition, even fixed rates in Canada are only for five years so around 20% of those roll over every year and they’ll be resetting higher. In the US, the 30-year fixed is standard so the only real pain is on the new buyers and sellers.
The absolute kicker is that it’s not really the Bank of Canada that sets the rates for Canada.
Surely you think I jest but I’m serious. Canadian mortgage rates are set around the 5-year government of Canada note. The BOC has some impact on where that trades but the biggest determinant is where Fed funds are.
In a nightmare scenario for the Canadian economy, the housing markets goes into a crash and even with the BOC dropping rates to zero, the Fed is still hiking or holding rates at a high level. Perhaps the BOC could counteract some of that with QE but the result would be a significantly weaker loonie.
The odds of an outcome along those lines are growing.