Rabo: The Market Is Telling The Fed That After September They Are Done

By Michael Every of Rabobank

Hopium and despairium

‘Asia Risk Assets Poised for Goldilocks Friday’, says Bloomberg this morning: “Asia will be hoping to catch the mood of firmer equities and lower yields, along with a softer USD/JPY and commodities. The 3% gain in the Nasdaq Golden Dragon China Index may also provide a boost. In early business on Friday, US equity futures are a tad lower. Federal Reserve Chair Jerome Powell called his commitment to curbing inflation “unconditional”. Meanwhile, the ECB may raise rates by more than 200bps in the next 12 months, Governing Council member Peter Kazimir said.”

**Sigh** And if you can’t see why I sighed at the above then I sigh at you again even louder.

It was nice, yet depressing, when the market showed logic this week as everything sold off: the sell-off was depressing; the ability to think was nice. Of course, it couldn’t last given our traders and analysts who have never seen real inflation, rate hikes, or geopolitics: their use of the “g” word is as methodologically sound as a doctor talking about “biology” rather than symptoms, diseases, and treatments. So, it was nice, yet depressing, when the market preferred another big prescription of hopium to logic yesterday.

We saw another hefty decline in bond yields, helped by weak global PMI data. Yet Mexico raised rates 75bps to 7.75%. The Fed-speak also flagged another 75bps in July, and 50-75bps steps in September, November, and December, at least. Fed Chair Powell even used the “unconditional” word again in his testimony on Thursday, which he had omitted on Wednesday. We also got the Fed mea culpa, “In hindsight, inflation was not transitory.” The ECB implied rates will rise 200bp.

The market that enthusiastically bought “transitory” is now buying all of the fixed-income things even as rates rise. There was a reassessment in the US short end, with 2 year yields -22bp intraday but closing -4bp at just over 3.0%, but 10s fell by more and are also not far above 3.0%. The market is telling the Fed that after September they are done, or will have to U-turn, which is not what the Fed is telling the market. Recall a month ago when US 10s dropped from 3.15% to 2.75% because the Fed was going to take it easy? Here we are, 75bps later, with another 75bps ready for next month.

Yet the hopium sold so well. Bund yields collapsed,… as Europe (finally) prepares for Russian economic warfare, which will mean gas rationing in Germany, and PPI of, what, 50% y-o-y(?), and CPI far higher than where it sits now. UK gilt yields also collapsed,… as it faces 9.1% y-o-y inflation, soon to be over 10%, higher PPI pipeline inflation, what many see as structural high inflation due to Brexit, and more workers walking out on strike in rejection of up to 10% pay rises.

Yes, one can make the ‘preservation of capital’ argument – but via buying assets that will soon yield less than the cash rate and inflation? Why not cash / T-bills?

Hopium also saw US stocks up. There is a logical case that the Fed over-tightens into a supply shock, prompting a recession. In fact, it’s our base case. Yet there is no logic that says all other assets must rally “because lower yields”. Mathematically, that might happen via multiples; but corporate earnings are not going to tell that story if recession means demand collapses while input costs soar.

There is also a logical case that the Fed has to hold off on rate hikes “because markets” – and there is a logical case that it cannot. The latter happens to be what the Fed itself is saying.

Yes, recession looms. So what? I keep being told inflation was not about strong demand, but rather weak supply. Indeed, today Bloomberg talks about the next LME crisis being in zinc, which is in very short supply; and someone in energy comments the only reason oil is not at $150 is due to the weak data backdrop, especially in China.

Commodity supply can’t come back online via monetary loosening, but monetary tightening can force out speculators from commodity markets, which acts like increased supply – look at the recent dip in broad commodity prices as the Fed got serious and QT started. Now imagine the Fed U-turns from September: commodities would rally again!

That’s even before we get to worst-case geopolitical scenarios. For example, where the EU accepts Ukraine and Moldova as accession candidates, and Lithuania cuts off Kaliningrad, which incentivizes Russia to deliberately destabilise the EU even further? As such, even a boring inflation forecast require a geopolitical one. Or how about if the BRICS countries try to create a rival global reserve currency to undermine the USD and EUR, necessitating higher US rates to push back? As such, even a boring rates forecast requires a geopolitical one.  Or how about the growing risks in the Middle East and Indo-Pacific that would also push supply of goods much lower and inflation much higher?

These scenarios all imply sustained incession and sustained high rates – as emerging markets who don’t control their supply chains experience all the time. Indeed, if supply can’t come back online we could theoretically be talking about a potential ‘lost decade’, not ‘two quarters of negative growth’ – as emerging markets who don’t control their supply chains experience all the time.

So, hard choices need to be made. The upcoming G7 will focus on energy. Proposals to cap Russian oil and gas prices or to stop US oil exports are already being floated but will likely sink. The EU is finding Qatar won’t sell it LNG without a 20-year contract, which clashes with its green targets. The White House wants more solar and yet just signed a law that bans them if they are made in China, where most are. A further Western green transition requires a vast stock of minerals that sit in countries already in or drifting into the Chinese and Russian camps, and/or removing environmental regulations in the West.

So, what is to be done? Until we see the answer, we must rely on central banks. Yet where once that meant low rates and QE, now it means high rates and QT.

However, I keep repeating I suspect we get more QE and rate hikes, giving us hypothecated credit allocation/rationing in the same way we used to have before financial deregulation in the 1980s. That will be fun for some but hard for others: the Fed can always buy US Treasuries and say, “defence!”, so the government borrows for free, and the private sector pays 3-4% or whatever is needed; the ECB can buy Eurozone peripherals so they borrow for free and say, “anti-fragmentation!”, while infuriating the Germans if that means selling core bonds to do so; but the RBA and BOC would have to buy MBS and say,… “we need high house prices!”.

Such policies would also mean downwards pressure on the FX of those economies if they are running balance of payments deficits –except the US– as emerging markets who don’t control their supply chains experience all the time. (Which is why JPY is so happy that US yields are edging lower.)

The logical solution is to increase supply (and until then, rates). That might mean states owning refineries as an energy transition measure, because no private firm will invest in an asset that has to be phased out almost immediately it is finished. Which, to extend an argument I made yesterday, is why markets don’t work in all areas. Paying people to sit around in expensive facilities and only rely on them in an emergency is economically ridiculous – until you call it an army: then it’s common sense. Or rather, it should have been: we are where we are today partly because too many snorting too much hopium for far too long thought it wasn’t.

Now it’s despairum in the air, which is a good segue to another Bloomberg story to close, that ‘China’s Tech Giants Lost Their Swagger and May Never Get it Back’:

“On trading floors in New York and Hong Kong, the brightening mood toward Chinese technology companies is unmistakable: With stocks like Alibaba Group Holding Ltd. and Tencent Holdings Ltd. surging from multi-year lows, talk of a new bull market is growing louder.

Yet speak to executives, entrepreneurs and venture capital investors intimately involved in China’s tech sector and a more downbeat picture emerges. Interviews with more than a dozen industry players suggest the outlook is still far from rosy, despite signs that the Communist Party’s crackdown on big tech is softening at the edges.

These insiders describe an ongoing sense of paranoia and paralysis, along with an unsettling realization that the sky-high growth rates of the past two decades are likely never coming back.”

The above applies all over when you think about it.