“Am I part of the cure, Or am I part of the disease?”
In the UK this weekend, the clocks go forward, signalling the start of British Summer Time (even if the weather forecast would argue otherwise!). As much as the extra hour of sunlight - even if not sunshine - will be warmly received, it really does feel like recent weeks have been made up of longer days already - especially from the perspective of macroeconomic content.
There are a number of topics worthy of comment this week, from the UK Spring statement and updated economic and fiscal forecasts, to the joint show of force from the West in a combined G7, NATO, EU Summit gathering. There is the further suspension of EU state aid rules, as the impact of the war on the need for direct energy cost support measures and pledges to increase military spending drive bigger than expected borrowing requirements and at the same time a bigger fiscal boost.
Indeed, there is also the encouraging trend towards the relaxation and suspension of Covid restrictions globally (notably in NZ, South Africa and Singapore), while the containment of the new Omicron strain in China remains a key challenge for China’s zero Covid strategy.
Not only do these developments highlight the uncertainties and complications in the global economy, they also emphasise the fact that different economic blocks have different policy priorities, and thus require different policy settings. This makes for a fascinating global macroeconomic backdrop.
However, this week we choose to focus on one factor - the US inflation dynamic and its requisite policy response. Some may well have been comfortable with the pricing of the US interest rate markets following last week’s FOMC meeting (where the updated ‘dots’ caught up to market pricing of 25bps at each of the remaining meetings this year). That was until the testimony of Chair Powell at the NABE at the start of this week unleashed a quite stunning (further) acceleration of the hawkish pricing of the front end of the curve, which resulted in a mere 17bps jump in an already elevated US 2y yield!
We think there are a some interesting areas of debate on this topic:
Firstly, the shape of the US yield curve now is very interesting. Essentially, the sovereign curve is flat from 3-10 years, suggesting that markets are comfortable with the Fed’s need to get rates up to the neutral level (let’s assume for now that this is around 2.5%), and not much further, accounting for a little bit of risk premium. Some Fed commentators have pointed to the fact that there is likely some safe haven bid at the long end that is keeping longer yields contained, and thus the curve flat.
By extension, this sparks a debate about what probability of a US recession is reflected in the shape of the curve. There are certainly some commentators that expect inflation to drive US rates into restrictive territory, and that the flat curve is a harbinger of recession. We are more inclined to think that there are a number of factors at play: (i) it is not clear, given the unpredictable, and relatively unfamiliar inflation trajectory, what level real equilibrium rates are currently, and thus beyond what point does monetary policy become restrictive - we are inclined to be more positive about the US growth backdrop and the ability of many parts of the economy to deal with higher rates and (ii) there is also a case to be made that much of the renewed hawkish rhetoric from the Fed is aimed at restraining the components of inflation over which they may have some control (i.e. the demand side factors). It is very possible that this brings a normalisation cycle where the Fed talks very tough, but acts less so. By my estimation, this likely extends the potential rate hike cycle, while keeping the inflation fighting credibility of the Fed ex-post - this could see a higher terminal rate and lower recession probability, as the cycle progresses (perhaps simply by keeping alive the threat of 50bp increments, but not using it).
What this means for the USD is likely more complex. Over recent weeks we have argued that there is likely a window for EUR appreciation at the current juncture. However, beyond the near term, it is clear that the Eurozone is facing far lower inflation (specifically wage inflation) pressures, a weaker underlying growth trajectory, and greater implications from the uncertainties of Russian aggression. USDJPY of late has been a perfect example of how a maintained widening of rate differentials can drive currency movements. For the USD, in general, beyond the near term, things likely still look constructive - a notable caveat or containing factor to our current more positive EURUSD bias.
However, there is one final point we would like to make and that is in relation to risk assets against the current backdrop - noting that risk assets tend to do well in hiking cycles. The idiosyncratic nature of the Ukraine invasion is that it is a negative shock to the global economy, but it is also highly inflationary - driven by the commodity channel. Risk off and inflation higher have brought conflicting ‘directional bias’ to many safe haven assets (US Treasuries and AUDJPY are two perfect examples. - Historic correlations would see a negative risk shock driving treasuries higher and AUDJPY lower. The exact opposite has happened, as inflation and commodity impacts have been dominant).
From our perspective, this has driven a relative shortage of suitable risk assets at the current juncture, and as such, we could still see some further disproportionate moves from the suitable assets that provide an expression of a positive risk outlook. For example, holding BRL vs. EUR generates a 12% carry and likely benefits significantly from the current commodity boom, while being relatively insulated from import price pressures due to its commodity self-sufficiency. ZAR, MXN and even AUD likely benefit similarly, if to a lesser degree.
By extension, if we believe that the US economy is more insulated from the global commodity boom due to its high payroll and wage growth, and that there are a number of large US companies (predominantly, but not exclusively tech), that have both pricing power and demonstrable future cashflows, then we can make the case for US equities as an inflation hedge and add them to the relatively select group of assets that could well at some point attract a significant portion of the wall of cash on the global investment sidelines.
These moves may well have surprised many (especially relative to historic correlations) but given the alternatives, their outperformance could have a long way to go yet!
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