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“To have a comeback, you have to have a setback"

Mr T

Another week into the New Year, and the market debate about the USD conundrum continues. The repricing of US rates has progressed, with hawkish rhetoric and further signs of strong, consumer led, economic activity driving both short end repricing and (as a function of balance sheet reduction) a long end sell-off in the US Treasuries. This repricing has also clearly been detrimental to long duration assets in the equity space, where this week marked a Nasdaq decline of 10% from the December highs - albeit briefly so far - a measure that can in technical terms be described as putting the tech benchmark in correction territory.

As we discussed last week, the change in emphasis (or urgency) from the Federal Reserve (Fed) has likely been driven specifically by the sharp move towards extreme tightness in the US labour market. The Fed’s September 2021 forecast for the U/E rate at the end of 2021 (4.8%), while lowered to 4.3% at the December meeting, proved to be an insufficient adjustment and thus a significant underestimation of the heat in the labour market in a very short period of time.  With inflation at 7.0% - an eye-popping 5% above the Fed’s policy target - it is no wonder the Fed have become increasingly uncomfortable with their position, now very much behind the curve.

In many ways, the USD’s seeming disinterest with the repricing of the US rate curve is potentially a problem for the Fed. Essentially, what the Fed needs at this juncture is / are tighter financial conditions, in order to combat the current red hot inflationary pressures - in line with their mandate of full employment and price stability (the Chicago Fed National Financial Conditions Index remains close to its lowest levels in 25 years - with maximum employment rapidly approaching and inflation at 7.0%)

The problem is that, despite ‘throwing the kitchen sink at it’ (as we have previously referred to recent Fed rhetoric) in terms of their recent communication around rate hikes, proximity and even balance sheet reduction, there has so far been only very modest tightening of financial conditions. A further tightening of financial conditions could come from the Fed tightening even further/faster (or surprising to the topside with balance sheet rundown) than is priced into the curve, allowing or encouraging equities and risk assets to decline, or through a stronger USD.

Years of evidence from successive Fed governors has shown a persistent inability of the Fed to resist monetary support for (significantly) falling equities - the ‘Fed Put’. From here, therefore, if the Fed is intent on tightening financial conditions in order to rein in the rising prospects of persistent and potentially pernicious inflation, then it would need to tighten more than the markets are currently pricing and or (continue to) encourage higher yields and a stronger USD.

Conversely, other central banks that are less comfortable with encouraging rate hikes (or even those that are actively pushing back i.e. Reserve Bank of Australia and European Central Bank (ECB)) are seeing significant rate hikes priced through the curve and (relative at least) currency outperformance.

This week, we saw the Bank of England (BoE) Governor testifying to a Parliamentary Select Committee. In the Governor’s responses to questions about the BoE’s likely actions to counteract the current high level of inflation (5.4% y/y in December), his body language was at times uncomfortable and his spoken words very carefully chosen as he tried to answer the questions and concerns of the Parliamentary Select Committee -  without explicit commitment to tighter monetary policy in response. The Governor was clear to give a balanced view and counteracting arguments against (over) tightening. My interpretation was that the Governor was trying to encourage the market not to expect too much - at least given his carefully chosen inference of energy price hikes to come, and tax hikes currently weighing on consumption as well as inflation itself.

“We can’t bring the gas price down… or change the supply of labour… or global supply chains”. If monetary policy cannot affect these factors, then tightening monetary policy simply restricts demand. Admittedly, in part this is the job of the BoE (realigning aggregate demand with aggregate supply to satisfy their inflation mandate). In this regard, markets are very keenly priced in the UK.

In Europe, we also had the minutes from the December ECB meeting.  While affirming their inflation fighting mandate with the commitment to communicate a more persistent inflation progression, they also very clearly expressed concerns about the premature scaling back of monetary stimulus and asset purchases. The ECB President went a step further in stating that the “ECB has reasons not to act as quickly as the Fed”.

There are many different reasons why the USD may have failed to gain traction this year against its DM counterparts (EMFX may be becoming much more interesting, but this is a discussion for another time). Some, such as the commodity price cycle undermining the USD, or market expectations of US growth underperformance in 2022 (returning the USD to the middle of the Dollar Smile) are credible, if they can be maintained.

However, the markets’ willingness to price policy normalisation in Europe ahead of (or in contradiction to) the central bank narrative is likely leading to tighter financial conditions, which in turn may reduce the extent of monetary tightening. In the USD, the argument may be the opposite… at the margin at least. From my perspective, the widening yield and (potential) growth differentials continue to argue for a stronger USD in DM.   In EMFX, there is a growing prospect that the huge amounts of cash on the sidelines, substantial yield buffers (and thus carry) and declining risk premia from both Fed tightening and Covid make EMFX a more attractive proposition - in many respects these arguments also hold for US tech equities (replacing yield with growth - nominal earnings, at least).

The year is young, and sentiment remains changeable, but I for one am happy to consider the prospect that across a number of asset classes (of differing time periods) the corrections may be over!

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