“If you are five minutes early, you are already ten minutes late"
Happy New Year to all. A new year and a new start for financial markets. Perhaps nowhere is this sentiment more pertinent than in FX markets.
At the November Federal Open Markets Committee (FOMC) meeting, the Federal Reserve (Fed) had clinically guided expectations towards a measured tapering of QE asset purchases that would begin in December and conclude in the summer of 2022. In delivering this message, it was clear (as we discussed at the time - Calm After The Storm, Nov 5th), that the Fed were conscious of past ‘normalisation experiences’ of the Fed - namely the ‘Taper Tantrum’ of 2013 - and thus very cautious about the language and inference of the taper communication. Indeed, as we wrote at the time, the Fed Chairman was very clear “to disassociate the process of tapering with the process or attainment of criteria for rate rises”.
It is also true that, at that time, the Fed were resolute, if less convinced, that inflation remained transient, and thus the new flexible Average Inflation Target (AIT) framework gave them the perfect cover to remain (intentionally) behind the curve to foster a ‘hot’ economic recovery, against a backdrop of higher public and private debt. Thus, as inflation expectations rose, real rates declined and the monetary stance in the US continued to ease. Indeed, the easing of financial conditions was aided and abetted by the ongoing impact of the unprecedented Democratic fiscal expansion. Behind the curve had begun to look late!
Back in November, we also stressed that we were “of the opinion that December witnesses a distinct hawkish pivot from the Fed”. The December FOMC brought the confirmation of an accelerated taper, significantly upgraded growth and inflation projections from the Fed and a markedly higher dot plot - highlighting greater potential rate hikes. Perhaps most strikingly, the Fed updated their unemployment forecasts including lowering their forecast for the end of 2021 from 4.8% in September) to 4.3%. Last week, the December employment report showed the unemployment rate at 3.9%. This is an incredible outperformance of the labour market, or misjudgement from the Fed in such a short space of time (3m: Sep - Dec 4.8% vs. 3.9%). At the December meeting, and more explicitly outlined in the minutes, the Fed also brought forward the prospect of QT - concurrent with rate rises.
However, in the weeks following the November Fed meeting, and with increasing urgency it seems, the Fed, in unison, has become audibly uncomfortable with the level of inflation and by extension the tightness of the labour market. It really was a matter of weeks; the post Thanksgiving Chairman’s testimony (Black Friday) saw the newly appointed Fed Chair posit the concept of an accelerated taper (bringing the QE conclusion to March from June), leading to a sharp repricing of the US curve (admittedly led by the front end - rate hikes brought forward rather than new hikes added).
This pace of accelerated hawkishness and increasing disregard for any kind of Taper tantrum has continued. Only this week, the Chairman, in his renomination testimony, threw in the kitchen sink of hawkish rhetoric - stating that the economic backdrop is clearly very different to the last time the Fed normalised and that balance sheet runoff would therefore be “sooner and faster” this time round; that he expects the Fed to “discuss” taper again at the January meeting; that “high inflation is a severe threat to maximum employment”; that the labour market is “very rapidly approaching, or at maximum employment”; and that the Fed is “trying to get policy to neutral, perhaps tighten”. Far from having a tantrum, risk markets rallied!
This is clearly a remarkable pivot from the Fed over a short period of time. However, retrospectively, the current backdrop is still likely to draw some confused faces at various points in the future. Not least in relation to the fact that, while headline inflation printed a new 40 year high of 7.0% y/y this week, the Fed still has its foot firmly on the accelerator of monetary policy; it is still easing policy - it is still increasing QE holdings, albeit at an amortising trajectory.
So what does this all mean for markets? This is the interesting question for 2022.
Fed speakers have continued their hawkish rhetoric coming into 2022, with comments such as “inflation is uncomfortably high”, “four rate hikes in 2022 now appear likely”, need to “shrink balance sheet as fast as possible without roiling markets”, suggesting that faster rate hikes and concurrent balance sheet runoff is high upon the Fed policy agenda for 2022, if not beyond. This combination of rate and flow support for fixed income markets should keep the US yield curve elevated.
However, we also remain of the view that the level of rates in the US are not an insurmountable barrier to higher equities. Indeed, far from it. While multiples expansion is less likely at current levels, earnings growth led by demand growth and margin expansion is very possible, in our view. We maintain our positive view of US assets and a multi-year tech-led global economic expansion.
For the USD, the situation is a little more complicated, so far at least. The US monetary evolution has clearly continued to support higher US yields and wider yield differentials in favour of the USD. However, this has been the case from early December (almost uninterrupted) and the USD has failed to break into new high ground against much of DM. It is possible that the failure of the US President’s Economic plan (Build Back Better) has implications for the fiscal comparative, potentially blurring the prospects for US growth outperformance over Europe (as the EU RRF funds are distributed through the eurozone). It is also possible that we are at a level of pricing in US Treasuries and or the USD where markets are unwilling to commit new capital but would prefer lower prices (higher yields in the case of Treasuries) in order to attract new global capital flows.
I am personally more of the view that the current backdrop is a bump in the road, rather than a u-turn for the USD. Global growth must stabilise from the elevated ‘reopening levels of 2022 (and beyond), this may cause some fluctuations but it is clear that the current growth trajectory and the equilibrium growth rate is higher in the US. BUT this is the start of a new year, markets have smaller risk tolerance and it is hard to square the indifference of the USD to the sharp acceleration of Fed hawkishness (most acutely since early December), if it persists for much longer.
The Fed through AIT were intentionally late, and some would argue they are later by the day. Some may argue that the USD was early in pricing Fed hawkishness. Whatever your views, with monetary cycles ending in EM and beginning in DM and, inflation cycles closer to the end than the beginning, one thing is clear for 2022 - Timing is everything!
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Eurizon SLJ Capital- https://www.eurizonsljcapital.com/the-long-and-short-calm-after-the-storm/
United States Senate Committee on Banking, Housing, and Urban Affairs - https://www.banking.senate.gov/hearings/01/04/2022/nomination-hearing
Federal Reserve - https://www.federalreserve.gov/newsevents/testimony/powell20220111a.htm
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