“Somebody has been sitting in my chair!"
- Goldilocks and the Three Bears
Last week, we discussed Omicron and the (further) hawkish pivot from the (newly re-nominated) Federal Reserve (Fed) Chair – whose narrative has arguably been the most consequential for markets, with the notion that the Federal Open Markets Committee (FOMC) are in favour of a faster pace of taper. The Chair, the most significant among the nine FOMC members, who have made the case for an accelerated taper over recent weeks, driving a re-steepening of the US curve and counteracting the more dovish initial reaction to the discovery of a new Covid variant. You could say that, returning to his chair, the Fed Chair quickly found the economy and inflation were too hot!
Since then, we have had the November US employment report and the global spread of the Omicron variant.
The Omicron variant has so far brought with it pretty mixed signals globally. Downing Street have emphasised their ‘increasing concern’ about the spread; the Russian President is said to have described the new variant as a ‘live Covid vaccine’; and the rest of the world remains somewhere in between.
The US employment report was very strong from our perspective. Whilst the headline payroll number disappointed expectations, the household survey pointed to very sharp employment gains - the gap at least in part a function of seasonal adjustments that are likely distorted by the extreme volatility of the data for the last couple of years. But it is the drop in the unemployment rate (and notable declines in much quoted subcategories) that is the headline grabber. Despite a rise in the participation rate, the sharp drop in the unemployment rate demonstrates the substantial tightness of the US labour market. The Fed Chair’s proclamation of structural changes to the labour market exacerbate this tightness, and after all, the pillars of US monetary policy are price stability and full employment - as measured by the unemployment rate, not the seasonally adjusted monthly payroll change.
From our perspective, this is an important part of the debate. The US labour market remains strong and tight, as implied by the ‘quits’ level and the job openings data - and thus the consumer is strong, generating excess demand. Growth is well above trend, inflation highly elevated, fiscal policy remains very stimulative (even if the second derivative is slowing) and monetary policy is still loosening or becoming more accommodative - albeit at a (soon to be expedited) diminishing pace. Interestingly though, while markets have been comfortable pricing early rate hikes, we continue to see the market as being insufficiently hawkish, relative to the growth/inflation dynamic in the US.
5 and done?
Current the market is pricing between 2 and 3 rate hikes in 2022 and between 2 and 3 rate hikes in 2023 but that is about it. Does a ‘5 and done’ normalisation policy seem appropriate? Rates would still be lower than pre-Covid, yet there is greater economic momentum, higher inflation and loose fiscal policy. Markets are underestimating the potential economic cycle and the monetary cycle, from our perspective. Indeed, after 5 rate hikes in the US, the economy would have looser fiscal policy, looser monetary policy (and based on the Fed dots) faster growth and higher inflation than pre-Covid - we see little to suggest late cycle dynamics that many commentators currently espouse.
Indeed, the flattening of the long end of the curve is not in our view an indication of ‘late cycle’, but a function of distortion from QE, the great inflation debate, Covid and broader demand for (/shortage of) positive yielding safe haven assets - in Europe there is even a shortage of negative yielding collateral due to QE purchases.
Perhaps we can draw some analogies to the Emerging Markets (EM) space. In the recent hiking cycle in EM, central banks raised rates aggressively to get ahead of persistent inflation - and to build a rate buffer that could cushion the prospect of a ‘taper tantrum’, as the Fed started to take its foot off the accelerator. Notably in Central and Eastern Europe, the market was initially reluctant to price a sustained rate hike cycle - or higher implied terminal rates - into the yield curves, at least until markets realised that the economies could cope with higher rates without collapsing growth - at which point extended rate hiking cycles were priced. We view this as implying a greater potential for higher US rates and a strong economy, and thus a stronger USD.
Indeed, more broadly, we have been very heartened by the price action in the EM space in 2021. There were numerous warnings over recent months of the threat to EMFX from a Fed Taper (and subsequent hawkish pivot), USD strength, inflation, Covid and a number of other headwinds. However, the price action in EMFX (barring the very specific, idiosyncratic story in Turkey) has been very resilient. From our perspective, this paints a much more positive backdrop for EMFX and risk assets in general going into 2022.
Earlier in the week, the IMF described underlying inflation in the eurozone as projected to “remain weak”, and that while fiscal policy should remain supportive, that the European Central Bank (ECB) should look through “transitory inflation pressures” and maintain “a highly accommodative policy stance”, even noting the potential for “modest” downward GDP revisions. Furthermore, there has been a similar bias from the Bank of Japan (BoJ), who have pledged to maintain current asset purchases (and YCC) beyond the end of the Covid period; and in the UK, while there will likely be rate hikes in 2022 (and we maintain our view that rate lift-off will come in February), it is very unlikely that the Bank of England (BoE) get anywhere near what is currently priced in by the market (around 100bps in 2022).
In the US, there is a clear case to be made for excess demand, strong growth potential, loose fiscal and ultimately tight monetary. The Fed is becoming increasingly hawkish, not just due to concern of more persistent inflation and a tighter labour market, but due to an increased confidence in growth. In short, we continue to see a divergent global growth backdrop where the US sees further widening of growth and rate differentials.
Next week is huge for financial markets with four central bank meetings to sign off the year with a bang, or a whimper! The FOMC, ECB, BoE and BoJ meetings will shape the monetary dynamic for 2022 and give us a greater understanding of the respective central bank sensitivities to growth (and in some cases this is a function of the current Covid wave/variant risks) and inflation. Maybe what is most interesting from our perspective is the clear inference of differentiation.
Ultimately, we see the ECB, BoE and BoJ as the three bears! It is very likely that the narrative from the BoJ is one of a maintained commitment to maximum accommodation (daddy bear?), for the ECB maximum caution, given the widening divergence between the inflation, growth and debt dynamics between member states (mummy bear?), and the BoE maximum hesitancy over the near term growth dynamic, set against an undoubted post Brexit shift in baseline inflation and a clear need for the BoE to challenge the deeply negative real yields priced into the UK curve (baby bear?).
The likely significant upward revisions to the Fed Summary of Economic projections and the likely further increase in the level and concentration of the Fed dots are a much more positive backdrop, on the right-hand side of our dollar smile framework. Indeed, you could call it Goldilocks!
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