Fed Starts To Walk The Impossible Trinity Tightrope

MARKETS

US equities were stronger Thursday,Endorsement foreign exchange dealer ignoring all the recessionary and Fed policy mistakes clamoring with the S&P 500 up 1.2%, 10-year yields down 2bps to 2.17%, and oil back up 8.8%. 

While stock markets liquidity isn’t getting any better, market internals is showing signs of improvement as shorter duration on kneejerk S&P 500 selling points to a decrease in speculative reactions to news flows. And if investors were indeed turning bearish longer term, they would buy-the-dip less often and start to take profits consistently on rallies. 

It's been a remarkable turn of events in FX land even though a hawkish Fed, which one would have thought would have supported the US dollar and sent stocks lower. However, the underlying risk tone was improving with the ‘china put’ Hence, that certainly allowed people to re-enter SPX longs, and then FX tends to have that mechanical reaction to chase risk higher.

Still, we need to be careful how we position FX as this was not the typical reaction one would have expected, but perhaps pricing in peak Fed hawkishness will allow the currency markets to climb. 

While I have some sympathy with the view that we have now reached peak hawkishness, the fact is that this was still an extremely hawkish pivot from the Fed both in substance as well as quantitatively, with Fed Chair Powell making it quite clear during the Q&A that they will become even more aggressive if needed to tame inflation even at the expense of growth.

Still, the Fed thinks it can achieve the impossible trinity of hiking rates, bringing inflation down while unemployment remains below long-run neutral. The bond and currency markets say no! The US curve bull flatted, and the dollar sagged across the board. Even a dovish hike by the BoE still had folks buying GBP straight up vs. the dollar.

OIL 

The Kremlin claiming there was no meaningful progress on the peace talks, started the oil ramp as fleeing optimism caused traders to hit the buy button again and again. 

The term War criminal, to describe Putin, is starting to get used quite freely on the Western political front and raises the specter of more sanctions, in my view. The Italian government has recently come out with a big statement saying that a halt of Russian natural gas imports in the short-term is “manageable.” is will add to pressure on Germany to consider an energy embargo.

Some positive headlines from China tech hub Shenzhen hit the wires overnight. The total lockdown is being eased; over the last two days, the Chinese government has realized its need to support businesses and communicate better, given the tame healthcare footprint Omicron presents. Further easing of restrictions could lead to a significant upward demand rerating across China as this initial walk back in restraint could trigger domino effects across lockdown China.

And I think the rise in Nat Gas after the EIA data showed a bigger than expected fall helped oil rocket higher.

Markets internals suggest that oil’s downside remains sticky even when Ukraine and Russia are inching towards peace. So there is a genuine belief that even if the war does end, sanctions on Russia will likely persist, making oil supplies tougher to source for longer. 

So when will OPEC react?

Part of the problem is that OPEC has always been focused on the longer-term outlook or has been slow to respond to real-time developments no matter how significant. Libya has joined the UAE in calling for a boost in OPEC production to help offset the risk of lost Russian production. Both in the case of Libyan comments and the UAE comments last week, the views were expressed by politicians rather than energy officials. Still, OPEC’s ‘business as usual approach’ looks increasingly indefensible given the disorder in the energy markets.

Gold

The Fed intends to get on top of inflation quickly, with seven successive rate hikes this year and four next. But critically, the Fed’s forecasts indicate that it only wants to pull inflation back down, not flame it out, which might be suitable for gold. Whether it can achieve its forecasts is another matter, but for now, the market will likely position for front end yields up while the long end gets contained by lingering inflation protection trade (TIPS), and gold could ride along for the ride.

As a long-time “maximum” buyer of physical gold, I cringe at issuing bullish gold calls in a Fed rate hike cycle. So perhaps I need the weekend to think this one through and observe how the inflation market reacts next week. Still, I’m going with the current momentum where the direction of travel is higher. 

Forex

The US dollar no longer appears to be the cleanest dirty shirt in the laundry this week as the Fed starts to walk the impossible trinity tight rope. But we also have very different reactions at the big three G-10 central banks. 

The ECB is focused entirely on pulling inflation down; the Fed is trying cool the economy and bring growth back towards the trend, but also get inflation down; the Bank of England is far more concerned by growth than inflation – easily the least hawkish of the three (though it started the hiking cycle some months ago). The key for the BoE seems to be no more than containing inflation expectations rather than chasing inflation down.

But the BoE is more worried about growth than the Fed.

Eur  

On Thursday, European Central Bank President Lagarde, speaking at the ECB Watchers conference, repeated the key points of last week’s decision, in my view – emphasizing the hawkish elements more than the dovish ones.

In terms of normalization, she stresses the baseline scenario of a Q3 end to APP and interest rate hikes “some -time after.”

The most crucial element of her remarks is an emphasis on the readiness to be “creative” and “design new instruments” if necessary to address any threat to the transition of monetary policy and fragmentation. Indeed, this is a strong hint of an energy emergency program similar to PEPP, possibly in the making as a colossal energy backstop.

Indeed this could be a pretty firm policy input to neutralize the damaging effects of higher oil prices and could drive more flows to Europe, ultimately supporting the Euro. 

Jpy

The yen’s sensitivity to US rate hikes can’t last much longer, especially with Japanese investors showing little interest in new overseas asset allocation while looking to support the domestic economy, which is on the mend and possibly supported by more fiscal. And if anything there may even be political support for FX hedging of existing assets. Above 120, it becomes easier to make the case that the yen is fundamentally too weak.

Differentials are less critical, whereas Tokyo flows will rule the USD/JPY roost. 

BoJ policy input, while still necessary, is likely to remain unchanged despite a potential willingness to curb the yen’s weakness in the face of rising oil prices to curb importing inflation.

Nzd

New Zealand’s current account deficit has widened to almost 6% of GDP, a post-GFC high. The NZD still looks too lofty in correlation. FX traders tend to price in 8 weeks ahead, but I’m not convinced the border opening will self-correct the services trade deficit soon. Frankly, New Zealanders suffering from Island fever may be quicker to go offshore than foreign tourists are to visit NZ. 

We are still trading under the positive China umbrellas, but I’m just throwing out another piece of the puzzle to hold in your back pocket from when needed.

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