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Rate Hikes Galore
BoE’s Rush To Kill Inflation Let’s talk markets. Up until now, the Uk has maintained an extremely accommodative monetary policy stance with rates at or just above 0% . So if we’re speaking about real interest rates (which accounts for inflation during a period of time) then we have really had negative rates since the GFC (Great Financial Crisis) in 2009. For those who may not be familiar with real/nominal rates; let me quickly break that down. Nominal interest rate refers to the rate of interest before adjusting for inflation; e.g if a bond is paying 2% per year then the nominal rate/yield would be 2% as we wouldn’t need to adjust for any other measurement. Real interest rate as you can assume by the name refers to the rate of interest after adjusting for inflation. So with the same example if inflation across that one-year period was 3.5% then the real interest rate earnt on that bond would be -1.5%. Pretty straight forward right? Negative real interest rates are considered to be accommodative to the wider economy, allowing credit to flow easier within the financial system. As Ray Dalio correctly said we live in a credit-centred economy where we bring forward tomorrow’s expenditure to today. And that’s exactly how we end up over-leveraging up until we fall into a credit crunch, but that’s not where I’m going for today! Currently, the base rate is sitting at 1.25% across the Uk with markets pricing in a hike of 50bps today at noon. Now, something I’ve been paying a bit more attention to is the bond market, mainly because it’s frankly a great forward-looking lense on where investors price rates to be in the future. Now, I’m no pro on the bond market but it doesn’t take an economist to see a potential flattening in the yield curve as conditions continue to weaken in the economy, let’s put it at a 40% probability. FYI, investors, banks & literally everyone pays massive attention to what yield curves are doing as longer-term yields should be higher than shorter-term yields due to the increased risk associated with holding a bond over a longer period of time things such as rate hikes, inflation etc make investors require a risk premia on such term investments. From where we are now I see an ever-increasing chance of a curve flattening in yields, meaning the economy is entering prolonged stagflation/low growth which would force the central bank to keep rates low or even cut back on the hikes we’ve recently seen. Unless we get a super-sized surprise from the BoE, which I doubt but do not completely rule out, the pound is probably well priced at 1.2100 RBA Goes All In. A wise man once said “don’t hate the player hate the game” — That wise man may as well be this man right here, Philip Lowe. What a guy. In response to a tonne of outcries for him to resign Philip Lowe presses forward with his belief that tighter monetary policy conditions are required to cut inflation at its knees. As it stands rates in Australia have risen back to back, meeting upon meeting to 1.85% as of Tuesday morning where rates were positioned at 1.35% before an additional 50bps was added onto the base rate. Now although the RBA may not be one of the “major” central banks everyone pays attention to it’s still equally important to have an understanding of what central banks globally are doing and how they are reacting to this chronic pain of inflation globally. Thanks for reading all the way through! As usual share with your macro heads and I’ll leave you with this quote; that applies to life and investing/trading:
Joe Olashugba
Aug 4, 2022 · 4 min read
Two Negative Quarters, Recession Finally Here?
Is it official, that the U.S is in a recession…or is there more to the story? According to widely accepted knowledge, a recession is defined as two consecutive quarters of negative declines in GDP, which we have seen in the U.S after Thursday’s reading. That was until Jay Powell decided to change the definition across the web; problem solved right? No. In Q1 the U.S economy's GDP figure declined at an annual rate of 1.6%, and over the last three months declined by another 0.9% . However, that is not an official definition of a recession, let me explain what is; A non-profit organisation called the National Bureau of Economic Research defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months”. Ok, so now that we know what an actual recession (officially) is, let’s look at what Jerome Powell had to say in response to comments about the U.S sliding straight into one. Typical Powell, to boast about the state of the labour market which we both know is a lagging economic indicator and as we have been seeing across the news prominent corporations like Robinhood , Netflix and Shopify are just a few of the many Technology firms being forced to fire/cut employee numbers due to economic conditions tightening up. So the question to ask is when will we begin to see job layoffs impacting the wider Non-farm Payroll data figure we’re seeing? Now that we’ve opened up the floor let’s take a look at the Fed hike and the message perceived by the markets. We saw the Fed hike rates by 75bps which was pretty much priced in by markets, what wasn’t priced in was the dovish comments made by Powell which sent risk assets rallying. So if your equities or crypto holdings are up, thank Jay Powell :) After reading the transcript of Jay Powell’s conference this week here’s what stood out to me: Powell acknowledged the fact that the unemployment rate is currently sitting near a “50-year low” , which although that sounds good from the outside looking in, we have to understand that his goal and overall purpose is to deliver his speech with the utmost confidence in the labour market further backing the actions the Fed take; however, the markets picked up on the dovish comments made by Powell which I’ll highlight later in this piece. Starting with the labour market I’m seeing a consistent increase in the initial jobless claims, showing more people filling for unemployment on a weekly basis which could be a sign of cracks appearing within the perfect labour market Powell keeps rambling on about. Not only is the outlook looking weak in employment, but a look into pending home sales provides a leading insight into how consumers are pricing up the market for purchasing new homes. If both the housing price and mortgage rates are looking attractive then you can expect a higher number of pending home sales across the U.S and the exact opposite for unpleasant conditions. The latest reading came in at -8.6% , the worst reading we have seen since early March ‘21. It’s clear to say we are already experiencing demand destruction across the U.S with pending home sales declining rapidly as well as new home sales. This shouldn’t come as a surprise considering where 30y Treasuries are at, taking a mortgage out in this environment would be crushing to your pockets. I said I would cover it so here it is, bare with me… Post the Fed Interest rate hike you would expect equities to shift lower and borrowing costs in yields to steepen right? That wasn’t the case and the reason why is statements such as these from Jay Powell: Both statements have indirectly told market participants that we will no longer be looking to hike aggressively above the neutral rate into the restrictive territory; so you can start buying up risk assets since the bad days are over. So in this hiking cycle, Powell has given equities, crypto and other higher-risk assets room to rally with such comments; if there’s one thing we know about inflation is that it’s like a helium balloon, easy and quick to go up but painfully slow to go down. Moving forward I’ll be watching closely how leading/lagging indicators line up giving me a clue on how conditions are shaping up and what that means for the Fed meeting in September. As always, thanks for reading this! Share with your macro heads in your group— much appreciated.
Joe Olashugba
Jul 30, 2022 · 5 min read
Let's Talk Eurozone Economic Conditions
Ok, it’s final. They’ve moved from their negative stance on all three key rates, about time… So let’s dive into what’s really going on in the Eurozone. For the first time in 11 years, the ECB hiked their interest rates by 50bps, taking its rates out of negative territory. Now the hike came at somewhat of a surprise considering markets were pricing in a 25bps hike after hearing from the ECB that they would ideally like to ease into the interest rate normalisation process. Now, although the hike we saw from the ECB was more than what we expected it’s clear to see that markets, particularly bonds didn’t agree. When a central bank tightens its monetary policy, usually we see spreads on bonds decrease/tighten. However, in this particular scenario, we had a widening as shown above. Now, this is simply telling us that the bond market doesn’t believe in the ECB’s ability to navigate this hiking cycle until the point where inflation is no longer a problem. I listen to quite a few good macro voices in the space and the common message is that we’re seeing a curve flattener in Eurobonds. To just clarify, this is why a flattening curve is a bad thing for the economy and sentiment: Before I define what a curve flattener means for the economy let me just say this; bonds are forward-looking instruments, 5y bonds reflect investors’ expectations for the interest rate in 5years . All in all, that shows that investors see economic conditions to be sluggish for the medium-long term as rates will be either lower or the same. So in the case of the ECB, investors aren’t fully believing what Lagarde has to say to us. With the Euro hitting parity against the dollar, it’s pretty hard to see things brightening up for the Eurozone as a whole. Now the ECB has also implemented a new tool called TPI, which in laymen's terms has been introduced to prevent the widening of borrowing costs across the Eurozone, particularly in countries such as Italy, the main culpr i t , Portugal and Spain, and even Greece. What this tool will aim to do is prevent further widening of spreads between countries such as the ones mentioned above; however, with turmoil politically in light of President Draghi’s resignation, the ECB will not be able to stop the uncertainty spilling over into the credit market. I know, it sounds all grim for the Eurozone doesn’t it? On a mixed note, Russia and Ukraine have agreed to release millions of tons of grain piling up on ports since the invasion began. As we know, here in the UK alone food prices have rocketed 9.1% already! That’s based on what we’re told, so we know the figure is already double digits. So with this agreement hopefully we can see a reduction in food prices over the next 6 - 12 months as there’s a delay in how these circumstances evolve into our financial system. Although this was already a signed deal at the time, Russia thought it worthwhile to attack (bomb) the Odesa port after the agreement to resume the trade of grain globally. Remember, 40% of global wheat(grain) comes from Ukraine alone, now looking at the recent CPI figures ( 9.4% in the Uk), what has predominantly been an issue alongside fuel and gas costs; is food prices. If supply chains can get going in full motion we should hopefully start to see a gradual decrease in the food element of inflation over the next few months; my worry is as we approach winter the true force of fuel prices will show its strength cancelling out any reduction we have in other inflationary entities such as food. Now, a quick sidenote and alert that by the time you’re reading this the Bank of Japan would have already met; if you recall my previous article touched on the importance of the BoJ; so expect me to highlight a few things from the meeting. I’ve had a few good weeks to settle other work but feel glad to be back to some sort of routine with my articles; I will be back this week for sure! Thanks for getting through as always! — Any recommendations on pieces or topics send them my way
Joe Olashugba
Jul 26, 2022 · 5 min read
How Aggressive Will The Fed Have To Get?
One Long Inflation Nightmare Last week Thursday was a colourful day, to say the least in markets. Inflation readings for the U.S came out at 9.1%, multidecade highs; but what really stole the show was the Bank of Canada. A surprise 100bps hike came out of the Canadian central bank which rocked FX markets, particularly CAD crosses. The reasoning behind that, well I’m sure you can imagine…kill off their 7.7% inflation figure. With the 9.1% print for June’s inflation, markets are repricing their expectations for the next Fed hike. Just take a look at the image below. Prior to the June inflation print, expectations that the Fed would hike into the 225-250bps range were >90%, after we got the reading notice how expectations have pivoted to now ruling in a 100bps hike from the Fed which was unlikely with <12% probability just a month ago. So to answer the question; “How aggressive will the Fed have to get”. The answer the market is giving us is very aggressive; to a certain degree, I also agree the Fed will really have to tighten to its target rate of 3.4% before we see any real decline in inflation readings. The bond market also agrees, with inversions across the 2s & 10s sighted once again. So on the long end of the yield curve, this hiking cycle is flattening yield curves. If you’re thinking why is this bad, let me quickly explain. If you were tomorrow to take out a loan from the bank to purchase a home (mortgage) over a 30year period with a rate of 4.00% (current mortgage rates in the U.S), and John was to take a loan out for 5 years with a similar rate of 4% that essentially means you are paying the same to borrow money for 5 years as you would for 30 years when the term/rate for 5 years should be less than the term for 30 years since there is more risk/exposure to rate changes or another inflation scare so one has to account for the added risk. Markets clearly are expecting a steep period of tightening followed by easing where rates will be close to 3% in the long run. All this hiking must be doing something to the dollar right? That’s correct. Now, remember, everything is interlocked from FX to Bonds/Credit, to Equities and even commodities. We’ll look into the finer detail of what a strong dollar means for corporate earnings. Let’s rewind back to 2014; AAPL’s 10k filing (Apple) mentioned the below: A strong dollar hurts corporations’ earnings ability as a strengthening dollar cuts into their bottom line as exchange rates are no longer favourable for healthy margins. So businesses are faced with a trade-off, allow the exchange rates to eat into their bottom lines or hike prices to offset the currency exposure. In the case of Apple, the strengthening dollar caused them to raise prices in 2015 across stores ranging from Australia, Canada, France, New Zealand and other EU-based countries. So looking forward as we always do, corporate earnings will become less attractive as we see the full effect of a bullish dollar. Generating Alpha Now for the most part, and by most, I mean a large majority of institutions and retail traders these conditions have proven to be difficult to trade/maintain positive real returns. This also applies to the hedge fund industry. You can see here that the major strategies applied by hedge funds haven’t played out as they would have liked or even forecasted to investors. One umbrella strategy seems to be doing well which is Macro & CTA. So not a bad time to be learning macro at all I’d say… In all seriousness, we’re experiencing market conditions that haven’t yet been experienced when combining all the global events occurring at once. Be wise with positioning and leverage in conditions such as these. Thanks for reading once again! Always appreciated Until next time
Joe Olashugba
Jul 19, 2022 · 4 min read
Recession Fears & Demand Destruction
Where Are We Now? Starting off with the FOMC speech last week where we heard from Fed Bullard and Waller who both openly backed another 75bps hike in July followed by 50bps until the neutral rate of 2.4% is met. From this point forward they would want to see hikes reduced to 25bps upon review of economic conditions. Waller had this to say about the U.S economy: It seems like the Fed is viewing the economy with a completely different lens than what we’re currently seeing. As it stands the Fed seem to draw its conviction and hawkish tone from the present labour market NFP readings which beat the expectations of 268k by 104k totalling 372k over the month of June. Not bad I must say. But let’s take a look at the chart below; as you know I always prefer leading indicators over lagging data i.e (Non-Farm Payroll) Jobless claims are a forward-looking indicator of the health of the labour market; from what we can see from the most recent reading, the amount of individuals filing for unemployment has risen to levels not seen this year; to add on, since June we have been at elevated levels compared to the period of Apr-May. So what is that actually telling us? Very straightforward, the U.S has peaked in strength within the labour market and with the current pace of tightening within the economy, there has to be a trade-off. Either inflation or employment . We already know the Fed is willing to see unemployment reach 4.1% in 2024 so the next observation is to look at what happens when we get an unwinding of lay-offs and firings (something we’ve seen already in Tech firms thus far). You guessed right, a recession. In this unique scenario that will be combined with demand destruction. Let’s couple the view above with a look at the current commodity landscape and what message is being delivered. When it comes to understanding global growth/cycles there’s no better commodity to look at than copper. With its multi-dimensional use cases, this commodity is a leading indicator of the current level of demand within the economy. When global demand is expected to pick up we’ll see a rally in commodities such as copper and even oil since these two are direct sources for fueling the growth cycle. The same is true for global slowdowns, copper will be the first to let you know when demand is off, or in this case en route to destruction. Not only is the aggressive tightening of the Fed sending market signals that demand is already being destroyed but further lockdowns in China due to covid cases is sending commodities to new lows for the year. Just take a look at the returns of Iron Ore, Copper and Silver. Painful. If you recall my piece where we covered China being the leader of global synchronised growth, you may be able to put two and two together to realise China is also the largest consumer of copper globally . So what happens when you take your biggest buyer and lock them down? Copper alone is down -20% for the month! The next topic to prove how demand is already being destroyed is consumer credit and the potential for us to start seeing defaults later this year as higher yields make it increasingly harder to finance debt. I’ll save that for another piece, the main thing to remember is that in the economy we live in today, credit is what drives the world. One man’s debt is another man’s asset and so forth, as credit increases, we have periods of great conditions (expansions) followed by over-leveraging which leads to our current positioning within the curve where credit is withdrawn and those overleveraged are left dancing to the tune of the easy-access-cash, yet to realise the music has stopped and the Fed is hiking. Thanks again for your consistency in reading through! If you’re new, make sure to give some feedback and share with your macro-addicts! See you soon!
Joe Olashugba
Jul 12, 2022 · 4 min read