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The "Super Bowl" Central Bank Week
Firstly, what a week, right? Let’s dive into the meat, and as usual, lend me your attention from here onwards. Successive 75bps Hikes, Enough To Solve Inflation? It’s set in stone, if you were anticipating a Fed Pivot, i.e a diversion from their aggressive monetary policy stance, you can say goodbye to that dream. Rates are up 75bs to 3.25% in the U.S , and it’s about to get hotter. Let’s dissect the newly released Summary of Economic Projections (SEP) from the Fed. Now, what’s the first thing you notice when comparing some of the projections to the previous June release? It’s the change in expectations for real GDP growth this year and in 2023. Initially, in June ‘22 the Fed projected real GDP growth to be at 1.7% whereas projections now are showing revisions for real GDP growth to be subdued at 0.2% a whole (1.5%) cut! Fed Jay Powell pointed toward “high-interest rates” as the reason we’re seeing such low revisions for economic growth. The question is, how did markets perceive the initial release and what is the market pricing for the future? To answer that, let’s take another look at the Federal funds rate projections vs the June figures. What markets instantly would have seen is that now interest rates in the U.S are expected to rise higher than previous projections and stay elevated/ in restrictive territory for a longer period of time. And if you’re judging how restrictive rates will be, the neutral rate is 2.50%, and we’re expected to see interest rates climb 200bps above neutral rates. That just goes to show how serious the Fed is about getting to its inflation target. You might be thinking, why does that matter? Here’s why. What affects the wider scale economy isn’t just what interest rates are, whether restrictive or accommodative, it is the duration , the length of time financial conditions are either loose or tight . So, if we experience a tightening in financial conditions only up until mid-2024, a shorter time window as seen in the June SEP revision, you would expect asset markets to take a relatively small downturn as seen, in anticipation that the Fed will have to pivot from their aggressive stance at some point to support the economy, eventually boosting risk assets once again. However, what we’re seeing now with the recent SEP revision, is that the Fed will now maintain a tightly restrictive monetary policy for much longer with rates expected to reach highs of up to 4.75% as shown in the dot plot below. The main point, I want you to take away from this dot plot which simply shows all 19 FOMC member’s projections of interest rates for the years 2022 - 2025, is the level at which members expect rates to be in order to get inflation under control. That being between 4.50% and 5.00% by 2023 vs the June expectation of 3.50% and 4.25% by 2023. That shift only signals more hawkish behaviour from the Fed and further pain for stocks, crypto, EM & G-7 currency valuations which have already taken a hit YTD. In short, I think the Fed has made the correct step in its monetary policy stance which is to bring back inflation to 2% , through successive rate hikes and balance sheet reductions (something we’ll look at later). My central focus will be on how equities price in tighter financial conditions for longer as well as how leading economic indicators will react. Bank Of England Join The Party: 50bps Very similar to what we have going on in the U.S; the BoE stepped up its interest rate expectations after raising its base rate to 2.50% from 1.75% on Thursday . I must say, the narrative in the Uk in regard to where we are headed as a nation is a forever dwindling picture. Amidst all of the rate hikes, cost of living remains the biggest soreness within the economy. A testimony to the current weakness is the rate at which the BoE stepped up interest rates. Remember, at the end of the day what really matters most to central banks, is their credibility . Now onto an even bigger focal point, when assessing the relative strength of a currency relative to the G-7 basket one of the first things you would look at would be the IRD (interest rate differentials). With the Fed recently hiking rates by 75bps, the ECB by 75bps and even the SNB (Swiss National Bank) hiking rates by 75bps , you have to ask. How is the strength of the UK’s economy perceived by the world against other major economies? Especially when the BoE is only able to deliver a 50bps hike unlike its G7 counterparts. Yes, you may be thinking we are ahead on the hiking cycle, having a positive rate differential vs ECB & SNB, but the important factor at play is the ‘rate of change’ and monetary policy stance. Even though rates may be higher in the Uk economy, if the future economic picture is looking weaker, that will translate through to monetary policy conditions materially softening resulting in lower rate hike increases like the one we just saw. That is the ebb and flow of where the Uk is positioned. I know we saw some really interesting action from the BoJ this week as they intervened to stop the Yen from sliding! I will save that for a detailed piece coming out on Tuesday; as for now - thanks for reading and supporting as always. I’m getting heavily active on Twitter and Instagram for Macro-related purposes so be sure to give me a follow and connect! Appreciate the feedback and the love you guys show Twitter - @JoeOlashugba Instagram - @Joe.olashugba Until next time. MMH
Sep 23, 2022 · 5 min read
Strap In, The Fed Is Coming.
What’s going on guys? Had a slight issue publishing on Friday, but back to the usual schedule going forward! Lend me your attention for the next few minutes. In what is set out to be a heavy week of economic releases, particularly rate decisions from the big central banks, the Fed, BoE & BoJ, we look at the most recent CPI release and what that means for markets. CPI Overshoots To 8.3% YoY Yes, it’s the topic of the conversation once again! CPI in the U.S beat forecasts of 8.1%, finding some resting ground at 8.3%. Increases in the shelter, food , and medicare indexes were the largest of many contributors that pushed the CPI readings higher. Luckily, a 10.6% decline in the gasoline index offset the majority of the shelter and food-related increases. The Weighting of Shelter Within CPI In case you didn’t know, out of all the categories that combine to form the CPI reading, the weighted shelter takes up roughly 32% of the CPI print! That’s just under 1/3 of the whole reading, and from observing Chart 1 below we can see the sharp increase from July to August when the shelter CPI reading rose the most since 1991! Commodities Shortage Effect on The Housing Market Now, from as early as 2021, post Covid-19 recessions and amidst several global lockdowns in major commodity/goods exporting countries we saw U.S home buildings drop drastically and a surge in the number of construction backlogs due to shortages. Both on the commodity front foot and also on the transportation side where there was a clear reluctance within the U.S workforce. Particularly in the transportation of goods (truck drivers). Now, I am not pointing to this alone as the main contributor to elevated home prices but if we lay out the facts I’m sure you will see why there’s a direct link. During the wake of the Covid crisis, lumber prices, copper prices, aluminium and all construction-related materials were extremely expensive to attain, (as shown in Chart 2). What is the direct effect of elevated commodity prices? Simple, delays and cancellations of new residential construction and commercial developments . So, the delays in construction projects only did one thing to the available supply/demand distribution; this lowered an already scarce housing market even further to the point where new home buyers’ demands couldn’t be met so home prices elevated to levels not seen in decades. To put this into context, the home price to median household income index shows the average cost of a house in the U.S relative to the households’ income. Historically, an average house in the U.S. cost around 5 times the yearly household income. During the housing bubble of 2006, the ratio exceeded 7 - meaning that for a single household, it cost more than 7 times the average annual U.S household income. Pretty scary to see levels in the U.S above 2006 records by a country mile… Bear in mind this ratio is heavily affected by interest rates within the economy; as a result when borrowing rates are relatively accommodative/cheap the demand and cost of homes increase due to the pent-up demand to purchase at low rates. As rates increase and yields on the U.S 10y & 30y increase, (the rate majority borrowing costs derive from), the affordability of homes decreases and so does the home price index. Fed Rate Decision With inflation still elevated despite hopes that we will see a decline following July’s stagnation, asset markets, in particular, the Nasdaq had a horrific close to the week. Close to 6% wiped off tech stocks; I think it’s safe to say the equity bulls are back to hibernation until further notice. Looking forward, the market is expecting to see either a 75bps or a 100bps hike this week, I see a 40% chance the Fed do a supersized 100bps hike ; if you recall my previous note on CPI’s effect on rates, you would remember me specifically noting that if we see inflation come in above expectations we will see yield curve inversions between 2s&10s deepen further. If you didn’t get to read the note I’ve quoted my comments below for you. For those who aren’t familiar with what an inversion in bond yields means, I’ve linked a previous note on the importance yields play within the economy. Short-end yield curves are pricing in interest rates to peak at 4% in the U.S; so this is a forward look at investors’ expectations of the Fed hiking cycle. As the Fed has said, the unfolding of economic releases will reveal to what extent they will have to hike until inflation is under control; that’s a long-winded journey for both the Fed and market participants. I recently caught up with a friend of mine who specialises in EM (emerging markets) and heard how bad some of these EM funds are down due to interest rate hikes. Instantly this put in perspective the ripple effect that this hiking cycle will have across every single market both developed and emerging. Countries like Sri Lanka recently defaulted early in May ‘22 for the first time in history ; the reason rates play a crucial impact on EM countries is because a stronger dollar makes it more expensive to service debt repayments/infrastructure expenditure and usually triggers capital outflows as investors can now attain modest returns at lower levels of risk holding deposits in the U.S. We won’t dive into EM, but that’s just a touch on the depth and weight the Fed interest decision has on the markets. As always appreciate you for reading. Don’t just stop there, make sure to share this, doesn’t cost anything but means everything & subscribe if you haven’t already! We’ll be back on Friday covering the rate decisions & a look into the BoJ Joe
Sep 19, 2022 · 6 min read
U.S Inflation vs Markets Expectations...
Risk-On Suggests Weaker CPI Figure? If you’re like me, you were probably wondering what on Earth were the markets so excited about yesterday, and for equities the past week? Lend me your attention for a few minutes… Why the optimism in markets you may ask? If we recall inflation within the U.S, up until this point, we can see it has been a very steady rise across the board; we saw a peak in June followed by the first sign of a slowdown in July. This was mainly attributed to the slowdown in inflation across energy prices only rising 32% vs 41% YoY in June , with gasoline seeing a slowdown to 44% from June highs of 59.9% . So now, back to the question. Why the positive shift in markets? Let’s look at this from an investor’s point of view; if inflation is cooling down what does that have direct implications on? The Federal Reserve interest rate decision . More importantly, the level of how aggressive the Fed will be when it comes to tackling inflation, as we heard from the Jackson Hole event a 75bps hike isn’t off the table, in-fact, its back on with greater probability. Since July ‘22 the Fed removed forward guidance acting on a “meeting by meeting basis”. Which, if you would like that translated means, “things might get even more out of hand, so let’s just save ourselves and play it by ear”. Pretty accurate if you ask me. So, the removal of forward guidance means one thing to the market, increased volatility surrounding such economic releases and today’s CPI release will finalise what Fed we will see at the September Fed decision. Now, as you already know, the bond market is a great forward looking indicator into the mind of investors and where they see either near term or long term rates going. Here we have the 1 year treasury bond which has priced interest rates to be at 3.6% in 12-months time. How may this and other debt instruments be affected by tomorrow’s figure? Simple, if we see CPI come in below, which is what the market has already priced in, then we can expect the short end of the yield curve to remain relatively stable/potentially decrease allowing the yield curve to move away from an inversion or a curve flattener. Simply pricing in less hawkish central bank action at following meetings. Now if CPI surprises us to the upside, well, just expect to see the 2s & 10s inversion deepen even more and long end yield curves to take a decline pricing in the aftermath of a deep recession. Notice how yields are pricing themselves ahead of the release. What trade could come off this? Good question, we’ll visit some ideas on Friday! A Cold Winter For Europe What exactly do you do when 40% of your energy consumption comes from one country? You make peace with the Russian’s and come to an agreement; there’s no other way this ends. Figure 5 just puts into perspective how deep in the well Europe is with it’s reliance on Russia for crucial commodities of natural gas and oil. Now, although Europe will bear the brunt of the energy crisis you have to remember that Europe was Russia’s top trade partner before restricting and eventually cutting off Nord Stream 1. Figure 6 shows you to what extend Europe & Russia were engaged. Nearly ¾ of Russia’s total gas exports last year went directly to Europe. Of recent we have seen China & India become particularly close with Putin; trade agreement talks and China receiving more of Russian LNG & gas has been Putin’s execution plan to tighten trade strength with the non-westerners. As the situation evolves, there will be more to analyse and depict but for now a short view on Eur/Usd remains predominantly my bias for the near to long term. Thanks for lending your attention to me! Don’t just stop there, make sure to share & subscribe if you haven’t already! We’ll be back on Friday with a detailed piece — Look forward to it Joe
Sep 13, 2022 · 4 min read
Is Uk & EU's Financial Outlook As Bad As Analyst' Reports Say?
I know a lot has happened these past 24 hours alone so before we dive into it quickly take a look at how the major economies are positioned. Not good at all. Painful Times Are Ahead For The Uk As you may have already seen, Queen Elizabeth II died yesterday at the age of 96. A sad moment for millions around the world, but a life well lived if you ask me. ‘Operation London Bridge’ is underway so expect a lot of changes to happen and on top of the Queen’s untimely passing, we’ve had a change within the parliament as Liz Truss took over her predecessor Borris Johnson to navigate the Uk out of what seems to be an unavoidable crisis. Liz Truss Announces Cap on Energy Bills Being a citizen of the Uk I must admit the recent weeks have really presented challenges as you hear projected costs of living and the cost of energy jumping by north of 80% from the month of October. Within her first week Liz Truss has sworn to cap energy bills to £2,500 a year for the next two years compared with the figure of £3,548 we would have been paying if not for the energy plan. Now, similar to the Covid-19 relief package there's always a tail-end of any support package, as this energy relief plan is expected to run into the billions for the Treasury. The question is, how will we pay for it all, taxes? Judging this situation from an unbiased view there’s little one can do to avoid any sort of extreme outcome as the current economic climate has deteriorated faster than one could have predicted leaving two outcomes. One, soaring inflation amidst uncontrollable energy inflation (due to Russia) or two, elevated inflation with more spending/debt incurred to finance such support to Uk Citizens. The strain isn't just being felt in consumers’ pockets, take a look at cable rates below. YTD the pound is down 17% , yes 17%. A price point of 1.16 Analysts across tier 1 banks have been calling for the pound to hit PARITY against the dollar! I would have never expected to see that in an analysts report but with the current array of financial conditions unfolding never say never. With the Bank of England expected to continue with it’s path of hiking there’s realistically only one way this ends, a deep recession within the Uk which resets everything. When glancing at all major economic indicators the picture worsens; the rule is manufacturing is the first industry to take a hit before a recession starts then housing . The reason being both manufacturing and the purchasing of new homes requires one thing. Accessible and attainable credit , which in an environment where rates are sitting at 1.75% and expected to go up only makes it increasingly difficult to finance such projects/ purchases. The knock on effect you may ask? Simple, we see that same conservative and fearful mindset, seep into retail sales as consumers step back on discretionary items flowing throughout the wider economy. So you end up with lacklustre growth, declining consumer confidence, negative real wage growth and elevated inflation. A perfect recipe for disaster. ECB Move Aggressively To Fight Inflation Frenzy Since the GFC of 2008 we have become immune to seeing Euro area interest rates so low across all three rates; however, yesterday we saw an unprecedented hike in interest rates with rates now sitting at 1.25%! The ECB hiked rates a substantial 75bps taking their deposit interest rate to 0.75%. After recent events in Ukraine it’s clear to say Putin has got the Eurozone at his mercy; cutting off the Nord stream pipeline and strengthening ties with China & India to redirect gas intended for the Europeans to his fellow trade partners. The second layer affects are due to stretch far and wide. You may be thinking; it’s only going to affect energy prices and inflation right? Yes, but think deeper on how the Euro area economy works, what drives its productivity. The ability to attain cheap energy and use that to produce manufacturing goods. What happens when you change the top funnel component which is the golden key? You get a whole new situation which is what the Europeans are awakening to. The central bank only has the ability to control monetary policy not individual, sensitive parts of an economy. As Ben Bernanke former Chair of the Federal Reserve said: For now, that’s all we’ll cover but next week we’ll take a deeper look at the energy crisis. Thank you for reading, for those who have been sharing thank you as well, we’re seeing an influx of new macro heads! I would love to hear from you guys, both topics you would like covered and even ideas; you can reach me on Twitter, Instagram, LinkedIn or email. Until next time (Tuesday) goodbye! Joe
Sep 9, 2022 · 5 min read
Let's Talk About U.S NFP Data
Before you say anything, I know exactly what you’re thinking. What happened to the article scheduled for Friday? Here’s the brief answer, I wanted to digest the NFP data coming out later in the afternoon, and being completely honest, writing a piece without covering such a crucial reading wouldn’t be the best value for the MMH community! Now, let’s get into it! Non-Farm Payroll Data & The Labour Market Friday we had the non-farm payroll data release, and once again the actual print beat the expectations of 300k totalling 315k job additions. Now, what I always tend to focus on isn’t the number of jobs added or whether the print "beat” or “missed” the prediction. That doesn’t really matter. What matters to me and what should matter to you is the below: Average hourly earnings. The reason this measurement holds more weight is because non-farm employment numbers only tell you the change in the number of people employed during the previous month; whereas average hourly earnings gives you a broader horizon to get a picture of how conditions are shaping up. Here’s how. If non-farm data beat expectations yet average hourly earnings are lower by 1% (YoY) . What benefit does that have to the economy’s GDP? What value is it to fill the labour market but employees aren’t paid well enough to spark activity within their domestic economy? Absolutely none. The point of tracking such data is to ensure that the labour market remains strong but, more importantly, average hourly earnings grow. So the next time you look at NFP pay attention to more than what the number is, look at how the % change in hourly earnings because that will tell you a lot about the health of the labour market. Unemployment Rate Hits 3.7% Unsurprisingly, we saw the unemployment rate tick higher shown in figure 1 to 3.7% . As a result of the increase in interest rates, we’ve seen massive layoffs across the U.S tech sector; names such as Paypal, Stripe & Robinhood. As it stands the federal funds rate is 2.5% and from figure 3 below we can see the expectations for the upcoming rate decision are tilted towards either a 50bps or 75bps hike. One reason I love looking at the CME FedWatch Tool (source for the above chart), is because you can see the live probabilities and changes in investors’ minds for the Fed funds rate. Predicated on what may be happening, you’ll see investors betting on either a low-size hike, i.e 25-50bps or a larger-sized hike leaning towards 75bps. Take a look at figure 4. Just over a month ago now, market participants were betting on a 25bps hike, probably due to the dovish comments we heard from Jay Powell on the “strength of the U.S labour market”, “neutral rates” and a ‘soft landing’. Shift your focus to 1 Week 26 AUG 2022. What happened that weekend? That’s it, The Jackson Hole summit. From this, we saw equities take a sell-off after listening to a firm message from the man Jay Powell that they will not make the same mistake as they did during the 70’s inflation peak. The result, a sell in any risk-on asset. Plus, Jay Powell basically put a 75bps hike back on the map again so that fuelled bets that we will see further aggressive tightening into deeper restrictive territory in monetary policy. The Dollar Surge The last run I can remember the dollar having like this must have been the rally of late 2014 which ran into 2016 causing many companies like Apple to cut their revenue and profit forecasts. For those who can recall a previous article, we looked at how one could have positioned oneself in a long-on-the-dollar ETF trade to bet on its inevitable appreciation against a basket of G10 pairs. That trade to date has delivered 14%, so believe me I’m just as gutted I missed out on such a good opportunity. Looking forward, I see a short on the dollar as a good opportunity for some alpha as we draw near to the end of the hiking cycle sometime in ‘23. The extension and bull run we have seen have been mainly attributed to rising global fears of war, a recession, an energy crisis across Europe and not to mention a widening interest rate differential between the Fed and other major central banks globally. To touch on the last point and the importance it has, put yourself in the shoes of an investment manager or a large body in charge of capital placement. The drivers of capital flows have all revolved around the stability and growth potential of a nation; meaning the political policy, monetary policy, GDP outlooks and growth. So when eyeing up the U.S economy against other G-10 nations you can see why it would stand out and attract the large majority of capital flows. Number 1, the U.S doesn’t have the basic energy exposure many of the European countries have, 2, the U.S when compared to G-7 nations has a politically sound policy. Take a look at Italy and you’ll understand the importance of that point, Italy has been hit with the brunt of the stick both politically and with inflationary and other economic conditions. Finally reason number 3, the U.S is simply ahead on the tightening cycle within financial conditions so the U.S presents the safety of capital and a good yield. So, due to these fundamental and economic drivers, the flow of foreign capital has found a haven in the dollar which has paid dividends. Coming out of this I am keeping an eye out for the other side. I’ll leave you with this quote from Ken Griffin: Appreciate you as always for reading until this point! Do me a favour and share this with someone you know will pick up some value, subscribe and share your thoughts and ideas with me on Twitter, LinkedIn or Instagram! Until next time
Sep 5, 2022 · 6 min read