In his Jackson Hole speech Chairman Powell’s went out of his way to shut down talk of a pause in Fed rate hikes. He repeated the message at the press conference of last week’s FOMC meeting, perhaps with even greater emphasis. This is not routine policy making. Normally, the Fed goes out of its way to signal its intentions on rates to the market - forward guidance if you like.
But that’s all out of the window now. Powell has told us that rate hikes are open ended and he doesn’t even want to discuss if, when and where they might pause. Unless and until the Fed can be “sure" of getting inflation back to target. And having been too fearful about jobs and too complacent inflation a year ago, it seems that they will now be willfully slow to recognise the early signs of progress on inflation too.
The difference between the Jay Powell of May to October last year and his latest press conference is like chalk and cheese. Back then the FOMC was focused far more on jobs and the ongoing risks from COVID than on inflation, despite plenty of evidence that a powerful recovery was under way and that successive waves of the virus were becoming more manageable. They were driving with their eyes firmly on the rear view mirror, not really looking forwards to what lay ahead. Now we have the mirror image: with the FOMC presenting as too fearful on inflation and too complacent about growth.
The main rationale for this one eyed way of looking at the world is that the Fed seems to think its credibility is at stake, a point repeated by James Bullard in his first speech after the latest FOMC meeting. It’s not a huge stretch to say that the Fed is currently in a panic about its credibility. And when the Fed panics, the markets panic too.
The price action in (global) fixed income and FX markets over the past week is extreme and disorderly, redolent of forced liquidations of (huge) positions built up over the long period of QE. There is no firm anchor for pricing rates, and no support from central bank purchases to smooth the transition either. We no longer calculate a fixed income risk appetite index, but if we did it would be in panic for sure. It is the type of price action which is typically seen at the end of a major trend, not the middle or the end. So we can surmise that both the dollar and US yields are most likely at the tail end of their cyclical bull and bear markets respectively. And becoming ripe for a reversal, possibly a violent reversal once the current liquidation has run its course.
By default Fed Funds futures markets have now re-priced the terminal rate in this cycle to the median FOMC dot plot for 2023 (4.5 to 4.75%). But further down the curve the markets know all too well just how much the FOMC thinking can move between meetings (a full percentage point between June and September, for example). And so we are resurrecting the long dormant duration risk premium.
Suppose that process takes US 30-year yields to 4% or thereabouts. That would take nominal 30-year yields back to the 2014 high. It would also take real 30-year yields (on our measure of long-run inflation expectations) slightly above the 2018 peak, but also 3 standard deviations above their (declining) long-term trend. Over the last 35 years previous cyclical peak in yields have all occurred at 1.5 to 2 standard deviations above trend.
As for equity markets, they are currently caught between the devil and the deep blue sea: if the economy holds up multiple compression seems to await via higher real yields; if it rolls over towards recession, downward earnings revisions will take over as the driver of de-rating. It feels like late-2018 all over again - only more so because inflation is much higher, the Fed is ready to save its reputation at the cost of tipping the US economy into recession, and the world outside the US is in a pretty grim state.
Counter-intuitively perhaps, Global Risk Appetite itself is not yet in outright panic (because the sell-off in safe assets has been almost as bad as the downdraft in equities) but in absolute terms the mood amongst equity investors is extremely grim. Precisely because there seems to be no easy off-ramp for risky assets from the current dilemma.
Or to be more precise, there is one but little expectation that it will come riding to the rescue.
For all the chatter about structural changes in the world economy leading to higher inflation it is it is clear that energy supplies and prices are at the center of the current crisis.
In the US, petrol prices at the pump are the most important short-term driver of inflation expectations, and inversely linked to consumer confidence. They peaked in June at $4.80 a barrel and have since fallen by 25% to $3.60. The norm over the past several years has mostly been between $2.50 and $3 a gallon. Joe Biden is determined to keep them down or get them down further ahead of the mid-term elections on November 8th. But it will depend in large part on the ongoing G7 arm-wrestle with Russia over the proposed price cap for Russian oil, though domestic driving habits (most Americans are driving less), as well as refinery capacity and margins also come into the equation.
In Europe, gas and electricity prices in Europe are the main drivers of the squeeze on disposable income, profit margins and corporate free cash flow – a squeeze which is several times worse than it is in the US. Every single government in Europe is trying to offset (most) of that impact , especially for the most vulnerable (elderly pensioners, small businesses etc.) but in some cases the fiscal cost appears huge, comparable to COVID.
European natural gas futures for January 2023 (January is the peak month for gas demand and inventory drawdown) peaked in August just above $100 per mm BTUs, halved by the middle of September and are back up above $60 now. Until recently, the normal winter price was $6 per barrel!
The good news is that reserves of gas for the winter are running close to normal levels despite lower deliveries from Russia over the summer. The bad news is that it there’s likely to be no Russian gas flowing to Europe over the next several months, and to avoid a sharp drop in industrial production during January and February EU gas consumption will need to fall 10-15% from last year, more if there is a colder than usual winter. (See previous post).
What happens next to key energy prices on both sides of the Atlantic is very difficult to say (more on that shortly) but the point worth making in the midst of all this gloom and doom is that “normalisation” of energy costs would both placate central banks and cushion the squeeze on disposal income and margins that threatens to undermine global growth right now. It’s also true that in conditions when supply is very tight (vertical supply curve) any small fall in demand or small increase in supply will have an exaggerated effect on price. (That works in reverse too of course).
The second, slightly less obvious, point is that Putin is bringing the Ukraine situation to its most serious point yet by moving to declare the territory already occupied to be part of Russia itself. The intention is to get the Ukrainians to back off and begin talks. Good luck with that is the obvious thought, but in matters like this we should never say never.
As an aside, the S&P 500 fell 7.6% in the week after the December 19th FOMC press conference in 2018 at which Powell firmly rejected calls for the Fed to stop tightening. But stocks bottomed on Xmas eve and by mid-January the Fed had capitulated to market pressure to change policy.
For what it’s worth the S&P 500 has also sold off by 7 1/2% since Powell’s most recent press conference and is trying to bounce today. Bear markets are often punctuated by short-covering rallies but if we are going to have a decent one now, something very unexpected needs to happen on the Russia/Ukraine front.
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