Could Cause Contraction
A story that’s gained lots of traction Is Jay will soon jump into action By cutting the rates They charge for short dates Cause high real rates could cause contraction In fact, this idea ‘s gone mainstream And it’s now a favorite theme But history shows The ‘conomy grows Despite real rates high with esteem
After a spate of slightly softer than expected data in the US, it is very clear the consensus in markets is that not only is the Fed finished raising rates, but that cuts are coming soon. At this point, based on pricing on the CME for Fed funds futures, the Fed is going to cut rates by 100 basis points next year. While I’m certainly no PhD economist (thank goodness!), this strikes me as a mistake. Consider the following:
1. If the economy really does go into recession in Q1 or Q2 of next year, where GDP turns negative and the Unemployment Rate rises close to 5.0%, it strikes me that the Fed is going to cut a lot more than 100bps. In fact, the one thing we know is that Fed funds tend to decline much more rapidly than they rise as the Fed is usually responding late to some crisis. So, a simple model can be created that shows 100bps of rate cuts is made up of a 20% probability of no movement at all; a 60% probability of 50bps of cuts next year as they try to tweak policy at the margin, and a 20% probability of 350bps of cuts as they respond to a recession and get aggressive. Now, you can adjust those probabilities in any number of ways, but that seems reasonable to me. However, that is not the market narrative. Rather, the narrative is that the Fed is going to start to cut rates because policy is already overtight (real rates are positive) and they will want to get ahead of the curve.
2. However, exactly why will the Fed need to cut, absent a full-blown recession? Going back to 1982, these are the highest and lowest levels for real 10Yr yields, real Fed funds (defined as Fed funds – CPI) and Y/Y GDP each quarter:
Real 10Yr Real Fed funds GDP Y/Y Max 7.60% 8.30% 9.60% Min -0.35% -7.90% -2.20%
Data: FRED database, calculations Fxpoet
So, we have seen real yields, both short- and long-term much higher and much lower than the current situation. But the funny thing is, the relationship between GDP growth and real interest rates, whether 10Yr or overnight, is basically zero. In fact, I ran the numbers and came up with an R2 of just 0.03 which tells me that there is no relationship of which to speak. My point is just because real rates have risen to a positive level in the past year does not mean that the Fed has ‘overtightened’. It just means that they have tightened policy trying to address what they still see as too high inflation. It also does not indicate that because real yields have risen over the past quarters, that the economy is about to crash. That’s not to say we are going to necessarily avoid recession, but the point is it will take much more than modestly higher real interest rates to push us over the edge. At least that’s my view.
But for now, most markets are getting quite excited about the idea that peak interest rates are behind us and that the upcoming lower interest rates are going to support risk assets, especially equities, aggressively. I feel a lot can go wrong with that model, but then I’m just an FX guy.
The Argentine people have spoken As they want to fix what’s been broken So, starting today The new prez, Milei Must change more than merely a token
A brief comment on this electoral outcome. While Argentina’s economy is quite small on the global scale, I believe this is a harbinger of far more electoral shake-ups in 2024 and 2025. We need only go back to 2015 when the Austrian presidential election was initially called for the complete outlier candidate, a non-politician as well as a right-wing firebrand, before being overturned by the courts there. That story preceded the Brexit vote and then, of course, the election of Donald J Trump as US President in 2016. People were very clearly tired of the political elite explaining why the masses needed to suffer while the elite got along just fine.
The ensuing resistance by the entrenched politicians was fierce and so we saw Trump lose his reelection bid amidst great turmoil and then the election and collapse of Liz Truss in the UK. But it appears that things have gotten worse in the broad populace’s collective mind, with inflation remaining stubbornly high, and perceptions of opportunity shrinking. Combining those features with a growing distrust of media and government pronouncements after the Covid situation, where vaccines did not prove as efficacious as promised and, in fact, seemed to result in at least as many harms as benefits, and people are ready for a new look.
So, be prepared for some more non-traditional electoral winners next year. Presidential elections are due in Taiwan, Mexico and the US with major regional elections throughout Germany, Canada, South Korea, India and the UK as well as the European Parliament. Many people are quite pissed off at the incumbents around the world so look for more fragmentation and new faces.
This implies that much of how we consider the macroeconomic picture could well change. And that means market volatility seems likely to increase further. Just something to keep in mind, and an even more important reason to maintain hedges for major exposures, whether FX or interest rates.
Ok, it was easy to spend time on these issues as there is really nothing else going on. Overnight, the only news was that the PBOC left their Loan Prime rates unchanged, as expected, so not really newsworthy. Else, the biggest news over the weekend was arguably the Argentine elections.
It should not be surprising that market movement has been quite muted with the biggest equity move in Hong Kong (+1.85%) which is just a retracement of its recent woes. Otherwise, Japanese markets fell somewhat (-0.6%) and the rest of APAC was very muted. In Europe, there is a mix of gains and losses with nothing more than +/- 0.25%, so no real news and US futures are essentially unchanged at this hour (7:00).
Bond yields are, overall, a touch firmer this morning with Treasury and most European sovereign yields up 3bps. But that is after another decline on Friday, and the 10yr remains quite close to its new home of 4.50%. The ‘inflation is dead’ theme had a lot of proponents last week, but as we head into this, holiday shortened, week with limited new economic data, I suspect that things are going to be quiet without any new trends taking hold. The market technicians explain that 4.33% and then 4.00% are the key yield supports. So far, the first has held and I expect we will need to see much softer data to break it.
Oil prices are rebounding further this morning, up 1.5%, as there is talk that OPEC+ may be set to cut production even further with the price now below the level when they first initiated cuts in the summer. There seems to be a disconnect between the official supply and demand data and the price, where the data would indicate prices should be higher. One possible explanation has been that more Iranian oil has been reaching the market than officially allowed and so weighing on prices. Alas, that is a very hard story to prove. As to the metals markets, precious metals are softer this morning, but still retain the bulk of their recent gains while copper (+0.4%) is higher after Chinese demand indicators started to show strength.
Finally, the dollar is starting to edge lower this morning as NY walks in the door after a very quiet overnight session. USDJPY is the leader here, falling -0.8%, and we are seeing a large decline in USDCNY (-0.55%) as well. Recently, there has been a distinct uptick in the number of pundits who are calling for a sharp decline in USDJPY. Much is predicated on reading between the lines on Ueda-san’s pronouncements and expecting that QQE is finally going to end there. Ironically, 10yr JGB yields are down to 0.74%, well below the highs seen at the beginning of the month and do not appear to be headed higher, at least for now. To the extent that the Japanese MOF actually does want a stronger yen, something about which I am not at all certain, one must beware the idea that they could come in and intervene now, when they are jumping on the bandwagon rather than trying to stop a rush against them. It would certainly be a lot more effective and would likely change a lot of opinions. The one thing I have learned in my time in the markets is that when USDJPY starts to move lower, it can do so very quickly and for quite a long way.
Away from those two currencies, both Aussie and Kiwi are firmer by about 0.6%, benefitting from strength in the renminbi as well as most commodity prices. Not surprisingly, NOK (+0.5%) is rallying although it is a bit more surprising that CAD is essentially unchanged on the day. Also remarkable is that CNY is the biggest mover in the EMG space, with most other currencies just barely changed on the day.
During this holiday week, there is very little data to be released with Existing Home Sales (exp 3.9M) tomorrow along with the FOMC Minutes and then Durable Goods (-3.2%, +0.1% ex transport) on Wednesday along with the Claims data. Happily, it appears that the FOMC has taken this week off and will not be adding to their recent commentary.
Overall, the short-term trend appears to favor softness in interest rates leading to modest strength in risk assets and weakness in the dollar. I am not yet convinced that is the long-term view, but for this week, I think that’s a fair bet.
Good luck
Adf
thank you