Midday Macro - Bi-weekly Color – 3/22/2022
Overnight and Morning Market Recap:
Price Action and Headlines:
Equities are higher, despite rising yields as markets are more comfortable with the Fed’s tightening plans and the effects of the war in Ukraine on commodity markets
Treasuries are lower, with the 5yr yields now above the 10yr and other parts of the curve near inversion as expectations are for an overshoot of r* as the Fed finally fully addresses inflation
WTI is higher, but off of recent overnight highs following its drastic correction to pre-invasion levels last week indicating a high level of uncertainty over demand and supply remains
Narrative Analysis:
Equities are again rising, with the S&P pushing above 4500, helped by improving positive technicals and optionality positioning and shrugging of higher Treasury yields driven by increasing Fed tightening expectations while the growth outlook weakens. We find this a little irrational when coupled with the continued uncertainty the Ukrainian war brings to commodity markets and hence increased energy and food inflationary pressures while China is still struggling to contain its recent Omicron surge. However, reductions in cross-asset volatility are allowing sidelined money to be put to work, with correlations between stocks and bonds returning to a more historical relation. We continue to remain extremely unimpressed with macro fundamentals and see risk-assets approaching the highs of a range that may last until Fed tightening expectations are reduced. Finally, oil is again moving higher towards the middle of its post-invasion range while the dollar is slightly off recent highs as commodity currencies and the Euro are better bid on the session.
The Nasdaq is outperforming the S&P and Russell with Growth, Momentum, and Value factors, and Communication, Financials, and Consumer Discretionary sectors outperforming.
S&P optionality strike levels have the Zero-Gamma Level at 4476 while the Call Wall decreased to 4500. The Call Wall falling to 4500 means that the S&P is currently up against significant resistance given the levels of open call positions there. Post-Friday’s large OPEX, hedging flows are less impacted by drops in implied volatility but put positions are still larger than calls. Therefore, any drop in vol offers some positive directional dealer hedging.
S&P technical levels have support at 4565, then 4425-35, and resistance is at 4500, then 4545. The S&P is trying to remain above its 200-dma (4460) after breaking out of its post-Jan highs downtrend channel, a breakout that is now confirmed by staying above the channel on a multi-day basis. Expectations are for a further consolidation after the breakout before a move higher.
Treasuries are lower, with the front-end and belly again under increasing pressure due to hawkish Fed rhetoric. The 10yr yield is now at 2.37%, higher by around 8bps on the session, while the 5s30s curve is little changed at 19.8bps.
Deeper Dive:
We underestimated the hawkish pivot now clearly underway at the Fed but were correct in calling for a further rally in U.S. equities last week (due to technicals and optionality in the market). In our defense, a few things don’t make sense with the Fed’s economic projections showing a belief they can quickly move policy to above neutral without negatively impacting unemployment. A the same time, growth will be slowing while there is greater uncertainty regarding this growth and inflation more broadly due to the war in Ukraine. Given our expectation for a deterioration in economic fundamentals/activity into year-end as the consumer increasingly becomes taxed by energy and food inflation, lowering aggregate real disposable income coupled with the lagged effects of higher yields and tighter financial conditions on business/consumer confidence/activity already occurring, we increasingly see equities (and risk assets more generally) closing in on the top of a broader range that will persist until the “neutral” Fed level is reached at some point in mid-2023.
We see a growing risk of a policy error (that is the result of the previous policy error of waiting too long to start tightening), with the Fed’s increasingly aggressive rate hike cycle (potentially now with subsequential 50bp hikes over the next two meetings) and a faster pace of balance sheet reduction overly tightening financial conditions and subsequently slowing the real economy right as supply-side shortages of materials and labor are finally normalizing (and reducing the main driver of inflation), improvements we continue to see slowly materializing.
*“You can not have your cake and eat it too.” – labor markets are tight but given gains in productivity that occurred during the pandemic, with firms learning “to do more with less,” we question how sticky labor will be if current demand and the future outlook weaken.
Powell and company are clearly prioritizing inflation over maximum employment, which they believe is effectively achieved despite a lower EPOP level and minority-UER still higher than pre-pandemic levels. Powell acknowledged this in a speech yesterday, noting the current tightness in the labor market may fade while the labor force was still below pre-pandemic levels. This indicates that he believes that wage pressures will fall while the Fed still has some work to do in creating a more inclusive labor market. As a result, there is now a likely scenario in the second half of this year where labor markets will be deteriorating while inflation is falling, causing the Fed to talk/walk back 2023 tightening expectations. Something the market is increasingly pricing.
*The overshoot of the longer-term neutral rate (while the balance sheet is being shrunk) without any detrimental effects on the labor market does not seem likely, and trends in labor and inflation in the second half of the year could increasingly reverse
As a result of our expected changes in labor and inflation trends in the second half of the year, we believe the Fed will not achieve the amount of tightening priced into markets. However, we will not reach peak Fed hawkishness until breakeven rates stop rising, which will not occur until the volatility in oil markets subside. Once market-derived inflation expectations stabilize, the Treasury curve can stop flattening as the front-end will stop pricing in Fed tightening. At the same time, the back can reflect a higher term premium due to a more “neutral” future policy.
*Breakeven rates continue their impressive gains, driving nominals higher and showing markets have yet to settle on a future inflation level/range
To summarize, yields are being driven higher by increases in demand for inflation compensation (given Fed policy is being driven by inflation). This higher and persistent inflation has increased Fed tightening expectation to now move quickly above the neutral level by the end of the year. This will slow business and consumer demand at a time when decreasing, but still, high energy and food inflation continues to be a drag on earnings and disposable income (although core inflation will be more meaningfully falling). As a result, firms will reduce their output and hiring levels causing unemployment to increase and forcing the Fed to reprioritize its “maximum employment” mandate in 2023. Until this pivot, likely in the first half of 2023, risk assets will be range bound as earnings growth fundamentals and liquidity conditions become increasingly challenged.
*Consumer confidence/sentiment continues to be held higher by the household balance sheet and job outlook, both areas we believe will worsen in the second half of the year
*As the yield curve inverts expectations for a slowdown to an outright recession in the economy are increasing
The war in Ukraine looks to be settling into a stalemate as Russia has failed to gain air superiority and execute its initial strategic goals. As a result, their ground operations are becoming more bogged down with reduced morale and supplies. This is leading to a change in tactics that are increasingly punishing the civilian population. As a result, it is still unclear where global sanctions and self-imposed boycotts will end up. It is also unclear whether China will offer Russia new assistance, something that could clearly further strain relations between Beijing and the West while also leading to new sanctions and anti-Chinese legislation that could disrupt trade/investments and global growth.
The meeting last weekend between Xi and Biden resulted in zero new concessions from Beijing. At the same time, the U.S. and NATO communicated their position and expectations at the highest level.
*Beijing released a transcript of the call while the meeting was still ongoing, showing no desire to change posturing as a result of what was discussed
On Monday, the Chinese ambassador to the U.S. said that China would not send weapons to support Russia’s war in Ukraine and that Beijing would “do everything to de-escalate the crisis,” indicating a softer stance than the official transcript of the Biden-Xi meeting indicated. It also indicates the Biden-Xi meeting was not a complete loss, with China now clear on what is expected of them moving forward.
*China’s message regarding Russia and the Ukrainian war has varied depending on official and channel, leaving a high level of uncertainty over what role they will play moving forward
If the U.S. wants China to play a more constructive role, it will need to give concessions itself, either in the form of targeted sanction relief or clear the way for mRNA vaccines and therapeutics to be produced in China, supporting a “safe” reopening and improving the economic backdrop domestically there. This will also help alleviate renewed supply chain disruptions and reduce gloabl inflationary pressures.
*China continues to accelerate the development of its first homegrown mRNA Covid-19 vaccine but giving approval of Western ones and ultimately producing those domestically would expedite the reopening
We will be watching for the previously mentioned U.S. concessions, whether Chinese firms actually abide by the sanctions, and increased neutral rhetoric out of Beijing calling for further de-escalation as signs that China is choosing to support the Western rule-based world order, which it has immensely benefited from, and not engage in further Wolf Warrior posturing via siding with Putin.
*Beijing will have to pick a side, although it may not do so publically, as it likely prioritizes economic relationships over ideological ones
Econ Data:
The Richmond Fed’s Manufacturing Index increased to 13 in March from 1 in February. Improvements in activity were broad-based, with every sub-index improving on the month. Demand increased with New Orders (10 vs. -3), Shipments (9 vs. -11), and Backlog of Orders (7 vs. -4) returning into positive territory after a drop into negative territory in February. Employment levels held steady while the Average Workweek increased notably. Firms reported a slight worsening in their ability to find needed labor. The vendor lead time indicated that most firms were still reporting growing lead times. Finished Goods (-15 vs. -14) and Raw Materials (-15 vs. -22) inventories remained low, and firms expected that to persist for the foreseeable future. The average growth rate of Prices Paid remained elevated (11.05 vs. 12.27) but continued a three-month downward progression. However, average growth in Prices Received inched up (9.16 vs. 8.77). The expectations for both increased after dropping in February.
Why it Matters: A notable rebound in business activity on the month. Of note was a decrease in Capex, with Equipment and Software spending decreasing, all be it off high levels in February, while future expectations remained stable. Prices Paid and Vendor Lead Times are stabilizing, showing some reduction of supply-side problems. Increases in Prices Paid are also showing firms continue to be able to pass on cost increases. Employment expectations fell across the four sub-indexes, something we will be watching closely given our belief that labor demand will begin to cool.
*Prices Paid and Received, Lead Times, and Wages all remain elevated while demand measure returned to Positive territory in March
Policy Talk:
On Monday, Federal Reserve Chairman Jerome Powell vowed tough action on inflation, which he said jeopardizes an otherwise strong economic recovery. “The labor market is very strong, and inflation is much too high,” he said in prepared remarks for the National Association for Business Economics. He noted the inflation outlook “had deteriorated significantly even before Russia’s invasion of Ukraine,” and he warned that the effects of the war in Ukraine and resulting sanctions on Russia could further aggravate supply-chain disruptions while sending up prices of key commodities used to make a range of goods. “There is no recent experience with significant market disruption across such a broad range of commodities,” said Mr. Powell. He added that the experience with oil-price shocks in the 1970s was “not a happy one.” But Mr. Powell repeatedly stressed the uncertainty facing Fed officials as they await the normalization of the supply-side impairments and try and better understand the effects of the war in Ukraine. He said officials are ready to shift their policy in a more disruptive direction if needed, indicating a faster pace of rate hikes, with subsequential 50bp hikes possible in the next meetings and a potentially faster reduction in the balance sheet than expected.
“I hasten to add that no one expects that bringing about a soft landing will be straightforward in the current context — very little is straightforward in the current context, and monetary policy is often said to be a blunt instrument, not capable of surgical precision.”
“The Delta and Omicron variants' complicated hiring and the strong financial position of households may have allowed some to be more selective in their job search. Over time, we might expect these factors to fade, reducing pressure in the job market.”
“We will take the necessary steps to ensure a return to price stability. In particular, if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.”
Last Friday, St. Louis Fed President James Bullard released a statement explaining his dissent and saying he would like to see the Fed Fund's rate boosted to above 3% by year-end. "This would quickly adjust the policy rate to a more appropriate level for the current circumstances," he said. He added that the Fed should have started reducing its bond holdings at the meeting as well. Bullard pointed out that the Fed has moved that aggressively before, in 1994-95, to combat a gradual rise in inflation. "The results were excellent," Bullard said. "The Committee achieved 2% inflation on average, and the U.S. economy boomed during the second half of the 1990s. I think the Committee should try to achieve a similar outcome in the current environment."
Raphael Bostic, president of the Atlanta Fed, said on Monday that he supported just five more interest rate increases this year. He pushed back on the idea that the Fed would need to “actively slow the economy” in order to get inflation back under control by moving rates above neutral. “I’ll be comfortable going above neutral — that’s just not my baseline today,” he said. Further, Bostic said he supports the Fed “quickly” starting to shrink its massive $9 trillion balance sheet. The specifics about the plan are still being debated, he added.
Minneapolis Fed President Neel Kashkari said on Friday, through a Medium post, that inflation is significantly higher than the Fed wants it to be and, as a result, the Fed has to normalize monetary policy to bring supply and demand back into balance faster than previously thought. Kashkari said that he is in favor of beginning to shrink the Fed's balance sheet as soon as the next meeting and that we should shrink the balance sheet at a much faster pace this time versus last. “I would shrink the balance sheet at double the pace versus last time,” he said. His projected Fed Fund’s rate at the end of 2022 is between 1.75% - 2% in the dot plots. He highlighted in his remarks that even though labor supply has materialized, “I expected this increase in workers to relieve pressure on businesses, supply chains, and wages. As more workers came back to work, temporary inflationary pressures would relax. That hasn’t happened with wage growth picking up to around 5 percent and businesses continuing to struggle to find all the workers they need.”
Technical and Charts:
Four Key Macro House Charts:
Growth/Value Ratio: Growth is higher on the day and week. Large-Cap Growth is the best performing size/factor on the day.
Chinese Iron Ore Future Price: Iron Ore futures are lower on the day and the week as Evergrande unveils a restructuring plan helping property developers rally on the day
5yr-30yr Treasury Spread: The curve is flatter on the day and week, as last week's FOMC and continued hawkish rhetoric following it has markets increasingly pricing in 50bp hikes in the coming meetings
EUR/JPY FX Cross: The Euro is higher on the day and the week, as the BoJ looks like it will be the last central bank easing as the yen hits a decade low against the dollar
Other Charts:
The forward 12-month P/E ratio for the S&P is currently 19.1, above the 5-year average (18.6) and the 10-year average (16.8), signaling markets remain historically expensive
Goldman Sach’s latest U.S. Financial Conditions Index slightly eased after last week’s rally in risk assets
Goldman is also again reducing their expectations for global growth this year, looking increasingly more pessimistic than peers
Being long commodities is now the “most crowded trade”, significantly increasing in popularity in March
Commodity markets are experiencing broad backwardation, the strongest in decades for some, which has historically been a sign of peak speculation. However, indicating some panic has come out of the market, backwardation in oil markets has fallen off highs seen at the start of the war.
Even though oil is off its peak by $20, gasoline prices continue to rise or are barely off their highs in many places, showing the stickiness of prices there
The rise in fertilizer prices over the last year and now disruptions to supply from sanctions and embargos against Russia will only put further pressure on agriculture production and food inflation
Significant acceleration in home equity withdrawal as consumption is increasingly subsidized by home price appreciation; all be in it at a much lower rate than seen before.
Don’t count the dollar out just yet, with the increasing weaponization of it over the last decade having little effect on its usage as a reserve currency
Articles by Macro Theme:
Medium-term Themes:
Real Supply-Side Improvements:
Splitting Up: Manufacturers With Ties to Russia Struggle to Unwind – WSJ
Executives of Russia-connected companies said they are reconfiguring suppliers and logistics, temporarily suspending production, and transferring control to U.S. employees in an effort to keep doing business. Continual new sanctions and actions from private companies leaving the country are making it difficult for businesses to know what to do. The House has passed legislation that would sever normal trade ties with Russia, which could lead to increased tariffs on products made in Russia, while Russia has said it would ban some exports.
Why it Matters:
Russia was the 24th-largest trading partner with the U.S. in 2021, according to census data, with the U.S. importing about $29.7 billion worth of goods from the country and exporting about $6.4 billion. Many of the imported goods from Russia include oil and other energy products, as well as fertilizers, nickel, steel, and other industrial materials. As a result, there is a real impact on American firms, and it will take time for these firms, previously reliant on Russian imports, to find alternative sources of materials or workarounds in production.
China Macroprudential and Political Loosening:
Summons: China Tells EV Battery Chain It Wants 'Rational' Lithium Prices - Bloomberg
According to the Ministry of Industry and Information Technology statement, the government called in a range of market participants, from lithium producers to the main carmakers’ association, last week to discuss “a rational return” for lithium prices. The burgeoning EV industry is grappling with growing risks around cost inflation, with some carmakers starting to feel the pain and raising their own price tags.
Why it Matters:
The meeting underscores how Beijing is getting nervous about lithium’s prolonged surge, and it’s also in line with a broader push to manage soaring commodity prices more generally. In similar events in the past, rare earth manufacturers were summoned for a meeting after prices jumped there. This leads us to question the ability of any firm in China to make significant profits without receiving the scorn of Beijing.
Changing: Hong Kong to ease restrictions in marked shift from zero-COVID - NikkeiAsia
Hong Kong on Monday laid out plans to cut back on some of the world's toughest virus restrictions, including lifting flight bans and shortening its quarantine period, in its most dramatic shift yet away from a zero-COVID policy. Flights from nine countries, including the U.S., Australia, the U.K., and Canada, will be allowed to resume, starting April 1, after a nearly three-month ban, while a 14-day hotel quarantine will be cut to one week for incoming passengers if they test negative during their final three days in isolation.
Why it Matters:
Last week, the industrial hubs of Shanghai and Shenzhen were temporarily locked down as China also recorded its highest case rates since Covid was first identified in the central Chinese city of Wuhan. But Beijing has also recently signaled that it may shift to more targeted measures. We have been expecting an evolution in Beijing’s Covid policy and see the recent events as a positive sign that it is occurring. This means the increases in Omicron cases will not be as significant of a drag on growth as feared.
Longer-term Themes:
National Security Assets in a Multipolar World:
Back Scratching: U.S. Sends Patriot Missiles to Saudi Arabia, Fulfilling Urgent Request – WSJ
The Biden administration has transferred a significant number of Patriot antimissile interceptors to Saudi Arabia within the past month, fulfilling Riyadh’s urgent request for a resupply amid sharp tensions in the relationship, senior U.S. officials said. The need for the interceptors was further underscored following an attack late Saturday and early Sunday when Houthi forces in Yemen fired missiles and drones at energy and water-desalination facilities run by Aramco, the Saudi state oil company.
Why it Matters:
The decision to go ahead with the arms transfer was part of an effort by the Biden administration to rebuild its relationship with Riyadh. Among other things, the U.S. hopes Saudi Arabia will pump more oil to mitigate soaring crude prices, officials said. But providing Patriot interceptors hasn’t resolved all the strains in the relationship. The U.S. defense industry will be increasingly in demand as parts of the world further test the West’s rule-based order and capabilities to defend that order.
Electrification and Digitalization Policy:
Balance: Surveillance Risks Shape How Central Banks Test Digital Currencies – WSJ
When the Eastern Caribbean Central Bank proposed a digital currency for its island-nation members, many consumers, merchants, and commercial bankers asked: What happens to my data? The bank responded by launching a pilot of its DCash payment system last year on a private blockchain. It spread information among participants, including commercial lenders, and limited authorities’ visibility. The design speaks to trade-offs between performance, privacy, and security.
Why it Matters:
Central banks must grapple with how centralized they want the design and governance of digital payment systems to be. More centralized approaches, which can include a single database to record transactions, could enable more widespread surveillance, leading to abuse. They could also make governments more enticing targets for hackers. Decentralized concepts that often rely on distributed ledgers such as blockchains may improve privacy but slow payment processing. The article elaborates on a number of digital currency projects underway globally by central banks.
Commodity Super Cycle Green.0:
Split: Fertilizer Sanctions Split Farm Superpowers as Costs Surge - Bloomberg
The world’s agricultural superpowers are divided over whether Russian fertilizers should be sanctioned as surging prices threaten to further stoke food inflation. Brazil, the top exporter of everything from soybeans to coffee and sugar and the biggest importer of fertilizers, argues for keeping crop nutrients sanction free in the name of food security. The U.S., on the other hand, leans toward upping the ante against Russia.
Why it Matters:
“Restraining fertilizer consumption may hurt crop yields, boost inflation and threaten food security,” Brazilian Agriculture Minister Tereza Cristina said. “We can create a bigger problem by worsening global hunger.” Opposingly, U.S. Agriculture Secretary Tom Vilsack said, “Maybe sacrifices are necessary to address the unjustified war that Russia has chosen to start.” Fertilizer perfectly highlights the hard choices each nation must now make when prioritizing its own needs verse standing up to Russia.
Current Macro Theme Summaries:
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