Global trends in inflation and growth are increasingly a concern, and worryingly, a recessionary base case is where many investors appear to be heading. Top of mind factors the market is still digesting continue to be China’s commitment to zero-covid exacerbating supply chain issues and expectations turning more hawkish for Wednesday’s June FOMC meeting, driving UST yields higher
Indeed, the blockbuster CPI print on Friday has mounting pressure on the Fed to continue tightening aggressively, but the question is, will there be more front-loading or a longer strand of 50bp increases to come? Although the markets have had a chance to brace for 75bp, it would still add a great deal of asset-price volatility associated with that big move in one shot.
A hard landing is considered a certainty now for the U.S. as conversations fall silent on any version of a soft landing. The speeding Fed rate hike freight train is looking to drive inflation down, no matter what happens, irrespective of economic damage.
And the core uncertainty is how far and how fast that freight train will need to push rates higher to temper inflation. If it is months, no problem, but if it stretches through multiple quarters, investors will be in an inflationary world of hurt. But for today, investors are bracing for the first major impact.
A bigger question at the moment is how high the Fed terminal rate needs to go before inflation vectors lower; right now, that stands at 4%, So for stocks even to stabilize, there will need to be some calm in the bond market. However, the much taller order for stocks to return to any semblance of bullish form would likely require an improbable upbeat mix of a coherent China growth recovery, a convincing deceleration of U.S. inflation, and softer oil prices.
You know things are getting bad when clients start worrying about that last bastion of safety in USD and wondering how that can go wrong. It tells me investors are running out of options to hole up and wait out this storm.
Indeed, there has been a sharp deterioration of liquidity in government bond markets over the last few days approaching levels not seen since the onset of the covid pandemic in March 2020. Indeed, this seems to be driven by one-sided hawkish flows hence poor bid side liquidity. The Bloomberg US bond liquidity index continues to rise to the highest level since the pandemic, which is a sign of poor liquidity.
Oil is trading lower, likely due to pre-FOMC profit-taking and the surging dollar as global investors run for cover in cash under the U.S. dollar umbrella. Cross-asset traders are bracing for a 75 bp impact with the Fed rate hike steamroller apparently on a mission to pancake U.S. consumer demand across the board to stem inflation.
The outlook for oil cannot remain uncorrelated to sentiment and the not-so-rude health of the global economy over time. Still, in the short term, with summer drivers still lining up for gas regardless of price amid ongoing supply problems, oil prices remain relatively robust despite growing uncertainty for the global economy.
Once the Fed hike is in the rear window, OPEC will return as the most significant focus on oil after OPEC’s MOMR release overnight. Not only did OPEC not lift its production as agreed, but output decreased last month thanks to even more significant declines in production from Iraq, Libya, and Nigeria.
All eyes will be on next month’s report on whether OPEC follows through with their agreement. Given their recent history, I am not sure how optimistic folks are.
While global bond markets remain under pressure, the move in UST yields this week is proving impossible for USDJPY traders to ignore. In addition, the BoJ purchased a record amount of JGBs overnight (at its fixed-rate operation) and announced an increase in JGB purchases for Wednesday to keep a lid on JGB yields (defend its YCC policy). As mentioned on Monday, this type of action makes it incredibly difficult for USDJPY to come off, as it signals to the market that the BoJ is intent on not changing policy.
Moving forward, the million-dollar question is going to be at what point does the tightening priced into the curve tilt the scale from a story of U.S. rate differentials driving the likes of USDJPY higher versus recessionary fears taking the wheel as the Fed moves us towards a harder-landing scenario (USDJPY lower)?
The market will ponder this question on the not-so-distant horizon. Still, for the time being, the USD’s higher direction of travel seems to be in control as the Fed pricing continues to adjust to a significantly hawkish level to take the heat out of inflation.
The FX Truth Index
In the $bloc, there is a preference to sell the likes of AUD and NZD on the back of the evolving, hence economically devolving covid situation in China.
Elsewhere, with stagflation fears the primary concern, CAD is on people’s radar as a currency that could weaken further, despite the Bank of Canada ramping up its hawkish rhetoric and in contrast with month-to-date performance versus its G10 peers – the 1.3000 level to the topside is being touted as the level to watch for further momentum. Short CAD was a keen trade for Bay street CAD traders on Friday, who often refer to the loonie as the F.X. Truth Index.
( Friday, June 10 Morning note: in an ominous signal, the loonie is lower despite a hawkish Tiff. And for us, that cut our FX chops trading CAD on Bay Street, and who refer to the loonie as the ” truth,” it is a gnarly sign for global growth. )