Fed Pivots vs Cruel and Unusual Punishment

In a widely expected move, the ECB hiked by 75bps. It was interesting to note the less hawkish tone when they suggested less scope for further rate increases; hence the EURO is trading softer across the board.

With the ECB’s less hawkish tone coming hot on the heels of the BOC’s smaller-than-expected hike, it should help fuel the dovish ‘vibes’ that are starting to filter through to investor positioning.

In US Equities, the technology sector was hit with individual names reporting challenging sales outlooks, and the Nasdaq closed down 1.6%. Interestingly this weakness was very sector-specific, with the S&P 500 only down 60 bps and the DOW and RTY actually up on the day. Indeed, this shows broader strength across the asset class and could force the bears to look closely at the recent bounce.

The news flow could be better, but at the moment, investors are just focusing on what is directly in the headlights.

That said, markets are taking it all quite well, partly as the notion ‘bad news is good news” is increasingly driving price action as Fed hikes expectations are lowered in the face of weaker data. Bank of Canada’s surprise 50bp hike on Wednesday, coupled with a less hawkish forward guidance from the ECB overnight, added to the idea that peak tightening globally has passed.

 OIL

Brent is back to a 2-week high, although off overnight highs supported by the weaker US$ and expectations of slower rate kikes from the Fed.

Oil traders were initially charged after the GDP proved more resilient in Q3 than expected. However, the forward-looking offset is that consumer spending remained under pressure, which is more critical to the Q4 demand outlook; hence prices peaked and turned lower.

It is Friday, so we are trading off the weekly headline dregs, which still lend support for oil prices. Specifically, the EIA data shows record-high exports of crude and products and product inventory draws in the US, pointing to robust oil demand.

Meanwhile, press reports indicate US officials are planning to scale back plans for a price cap on Russian oil to a more loosely maintained cap at a higher price, in line with a historical average of $63-64/bbl, as few countries have committed to the lid.

Ahead of the Fed next week, my best guess is that we could see more long position squaring given the prevailing narrative supporting Oil has been increased bets on a Fed pivot.

THE FED PIVOT

Market narratives can be compelling for generating their idiosyncratic flows and price action. The Fed’ pivoting’ has been the most prominent narrative this week for investors globally as some brave souls have moved out of a state of pivot procrastination and are now thinking about a soft Fed U-turn, which has lifted equities and pushed down the dollar. However, the FOMC will not welcome the resulting easing in financial conditions and will likely use next week’s meeting to push back hawkishly. So best to get set for another period of Fed-induced cruel and unusual rate hike punishment.

San Francisco Fed President Mary Daly’s speech was the most direct evidence supporting the theme of a Fed pivot, but her colleagues in the Northeast and Midwest may have differing views. Also, four regional Fed governors in the current committee are from those regions, and Daly will not be a voter until 2024. Both the Fed statement and press conference will try to maintain a hawkish tone and avoid giving the impression of a Fed pivot. The Fed will likely wait for two more employment and inflation reports before drawing any conclusions but expect the market to run with Bad News is Good on the employment front.

FOREX

The ‘Fed pivot’ narrative remains the market’s focus, but there are a lot of other factors at play in the recent USD turn, stretched-long USD positioning notwithstanding. I do not see the soft turn being sustainable and remain biased for the USD to continue grinding higher.

Meanwhile, dynamics in Asia remain weak from depressed current account balances, reduced carry, and manufacturing downturn viewpoints.

Cracks in the Asia financial system are widening. The Bank of Korea intervened to stabilize its markets Thursday. Chinese state-owned banks have sold dollars. These  these are band-aids to mask the issues and  do not fix the core problems

Globally Egypt devalued its pound and raised rates by 200bp, the UK’s mortgage market has collapsed, and the Eurozone system has collateral shortages. The US system is facing dollar scarcity.

While investors are focused on what is directly in the headlights – and whether the Fed will pivot, they should pay more attention to their peripheral vision. Indeed, this is a time to be long dollars, de-lever everything risky and switch out of illiquid credit while there is still a possibility.

Credit spreads are the forerunner, and risk is mounting; IG is hugely underperforming. The IG/HY spread has contracted as IG rates have lifted due to a “get me out” mentality. HY will likely explode wider as the recession hits and any bids evaporate into thin air.

The UK was considered an exception a few weeks ago. It is now joined by Korea, where The Bank of Korea is stepping in with a $4 bln repo facility. The Korean case is another example of inefficient markets syndrome.