Inflation: Coming down the mountain

• Cooling US inflation argues for a step down in rate hike pace, but not lower terminal rate levels. GLOBAL MARKETS
• It would be challenging to supplicate a more toxic cocktail for the US Dollar. ( FED vs ECB & BOJ divergence) YEN & EUR
• Q1 2023 should see a massive reversal of Asia exporters hoarding USD liquidity accumulated in 2021-22, especially in Malaysia. MYR
• Signals of activity and mobility are already bottoming in key densely populated Chinese cities. BRENT OIL

MARKETS

This week’s holiday-shortened economic calendar features a handful of data releases alongside a gaggle of Fedspeak ahead of next week’s blackout before the February 1 FOMC meeting.

Of particular note will be how Fed officials incorporated last week’s CPI data into their views regarding the potential downshift to a tightening pace of 25bps at their upcoming gathering. And could provide a reality check for the “risk-on” and “low-volatility” camps.

As a reminder, both headline and core CPI were spot on the consensus forecasts, coming in at -0.1% and +0.3%, respectively, which brought their year-over-year rates down to 6.5% and 5.7%.

Whether to bear or not to bear is the critical question for 2023.

Equity markets have rallied out of the gate in 2023, offering some hope that the dark days of 2022 are behind us from an asset price perspective.

While cooling US inflation argues for a step down in rate hike pace, not lower terminal rate levels yet. Still, that dynamic reinforces the notion that we are moving – at a minimum – towards a more “traditional monetary policy” setting and lower rate volatility after last year’s front-loaded hikes.

Markets could remain in a festive mood on bettering Europe and China’s growth outlooks, decelerating inflation in the US, and an improving backdrop for the Fed to ratchet back on rate hikes in the months ahead. But the leadership may continue to shift, at least in the near term, to Asian and European equity markets.

If the market is going to chase stocks higher ahead of a quorum of Fedspeak and a slew of earnings reports from corporate America this week, it could be outside the US.

Over the last few months, activity news outside of the US has surprised investors to the upside. China is reopening much earlier and more quickly than expected, and milder weather alleviates European recession fears amid improving growth expectations. If energy prices do not go on another ripper and US inflation and wage trends continue to show moderation, the market might remain in a zone where it can relax further about US inflation and non-US growth risks.

From a bigger-picture perspective, moving from high and rising inflation to disinflation is historically a positive shift for both stocks and bonds.

Coming down the mountain with inflation above 3% is still good.

While there is probably some nuance with where we are in the rate hike/cut cycle, if we are past the peak of inflation, it’s excellent news at the margin for investment portfolios, as both bonds and stocks can live in harmony with that outcome.

US markets are closed Monday for Martin Luther King Day, but for the rest of the week, stock pickers will dial in on earnings season with a continuing swath of Banks and Credit Card companies set to report, plus a slew of non-Financials, including NFLX, PG, SLB, PPG, UAL, and JBHT – all of which should give us a good picture of how Corporate America held up in the last quarter of 2022

FOREX

Spot inflation in the US has been mild enough to diminish the risk of an even more aggressive Fed hiking cycle while the ECB and BoJ have moved in a more hawkish direction. It would be challenging to supplicate a more toxic cocktail for the US Dollar amid improving global growth impulses. And, importantly, there are few obstacles to obscure this path of least resistance in the near term.

The Bank of Japan is at a crossroads as the market debate continues whether BOJ will maintain yield curve control (YCC) at its upcoming monetary policy meeting. However, following a media report (January 12, Yomiuri Shimbun), a mistrusting view on the tenability of YCC had spread extensively in the JGB market, and yields increased across the curve, despite the BOJ’s efforts to contain it.

In this regard, traders anticipate these developments might lead the BOJ to finally decide to do away with YCC all at once, similar to the RBA, or at minimum, tweak the influential band higher. If the BoJ does away with YCC, JGB yields will rise like a weather balloon. Hence the Yen moves into the Tokyo fixes early this week will be monitored, as will the BoJ’s willingness to toe the YCC line heading into the MPM may hold the key. If JGB yields become untethered, watch out bellow on USDJPY as the big pile of offshore dollars Japanese institutional investors are sitting on will re-shore quickly.

ASIA FOREX

Q1 2023 should see a massive reversal of Asia exporters hoarding USD liquidity accumulated in 2021-22, especially in Malaysia.

Foreign currency deposits as a percentage of system deposits rose from 4-5% in 2019 to around 16% in 2022, driven by the more favourable USD vs MYR interest rate differential, the USD rally in 2022 and heightened political risk premium.

A critical factor that would prompt exporters to sell their USDs is the conviction they have seen peak US dollar and yields.

And importantly, signs of improving political stability should attract more FDI flows.

Moreover, the MYR is highly correlated with CNY, so as the Yuan strengthens, we should expect the ringgit to ride its coattails. The China reopening boost should also be an economic boon via goods and services.

OIL MARKETS

Oil prices closed higher Friday, very much in line with China’s notably brighter growth outlook; indeed, signals of activity and mobility are already bottoming in key densely populated reopening cities. In the absence of government-supplied Covid case counts data, the market continues to focus on mobility trends as an indicator of improving oil demand on the Mainland.

And while we see a chance and the rally deflating post-Chinese Lunar New Year due to falling off on mobility as another expected Covid surge keeps folks inside, we think the backdrop is very bullish for oil for several reasons that stand out: i) we are starting from extremely low inventory levels; ii) China mobility is turning, and onshore inventories have been drawn down; iii) ~2mm bpd of refining capacity is coming online in 2023 (S&P Global article –– here); iv) Speculative/CTA positioning looks short and our modelling forecasts a large asymmetric buying near current level; v) potential for a reduction in CAPEX from US shale companies in Q4 earnings declarations given the price moves.

If the oil market turned out to be softer, then OPEC should be able to put another floor under prices, given its strong pricing power. OPEC could keep its production lower for longer beyond its June 4th meeting or implement further cuts. The stated frustration of the producer group with the Western energy policies, including the price cap on Russian oil (and the risk it creates precedents), likely also limits OPEC’s willingness to raise production.

Published by Stephen Innes, Managing Partner, SPI ASSET MANAGEMENT