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The Big Conversation

Episode 115: Should the fed raise rates? 

This week Roger Hirst looks at the surge in commodity prices and the flattening yield curve, both of which have historically been precursors to recession. What can policymakers do and is a recession now inevitable? The size and speed of some of the moves in the commodity complex suggest that there could be acute liquidity issues across supply chains too.

In the chatter, LSEG’s macro strategist Michael Hampden-Turner discusses the likely path that policymakers will now take.

  • Roger [00:00:00] Whilst many commodities continue to surge higher, with significant implications for future inflation, the US yield curve has flattened further, getting to within 20 basis points of an inversion. But is the yield curve still a trustworthy indicator of future recession? That's the Big Conversation.

    Roger [00:00:19] An inversion of the US 2 year to 10 year yield curve has been a precursor of every US recession since the 1970s. But we haven't had an inversion yet, and it's a terrible timing tool over the last 30 years. Inversions have taken place anywhere from a few months to even a couple of years ahead of an actual recession. But the dynamics at play today are nothing like we've seen in those previous 40 years. Many of the previous inversions were primarily the results of the US Federal Reserve raising interest rates into a strong economy. With short dated interest rates going higher at a faster pace than longer dated yields, the US curve bear flattened and eventually inverted when those 2 year yields moved higher than the 10 year yield. Eventually, this tightening led to a slowdown in the economy, and the 10 year yield, which is a proxy for optimism and pessimism, would start to fall, reflecting the pessimism of a slowdown and the curve would re-steepen. But what's remarkable today is that the Fed is contemplating hiking into a curve that's almost inverted. Furthermore, they're also about to end QE, and as we've shown before, periods without QE tend to put downward pressure on bond yields. Additionally, longer dated bond yields have been falling because the wild surges in commodity prices are expected to be a significant drag on future growth. But if the Fed does tighten, 2 year yields may actually fall, and that's because a Fed that's tightening into the current environment could increase the expectations that the tightening cycle will be shorter. Now the 2 year yield is basically an expression of 1 to 2 year rate expectations, and it could start to drop if inflation hurts growth. 2 year yields have surged, even though the Fed has not yet started to tighten. Tighter monetary policy would impact demand, but it has little effect on supply-side issues like the ones the global economy is facing today. Therefore, tighter rates may have little or no impact on prices, but it could hurt demand at a time when the growth potential is already being eroded by surging commodity prices. And as almost everyone is aware, commodity prices have skyrocketed. Brent crude oil briefly reached $139 per barrel, its highest level since 2008 on an intraday basis, when markets opened on Monday. Although on an inflation adjusted basis, crude oil is still well below those 2008 levels, it's the speed of the moves that are startling. Wheat futures on the Chicago Board of Trade posted their largest by far single week gain by the end of Monday. The future had hit a succession of limit up positions - the maximum intraday move allowed - before finally taking a breather on Tuesday. Many agricultural commodities are back at absolute levels today that a decade ago caused turmoil in many of the world's grain importing countries. European natural gas futures have surged to a record high. At their peak, they were equivalent to a crude oil price in the many hundreds of dollars per barrel, compared with prices around $120 today. If energy and food prices remain at these levels for a sustained period of time, then they will be a significant drag on the global economy. Indeed, the size of the moves that we're seeing across the commodity complex are probably having serious implications for many of the commercial players who had been hedged with shorts in the forward market. Now, derivatives are a key element in this space, but that means there is a buyer and a seller for every contract. Nickel doubled on Monday and then doubled again the following day to around 100,000 dollars before trading was halted and those trades were cancelled. Margin requirements, which are the amount that users of derivatives such as futures and forwards have to put up as security, have been rising dramatically for many commodities, and some companies have already been given a reprieve on payment in order that they can find additional capital. Providing some leeway could be key. The global web of trade linkages means that failures along the chain could easily create a domino effect of defaults. But the outcome of some of the changes of the global invoicing system that have taken place in recent days are still unknowable. Some think it could be a red herring like the Y2K fears in 1999. Others think that this could be like the combined shock of the Asia crisis and the failure of Long Term Capital Management between 1997 and 1998, which resulted in a coordinated response from global central banks. The surge in commodity prices could create a liquidity shock if the free flow of capital that finances trade starts to break down. Central banks that are currently poised to tighten rates may also need to ready their balance sheets once more. We can already see the impact this is having across the emerging market complex. The Emerging Market Bond ETF has fallen sharply in recent sessions. While there's still some way to go to match the lows of the pandemic and the great financial crisis, the trajectory looks ominous. The JP Morgan EM FX Index has also made a new all-time low. Although many countries are exporters of raw materials, there are also a large number of emerging market countries that are reliant on imports of both food and energy. Overall, emerging markets are in a much healthier position than they were during the 1997 crisis. But whilst reliance on dollar denominated debt has fallen significantly over that time, reliance on global trade receipts has increased instead. And although the US dollar has only had a small squeeze higher so far, there are some tentative signs that the funding costs for swapping other currencies into US dollars have started to pick up. The three month basis swapped for euros into dollars has increased. Those higher costs are depicted by the declining line. So far, it's not surpassed the cost of year end currency hedging, but like the emerging market bond index, it's been heading in the wrong direction. The surge in commodity prices therefore has implications for inflation and living standards. It also has implications for the complex web of trade linkages that could lead to disruptions in trade finance. If commodity prices stay elevated for a long time, it would likely shave significant growth off global GDP. And all this is happening in superfast time. The yield curve may never go negative if short-dated yields drift lower as rates start to rise. But the speed of the decline in the curve is a clear indication that growth is struggling, and this was the case before volatility picked up over the last few days. Policymakers may have to revise their outlook, and they may have to do so in rapid order. To discuss how these shifts in the commodity landscape might change their outlook, I spoke with Michael Hampden-Turner of LSEG and formerly the Debt Management Office about the possible policy path for the rate setters.

    Roger [00:06:24] Michael, good to see you. We're going to talk about inflation, commodity prices and central banks because obviously, you know, we saw some quite extreme levels of inflation in terms of some of the prints, even before what we're seeing now. And obviously now we're seeing some supercharged moves in many commodity prices, which presumably is going to lead to yet higher inflation down the road. What does this actually mean for policy makers, particularly European policymakers and US policymakers? Is it going to change how they deal with this in terms of the rate-hiking cycles that we thought that they were going to get into?

    Michael [00:06:57] So I guess it's it creates a dilemma for them. On the one hand, normally with high inflation, what you want to do is to hike rates in order to try and cool it. But as with COVID, we have a new sort of an emergency situation in which really hiking rates probably will be ineffectual and any way the type of inflation that's been created is sort of artificially created rather than creating through, created through growth. So trying to cool growth isn't really going to help. So that, that dilema creates quite a problem for them, and I think it's going to make them more likely to be tolerant of higher inflation, especially in Europe, which where it's really sort of much closer to the disruption, less so perhaps in the US, which is obviously a little bit more remote in terms of the effects.

    Roger [00:07:40] Do you think that means, you know because in the US, they're already starting to see a little bit of tightness in the labour market? And I think sort of variously we've seen some people going for 9 rate hikes on the trot, maybe I think there's still 6 priced in, maybe it's now close to 5, but do you still think it's going to be kick off in March and 5 over the year? Or do you think that the actual number of hikes will be fewer given that the the sort of, you know, hiking rates is normally a way to sort of bring in demand, but often doesn't help supply side of supply shock inflation?

    Michael [00:08:10] So my personal feeling is, is they are likely to start right. I think that there's sort of a feeling and a need to signal that that we're we're in a new phase of of of the rate cycle. So I think they will start. But I think the pace is bound to be slower and I can't see, even if the tanks turn around and reverse their course that we're going to get an unwind of the current sort of supply, and supply disruption. You know, for instance, since since COVID finished the sort of cost of shipping containers from Asia to the US or UK or whatever, it sort of went up by 5 times and just after as things began to thaw a little bit on the COVID side, we saw that sort of those shipping rates drop, but now they've perked right up again. So we've got the same type of effects occurring, we've got the same sort of pressures on inflation now combined also with with energy prices. And so I think that's going to make caution, people more cautious, but I think they want to signal that they are willing to tackle inflation. So i think that we get fewer rate hikes, but still starting.

    Roger [00:09:14] If we start getting the rate hikes and we've got sort of a very unusual position in a way that we're starting potentially rate hiking from a position in the US where the yield curve is getting close to zero, I think it's sort of 20-30 basis points, this is the 2 year 10 year. We've got this sort of very unusual scenario where it's almost as if they're going to be hiking into something which might be slowing down already. Is is that, is there a risk that the tightening cycle could tipple, knock things effectively over the edge?

    Michael [00:09:42] So I think there's a huge risk that that it creates a sort of stall speed in the economy, which is why they're likely to be cautious. But I think if you think of the rates market, I always think of it like a big, big pendulum. And in terms of the way it swings, it swings too optimistic, too pessimistic. And I think we're in a phase now with things picking up in Ukraine that we are, we've had poor performance in equities, people piling into rates as sort of protection, so we're sort of swinging a little too far in that direction. And of course, I may be proved wrong and things may step up, but if we get now more of a, not a lull is the wrong word, but more of a sort of stalemate for a longer period of time then we might see that pendulum swing back a bit.

    Roger [00:10:24] And in terms of other areas, I mean, everyone's obviously focussing,  Europe's been the primary focus, obviously, with what's going on. People have been focussing on the US in terms of the rate hiking cycle, but obviously and sometimes the transmission mechanism for US tightening is often felt more keenly in places like emerging markets. How do you think all this is going to, you know, higher commodity prices, hiking cycle in the US potentially kicking off, how does that play out for emerging markets?

    Michael [00:10:49] Well, that's quite an interesting question. I think the typical thing you see with it with a strong dollar. So if we're going to have the US sort of with, with sort of more like more hikes, and more likely to hike, or being perceived that way in Europe more sort of in the grips of a grip of inflation and not moving anywhere, then we're likely to see a strong dollar, we're likely to see a higher rates of entry to Europe, which would typically mean an underperformance of, say, LATAM, with maybe the exception of a few of those commodity currencies, which obviously sort of are benefiting from that element. But that would be a typical thing is is is dollars work their way back home in that sort of circumstance and that the sort of tourist money out of EM comes out and you're left with the sort of more residual long term players. So it's likely that that that plays out, we should see EM come off along with a lot of other risk assets. I mean, it would make sense. I would say you have to sort of segment EM these days. I think China is probably in a different phase of the cycle. It's in a more tightening phase. So I think that that sort of continues to outperform. It had its own momentum, it's big enough now and it may attract additional investment because of that sort of decoupling from from other fixed income markets. But for other EMs I think it's probably not as good news.

    Roger [00:12:07] And so just to finish off then for Europe, I mean, a couple of weeks ago, it was looking like we were pricing in 2 rate hikes from negative into marginally into positive territory. Do you think Europe will still hike rates sometime this year or do you think that's just off the table now?

    Michael [00:12:21] They're always going to be more cautious. I think there was nothing, nothing was going to happen with it, they were still purchasing assets up until March. I think it was always going to be a longer game for them, and I think caution is much more likely, unless things radically turn around in Ukraine, which seems highly unlikely, I think we're talking about 2023 is a more likely start for for their cycle.

    Roger [00:12:46] Thanks very much, Michael, for those insights. I'm really interested to see how they are going to pan out, obviously, particularly in this European sphere with the ECB.

    Michael [00:12:53] All right. Well, thank you very much for having me.

    Roger [00:12:55] And if you've got any questions about this episode, the economy or financial markets, please put them in the comments section or send them to TBC at Refinitiv dot com.