The Big Conversation
Episode 130: The first signs of demand destruction?
This week Roger Hirst looks at whether recent weakness in some commodities are signs that demand destruction is starting to appear. Copper has been breaking down and crude oil has pulled back from the highs, but are financial conditions yet tight enough to bring inflation under control? An additional risk is the uncertainty around the Bank of Japan, which appears to have supercharged its loose monetary policy. Is that sustainable? Each time that risk assets rally, financial conditions ease, increasing the potential for inflation to remain untamed and for the Fed to get more aggressive again.
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Rog [00:00:00] For most of the last 25 years, the central bank conundrum was strong growth and low inflation. Today, the reverse is true with growth under pressure because inflation is at multi-decade highs. The response from the Bank of Japan has been yield curve control and the ECB may not be far behind. But could this be the beginning of the end of a multi-year monetary experiment? That's the Big Conversation. If we look at the US yield curve or the ISM manufacturing survey, we could assume that a slowdown is still some way off. The yield curve usually inverts and then risk deepens before recession in a process that can take anything from nine months to almost three years. The yield curve has only recently inverted, and the last reading of the ISM was 56.1 well into expansion territory and well above the 45 level that usually coincides with the recession. But this time the slowdown has started in a different area, with inflation quickly biting at small businesses and the consumer end of the US economy. This segment has little protection from higher prices because unlike large companies, they have little ability to hedge in the futures market to smooth out those price fluctuations. The University of Michigan Consumer Sentiment Survey has reached a record low since the main survey began in the late 1970s. These levels of pessimism also exceed the lows of its earlier incarnation, stretching back to the early 1950s. The NFIB Small Business Outlook for General Conditions has also hit an all-time low, amidst a battle to find sufficient labour at the right price. Small businesses make up a larger proportion of the US economy than do the larger businesses represented by the ISM. And the reasons for these issues are largely down to the combination of price and the speed with which these price rises have impacted consumers and businesses. US mortgages have hit the 6% mark again, but the actual year-on-year change is the fastest since 1995. They're still well below the levels of the 1980s, but it's much more of a shock going from 4% to 6% than it is going from 12 to 14. And that rate of change can be seen even more clearly when we look at the year-on-year percentage change in mortgages. This is the fastest increase in mortgage rates in the last 40 years. The speed of change is nearly always more relevant than the absolute level of an asset or price. At the institutional level you can see this type of move in extremis with the US two-year yield. In percentage terms this is a stunning move, though this is obviously exaggerated by the fact that our starting point was close to zero only a few months ago. In absolute terms, the two-year yield has reached its highest level since 2007, and this is the first time that we've seen yields make a significant higher high over the last 40 years. The last time inflation was at these levels, it had built up a head of steam over the previous decade. The peak in the early 1980s was the culmination of four successive peaks. That was nowhere near as sudden or as swift as it's been over the last 12 months. Consumers are having to rapidly adjust. The savings rate has now dropped towards the levels last seen during the financial crisis, when consumers en masse were struggling to make ends meet. Whilst there are residual savings from the stimulus check handouts, these are not evenly distributed. Consumers have also turned to credit cards, with a monthly increase in revolving credit recently hitting a 40-year high. This is not representative of a consumer that's in good health. The labour market may appear to be tight, but this is also a lagging indicator. Peak employment usually occurs just before a recession appears. During the inflationary decade of the 1970s, a recession occurred at peak employment on three out of four occasions. Tight labour markets during these times are often one of the triggers of recession. Labour, however, may not actually be as tight as we imagine. The participation rate remains well below pre-pandemic levels. The differential was partly due to people taking early retirement. Many of these early retirees are rethinking this move now that so much wealth has been wiped out and the cost of living has risen. But labour markets won't normalise in time to change the Fed's short-term tightening path. The most likely source of an easing of the tightening bias would be a clear and present demand destruction that leads directly to weaker growth. But even that's not a certainty of a change in the policy stance, because inflation will remain sticky even when many growth indicators have rolled over. And the risks that an early relent by policymakers could create another round of inflation that builds successive peaks, just like we saw during the 1970s. But there are some signs at the margin that demand destruction is starting to appear. Metals are usually the first of the major industrial commodities to show signs of weakness, and copper looks like it's building a topping formation. And on Friday last week, we also saw a sizeable single-day decline in crude oil that has followed through today. But the one that the Fed will really want to see rollover is gasoline, which has recently made a new high. If anything, the Fed is fighting against higher energy and food prices, the essentials of everyday consumers, rather than outright CPI or its preferred measure of inflation PCE. A peak in CPI will not be enough. Policymakers want to see a significant decline. The May print for month-on-month CPI was 1%. This needs to be close to 0.3% before the Fed can consider that inflation is being successfully capped. But if you think the Fed has problems in its fight against inflation, it pales in comparison with the issues facing Japan and Europe. So let's start with Japan. Last week we highlighted the predicament for Japan. The BOJ appears to be determined to use yield curve control to cap those yields. They're targeting a cap of 25 basis points. So when yields briefly broke higher, they reiterated their commitment to the cap. Last week saw the BOJ buy a record number of bonds. On a GDP-adjusted basis this is the equivalent of the US doing about $300 billion per month of QE. Last week we saw how this is distorting prices. The 30-year yield on the ten-year swap have all moved significantly higher, indicating that the natural path is for those yields to rise in line with other global benchmarks. If policymakers are trying to cap yields, then the currency should be the release valve. And the Yen has been weakening versus the US dollar with the reverse head and shoulders pattern suggesting the Dollar Yen could rise to 170. Although this is a very long-term pattern in the making. But the problem with a weaker Yen, is that it exacerbates the inflation issues. Currently, Japan's CPI looks relatively well-behaved, but it could easily follow the spike in PPI. Japan, like Europe, imports most of its energy requirements, and energy prices remain stubbornly high. Without global demand destruction, the risks to energy prices are to the upside. Therefore, capping yields could create a vicious spiral for the Yen, in which a weaker Yen leads to more inflation and a further weakening of the Yen. As a result, many people think that the BOJ's commitment to yield curve control will waver if inflation moves higher, and this creates significant asymmetric risk for Dollar Yen. If yields were allowed to freely float, they should move higher. And Dollar Yen could reverse and then gap lower. Positioning for this potential in the currency markets is not cheap, however, because three month at the money implied volatility on Dollar Yen has significantly increased in recent weeks. Furthermore, if Japan's yields also gapped higher, that could put upward pressure on other global bond yields because these markets are all fungible. Investors often compare the yield differentials once offset for currency hedging costs. If Japan's yields rise, domestic investors may repatriate capital out of those overseas markets. Japan is one of the world's largest creditor nations, and therefore, what Japan's policymakers do matters for global assets. Sudden changes are always difficult to manage. Yen weakness was one of the precursors to the Asian currency crisis in 1997 and 1998. As long as the BOJ maintained its yield curve control, then the Yen should weaken. In Europe, there is a slightly different dynamic to a potentially very similar theme. After the most recent ECB meeting, European bonds, equities and the euro all fell. Italian 10-year yields reached their highest level since 2014. Although the spread between Italian and German 10-year yields has not yet broken out, these moves once again set off alarm bells in Frankfurt. Europe wants inflation and growth, but it doesn't want higher yields because of the levels of debt in some of the eurozone countries and parts of the banking system. But Europe still has an inflation problem. German PPI hit a new all-time high of 33.6%. European CPI is also at multi-decade highs and has the potential to go much higher, especially with the ongoing issues around energy security. And the ECB wants to sound hawkish, but they don't want to break the banks. And that's why they're mulling a bond-buying programme for certain parts of the European debt universe. And this would be a type of yield curve control in all but name. Now they wouldn't specifically target a yield level, but they would target certain types of bonds. That in itself has political ramifications, but the ECB usually tries to verbally fix a problem and then deal with the legal issues afterwards. And the initial currency dynamic in Europe could be quite different from that of Japan. Capping yields should allow the currency to weaken. But the eurozone, however, has often been rewarded for stability. If the ECB implements a new programme that helps to avoid concerns around eurozone fragmentation, then the euro might initially strengthen. And we saw that in 2020. The Fed expanded its balance sheet first, but when the ECB eventually came in with an offsetting move, this increase in European QE also saw the euro rally because it was perceived as providing stability. Although a rally in the euro does reinforce this relationship. And this is a reminder that sentiment can be as important as yield differentials when it comes to currency performance. Support for the Eurozone and a rally in the euro could help initiate a bounce in risk assets. So far, we've not seen a lasting bounce since the initial post-Ukraine rally. Markets are obviously oversold, but central banks are still grappling with rising inflation that's concentrated in the wrong areas. And whilst the ECB can try to cap Italian yields, German yields could rise further given the extreme in producer prices. Once again, US yields could be influenced by external sources. There was some relief last week when we saw yields in the 10-year space hit 3.5% and then reverse intraday to 3.2% as a result of those first signs that demand destruction was breaking through. But for policymakers, the dilemma remains. If markets start to price in a potential peak in the rate hiking cycle, but equities and bonds could rally and that would lead to a loosening of financial conditions, which could give inflation another boost. And the Federal Reserve has made it clear it wants to tighten financial conditions sufficiently to rein in inflation. Financial conditions are currently at the average of the last 20 years and nowhere near the inflation-fighting levels that were seen in the 1970s. It will take more than just a wobble in commodities for the Fed to reverse course. But it's the experiment in loose monetary policy in Europe and particularly Japan that we should be watching. The BOJ has been soaking up the sales of bonds at an unprecedented rate. Either Yen falls much further or they walk away from yield curve control. China's policymakers are unlikely to stand by and watch the Yen fall without adjusting their own currency lower in order to remain competitive. And that would see the US dollar strengthen and then tighten financial conditions that would negatively impact global risk assets. However, if Japan walks away from yield curve control, then yields will rise, again tightening financial conditions and having a negative impact on risk assets. Either way, inflation is testing Japan's long term monetary experiments, and if that ends, it could send tremors through global markets. And if you have any questions about this episode, financial markets or the economy, please put them in the comments section or send them to firstname.lastname@example.org