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The Big Conversation

Episode 132: Will the FED Flinch?

This week Real Vision’s James Helliwell uses best-in-class data to look at whether the current growth scare in commodity markets will mean that the Fed can dial back its rate-hiking commitments. The market has been lowering the terminal rate and bringing forward the next rate cuts, but the Fed still needs to get inflation under control. But will they flinch before then? If they do, then they may be storing even more inflationary problems for the future.

  • James [00:00:00] Now that growth is starting to come under significant pressure and Fed Funds futures are beginning to price out some of the recent rate hike expectations, will the Fed actually oblige the market with a policy U-turn? That's The Big Conversation.

    James [00:00:17] Growth is coming under pressure from all angles. Firstly, the Atlanta Fed's GDP Nowcast has moved into negative territory. If the forecast is correct and the negative Q1 GDP is unaltered by revisions, then the US will have experienced two consecutive quarters of negative GDP, which qualifies as a technical recession. GDP is, however, a flawed metric for measuring economic health, because it can be skewed by extremes in one input, like inventories, which can disguise other sectors which are doing fine. Nonetheless, very few analysts were expecting one quarter, never mind potentially two-quarters of weak GDP growth during 2022. And we can see cracks appearing in other datasets. U.S. employment looks strong with the unemployment rate close to its historical lows, but unemployment is often at its lowest point just before the onset of a recession. And the ISM employment index had already rolled over and is now dipping below 50, indicating companies want to let go of more people than they want to hire. This is all happening despite the JOLTS, job openings data suggesting there is still a huge shortfall in labour supply. But things move pretty quickly when inflation is at these levels. The year-on-year change in U.S. wholesale inventories of durable goods has recently made a record high. Rising inventories are usually a positive for the economy, as a build-up is indicative of strong production. But when economic momentum starts to change, unsold inventories are often a drag on the economy because they need to be sold, often at lower prices than initially desired in order to remove them from the shelves. Inventories at these levels is therefore a red flag, and this is one of the factors that's led to more and more calls for a peak in US inflation and even the risk of outright deflation next year once the base effects of this year's high commodity prices are taken into account.

    James [00:02:03] Levels of inflation have historically peaked during a recession and then fallen dramatically during and after that recession. CPI fell 7 percentage points from the 1974 peak and 12 points from the 1980 peak. Inflation has fallen during or after every recession since 1965, and the slowdown has not just been a US experience. The OECD Total Consumer Confidence data has fallen into recessionary territory. The impacts of high energy and food prices are being felt on a global basis by all those who are net importers of these requirements. China consumer confidence has also been at record lows. The zero-Covid policy is still rumbling on, and while some of the measures of economic activity are returning to normal, there remains the spectre of rolling lockdowns on the back of any resurgence. The UK, for instance, is currently experiencing another surge of a new variant, and for some regions this will remain a critical issue. Europe's primary issue, on the other hand, is its ongoing energy crisis. Germany, in particular, has been badly affected by surging energy costs, as well as a slowdown in demand that was occurring before inflation even became a real issue. The German trade balance has just gone into negative territory for the first time since 1991 because the rising cost of energy imports has now offset the slowing demand for her exports of goods and services. The impact of higher energy prices, which is unlikely to abate any time soon, has seen the Euro come under pressure and make a new 20-year low. At one point on Tuesday, the 5th of July, it had fallen 1.7% against the dollar. This is taking place even as the US interest rates market has reduced its own expectations for policy tightening over the next 12 months, which might normally take some of the fizz out of the dollar. On Tuesday, however, the opposite was true as the US dollar surged. But Europe's issues are mainly structural and can't easily be fixed by monetary policy alone. However, on this occasion, it's not just commodity importers like Europe that are coming under pressure. Some of the main commodity exporting currencies were also under pressure on the same day. The Australian dollar made a new low for this move, dropping almost 1.5% intraday versus the greenback. And the US dollar has been making new highs against the Norwegian Krona. Commodities remain historically elevated in many cases, but high prices have been partly created by supply constraints rather than high demand growth. Exporting nations are not reaping the full rewards of both volume and price across the commodity complex. And now the market is beginning to price for even slower growth in anticipation of volumes dropping further. Because the dollar strength has been relatively broad-based, the dollar index, or DXY, has also made a new high, the highest level since 2003. If the dollar continues to rally, this may put additional downward pressure on commodities after an unusual period of both dollar and commodity strength in recent months. Normally, a stronger dollar would cap commodity prices, and that relationship may now be reasserting itself. Crude oil in particular, could have a long way to fall if the historical relationship kicks back in. COMEX copper futures fell over 4.5% on Tuesday, whilst broad-based European miners and energy sectors fell over 5% and 6% respectively. In a growth slowdown, these sectors are likely to fall much further, as they have been some of the major beneficiaries of the fiscal reflation trade. If a recession is confirmed and we start to see a peak in the US dollar, these are the sectors that have significant structural tailwinds because of long-term underinvestment. Even some of the major food prices are now coming under pressure and appear to be testing major support levels. U.S. wheat futures have now almost given back the gains made after the Russian invasion of Ukraine. The declines in soybean and corn futures are not so dramatic, but they both look like topping formations that are close to breaking down. Their risks are starting to look asymmetric in the short term, even though it's probably next year's harvest that will be impacted by this year's issues in fertiliser production. It may come as no surprise, therefore, that global bond yields have also significantly pulled back from the highs. The US 2-year yield has fallen by almost 75 basis points, while the US 2-year versus 10-year yield curve has been attempting to invert once again. Back in the 1970s, the yield curve tended to invert into a recession rather than the pattern experienced between 1990 to 2020, where the inversion would often occur many months before a recession. So with all these signs of a slowdown in both US and global growth, will the Fed also be contemplating a slowdown in its rate hikes? Of course, they will be keeping a close eye on the data, but right now they are ultimately driven by the focus on inflation, not growth. And inflation is a lagging indicator. So whilst growth may indeed be rolling over, the Fed's dilemma is that if they reverse engines and worry about growth before price is under control, then they are at risk of prices moving higher again before they've even been capped. And higher prices will cap growth anyway. Therefore, they need to cap prices if they are to return the focus to growth. But what really matters is what the market thinks the Fed will do rather than what the Fed actually does at the meetings. The market was pricing higher inflation long before the Fed turned hawkish, but it was only when the Fed turned properly hawkish, after a series of false starts, that we saw the most dramatic moves in bond yields. Because of all the weak data today, markets are now looking for the Fed to tighten less aggressively than a few weeks ago. Some of the expectations for 75 basis point hikes have been replaced with 50 basis points, but the Fed will still be tightening just at a slower pace. Over the previous 30 years, the Fed may have halted completely all reverse course at the first signs of stress. But during those time periods, inflation was under control, or it was the result of growth itself, which is not the case today. The problem for the market is that a pullback in yields, or a rally in equities helps to loosen financial conditions, and looser financial conditions increases the upward pressure on prices. To fully kill inflation, the Fed will have to tighten financial conditions a lot further. One way that they can achieve this goal is by letting the US dollar continue to strengthen. We've already noted that it's moved higher versus the Euro and some commodity currencies. And it's also been moving higher against a broad-based Emerging Market Currency Index, which is yet another indication that the growth concerns have gone global. The Tuesday move had seen a decline in this index of 2.5%, which is extremely sizeable. Even the Swiss Franc was weaker versus the US dollar. Very few currencies were spared in the initial stages of that day's dollar move, and a stronger dollar could also help to reduce imported inflation into the US. Though this will be at the expense of other countries, where their weaker currencies would have the opposite effect and increase the amount of imported inflation. U.S. policymakers may accept a reduction in global growth as a by-product of their attempt to control domestic inflation. The Euro and Sterling continue to look vulnerable in an environment where European energy prices remain disconnected for world benchmarks, thus negatively impacting trade balances, as we've already seen with Germany. The Japanese Yen should be even more vulnerable than these because of the Bank of Japan's commitment to a 25 basis points yield cap on the 10-year government bond. There are, however, large short positions being built in that market in anticipation that the BOJ won't be able to withstand the pressure of higher inflation. If they remove the cap, then the Yen could suddenly strengthen, making shorts on the Yen a difficult asymmetric trade, as we covered a couple of weeks ago.

    James [00:09:33] Amongst all that dollar strength on Tuesday, the Yen, interestingly, was relatively subdued. In the scenario where Japanese yields rise then so should other global yields, because for international investors, they're interchangeable. Higher JGB yields make those bonds relatively more attractive than the US, for instance, which might see capital sell out of the US, and buying in to the Japanese market. So, although many bond yields have started to price a global slowdown, there are still inflationary risks that remain because of this potential JGB dynamic. US and European yields that have been falling due to growth concerns can still rise due to an exogenous shock from Japan. But the main reason why we're unlikely to see a reverse from the Fed is that they're still concerned about energy and food prices, which are working their way through the system. Gasoline prices have declined from their highs, but not sufficiently so. Crude oil may decline further and bring about a peak in inflation. But these will still be taking a disproportionate amount of household incomes compared to 12 months ago, because real household incomes have been falling. Many of the structural issues within the commodity complex remain. This cannot be fixed by monetary policy unless it's so severe that it takes demand below supply. And given that supply is currently constrained, that would require a level of demand that is significantly below trend, and the Fed may need to engineer that if they want inflation to subside towards a 3% year-on-year level. If the US government also tries to combat the cost of living crisis with more fiscal handouts, which has been one of the primary reasons for this inflation problem in the first place, then an early turn from the Fed could easily fuel a series of inflation hikes like the ones we saw during the 1970s. Month-on-month US CPI is around 1%, but this needs to fall to around 0.2 or 0.3% on an average basis over a 12-month period for the Fed to feel more comfortable. Growth could even fall off a cliff whilst backward-looking CPI remains in the high single digits. So the Fed may still need to tighten into falling growth. And historically, the Fed have often begun to reverse course once the ISM manufacturing index has hit 45. However, the inflation of the 1970s was also about growth. Today it's not. It's about a rebound from low growth. And this time the Fed may need to keep going even when growth is significantly weaker. It's what they did in the early 1980s, when rates continued to rise even after inflation had peaked, and they remained rates vigilantes for most of the following decade. The current repricing of yields to a lower level is probably the right response to the weaker data. But if bad data becomes good for markets, then the Fed may need to remind investors that they are still focussed on capping price and not supporting growth with one more hawkish shock to rein in medium-term expectations. If you have any questions about this episode, the economy or financial markets, please put them in the comments section or send them to FMT@LSEG.COM