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The Big Conversation

Episode 141: Will a rally prevent a pivot?

This week we're asking the big question on everyone’s lips right now: “Are we about to see capitulation in markets?" With the help of Refinitiv’s exhaustive data, the answers lie in keeping a close eye on measurements such as unemployment, consumer sentiment and the ISM. But keep an eye too on the correlation between assets, because that can be a very good sign that we are teetering on the edge. 

  • Roger [00:00:00] Over the last couple of weeks, we finally started to see things beginning to break in the market. The resulting anticipation of a Fed pivot, backed up by weaker than expected ISM survey data, has led to a rally on bonds and stocks. But if the market pivots first, does that actually buy policymakers more time to tighten further before they hit the pause button? That's the Big Conversation.

    Roger [00:00:29] The UK government looked down both barrels recently when the market was driving down the British pound and the price of government bonds, called gilts, at the beginning of last week. Many central banks, like the Bank of England, are currently caught between a rock and a hard place. The policy required to cap inflation is undermining assets. But the pivot to protect assets could help keep inflation elevated, requiring more aggressive policy to cap prices. In the UK attempts to dilute the energy and cost of living crisis with additional fiscal support could actually increase the chance of more inflation. Fiscal support during COVID was one of the reasons that we had inflation in the first place, along with restricted supply and obviously the shock of the Ukraine war. But for countries like the UK, already saddled with debt, spending their way out of the crisis with no obvious source of generating offsetting revenues is going to put downward pressure on those bond markets in anticipation of more issuance and potentially the inability to meet those future IOUs. Furthermore, issuing more debt will push bond yields higher, and in the case of a country that could struggle to repay that debt, the currency could weaken further. A weaker currency then increases the cost of imports and specifically the energy requirements, which therefore could add to the cost-of-living crisis. And that dynamic created a vicious spiral of de-leveraging in the UK that posed a severe threat to the pensions industry, which had levered up in an era of lower yields in an attempt to hit their investment targets. The solution provided by the Bank of England was to buy bonds and try to cap yields on the 30-year government bond. And although this is a form of QE and that these are asset purchases, this was a necessary attempt at stabilisation because of the disorderly surge in those yields. And whilst the initial reaction to this was a relief rally on both bonds and the British pound, primarily because it stopped the rot, and the notional amount of bond buying has so far been relatively light. This is still a structurally short position on the currency. Open ended fiscal support for the economy and potentially open-ended bond buying, even though a maximum figure and an end date have been provided, require more bond issuance and potentially more money printing, even though QE in its various forms does not necessarily lead to more currency in actual circulation. And this is what we've seen in Japan, where yield curve control has weakened the Yen versus the US dollar, forcing policymakers to intervene with Yen buying for the first time since 1998. And even with this in place, uS Dollar Yen has been re-testing the highs. Whilst the UK is firmly in the spotlight, similar policies are being pursued in other regions. The need to offset higher energy costs in Europe has also seen the euro decline through parity versus the US dollar. And this is the same dynamic that we've seen playing out on the British pound, though the policy response from the eurozone has not yet been as explicit or as large as the one from the UK. But since the Bank of England intervention, we have seen most of these currencies rebound, and part of this rebound was because of the big resistance level in the dollar index at the time when bets from the professional community had started to reach extremes. Add to this the anticipation of a Fed pivot that has emerged since the surge in bond yields, and markets are trying to stage a recovery. But if the market pivots, then the Fed doesn't need to. If the Bank of England and the Bank of Japan are intervening, then the relief rally again reduces the need for the Fed to change course. And even the Reserve Bank of Australia has provided additional expectations of a pause, with a smaller than expected hike of 25 basis points when 50 was expected. But we should note, hiking at a slower pace is not a pivot. It's not even a pause. But if markets can pare back their rate hike expectations, then some relief should be expected. And this is what we've seen in the U.S. with Fed Fund futures rate expectations reduced by around 20 to 25 basis points over the last few days. Although the pivot to rate cuts is still expected around the end of Q1 2023. But right now, however, levels of financial stress are remarkably low, according to the St. Louis Fed model. Now, clearly, this is not a true reflection of the conditions that cause serious tremors through the UK's pension industry. But it is a factor for the Fed. Rising equity markets, falling bond yields and a pullback in the dollar all helped to loosen financial conditions, which in turn supports growth and higher prices. Meanwhile, month on month, CPI needs to come in at 0% for the rest of this year just to get headline CPI close to 6% by year-end. And that's well above the current target, though many expect that central bankers will eventually have to give up on their 2% targets for something much higher. And as we discussed back in July, we should be careful what we wish for. Positive price action from the markets in anticipation of a pivot increases the chance that the Fed won't need to pivot at all. When the Fed relented in 2018 and 2020, they did so into the lows, which were much lower down than today's levels. There is no need to pivot if markets are already rallying. And for the Fed, the unemployment outlook and wages in particular are part of the problem. Workers are now demanding higher inflation, beating wages, and they are not looking at market-based inflation expectations for wage demands, but CPI. Whilst the market is fixated with break evens - which are used to calculate real yields on bonds - the real world is fixated with actual inflation, even though this is lagging. And these are significantly higher and core inflation CPI reaccelerated last month. We can think of the decline in market-based inflation expectations as similar to the sentiment of bearishness in the Bank of America surveys. These are all professionals voting about the markets and the economy and what they expect the Fed to do to save Wall Street. But at the moment, the Fed is focused on Main Street. Wage negotiations will define the ability of core inflation to return to normal levels, with many unions now demanding double digit increases, this appears unlikely in the near term. And it's wage increases that will eventually feed through to either lower corporate margins or higher levels of unemployment if corporates try to preserve their margins. Historically, inflation has only meaningfully come down during and after a recession. Historically, recessions have been defined by large increases in unemployment. That's one of the reasons for the declines in inflation. So far, there has not been a meaningful pickup in unemployment. That suggests that the main recession, the pickup in unemployment and the lows in the equity market, are still probably ahead of us. And that's because the lows in the equity market are not caused by fears in financial markets, but by fear in the economy - which is the fear of losing a job or future income stream and the need to sell assets to offset a shortfall in incomes or mortgage repayments. That's when we get the redemptions and the liquidations that drive correlations across equities and sectors towards one. Which is when we get the panic lows and these nearly always occur within a market that is already oversold. And this process has not started yet. That's in the future. The massive decline in job openings released this week suggests the jobs market is beginning to turn. But this is a very slow process. And if we get a pivot today before events that usually bring inflation under control, those if they haven't properly begun, then the risks are that wage increases will continue to come through and inflation will remain sticky. The market would then need to re-pivot back towards tighter conditions if inflation persists. In the 1970s, the most persistent inflation came when the Fed pivoted too early in response to a drop in equity markets. As a result, that era saw repeatedly higher peaks in inflation until it was finally tamed by a combination of money supply control and higher interest rates. Historically, the Fed has always raised interest rates above the prevailing level of core inflation in their attempt to bring inflation under control. Currently, US interest rates are still below core CPI. Will the Fed wait for inflation to come to them or will they be more aggressive in meeting inflation head-on? While today's expected rate hikes are causing problems for financial markets, stepping off the gas could allow inflation to rebound and then the problems would still require an aggressive response in the future. That's unless a major recession is already underway. But whilst ISM has drifted lower, unemployment levels suggest that the main event is a story for 2023. It's the job losses and recessions that usually define the lows in the equity market. But can a recession be avoided? Well, that depends on what type of recession we're talking about. Currently, the huge losses of wealth in financial markets could create a contagion effect if they're not brought under control. And that's what the Bank of England was attempting to halt with its bond-buying programme. In this hyper financialized world, losses across risk assets could lead to a full-blown recession. But if we avoid recession now, it will embolden wage negotiations in the future, which will help to embed higher prices in the economy. And that will still require the attention from the Fed, but it may take a bit longer. And that would suggest a pause rather than a pivot if indeed, the Fed is even feeling charitable today. Maybe the employment situation today is structurally different to what it was pre-2008. Well, that might be the case. Today's labour market does appear to be tight, but it may not be strong. At least it wasn't strong when workers were receiving negative real wages. Therefore, the nature of today's labour market will not put an end to the demands for higher wages. That will only come once unemployment has risen and puts employees on the back foot once again. And that's the time when you get the unemotional redemptions that drive equity markets into their lows. But there are always risks of markets ripping higher in the short term. The 2000 to 2003 equity bear market was extremely difficult to trade, because the numerous double digit rallies along the way. Each one came with a feeling that this one could be the last. And what some institutions are therefore doing today is looking at hedging their underweight equity positions with call options on the index. The last rally from current levels, which took place in Q3 and reached a 200-day moving average, was just above 4300 on the S&P. The 200-day moving average is now at 4200. The main November expiry on the S&P is on the 18th of that month, and that gets us through the next FOMC meeting, which takes place on the 2nd of November. Despite relatively high levels of volatility, call options are fairly priced. For instance, a 4000 strike has an implied volatility that was indicatively early around 23 on Tuesday the 4th of October, the 30-day realised volatility of the S&P is around 27. So it could be argued that these options are around fair value, and institutions have been active in the options market in both directions because implied volatility has been relatively well behaved throughout this year. And what about the dollar? Well, whilst a Fed pivot should see a pullback, this still looks like a technical pause at key resistance. Professionals may be long, but policymakers in Europe and Japan are stuck with structurally short positions if they're combating higher energy prices or trying to cap yields in the bond markets. All the time, this could encourage the Fed to maintain their hawkish stance, despite protestations from the UN and the IMF in recent days. And bond yields may now be capped by the actions of the Bank of England and the Bank of Japan, but those bond yields normally see the most emphatic declines during the depths of recession. And so far, the US slowdown has been neither deep nor diffuse. Therefore, as we discussed previously, the real market lows still look to be ahead of us. A relief rally may well be underway, but the Fed is unlikely to pivot if the market has already pivoted for them. Pivots come from a point of pain and not a place of pleasure. In fact, the more the market pivots, the more the Fed can maintain course until something breaks domestically. So far, most of the breaks have been overseas, and that is unlikely to bring US wage inflation under control anytime soon.