Roger [00:00:00] A better than expected US CPI print last week, followed by a softer PPI print this week, has propelled the US dollar to much lower levels, extending its losses since the September highs to over 8%. So does that mean that the peak is now in for the dollar? And what would that mean for the Fed? That's the Big Conversation.
Roger [00:00:25] Now, there's always been this debate about the dollar in which the level of the dollar is often confused with the relevance of the dollar. The relevance of the dollar may decline, but that doesn't mean that the value of the dollar necessarily will and vice versa. Today, amongst other things, we're just going to be looking at the short-term drivers of the dollar rather than the implications of a structural change in the global dollar payment system. But first, we should look at the current context. The dollar index had already been on the back foot after hitting the 15-year resistance two months ago. This move, however, accelerated lower with the release of the US CPI. The headline level came in at 7.7% versus 7.9% forecast, and it showed a narrowing of the number of components contributing to higher prices. Prices are starting to move in the right direction, and the Producer Price Index has dropped 8% year-on-year, having been in double digits only a few months ago. That said, however, core CPI has only marginally pulled back from its recent high and it's not the peak that matters, but the speed of the potential retracement. There's still a long way to go before core CPI will reach the current Fed target of 2% and it will require some very impressive month-on-month declines if it's going to reach acceptable levels by the time of the pivot that's currently priced into the Fed funds future for Q2 of 2023.
Roger [00:01:51] According to the Bank of America in developed countries, it has usually taken 4 to 6 years for inflation to drop back to 2% once it has exceeded 5%. The market is looking for the Fed to pivot in just 6 to 7 months’ time. Furthermore, futures have been pricing out a few basis points from the Fed's terminal rate, and this has helped other risk assets rally, most notably the 7% gain for the Nasdaq on the day of the CPI release last week, with some of that momentum continuing in subsequent sessions. But has the dollar moved too far too fast? And could this now be counterproductive? Whilst we have seen yields across the curve retreat from their highs, they have not been as dramatic as the move in the dollar. The decline in the implied Fed Funds future for May 2023 is a shadow of the move in the dollar index. Longer-dated yields have dropped, but once again the dollar has moved far more dramatically than bond yields. Of course, this may be about to change with the dollar being the lead indicator. And some investors have already been adding calls to the long bond ETF, the TLT. And the differential between European and US nominal yields, and also European and US real yields are currently not an obvious driver of dollar weakness either. The spread of the US yield versus German yields has declined but remains within the one-year range. And although the pullback in the dollar and the rally in the Nasdaq looks like a wholesale recalibration of a potential Fed pivot, not all assets have followed their lead. Also, the move in the equity market has been accentuated by a surge in options activity. Huge volumes of put buying have been taken as a contrarian indicator, but the informational value from these positions may be different from previous periods. This is because many of these are one-day to expiry options. Actual open interest in puts and calls has not reached new highs, and put open interest is still below call open interest suggesting that many of these puts are open and closed on the same day. Excessive put buying has quickly swung back to excessive call buying. Both retail and institutional traders have been fueling this trend. Twice in the last month we have seen extreme intraday equity moves. The first was the reversal on October 13th. The second was a 7% gain on November 10th. In the first instance, retail had bought puts, which started off in the money after the market sold off on a stronger than expected CPI print that month. As the retail traders sold the puts to take profits, it helped fuel the rally off the lows, which then led to a scramble to monetise these positions before their paper, profits evaporated, followed by a surge in short-dated call buying, which then supercharged the rally. Last week's CPI rally was similarly accelerated by a proliferation of call buying that drove the index to new highs. The overall sell-off in the equity market has seen more high option volume rallies than it has seen high cash volume lows. And that in addition to the index and sector rotations that we've seen, rather than correlated declines across all equity markets, has many of the characteristics of a topping process rather than a classic bottom. And all this price action, rallying equities, declining yields and a declining dollar creates a real problem for the Fed. It will help to loosen financial conditions, which in turn will help support future growth and therefore prices. And the more than market prices a pivot from the Fed, the less the Fed is likely to actually pivot. But the market is anticipating an economic slowdown that should lead to rising unemployment and the decline in CPI. The two have usually taken place together with rising unemployment leading the peak and decline in CPI. But if the Fed pivots too early, they run the risk that the slowdown that is expected to cap prices will not actually take place as quickly as hoped for. And this might force the Fed to become more belligerent at a later date. And this brings into focus what we mean by a pivot. A slower pace of rate hikes is not a pivot, and a pause is not a pivot. A pivot is a full reversal in rate hikes by the Fed. But is that realistic in the next 6 to 7 months? It looks like it's going to be a race between a decline in CPI and an increase in unemployment. CPI has historically peaked during the recession and whilst there have been two quarters of negative GDP growth in 2022, this year has been a price shock and a readjustment of financial markets rather than a broad-based economic shock. Many households and small businesses are in a recession, but this slowdown has not had the depth, duration or diffusion that defines an NBER recession. For that, we need to see unemployment pick up. But if we look at some of the very backward-looking data points, such as payrolls, we can see that there is still a long way to go before payrolls data is commensurate with recessions. Now, this will surely change, with the tech sector now shedding jobs at a rapid pace and the transport sector starting to normalise after the post-pandemic boom. But with labour markets still relatively tied to the moment, how likely are the Fed now to pivot before they've completed the job of containing inflation? The repricing of rates this year has already caught a record breaking sell off in the bond market and substantial losses in equities and other assets. But after tolerating these losses, will the Fed want to reverse course before they've capped prices? They've recently highlighted their 'Humpty Dumpty' policy whereby they think it's easier to put broken markets back together again than it is to put the inflation genie back in the bottle once it's escaped. And the Fed's Neel Kashkari recently highlighted this point at the Ness School of Management and Economics in Dakota. He explained that the Fed would consider supporting growth if employment was in clear conflict with price. If 2% is their price target and 4% is their unemployment target, they would be in conflict if both were, for instance, 50% above those targets at 3% for CPI and 6% for unemployment. Currently price is at 7.7% and unemployment is at 3.7%. There is currently no conflict. Price still needs to be brought under control, not just capped. The Fed has historically taken their target rate above the level of core CPI to combat inflation. Currently, the target rate is well below core CPI. Now they could wait for core CPI to drop to their target rate. Or they could continue raising rates until they create sufficient unemployment to take the heat out of what is still a tight labour market. So when will the Fed pivot? Will it be in anticipation of a real economic slowdown? Or will it be when the economy is actually clearly in a slowdown? Or will they keep tightening in order to manufacture a slowdown? Pre-emptive pivoting has not been the Fed's forte, though they have often pre-emptively paused. But let's see how that's turned out. On previous occasions when they have paused, shown here is a vertical black line, there has sometimes been a reasonable amount of upside in the equity market, but we can see two very distinct time periods. The pauses in the period from 1985 to 2020, prior to recessions, were during the period of moderation during which inflation and interest rates were generally in a downward long-term trend. Now, if we zoom in, we can see that the pause often preceded further gains, but the actual pivot to lower rates was at or after the peak in both 2000 and 2008. Equities saw further declines after the pivot and recessions invariably followed, also after the pivot. Now moving to the 1970s, we can see a very different setup. Here the peak in rates took place within the recession and on two occasions there was still considerable downside in the S&P 500. Today, we are clearly in a period of higher prices and rising interest rates, much more akin to the 1970s than that period of moderation from 1985 to 2020. And what has really mattered for the equity market over the last 50 years is recessions. The S&P 500 either made a low or was on its way to a major low through every recession since 1970. This is partly because of the indiscriminate selling that has arisen from households selling assets to offset the loss of wages or the potential loss of wages, as well as ingrained belief that equities should struggle during an economic slowdown. However, it's never quite that simple. We can't just wait for a recession. Because recessions are usually identified in retrospect by the NBER. On Twitter. Mark Ungewitter has pointed out that whilst the S&P 500 has bottomed into or after all recessions, it was usually much closer to the lows by the time that the NBER actually announced retrospectively that a recession has occurred. So are we therefore currently in the depths of a true recession today? Well, that's very unlikely. ISM manufacturing is currently above 50 and it's usually around 45 during a recession. So far, corporates have maintained margins, but these may now be under pressure because of inflation beating wage demands being negotiated in the public and the old economy sectors. And if margins come under pressure, companies will either raise prices or cut jobs, or maybe even both. And that suggests the recession is still ahead of us. And as we've seen before, when looking at unemployment and initial jobless claims, recessions usually take place as claims and unemployment are accelerating higher. So far, claims have hardly turned. Again, revisions may become a factor, but it appears that we are still a long way from the levels of unemployment that are commonplace during normal recessions. Will CPI drop fast enough for the Fed to be able to ease off on the rate hikes? Well a tight labour market will threaten higher inflation. Therefore, the Fed may want to hold its current course. Despite the comments from the devilishly aligned voting member Brainard, Powell remains hawkish. And with the midterms out of the way, may be comfortable continuing to frontload the hikes. And all of this comes back to the dollar. If the dollar drops too fast, it may rekindle the old dollar / commodity correlation from 2000 to 2020, where a weaker US dollar leads to higher commodity prices. The current pullback in CPI and PPI is largely a function of base effects from commodities and the goods that they've fed into. But if commodities, especially energy, starts to run higher again, then month on month comparisons could start to become troublesome once more. Julian Brigden of MI2 Partners has recently shown the relationship between New York Harbour Diesel and US PPI. If diesel rebounds, so could PPI. And if the US dollar declines in value, there is a greater chance that commodities like diesel will rebound. Therefore, a declining dollar is a double-edged sword. It helps commodities rebound and it also increases the level of imported inflation. The Fed will therefore be nervous about letting the market get too excited about a pivot because it could undo much of the work they've done. Whilst the dollar index has experienced a significant amount of technical damage, we should still be wary of a rebound. Powell may maintain his hawkish stance and again disappoint the doves. And even if the economy is beginning to turn, we also have to be aware that the dollar usually rallies during a global recession. Recessions may be a consensus, but that doesn't mean they won't happen. And on the other side of the dollar, at the same time, we've got some very structurally challenged currencies. The Eurozone might be having some respite from the energy crisis given the warmer weather and the refilling of gas storage, but this is still a structural energy short that will probably continue into 2024. And the UK has a similar position. The pound may be justified in recovering from the shock of the Truss and Kwarteng budget, but deficits and austerity will continue. And Japan is still structurally diluting its own currency via yield curve control. Now, obviously, the pull-back in global yields helps, but inflation is also starting to weigh on the economy, where GDP growth has turned negative. And whilst China is attempting to support its ailing property market, the much vaunted reopening is still a mirage rather than a reality. When China does reopen, it will also put upward pressure on energy prices, which could again push US inflation higher. Therefore, if there is a US recession ahead, there is a good chance that the dollar makes another high. Obviously, that might depend on the severity of the recession. But if financial markets, think that the Fed can pivot and the subsequent reaction from asset prices may require the Fed to tighten harder to prevent consumer prices from rebounding. This is what happened in the double dip of 1980 to 1982. Inflation didn't fall quickly enough and the Fed tightened more aggressively. The dynamic, which is currently allowing the dollar to decline, may therefore become the very reason the Fed needs to tighten harder and push the dollar higher until the level of consumer prices begin to conflict with the level of unemployment. But that is not yet the case today.
