It's always about liquidity

Markets

Ahead of a gaggle of Fed officials this week, there is some thought that "Fed Speak" could attempt to reconnect the market's rate cut expectation with the reality of a sticky 3 to 4 % one-year inflation outlook, so the primary question that has seemingly come to the forefront is whether interest rate traders have assessed the inflation situation accurately. Although given the holiday-infused nature of yesterday's market, “If a tree falls in a forest and no one is around to hear it, does it make a sound?

Recent updates on employment and inflation, culminating in an unexpected drop in producer prices on Friday, have led markets to assign an 80% probability of initiating rate cuts in March. This development has driven benchmark US two-year note yields to their lowest since May. Notably, this trend persists despite Federal Reserve officials expressing support for a more gradual pace of rate reductions throughout the year.

Indeed, the current market pricing indicates anticipation of nearly seven rate cuts in 2024, driven by the belief that the disinflation process is firmly entrenched and unlikely to be easily dislodged. It's essential to recall that the market consistently underestimated the Federal Reserve's willingness to raise rates during the hiking cycle. So this prompts a straightforward question: Is the market now overestimating the Fed's readiness or capacity, particularly in the context of prevailing inflation dynamics, to implement rate cuts over the next 12 months?

As long as the current standoff persists, the financial markets may experience some whippyness. The uncertainty stemming from this divergent policy tension is also reflected in the realm of economists, where diverse forecasts for longer-term yields contribute to a lack of clear consensus. Indeed, many economists still think the Fed's restrictive monetary policy has some more wringing out of inflation to do, and hopes of an early monetary policy easing may be premature.

In this holiday-shortened week, the Federal Reserve speakers and a lighter schedule of tier-one economic data are not expected to shake the current narrative too much. But if the market veers off the dovish script, it will trigger a highly volatile inflection point.

Still, there is likely more to the Fed's mechanical rate cut thinking than meets the boilerplate.

"The dial hasn't moved much on March rate-cut expectations. Such a reaction looks consistent with a theory that I put forward this week — that liquidity, i.e. reserves, have become the Fed's primary de facto reaction function."

— Simon White, macro strategist( Bloomberg) 

As we enter 2024, particularly in terms of liquidity, it looks much different than 2023, especially with the supportive nature of the reverse repo fast fading this year due to its extensive draining. Additionally, the Bank Term Funding Program (BTFP) is slated to conclude in March, and the prospect of an extension remains uncertain given the relaxed financial conditions. 

Not only could the Federal Reserve cut interest rates aggressively ( 100 -150 bp), especially with disinflation entrenched in the PCE pipeline, but it could halt the balance sheet runoff as a precaution, especially with the liquidity tailwinds from 2023 quickly receding. Perhaps the Fed wants to avoid at all costs sudden and unexpected liquidity issues that could cause Black Swans to flap.

 Lorie Logan, in a speech on January 6, emphasized the potential difficulty the Fed may face in taming inflation amidst easier financial conditions. However, she also initiated discussions about slowing Quantitative Tightening (QT), indicating the importance of considering parameters guiding the decision to decelerate the runoff of assets as the level of Overnight Reverse Repurchase Agreement (ON RRP) balances declines.

Logan stated, "While the current level of ON RRP balances provides comfort that liquidity is ample in aggregate, there will be more uncertainty about aggregate liquidity conditions as RRP balances approach a low level. Given the rapid decline of RRP, I think it's appropriate to consider the parameters that will guide a decision to slow the runoff of our assets."

The current market landscape has significant US election, global geopolitical and macroeconomic tail risks. Therefore, it's not the time to become overly complacent. The intricate political and geopolitical challenges could impact consumer sentiment, holding it hostage to the complex nature of uncertain dynamics. Policymakers, companies, and investors could struggle to navigate through a highly politically charged environment, adding an extra layer of complexity to their operations and decision-making processes.

Asia markets 

Given the economic challenges the country is grappling with, China faced a pivotal moment on Monday as the expectation was for a rate cut. Consumer prices have been stagnant in favourable months and flirting with deflation during unfavourable ones, with the last three months of 2023 proving challenging. Despite economic reasons supporting a rate cut, including a sluggish economy, a property crackdown, and lacklustre consumer sentiment, the People's Bank of China (PBoC) chose not to cut rates. This decision, reflected in the unchanged one-year MLF rate, leaves room for speculation on the central bank's approach to monetary policy amid ongoing economic uncertainties

The People's Bank of China (PBoC) decision not to cut rates, despite broad expectations for the first Medium-Term Lending Facility (MLF) cut in five months, indicates a complex economic scenario. One possible reason could be the reluctance to send a premature signal ahead of key data releases this week( Maybe they know something we don't_. Additionally, despite the potential inflationary benefits of a weaker Yuan, Beijing might strategically align any further rate cuts with potential moves by the Federal Reserve, aiming to minimize the impact of broader rate differentials. The consideration of bank margins and the realization that cutting rates may not stimulate demand significantly amid a sluggish economy contribute to the nuanced decision-making process.

The challenge for China lies in the need for fiscal stimulus, mainly when policymakers can't squeeze juice from the private sector, necessitating state intervention to drive productivity. And there is no guarantee that big China QE-styled fiscal will shake the trees significantly to drive consumer growth.

Following Wall Street's bullish recommendations, foreign investors purchased Mainland stocks during the final weeks 2023. However, in the initial two weeks of 2024, these investors reversed their position by selling more than $1 billion in A-shares.

China has been uninvestable for some time, in my view. The crackdown on the internet sector and concerns about contagion risks in the property sector have cast a shadow over the mainland's consumer sentiment. The worry is that this sentiment may have been irreparably damaged, or at the very least, it will take years to recover.

As the focus shifts towards the US election, heightened attention on China's security issues is expected, particularly in the semiconductor and chip sectors. However, it would be a mistake not to consider Taiwan a potential major global destabilizer. The potential ramifications of such a flash point scenario could wildly disrupt the global landscape, deviating significantly from anticipated trajectories. Given the market's existing challenges, this uncertainty is a significant concern, even when navigating within the expected parameters of a flash point is an unlikely scenario