With central banks shifting towards accepting that monetary tightening is impossible without some economic damage, the market narrative has swung 180 degrees this week – and indeed, that wind direction change has taken place in real-time.
Rather than sticky inflation, the market is now panicky about slumping growth. You can roll out various indicators like the weaker PMI and ISM prints, which point to a consumer-driven economic slowdown. Still, the big differentiator is Germany's energy problems.
The markets now fear a significant deceleration in Germany against the ECB's intent on raising rates triggering thoughts of a global contagion risk emanating from Europe's industrial powerhouse diving headlong into the economic plunge tank.
And with central banks willing to hike into the perfect financial storm, cracks in consumer demand will surely widen and cut deeper worldwide, which could exert significant disinflationary forces if the central banks act too aggressively for too long.
In the meantime, central bankers are entirely willing to accept economic damage as the price for slower inflation. US inflation is back in line but at the cost of a scorched consumer demand policy. Powell and company left it too long to chase down inflation, and now growth is slowing at peak hawkishness.
When the Fed chair uses terms like " pain " and repeats the phrase "the clock is ticking," he sends a very deliberate signal, basically telling us there is less of an open playing field for the Fed to sprint to the finish line. The Chair is well aware of the political and public fallout to come, so the frontloading of rate hikes makes sense both in terms of not allowing inflation expectations to de-anchor and when public and political pressure is minimal. And the hope is that by the November midterm elections, when the economy has chilled enough, it will be possible to pause or at least significantly slow further hikes to allow investors to enjoy a Santa Claus rally; otherwise, it could be a winter of discontent.
In the meantime, there will be little breathing space for risk markets until rates price meaningful rate cuts representing how economies can bounce back from a short recession. Indeed, a southbound central bank pivot is probably the only catalyst runway to get us out of this mess.
Oil prices pressed down after US President Biden said he would ask the Gulf Alliance to increase output. WTI is down about $9 from Wednesday's high. The inter-week collapse in oil price reflects growing recessionary concerns and risk-aversion. The general sense is that oil has overheated amid mounting consumer recession risks that seem to be putting a cap on near-term prices. And with energy bulls having a good run this year, investors seem more inclined to take money off the table in the face of growing uncertainty as the energy crisis moves onto the global recession phase. As the adage goes, the best cure for high prices is high prices.
The Uniper news is a confirmation of a fear. German and Italian governments are hastily reloading the fiscal bazookas to attenuate the worst for the average person. In that light, the fragmentation plan is now critical to calm sovereign debt fears – if underwhelming, the BTP spreads are vulnerable to another attack, and so is the EURO.
The market seems to assume that ECB PEPP reinvestments will be used to buy periphery today – BTPs in particular. It does not make sense; then again, anything the ECB does tends to come with conditional question marks.
I expect BTP spreads to widen once the market realizes the tool is an insurance policy that would only kick in at 250-300 bp for Italian spread. So, despite the EURCHF jumping above par at the 16.00 London cut-off, indicating rebalancing flows, the short EURCHF will cover the ongoing market pain.
I feel safer pivoting to China this week and long CNH on the China reopening vibe.
Honestly, the best place is cash under the mattress right now; however, the Yuan could offer a safe harbour while the street tries to figure out the cleanest dirty shirt in the Forex laundry basket.
But importantly, it is back to basics and tracking consumer data which is improving in China and weaker everywhere else.
And to a large degree, the next 5 % move in the US dollar could be a function of just how resilient the US consumer is, which will be critical to a not-so-hard landing in the US economy.
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