1. The Fed dots versus market expectations
By far and away the biggest battleground for financial markets in 2023 will be in the US rates space and who, if any, of the two sides will prevail. Powell made it clear back in December, in both his statement and press conference, that the Fed was not for turning and rates would continue to rise in the US albeit in a slower fashion but they would reach a higher terminal rate than previously thought and for a longer period of time. The updated Fed dots, which were released at the same time, showed a subsequent uptick in the terminal rate to 5.1%. Given no rate cuts are anticipated by the Fed next year 5.1% will also be the 2023 year end rate. For reference 10/19 FOMC members saw 5.1% as the terminal rate but remember 7 members anticipated higher levels. The market once again is not keen to take the bait and is firmly of the belief that a recession is coming down the tracks and hence the Fed will have to cut rates and subsequently, they see a 2023 year end rate in the mid 4% range.
Another couple of points to bear in mind; the inflation trading community is looking for a 3% print for inflation in the summer of next year and looking back at the Fed dots from the December 2021 meeting the Fed saw a year end rate for 2022 at 0.9% and we shall close the year at 4.5%!
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Something has to give then. The market has played the Fed pivot trade three times this year with little success and, given the disparity between the two year end projections, it looks set to take the same trading strategy into the new year.
The market has had much encouragement in its way of thinking, with the majority of Wall Street forecasters and fund managers looking for a US slowdown in 2023 driven mainly by a strong uptick in the unemployment measure, in line with the Fed’s way of thinking, into the mid 4% region from the current 3.7%. The labour market and how it reacts to the lag factor of the Fed hikes throughout 2022 is where the battle will be won. The market has long anticipated a correction in the labour market and, as we have said many times this year, they continue to undercook their monthly NFP forecasts. The Fed will not turn until either the labour market turns or something breaks in the financial system. The latest NFP headline prints still remain healthily above trend and initial claims continue to show no sign of a turn either. Wage growth remains around the “unhealthy” 5% mark and job openings still easily outflank the numbers seeking work. If this trend continues the market is going to continue to bet on losers.
History tells us that short-term US rates always have a higher top than the Fed’s terminal rate, so on that basis, US yields have a lot further to climb. If the Fed is right and the economy is not going to hit a recession, or at the very most a short and shallow slowdown, then longer-end yields should equally climb and at a higher rate than the short end closing the inversion somewhat. If the market is right, then the spread between US2y10y should remain inverted for sometime yet and even widen.
What If they are both right? The Fed keep on hiking and get to 5/5.25%+ as the labour market remains tight and inflation sticky throughout the year, but as we hit the autumn months the “lag factor” kicks in and the key data points start to turn sharply with rate cuts priced in aggressively for the start of 2024? It’s certainly one potential outcome.
My view is that the Fed will over tighten and get to 5.25% but remain stubborn to pull the trigger on a full pivot. The market then gets more aggressive on its cutting cycle pushing their year end rate to 4% and below with the Fed subsequently joining the party in the autumn but remaining well behind both the curve and market expectations.
Remember this is the furthest and fastest the Fed have hiked in anytime in their history. If you also look at the Fed rate hike/cut cycles one thing to note is that the Fed take the stairs up and the lift down in terms of rate changes. In other words, on their hiking cycle they tend to hike slowly and over a more prolonged period of time whilst the rate cutting cycles tend to be shorter and more aggressive in nature. Agreed this cycle has been different as the Fed has had the backdrop of the pandemic and QE to contend with as well as getting delayed by all that “transitory” chat. So perhaps this cycle they have taken the escalator rather than the stairs up but that lift option for the way down looks like it could be getting exercised especially if they over tighten as the market is anticipating and indeed some of the recent Fed speakers have alluded to. 100bp rate cuts anyone?
Blockworks - The Fed will tighten "as far as they can"
ZeroHedge - Fed making things up as it goes along
2. China reopening
China reopening was something we felt would not happen as swiftly and hold as it has, and we hold our hand up on that one. We were surprised that, after the Party Congress had shown no willingness to change tack, the country wide demonstrations, after the fatal apartment block fire in Xinjiang Province, which called for an end to the Covid zero policy, seemed to be enough for the government to about face.
December 26 saw further lifting of restrictions, and to all intents and purposes, borders have been reopened and quarantines lifted with the obvious increase in deaths and infections. It certainly won’t be smooth, and it will take a period of adaption by the population as it starts to emerge and “live with” the disease. It cannot be denied that this is a major step towards a full reopening, and the authorities will be keen to see how the country comes out of the Lunar New Year holidays towards the end of January. Figures for fatalities and the infection rate over that period will make for interesting reading, as will how the medical services cope with the inevitable fallout from the holiday period.
Equally, the transition will not be straightforward as China starts to face the rest of the world with already restrictions being put in place for Chinese travellers in other countries. The US now insists on a negative test pre flight for inbound flights from China. Whilst Milan has been hit with 50% of inbound travellers from China carrying the infection. Japan also has tightened its border policies for inbound Chinese passengers. It won’t be an easy process.
If they can manufacture a successful exit of sorts, then it will certainly give a fillip to both domestic and global growth. However, the ailing property sector remains a major worry but needless to say, the Chinese authorities will manage to extract a 5% growth rate for the coming year one way or another. Whether it’s real, via consumer spending or forced, via government infrastructure spending is another matter.
My view is that China will start to emerge, but it will take time, particularly post Lunar New Year, where a further spike in cases is surely inevitable. This will have a subsequent lag on growth which will have to be eased with help from the authority’s purse strings. However, once China emerges from this period of adjustment, we should see a real positive uptick to growth. The downside to that, of course, is what implications that has for the global inflation profile!
An extreme worst-case scenario would be a post Lunar New Year spike which overwhelms the Chinese medical services and infrastructure. This subsequently hits China growth dramatically and pushes the world further into a global recession. The governing party is seen as weak and President Xi, as a distraction tool, becomes more aggressive towards Taiwan and subsequently brings forward his plans to “repatriate” the country.
Macrodesiac - China the Key for 2023
3. BoJ transition
Lot of talk on the BoJ of late after their surprise raising of their cap on the 10y yield to 0.50% just before Christmas. Subsequently, in the minutes of the meeting, they described the adjustment as a technical measure to allow the bond market to function better. However, the minutes also alluded to rising wages which have previously been noted as a possible factor in any change in monetary policy. Truth of the matter is it looks more and more likely that the Bank realised they had an unsustainable policy which had to be lifted at some point and by doing it in such a manner they could try to “control” any market fallout. One other point of note would be the debt/GDP ratio in Japan, which remains unsustainably high. Higher rates will ultimately have a major knock-on effect as to Japan’s ability to finance such a debt mountain.
Of course, before all this the market had anticipated a potential change in tack in BoJ policy with the changing of the guard this year, at the BoJ, as Governor Kuroda is due to step down at the end of the financial year in March. The uber dove’s replacement can only be more of a hawk than his predecessor the question remains though; how hawkish? This comes as the Deputy Chief Cabinet Secretary Kihara declared that the government’s focus in the coming year will be achieving wage growth, especially with inflation on the rise. Prime Minister Kishida has also expressed an increasing willingness to move away from the “Abenomics” reflationary policies of the past several years.
On the succession note, a former deputy governor of the BoJ and long time critic of Kuroda’s stimulus package, Yamaguchi, looks like he is throwing his hat in the ring for the top job. In a recent speech, he encouraged the BoJ to make its monetary policy framework more flexible and to prepare to raise its long-term rate target next year so long as this does not jeopardise any Japanese economy revival.
All the ducks seem to be aligning with the tweak to the upper band for 10y, a change of leadership in the BoJ and a government onside. Who knows, we could even see a BoJ hiking into a Fed cutting cycle! Who’d have thought! 100 USDJPY anyone?
Project Syndicate - Is the BoJ holstering a bazooka?
4. UK economy
So the Sunak/Hunt show has managed to drag the UK back from the Liz/Kwasi abyss, but there’s a long way to go in terms of rebuilding credibility and repairing the UK balance sheet. Equally, the incumbents can do little about an incoming recession which seems to be hurtling towards us with the inevitability of a festive season family bust up!
The UK faces the same energy crisis backdrop as Europe but its labour market remains a lot tighter than its European counterparts in a large part due to the fallout from Brexit on the employment sector. The consequences for the UK are a higher interest rate profile from the BoE in comparison to the ECB. The BoE, believe it or not, were the first major central bank to start to hike rates and remain well ahead of the ECB in terms of rates. The December meetings saw perhaps the first sign of divergence between the two as the ECB were at pains to be as hawkish as possible as they hiked a further 50bps whilst the BoE, in hiking by the same amount, were much more guarded in their forward guidance outlook and indeed there were a number of dissenters, for such a magnitude of hike, on the committee.
The hope is that the Hunt “take 2” budget, as well as the monetary tightening by the BoE will tame inflation in the UK. The fear is, however, that the structural wage spiral may make inflation more entrenched, leaving the BoE with the unenviable decision of whether to continue to keep raising rates into an ever-deepening recession. My view is that they would be forced to do so on the basis that conquering inflation, with the subsequent negative effects on the economy, is the lesser of two evils when compared to allowing inflation to become more entrenched for years to come.
The other issue that stands out when you compare the EU to the UK is the housing market, where we find that the UK has a much larger proportion of homeowners in comparison to the EU. On top of that, a large proportion of these homeowners are very exposed to the BoE’s rate profile. It is estimated that 50% of the UK housing mortgages are on a short 2 year fixed term with a further 25% on variable rates. Obviously, this makes the UK housing market very sensitive to rate hikes with the inevitable double whammy of falling asset prices and declining disposable incomes.
The Covid saving mountain has slowly been eaten away over the last couple of years, with the UK household savings ratio dropping by two thirds over that period. That cushion and the Government’s Energy Price Guarantee will only have gone so far in padding out this year’s Christmas stockings. It feels very much like being a rough year ahead for the good ship UK which is already propping up the table on the growth stats in the G7. It feels to me like things will only get worse before they get better.
OilPrice - UK economy is facing an exceptionally tough year
5. European recession
Like the UK, rising food and energy costs, as well as the monetary hiking cycle, have pushed the EU economy into recessionary territory. However, unlike the UK, the labour market is not as tight and wage growth is not expected to spiral as much. Subsequently, the inflation profile is not as “sticky” as it would seem it is in the UK. Added to the fact that thus far, apart from the sharp cold snap pre Christmas, the European winter has been mild, with temperatures over the New Year period expected to be well above average temperatures. On that basis, are we set for a milder recession and a swifter recovery for the EU? The hawkish stance from the ECB would suggest that rates are set to continue to rise aggressively in the first quarter of 2023, but after that, the jury is out. Is it possible that as winter is behind us and the ECB pauses for breath, the green shoots of recovery across the EU start to show some signs of life?
The hard data out of Europe has held up relatively well, despite the surveys more despondent tone, and with a mild winter continuing, it is possible that the EU escapes the clutches of a deeper recession. Could you imagine Lagarde’s smugness if this comes to pass? Well, as the old trading saying goes; “better be lucky than good”.
There are obvious dangers to this analogy, with the most obvious being a further escalation in the conflict in Ukraine, leading to further energy and food supply chain issues. Equally, the ECB could over-tighten as they follow the Fed into the valley of death. Upside scenarios would of course be led by a ceasefire and peace initiative in Ukraine.
Whatever happens, any recovery will likely be anaemic at best.
Global Europe - European economic outlook
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1. A new pandemic emerges
A new global pandemic throws another spanner in the global recovery works. Perhaps as China reopens and starts to emerge, a new variant starts to spread worldwide. Less severe than previous but nevertheless extremely contagious.
Back to square one? Rate cuts and QE? Rushi’s Eat Out to Help Out gets dusted down? Hancock returns, post jungle, to the health department? Fauci delays his retirement? China reverses back into its zero policy?
Doesn’t bear thinking about, but surely some lessons will have been learnt by the powers that be that would make the experience a touch less painful than previous?
2. Putin out/Ukraine peace deal
As Putin digs in and warns of a long war, understandably, little is being made of the chances of some sort of positive resolution to the conflict in Ukraine. The two possibilities I consider are both positive for markets although the removal of Putin, one way or another, would be a turbo positive if, of course, he was replaced by a more moderate leader.
Food and energy costs would be the obvious winners, with their price fall contributing to a downdraught in inflation which in turn would get the central banks all twitchy and the equity liquidity junkies all of a fluster!
3. Central Bank QE makes a comeback
The Fed leads all major central banks down the “over tightening is better than under” path as the labour market remains tight and inflation sticky only for the data to turn on a dime with the prospects of a deep recession inevitable and talk of a deep depression forcing the central banks to resort to slashing rates aggressively. However, learning from their mistakes (go figure), they realise the lag time for these cuts to have an effect will be way too long, and they resort to reopening the QE pipes!
The equity markets love it and reconnect their punch bowls whilst crypto, remember that, moons it!
4. SBF goes to jail
With Wang and Ellison stacked on the prosecution benches and his political donees running to the hills, SBF is left with no exit strategy. Despite his “I fucked up” plea bargain, the “look I’m no genius I wear shorts” and his charm offensive around the TV show circuit all eventually counts for nothing. Heck, even more puff pieces from the NYT cannot save him, and the day he is sentenced to 138 years in jail (137 of which are suspended), Michael Lewis’s book on the boy wonder hits the shops. As he tucks up for his first night in a US penitentiary, he rocks himself to sleep safe in the knowledge that Brad Pitt will play him in the forthcoming movie of Lewis’s book.
January - Australian Open, Melbourne
February - Super Bowl, Glendale Arizona
March - Cricket World Cup, India
April - Masters, Augusta
May - Kentucky Derby, Kentucky
June - Champions League Final, Istanbul
July - Women’s Football World Cup, Australia/New Zealand
August - World Athletics Championships, Budapest
September - Ryder Cup, Rome
October - Rugby World Cup, France
November - Melbourne Cup, Victoria, Australia
December - PDC World Darts Championships - London (sparse pickings in December next year)
I wish all the TMH readers a very Happy, Healthy and Prosperous New Year.
TMH daily will return on January 2, and once again, thank you all for your continued support.
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Happy New ear Charlie. I look forward to resuming my routine next week, starting every day with TMH
Love it! Happy New Year, wishing you the best in 2023!