Tape Bombs And Technocrats

Traders and investors will hear from a long list of Fed speakers in the new week, as policymakers look to refine the message after taking the first tentative step towards what, if you believe the dot plot, will be a total of seven rate hikes in 2022.

The market is already pricing a dovish pivot for 2024, and recession calls are growing louder alongside flatter curves. The odds of stagflation have risen materially, leaving multi-asset investors to ponder a prolonged period of subpar real returns.

Barkin, Bostic, Bullard, Daly, Evans, Kashkari, Mester, Waller and Williams will all speak this week, as will Jerome Powell. The data docket is a smattering of second- and third-tier numbers that won’t move any needles.

“Inversions are coming more quickly than during prior cycles; the inverted club already includes 3s5s, 7s10s, 3s10s, and 20s30s [and] more inversions are sure to follow,” BMO’s Ian Lyngen and Ben Jeffery said. “Instrumental in the curve flattening as of late has been the war in Ukraine and expanding geopolitical uncertainty as Russia struggles to achieve its invasion objectives,” they added, noting that attempts to “separate the flattening impulse provided by rate hikes from the safe haven flows would be folly.”

One way or another, BMO remarked, “an early curve inversion will be a defining characteristic of this particular Fed cycle.” The 2s10s was as low as 18bps last week.

For many market participants, the curve is beyond reproach. If it’s inverted, a recession is coming, some argue. It’s a bit more nuanced than that, I’m afraid.

“It was a bit unsettling to see parts of the yield curve invert, leading some to worry of a pending recession,” Morgan Stanley wrote, in a summary of recent research. The bank’s Guneet Dhingra called it merely “a natural consequence” of rates headed towards restrictive territory. “While the debate around this will continue, Guneet is confident that the Fed, the US economy, the US banking system and investors can live with an inverted term structure,” Morgan said, adding that Ellen Zentner thinks “higher inflation, stronger growth, a more accommodative back-end of the curve and a more supportive global economic environment should allow for a higher peak and longer hiking cycle.”

Still, Zentner conceded that rapid balance sheet rundown could unnerve markets, and even compel the Fed to stop hiking “early.” Recall that the last time the Fed tried this, it dead ended with the worst December for US equities since the Great Depression. Note in the figure (below) how quickly things turned around once Powell pivoted dovish on January 4, 2019. Realized vol collapsed and equities surged. Stocks didn’t have another down month until May, when Donald Trump turned the screws on Huawei.

The Fed is obviously hoping to avoid another 2018, especially given how poorly things are already going in 2022.

For their part, Goldman thinks markets “are underweighting the odds that the Fed will have to deliver more hikes to bring inflation back towards its target, which continues to weigh on terminal rate pricing.” That’s according to the bank’s Praveen Korapaty.

Although market pricing is now consistent with the dots and Goldman’s outlook for 2022, the divergence is notable in subsequent years (figure below).

I suppose I’d be inclined to side with market pricing. It seems highly unlikely to me that the Fed will manage to get rates into restrictive territory and keep them there for any appreciable length of time without risking a downturn or an undesirably large drawdown in risk assets.

Speaking of risk assets, equities are coming off their best week since 2020, but there’s scope for more volatility. Friday’s “monster expiration means a huge Gamma ‘unclench’ thereafter, which means likely ‘vol expansion window’ ahead as prior hedging barriers are removed / reduced and the distribution can widen out going forward,” Nomura’s Charlie McElligott said. That doesn’t necessarily mean declines, it just means scope for outsized moves.

On the bright side, the systematic universe has de-risked so much by now that any sustained rally could easily get some help from exposure adds. “Equity exposure for volatility sensitive investors — the largest and fastest group of investors — is now in its ~5-10th%ile,” JPMorgan’s Marko Kolanovic wrote, in his latest. “For this reason, risks are skewed to the upside.”

Needless to say, the odds of tape bombs are high what with the actual bombs still falling in Ukraine. There was some speculation that Kyiv and Moscow were moving towards consensus on key issues, but the Russian bombardment continued. In an interview with CBS, China’s Ambassador Qin Gang promised Beijing “will do everything to de-escalate the crisis.”

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4 thoughts on “Tape Bombs And Technocrats

  1. I’m not sure I’m alone in not being able to keep up with everything or digest enough materials. I was just getting comfortable tuning everything out.

    I missed this little thing from a few weeks ago, but it stands out in an interesting way. The capital control related to Russia forex, seems to imply that a massive amount of Russian corporations that were involved with international trade had to sell their positions and apparently end up holding rubles. That was intended to prop up the crashing rouble and lock currency inside Russia.

    That short-term goal to control volatility is essentially a one trick pony that can’t be used to support Russian future value. Locking up Russian money locks out private investments in their economy and will help destabilize their GDP, which obviously won’t support stability with their currency.

    I read that gazaprom has just introduced a crypto card, but the adoption rate will be hindered by inflationary war dynamics.

    Anyway, I think that tidbit is one of those shoes that’s dropping.

    “Feb 28

    On Monday, the central bank and the finance ministry ordered exporting companies, which include some of the world’s biggest energy producers from Gazprom to Rosneft, to sell 80% of their forex revenues on the market, as the central bank’s own ability to intervene on currency markets was curbed.”

  2. “The Fed is obviously hoping to avoid another 2018, especially given how poorly things are already going in 2022.”

    I don’t understand when one of the FED’s mandates became propping up equities. Would it really be that bad if they only worried about getting inflation under control? They’re called risk assests for a reason. I guarantee private investors will buy a business with a cash flow for something.

  3. There are mandates and then there are MANDATES. For the Fed, preventing a repeat of 1970s style inflation is surely the premier mandate, the One Mandate To Rule Them All. When mandates conflict, you choose the primary one.

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