Like March 2020. But Without A Backstop

Markets can look forward to incessant Fed banter in the new week. And I do mean incessant.

On deck, in order of appearance, are Collins, Bostic, Logan, Mester, Evans, Evans again, Powell, Bullard, Daly, Bostic again, Bullard again, Powell again, a Bowman sighting, Evans a third time, Bullard a third time, Mester again, Daly again, Brainard, Bowman a second time (which is like finding a four-leaf clover), Barkin and Williams.

Suffice to say the Fed isn’t interested in saying less. Instead, they’ll say more. Much more. And that has the potential to drive much more in the way of rates volatility and dollar strength.

Note that I said “has the potential.” It’s not guaranteed. Not every Fed speaking engagement is market-moving. Sometimes they don’t discuss the economy or monetary policy at all (which makes you wonder what the point is). But in all likelihood, this week will be a hawkish procession. Policymakers will reiterate the primacy of the inflation fight, and that could roil nervous markets, especially given poor liquidity (figure below).

“Rates do not work as a hedge when risk taking is cut and liquidity is thin,” BofA’s Mark Cabana wrote. “Markets today feel increasingly like March 2020 but without a policy backstop.”

That’s not particularly encouraging. Cabana suggested central banks will be compelled to intervene more often going forward if rates markets are to stay liquid. And yet, there’s tension with the inflation battle. “Pronounced market illiquidity will be one of the fastest ways to tighten financial conditions and slow growth,” he said. “The fight against inflation is going to hurt.” As I put it previously, the Fed can always close bases, but the concern is that doing that would be tantamount to easing, which is counterproductive.

I’d be remiss not to suggest the dollar’s move looks stretched, and the surge in US yields overdone. That could be the best argument for a break in the storm, but there’s no reason to believe Fed officials will do anything other than double, triple and quadruple down on their single-minded pursuit of lower inflation.

That’s as it should be, by the way. I’ve spent considerable time over the past two or three weeks warning on the risks associated with an ever stronger dollar, an ever more aggressive rate path and ever higher US real yields, culminating in “Apocalypse Soon,” published here over the weekend. The point isn’t to suggest the Fed shouldn’t engineer some “healthy” domestic demand destruction. They should. But the list of caveats is growing by the week.

I don’t believe monetary policy has all the answers to the current inflation problem in developed economies. I do believe monetary policy has to try — where it’s feasible. Given a robust labor market and Americans’ propensity to consume come hell or high water, it’s feasible in the US. The problem for the rest of the world is that you can’t not hike while the Fed’s hiking. That’s a recipe for disaster. But hiking can be a recipe for disaster too if trying to keep up with the Fed (to support your currency, for example) means pushing economies which are already headed for recession into even deeper downturns. That’s what’s going on in the UK and in Europe.

There’s a sense in which “Keeping Up With the Jeromeses,” as TD’s chief Canada strategist Andrew Kelvin called the global effort to avoid falling behind the Fed, is impossible. If the Fed’s hiking aggressively and markets are risk-off (which they often are during Fed tightening cycles), tracking a hike or two ahead isn’t going to be sufficient to shield your currency. US reals are rising inexorably. The figure (below) shows the contribution of reals to the run up in five-year US yields.

It’s almost all reals-driven. That’s pure tightening, and it’s daunting for anything that isn’t the US dollar. During panics, market participants rediscover that nothing is the US dollar. Not the franc. Not the yen. Not gold (which is absolutely hopeless when US reals are rising sharply). And most assuredly not any digital tokens generated by a shared spreadsheet. When everything goes left, you go right to dollars. Accept no substitutes.

Looking ahead, most are reluctant to fade what seem like sure bets. “Our bearishness in the front-end of the curve remains solidly intact with 4.25% 2s continuing to represent upside yield potential versus the Fed’s 4.6% terminal guidance,” BMO’s Ian Lyngen and Ben Jeffery said. “We’d be a seller of TIPS (i.e., higher real yields are coming) and stocks (impact of swift policy tightening), while anticipating breakevens will decline and 10-year nominals will outperform on a relative basis if nothing else.”

Traders and investors (and those aren’t interchangeable) will also be compelled to digest critical personal consumption data for August this week. That’ll be accompanied by PCE prices. The final read on University of Michigan sentiment for this month is also due. Mercifully, August’s above-consensus core inflation impulse is already “in the price,” so to speak. The CPI report was baked into the new dot plot, and thereby into market pricing, so that should lessen the risk associated with the update on PCE prices. Nevertheless, incrementally bad news would be… well, incrementally bad.

“The Fed seems to have turned into a single-mandate central bank,” TD’s Priya Misra and Gennadiy Goldberg wrote, after getting stopped out of a three-year long. “We do forecast a lower three-year rate in 2023 as we believe the Fed will be forced to cut rates aggressively once inflation declines, but the risk-reward of the position is not attractive given the risk of sticky inflation,” they added.

SocGen’s Subadra Rajappa summed it up. “Higher yields are attracting investors to bonds as economies are slowing down, geopolitics remain tense and risky assets are shaky [but] duration longs won’t be comfortable before central banks are seen to have done the bulk of the job to combat inflation.”

So, nothing is safe. Well, nothing other than USD cash which, if things keep heading south for commodities, may end up being the only major asset class with positive nominal returns in 2022. Nothing is especially likely to deliver positive real returns.