Sive Morten
Special Consultant to the FPA
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Fundamentals
As geopolitical tensions and military news are becoming routine, the financial events again come on the first stage. No doubts, this week everybody was watching for Fed rate decision and other important statistics, such as Retail Sales. But, based on the market reaction, it seems that not everybody understand it correctly.
Market overview
It was exactly two years ago on March 15 2020 that the U.S. Federal Reserve, in the words of its boss Jerome Powell, "crossed a lot of red lines that had not been crossed before." In the face of a pandemic that threatened recession on a scale not seen since the 1930s, Powell cut interest rates to zero, announced huge asset purchases to deflect bond market stress and opened dollar supply lines for other central banks.
Now, the Fed is about to throw its pandemic emergency measures into reverse. Later on Tuesday, it starts a two-day meeting that should deliver a 25 basis-point rate rise and could signal how far and fast policy tightening might go. The challenges, while less monumental than in 2020, are nonetheless daunting. A war is raging, sending food and fuel prices soaring. That could exacerbate inflation, already more than three times the Fed's target. A sharp rise in Treasury yields and futures reflect expectations of aggressive policy-tightening ahead, yet stamping on inflation rather than economic growth will be no easy task.
The Federal Reserve on Wednesday raised interest rates for the first time since 2018 and laid out an aggressive plan to push borrowing costs to restrictive levels next year in a pivot from battling the coronavirus pandemic to countering the economic risks posed by excessive inflation and the war in Ukraine. The U.S. central bank's Federal Open Market Committee kicked off the move to tighten monetary policy with a quarter-percentage-point increase in the target federal funds rate, lifting that key benchmark from the current near-zero level in a step that will ripple through a variety of other rates charged to consumers and businesses.
But more notably, new Fed projections showed policymakers ready to shift their inflation fight into high gear, with one policymaker, St. Louis Fed President James Bullard, dissenting in favor of an even more aggressive approach. Most policymakers now see the federal funds rate rising to a range between 1.75% and 2% by the end of 2022, the equivalent of a quarter-percentage-point rate increase at each of the Fed's six remaining policy meetings this year. They project it will climb to 2.8% next year - above the 2.4% level that officials now feel would work to slow the economy.
Fed Chair Jerome Powell, speaking after the end of the latest two-day policy meeting, said the economy is strong enough to weather the rate hikes and maintain its current strong hiring and wage growth, and that the Fed needed to now focus on limiting the impact of price increases on American families. Even with Wednesday's actions, inflation is expected to remain above the Fed's 2% target through 2024, and Powell said officials would not shy from raising rates more aggressively if they don't see improvement.
Rate increases work to slow inflation by curbing demand for big-ticket items like houses, automobiles or home improvement projects that become more expensive to finance, which can also slow economic growth and potentially increase unemployment. The economy may already be slowing for other reasons. Fed policymakers marked down their gross domestic product growth estimate for 2022 to 2.8%, from the 4% projected in December, as they began to analyze the new risks facing the global economy.
The Fed's preferred measure of inflation is currently increasing at a 6% annual rate. The policy statement, which dropped a longstanding reference to the coronavirus as the most direct economic risk facing the country, marked the end of the Fed's full-on battle against the pandemic. After two years focused largely on ensuring families and firms had access to credit, the Fed now pledges "ongoing increases" in borrowing costs to curb the highest inflation rates in 40 years.
The interest rate path shown in new quarterly projections by policymakers is tougher than expected, reflecting Fed concern about inflation that has moved faster and threatened to become more persistent than expected, and put at risk the central bank's hope for an easy shift out of the emergency policies used to fight the fallout from the pandemic.
Two-year Treasury note yields rose to 2.002% while benchmark 10-year Treasury yields reached 2.246%, both the highest levels since May 2019, before falling back to 1.948% and 2.188%, respectively. The dollar traded lower against a basket of currencies.
Even with the tougher rate increases now projected, the Fed expects inflation to remain at 4.3% this year, dropping to 2.7% in 2023 and to 2.3% in 2024. The unemployment rate is seen dropping to 3.5% this year and remaining at that level next year, but is projected to rise slightly to 3.6% in 2024.
The new statement said the Fed expects to begin reducing its nearly $9 trillion balance sheet "at a coming meeting." Powell told reporters that policymakers had made "excellent progress on that front and could finalize details at their next policy meeting in May. The central bank's holdings of Treasury bonds and mortgage-backed securities ballooned after the start of the pandemic in 2020 when it began making massive monthly asset purchases to bolster the economy.
The effect of announced "Fed new policy" comes faster than ti might seemed.
U.S. retail sales increased moderately in February as more expensive gasoline and food forced households to cut back spending on other goods like furniture, electronics and appliances, which could restrain economic growth this quarter. The rebound in sales in January was much stronger than initially estimated. Record gasoline and high food prices are hitting lower-income households the hardest. Overall, consumers are being cushioned by at least $2.5 trillion in excess savings accumulated during the COVID-19 pandemic.
Retail sales increased 0.3% last month. Data for January was revised sharply higher to show sales surging 4.9% instead of 3.8% as previously reported. Economists polled by Reuters had forecast retail sales growth slowing to 0.4%, with estimates ranging from as low as a 0.7% fall to as high as a 1.7% rise. Retail sales increased 17.6% from a year ago. Economists also viewed the pull back in monthly sales last month as pay back after January's surge, which was the largest gain in 10 months.
Economists at Morgan Stanley raised their consumer spending growth estimate to a 4.3% annualized rate from a 2.7% pace. That lifted their GDP growth forecast for the first quarter to a 3.7% rate from a 2.5% pace. Morgan Stanley's GDP growth estimates are on the upper end of the range, with some forecasts below a 1% pace. The economy grew at a robust 7.0% rate in the fourth quarter.
U.S. home sales fell by the most in a year in February as a perennial shortage of houses and double-digit price growth continued to squeeze first-time buyers out of the market. With mortgage rates rising above 4% for the first time in nearly three years, sales are likely to slow this year, though that would do little to curb house price inflation. Contracts to buy previously owned houses, a leading indicator of home sales, fell for three straight months through January.
Existing home sales dropped 7.2% to a seasonally adjusted annual rate of 6.02 million units last month, the largest decrease since February 2021, the National Association of Realtors said on Friday. Sales fell in all four U.S. regions. Home resales account for the bulk of U.S. home sales. They dropped 2.4% on a year-on-year basis in February.
Mortgage rates surged in February, with the 30-year fixed rate approaching a three-year high, according to data from mortgage finance agency Freddie Mac. It averaged 4.16% in the week ending March 17, breaking above 4.0% for the first time since May 2019. Still low by historical standards, mortgage rates are set to increase further after the Federal Reserve on Wednesday raised its policy interest rate by 25 basis points, the first hike in more than three years, and laid out an aggressive plan to push borrowing costs to restrictive levels by 2023.
The median existing house price increased 15% from a year earlier to $357,300 in February. House prices have increased on a year-on-year basis for a record 120 straight months. Bank of America Securities expects strong house price growth will continue this year and into 2023 because of tight supply. According to the NAR, the typical monthly mortgage payment has surged 28% from a year ago, a huge burden for first-time buyers, who accounted for only 29% of sales last month. Economists and realtors say a 40% share of first-time buyers is needed for a robust housing market.
One generally accepted, forward-looking indicator for a recession has been the 10-two Treasury yield spread. When this figure becomes inverted, market participants are no longer incentivized to invest in longer-dated securities since short-term issues provide the same yield and similar risk. The 10-two Treasury yield has fallen 59.5% so far this year and is currently hovering at 0.31%. As we approach zero, the wider market will prepare for a market contraction that normally takes place about three years afterward.
The euro zone's trade balance was in deficit for the third consecutive month in January as surging energy prices led to a sharp increase in the value of imports. Eurostat said the non-adjusted trade deficit of the 19 countries sharing the euro was 27.2 billion euros ($30.1 billion) compared with a 10.7 billion euro surplus a year earlier in January 2021. Payments for imports jumped by 44.3% year-on-year, while revenues from exports grew by only 18.9%. Euro zone trade is rarely in deficit, but this was the third consecutive month of shortfall, and a substantially larger figure than in the previous two months.
Investors are more concerned about the outlook for global growth than at any time since the financial crisis in 2008, and they have ramped up their cash holdings to a two-year high, according to a monthly fund manager survey by BofA. The majority of investors managing about $1 trillion in assets polled between March 4 and 10 now expect an equity bear market in 2022 and allocations to global equities have dropped to their lowest levels since May 2020.
Cash levels among investors rose to nearly 6% while allocations to commodities soared to a record 33%. Hedge funds net exposure to stock markets is at its lowest level since April 2020, according to the survey.
The European edition of the monthly fund manager survey made for grim reading with investors slashing their growth outlook for Europe in response to the war in Ukraine. A net 69% of respondents expect the European economy to weaken over the coming year, the highest share since 2011. The 81 percentage point swing from February's net 12% who still expected to see growth marks the biggest month-on-month drop since BoFA's records began in 1994.
Investors pulled money out of European equities for a fifth week in a row and flocked to U.S. equities as the war in Ukraine weighed on the continent's bourses, BofA wrote on Friday in its weekly report based on EPFR data. Flows out of European equity funds amounted to 3.2 billion dollars while $32 billion went into U.S. equities, the largest amount in five weeks, the U.S. investment bank said.
The U.S. dollar fell on Thursday and hit its lowest in a week as investors digested the Federal Reserve's monetary policy outlook a day after the U.S. central bank's expected rate hike, while the euro rose as investors kept an eye on Russia-West talks.
St. Louis Fed President James Bullard, who dissented on this week's action in favor of a half-point increase, said on Friday that officials should raise the Fed's overnight lending rate to more than 3% this year.
COT Report
This week CFTC data shows miserable plunge in EUR sentiment. Open interest has dropped for 10%, which is around 73K contracts with drastic contraction of bullish exposure. As speculators as hedgers were closing positions in favor of the EUR. As a result, net long position has dropped sharply.
Next week investors will be watching for PMI/ZEW indexes. It's flash PMI week. The forward-looking gauge of economic activity for March will be a litmus test of sorts of the impact from the war in Ukraine. Generally, PMIs have held above the 50-mark that divides contraction from expansion. But after the ZEW index showed a record slump in German investor morale in March, a recession in Europe's biggest economy cannot be ruled out. The ZEW hardly registered with markets, more focused on central banks' efforts to stamp on inflation.But as soaring energy costs squeeze real incomes and consumption, a seriously downbeat batch of PMIs might set the recession warning bells a-ringing.
Ten-year Treasury yields have risen nearly 70 basis points this year, while 2-year yields have jumped 120 bps. If the gap between the two segments, currently around 20 bps, turns negative, it could mean an economic recession is coming. After the Fed laid out a steeper rate-hike trajectory than many expected, markets will watch upcoming data - besides PMIs, consumer sentiment, new home sales and durable goods are due. They may indicate whether the S&P 500 can claw back a year-to-date 8% loss.
As geopolitical tensions and military news are becoming routine, the financial events again come on the first stage. No doubts, this week everybody was watching for Fed rate decision and other important statistics, such as Retail Sales. But, based on the market reaction, it seems that not everybody understand it correctly.
Market overview
It was exactly two years ago on March 15 2020 that the U.S. Federal Reserve, in the words of its boss Jerome Powell, "crossed a lot of red lines that had not been crossed before." In the face of a pandemic that threatened recession on a scale not seen since the 1930s, Powell cut interest rates to zero, announced huge asset purchases to deflect bond market stress and opened dollar supply lines for other central banks.
Now, the Fed is about to throw its pandemic emergency measures into reverse. Later on Tuesday, it starts a two-day meeting that should deliver a 25 basis-point rate rise and could signal how far and fast policy tightening might go. The challenges, while less monumental than in 2020, are nonetheless daunting. A war is raging, sending food and fuel prices soaring. That could exacerbate inflation, already more than three times the Fed's target. A sharp rise in Treasury yields and futures reflect expectations of aggressive policy-tightening ahead, yet stamping on inflation rather than economic growth will be no easy task.
The Federal Reserve on Wednesday raised interest rates for the first time since 2018 and laid out an aggressive plan to push borrowing costs to restrictive levels next year in a pivot from battling the coronavirus pandemic to countering the economic risks posed by excessive inflation and the war in Ukraine. The U.S. central bank's Federal Open Market Committee kicked off the move to tighten monetary policy with a quarter-percentage-point increase in the target federal funds rate, lifting that key benchmark from the current near-zero level in a step that will ripple through a variety of other rates charged to consumers and businesses.
But more notably, new Fed projections showed policymakers ready to shift their inflation fight into high gear, with one policymaker, St. Louis Fed President James Bullard, dissenting in favor of an even more aggressive approach. Most policymakers now see the federal funds rate rising to a range between 1.75% and 2% by the end of 2022, the equivalent of a quarter-percentage-point rate increase at each of the Fed's six remaining policy meetings this year. They project it will climb to 2.8% next year - above the 2.4% level that officials now feel would work to slow the economy.
Fed Chair Jerome Powell, speaking after the end of the latest two-day policy meeting, said the economy is strong enough to weather the rate hikes and maintain its current strong hiring and wage growth, and that the Fed needed to now focus on limiting the impact of price increases on American families. Even with Wednesday's actions, inflation is expected to remain above the Fed's 2% target through 2024, and Powell said officials would not shy from raising rates more aggressively if they don't see improvement.
"The way we're thinking about this is that every meeting is a live meeting" for a rate hike, Powell said in a news conference, emphasizing that the Fed could add the equivalent of more rate increases by also paring its massive bond holdings. "We're going to be looking at evolving conditions, and if we do conclude that it would be appropriate to move more quickly to remove accommodation, then we'll do so."
Rate increases work to slow inflation by curbing demand for big-ticket items like houses, automobiles or home improvement projects that become more expensive to finance, which can also slow economic growth and potentially increase unemployment. The economy may already be slowing for other reasons. Fed policymakers marked down their gross domestic product growth estimate for 2022 to 2.8%, from the 4% projected in December, as they began to analyze the new risks facing the global economy.
"That is just an early assessment of the effects of spillovers from the war in Eastern Europe, which will hit our economy through a number of channels," Powell said. "You are looking at higher oil prices, higher commodity prices. That will weigh on GDP to some extent. Over time, Fed policy itself would begin curbing economic activity, Powell said.
The Fed is playing catch-up and clearly recognizes the need to get back in front of the inflation situation," said Seema Shah, chief strategist with Principal Global Investors. It won't be easy - rarely has the Fed safely landed the U.S. economy from such inflation heights without triggering an economic crash. Furthermore, the conflict ... has the potential to disrupt the Fed's path. But for now, the Fed's priority has to be price stability."
The Fed's preferred measure of inflation is currently increasing at a 6% annual rate. The policy statement, which dropped a longstanding reference to the coronavirus as the most direct economic risk facing the country, marked the end of the Fed's full-on battle against the pandemic. After two years focused largely on ensuring families and firms had access to credit, the Fed now pledges "ongoing increases" in borrowing costs to curb the highest inflation rates in 40 years.
The interest rate path shown in new quarterly projections by policymakers is tougher than expected, reflecting Fed concern about inflation that has moved faster and threatened to become more persistent than expected, and put at risk the central bank's hope for an easy shift out of the emergency policies used to fight the fallout from the pandemic.
Two-year Treasury note yields rose to 2.002% while benchmark 10-year Treasury yields reached 2.246%, both the highest levels since May 2019, before falling back to 1.948% and 2.188%, respectively. The dollar traded lower against a basket of currencies.
Even with the tougher rate increases now projected, the Fed expects inflation to remain at 4.3% this year, dropping to 2.7% in 2023 and to 2.3% in 2024. The unemployment rate is seen dropping to 3.5% this year and remaining at that level next year, but is projected to rise slightly to 3.6% in 2024.
The new statement said the Fed expects to begin reducing its nearly $9 trillion balance sheet "at a coming meeting." Powell told reporters that policymakers had made "excellent progress on that front and could finalize details at their next policy meeting in May. The central bank's holdings of Treasury bonds and mortgage-backed securities ballooned after the start of the pandemic in 2020 when it began making massive monthly asset purchases to bolster the economy.
The effect of announced "Fed new policy" comes faster than ti might seemed.
U.S. retail sales increased moderately in February as more expensive gasoline and food forced households to cut back spending on other goods like furniture, electronics and appliances, which could restrain economic growth this quarter. The rebound in sales in January was much stronger than initially estimated. Record gasoline and high food prices are hitting lower-income households the hardest. Overall, consumers are being cushioned by at least $2.5 trillion in excess savings accumulated during the COVID-19 pandemic.
"Though cooling after January's splurge, American consumers appear reasonably well positioned to keep spending, supported by recent massive job gains and high household savings," said Sal Guatieri, a senior economist at BMO Capital Markets in Toronto."This assumes, of course, no further major blows to fuel and food costs, confidence, and financial conditions stemming from the Russia-Ukraine war."
Retail sales increased 0.3% last month. Data for January was revised sharply higher to show sales surging 4.9% instead of 3.8% as previously reported. Economists polled by Reuters had forecast retail sales growth slowing to 0.4%, with estimates ranging from as low as a 0.7% fall to as high as a 1.7% rise. Retail sales increased 17.6% from a year ago. Economists also viewed the pull back in monthly sales last month as pay back after January's surge, which was the largest gain in 10 months.
Economists at Morgan Stanley raised their consumer spending growth estimate to a 4.3% annualized rate from a 2.7% pace. That lifted their GDP growth forecast for the first quarter to a 3.7% rate from a 2.5% pace. Morgan Stanley's GDP growth estimates are on the upper end of the range, with some forecasts below a 1% pace. The economy grew at a robust 7.0% rate in the fourth quarter.
"Today's report continues to reflect strong consumer demand in the first quarter, despite the headwinds of elevated inflation," said Ellen Zentner, chief U.S. economist at Morgan Stanley in New York. "Upside in food services spending also indicates that we should see more upside in services spending this month, which will be reflecting in the personal spending report in two weeks."
U.S. home sales fell by the most in a year in February as a perennial shortage of houses and double-digit price growth continued to squeeze first-time buyers out of the market. With mortgage rates rising above 4% for the first time in nearly three years, sales are likely to slow this year, though that would do little to curb house price inflation. Contracts to buy previously owned houses, a leading indicator of home sales, fell for three straight months through January.
"It will take a sharper drop in sales to bring the market back into balance and allow prices to increase at a more modest pace," said David Berson, chief economist at Nationwide in Columbus, Ohio.
Existing home sales dropped 7.2% to a seasonally adjusted annual rate of 6.02 million units last month, the largest decrease since February 2021, the National Association of Realtors said on Friday. Sales fell in all four U.S. regions. Home resales account for the bulk of U.S. home sales. They dropped 2.4% on a year-on-year basis in February.
Mortgage rates surged in February, with the 30-year fixed rate approaching a three-year high, according to data from mortgage finance agency Freddie Mac. It averaged 4.16% in the week ending March 17, breaking above 4.0% for the first time since May 2019. Still low by historical standards, mortgage rates are set to increase further after the Federal Reserve on Wednesday raised its policy interest rate by 25 basis points, the first hike in more than three years, and laid out an aggressive plan to push borrowing costs to restrictive levels by 2023.
"Home buyers have likely missed their opportunity to lock in ultra-low mortgage rates," said Mark Vitner, a senior economist at Wells Fargo in Charlotte, North Carolina. But Vitner also noted that the 30-year conventional mortgage has been higher than its current level for more than 90% of the time over the past 30 years, which he said was "an important reminder that home sales should remain fairly strong even if mortgage rates rise a bit further."
The median existing house price increased 15% from a year earlier to $357,300 in February. House prices have increased on a year-on-year basis for a record 120 straight months. Bank of America Securities expects strong house price growth will continue this year and into 2023 because of tight supply. According to the NAR, the typical monthly mortgage payment has surged 28% from a year ago, a huge burden for first-time buyers, who accounted for only 29% of sales last month. Economists and realtors say a 40% share of first-time buyers is needed for a robust housing market.
One generally accepted, forward-looking indicator for a recession has been the 10-two Treasury yield spread. When this figure becomes inverted, market participants are no longer incentivized to invest in longer-dated securities since short-term issues provide the same yield and similar risk. The 10-two Treasury yield has fallen 59.5% so far this year and is currently hovering at 0.31%. As we approach zero, the wider market will prepare for a market contraction that normally takes place about three years afterward.
The euro zone's trade balance was in deficit for the third consecutive month in January as surging energy prices led to a sharp increase in the value of imports. Eurostat said the non-adjusted trade deficit of the 19 countries sharing the euro was 27.2 billion euros ($30.1 billion) compared with a 10.7 billion euro surplus a year earlier in January 2021. Payments for imports jumped by 44.3% year-on-year, while revenues from exports grew by only 18.9%. Euro zone trade is rarely in deficit, but this was the third consecutive month of shortfall, and a substantially larger figure than in the previous two months.
Investors are more concerned about the outlook for global growth than at any time since the financial crisis in 2008, and they have ramped up their cash holdings to a two-year high, according to a monthly fund manager survey by BofA. The majority of investors managing about $1 trillion in assets polled between March 4 and 10 now expect an equity bear market in 2022 and allocations to global equities have dropped to their lowest levels since May 2020.
Cash levels among investors rose to nearly 6% while allocations to commodities soared to a record 33%. Hedge funds net exposure to stock markets is at its lowest level since April 2020, according to the survey.
The European edition of the monthly fund manager survey made for grim reading with investors slashing their growth outlook for Europe in response to the war in Ukraine. A net 69% of respondents expect the European economy to weaken over the coming year, the highest share since 2011. The 81 percentage point swing from February's net 12% who still expected to see growth marks the biggest month-on-month drop since BoFA's records began in 1994.
Investors pulled money out of European equities for a fifth week in a row and flocked to U.S. equities as the war in Ukraine weighed on the continent's bourses, BofA wrote on Friday in its weekly report based on EPFR data. Flows out of European equity funds amounted to 3.2 billion dollars while $32 billion went into U.S. equities, the largest amount in five weeks, the U.S. investment bank said.
'Inflation shock not over, 'rates shock' not over, 'recession shock' likely second half of 2022", the bank's analysts wrote in a weekly note.
Strategists at Wells Fargo Securities called the Fed comments "very hawkish," in a note to clients and said it should be good for the dollar going forward.The decline in the dollar index was surprising and could reflect disappointment that the Fed rhetoric was not more hawkish, they said.
The U.S. dollar fell on Thursday and hit its lowest in a week as investors digested the Federal Reserve's monetary policy outlook a day after the U.S. central bank's expected rate hike, while the euro rose as investors kept an eye on Russia-West talks.
"The strongest message yesterday was that the Fed was going to hike and it was primarily concerned with elevated inflation pressures," Bipan Rai, North American head of foreign exchange strategy at CIBC Capital Markets in Toronto, said."The market is kind of taking the bet that the Fed has this view now but that could shift in the coming quarters, and there's a lot already priced in to the short-term interest rate markets for the Fed this year. Some of that is being pulled back, and that's one of the reasons why the dollar has come under pressure."
St. Louis Fed President James Bullard, who dissented on this week's action in favor of a half-point increase, said on Friday that officials should raise the Fed's overnight lending rate to more than 3% this year.
COT Report
This week CFTC data shows miserable plunge in EUR sentiment. Open interest has dropped for 10%, which is around 73K contracts with drastic contraction of bullish exposure. As speculators as hedgers were closing positions in favor of the EUR. As a result, net long position has dropped sharply.
Next week investors will be watching for PMI/ZEW indexes. It's flash PMI week. The forward-looking gauge of economic activity for March will be a litmus test of sorts of the impact from the war in Ukraine. Generally, PMIs have held above the 50-mark that divides contraction from expansion. But after the ZEW index showed a record slump in German investor morale in March, a recession in Europe's biggest economy cannot be ruled out. The ZEW hardly registered with markets, more focused on central banks' efforts to stamp on inflation.But as soaring energy costs squeeze real incomes and consumption, a seriously downbeat batch of PMIs might set the recession warning bells a-ringing.
Ten-year Treasury yields have risen nearly 70 basis points this year, while 2-year yields have jumped 120 bps. If the gap between the two segments, currently around 20 bps, turns negative, it could mean an economic recession is coming. After the Fed laid out a steeper rate-hike trajectory than many expected, markets will watch upcoming data - besides PMIs, consumer sentiment, new home sales and durable goods are due. They may indicate whether the S&P 500 can claw back a year-to-date 8% loss.