Sive Morten
Special Consultant to the FPA
- Messages
- 17,453
Fundamentals
So, here is the Christmas week already. It is a common habit to make a bottom lines and conclusions of the year. And probably we could say that Fed and other central banks are coming to some end point of particular stage. Epic interest rates hiking cycle is coming to an end. Yes, we could get 1-2 rates changes probably, in particular we expect 0.25% move in February, but this is not as important. We suggest that overall economy background that Fed has appeared at is more interesting. They have made strong step, but now Fed needs to look around, and it seems that Fed by the end of IQ of 2023 will appear in more difficult situation, because now they can't do anything with the interest rate any more. More or less but threshold level is reached.
Poor, poor Fed
To be honest, guys, I do not know how J. Powell cares this burden, without getting any positive shifts, without any improvements. The whole year cycle ends with nothing. Yes, CPI/PPI numbers show decreasing. But mostly because both components have statistical tails, outbreaks, such as energy prices. These tails were major reasons of outstanding high inflation levels in past months, but these tails have to be smoothed, that we see now. At the same time core inflation, that we could call as a "structural" component remains stubbornly stable. So, nominal inflation by smoothing outbreaks is converging to core, structural numbers. It has to happen. Take a look at recent CPI numbers. Total CPI stands at 7.1%, major outbreaks are Food (+10.6%) and energy (+13.0%), while other components show "structural" inflation of 6%.
And reality stands so that structural component is not affected by interest rates change, because this is purely monetary tool, it could cut only monetary component of inflation. To normalize structural inflation you have to restructure national economy to match production, goods supply and consumption, demand. This yet to be done, and could take long time. Inflation slows down naturally against the background of a decline in the raw materials market, normalization of inventories and supply chains. Thus, we could see the neutralization of the main factors of inflation that operated in 2020-2021.
However, the growth of prices for education will tend to 4% in the medium term, for medicine about 5%, the sphere of services in culture, sports and entertainment – 4-5%, other services and goods – about 5-6%. Inflation is becoming structural and about twice as high as normal – about 4-5%. The slowdown in price growth will continue and will tend to 5%-6%, where stabilization will occur due to structural deformations in the US economy.
But what Fed has to do know? They have exhaust interest rates hike margin, but are just coming to inflation stabilization, that is far above 2% desirable level. Powell said that the Fed has not yet reached a "sufficiently restrictive position" and the upward movement of the rate will continue. A continued rate hike would be appropriate. The Fed will seek to tighten financial conditions.
17 of the 19 members of the Fed recorded a peak rate of 5% or slightly higher – this is the estimate of the marginal threshold of the rate in 2023. However, Powell rightly noted that the Fed has been continuously raising the terminal rate over the past 1.5 years and there is no universal predictive tool to fix some plausible model of the future. There is no certainty that the peak level will not be pushed above 5-5.2%.
The "restrictive level" on the rate will be until the Fed is convinced that it has made progress in reducing inflation. The imbalance in the labor market is still significant and it will take quite a long time to correct it. Inflation in the service sector may be more stable and prolonged than inflation in the commodity segment. That is why the Fed is going to keep rates high for "some time" until the normalization of price imbalances.
WE alos should keep in mind that despite J.Powell said that there is no rate cut in 2023 on the table, the Fed is not isolated, it exists in a complex world, and if some "too big to fall" appears on horizon, reality could be a cold shower. Therefore, in reality, all their plans to continue raising rates and tightening financial conditions will fly into the trash as soon as someone big goes downhill, which actualizes the question of an immediate easing of monetary policy.
So the rate increase by 25 bps to 4.75% is estimated at 76% at the meeting on February 1, 2023, while an increase of 50 bps now has a probability of only 24%. Although major consensus now suggests 5-5.25% as a terminal rate, there is an opinion that 4.75% will be the final step, but why?
That's because rate was really high only when it has exceeded 2.5% level. And negative effect of the high rate has started after this level was exceeded. Hence, the total power of a negative effect is yet to be seen. Currently we see effect of 3-3.5% interest rate level only. Take a look - the average rates at the upper limit of the Fed's target range in the 1st quarter of 2022 were 0.29%, in the second quarter of 2022 – 0.93%, in the 3rd quarter of 2022 – 2.36%, in the 4th quarter of 2022 will be 3.83% and closer to 4.65% in the 1st quarter of 2023.
That's why we don't see the effect, because in the 3rd quarter the rates were below 2.5%, and the Fed margin of safety is enough to compensate for the destructive consequences of the increase in the cost of funding and limited demand for debt instruments.
As you can see, average rates are rising rapidly, the margin of safety is being depleted, so at the beginning of 2023 there may be the first negative news from financial reports in the United States and Europe. In March-April 2023, this will be visible to the naked eye, so at the Fed meeting on March 22, the conditions will be completely different, so everyone ... finished with tightening. Soon, the Fed will be in an awkward position when inflation is significantly higher than the target level, and the financial system begins to crack at the seams.
But why we so sure with the stalemate situation that Fed is coming to? Here is time to recall the Fed's safety margin. In summer, almost in every report we were looking at US Treasury assets on Fed's account, the QT tempo and other liquidity data. And we said that nobody is going to buy US bonds because too negative yield.
Here is what we have now:
The US Treasury Department's plan for "grandiose" borrowings of $ 550 billion in the IVQ 2022, is expectedly failed. Net borrowing stands only for $131 Bln ($216 Bln borrowed and $85 Bln repaid). Obviously, this will not be closed at the end of the year.
The cash on the balance sheet of the US Treasury was expected at the end of 2022 at the level of $ 700 billion. They have missed once again. The current amount of cash on the balance sheet is 342 billion, having decreased by 190 billion from December 1 to December 14, 2022. Here is actually, guys, where stock market rally comes from. S&P bottom has been formed on October 14th, and take a look, right from this moment Fed has pumped up ~ $400 Bln:
Due to debt reduction, the buffer up to official national debt ceil has expanded to $166 billion. This is how much you can potentially borrow, i.e. even if we assume that 166 billion will be issued by the end of the year, it will still not be enough to implement the announced plans for borrowing and the amount of cash on the balance sheet.
Things have also not gone well with the Fed over the past two weeks. In October-November, the Fed came out with its plan to reduce the balance sheet, and since December there have been no sales yet (neither treasuries nor MBS).
Usually, the Fed implements sales in conditions of "favorable market conditions", as it was in October-November, when there was an increase in the markets, both stocks and bonds (a decrease in yields). Since December, the tension in the financial markets began to be felt and the Fed put on the brakes as it did in June-July.
As a result, the gap between the plan for the sale of securities and actual sales increased to 172 billion compared to 130 billion two weeks earlier. It is still the financial conditions have not started to deteriorate and the markets are in quite comfortable conditions.
The lack of sales from the Fed and the release of almost two hundred billion dollars into the system supported the system, but it can't go on like this for a long time, because the cache from the US Treasury is being depleted and will soon have to borrow again.
But not only the Fed has difficulties with borrowing. Companies are running into the banks' loans out from bond market. For the first time in 15 years, the growth rate of lending in the United States is steadily higher than the growth rate of debt in bonds. From 2009 to 2021, the proportion was opposite. On average, for every dollar of increase in liabilities in loans, debts in bonds grew by $3.5.
Commercial banks, in conditions of excess liquidity, are quite willing to issue loans, which cannot be said about the demand for bonds, which you will not find at all. Partially, it explains the interest drop to the US government debt as well - the lost of confidence and trust to the system, to the Fed's ability to control situation.
J.P. Morgan Asset Management, in a research note, has increased the odds of recession to 60% from its initial forecast of 50%.
ECB Step
Here we could bring very similar conclusions as EU has almost the same problems but at higher degree. Speaking about terminal rate, now big banks suggest that it should be around 3-3.25%. The ECB eased the pace of its interest rate hikes on Thursday but stressed significant tightening remained ahead and laid out plans to drain cash from the financial system as part of a dogged fight against runaway inflation.
The sources said this was the result of a difficult compromise after Philip Lane's proposal to raise rates by half a percentage point on Thursday met with significant opposition from policymakers insisting on a 75-basis-point increase. The stalemate ended when Lagarde offered to signal more 50-basis-point rises and a hawkish message on inflation during her press conference, convincing enough policymakers to back the proposal.
Two of the sources said this could even mean three back-to-back 50-basis-point moves if the inflation outlook failed to improve, though there was no explicit commitment to such a policy path. At a press conference after the decision, Lagarde said that, based on current data, she anticipated another 50 basis-point rise at the ECB's next meeting on Feb 2 "and possibly at the one after that, and possibly thereafter".
The ECB also laid out plans to stop replacing maturing bonds from its 5 trillion euro ($5.31 trillion) portfolio, reversing years of asset purchases that have turned the central bank into the biggest creditor of many euro zone governments. Under the plan, it will reduce monthly reinvestments from its Asset Purchase Programme by 15 billion euros starting in March and revise the pace of balance-sheet reduction from July.
The move, which mops up liquidity from the financial system, is designed to let long-term borrowing costs rise and follows a similar step by the Fed earlier this year.
The impact was immediately felt by the euro zone's weakest borrowers, such as the Italian government, which have come to rely on the ECB as a major buyer.
Investment bank JPMorgan ramped up its forecast on Thursday for how high euro zone interest rates will go to 3.25% from 2.50%, after the European Central Bank vowed to keep raising them at a meeting earlier.
Societe Generale hiked on Thursday its forecast for how high euro zone interest rates will go to 3.75% from 3% previously, after the European Central Bank vowed to keep raising them at a meeting earlier.
Conclusion:
Well, guys, it would be prominent to add some additional data on claims, Retail sales etc, but I'm afraid to overload the research. So, we put them tomorrow in the gold market update. Take a look how fast the public sentiment changes. Just after CPI numbers everybody were ultimately dovish - inflation is defeated, Fed is pivoting etc., and what we have now - new higher terminal rates are widely expected, as in the US as in EU. Plans, plans... I would ask you, when the Fed plans ever have been fulfilled? I tell you - never. Just recall that we should have "temporal" inflation now, guys. Take a look at this - two Fed projections with 1 year gap:
The point of comparing the two meetings is to show the zero predictive ability of the Fed – they are not able to build realistic development trajectories, not just for several years ahead, but even for 6-12 months they cannot predict. Therefore, in terms of content, the value of the Fed's forecasts is close to zero. Based on their projects, it is impossible to build investment strategies, because the percentage of errors is incredibly high, and delays are prohibitive.
What's the point? As recently as yesterday, Powell stated that the Fed will continue its restrictive policy for as long as it takes to bring inflation under control, and in 2023 there is not even a question of lowering rates. But this is bluff and stupidity. The system will begin to shake to the borderline levels in the spring of 2023, so the refusal to tighten financial conditions will be quite rapid – you should not bet on the determination of the Fed in the matter of tightening.
And another moment. The Fed does not forecast a recession in 2023, expecting growth of 0.5% (!!!). Forecast statistics are presented in the tables, but as it is shown - the Fed always misses. Recession is inevitable, the margin of safety is running out.
Fed stands in situation now when it can't borrow sufficient funds on the market. First is because nobody's buying, second - because it is just 166 Bln until debt ceil, and Reps with big pleasure do the dirt to Dems in discussion of rising of national debt ceil, as usual. Based on US Treasury balance dynamic, 340 Bln of existed reserves should be enough until summer, to keep system on a surface. And this is most positive scenario. If somebody really big will default, it will be much worse. Finally, Fed has reached a threshold rate level and scares to rise it more, because as we've explained the effect is lagging a bit for 4-6 month. With no ability to rise rates more, high inflation of 5-6%, high interest rates of ~5% and exhausting reserves to support system Fed probably will start easing. Maybe we're wrong but currently we do not see any other scenarios.
The same things we could say about EU, where situation will be even worse due total destruction of national industry sector, big financial fragmentation among different countries. 5% vs potential 3.25% looks not in favor of EUR. Besides, ECB could meet the same problem of urgent stop rate hike, if system will start falling apart. Especially on a background of coming QT in 2023. I wouldn't rely on forecasts as of ECB as of Fed. Still, as they mostly go in the same direction, and now both suggest stay hawkish, the EUR/USD balance should be re-established, and demand for the USD should start rising again, which is also suggested by our DXY monthly B&B "Buy" setup. Let's see. Also we do not see any clear signs yet to cancel 0.9 target. Although the way might be more bendy now.
So, here is the Christmas week already. It is a common habit to make a bottom lines and conclusions of the year. And probably we could say that Fed and other central banks are coming to some end point of particular stage. Epic interest rates hiking cycle is coming to an end. Yes, we could get 1-2 rates changes probably, in particular we expect 0.25% move in February, but this is not as important. We suggest that overall economy background that Fed has appeared at is more interesting. They have made strong step, but now Fed needs to look around, and it seems that Fed by the end of IQ of 2023 will appear in more difficult situation, because now they can't do anything with the interest rate any more. More or less but threshold level is reached.
Poor, poor Fed
To be honest, guys, I do not know how J. Powell cares this burden, without getting any positive shifts, without any improvements. The whole year cycle ends with nothing. Yes, CPI/PPI numbers show decreasing. But mostly because both components have statistical tails, outbreaks, such as energy prices. These tails were major reasons of outstanding high inflation levels in past months, but these tails have to be smoothed, that we see now. At the same time core inflation, that we could call as a "structural" component remains stubbornly stable. So, nominal inflation by smoothing outbreaks is converging to core, structural numbers. It has to happen. Take a look at recent CPI numbers. Total CPI stands at 7.1%, major outbreaks are Food (+10.6%) and energy (+13.0%), while other components show "structural" inflation of 6%.
And reality stands so that structural component is not affected by interest rates change, because this is purely monetary tool, it could cut only monetary component of inflation. To normalize structural inflation you have to restructure national economy to match production, goods supply and consumption, demand. This yet to be done, and could take long time. Inflation slows down naturally against the background of a decline in the raw materials market, normalization of inventories and supply chains. Thus, we could see the neutralization of the main factors of inflation that operated in 2020-2021.
However, the growth of prices for education will tend to 4% in the medium term, for medicine about 5%, the sphere of services in culture, sports and entertainment – 4-5%, other services and goods – about 5-6%. Inflation is becoming structural and about twice as high as normal – about 4-5%. The slowdown in price growth will continue and will tend to 5%-6%, where stabilization will occur due to structural deformations in the US economy.
But what Fed has to do know? They have exhaust interest rates hike margin, but are just coming to inflation stabilization, that is far above 2% desirable level. Powell said that the Fed has not yet reached a "sufficiently restrictive position" and the upward movement of the rate will continue. A continued rate hike would be appropriate. The Fed will seek to tighten financial conditions.
17 of the 19 members of the Fed recorded a peak rate of 5% or slightly higher – this is the estimate of the marginal threshold of the rate in 2023. However, Powell rightly noted that the Fed has been continuously raising the terminal rate over the past 1.5 years and there is no universal predictive tool to fix some plausible model of the future. There is no certainty that the peak level will not be pushed above 5-5.2%.
The "restrictive level" on the rate will be until the Fed is convinced that it has made progress in reducing inflation. The imbalance in the labor market is still significant and it will take quite a long time to correct it. Inflation in the service sector may be more stable and prolonged than inflation in the commodity segment. That is why the Fed is going to keep rates high for "some time" until the normalization of price imbalances.
WE alos should keep in mind that despite J.Powell said that there is no rate cut in 2023 on the table, the Fed is not isolated, it exists in a complex world, and if some "too big to fall" appears on horizon, reality could be a cold shower. Therefore, in reality, all their plans to continue raising rates and tightening financial conditions will fly into the trash as soon as someone big goes downhill, which actualizes the question of an immediate easing of monetary policy.
So the rate increase by 25 bps to 4.75% is estimated at 76% at the meeting on February 1, 2023, while an increase of 50 bps now has a probability of only 24%. Although major consensus now suggests 5-5.25% as a terminal rate, there is an opinion that 4.75% will be the final step, but why?
That's because rate was really high only when it has exceeded 2.5% level. And negative effect of the high rate has started after this level was exceeded. Hence, the total power of a negative effect is yet to be seen. Currently we see effect of 3-3.5% interest rate level only. Take a look - the average rates at the upper limit of the Fed's target range in the 1st quarter of 2022 were 0.29%, in the second quarter of 2022 – 0.93%, in the 3rd quarter of 2022 – 2.36%, in the 4th quarter of 2022 will be 3.83% and closer to 4.65% in the 1st quarter of 2023.
That's why we don't see the effect, because in the 3rd quarter the rates were below 2.5%, and the Fed margin of safety is enough to compensate for the destructive consequences of the increase in the cost of funding and limited demand for debt instruments.
As you can see, average rates are rising rapidly, the margin of safety is being depleted, so at the beginning of 2023 there may be the first negative news from financial reports in the United States and Europe. In March-April 2023, this will be visible to the naked eye, so at the Fed meeting on March 22, the conditions will be completely different, so everyone ... finished with tightening. Soon, the Fed will be in an awkward position when inflation is significantly higher than the target level, and the financial system begins to crack at the seams.
But why we so sure with the stalemate situation that Fed is coming to? Here is time to recall the Fed's safety margin. In summer, almost in every report we were looking at US Treasury assets on Fed's account, the QT tempo and other liquidity data. And we said that nobody is going to buy US bonds because too negative yield.
Here is what we have now:
The US Treasury Department's plan for "grandiose" borrowings of $ 550 billion in the IVQ 2022, is expectedly failed. Net borrowing stands only for $131 Bln ($216 Bln borrowed and $85 Bln repaid). Obviously, this will not be closed at the end of the year.
The cash on the balance sheet of the US Treasury was expected at the end of 2022 at the level of $ 700 billion. They have missed once again. The current amount of cash on the balance sheet is 342 billion, having decreased by 190 billion from December 1 to December 14, 2022. Here is actually, guys, where stock market rally comes from. S&P bottom has been formed on October 14th, and take a look, right from this moment Fed has pumped up ~ $400 Bln:
Due to debt reduction, the buffer up to official national debt ceil has expanded to $166 billion. This is how much you can potentially borrow, i.e. even if we assume that 166 billion will be issued by the end of the year, it will still not be enough to implement the announced plans for borrowing and the amount of cash on the balance sheet.
Things have also not gone well with the Fed over the past two weeks. In October-November, the Fed came out with its plan to reduce the balance sheet, and since December there have been no sales yet (neither treasuries nor MBS).
Usually, the Fed implements sales in conditions of "favorable market conditions", as it was in October-November, when there was an increase in the markets, both stocks and bonds (a decrease in yields). Since December, the tension in the financial markets began to be felt and the Fed put on the brakes as it did in June-July.
As a result, the gap between the plan for the sale of securities and actual sales increased to 172 billion compared to 130 billion two weeks earlier. It is still the financial conditions have not started to deteriorate and the markets are in quite comfortable conditions.
The lack of sales from the Fed and the release of almost two hundred billion dollars into the system supported the system, but it can't go on like this for a long time, because the cache from the US Treasury is being depleted and will soon have to borrow again.
But not only the Fed has difficulties with borrowing. Companies are running into the banks' loans out from bond market. For the first time in 15 years, the growth rate of lending in the United States is steadily higher than the growth rate of debt in bonds. From 2009 to 2021, the proportion was opposite. On average, for every dollar of increase in liabilities in loans, debts in bonds grew by $3.5.
Commercial banks, in conditions of excess liquidity, are quite willing to issue loans, which cannot be said about the demand for bonds, which you will not find at all. Partially, it explains the interest drop to the US government debt as well - the lost of confidence and trust to the system, to the Fed's ability to control situation.
J.P. Morgan Asset Management, in a research note, has increased the odds of recession to 60% from its initial forecast of 50%.
ECB Step
Here we could bring very similar conclusions as EU has almost the same problems but at higher degree. Speaking about terminal rate, now big banks suggest that it should be around 3-3.25%. The ECB eased the pace of its interest rate hikes on Thursday but stressed significant tightening remained ahead and laid out plans to drain cash from the financial system as part of a dogged fight against runaway inflation.
The sources said this was the result of a difficult compromise after Philip Lane's proposal to raise rates by half a percentage point on Thursday met with significant opposition from policymakers insisting on a 75-basis-point increase. The stalemate ended when Lagarde offered to signal more 50-basis-point rises and a hawkish message on inflation during her press conference, convincing enough policymakers to back the proposal.
Two of the sources said this could even mean three back-to-back 50-basis-point moves if the inflation outlook failed to improve, though there was no explicit commitment to such a policy path. At a press conference after the decision, Lagarde said that, based on current data, she anticipated another 50 basis-point rise at the ECB's next meeting on Feb 2 "and possibly at the one after that, and possibly thereafter".
The ECB also laid out plans to stop replacing maturing bonds from its 5 trillion euro ($5.31 trillion) portfolio, reversing years of asset purchases that have turned the central bank into the biggest creditor of many euro zone governments. Under the plan, it will reduce monthly reinvestments from its Asset Purchase Programme by 15 billion euros starting in March and revise the pace of balance-sheet reduction from July.
The move, which mops up liquidity from the financial system, is designed to let long-term borrowing costs rise and follows a similar step by the Fed earlier this year.
The impact was immediately felt by the euro zone's weakest borrowers, such as the Italian government, which have come to rely on the ECB as a major buyer.
Investment bank JPMorgan ramped up its forecast on Thursday for how high euro zone interest rates will go to 3.25% from 2.50%, after the European Central Bank vowed to keep raising them at a meeting earlier.
Societe Generale hiked on Thursday its forecast for how high euro zone interest rates will go to 3.75% from 3% previously, after the European Central Bank vowed to keep raising them at a meeting earlier.
Conclusion:
Well, guys, it would be prominent to add some additional data on claims, Retail sales etc, but I'm afraid to overload the research. So, we put them tomorrow in the gold market update. Take a look how fast the public sentiment changes. Just after CPI numbers everybody were ultimately dovish - inflation is defeated, Fed is pivoting etc., and what we have now - new higher terminal rates are widely expected, as in the US as in EU. Plans, plans... I would ask you, when the Fed plans ever have been fulfilled? I tell you - never. Just recall that we should have "temporal" inflation now, guys. Take a look at this - two Fed projections with 1 year gap:
The point of comparing the two meetings is to show the zero predictive ability of the Fed – they are not able to build realistic development trajectories, not just for several years ahead, but even for 6-12 months they cannot predict. Therefore, in terms of content, the value of the Fed's forecasts is close to zero. Based on their projects, it is impossible to build investment strategies, because the percentage of errors is incredibly high, and delays are prohibitive.
What's the point? As recently as yesterday, Powell stated that the Fed will continue its restrictive policy for as long as it takes to bring inflation under control, and in 2023 there is not even a question of lowering rates. But this is bluff and stupidity. The system will begin to shake to the borderline levels in the spring of 2023, so the refusal to tighten financial conditions will be quite rapid – you should not bet on the determination of the Fed in the matter of tightening.
And another moment. The Fed does not forecast a recession in 2023, expecting growth of 0.5% (!!!). Forecast statistics are presented in the tables, but as it is shown - the Fed always misses. Recession is inevitable, the margin of safety is running out.
Fed stands in situation now when it can't borrow sufficient funds on the market. First is because nobody's buying, second - because it is just 166 Bln until debt ceil, and Reps with big pleasure do the dirt to Dems in discussion of rising of national debt ceil, as usual. Based on US Treasury balance dynamic, 340 Bln of existed reserves should be enough until summer, to keep system on a surface. And this is most positive scenario. If somebody really big will default, it will be much worse. Finally, Fed has reached a threshold rate level and scares to rise it more, because as we've explained the effect is lagging a bit for 4-6 month. With no ability to rise rates more, high inflation of 5-6%, high interest rates of ~5% and exhausting reserves to support system Fed probably will start easing. Maybe we're wrong but currently we do not see any other scenarios.
The same things we could say about EU, where situation will be even worse due total destruction of national industry sector, big financial fragmentation among different countries. 5% vs potential 3.25% looks not in favor of EUR. Besides, ECB could meet the same problem of urgent stop rate hike, if system will start falling apart. Especially on a background of coming QT in 2023. I wouldn't rely on forecasts as of ECB as of Fed. Still, as they mostly go in the same direction, and now both suggest stay hawkish, the EUR/USD balance should be re-established, and demand for the USD should start rising again, which is also suggested by our DXY monthly B&B "Buy" setup. Let's see. Also we do not see any clear signs yet to cancel 0.9 target. Although the way might be more bendy now.
