Mutual Daily Mutterings
Quote of the day…
”Gentlemen, you can’t fight in here! This is the War Room”…President Merkin Muffly, “Dr. Strangelove or: How I Learned to Stop Worrying and Love the Bomb”
“Watch Your Step…”
Overview…”Faster is better…apparently”
- Moves: risk on … stocks ↑, bond yields ↑, credit spreads ↓, volatility ↓ and oil ↑….
- A solid rally in stocks across the board, with US, European and Asian markets shrugging off geopolitical risks and likely consequences of monetary policy tightening. Markets seem to be of the view that the Fed has everything under control…Bahahahahahaha! Bonds continued to puke themselves with European yields +3 – 7 bps higher, while US treasuries (10Y) were +9 bps higher, with a bear steepening of the curve. Short-date treasuries are now on course for their worst quarterly performance since the early 1980’s. Oil fell after a volatile session for crude futures as Germany and Hungary put the brakes on a potential embargo on Russian oil.
- Fed speak…the Fed’s Bullard doubled down on his hawkish call, “faster is better” in his book, when it comes to tightening. He reiterated his call for rates to rise above 3.0% this year. Many would argue the Fed is scrambling to reclaim lost credibility after failing to recognise inflation risk correctly.
- “Recession risk” is back in the narrative, with Dallas Fed economists predicting a global recession is unavoidable without resumption of Russian energy exports this year. According to their analysis, the imminent slowdown could be more protracted than in 1991, when recession was triggered by Iraq’s invasion of Kuwait a year earlier – and the subsequent spike in oil prices, +140% (to US$39/bl).
- Still on recession risk, the IMF has warned that some countries are on the brink of recession as a result of the war impact (indirect), and the fact that many have yet to recover from the pandemic. According to IMF numbers, some 60% of low-income countries are now in or near “debt distress,” up from 30% prior to Russia’s invasion of Ukraine.
- War latest…”Russia’s parliament voted to expand a law targeting the publication of “fake” news and a court sentenced jailed opposition leader Alexey Navalny to another nine years in jail. A top advisor to Volodymyr Zelenskiy said there’s “no wiggle room” for territorial concessions but that the president sees potential for progress in talks on neutrality. The Kremlin reiterated that discussions are going more slowly than they’d like.” (Bloomberg)
The Long Story….
- The war impact so far….
Source: Bloomberg, Mutual Limited
Source: Bloomberg, Mutual Limited
- Offshore Stocks – I’m struggling to explain stocks at the moment. A solid rally across the board globally overnight with European markets up over +1.0% on average, while the DOW in the US rose +0.7%, the S&P 500 advanced +1.1% and the NASDAQ almost gained +2.0%. Just under three-quarters of the S&P 500 advanced, with only one sector, Energy (-0.7%) failing to get out of bed. Discretionary (+2.5%), Telcos (+2.0%), and Financials (+1.6%) were top performers on the day.
- I touched on yield curve inversion yesterday and how this historically has foretold looming recessions. I stand by that comment, but some interesting commentary came across my screens yesterday that indicated, while, yes, inversion is a prelude for recession, there is a lag. For instance, the 2s10s curve first turned negative in December 2015, two full years before the economic downturn. Investors who sold stocks (S&P 500) in December 2015 would have missed a total return of 22% by the time recession hit. Since 1976, post curve inversion plus 250 days, the median S&P 500 return has been +12.5%. The data-set included a dozen instances of curve inversion, but not all experiences resulted in gains for the S&P 500. A third of instances saw stocks retreat, as much as -9.5%. The author of this analysis suggested the time to run for the hills is when curves re-steepen, which is when the Fed was generally cutting rates, as the economy slowed. In this regard, rate markets are expecting rate cuts to kick-off in 2024, which is not unreasonable. Until then, equity investors should stop worrying about curve inversion…because there are many other things to worry about.
- Local Stocks – solid gains again for the local indices as Australian stock markets benefit from their proportionate weighting to energy and commodities. The ASX 200 rose +0.9%, albeit a narrow rally with only just over 50% of stocks advancing. Materials did all the heavy living, up +3.3%, ably assisted by Energy (+1.7%) and Financials (+0.6%), with these three sectors offsetting losses elsewhere. Tech (-1.3%) suffered most, which is to be expected given higher yields – please explain! Tech stocks are generally considered growth stocks, i.e. they tend to sport high PE multiples, and as yields increase, discounted cash flows deteriorate.
- Offshore credit – the grind tighter continues in offshore cash spreads, and the same in CDS with the MAIN (-1.9 bps) and CDX (-2.4 bps) both tighter. Cash spreads, in the IG space, were a basis point tighter on average. Over the war period it is interesting to note that offshore high-yield has meaningfully outperformed the IG space. The US HY index is -2 bps since the commencement of the war. Ironically, the entire war backdrop has probably been supportive of high yield via the energy complex, with energy spreads close to their tightest of the year thanks to elevated oil prices. Primary markets were active with eight deals pricing US$10.5bn, taking WTD issuance to US$26bn (vs US$30bn full week forecasts).
- Local Credit – traders…”better buying on the day as a combination of sharply higher yields and sustained risk on sentiment in offshore markets has helped stabilise local credit. An uptick in flow with a number of accounts active.” Despite the better buying in general, the action in major bank senior paper has been described as a benign and flavourless custard…”senior FRNs remain mothballed as the blancmange that was the WSTP 3yr deal continues to keep the mid-curve static in the high-to-mid 60s. Some buying of 5yr FRNs by an offshore bank balance sheet and ongoing buying of fixed rate paper at these outright levels. Front end inventories remain elevated and it feels like the entire curve would benefit from a prolonged absence of primary issuance which would go a long way to reintroducing interest and price tension back into this market.” As you assume, no changed in the senior curve. A little more-frisky in tier 2 markets, with spreads marked a smidge tighter across the 2025 (+156 – 157 bps) and 2026 (+174 – 179 bps) callable lines, all a basis point tighter. Offshore tier 2 has performed of late, so it was only a matter of time before they became fashionable again locally.
- Bonds & Rates – duration managers were taken behind the woodshed yesterday and roughed up, with a gnarly lump of timber. As expected, two-year ACGB yields broke through 2.0%, up +19 bps on the day, closing at 2.15%, while ten-year yields climbed +14 bps to 2.73%…3.00% here we come? Three-month BBSW hit 0.18%, while forward implied cash rates were on the rise also, with two RBA rate hikes by the end of July priced in. As a result of yesterday’s moves, the Bloomberg AusBond ACGB index dusted -74 bps in performance, with month to date losses falling to -3.29%, with YTD losses at -5.55% and likely more pain today with US treasuries continuing to sell-off (yields higher) overnight. Semi’s fared worse, dropping -82 bps yesterday to -2.95% month to date and -5.32% YTD. It was a little less painful for fixed credit, dropping -57 bps on the day, taking month to date losses to -2.39% and -3.99% YTD. Floaters performed better, dropping just a lonely -1 bps, taking month to date losses to -0.29%, or -0.28% YTD. I expect more pain for local duration managers today, but also see yields overshooting and expect a pull back at some stage. Problem is picking the timing, but relative strength indicators are flashing “oversold” with an RSI of 77 (>70 = oversold). This has occurred over a handful of times in the past year, with a rally in yields more often than not following.
- As I write, US treasury ten-year yields are +9 bps higher, to 2.38%, while two-year yields are +4 bps to 2.16%. The US curve is now essentially flat from 2Y to 10Y, highlighting the markets complete lack of an idea on where this poop-show is going. The ‘poop-show’ being the state of affairs the world finds itself in with war in Eastern Europe, commodities surging, the inflation genie out of the bottle, and, and it’s a big and, an almighty monetary policy hangover. Relative strength indicators (RSI) are flashing “oversold” for treasuries also, currently sitting at 73. This has happened six times in the past year, and in each instance, yields have dropped promptly by anywhere between -7 bps and -20 bps in the subsequent week.
- Macro – nothing of note.
- Stake Knives….Fed Being Pushed Into Developing-Economy Camp: Mohamed El-Erian
Judging from price movements on Monday, the Federal Reserve risks slipping further into a no-win interaction with markets that is more familiar to developing countries that lack policy credibility than to a systemically important central bank — let alone the world’s most powerful one. Absent a quick reestablishment of its inflation credential, something that the markets doubted again on Monday, the Fed would face even more of a no-win policy paradigm that would cause what, only a few months ago, was avoidable harm to livelihoods in the U.S. and beyond.
This unfortunate sequence is painfully familiar to some developing countries:
- First, through a misdiagnosis of the economic situation or policy inertia or both, the central bank falls behind inflation realities and erodes its inflation-fighting credibility.
- Second, swallowing its pride, the central bank acknowledges that inflation is too high, toughens up its policy narrative and embarks on the needed measures.
- Third, rather than be reassured by this (albeit late) change, markets run further away from the central bank and signal the need for even more aggressive policy measures.
- Fourth, the central bank finds itself in the dilemma of either risking a recession by validating the ever-more hawkish market pricing or seeking to minimize such damage, often unsuccessfully, by enabling high and potentially more destabilizing inflation to persist even longer.
With this sequence in mind, consider what happened on Monday, less than a week after the Fed’s top policy-making committee raised interest rates by 25 basis points and signalled further increases.
In a presentation to the National Association for Business Economics, Chair Jerome Powell tried to restore the Fed’s eroded inflation-fighting credibility by signalling that the central bank is willing to increase interest rates by 50 basis points in May, repeat that at other meetings and continue raising past the neutral level in a bid to meet its inflation objective. Yet nominal market yields, the yield curve and inflation breakevens were far from reassured. Instead, they moved further away from the Fed.
While Russia’s invasion of Ukraine has amplified the Fed’s policy challenges, the hole it is in is of its own making, and that was illustrated by Monday’s developments.
Despite ample evidence to the contrary starting almost a year ago, the Fed stuck to its “transitory” characterization of inflation until the end of November — what I called months earlier one of the worse inflation calls in the history of the Fed. Even after it belatedly “retired” the word from its vocabulary, the Fed kept its foot on the accelerator of policy stimulus. To illustrate the extent to which its policies remained misaligned, it was still injecting liquidity through its asset purchases earlier this month, including the week in which the February reading for U.S. inflation came at 7.9%.
For many months, I have been arguing that the Fed should come clean on why it got the inflation call so wrong, explain how it has improved its understanding and forecasting of the current inflation dynamics, immediately stop its liquidity injections and start its interest rate hiking cycle. The idea was to ease off the accelerator and start tapping the brakes softly instead of having to do what the market is asking for now and Chair Powell acknowledged on Monday: Having to hit the brakes a lot harder.
That was then. What about now? Is there still an optimal policy response for the Fed?
I worry that, being so late and having lost so much credibility, the Fed is far away from the policy world of “first bests.” Rather than having a way to contain inflationary expectations, cause no undue damage to the economy and meet its dual objective, the Fed is increasingly being forced to consider what is the least bad policy mistake it wishes to be remembered for: meeting its inflation target by causing a recession, or allowing high and potentially destabilizing inflation to persist well into 2023.
This awful trade-off is familiar to too many developing countries. And one of their typical reactions may also shed light on what may be tempting for the Fed: simply hope for an immaculate recovery — that is, some mix of consequential productivity gains, quick-healing supply chains, surging labour force participation and continued financial market resilience to pull the central bank out of the deep hole it has dug for itself.
Source: Bloomberg, Mutual Limited
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Scott Rundell, Chief Investment Officer
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