Bilal’s Macroscope: 3 Puzzles to Solve

Explaining market moves is hard enough, let alone forecasting them. And there are three market dynamics on my mind:

1.    Why Are Stocks Up if Rates Markets Are Pricing a Recession?

As soon as Silicon Valley Bank failed, rates markets priced dramatic Fed easings. Markets went from pricing a peak Fed policy rate of 5.5% and barely any cuts for 2023 to pricing a peak of 5.25%, at least 50bps of cuts in 2023 and another 150bps for 2024. The sharp inversion of the US 3m2y curve reflects this (Chart 1). It suggests rates markets are pricing a recession. Yet the S&P500 has surged over the past month (Chart 1). What gives?

One answer is that US big tech companies are less sensitive to recessionary dynamics and benefit more from lower rates. Indeed, they have already been shedding labour and so are in recession mode. US tech also benefits from non-US growth. Focusing on small caps, which likely reflect expectations of the US real economy, we find that they have indeed underperformed since the Fed repricing (Chart 2).

If we look at US rates markets in more detail, we find a clear narrative. The SVB failure introduced a new shock to the US system. There has been a flight to high-quality collateral with short-term US T-bill yields collapsing (Chart 3). At the same time, the shock has sharply lowered 1y inflation expectations. This suggests rates markets are implying a credit crunch sufficient to bring a US recession, lower inflation and the start of a Fed easing cycle.

Taking this at face value, we have two further questions. Can US tech and the S&P500 still perform in a US recession? Can the rest of the world de-couple from a US recession?

2.    Inflation Is Falling or Inflation Is Sticky?

The latest US CPI report showed a large drop in the headline rate of inflation from 6% in February to 5% in March. Declines in food and energy drove much of this, since core inflation remained sticky around 5.6% (in February, it was 5.5%). Reading inflation since COVID has been a challenge because the US economy has undergone a sectoral shock. Lockdowns led to a goods boom and services bust; the re-opening has seen the reverse.

The breakdown of CPI components shows that this continues to be the case. The inflation pulse for energy, food at home, used cars and medical services continue to show deflationary pulses (Chart 4). These were sectors that boomed during lockdown. On the other side, we continue to see inflationary dynamics in food away from home, shelter, transport and recreation.

This divergence is visible in the less discussed food component. The BLS bundles ‘food at home’ with ‘food away from home’ (restaurants). Yet different dynamics can drive these components. Notably, households that feel comfortable with their income are more likely to go to restaurants, which in turn leads to higher restaurant prices.

Looking at y/y changes in both components since 1970, ‘food at home’ exhibits high volatility while ‘food away from home’ is smoother (Chart 5). Notably, the ‘food away from home’ measure has yet to fall, suggesting inflationary pressures remain. The 3m pulse in these components confirms this – it shows ‘food away from home’ is stabilising around the 7% mark (Chart 6).

3.    What Are US Small Businesses Telling Us?

This week’s US small business (NFIB) survey brought much attention. Overall optimism was a low 90, which it has been since June 2022. The index has been falling since 2018.

Yet within the components are conflicting signals. Actual capex has risen since last year, despite small businesses thinking it is a bad time to expand. On the credit side, which covers the SVB failure period, the availability of loans fell, but more small businesses felt their borrowing needs were being met. This shows the challenge of using the NFIB survey: you can pick a bullish or bearish take depending on your bias.

My preference is to focus on the survey question, ‘What is the single most important problem you face?’ On that front, by far the biggest problems are either the labour market (costs or quality of workers) or inflation (Chart 7).

Financial issues barely register. Even during the GFC, the bigger challenge was poor sales rather than financial issues. We have to go back to the early 1980s to see a time when financial issues were the biggest problem.

To me, this suggests that small businesses are not feeling a credit crunch or collapsing demand. Of course, it may take a few months for these issues to come to the surface, but the message from the latest survey is that we are not there yet.

Our Current Discretionary Trades

For now, we are running with a bullish risk theme, especially in EM. We are short USD against EM, and long EM equities. In DM, we are long US real rates and short Italy. Here are the details:

1. Long 5Y TIPS vs US 2Y (target: 90bp) – read here.
   • Trading the Fed need not be directional. Mustafa sees value in buying TIPS and hedging it with the nominal US 2Y to trade both the ‘end of the Fed cycle trade’ or the ‘hard landing’ scenario.
2. Short BTP vs Bund 10-year (target: 220bp) – read here.
   • Henry sees the BTP vs Bund 10Y spread trade reaching 220bp.
3. China re-opening – read here.
   • Long SHCOMP (target: 3,600)
   • Short USD/CNH (target: 6.65)
   • Short USD/COP (target: 4,100)
4. Receive 2Y INR OIS (target: 6.0%) – read here.
5. EM to rally – read here
   • Short USD/IDR 3M NDF (target: 14,000)
   • Short EUR/CZK (target: 23.25)

Recent Questions From Clients

• Doesn’t the pace of Fed hikes mean we haven’t seen their full effects yet?
• Haven’t US household balance sheets worsened recently?
• Will EUR/USD reach 1.15/1.20?
• Why haven’t EM rates rallied more given the US rates move?
• Why won’t the BoJ hike at their next meeting?
• Is IDR still a good trade?

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)