Hive Intelligence Report: The Bid in Rates, Risks to a China Trade, and What Annoys Russia

Every week, we bring together our community of macro experts to discuss the latest market developments. In this piece, we distil the insights from our conversations up to 31 January. These are views from our network rather than the views of the Macro Hive research team. ‘[Day]’ indicates the day the comment was made.

US

What’s behind the bid in fixed income? [Thursday]

• Curve flattening is taking a lot of duration from the market; USD strength/equity weakness is an FCI tightener which also helps the curve. Furthermore, at 25+bps for March and 100+bps for 2022 and the balance sheet shifting in H2, it’s a reasonable discussion – what more do you want now, and/or do you really think they can deliver all of that? Also, it was a day after a highly anticipated event, the market has shorts, there’s risk reduction/gross reduction in the leveraged space into month-end, and a lingering risk is whatever happens between Russia and Ukraine. Lastly, is fixed income really bid or is it just not selling off?
• There was a blow out 7-year auction. $53bn in 7y notes, 0.1bps through WI levels, without any concession, at a B/C of 2.36 with 85.5% going to non-dealers. But really the concession happened yesterday.
• Did the dealers max out?
• Despite still easy quantitative policies, reserves have collapsed. When participation in all other facilities remains highs, the draw comes because of the TGA build up, and points to a very sensitive dealer community in response to QT. It can be a real issue.
• It could be. But reserves to TGA is simply mechanical. Also, if the Treasury funds with T-bills, at least in the beginning, as they should, you will get the RRP draining and not reserves. The Fed moved from forward guidance to data dependency, which itself is nothing usual, last time it did that was perhaps 2018. But it creates uncertainty. So, it was not necessarily the hawkishness driving the markets, but the fact that the Fed could become even more hawkish. And then the next big switch that could happen this year if the Fed moves from fighting disinflation to fighting inflation – the Fed has recently moved to the fence only. That switch has not happened for many years.

Will the Fed hike by 50bps in March?

• There’s a chance. But there’s still a while until the March meeting. If the market prices it by that time, then the Fed should take the opportunity.

What trades will there be?

• A key moment will come when markets fully price the most hawkish outcome – somewhere between five and seven hikes – and that’ll be the point to buy stocks and sell USD.

What does history tell us?

• The Fed has never started an interest rate cycle with a 50bps hike (if you exclude the 1970s when monetary policy was conducted differently anyway). But, then again, inflation has never been this high either. So, it is possible. That would be a clear acknowledgment from the Fed that it has been behind the curve.
• The experience from most hikers, until today, has been early and aggressive tightening that goes beyond guidance or expectations.
• If they go too slowly, they will lose control of inflation. Arguably, more hikes now mean less hikes in total.

What will they do when the curve starts inverting?

• Actively sell their bonds.
• It’s not an issue of them selling. It’s an issue where the market genuinely seeks insurance.
• If inflation settles at 4-5% in the summer, then we will see long end yields reprice.
• Given the meaning of signaling an inverted yield curve gives (monetary policy is too tight), selling coupons may steepen the curve mechanically but also tighten policy further which would make things even worse.
• Yes, but given the Fed owns trillions of bonds to begin with, couldn’t you say that the level of long-term yields is artificial at this stage anyway?
• The marginal seller and buyer determine the price. It’s not the stock of homeowners that determines the price, but the incremental buyers. One can say that if the Fed owns so much debt, and given there are no volatile price driven sellers, that makes USTs a safer place to be.
• The Fed owns almost near equal amount of coupons 1-5-year, and 5-year and over. The long-end yield is as ‘artificial’ as the short-end yield. The Fed is not necessarily distorting the shape of the curve. The signal the shape of the yield curve is sending should not be affected by QE.

UST Curve and the Fed Rate Cycle

• In 1995, the shape of the UST curve signaled market interest rates are in a restrictive territory (same UST 2s10s steepness as now), but there was no recession until 2000.
• The only difference to today is that administered rates are not there yet: the shape of the UST curve is signaling market rates are in the restrictive territory even before the Fed has started hiking the Fed Funds rate – at least compared to the last three rate hiking cycles (2016-18, 2004-06, 1994-00).
• During the 1994-00 cycle, the curve started signaling restrictive policy already in 1995 but the Fed Funds properly peaked only in 2000. Before 1994 it was either communication policy being messy (before 1994, the FOMC often changed its policy stance between meetings) or monetary policy was messy (Volcker was targeting the money supply pre-1982). So, it’s difficult to make direct comparisons with today.
• It’s one of the current macro debates. Are we in 1994, when the aggressive Fed tightening extended the business cycle and the stocks had some amazing years ahead? Or are we in 2006, when slow hikes resulted in excess accumulating and a sharper recession in the end (of course cannot say that we have similar excesses as in 2006-07)?
• The mid-90 cycle was fun, surprise 50bp Fed hike, total data dependency, strong economic growth, it feels like today. Today has nothing to do with the 2006 cycle.

Is there a wealth illusion?

• Credit creates the wealth illusion. Tighter credit destroys it. It will take some adjustment. Younger generations have never experienced this.
• Wealth is a credit, and credit is wealth. This is the single biggest innovation that took us from the middle age feudal structure to an economy of enterprise.

Reaction to Tesla earnings

• Planned supply way before COVID-19 allowed Tesla to be well supplied in chips and increase their production. All their suppliers prioritise them.
• It’s a very good and improving company with a clear proposition that goes more into technology than into automobiles.

Where are China risks?

• Short China was the second most crowded trade. Tech was first. Probably now, short China has taken the top spot.
• A common trade in our network has been long HSI. But it hasn’t gone anywhere yet.
• But if the Ukraine situation is any guide for Taiwan, you can imagine a lot more damage being done on Chinese assets.
• There’s no connection, China is nowhere near invading Taiwan.
• Russia is not near invading either. But they don’t need to invade for the US to inflict damage on them through sanctions.
• The US will continue their piecemeal sanctions against China. It’s hard to see an immediate market moving sanction, for now. China doesn’t care about these human rights sanctions. China will grumble, accept, and move on. Economic sanctions are a different matter.

Does it matter if China gets stripped from index inclusions?

• For politicians, the index inclusion appears too arcane a process to get involved, except for Rubio who’s been talking about it, but these never go anywhere.
• As for index providers, they will not unilaterally take the step to remove China. It will have to be forced upon them.

Europe

Are BTPs a buy now that Draghi will continue as PM?

• The premium for the presidential mess was small. So, the market will react positively for a day or two. But the next inflation release will matter more down the line, and there are some banks calling for a sharp inflation drop for technical reasons.
• Effectively, you are trading ECB more than Mattarella.

What’s important for the ECB

• It’s unlikely to see a recession by June to start QE again. BoE will not be reinvesting, so pressure is on the ECB. There’s huge pressure on the ECB to stop QE earlier. Net supply, excluding QE, is already expected to be positive for the first time since 2019. Likely to be even more so if they taper again.
• Now H2 may be a different story if inflation and growth have materially slowed down. But the direction of travel in H1 looks more like a hawkish ECB. Jan HICP print is important. Maybe gas prices come down, given the warmer weather, and China LNG exports. That could help. Also, NS2 made the Swiss entity required. But these can only help later, not now.

ECB TLTRO 50bps discount expires in June this year. Can’t this be considered an automatic stealth hike by the ECB?

• It will withdraw liquidity too. Could be €1tn less, depending on repayments. Still a lot of excess liquidity, but the balance sheet will decline. A bit like around 2013 when the first LTROs were being repaid. And the multiplier will increase, so more money is taken from cash bonds into reserves.

Russia and Ukraine

• Much of the current standoff between Russia and Ukraine revolves around ensuring Ukraine never joins NATO. NATO was formed in large part to defend Western Europe against Russia and the USSR. Arguable that during the Cold War it served as a useful purpose. For the past 30 years it has been a relic of the Cold War, a constant reminder to Russia that the West has an adversarial relationship with Russia.

Food for thought

• In a counterfactual world, what if after the Berlin Wall fell and the USSR collapsed, NATO disbanded, or was repurposed into something different, thus removing that constant irritant to Russia? Could Russia have evolved into a more West-friendly country or was it always going to have dreams of becoming a super empire?
• The vested interests of the military/industrial complex were making too much money to ever let NATO slip. Regardless of its need or utility.
• NATO is obsolete. The counterfactual could be more stable in the long term.

What destabilises Putin? Or will Biden be destabilised before Putin?

• Destabilisation of Biden is already underway – but there are plenty more who can carry on his work. Destabilising Putin is entirely different in terms of its consequences. That is, this is a known known versus a known unknown.

What annoys the Russians?

• Early in the 2000s, Putin wanted Russia to join NATO. And back in the early post-WW2 years there was the Molotov memorandum which called for the Soviet Union to join the formation of a European collective security organization, without the US (which the Americans blocked). Putin was very much pro-US/the West in the 1990s. What changed the game was the privatisation campaign back then. No sane or sober Russian leader would have allowed foreign ownership of strategic resources, such as oil and gas, for example to Western/foreign forces. Once Putin became president, he made sure that this is the case. The Yukos case annoyed the Americans, and it has been such ever since.
• One other thing that bothers the Russians is the 1998 default and the way it was arranged. Who defaults on their own local currency debt and at the same time devalues their currency and makes sure that foreign holders of USD debt get paid in full (with some exceptions)?

Assessing the RUB

• Russia is mostly about oil. If you look at USD/RUB price action after Russia took control of Crimea in Feb-Mar 2014, the RUB strengthened in the weeks after. Even after the first round of US sanctions in April, it did nothing. Only after crude halved, collapsing from 100 to 50 after July, did the RUB also start moving (USD/RUB doubled by that year-end, though US imposed more severe sanctions that August).
• Arguably, Russia has since strengthened its economy to withstand foreign sanctions. For example, total trade with the EU has collapsed almost 50% since 2013, while trade with China has increased by about 20%. In 2013, Russia-China trade volume was about 30% of the Russia-EU trade volume. In 2020 that number had doubled to 60%.
• If crude stays big and Russia stays in SWIFT, Russian assets would be ok through turbulence. But one thing that is worrisome is that Russia has been a consensus long for many investors, and probably still is – knee-jerk price action if they panic and want to exit will be bad.

Will Russia continue to have access to SWIFT?

• If Russia loses access to SWIFT, participation in DeFi will increase, and not just in Russia.
• But the US cannot unilaterally remove Russia from SWIFT. SWIFT is governed by EU law. The US can twist their arms but it’s not the same as having a veto. The real beneficiaries of Russian expulsion from SWIFT would be Russia’s own SPFS and China’s CIPS. DeFi is not yet in the league. Ultimately, such an act could be more damaging to SWIFT and the dollar long-term, than to Russia, though, short-term, Russia would be in trouble.

Could China and Russia act together?

• If they both acted simultaneously, could the world’s military manage two theatres of conflict of that magnitude? Likewise, the economic consequences of placing economic sanctions on both China and Russia simultaneously would damage the global economy in unison, prompting the question ‘who wins the catch22 scenario?’

When is it optimal for Russia to invade?

• Mid-February is optimal for invasion as it allows Russian heavy troops to move over the vast frozen marshes to Belarus, allowing for a direct assault on Kiev’s west side of the river. Russia has deployed 140 navy vessels in operation, all its four fleets are engaged.

Modern Warfare

Why do we need F35s and aircraft carriers when the military technological frontier is cyberwarfare and drones?

• It’s going to be drones.
• Think about post Iraqi conflicts and the rise of insurgent conflict (street to street) – the nature of the battlefield changes. Likewise, as an expression of strength, the superpowers need to impose their strength by showing capacity to fight in all modern theatres. A million drones may not (yet) be able to deliver the same ferocity and guarantee of delivery as a hypersonic missile strike?
• It’s easier to shoot down drones if you have an air defense. Drones are more effective against terrorists. They may also be less effective for heavy bombardment.

Inflation

Will there be permanent inflation?

• What is interesting is how much pressure one year of high inflation has created. Inflation is a social choice, younger populations live happily with it, older populations not so much. So much reflex against inflation probably explains why the market doesn’t price a structural change.

How does this help the young?

• Younger people can benefit from more dynamic jobs and switching between them and can replenish their incomes fast or even increase incomes more than the rate of inflation. Older people don’t stand a chance. You can map US levels of inflation with the population share of baby boomers.

Where have all the MMTers gone?

• MMT theory clearly cites high inflation as a limiting factor for monetary policy – in that sense nothing to see here – high inflation does not necessarily discredit MMT theory.
• There is a basic argument that even Galbraith has made in the 50s that fiscal resource is politically asymmetric – easier to scale up than down.
• But in theory, MMT suggest that once inflation gets high, fiscal policy should be tightened via austerity. But that’s not what is happening. Very difficult to do politically.
• Imagine Biden doing budget cuts because of inflation, ahead of midterms.
• Exactly. Monetary policy has to do more (the opposite of the 12 years post-GFC).

What’s worse for risk assets: fiscal or monetary tightening?

• The best thing I have seen in this is the Chilean fiscal rule, but that has been dropped now.
• MMT theory holds, nevertheless. We choose not to implement it, sure. MMT implementation problem is not on the political side but more on the accounting side in any case. But even here it is not a problem which is insurmountable.
• All theory of this type abstracts so much and they are incomplete as models. At the best they can be seen as making ‘an argument’. MMT is an argument, not a policy toolkit. In fact, it is an argument against some policies instead of in favour of a novel one.
• Every theory is an argument before it becomes a policy – it does not mean it should be rejected.
• No, it should however be seen for what it is  – an oversimplification of reality.

Economic Models

• Economics is one of the few fields where reality is seen as a ‘puzzle’ because models have little link to it. In fact, the best models in economics tend to be in the micro space. Every theory places its foundations on a few equations which reflect basic assumptions. Most of the policy debate in the US is centered around whether fiscal policy works in the short or long run. The current state of affairs sees two camps, and these are reflected in the Fed’s two main models.
• The Neo-Keynesian side assumes a set of equations that only work in a world of rational expectations because of a very specific assumption about how wages are formed in a way to lag inflation. And their main tool with which they work is erosion of real incomes paradoxically.
• The other camp is the DSGE camp, which attributes everything to random exogeneous shocks. To the real business cycle crew, the world is entirely random and all we do is decide whether it makes sense for us to go to work in a world that changes without cause and effect.
• MMT does none of the above and proposes no formulation with which the world works. So there is very little space for critique, but also improvement. All they say, rightly, is that debt stocks in countries with reserve currencies are interchangeable with cash money. Meanwhile, a central bank empirically faces: a) an IS curve that doesn’t  equilibrate at the zero-bound; b) a Phillips curve that doesn’t work with the data; c) a real wage path that is unrelated to consumption and subsequent price inflation empirically; d) very low passthroughs from FX to trade or inflation; e) asset markets that obey to very little ex ante modelling; f) fiscal frameworks that are done very quickly to fight crises but not very thoughtfully and few know their impact over time; and g) a complete collapse of sense within how monetary aggregates work.

Market Movements

In the vol world

• Autocallable vega issuance has been huge last week as people clamor to harvest the bid to risk. From the other end of the curve, gamma issuance appears consistent. As the pain of the January expiry slowly shifts off the pad, and portfolios are rebalanced, a lot of market calming gamma/vega is coming to the market.

Is Korea worth investing?

• Korea is a tough one. The dram cycle is tricky. The election currently favouring the left-wing party doesn’t help either. It would be worth it if the right-wing part looked like winning.

COVID-19

• The new BA.2 strain of Omicron is two times more transmissible than the current BA.1 strain. However, also benign in terms of hospitalisations.
• If the US follows South Africa and UK and returns to work in the next two to four weeks, we can begin to address domestic supply chain issues, and Asian ports after that.

Cryptocurrency

• Stablecoins are printing 300mm a day now. Will this break?

What does ‘printing 300mm a day’ mean?

• It’s a story that is well understood but somehow doesn’t seem to have mattered. How stablecoins send money to the exchanges where they are used to buy crypto, and the question was ‘where does this come from?’

Where does this ‘300mm a day’ come from?

• Supposedly backed to the USD. But it’s unclear how this can be and where these USD are.
• So, if people want to get out of crypto, instead of just shuffling in and out of stablecoins to go into and out of Bitcoin etc, then you could get a run on the bank type scenario. What will actually happen is that people may not have a way to get real FIAT back.

How can you think about stablecoins?

• The yields on USD stablecoins are around 8%. You could deposit USD to Gemini, transfer into USDG, which is their stable coins, park in their earn function, and return 8%.

Why do you earn 8%?

• Gemini lends it to Genesis trading at 10-11%, and then they lend it to hedge funds at 12-15%.

Trade Ideas

• Bought Council of Kingz NFT [Thursday]. Like a REIT, but in the metaverse.
• Adding China beta risk to portfolio [Thursday].
• Peacetime trades: short EUR/CHF, short EUR/GBP, long NOK/SEK, and long 3-year UST.

Interesting Reads and Watches

Read

• The Trouble With Macroeconomics | Professor Paul Romer of Stern School of Business, New York University
• On Russia, NATO cannot fold | Politico
• When People Listen to Happy Songs, the Market Outperforms | Harvard Business Review
• Did Powell Just Burst The ESG Megabubble | Zero Hedge
• A Big Change Is Afoot. It’s Not Just a Rate Hike | Bloomberg Quint

Watch

• COVID-19: A Second Opinion with Senator Ron Johnson

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.

(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.)