Bilal’s Macroscope: Back to the (Fed) Future

Many are squabbling over whether the Fed goes 75bps or 100bps next week (we are in the 75bps camp). But for me, the more important milestone is that the Fed policy rate will exceed 2.5% – the peak rate seen in the last Fed hiking cycle (2015-2018). Many were sceptical that was even possible at the start of the year, and it was only since Q2 that consensus started to entertain that possibility.

Don’t Fight the Fed’s Volker Pivot

Yet, when I speak to clients, most are sceptical the Fed will hike to 5.25% – the peak policy rate of the 2000s. I like to point out that was a period when inflation was lower than today, and unemployment was higher. And clients are even more sceptical about Dominique’s view that the Fed could reach 8%. I think the news flow over the past month has certainly helped our view – core inflation remains high, growth momentum is solid, and the Fed has started to invoke Volcker – what more clarity could we ask for?

So, what is the implication of this view? For one, it suggests front-end yields could go higher. This could see the US yield curve (2s10s) flatten to well below -50bps, which were the previous troughs since the late 1980s. During the Volcker era, it fell to -200bps. Forwards have the curve at -35bps in a year’s time – so there is clear value in this trade.

Dollar Surge

Another implication is that the dollar could continue to overshoot to new highs. The real trade-weighted dollar has blown past the late 1990s/early 2000s highs but has yet to reach the highs of the mid-1980s. That ended with the Plaza Accord, which contributed to lowering the dollar. Right now, we have some grumblings from the Japanese about dollar strength, but there appears to be no broader global concern.

On top of that, the US trade balance has sharply improved – it had fallen to -$106bn in March but has now bounced to $70bn. Meanwhile, the Euro-area trade balance has tumbled to -EUR40bn (before COVID, it was clocking in at +EUR20bn). And Japan’s trade balance has fallen to -JPY2.4tn a month. Only China’s trade balance has shown any strength, but that likely reflects weakness in domestic demand (hence weak imports) and explains why the PBoC is easing. We like to be short EUR/USD and long USD against Asian FX.

Missing Japanese Inflation

Next week, we also get BoJ and BoE meetings. I have always wondered why Japanese inflation has been so low compared with other countries since COVID. Currently, core inflation is +0.4% against the US’s 6.3% and Euro-area’s 4.3%. So I crunched the numbers to understand this better. It turns out that Japan’s food inflation has been less acute than the West’s, and there have not been the same COVID bounce-back effects on services inflation. On top of that, rental inflation remains anaemic. From a macro perspective, the large negative output gap has certainly weighed on inflation – both the US and Euro-area have seen their negative output gaps end. Given this, I am sceptical the BoJ will end YCC next week. But perhaps with all the FX intervention talk, they may make a move.

As for the Bank of England, they have been trying to be dovish for a while even in the face of rampant inflation. But now, with the energy price caps, they have an excuse to expect inflation to ease. So, they will likely hike 50bps but sound dovish thereafter. From a rates perspective, curve steepeners make sense – dovish central bank and wild debt issuance. This should also weigh on the pound.

Do Models Agree With Us?

So far, I have given our macro-based views, but we could be wrong. So I like to cross-check views with a more quantitative approach. We have a plethora of models, and here is what stands out from them:

• Momentum models have not worked well for equities recently, nor rates (except gilts – current signal is a sell), but have worked well for FX. They are currently giving buy USD signals.
• FX carry trades are performing well, especially our carry:vol strategy. It has delivered a Sharpe ratio of 1.4 over the past year. Currently, it signals being long TRY, INR, PHP, MXN, HUF and short JPY, CHF, EUR, NOK, SEK.
• Our positioning data finds hedge funds and real money disagree on the euro. But both are bearish yen. They also disagree on UST but somewhat agree on being bearish equities (hedge funds are short and real money are the least long in a year).
• Our European bond issuance tracker suggests EGB issuance will pick up in coming months. We currently favour EGB flatteners, so this could be a risk to our view.
• Our flight tracker shows Chinese flights are falling again and remain far from their pre-COVID levels – this supports our bearish China growth view.

Oh, and if you want to sound smart on crypto, check out our piece on the ethereum merge.

Recent Questions From Clients

• Would Japanese FX intervention make the BoJ dovish or hawkish?
• What would cause the Fed to hike 100bps next week?
• What should the BoE do?
• How high can USD/CNH go?
• By how much has China’s zero-COVID strategy lowered growth? And would we see an equivalent growth boost if the policy ended?
• Which part of credit would be most impacted by a higher Fed?
• Which CE-3 market is most vulnerable?

What I’m Reading and Watching

• This new paper on ‘The Midlife Crisis’ is worrying – ‘This paper documents a …crisis of midlife among the inhabitants of rich nations …[despite being] close to their peak earnings. The paper shows hill-shaped [data] patterns …on midlife suicide, sleeping problems, alcohol dependence, concentration difficulties, memory problems, intense job strain, disabling headaches, suicidal feelings, and extreme depression.’
• I like to read old religious texts – not because of any religious beliefs, but rather because they are a repository of time-tested self-help tips. Currently, I’m reading the 2,500-year-old Hindu text ‘Bhagavad Gita’. I liked these lines, especially when you are suffering drawdowns (!): ‘Seeing the same in pleasure and pain, gain and loss, victory and defeat…then you will be sinless’ and ‘Because you let go of attachments to the fruits of your actions, you are ever content and have no dependence.’
• I came across this new tool that tracks political podcasts and their political persuasion. I am thinking we could do something for finance, too.
• I am loving the Game of Thrones prequel, House of the Dragon. I also like the new season of Industry – the best show on what it is like working on a trading floor.

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.)