Month: July 2022

By Elwin de Groot, head of macro strategy at Rabobank

After last week’s recession fear-driven bounce-back in bonds (especially those at the shorter maturity section of the curve), markets took a breather on Monday as the US were closed for Independence Day. The European 2-year swap rate (which declined by a whopping 80bp in the last two weeks of June), recovered by more than 10bp yesterday. Arguably that was also driven by hawkish comments from ECB officials, such as Bank of Slovenia Governor Vasle, who warned that there will “likely be more rate hikes […] after September”. The RBA’s second consecutive 50bp hike this morning – albeit in line with the market’s expectations – served as another reminder that short-term rates are on a (steep) upward slope, globally.

Meanwhile, the US and China are in talks over a roll-back of tariffs imposed by the former Trump administration. It is our understanding that Treasury Secretary Yellen is a proponent of such a reversal, but that there is no unity on this issue in the Biden team. US Trade Representative Katherine Tai, for example, sees the tariffs as useful leverage in broader discussions with China (although sceptics will argue that the tariffs have done little to rebalance the trade relation between the two countries). The downward impact this would have on inflation is likely to be quite modest according to many analysts. Still, if such a decision were to coincide with the start of a downward trajectory in inflation (for entirely different reasons, such as ‘peak’ commodity prices), President Biden –who has also expressed great concern over cost of living issues for US households– may spin it as a vote-winner as the November mid-term elections are drawing closer.

Overnight, we’ve seen more ‘positive’ news from China, as the Caixin composite PMI survey for June rebounded strongly (55.3 from 42.2 in May) following the relaxation of lockdown measures in big cities such as Shanghai and Beijing. However with new reports of flare-ups of Covid-19 in the eastern province of Anhui as well as the broader Yangtze Delta region, which is a key economic hub, the pick-up in activity may well prove to be short-lived.

Indeed, we would argue that it is far too soon to throw recession fears out of the window. From the European side, we were also kindly reminded of that over the weekend by German Federation of Trade Unions (DGB) head Yasmin Fahini, who warned in an interview with Bild that “entire industries are in danger of permanently collapsing: aluminum, glass, the chemical industry” as a result of the current gas bottle necks. The 60% decline in Russian gas deliveries through the German Nordstream-1 pipeline system has pushed European gas prices to levels not seen since the first weeks of the Russian invasion in Ukraine. The TTF 1-month contract rose above EUR160/MWh yesterday, the highest level since 8 March. Rising import prices were also the main culprit behind Germany’s first monthly trade deficit (a EUR 1bn net loss) in May since 1991, as export activity is being hampered by Chinese lockdowns, slowing global demand and ongoing supply chain issues whilst import prices (of energy in particular) are going through the roof.

Germany has already switched to phase 2 of its national gas emergency plan, just one step shy from taking complete control over the allocation of natural gas. Its previously mothballed coal-powered electricity plants are being fired up again and the government is still in talks with Uniper, its biggest gas importer, on what support measures it will provide. According to Germany’s Spiegel magazine, the government is working on legal basis to support gas supply companies with measures that could include the acquisition of shares and/or grant loans or guarantees. The Lufthansa bailout is seen as a blueprint for such measures. Bloomberg reports this morning that the potential bailout package could be as much as EUR 9bn.

But Chancellor Scholz acknowledged yesterday that the country is facing a “historic challenge” and that the rising costs of living could have “explosive” effects on German society, as it also drives a further wedge between the rich and the poor. Arguably, the Chancellor himself is facing one of those Unholy (or Impossible) Trinities: he cannot prevent social unrest, if he wants to have lower inflation and wants to prevent a recession at the same time. One could argue that simultaneously achieving the latter two objectives are already a daunting task in itself, let alone doing so without causing tensions between those in work and those enjoying their pension, or  between the providers of capital and the providers of labour.

So he’d better leave the prevention of inflation in the safe hands of the ECB, right? Oh, hang on, that other institution is actually dealing with an Unholy (or Impossible) Trinity itself. In fact, we would argue, one that is of its own making.

Before you start googling, the “Impossible trinity” concept dates back to the research by international economists Robert Mundell and John Fleming. The central tenet of their reasoning is that it is impossible to have all three of the following at the same time:

• i) independent monetary policy (i.e. full control of your money supply),
• ii) a fixed/stable exchange rate and
• iii) the free movement of capital.

The prime example often used to explain the trinity is the situation where the central bank choses its own monetary policy amidst free capital flows. Under that regime – which basically is the regime under which many developed-markets central banks are currently operating – the central bank cannot control the exchange rate. For if it wants to fix the exchange rate it would have to use its FX reserves to steer the exchange rate. Since these reserves are limited it cannot support its currency indefinitely should it want to maintain an interest rate that is below the ‘global’ interest rate. Should it want to maintain an interest rate that is above the global level, it would likely see considerable capital inflows and the only way to stabilize the exchange rate is to purchase the influx of foreign currency by printing more of its own money, thus raising the money supply and stimulating growth and inflation.

But, we hear you thinking: things are absolutely fine for the ECB, right? Because the “exchange rate is not a policy target”. So no problem there. However, we are actually thinking about yet another Impossible Trinity that is currently playing havoc with the ECB. Over the weekend, the FT reported that the ECB is in discussion over whether and how it could prevent banks from making “multibillion euro” windfall profits from the cheap loans that the ECB has provided them during the pandemic. The basic idea here is that many banks have met their TLTRO targets and therefore borrow at the average deposit facility rate over the entire life of the loan. Since this average rises much more slowly than the actual deposit facility rate when the ECB hikes rates later this month, this effectively offers banks a free lunch.

We asked ourselves: this is not a new issue and the ECB could have seen this coming when it devised the policy. So why and why now? Well, one explanation could be that the ECB has been surprised by the relative low amount of TLTRO repayments by banks so far. But a more interesting explanation – in this regard – is that, in the process of designing its Anti Fragmentation Tool, the ECB may suddenly be realising that it has to give up control of the size of its balance sheet (or better: the monetary base), if it wants to maintain control over interest rates and spreads and prevent fragmentation at the same time.

A thought experiment helps explain the issue. Let’s assume concerns over Italian spreads force the ECB to buy more Italian bonds. And let’s assume that in order to fully sterilize the impact on the monetary base, the ECB decides to sterilize by mopping up liquidity through ‘weekly deposits’ (at a slight premium over de deposit facility rate). This, however, implies that the monetary base would effectively continue to expand, posing long-term risks to inflation. Alternatively, should the ECB decide to raise its reserve requirements by the same amount as it has pumped into Italian bonds, the increase in those requirements would likely pose a problem for those banks already low on excess reserves and who would not see a commensurate increase in their reserves. As a consequence, the fragmentation issue may not be solved. And if the central bank were to issue securities with a long maturity, this would probably raise long-term interest rates (as they would compete with other core bonds). So while that may contain spreads, it would not be able to contain long-term yield levels.

So the basic conclusion here is that, with so many goals to achieve, the ECB risks becoming all tied up in its own instruments. Failure is almost guaranteed. It just has to choose where it accepts such failure.

Tuesday was hailed as a “historic day” as NATO chief Jens Stoltenberg oversaw members of the military alliance formally signing the protocols of accession related to Sweden and Finland’s bids. “This is a good day for Finland and Sweden, and a good day for NATO. With 32 nations around the table, we will be even stronger and our people will be even safer, as we face the biggest security crisis in decades,” he said. 

“Russia has shattered peace in Europe so it’s important we stand together at this important time,” Stoltenberg declared further. However, a mere week after finally agreeing to the Scandinavian countries’ joining, Turkey is threatening to block the expansion if they don’t follow through on extraditing people the Turkish government sees as terrorists.

The expansion requires ratification by parliaments and governments of each of the alliance’s 30 member nations in order to continue. Stoltenberg said in his remarks that NATO’s door is open for those democracies which stand “ready and willing to contribute to our shared security.”

After signing a joint memorandum paving the way for expansion last week at the NATO summit in Madrid, Turkish President Recep Tayyip Erdogan said that Sweden committed to extraditing 73 “terrorists” linked to the Kurdistan Workers Party (PKK), which is a designated terror group also under the US, UK, and EU.

The memorandum indicated the Nordic countries agreed to promptly pursue “pending deportation or extradition requests of terror suspects expeditiously and thoroughly,” with “bilateral legal frameworks to facilitate extradition.”

According to the BBC, Sweden “had already sent three or four of them. Pro-government Turkish daily Hurriyet published a list of 45 people, including 33 sought from Sweden and 12 from Finland.”

Others on the list include members of the Gulen movement, or what Turkey sees as the Fethullah Terrorist Organization – a global Turkish opposition network which has set up schools in the West. BBC details of one Gulen-associated journalist now wanted by Turkey, Bulent Kenes:

For years, he was editor-in-chief of Today’s Zaman, a major English-language daily in Turkey, before it was shut down in 2016. Now, he lives in exile in Stockholm.

…Mr Kenes said he became a target for his outspoken criticism of President Erdogan and faced accusations of plotting to topple the government: “All the allegations are fabricated. I am an independent journalist with no affiliations with any organization.”

Kenes fled Turkey and went to Stockholm after being accused and convicted of “insulting the president” in 2015, in a case which underscored the Erdogan government’s increasing crackdown on anti-Erdogan speech.

It will be interesting to see if Sweden in particular, which is home to many Turkish and Syrian Kurds, moves legally against individuals Turkey has listed as having terror links, yet who ran afoul of Ankara for mere free speech related issues such as criticism of Erdogan personally.

Authored by Mohamed El-Erian, op-ed via Bloomberg.com,

The pain may not be over for investors, but genuine value is being restored, government bonds are mitigating risk again, and the chief risks aren’t derailing the system’s functioning.

To say that the first half of the year was painful for investors would be a big understatement. They suffered large losses on their holdings of stocks, corporate bonds, emerging markets, crypto and other assets; and, for most of the last six months, they received no protection from government bonds whose traditional risk mitigation attributes gave way to big losses, too.

Indeed, other than oil and some other commodities, it was a dismal picture all around in public markets. It is only a matter of time until valuations in private equity follow suit. 

This is an environment in which it is hard to argue for silver linings, especially when so many analysts are warning that additional losses may be ahead in both public and private markets.

Yet three are already evident.

First, genuine and more sustainable value is being restored after a period in which asset prices were lifted artificially and distorted by huge and predictable injections of liquidity by central banks. Already some prominent individual stocks are in oversold territory, having been technically contaminated by what has been a generalized selloff as liquidity has been receding.

Second, after tracking equities lower and, in the process, experiencing historic losses, government bonds are resuming their role of risk mitigators in diversified investment portfolios. This is better news for investors who, for most of the first half of this year, felt that there was nowhere to hide.

One reason for the return of the traditional inverse correlation between the price of government bonds (the “risk-free asset”) and that of stocks (“risky”) is that the three main risk factors in play have evolved sequentially — the third silver lining. Had they operated simultaneously, the damage to markets and the economy would have been significantly worse.

The market selloff started with surging “interest rate risk” because of inflation and the sluggish policy reaction function of the Federal Reserve. This hit both stocks and bonds hard. It was joined in the last few weeks by higher “credit risk” as investors fretted that a late Fed scrambling to catch up with inflationary realities would push the economy into recession. The more these two risks persist, the greater the threat of unleashing the third, more damaging risk factor: stress to market functioning.

For long-term investors, it will prove beneficial over time that markets are exiting an artificial regime that was maintained for far too long by the Fed and that resulted in frothy valuations, relative price distortions, resource misallocations and investors losing sight of corporate and sovereign fundamentals. The promise now is one of a more sustainable destination. Unfortunately, it comes with an uncomfortably bumpy and unsettling journey.

With the US away yesterday, the rest of the world decided it was time to buy stocks and sell bonds. But now that Uncle Sam is back – all of that is reversed…

US Treasuries are bid – aggressively – with 10Y Yields down 14bps from overnight highs but the belly is outperforming overall…

And that has inverted the 2s5s spread for the first time since Feb 2020…

All of which is driving market expectations for The Fed’s rate-trajectory significantly lower (dovish) as rate-hike expectations have plunged and subsequent rate-cut expectations are notably higher (almost 4 x 25bps cuts now priced-in)…

And it appears that recession fears are trumping post-recession-easing hopes as US equity futures tumble from yesterday’s highs…

And for now The Fed refuses to back away from the ‘strong economy can take it’ narrative…

We have long mocked the ECB for making the typical European mistake codified over a decade ago by Jean-Claude Trichet, when it launches rate hikes right into a recession (and after that, debt crisis).

*ECB SLASHES GDP FORECASTS, NOW PREDICTS 2.8% IN 2022

hiking into a slowdown and then recession

— zerohedge (@zerohedge) June 9, 2022

Today, it finally appears that the market got the memo and sent the euro plunging crashing a 20-year low against the US dollar as traders bet that the European Central Bank will go slower on raising interest rates as the economy risks being tipped into a recession.

The artificially constructed common currency which was meant to keep German exports competitive, fell as much as 1.4% to $1.0281, its weakest level since December 2002. The losses came as money markets finally agree with us, and continued to trim bets the ECB will tighten as the growth outlook for the region darkens, with traders now eyeing the prospect of gas shortages as Russia cuts back on supplies.

Europe’s slide into recession was accelerated by the latest Italian and Spanish composite PMIs which both declined in June, led by a deceleration in the services sector, and which Goldman said was “consistent with our view of a deceleration in the growth momentum across the Euro area going into H2. Accordingly, we continue to forecast subdued growth in the second half of the year and see risks as skewed towards the downside if gas flows from Russia do not pick up following the end of the pipeline maintenance period in mid-July.”

Indeed, the fallout from war in Ukraine is hampering the ECB’s ability to raise rates as fast as the Fed, despite record inflation, widening the interest-rate differential.

According to Bloomberg’s options-pricing model, there is a 60% chance the currency hits parity versus the dollar by year-end, up from 46% on Monday.

“Parity is just a matter of time now,” said Neil Jones, head of FX sales to financial institutions at Mizuho.

Parity may be on deck for the EURUSD, but it already well in the rearview mirror for the swiss franc cross, with the EUR now trading at levels last seen when the SNB broke the peg against the euro: the euro fell as much as 0.9% against the Swiss franc to 0.99251, the lowest level since 2015, a tumble compounded by by poor liquidity.

Even as they price in a recession, traders also bet the ECB will kick off their first tightening cycle in a decade later this month with a 25 basis-point increase. The Fed in contrast has already raised rates by 150 basis points, with markets pricing in an 80% chance of a 75-basis-point hike at their July meeting; the US is also now widely expected to enter recession by late 2022 or early 2023 at the latest.

“It is hard to find much positive to say about the EUR,” said Dominic Bunning, the head of European FX Research at HSBC. “With ECB sticking to its line that we will only see a 25bp hike in July – at a time when others are hiking much faster – and waiting for September to deliver a faster tightening, there is also little support coming from higher yields.”

And while few are predicting the ECB will capitulate before it hikes even once, money-market traders are betting ECB will deliver around 140 basis points this year, down from more than 190 basis points almost three weeks ago. The repricing gathered pace after a string of weak economic data last week, with traders trimming bets again on Tuesday after French services PMI was revised lower.

Investors have also been more cautious on the euro due to the risk of so-called fragmentation, when economically weaker nations see unwarranted spikes in borrowing costs as financial conditions tighten. The ECB is expected to deliver further details of a new tool to backstop more vulnerable countries’ debt at their policy meeting later this month.

“The FX market is not back up to full liquidity given the US holiday,” said Mizuho’s Jones. “Any given size of trade is likely to have a greater impact on market movement.”