Hurt / The Downward Spiral

By Michael Every of Rabobank

Hurt / The Downward Spiral

“I hurt myself today; To see if I still feel; I focus on the pain; The only thing that’s real”

Post-Fed, equities closed slightly lower yesterday (S&P -0.3%), 2-year Treasury bond yields dropped 10bps before rising slightly from that floor, and 10-years were down 11bp before ending at 4.63%, or 5bp on the day, while the US dollar dropped back below 105.5 on the DXY, with JPY seeing sharp moves. However, many are likely to emerge feeling ‘Hurt’ from what the Fed had to say.

“I wear this crown of thorns; Upon my liar’s chair; Full of broken thoughts; I cannot repair”

Notably, Fed Chair Powell said the US isn’t making sufficient progress on getting inflation back to 2%, so the FOMC will keep Fed Funds at 5.50% “for longer” until this happens: and yet he eased policy anyway. First, the Fed tapered QT more than expected, from $60bn to $25bn a month; that’s not QE, but it’s a $35bn step towards the argument made here that you can have high rates and QE simultaneously. Second, Powell downplayed inflation upside surprises –our Fed watcher Philip Marey noted acerbically, “Powell said he doesn’t see the stag or the flation”– to make clear there’s little risk of a rate hike: yet by removing that gun from the table, yields fell and equities rallied, albeit briefly. Third, if inflation ticks higher and nominal rates stay the same, as suggested, then we are going to see a lower real rate of interest at a time when financial conditions are objectively already loose, not tight.

“Beneath the stains of time; The feelings disappear; You are someone else; I am still right here”

Nominal wage growth via the Atlanta Fed was 4.7% y-o-y in March and 5.2% for job switchers, and yesterday’s ADP report said job changers got a 9.3% y-o-y pay hike vs. 5.0% for job stayers; so while some other data are more dovish, in Philip’s eyes, we are still dealing with a decelerating wage-price spiral, where the feedback between prices and nominal wages is slowing down the decline in inflation. Maybe more of the same (and easier policy?!) will work in time, but “for now, inflation seems to have a life of its own.”

Worse, Philip underlines that while he still expects two Fed cuts this year, in September and December, they won’t be cutting because of inflation, but because of rising unemployment. So, Powell will see the “stag”, not the “flation”. If markets don’t like that, and they shouldn’t, then they will be clutching their pearls at Philip also pointing out Powell has a personal incentive to cut before Election Day since Trump is not going to extend his tenure as Fed Chair; that he has acted in a political manner before; and that his current baseline scenario remains a Trump win, and an inflationary universal tariff in 2025 that stop the Fed’s cutting cycle in its tracks.

“The needle tears a hole; The old familiar sting; Try to kill it all away; But I remember everything”

Meanwhile, we saw more JPY intervention and market chatter of just how destructive it would be if CNY followed JPY lower. Yet even if Jay Powell is acting like Arthur Burns wearing a Halloween mask of Paul Volker as he tries to please the White House, US markets, and the publisher of his inevitable post-office autobiography, that only increases the flow of global capital into the US dollar and US assets. King Dollar is Johnny Cash. Those with historical market memories rightly see worrying echoes of past periods of extreme systemic stress and global volatility in that set-up. But the Fed is gonna Fed regardless, as it always does, and most especially in an election year.  

“And you could have it all; My empire of dirt; I will let you down; I will make you hurt.”

That on-the-edge-of-something atmosphere is of course matched by shifts in geopolitics.

Recent news suggests that the Houthis were not boasting when they stated that they are now capable of hitting vessels as far away as the Indian Ocean. What that means is shipping opting to go round Africa rather than via the Red Sea and Suez is also vulnerable to attack. That is going to mean higher insurance premiums, and then higher freight rates, and then higher inflation. And, at worse, it could mean far worse disruption to all Asia-Europe cargo flows – or at least that on behalf of the West and Israel.

The US Congress is pushing ahead with a ban on Russian uranium imports; US graphite miners are lobbying for tariffs on Chinese exports of the same; the US, in collaboration with Australia and Japan, announced it is to work with the Philippines to reduce China’s dominance in that industry; and South Korea suggested it would like to help with AUKUS alongside Japan, so AUKUS > JAUKUS > JAUKUSK?

Ukraine is still losing key ground before new weapons arrive, and hitting Russian oil refineries in response, as Russia hits Ukraine’s gas and electricity facilities.

In the Middle East, today we should hear if Hamas accepts the latest ceasefire-for-hostages deal, with suggestions Hezbollah may then agree to retreat from parts of southern Lebanon for quiet on that front. However, the risks are clear that Hamas could walk away, Israel could walk into Rafah, and Hezbollah and Israel could stumble into war. Indeed, the latest rumor is that Hezbollah has surreptitiously relocated hundreds of key officers’ family members out of Lebanon, which bodes as well geopolitically as western airlines cancelling normal flight routes.

There’s also a signal that Saudi Arabia has agreed to normalize relations with Israel: the only question –as with Powell– being if they want to help the White House in moving before the election. This is also tied to Israel’s commitment to working towards a framework for a Palestinian state. Yet at the very least, the US is prepared to agree a NATO-style defense guarantee for Riyadh, and to transfer nuclear technology without local uranium processing. That would cement the Saudis and the UAE into the US camp, as well as to the US dollar to which their currencies are pegged. However, to think that this would end all instability in the region is naïve. One would have to be a National Security Advisor to predict such things.

Here’s the key question: can you see the sides in this new Cold War, its fault lines, and its gradual upstream-to-downstream global fragmentation of trade and capital flows?

“If I could start again; A million miles away; I would keep myself; I would find a way”

Here’s another key question: where does Europe, 20 years after it expanded to include 10 Central and Eastern European nations, sit as:

• Russia advances in Ukraine and once again it was the US who stepped in to act when needed;
• the Houthis threaten the Asia-Europe shipping route via Africa;
• the US uses its defense umbrella to get access to nickel, and influence in Asia and the Middle East; and as the US taps its own domestic potential in graphite and uranium (at a price)?

“Closer to a 25bp rate cut in June” is nice, but not a relevant answer to this kind of ‘Hurt’ or the EU’s realpolitik downward spiral.