Daily Comment (January 13, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with a discussion on whether the Fed is close to ending its rate-hiking cycle. Next, we explain why changes to Japan’s controversial yield-curve-control policy pose a risk to the international financial system. The report ends with our thoughts on the state of the global economy.

 Is the Fed Finished? Investors and policymakers are growing confident that inflation is on the right path; however, the two groups disagree about when tightening will end.

  • The latest CPI data showed that inflation is continuing to decelerate. Consumer prices rose 6.5% from the prior year, the slowest increase since October 2021. The easing of price pressures has added to the speculation that the Fed will reduce the size of its rate hike to 25 bps at its next meeting in February, with some investors pricing in a pause for March. That said, Fed officials insist that the central bank is not finished. St. Louis Fed President James Bullard insists that the Fed quickly raise rates above 5%, while Richmond Fed President Thomas Barkin urged the central bank to be deliberate in its next rate increases.
  • The market responses to the data were relatively mixed. U.S. Equities whipsawed but ultimately closed higher. Meanwhile, the U.S. dollar index dipped, and the ten- and 2-year bond-yield spread narrowed. The overall mood of investors appeared to be bullish for stocks as traders now believe that the Fed is nearing the end of its tightening cycle. After the report, swaps signaled less than 50 bps of tightening over the next two FOMC meetings, a sign that investors believe the next hike could be the last one.
  • It is unlikely that the Federal Reserve will pause rate hikes before lifting its policy rate above 5%. If 2022 serves as a guide, the Fed will lift rates whether markets like it or not. Recent comments from Fed Chair Jerome Powell reinforce this belief. On Tuesday, he warned that the central bank is prepared to raise rates despite political pressures to stop. We suspect that the Fed views the tight labor market as evidence that it can raise rates even during a recession. Thus, market bets of an imminent pause may be short-sighted while inflation remains well above the Fed’s 2% target.

JGB Headaches: The Bank of Japan continues to deal with the fallout after it widened the target range for yields on 10-year bonds.

  • The announcement that the BOJ will review the side effects of its ultra-loose monetary policy has led to speculation that it could end yield-curve control (YCC). On Friday, the central bank vowed to intervene in markets after traders pushed the yield on the 10-year JGB above the 0.50% target. The jolt in yields was related to a Citigroup report which predicted that the bank could abandon YCC as soon as next week. The added pressure for the BOJ to pivot away from its ultra-loose accommodative policy has boosted the JPY. The currency has now surged more than 3% against the dollar since January 11.
  • Although the BOJ has consistently maintained that its decision to widen the target range on 10-year bonds was to improve market functionality, traders have interpreted the move as a sign that it was preparing to tighten policy to address rising inflation. As a result, the bank may be forced to delay ending YCC until markets are calmer.
  • The market rout in Japan poses a risk to the global financial system. The country’s low-interest rates and cheap currency have made it attractive for investors to generate arbitrage profits, known as the yen carry trade. In this situation, investors borrow in one currency and invest the money into high-yielding assets in another currency. As a result of the JPY’s relative weakness against the dollar, it was used as the go-to funding source for cross-border lending, and, therefore, a sharp appreciation in the currency will make it more expensive for borrowers to make debt payments.

  • The fight against inflation has made the market very sensitive to changes in monetary policy. Hence, central banks and governments must be mindful of major policy changes as they could create a financial crisis. The international financial system narrowly avoided a blowup last year following the release of former U.K. Prime Minister Liz Truss’s disastrous mini-budget.
    • As previous reports mentioned, we suspect a U.S. recession is imminent but will likely be of the garden variety. However, a financial crisis, housing market crash, or major geopolitical event could cause a severe downturn.

Recession Receding: There is growing optimism that the global economy is positioned to bounce back from its slowdown.

  • The IMF believes that the global economy may have averted a recession but has warned that the situation is still fragile. Warmer-than-expected weather helped cushion Europe from the worst of the effects from the war in Ukraine. The better temperatures have meant that EU countries have not needed to use much of their energy inventory through the winter thus far. As a result, Europe has been able to avoid a possible energy crisis. The U.K. also appears to be on better footing. The latest GDP figure showed that the economy grew in November, suggesting that the U.K. avoided a recession toward the end of 2022.
  • China still poses a risk to the global economy. The latest trade figures from the country showed that exports fell 9.9% in dollar terms from the previous year, while imports fell 7.5% in the same period. The sharp drop in foreign and domestic sales reflects the devastating impact that Zero-COVID has had on demand and production within the country. Although there is much optimism that the country’s reopening will help lift world GDP growth, the chaotic transition away from these restrictions threatens to undermine the confidence of the Chinese consumer, which could crimp future spending.
    • Chinese Lunar New Year should provide insight into the psychological impact that the transition has had on consumers. A jump in spending will be a positive sign for the global economy.
  • Despite the upbeat outlook on the global economy, it is important to remember that many countries will likely face economic contractions this year. The length and severity of the downturns depend on the cause of the contraction. A major unknown is whether central banks will tighten during this period. Policymakers from the European Central Bank, Federal Reserve, and the Bank of England have held steadfast to the idea that increasing rates in a downturn is not out of the question. However, markets have doubts as to whether these officials are serious. As a result, investors should still be vigilant of sudden market changes.

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