The US increasingly stands alone with a demand side inflation problem, tight labor market and a committed inflation fighting central bank. If CPI surprises to the upside the Fed will shift even more hawkish (in contrast with the dovish surprises we are beginning to see from the rest of the world) which may result in a volatile tightening in financial conditions via a much higher USD and lower equities
The start of the 4th quarter has seen no let up in the market volatility that has characterized the last 9 months. However, there were some notable developments that support our view that we are shifting into an environment of greater divergence.
Last week saw significant ranges in global rates and currencies. 10y US yields fell by 25bps (a 4 stdev daily move) last Monday, before ending the week 7bps higher in yield. Similarly, Dec 23 Euribors traded in a 60bp range over the week, and a volatile position unwind in the USD saw GBPUSD trade briefly on a 1.1500 handle before ending the week <1.11. Oil rose by ~10%, a 1.8 weekly stdev move, following the decision by OPEC+ to cut its production quota by 2mm b/d. Global equities traded in a volatile range, with Nasdaq ending Friday unchanged, having been up 6.3% on Wednesday.
The key data release of the week was the US employment report, which continued to show a tight and strong US labor market. Headline nonfarm employment increased by 263,000 last month. Close to expectations, the unemployment rate fell back to a cycle low of 3.5%, and average hourly earnings growth rose 0.3%, or 5.0% on a year-ago basis, and blue-collar wages were up 0.4%, for a 5.8% year-ago gain. This data is consistent with the low level of initial and continuing claims, and there is very little sign of any meaningful easing in the tight labor market conditions in the US.
Notably, despite limited signs of any easing in global inflation, we have seen three dovish central bank surprises in the last ten days. Overnight the Bank of Korea had two dissenters for a 50bp hike, decreasing the likelihood of a further 50bp hike in November. More interestingly The Royal Bank of Australia raised rates by 25bps, when there were ~44bps priced, and the National Bank of Poland held rates unchanged (33bps priced), despite last Friday's inflation reading showing a re-acceleration in CPI, bringing yoy CPI to 17.2%. It is worth remembering that Australia and Poland were the lead indicators last year for policy pivots hawkishly.
Tomorrow we will get the key US CPI reading for September. After August’s surprisingly strong reading the market expects a sequential fall to 0.4% from 0.6% in mom core CPI. The key watchpoint will be whether the shelter component shows any signs of softening. A drop in inflation driven by goods (used cars) will have limited impact on the monetary policy stance of the Fed.
Overall the volatility over the last 14 days is indicative of a few key themes that we believe will drive the next quarter.
Despite the fall in financial assets, a cooling housing market, and 300bps of hikes so far from the Fed, the US labor market remains on very firm footing. Wage growth, trend hiring, and unemployment rate are all historically strong. The inflationary impulse from the labor market has not yet responded meaningfully to tightening financial conditions, and is indicative of broad strength in the outlook for US demand. The fact that US inflation is clearly demand driven means the Fed will tighten until they see clear signs of these measures falling. This narrative can be changed with a weak CPI but on the other hand, if CPI does not show signs of easing the Fed is likely to become even more hawkish in the near future.
In simple terms, the evidence so far suggests that we have not yet found a level of rates that is enough to significantly slow the demand side of the economy. This, however, is a different dynamic than when the Fed is starting its hiking cycle. Now we are at the “price discovery stage” - ie. How far do rates need to go until data turns? This brings in a more two-sided distribution for rates. Negative data surprises will lead to some easing in financial conditions, but strong data (especially employment and inflation) should extend the duration and peak of the hiking cycle. This is the reason for the extreme volatility priced for tomorrow's CPI with the market pricing a move of 2.5% in S&P 500 – the second highest implied move since 2010 (only after March 2020, 3%).
However, in our view, the fact that the US labor market remains so robust means that the likelihood of a meaningful Fed pivot in the near term is low. This means that the risk remains skewed higher for nominal rates, with the market still pricing an effective end to the hiking cycle by Q1 2023. For long duration assets like equities, this means the likelihood of a truly risk supportive Fed is slim. Indeed, a real income shock from higher oil prices may be one way to accelerate a recessionary slowdown, but this is unlikely to be broadly risk supportive.
In contrast, the rest of the world is increasingly facing a much less straightforward policy decision set. In Europe, the energy supply shock means policy makers cannot control a key aspect of the inflation shock, while the economy suffers to a greater extent. Poland has blinked, clearly signaling that the central bank is unwilling to bear a level of growth destruction. In Australia, the impact of a weaker China and the downside risks to the housing market pushed the RBA to adopt a slower approach. Similarly, in the UK, the risks to the domestic housing market from the currently priced rates are severe, limiting the BoE's ability to over deliver and indeed maintain a very hawkish policy stance.
This is a world that is looking increasingly divergent. At one pole are the US and the Fed, while on the other are the countries facing real stagflation and growth shocks. This divergence, alongside the impact of data prints as we move later in the cycle, means greater volatility, but it is also a strong environment for currency trades and relative rates trades. However, if US Inflation shows further signs of firming, this divergence is likely to manifest in a very strong USD rally and a sharp selloff in equities. The good news of a strong US economy is ultimately bad news for risk asset holders and the rest of the world.