Interest rate and bond markets are caught between pricing more aggressive inflation fighting measures by central banks and a flight to “safe” assets as geopolitical risks rise regarding Russia and Ukraine. However, with inflation likely to remain high and possibly accelerate further in a conflict, bond markets won’t offer safety they have in past risk-off episodes.
It was another volatile week in global markets, driven by extreme moves in rates in DM and EM, and renewed concerns about the risk of a Russian military action against Ukraine. Consistent with what we have seen recently, the largest moves were at the front end, with multi standard deviation moves higher in US, Colombian, Chilean, Mexican, Hungarian and Czech rates. Inflation surprises and hawkish policy developments were again the drivers.
The most important macro development was Thursday’s US CPI print and subsequent comments from FOMC members, most Notably St. Louis Fed Chairman James Bullard. This CPI print was a shocking number and possibly catalyzed a well overdue awakening from the Fed.
Specifically, headline and core indexes rose 0.6%m/m last month, pushing yoy headline inflation to 7.5% in January, the highest level since 1982 and core inflation to 6%. Tenants’ rent increased 0.54% last month, the fastest monthly gain since 1992, and reopening proxies such as airfares and dining away from home were firm. The broadening of inflation is seen in the Cleveland Fed’s trimmed mean measure (which removes outliers) rising by 5.4%oya last month, faster than at any point in the last thirty years. Viewed in the context of accelerating wage inflation, this is evidence consistent with an economy which is dangerously hot.
Unsurprisingly, front end rates moved higher following this print, however comments from Bullard added fuel to this rate selloff. He stated he was in favor of a 50bp hike and that an emergency intra meeting hike should be considered. Front end rates ended the day 25-35bps higher, and 2y rates had their largest intraday rise since the 1970s.
This price action reflects the growing risk that the Fed is much further behind the curve than was thought. Instead of easing, inflation is broadening to the stickier parts of the basket and accelerating, even as base effects should be placing downward pressure on headline inflation.
This data shows that the current policy stance is even more accommodative than we thought. The Fed is still buying bonds, and if we get another inflation surprise next month, the starting point for their hiking cycle could be inflation close to 8% yoy, with Unemployment at 4%.
US CPI Less Food / Energy / Shelter (Red) vs Fed Target (Blue)
The key point is that the Fed targets a level of inflation. By the time they hike, they will have allowed the economy to overheat for several quarters too long, and the probability of getting bailed out by easing supply chain pressures or base effects is being reduced by the incoming data. From this starting point, the type of hiking cycle required to get inflation close to the Fed target may be substantively different than we have seen before. This is what Bullard brought to the table – “this type of inflation is a regime shift from anything we have seen in the last 20 years, and therefore applying old frameworks may be inappropriate”.
More broadly, this week continues to show that the convexity in rates markets is to the upside as long as inflation remains high and does not signal a sharp turn around in supercore components. Quite simply, central bankers and street forecasts are consistently underestimating the inflationary pressures in an over-stimulated post-COVID world. Combining increased data dependency with heightened forecast uncertainty means the distribution of outcomes for global rate markets is very wide, and this means greater volatility. The addition of meaningful geopolitical risk and a potential energy shock only adds to this.
Several developments last week indicated to us that the risk of a military conflict between Russia and Ukraine had increased. Specifically, the military buildup had broadened to include significant naval assets in the black sea alongside forward deployment of rotary wing aircraft to the southeast border of Ukraine, both new developments. Further, diplomatic attempts had achieved no real progress with Putin’s press conference following his meeting with Macron marking a new departure in tone. Similarly, more worrying to us, the discussion on Russian local media has shifted somewhat. The news on Friday that the US had told allies that an invasion was planned for this week, and more importantly, that this information has been acted upon through the removal of both diplomatic and military personnel is consistent with a view that the risk of a military action has shifted meaningfully. The next few days will be crucial, with Chancellor Scholz visiting Kyiv and Moscow over the coming days. A key signpost for us will be whether Ukrainian and EU communication shifts, both have downplayed the risk relative to the US but ultimately the decision to invade rests with Putin.
Therefore, our portfolio continues to be balanced, with rates payers in the US, Europe and Poland and largely beta neutral equity exposure which is exposed to rising rate environments and our EM credit risk is low. We managed to exit our Russia equity positions profitably last week ahead of Friday's news due to increased local and international political noise mid-week. We will consider re-entering these equities lower as fundamentally they are excessively undervalued in but we need to see tangible political progress and we expect for now things are likely to get worse before we see this. We continue to own puts and put spreads on the Ruble in addition to FX shorts in CE3. With inflation prints in CE3, the Fed minutes, several ECB members speaking and the acute tensions in Eurasia, it is likely to be another volatile week ahead and our trading stance and portfolio remains tactical and opportunistic as we navigate this unique macro environment.
COVID Pandemic
World COVID cases continued to decline last week, with cases falling in Asia, Europe, and America last week and rising slightly in CEEMEA. In China, cases remained low last week, although they did rise. In India, cases continue to decline after the recent peak in their Omicron wave. In CEEMEA, cases continued to rise last week, although much of the increase was driven by record cases in Russia, and several CEE countries like Poland and Turkey have seen recent waves peak. In LatAm, except for Chile, most countries have seen the peak in Omicron waves, with cases broadly trending lower across the region.
Cases are falling in both the US and Europe, with the US Omicron wave leading Europe on its descent. Within Europe, the countries that first saw Omicron waves have led the descent in European cases. In the US, positivity rates continue to fall, and the leading data we track on wastewater COVID concentrations and Google Trends continues to point towards further declines in US cases.
Due to the combination of falling cases and changing perceptions about COVID risks, the share of Americans concerned with local COVID outbreaks (per the Civiq’s survey) is also falling sharply. These declines in COVID concerns and a likely further easing of concerns in the near term should support a renewed recovery in service sector activity.
Calvion’s View: We continue to be optimistic about the prospects for further recovery in activity in impacted services sectors, as COVID moves towards an endemic phase and COVID concerns fall further. However, some risk remains around policy responses, particularly in China, due to the country's zero-tolerance policy response.