To The Moon

Mixed signals from the FOMC and commentary from Jerome Powell caused a lot of volatility in bond and currency markets last week. In the end, the rate hikes predicted by Powell do not appear to deviate from what has already been priced in by the market. So the Fed is not doing more than previously expected. That could still change, of course, but that would have to be because there are indications of further rising inflation. The opposite is the case. All surveys of manufacturers, homebuilders, SMEs, consumers, and CEOs point to a significant slowdown in US growth. Interest rate curves are inverted, now not only for the 10-2 year but also for the 10-year minus 3-month indicator with a better track record. The leading economic indicator is also contracting year-on-year, as during every recession since the 1960s.

The Fed shuts itself off from this and mainly looks back, at inflation rates and employment trends. In the past, the economy was already in recession by the time unemployment rose. Even the fact that inflation is now mainly a result of developments in the service sector is more retrospective, than forward-looking. The service sector CPI is part of the Conference Board's lagging (coincident) indicators for a reason.

And there are plenty of signs that the labour market is calming down and with it inflationary pressures. The number of new jobs is rising, but the trend (the second derivative) has been downward since March this year. Furthermore, consumers are regularly asked whether there are enough jobs or whether it is difficult to find a job. The difference is reflected in the Conference Board Confidence Labor Differential and it is falling. Now that is just a survey by survey, but there is a strong correlation with the number of Americans quitting their jobs. Fewer people switching means less demand, so fewer wage increases, and therefore less inflation.

Surveys of purchasing managers also show that all sub-indicators indicating inflation (prices paid, supplier deliveries, backlog of orders) have now fallen below 50. Now 50 in ISM indices is a critical level. Normally, above 50 means growth, and below 50 means contraction. If we translate this to the inflation components, above 50 is inflation and below 50 is (yes) deflation. If only it were that easy. In practice, the growth turnaround is more likely to be around 43 and, of course, there are numerous other factors that also play a role.

Fortunately, no economist has yet succeeded in creating a conclusive model to explain inflation. So, despite all their brainpower, economists are clueless, and central bankers (at least the Fed) have now embraced that conclusion as policy. As so often in social sciences, models greatly underestimate human adaptability. Add to that the power of narrative and that explains the impossibility of predicting inflation. It relies mainly on narrative adapting to circumstances. Call this 'being between the ears' of inflation expectations or 'animal spirits', inflation is what people think it will be. And no, inflation expectations as inferred from the difference between inflation-linked and normal bonds are completely meaningless in this context. In any case, those 'inflation expectations' did not see the current high inflation coming.

So a Federal Reserve pivot is approaching, probably as early as 2023. In a recession, the Fed normally cuts interest rates quite aggressively (resulting in a falling dollar), but this Fed s pivot is not isolated. The Japanese central bank, too, will soon pivot in the policy. Japan's October 2014 quantitative easing policy was tightened by Yield Curve Control (YCC) in 2016. Besides a short-term interest rate of -0.1 per cent, the Japanese central bank imposed a commitment to long-term interest rates. Instead of a promise on the quantity (quantitative easing), the BoJ imposed a commitment on the price and when the price is fixed, there is no more influence on the quantity. At the same time, if the market is convinced that the central bank will basically buy up those bonds indefinitely, those same central bankers no longer need to do anything. The motivation for YCC in Japan was to prevent the yield curve from inverting. After all, this would mean bad news for Japanese banks. The downside of YCC is that it created a pro-cyclical policy. When interest rates fall (ahead of a recession), fewer bonds need to be bought, but when interest rates rise, more bonds need to be bought. This was never a problem until 2020. When other banks started stimulating in full as a result of the corona, the Bank of Japan had no room to do so because of YCC. Now Japan has approached a critical point. Because the BoJ is working with YCC, the contrast with other central banks is getting bigger and bigger, and therefore the yen is getting weaker. The BoJ is trying to do something about this by buying up the yen to support the currency, but those yen were created just before that under YCC. The question is who is now fooling whom. Now that the yen has fallen to its lowest level since 1970, the situation is becoming critical.

A Competitive Edge Over China 

Note: Shading denotes forecast

Japan is already accused of competitive devaluation (especially at the expense of countries like South Korea and Germany), incidentally, a weak yen was also one of the causes of the Asia crisis. The BoJ should therefore move away from the current YCC policy, for instance by adopting a range from now on or gradually accepting higher interest rates within YCC. This coming turn by the BoJ (e.g. associated with Kuroda's departure in March 2023) is good for the yen and good for Japanese assets and more or less coincides with the Fed's turn.

Besides the turn at Fed and the turn at the BoJ, there is another turn coming and that is the ECB's. Like the Fed, the ECB acts as if the central bank is also doing plenty to fight inflation. At the same time, the majority of ECB members also know that an interest rate as high as in the US is unfeasible here. The inflation problem in Europe is caused by higher energy prices, and these are so high that they are already causing a recession without any help from the ECB. Nevertheless, the market is counting on interest rates in Europe to rise further to 3.0 per cent by summer 2023. Still, the ECB is doing this mainly to prevent the euro from slipping further against the dollar. The ECB is also looking at the labour market. Right now, unemployment in the eurozone is 6.6 per cent, which has not been this low since the start of the euro. Moreover, Germany still has some 800,000 job vacancies and France 329,000. But labour market figures in Europe are also looking backward rather than forwards. In manufacturing, the weakening is now evident and it seems a matter of time until more people will be laid off. In Spain and Poland, this has been the case for several months. Furthermore, in Europe, rising interest rates and rising energy prices are reducing cash flow for staff and higher wages. So there is a good chance that the ECB will follow the Federal Reserve's turn in 2023.

This triple twist is not discounted in financial markets right now. Both equity and bond markets could benefit. A triple twist also means fireworks on the currency front. In particular, a turn in the dollar is good for the liquidity position outside the United States. Emerging markets in particular are likely to benefit. With inflation falling and the arrival of a recession, it will be harder for companies to grow profits. Fortunately, this is the most predicted recession ever, so CEOs have been able to take measures in time. This may limit the extent of the earnings decline and at the same time offset it by falling interest rates. In that scenario, equities are likely to outperform bonds.