At the risk of oversimplifying, there seem to be three sources of dynamism in the investment climate: the Covid, the Federal Reserve and market positioning. The last of these is often overlooked in press reports and market commentary, so let’s start there.

Anthropologist Clifford Gertz once asked the question of the distinction between someone who winks and someone with a tic in the eye, and a person imitating the wink or tic. Context matters. Not all purchases last long. Sometimes it’s short. Nor are all buying and selling an active response to what came before them. Sometimes it is passive because stop losses are triggered.

The forex market still tends to talk about the Japanese yen or the Swiss franc as safe havens. There may be an element of self-realization here. The yen is believed to be a safe haven, so they develop a formal or informal rule to buy the yen when the S&P 500, for example, falls sharply or, conversely, sell the yen during a stock rally. While there is undoubtedly an element of truth, it seems exaggerated and tends to make further analysis superfluous.

If in a hurry, some argue that the franc and yen are safe havens because they have current account surpluses. But draws attention to trade, and yet the daily turnover of the foreign exchange market in a week is more than covers world trade in a year. When North Korea launches missiles at Japan, is the fact that Japan has a current account surplus really relevant?

Conventional narratives usually focus on the spot market, but more activity in the forex market is in futures and swaps. Liquidity is easily transferred between major currencies during times of non-stress. Traditionally low interest rate currencies, such as Japan and Switzerland, perhaps in part because they have current account surpluses (savings surplus), are used to structure financial transactions. The yen is borrowed and sold and the proceeds are used to buy higher yielding or more volatile assets. When these assets go south, and they invariably do, they are liquidated and the funding currency has to be redeemed and returned.

The risk of redenomination (i.e. the chances of a country leaving the European Monetary Union) is low, so if the periphery-core spread widens, why is the franc often bought against the euro? Safe Haven ? Maybe the franc is used to fund the structure and when the spread widens the structure is unwound. The Euro-Swiss exchange rate is not neutral in dollars. The euro frequently moves in the same direction against the dollar and the Swiss franc.

II

The October impression of the US CPI at 6.2% was a game-changer. We immediately recognized it as such and quickly anticipated that the Fed would need to step up the pace of tapering. It follows from two considerations. First, because of the high degree of uncertainty, the Fed must have maximum flexibility to react to a wide range of likely outcomes. Second, the Fed has embarked on the logical sequence of completing liquidity provisions (buying bonds) before starting to remove the accommodation (raising rates). At the current rate of tapering, the Fed was unable to raise rates until June 2022 at the earliest.

This is no longer acceptable. It’s not only that the headline CPI is above 6%, but it hasn’t peaked. Of course, the Fed isn’t targeting the CPI but the PCE deflator, and it hasn’t peaked either. The deflator stood at 5% in October. The base effect alone warns of another sharp rise in the past month. Recall that in November 2020, the PCE deflator was unchanged and when it comes out of the 12-month comparison, the pace from one year to the next will accelerate. On an annualized basis, the PCE deflator rose just over 5.6% for the three months ending in October, the same as for the three months ending in July.

The headline CPI rose at an annualized rate of just over 6.4% in the three months to October. The overall US CPI rose 0.2% in November and December last year. These will be dropped and replaced with higher numbers. Consider the average monthly increase this year to be 0.6%. The median Bloomberg survey forecast calls for a 0.7% increase in the CPI last month after rising 0.9% in October. If correct, the year-over-year rate will reach 6.7%.

The base rate is also expected to trend higher through Q1-22. Consider that after rising 0.2% in November, the core CPI remained stable in December 2020 and January 2021. It rose 0.1% in February. As these drop out, the core CPI rate will accelerate. It has grown an average of 0.4% per month this year and the median forecast (Bloomberg survey) is for a 0.5% increase in November. This will bring the core CPI to close to 5.0%.

The rhetoric of many Fed officials had changed, but it was only President Powell’s pivot in his remarks prepared for his Senate testimony on November 30 that the market recognized him en masse. The two-year bond yield jumped eight basis points, offsetting the 14bp drop linked to the Omicron on November 26. The Federal Reserve is meeting in mid-March 2022, and if the Fed ends its cut that month, it could apparently raise rates at its next meeting, which is on May 4.

There is no meeting in April. The fact that the April fed funds contract implies an effective average for fed funds of 15.5bp when the current average effective rate is eight basis points means that the market estimates about a 1 in 3 chance that the Fed will rise. at the March meeting. It doesn’t sound particularly realistic. Meetings in May or June are more likely. If the Fed goes up in May, the fair value would be around 30bp for the May FF ​​contract. It stabilized around 21bp, which corresponds to a probability of around 50%. The June contract then has an almost 87% probability of the first hike.

A day before the October CPI was printed on November 10, the implied return on the May federal funds futures contract came in at 13.5bp, implying that about a 20% chance of an increase were discounted. By November 24, the day before the US holiday and 24-36 hours before South Africa announced the sequencing of the Omicron variant, the implied return had risen to almost 25bp, or about a 68% chance of a rise. . The new variant undermined growing confidence and the implied return fell back to 14bp (~ 25%) before Powell’s prepared remarks were released.

While the market did most of the heavy lifting for the Fed, Powell’s comments were significant. They reported that despite the unknowns surrounding the mutant virus, for which the Delta variant was already on the rise in the United States, even though it was slower than in Europe, the Fed was committed to preventing high inflation from s ” integrate into households, businesses and investors. ‘expectations. To put it another way, as a first step, the emergence of the Omicron variant adds color (and uncertainty) to the Covid wave that was already underway.

Powell recognized this uncertainty and the benefit of not having the FOMC meeting now. By the time it meets on December 15, more information on Omicron will be available. It is not just the negative risks associated with the new variant, although of course, deserves the initial attention. There are upside risks. This can help speed uptake of the vaccine. If it has a limited economic impact, it could boost consumer and business confidence. This could signal the end of the pandemic and the start of a more chronic phase. Either way, the point is that the Omicron variant increases the range of likely outcomes and the Federal Reserve will always see a need to ensure more flexibility. At this point, it can only be done by ending his bond purchases sooner.

Even if the first hike is still at least a few months away, it’s not too early to think about the final rate. Of course, such conclusions are provisional by their very nature. It seems that the market favors the peak at the end of 2023 around 1.50%. This has important implications for businesses and investors in discounting future income streams, managing pension funds and endowments, and returns on investment. It may well be that this rate cap is a more dreaded cap on long-term returns than QE itself.

Powell sought to explain why inflation is higher than he expected. Admittedly, he did not cite the neoliberal argument that March’s $ 1.9 trillion stimulus package was a multiple of the estimated output gap, leading to the classic too much money chasing too few goods. . Instead, he said the supply disruptions were not fully appreciated. Fair enough, and although he has stopped calling inflation “transient,” like Yellen and many economists, Powell still expects price pressures to ease in H2-22. The base effect is reversed. Big price jumps come out of 12-month comparisons. The Bloomberg survey’s median forecast sees the year-over-year CPI rate now peak and fall sharply in Q2-22. The same general trend is true for the PCE deflator. It is now peaking and halving by the end of next year.