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Three Market Questions: Week of February 7

CalendarFebruary 7, 2022
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Good morning, and welcome to Three Questions - a look at the big uncertainties facing currency markets in the week ahead.

Here are some of the things we're watching:


1. Will central bankers keep ratcheting up the rate rhetoric?

In a week crammed with central bank speeches, markets will continue to struggle with a sudden shift in monetary policy - one in which officials launch explicit “shock and awe” campaigns against the psychological forces that are believed to give rise to inflation.

Two years have passed since the pandemic forced central banks into emergency rescue mode, and market-implied yields are rising violently as investors position for a rapid tightening in policy. The Federal Reserve is now expected to raise rates at least six times this year, the Bank of England only narrowly avoided a 50-basis point rate increase last week, and the European Central Bank is threatening to raise rates.

In recent weeks, major central bank officials have followed their counterparts in smaller economies like Canada and New Zealand - and in emerging markets like Brazil and Mexico - in acknowledging that interest rate and balance sheet adjustments are ill-suited for managing supply chain issues.

Instead, they have explicitly suggested that a sudden and sharp increase in rates could suppress demand by helping to keep consumer inflation expectations under control.

This approach appears rooted in the long-cherished idea that prices tend to rise most quickly when workers, fearing future increases, demand higher wages. Although Federal Reserve economist Jeremy Rudd has shown that the scientific evidence for a link between consumer expectations and realized inflation is surprisingly flimsy, policymakers appear to think a sufficiently dramatic move - a front-loaded tightening cycle - might help reduce the risk of a wage-price spiral.

Put another way, policymakers are no longer content with merely taking away the monetary punch bowl - they want to go around slapping the party guests.

An abrupt and significant jump in rates could tighten financial conditions and weaken credit expansion, slowing growth down - but if economies aren’t overheating to begin with, this might not be terribly desirable.

And, as Dario Perkins of TS Lombard pointed out last week, there’s another problem - it isn’t clear that workers themselves understand the link between tighter monetary policy and lower inflation.

In fact, a survey conducted by the Economist and Yougov showed 45 percent of US consumers think tighter rates drive higher inflation, and 37 percent aren’t sure.

This makes intuitive sense when you think of inflation as most households do - as a measure of the cost of living. When rates go up, mortgages and loans become more expensive, adding to other household inputs to drive costs upward.

An overzealous communication effort could backfire, convincing consumers that prices are rising, not falling - touching off the very sort of psychological spiral policymakers are trying to avoid.

Against this backdrop, we think this week’s central bank speakers will choose to dial down the tightening rhetoric, preserving optionality while minimizing the likelihood of an accident. If so, front end rates - particularly in the US and UK - could come down, while long end yields stabilize or move higher. Exchange rates could retrace.

Call it shock and awwwwww.

- KARL SCHAMOTTA, CHIEF MARKET STRATEGIST


2. Could the petro-loonie make a comeback?

With oil demand rebounding, inventories tightening and geopolitical risks growing, global crude benchmarks are trading near seven-year highs.

The Canadian dollar isn’t.

Soaring oil prices and one of the biggest positive terms-of-trade shocks in Canadian history haven’t managed to shake the currency out of its slump. West Texas Intermediate prices have risen more than 59 percent over the last year, while the Canadian dollar has fallen -0.20 percent.

This is delivering huge benefits to the country’s oil producers, who, as Rory Johnston at Commodity Context has observed, are enjoying an easing in transportation bottlenecks and receiving almost 100 Canadian dollars per barrel - the highest since 2008.

But the relationship between oil and the loonie tends to follow a non-linear trajectory. In data going back to 2000, the average correlation between West Texas Intermediate and the Canadian dollar exchange rate peaked at prices between $75 and $100 a barrel. Below $50 and above $100, the link was far less evident.

There are many possible explanations for this, but the basic outlines are clear: When the world is awash in oil, other sectors (often other commodities) tend to take the lead in driving marginal Canadian growth. When prices hit a sweet spot above $50 - and look like they’ll stay there - foreign-funded capital investment in the energy sector tends to rise along with the country’s terms of trade - putting upward pressure on the exchange rate. And when oil becomes too expensive, meaning the world faces an energy shock, the negative implications begin to outweigh the positives, weakening the relationship.

This “sweet spot” for correlations may have moved higher. The United States is now a net energy exporter, and elevated oil prices are no longer negative for the greenback, so Canadian dollar correlations are unlikely to match the peaks hit in prior cycles. Interest differentials are also playing a critical role, reflecting the Bank of Canada’s aggressively-hawkish stance. And global financial conditions - critical to Canada’s over-leveraged household sector - have grown in importance.

But with oil prices currently sustaining levels well above the $75 mark, and North American central banks moving in tighter synchrony with one another, it seems likely that crude oil prices will begin playing a bigger role in determining the loonie’s direction.

If so, Canadian dollar bulls may want to apply some of the wisdom found on an old Albertan bumper sticker: “Please God, give me one more oil boom. I promise not to p*ss it all away next time.”

- KARL SCHAMOTTA, CHIEF MARKET STRATEGIST


3. Will a more subdued Olympics symbolize a shift in the Chinese economy’s global role?

The Olympics in Beijing this week will be a relatively understated affair, with lower levels of public interest reflecting the weaker pulling power of the Winter Games, exacerbated by pandemic closures, a diplomatic boycott, and Western anger.

This comes amid growing signs of divergence between the policy paths desired by authorities in China and in the US. Although the IMF’s latest estimates project that China will grow by 4.8 percent in 2022 (above the 4.0 percent projected for the US) this will mark a considerable narrowing of the multiyear growth differential between the US and China.

In the case of the US, a strong post-pandemic recovery has pushed inflation to multi-decade highs and is fueling speculation of aggressive Fed rate hikes. But China’s projected growth performance would mean a very sharp slowdown from 8.1 percent in 2021, and settling at such a level would be at odds with authorities’ current preference for a trend growth rate just above 5 percent.

Policy will thus be biased towards easing in China, versus tightening in the US. However, it is unclear how successful Chinese authorities will be in rekindling growth as the efficacy of stimulus will be limited by their own preferences and other considerations.

One short-term set of policies to cut down on emissions might be eased after the Olympics conclude on February 20th, but there are more structural factors weighing on consumption, production and output.

The stated goal of the authorities is to increase the role of consumption, but they face many hurdles. The lower efficacy of Chinese vaccines against newer variants suggests that while the harsh edges of Covid-zero policies might be smoothed, they cannot be rolled back completely. Uncertainties in real estate markets and the turmoil in equity markets that followed the “Common Prosperity” campaign have reduced confidence and perceptions of wealth among the middle classes. In contrast with the situation in the US, China’s limited fiscal support for household incomes during the pandemic has seen a drop in savings buffers. And a broad overhaul of the safety net to reduce the need for precautionary savings will take years to complete.

Real estate investment has long been a strategy to juice growth, but the aftermath of the Evergrande debacle seems to have made authorities more cautious. They will try to contain the broader financial stability spillovers, but those same considerations of stability are an argument to roll back the outsize role of residential real estate construction in the economy.

Investments in targeted green infrastructure and in technologies to substitute for those affected by Western curbs will ramp up, but are unlikely (and are not intended to) to fill the gap left by lower real estate construction. While growth in 2022 might be lower than desired, all official signaling points to an increasing focus on growth quality over quantity in coming years.

China is thus likely to slow more than authorities want in 2022, which will leave policy easy even as the Fed hikes. The spillovers for countries caught between tighter US monetary policy and weaker China will be a crucial narrative for commodity and currency markets to monitor. China is now riding a different cycle. - KARTHIK SANKARAN, SENIOR MARKET STRATEGIST


CATALYSTS

MONDAY

EUR European Central Bank Speech, Lagarde

TUESDAY

EUR European Central Bank Speech, Villeroy

INR Reserve Bank of India Rate Decision

WEDNESDAY

CAD Bank of Canada Speech, Macklem

GBP Bank of England Speech, Pill

USD Department of Energy Weekly Inventories

USD Federal Reserve Speech, Mester

THURSDAY

EUR European Central Bank Speech, Lane

EUR European Central Bank Speech, Villeroy

USD Consumer Price Index, January

USD Weekly Jobless Claims

USD Federal Reserve Speech, Barkin

MXN Bank of Mexico Rate Decision

GBP Bank of England Speech, Bailey

AUD Reserve Bank of Australia Speech, Lowe

FRIDAY

GBP Gross Domestic Product, December

USD Baker Hughes Weekly Rig Count


COUNTERPARTIES

“Importantly, keeping China closed for longer also supports Xi’s efforts to restructure Chinese society. The CCP is orchestrating far-reaching economic and cultural reforms, in part aimed at extending control over the country’s business and cultural landscape. The so-called common prosperity campaign, now entering its second year, appears to have both ideological and technocratic roots and has been executed via an onslaught of market-rattling crackdowns.”

Financial Times: Closed China

“Historically, it has been the Fed’s job to take away the monetary punch bowl before the party gets frenzied, and Congress’s job to be prudent about fiscal deficits and debt. But the Fed’s desire to spare the market from pain has driven more risk-taking, and reinforced expectations of further interventions.”

Project Syndicate: The End of Free-Lunch Economics

“The persistence of recent inflationary pressures at the goods CPI and PPI levels are importantly related to the evolution of global supply factors such as production or shipping bottlenecks and input prices: their global nature and their source (that is, supply as opposed to demand) suggest that domestic monetary policy actions would have only a limited effect on these sources of inflationary pressures.”

Liberty Street Economics: The Global Supply Side of Inflationary Pressures

“More QT (quantitative tightening) would mean fewer rate rises, not more, so could cause bond yields to fall. QT would have become, bizarrely, a source of stimulus—the last thing a central banker with an inflation problem should want.”

The Economist: Quantitative Tightening Is No Substitute for Higher Interest Rates

“The Fed itself agrees: tightening is on the way. But the question is whether it can still contain an inflationary spiral and keep expectations stable without having to inflict a recession. That is going to be extremely hard to pull off. Policymakers just do not know enough about the post-pandemic economy to calibrate the needed policy changes, especially as they are clearly too late.”

Financial Times: The Fed Is Too Late to Remove the Punchbowl

“In response to Lagarde’s press conference, traders increased their bets on higher euro area interest rates, with markets pricing in several increases in the ECB deposit rate from minus 0.5 per cent to minus 0.1 per cent by December. However, most council members think this is too aggressive. Even more “hawkish” central bank officials dismiss the idea of a rate rise this summer as “ludicrous” and say the earliest it is likely to happen is the fourth quarter.”

Financial Times: How the ECB was spooked into changing its stance on inflation

“In part, limes are subject to the same global forces that are driving prices up all over the world. But they also face a criminal form of price-fixing imposed by cartels, who are turning to the lime business to help finance their violent operations.”

Vice: A Drug Cartel War is Making Lime Prices Skyrocket in Mexico

“In practice, as we are seeing, when a lot of prices adjust by a large amount in a short space of time, they deliver a lot more than an efficient signal. What we receive is more akin to an information bomb.”

New Statesman: Why Inflation and the Cost-of-Living Crisis Won’t Take Us Back to the 1970’s 

“We estimate that the program cumulatively preserved between 2 and 3 million job-years of employment over 14 months at a cost of $170K to $257K per job-year retained. These estimates imply that only 23 to 34 percent of PPP dollars went directly to workers who would otherwise have lost jobs; the balance flowed to business owners and shareholders, including creditors and suppliers of PPP-receiving firms.”

The $800 Billion Paycheck Protection Program: Where Did the Money Go and Why Did it Go There?

“Russia has agreed a 30-year contract to supply gas to China via a new pipeline and will settle the new gas sales in euros, bolstering an energy alliance with Beijing amid Moscow's strained ties with the West over Ukraine and other issues.”

Reuters: Russia, China Agree 30-Year Gas Deal Via New Pipeline, to Settle in Euros

“Closures in the first two years of the pandemic lasted roughly twice as long in developing countries compared with advanced economies. And the adverse impact of this shock is magnified because the share of those at school age in developing countries is nearly double that of advanced economies.”

IMF: Pandemic Scars May Be Twice as Deep for Students in Developing Countries

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