Markets Don't Care Yet
2-Dec-2023. Soft or hard landing? Markets don't care yet. It's too early. 1) Slowing economy (ISM Manufacturing, S&P Global Manufacturing PMI, LEI, Atlanta Q4 GDP Nowcast), 2) Slowing labor market (continued claims, unemployment rate, slower payroll employment growth), 3) Slowing inflation (US, Euro Area, etc.), 4) FED turning dovish (e.g. recent Powell's comments), 5) And on top … Santa Claus rally/seasonality. This is the perfect mix for markets to play a soft landing scenario where typically stocks go up, bonds go up, gold goes up, the dollar goes down. However, the first assumption is that inflation has stopped being a problem, i.e. that we are back in “deflationary conditions”. The second assumption is that the real test of "soft landing or hard landing" is yet to come, and in the meantime, the markets will not care which scenario will win in the end. And this depends largely on the underlying strength of the economy, not the Fed. If the economy is too weak, it is already too late for the Fed to have a chance of engineering the soft landing (in such a scenario, rates probably should already be some 100 bps lower - which is practically impossible to happen). As we all know after the experience of the last almost two years... monetary policy works with long and variable lags - but this also applies to rate cuts… delivered too late will not reverse the hard landing. See Figure 1. If the economy is strong enough, a few rate cuts next year (i.e. mid-cycle adjustment cuts) will be sufficient for the economy to start accelerating again (like in 1996 and 1999). See Figure 2.
Hard Landings Full Cycles
3-Dec-2023. Soft or hard landing? Part 2. I decided to extend the timeline on the chart showing hard landings (Figure 1). Now the S&P500 (bottom panel) ends at the bear market low for each cycle. The top panel shows the scale of monetary policy easing during the hard landing in the full cycle of rate cuts: 1) In the 1990 cycle, the FED rate dropped by 675 bps (from 9.75% to 3%, on the chart the decline ends at 4%), 2) In the 2000 cycle, the FED rate decreased by 550 bps (from 6.50% to 1%), 3) In the 2006 cycle, the FED rate dropped by 512 bps (from 5.25% to 0.125%), however, after hitting zero-bound, the FED turned on QE, which led to a further drop in rates by another 300 bps (according to the Wu- Xia model), so the total easing was over 800 bps (see Figure 2), 4) In 2018, the FED rate dropped by 225 bps (from 2.375% to 0.125%), however, after hitting zero-bound, the FED turned on QE, which led to a further drop in rates by another 200 bps, so the total easing was 425 bps.
10-year Yield US Treasury
4-Dec-2023. Soft or hard landing? 10Y UST. Part 3. How does the 10Y US Treasury yield behave at the current stage of the cycle? The last 4 cycles (hard landings) are presented in Figure 1. Of course, these are deflationary cycles and the direction of 10y yield after the end of the FED’s hiking cycle is quite clear. But in today's cycle, this direction was/is not so obvious to the market. After the last rate hike in July this year 10-year yield continued to rise until the peak on October 19 (that was an inflation regime) - just as yields continued to rise in the 1970s after the end of the FED’s tightening - Figure 2 (10Y nominal values) and Figure 3 (yields rebased to 26-Jul-2023 level). Only since October 19 have we had a sharp decline in yields (called it a deflationary regime). In the case of soft landings from the 1990s, 10-year yield initially fell as in the deflationary regime (in general, there was no difference between hard and soft landings at this stage). However, relatively quickly (12-18 months) the bottom of the mid-cycle occurred and due to the accelerating economy 10-year yield began to rise to new "mid-cycle growth-acceleration" peaks - see Figure 4.
US $ - Soft or Hard Landing
7-Dec-2023. Soft/hard landing vs US Dollar Index. The relationship between the dollar and the cycle, the Fed rate, etc. is more nuanced. The US dollar index (DXY) consists of 6 currencies (EUR, JPY, GBP, CAD, SEK, CHF) with fixed weights and de facto does not accurately reflect the present-day U.S. trade. EUR is as much as 57.6% of the basket, JPY 13.6%, GBP 11.6%, CAD 9.1%, SEK 4.2% and CHF 3.6%. Generally, DXY should strengthen/weaken during US interest rate hikes/cuts. It is also important what is happening relatively in other countries from the basket, especially in Europe. During the Fed's pause, it should generally weaken if markets continue to see/play economic growth/soft landing. But if there are fears of a recession, the dollar should start to strengthen. In the current cycle (2021-2023; Figure 1), basically from mid-2021, DXY shows a high correlation with rising US rates (10-year UST yield). DXY reached its highest level in September 2022. Figure 2 shows the relationship between the Federal Funds Rate and DXY. Figure 3 shows how DXY has behaved since the last Fed rate hike in the 1989, 2000, 2006 and 2018 cycles. In general looking ahead in the current cycle, you can expect a weaker/neutral US dollar until the market is fine with soft landing narrative, and then a stronger dollar when the hard landing becomes the main scenario!
Anatomy of a Hard Landing
21-Nov-2023. The Anatomy of a Hard Landing. What is the difference between soft landing and hard landing? At the start, practically none. As the FED begins to cut rates, the soft landing/goldilocks narrative prevails in the financial markets. However, it is too late to avoid a recession and, as a rule, a bear market. The first cut occurs 2.5 months before the beginning of the recession (as in 2001) or 3 months before the recession (as in 2007). But the markets and the FED will find out that with a lag of up to 9-12 months. In the case of soft landing, there will be no recession, and the FED may return to rate hikes just after a few adjustment cuts. In the case of hard landing, the FED, after several gentle cuts, moves to the second, faster phase of cuts and ultimately reduces them to zero... and even lower by adding QE (the shadow fed rate then drops further below zero - the shadow rate can be estimated using various models, e.g. the Wu-Xia model). But how do markets react to the first rate cuts/end of rate increases etc.? “Always euphoric,” at first. On January 3, 2001, the FED unexpectedly (outside the regular meeting) cut rates by 50 bps. It was the first cut in the policy easing cycle. What was the stock market reaction? Euphoria.. below are the one-day returns on January 3 (Chart 1): S&P500 +5.01% Nasdaq Composite +14.17% Nasdaq100 +18.77%. The increase in stock indices lasted 3-4 weeks, we were back at zero after 7-8 weeks, and what happened next... is just history... see Chart 2.
Anatomy of a Soft Landing
20-Nov-2023. The Anatomy of a Soft Landing. On the example of the 1990s. In the 1990s we had two soft landings, the first started in 1995 and the second one in 1998 (see chart). This mini-cycle of Fed rate cuts is sometimes called “mid-cycle adjustment” – which literally happened in the 1990s. Both examples of soft landing meant 3 rate cuts of 25 bps each, then a pause and a return to hikes. At that time, stocks continued to rise, discounting a strong economy (higher future profits). Is soft landing possible nowadays? If the FED were to make a mid-cycle adjustment and cut rates three times by 25 bps, the FED rate would be 4.5% - 4.75%. Would this (still high) rate level allow the economy to accelerate again? Additionally, the situation is complicated by inflation. The Fed has an additional incentive to leave rates higher longer to make sure it has truly beaten inflation...
US Dollar: What to Expect?
21-May-2024. US dollar. What to expect in coming months? Unfortunately, there is not a clear-cut relationship between the dollar and the end of the cycle and the upcoming interest rate cuts. We had a significant strengthening of the dollar in 2014-2015 and 2021-2022 - that is, immediately before the interest rate hiking cycles. By coincidence, the dollar index increased by approximately 27% in both those periods - see Figure 1. In the 2015-2020 cycle of rate hikes/cuts, the dollar index practically did not change from March 2015 (index level 100.18) to February 2020 (index level 99.78). But of course, in the meantime, it was moving in the range of approximately +/- 7% - see Figure 2. 3 rate cuts in 2019 did not make an impression on the dollar. In the current cycle of FED rate hikes, the dollar strengthened only until September 2022, and the FED ended the its hiking cycle almost a year later in July 2023 - see Figure 3. The 2022 dollar peak partially included a premium for the market discounting the recession (the S&P500 was then 25% in down from its previous peak). The dollar then fell 12.6% and marked a local low at the time of the de facto last rate hike by the FED. Since then, it has been moving in a relatively sideways trend, with two stronger increases when markets expected a relatively more hawkish Fed. This is clearly visible in the correlation of the dollar with the yield of 10-year US bonds - see Figure 4. All-in-all, I would expect a weaker dollar if: (i)the FED no longer intends to raise rates, (ii)the labor market report for April was not dovish on one occasion but rather the labor market continues to slowly weaken, (iii)"hope disinflation" report on inflation for April is a harbinger of more dovish inflation readings in the following months. For the dollar to strengthen, a stronger hawkish narrative regarding rate hikes etc. should return - or in other words, 10Y yields should move closer to 5%.
Weak $ - Reflation Trade?
25-Aug-2024. Weak Dollar – is this a new reflation trade? While one could expect a weak dollar just before the Fed’s pivot (I wrote about it in May this year, giving three reasons why the dollar will weaken: link) – the current scale of the weakening is a bit surprising… Figure 1 shows the DXY (dollar index) and its components since January 1, 2022. In March 2022, we had the start of hikes in the US, in September 2024 we will have the start of cuts. During this period, only the Swiss franc strengthened against the dollar. A weak dollar (and a strong euro) can generally be interpreted in two ways: 1) The market is currently strongly betting on a soft landing scenario, or even the beginning of a new “reflation trade”. Previous reflation trades are clearly visible in the strong increases in EURUSD – see Figure 2 – blue circles. But in 2017 and 2020, reflation trades started from practically zero policy rates, 2) We only have strong currency movements due to the full confirmation of the pivot by Powell in Jackson Hole plus further strengthening of these movements by the risk of more leverage/carry trades unwind - especially since the currencies financing the carry trades are strengthening. The movement in currencies may be additionally strengthened by Trump's upward shift in the polls (remember how strong the reflation trade was after Trump's victory in 2016). All in all, I am definitely closer to the second scenario, because a new "reflation trade" starting at 5.5% level of US policy rate seems a bit doubtful ...
