Aurelia Butler

Good morning. Ethan here; Rob’s away this week.By 2022 standards, yesterday would’ve been just another day of bear-market selling. But after a euphoric January, a 2 per cent down day for the S&P 500 feels sombre. The clearest cause is the return of interest rate volatility, as markets start to believe the Federal Reserve really will raise rates to high heaven. The S&P peaked on February 2, a day after the Move index, a measure of rate volatility, bottomed. The Fed is still the biggest story in markets, and it isn’t close. Email me: [email protected] America is still investingAnswer this with one word: why has the US economy stayed strong? Our pick would be “consumers”. Buoyed by a structurally tight labour market and a still-intact pandemic savings cushion, consumers, who make up some 70 per cent of nominal gross domestic product, are powering through rate rises.But a good runner-up might be “corporations”. Business investment (something like a fifth of GDP) has likewise withstood higher interest rates. In the fourth quarter, S&P 500 companies grew capital expenditure 10 per cent year-on-year after adjusting for inflation, estimates Spencer Hill at Goldman Sachs. The nominal figure is a rollicking 17 per cent. There is talk of a “capex supercycle”.The backstory is that companies used the Covid stimulus to tidy up their finances, leaving behind a nice cash pile. Pantheon Macroeconomics puts the leftover cash buffer at about $400bn, compared to the pre-Covid trend. Meanwhile, balance sheets have gotten cleaned up and debt maturities pushed out well into the future. Many think this is blunting the immediate impact of rate increases on businesses.Higher rates still do bite, however. As we’ve written before, revenue growth is slowing and margins are compressing. But looking across the universe of US companies, Goldman’s Hill sees most cost cuts coming from a less-discussed source:So far, companies appear to be responding to lower margins and higher financing costs by cutting share buybacks — which fell 12 per cent in the [fourth] quarter — as opposed to reducing investment or employment.After months of news about job cuts and cost reductions, this explanation feels unintuitive, but it may better match the macro picture of steady capex growth and rock-bottom unemployment.Yet unless margin pressure abates, it’s hard to see investment being insulated for ever. If it gets cut, is the economy in trouble?The 2015-17 default cycle offers a useful comparison. Driven by a commodity downturn, it’s not a precise analogy (it rarely is). But it is a good example of a non-recessionary contraction in capex. Here’s what business fixed investment did during that period:A sector-specific bust created four quarters of contracting investment. But since (real) consumption spending kept chugging along at a 2.8 per cent rate, a recession was avoided.Maybe the fact that investment can shrink without causing a recession makes you more willing to believe in a soft landing. Or maybe it makes you think inflation is pretty darn entrenched (we’re sympathetic). The point is that despite real signs of slowdown building on the margins, the Fed faces an economy that isn’t just being pulled along by consumers. At its core, strength abounds.Will the Fed stick to 2 per cent?A few readers have recently written in to voice their suspicion about the Fed’s commitment to a 2 per cent inflation target — which Unhedged has often taken as a given. They think the US central bank is going to abandon the target the moment it is expedient to do so.Markets don’t discount the possibility. The five-year break-even, a proxy for market inflation expectations, sits at 2.6 per cent, compared with a 2003-19 average of 1.8 per cent. Survey measures aren’t much different; the New York Fed’s five-year expected inflation rate is 2.5 per cent.This looks consistent with the Fed reaching 3ish per cent inflation and deciding, well, close enough. It’s not hard to see why. As we’ve written before, the first leg of disinflation is probably going to be easier than what comes after. Consider that core inflation has taken a big step down — from a 0.6 per cent monthly pace in mid-2022 to 0.4 per cent in January — with no increase in unemployment. But it may get uglier. In a recent note, Don Rissmiller and Brandon Fontaine at Strategas write:Elevated job openings & consumer cash holdings are providing cushions now. But the last -1 per cent reduction in inflation (from 3 per cent [headline consumer price index] to 2 per cent) could be very expensive in terms of job loss. Perhaps a 6-7 per cent unemployment rate is needed (more consistent with historical US recessions).As job losses, and political pressure, mount for the Fed, Rissmiller and Fontaine think it will consider lowering the bar:Pushing all the way down to a 2 per cent number, which is chosen arbitrarily anyway, may not be credible. Declaring mission accomplished in the neighbourhood of 2 per cent provides the best hope of a “soft-ish” landing for the economy that we see going forward. The Fed declaring victory at 3 per cent, as long as 3 per cent looks anchored, would mean short rates could have a 3-handle in 2024 (as policy moves back towards neutral).This account seems plausible enough, especially since prominent voices are already calling for the 2 per cent target to go.But it also assumes the Fed knows at what level interest rates become restrictive, and thus has precise control over inflation and unemployment. It seems more likely to us that the Fed is feeling around in the dark. Yes, the central bank can always cut if it goes too far, but easy monetary policy exhibits long and variable lags, too. We would humbly offer up another scenario: by the time the central bank realises it has overtightened, it’s already too late.One good readScott Alexander revisits his predictions about 2023, made in 2018. More

The writer is an FT contributing editor and global chief economist at Kroll Quantitative easing has developed a certain resemblance to the Eagles’ “Hotel California” — you can check out any time you like, but you can never leave. We should pay more attention to quantitative tightening, suggest former Reserve Bank of India governor Raghuram Rajan and others in a recent paper. Commercial banks change their behaviour when there are plentiful reserves, making QT far more volatile and difficult to pull off than expected.Our grasp of how QE and QT really work remains tenuous. In announcing a bond-buying programme, a central bank signals to the markets it is committed to accommodative policy and that rates will be low for a long time. The entire yield curve drops as a result. In purchasing long-dated bonds, the central bank pushes their yield down and in theory incentivises investors to move into higher return securities (the so-called portfolio rebalancing channel).However, QT isn’t just QE in reverse. When rates are at the zero lower bound, the signalling channel is strong. But announcements about the central bank’s balance sheet are less effective when the policy rate is well above zero. In 2017, Janet Yellen, then Federal Reserve chair, promised QT would be more “like watching paint dry”. The reality has been somewhat different. Rajan argues this is because commercial banks change their behaviour when the central bank expands its balance sheet, but do not change it back again when the balance sheet shrinks.The mechanics of QE are a bit wonky. When the central bank buys bonds from investors, the proceeds are deposited in a commercial bank account. The banks steer the money into demand deposits (which can be withdrawn at any time) because they pay less interest than time deposits. To balance out these liabilities, the Fed credits the banks with the same amount of reserves as assets. The reserves give banks confidence they can weather any significant deposit withdrawals, and they are also used to extend credit lines that generate fees. This shortens the average maturity of bank assets, undermining the portfolio rebalancing channel and increasing bank vulnerability to liquidity shortages.According to Rajan’s data, none of this unwinds when the central bank shrinks its balance sheet and reserves become less ample. Instead, banks substitute lost reserves with other assets that are eligible collateral in repo transactions, to remain confident of getting enough cash if they need it. But if every bank tries to transform their assets into cash simultaneously, there will inevitably be a shortage, as happened in the US repo market in 2019. Banks also continue to extend credit lines even as liquidity wanes, to maintain client relationships.That means banks make greater claims on the system’s liquidity during QT, which may continue until there is a market blow-up. Central banks can step in and buy bonds again to paper over these liquidity crises, as they did in 2019, at the start of the pandemic and in the recent liability-driven investment freeze in the UK. But that ratchets up banks’ demands for liquidity still further — and makes QT even harder to pull off down the line.One way around this is to minimise the signalling channel of QE, as the Bank of England did last autumn when it announced it would buy gilts for a very limited period, after the fallout from the Liz Truss-Kwasi Kwarteng “mini” Budget. But that would only work in a small-scale market meltdown. Imagine the Fed announcing in March 2020 that it would buy bonds but only for a short time, reserves would not be plentiful forever and rates would rise soon. Investors would have continued their dash for cash.Central banks could simply forget about QT. Unlike commercial banks they can take losses and run in the red. But there are good reasons why they should not have an ever-growing balance sheet. Investors would have an incentive to take more risk. Governments may lean on the central bank to buy more bonds to finance pet projects. Central bank independence would be severely at risk, undermining credibility. A forever-distorted yield curve would make price discovery impossible.Better bank capitalisation could help reduce vulnerability in the face of greater liquidity needs. Bank regulators could prevent reserve hoarding by allowing banks to meet an average of liquidity requirements over time rather than daily targets. Standing repo facilities can be extended to non-banks with good collateral, as the Bank of England has recently done. Ultimately, however, the best way to get out of QE may be not to start it in the first place. You don’t have to check out if you’ve never checked in. More

Investors are betting the European Central Bank will raise interest rates to all-time highs, spurred on by the eurozone economy’s resilience and signs that inflation could prove tougher to rein in than expected.The Frankfurt-based central bank, widely seen as one of the world’s most dovish during its eight-year experiment with negative borrowing costs, is now expected to raise rates substantially this year. Swap markets are pricing in a jump in the ECB’s deposit rate to 3.75 per cent by September, up from the current 2.5 per cent. That would match the benchmark’s 2001 peak, when the ECB was still trying to shore up the value of the newly launched euro.“It is really surprising to see the ECB now looking like the most hawkish of the big central banks,” said Sandra Phlippen, chief economist at Dutch bank ABN Amro. Markets have revised forecasts of interest rates upwards after recent eurozone data on buoyant service-sector activity and wage demands. ECB president Christine Lagarde said on Tuesday that the bank was “looking at wages and negotiated wages very, very closely” — an indication of concern a sharp rise in salaries this year will maintain pressure on prices as companies pass costs on to consumers. The yield on German two-year bonds, which are highly sensitive to changes in interest rate expectations, hit a 14-year high of 2.95 per cent on Tuesday after the S&P Global purchasing managers’ index outstripped forecasts.The prospect of further substantial rate rises in the eurozone contrasts with the US and the UK, which are widely considered to be closer to the end of their interest rate rise cycles, having already increased borrowing costs earlier and by more than the ECB. However, US stock markets fell sharply on Tuesday as upbeat economic data prompted investors to re-evaluate how much further the Federal Reserve may raise rates.Eurozone inflation of 8.5 per cent in January compares with 6.4 per cent in the US. While UK inflation remains in double digits, it has fallen faster than expected and the country’s anaemic growth outlook has diminished pressure on the Bank of England to increase rates.In the past week Goldman Sachs, Barclays and Berenberg have raised to 3.5 per cent their forecasts for how much further the ECB will raise rates. Deutsche Bank on Wednesday raised its forecast to 3.75 per cent.“There is a risk that inflation proves to be more persistent than is currently priced by financial markets,” Isabel Schnabel, an ECB executive board member, told Bloomberg this week. Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, forecast ECB rates would peak at 3.5 per cent but added the central bank could “still be in tightening mode by September and that takes you close to a deposit rate of 4 per cent”.The ECB has already raised rates by an unprecedented 3 percentage points since last summer and this month signalled plans for another half percentage point move in March.Wages in the 20-country bloc have been growing at close to 5 per cent in recent months, according to a tracker published by the Irish central bank and jobs website Indeed. Unions are responding to last year’s record inflation by demanding even higher pay rises. FNV, the biggest Dutch union, is calling for a 16.9 per cent pay rise for transport workers, while Germany’s Verdi union wants 10 per cent pay rises for 2.5mn public sector workers.Although eurozone inflation has fallen for three consecutive months, core inflation — stripping out energy and food prices to show underlying price pressures — was unchanged at a record 5.2 per cent in January.“The performance of the economy is obviously good news in the short term for the eurozone, but for the ECB . . . it could suggest they may have more work to do on policy rates,” said Konstantin Veit, portfolio manager at bond investor Pimco. He added that the ECB had made clear that inflation fighting was its “absolute top priority”.Ducrozet at Pictet added: “Even the most moderate doves [in the ECB] are talking about a series of rate rises and not stopping anytime soon.”Resilient economic data across advanced economies this month has led economists and financial experts to bet that interest rates will stay higher for longer than they previously considered.“There has been a repricing in major developed rates markets,” said Silvia Ardagna, an economist at UK bank Barclays. “The fact that US core inflation was a bit stronger than expected last month has made everyone think that maybe it hasn’t peaked yet.” More

The panel is headed by the deputy chief of the top financial regulator, the Financial Services Commission (FSC), and comprises regulators, scholars, researchers and officials from financial industry associations, the FSC said in a statement.Kim So-young, vice chairman of the FSC, said at the panel’s inaugural meeting that it would study ways to boost competition either between existing banks or by allowing entries of niche service providers.The panel would also look into ways to help banks diversify their business practices, currently heavily dependant on interest rate margins, and improve their pay structure, he said.It would also discuss possible measures to strengthen capital buffers against external shocks.President Yoon Suk-yeol and other government officials have said there is growing public discontent over reports of big performance-sharing and early-retirement bonus payments by banks. More

TOKYO (Reuters) – Japan’s Nikkei 225 share index will hit the psychological 30,000 level by end-2023 on a better domestic corporate and global economic outlook in the latter part of the year, according to strategists in a Reuters poll.Strategists expect Japanese companies, many of which rely on exports, to particularly benefit from an improvement in China, which is gaining momentum after ending its zero-COVID policy.”Japanese companies will issue their outlook for 2023 by May, which will be based on the current macro environment. So the forecast will be conservative,” said Hikaru Yasuda, chief equity strategist at SMBC Nikko Securities.”But as the environment is not as bad as companies (now) expect, they will slowly raise their forecast towards the end of the year.”The median estimate of 15 analysts polled Feb. 10-21 was for the Nikkei to be at 30,000 at the end of this year, after rising to 28,000 by end-June. The end-year forecast is the same as the median from a poll taken three months ago, but the mid-year view is 2,000 points lower.The International Monetary Fund last month raised its 2023 global growth outlook slightly due to “surprisingly resilient” demand in the United States and Europe, easing of energy costs and the reopening of China’s economy.”Companies whose businesses are linked with China are expected to perform well,” said Hiroshi Namioka, chief strategist and fund manager, T&D Asset Management.The 30,000 mark would be a 9% gain from Tuesday’s close of 27,473.10. The Nikkei, which fell as low as 25,661.89 on Jan. 4, the first day of trading this year, has been hovering below 28,000 amid uncertainties about the pace of the U.S. Federal Reserve’s interest rate hikes.Investors also await details of the Bank of Japan’s monetary policy after Kazuo Ueda takes over as governor in April, replacing Haruhiko Kuroda who has been defending the central bank’s ultra-low rate policy over the past ten years.Many bond strategists expect Ueda to tweak or abandon the current yield controlling framework, which would push up the benchmark 10-year government yield.The yen strengthened against the dollar after the BOJ widened the trading band of the 10-year government bond yield at its December policy meeting.But the yen has since fallen about 5% from its mid-January high against a rising dollar, which has rallied in recent weeks on expectations the Fed has further to go in raising rates.”Japanese equities are undervalued due to caution for the currency movement,” said Hirokazu Kabeya, chief global strategist at Daiwa Securities.”They could be lifted if concerns about the yen’s extreme gain against the dollar will be removed.”(Other stories from the Reuters global stock markets poll package:) More