Sintra: Something Gotta Give
The ECB conference at Sintra, Portugal is more often a market-moving event than not. The panel discussion is an open dialogue and financial markets-focused discussion.
Such was the case when Powell was asked “So, rate cut by September?” Powell’s cautionary tone that disinflation is on track, but inflation would be at the same level a year from now limited the effect on rate expectations and equities.
Powell characterized disinflation as “quite a bit of progress” with an emphasis on “significant.” But that stopped him short of committing to September. Expectations for the Sep and Dec meetings moved 2 to 4 basis points while the yield curve “bullish steepened”, an expectation that the Fed will ease sooner (Figure 1).
On fiscal policy, Powell acknowledged (as before) that running deficits indefinitely is not sustainable, even in the good times. The yield curve’s bearish steepening expresses the risk of the “unsustainable” as opposed to the effect on GDP.
To Powell, rate cuts are not connected with keeping deficits sustainable. Rather, the neutral rate is where policy is heading over time, but it does not determine the number of cuts soon. Treasury yields did not move much, but the Yen remained hovering around the recent highs as Ueda was the notable absentee on the panel.
For markets, the takeaway is that Fed policy will move in the future, but the ECB and the Bank of Brazil will move sooner. Thus, 2024 is turning into a year again of “central bank divergence.” In 2015, the Fed fever reached new heights, but the Fed did not hike until the December meeting, and subsequent hikes were delayed in 2016.
When Sara asked Powell at the end “Were you a two-cut dot or a one-cut-dot for 2024?”, his uneasy laughter and facial expression, in my view, indicate that Powell’s reluctance to answer the question may not put him the camp of the four dots at the top of 2024 plot. That is a “clue” for markets because Powell leaving September open means that December remains an ultra-live meeting to kick off the easing cycle.
The yield curve finished with what bond traders call a “twist steepening”—i.e., the curve steepens bullish (2Y yield down) and bearish (10Y yield up) at the same time. The Yen reacted by weakening because as discussed on the panel, there could be because, as discussed, “spillover effects” from Fed policy.
A year ago on the panel, Ueda was ‘grilled’ about inflation and the Yen. He was careful to admit that inflation was moving closer to the BOJ’s goal, but he added they (BOJ) were “very carefully monitoring” the Yen. The currency was trading at 145 to the dollar and had already depreciated by 20%, a year later the Japanese currency was weaker by another 10% to 15%.
Then, it was unclear how many hikes the Fed would deliver. Now it is getting ‘clearer’ that the Fed could deliver the first cut in a few months. The Yen position, however, is in a more extremer short territory with volatility persistently higher, while the Yen-carry indices are on a decline (Figures 2 and 3).
So, last year the title of the Sintra note was “Something gotta break.” I re-titled it to “Something gotta give.” The BOJ hikes faster and the Fed moves to cuts or the Yen will weaken towards 175 to 200 to the dollar.
That could lead to the unwind of carry trades, which plays right into the US Treasury likely to get bearish steeper for financial stress reasons and that is not a positive for the stock market.
Figure 1: Yield curve and rate cuts (bps)
Source: US Treasury
Figure 2: Yen positioning and volatility (%)
Source: CME
Figure 3: Yen Carry: crumbling
Source: Bloomberg