JSTA 89 (free example)

Sections: 

- 5 to end 5, the Fed’s reaction function is clear 

- The ECB is dragging non-EUR European FX lower 

- Trades 

5 to end 5 

As we enter 2023, in terms of Fed policy, things are actually fairly clear in a  reaction function sense. The Fed is saying they are going to sit at a 5% funds rate until wage growth is no longer 5%. The way the Fed thinks about things right now  is that they are in the ballpark of where they want to be, and how long they stay  there is a question for wage growth to answer.  

For example, nominal wage growth has grown to 5 percent or more, which is  inconsistent with our 2 percent inflation target given recent trend productivity  growth. Monetary policy is the appropriate tool to bring the labor market back  into balance. - Kashkari blog post yesterday 

Given the trend in the inflation data, especially post the OER peak, it seems very  reasonable that the Fed is very close to a pause. Whether it comes in March or  May, is not really the point, the Fed is going to be around 5% on the funds rate  and the +/- 25bps isn’t really the story. The story for US rates this year is not  about hiking, it’s a question of attrition. How long will the Fed be able to stay at  5% rates? Inflation is coming down fairly quickly, especially once OER starts  feeding into the number. However, the Fed seems to be setting up for a policy  stance that believes that disinflation is not real unless it is coincided with  decelerating wage growth. AHE/ECI that is annualizing at 5%+ is the Fed’s  barometer for “some time” which is how long the Fed expects to stay at their  160bps real level.  

160bps real funds is their target, how long they stay there is going to be a  byproduct of wage growth. That is the current reaction function. 

The Fed knows that inflation is softening meaningfully, but they don’t seem keen  to embrace it at all really. From yesterday’s minutes: 

- but they stressed that it would take substantially more evidence of  progress to be confident that inflation was on a sustained downward path. 

- risks to the inflation outlook remained tilted to the upside. 

- Participants generally indicated that upside risks to the inflation outlook  remained a key factor shaping the outlook for policy. 

- Participants generally observed that maintaining a restrictive policy stance  for a sustained period until inflation is clearly on a path toward 2 percent is  appropriate from a risk-management perspective. 

And we saw Bostic say today that the Fed still has “much work to do.” 

The Fed knows the OER numbers are going to bullwhip the other way, the  commodity side is over and that core goods are going to continue coming down.  But in spite of that, the minutes showed that the Fed still thinks that inflation risks  are to the upside and that was shaping the outlook for policy. I think to properly  understand how the Fed is thinking about the outlook, we have to go back to John  Williams’ onion speech. John Williams’ “Pelling the Inflation Onion” speech at the  end of November was really a great lens into the extent of how wage Phillips  Curve the Fed has turned.  

However, lower commodity prices and receding supply-chain issues will not be  enough to get inflation back to our 2 percent inflation goal—it's the innermost  layer where the hard work lies. Overall demand for labor and services still far  exceeds available supply, resulting in broad-based inflation, which will take longer  to bring back down. 

This approach was followed by Powell’s Brookings speech that really introduced  this new tag line of core services ex OER as basically equaling nominal wage  growth.

So, we understand the Fed and what they are thinking pretty clearly, the question  now is what it does it mean for markets? Again, the question for this year is not  about how many more hikes, it’s about how long until cuts. Assuming a baseline  for the economy and the current disinflation trend, the question for markets is  how soon we can romance cuts because a steady state (no landing) 5% fed funds  world just doesn’t work for pretty much every price on the screen. Bonds are too  rich, multiples in equities are too high, BBDXY is too low and commodities are  probably still too high. The no landing world to me is where the real economy  just bleeds out the financial economy. 

The answer to this question lies in three potential worlds, which are somewhat  correlated to my (3 landings scenarios). These three camps assume a baseline for  both the current growth and inflation trend.  

1) The Fed is committed to this wage growth framework; 5 (funds rate) to end  5 (wage growth). The deceleration in inflation doesn’t faze them, and 5%  wage growth is inconsistent with 2% inflation. In this world, real rates shoot  up as the Fed is challenged on the inflation outlook by the market (2.25%  2y CPI swap) but the Fed continues to say the job is not done until wage  growth doesn’t have a 5 handle. This is really the “bleed out” scenario for  asset prices, cuts come out, multiples come down and the dollar goes  higher.  

2) The Fed uses this wage growth approach but when the OER numbers really  start to hit the CPI/PCE readings, they give in to the path of travel of the  inflation data. In this world, wage growth doesn’t really come down, but  the Fed decides the inflation readings are good enough to begin  

entertaining a mid-cycle adjustment to a lower level of restrictive that  would be in line with this 160bps real rate approach. Especially as CPI will  very likely be printing 3% by the middle of this year. This is the world where  real rates start to come down and that is very supportive for asset prices as  it is a clean immaculate disinflation.  

3) Powell gets his way and the Beveridge curve approach hits. While the  official line from the Fed is that they are watching the unemployment rate 

to measure the state of excess demand in the labor market, Powell told us  what he is watching. JOLTS and ECI. There is a world where the Q2 Waller  speech ends up happening, a low separation rate leads to JOLTS coming  down and as supply/demand rebalances in the labor market, wages come  down without a commensurate increase in the unemployment rate. This is  the soft landing the Fed has in mind which Powell does think they can  achieve. In this world, Z4 in SOFR is closer 97.50 and we begin a path back  to neutral policy rates.  

The ECB is dragging non-EUR FX lower 

The hawkishness from the ECB at the December meeting was pretty shocking and  led to a significant re-rate across fixed income globally. For me, the trade on this  re-rate continues to be playing whites/reds flatteners in the ER strip. However,  there is another theme I want to explore that is based on this re-rate in European  FI. The ECB has put non EUR European FX in a very vulnerable situation as they  are now well *behind the ECB. And this is something we have begun to see with  things like EURSEK making new cycle highs.  

This is where the ECB is (Schnabel interview last week): 

- The aim was to clarify that the terminal rate may be higher than many  market participants expected. 

- According to our assessment, this interest rate lies in restrictive territory – that is, above the neutral interest rate – even if the exact level is yet  

unknown. This means that the inflation problem will not go away on its  own. 

- At the moment, however, the danger of overreacting continues to be  limited, as real interest rates are still very low. 

The ECB is not comfortable with the 2022/2023/2024/2025 inflation forecast and  that was reflected in both the policy statement and the press conference. Lagarde  said that “significantly” and at a “steady pace” is likely for 50bp hikes. “Not a one 

shot thing.” So that means there is still a decent amount of time left in the ECB  hiking cycle. They will go 50bps at both the February and March meetings, and  from there it could be 50 or 25 in May and maybe they pause over the summer.  That is a lot of ground to cover. The story for the ECB in 2023 is finding their  “sufficiently restrictive” level, which the ECB told us last week is nowhere near  2.8% which was the pre meeting market implied terminal rate. 

This is where the BoE/Riksbank/Norges/SNB are: 

- BoE: The BoE is probably the standout for the most dovish developed  market central bank. The BoE hiked 50bps in December, but they think the  market has too much priced in implieds and had two members of the MPC  vote for a pause at 10% inflation. 

- Norges: Norges is trying to become more two sided in their reaction  function. At 2.75% in the policy rate, the December statement said that the  cycle likely has one more 25bp hike left: "the forecasts for the Norwegian  economy are more uncertain than normal, but if the economy evolves as  anticipated, the policy rate will be around 3 percent next year.” Norges has  been very hesitant about materially re-rating the destination of their hiking 

cycle as they are of the view that “long and variable lags” are about to kick  in and the economy is already beginning to soften. 

- Riksbank: The Riksbank is at 2.5% and as of their last meeting at the end of  the November, they also thought they were closer to the end. The Riksbank  forecast for terminal as of the November MPR was for 2.8% with an  adverse scenario forecast of much higher. But a baseline of 2.8% doesn’t  work with the ECB thinking terminal is closer to 3.5%.  

- SNB: The SNB wants to track the exchange rate and came across a bit more  hawkish at their last meeting where they hiked to 1%. However, the  statement still only suggests that “it cannot be ruled out that further  increases in the SNB policy rate will be necessary.” This is not a firm  

tightening bias at all when you are at 1% and the ECB is saying that 3% is  way too low for them.  

EUR v non EUR Europe DM basket (GBP/ILS/CHF/NOK/Norges)

The ECB took a massive step hawkish in December, and non EUR Europe is saying  that they are closer to the end. That doesn’t work and FX is really wearing it.  

- 11.20 was the high for EURSEK during the Covid lows, we have blown  through that and are trading around 11.25.  

- EURNOK is also at its highest level since 2020.  

- Since the end of the summer, EURILS is up almost 15%.  

- EURGBP has been flirting with 90c for a bit now, the top end of its post  Brexit range. 

- EURCHF is above its 100dma for the first time since the summer.  

And while the more popular trade post the December ECB has been to be short  bunds or short European rates in general, the action is in non EUR…. BTPs have  had to factor in new highs in terminal/pulled forward QT and supply and yet, no  new high in yield. 

Looking at EUR 10y IRS trading sub 3%, it’s the same thing. No new high in yield  despite what is material shift in the thesis. What is making new highs, EURSEK, so  that is where I want to be. I still think the best rates trade on the board right now  is this whites/reds trade in Europe. However, in terms of thinking about this ECB  re-rate, there is a lot of talk about directional rates, but not so much about FX,  which I would argue is reflecting this theme better.  

Sum of trades:  

1) Short CNHJPY: The inflection point that is beginning to become envisionable  for JPY is this bimodal setup where either global growth doesn’t crack and the BoJ  achieves its goals, or growth cracks and yields globally come down materially. 

2) Short GBP basket (AUD/USD/BRL): I think the market has been right to re-rate  UK risk premium, but now that it has, I don’t see the outperformance case. Which  means to me, we likely return to a grind lower in FX as the UK continues to face  significant structural challenges along with a relatively more dovish central bank.  

3) Flatten ERU3/ERU4: We are at the point of the cycle where things like the reds  and out on the strip will not be able to keep up with the pricing in the whites.  ERU4 may able to price something like +3% Euribor but from there the  distribution gets tricky.  

4) Flatten 5s30s JPY: The approach I am taking to December BoJ is that it is June  2021 FOMC or December 2021 ECB. In both cases, an A trade was the 5s30s  flattener.  

5) Long EUR/Scandi (NOK/SEK): The distributional setup seems much cleaner in  things like EUR/Scandi where its either the ECB is relatively more hawkish or they  break things, in both world EUR/Scandi goes higher.