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Hi everybody, and welcome back to The Macro Compass!

Powell didn’t push back enough, and so markets are now rallying hard in his face.And given J-Pow’s lack of real pushback, markets won’t stop unless data comes in very hot (or recessionary).

The window for the soft landing narrative is now extended.With one caveat: the narrative is very misplaced.

In this piece, we will:

* Dissect the Fed meeting, focusing on Powell’s important comments about inflation and the labor market;

* Scrutinize markets’ reaction, with a particular focus on the bond market;

* Conclude by refreshing our actionable tactical trades and ETF Portfolio

Powell didn’t nearly push back enough, and so markets are now rallying hard in his face.

And given J-Pow’s lack of real pushback, markets won’t stop unless data comes in very hot (or recessionary).

The window for the misplaced soft landing narrative is now extended. Picture this.

The first innings of a recession always look like a soft landing, as growth and inflation come down but not to alarming levels yet – exactly like today. And as markets myopically embrace this soft landing narrative, Powell’s lack of pushback against easier financial conditions adds fuel to the fire.

Taking a deeper look at what Powell actually said, it becomes increasingly clear markets don’t believe him.

At all.

#1: On Inflation

‘’We need substantial more evidence to be confident about inflation returning to 2%, in particular as we see core non-housing services inflation still running at 4% annualized with no progress there’’

‘’We need to be honest with ourselves: inflation might be more persistent in this sticky category, and that means we have to do more’’

The 6-month (annualized) rate of change in core services ex-housing CPI is down to 4% - and despite the clear downward trend, Powell told us he is not happy about it.

The composition of this downward move (right chart) is indeed a bit messy: medical care deflation accounted for a large portion of it.

Despite the progress on inflation, Powell didn’t remotely sound the all-clear yet. The bar for a proper Fed pivot remains high.

But then, why did the market rally like if a new round of QE was announced?What’s the bond market trying to tell us here?And most importantly, how to tactically position portfolios now?

Let’s dig in…

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Hi everybody, and welcome back to The Macro Compass!

The Fed intends to drain ‘’liquidity’’ at a rapid pace in 2023.And while the pace might be more friendly for the next months, don’t get distracted. Banks, the repo market and Wall Street will soon start feeling the heat.

In this piece, we will:

* Explain what ‘‘liquidity’’ really is in plain English;

* Go over the drivers of US liquidity in 2023;

* Assess how they will interact with each others and drive markets;

* Conclude by refreshing our market views and our actionable ETF Portfolio

Let’s start with the basics: ‘’liquidity’’ = bank reserves.It’s one line item you can easily track on the Fed balance sheet (liabilities), and you don’t need any fancy formula to calculate it.

Bank reserves are money for banks.

Banks use reserves to transact with each other and with the Fed: to settle transactions, buy bonds (!) from each other, and lubricate the biggest funding mechanism in the world – the repo market.

A regime of ample reserves helps banks in providing liquidity to financial markets.

In that regime, banks will facilitate a smooth functioning of the repo market and have appetite for absorbing high-quality bonds (Treasuries, high-rated corporate bonds and mortgage-backed securities etc).As repo markets work smoothly and banks bid high-quality bonds, investors tend to take more risks.

Instead, tighten ‘’liquidity’’ rapidly and over time investors’ risk appetite could fade.

No, I will not draw a line chart of ‘’liquidity’’ versus the S&P500 and tell you that is the magic formula. Because that’s macro gaslighting, or aka bull…. :)

Banks don’t use reserves to buy stocks because equities are not a regulatory well-treated asset (HQLA). Monetary plumbing is not so easy.

But yes, the amount and the rate of change of bank reserves matter for repo markets and risk appetite.

And in 2023, a lot will be going on with bank reserves. Let’s start with the elephant in the room: Quantitative Tightening.

In its simplest form, QT shrinks the balance sheet of the Fed on the asset side (bonds not reinvested) and on the liability side – here, the standard is that bank reserves are destroyed. As the government keeps issuing bonds over time, it’s up to the private sector to absorb bond issuance. Reserves are destroyed, and private investors have less room to allocate towards riskier assets.

The Fed will be running QT at a yearly pace of > $1 trillion. So, does this mean reserves are going to linearly shrink by $95 billion per month?

And most importantly: how will other factors like the Treasury General Account (TGA) or the Reverse Repo Facility (RRP) impact US liquidity?

Understanding ‘‘liquidity’’ is crucial to navigate markets.

Let’s dig in, and assess how we position for these dynamics at The Macro Compass…

From January 2023, getting access to the premium The Macro Compass content will require a paid subscription.

Not only deep and unique macro insights but also ETF Portfolios, tactical trade ideas, interactive tools, courses and much more are available on the TMC platform.

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Hi nice people, and welcome back to The Macro Compass.This is an old-style free macro piece for everybody - enjoy!

The soft landing crew is increasingly taking over.No, the bond market’s base case is not a recession - it’s immaculate disinflation.Yes, getting this call right is crucial for your portfolio performance in 2023.

In this article, we will:

* Look at different corners of the bond and equity markets to assess what are the market-implied probabilities of a recession or a soft landing;

* Debate how to approach macro investing in such a binary environment.

The Bond Market - Immaculate Disinflation

‘‘The bond market is pricing 200 bps of cuts = the bond market says recession - 100% !’’

No, not really.The bond market’s base case is immaculate disinflation, and let me show you why.

Most of the confusion stems from an overly simplistic approach.In the average recession over the last 30 years, the Fed cut by 350 bps over an 18 months period.The bond market is pricing 200 bps worth of cuts between Jun-2023 and Dec-2024, so that must mean the bond market’s base case (60%) is a recession.

This simplistic analysis is misleading because it ignores:- The ultimate landing point for Fed Funds and real yields- The credit market- The tails

Let’s start with a clear chart.

Fed Funds are priced to peak at ~5% in summer, and then 200 bps of cuts are expected.Yet, Fed Funds are never (!) priced to be below reasonable estimates of neutral rate (2.25-2.75% in nominal terms) throughout the next 2-5 years.

This would be the first time ever the US is in a recession and the Fed doesn’t cut rates below neutral - it doesn’t make sense, right?

Indeed, because the bond market’s base case is not a recession: it’s immaculate disinflation.

This is also evident in the expected path for real yields, which compares expectations for Fed Funds (see above) against inflation expectations.

In any recessionary or growth slowdown episode of the last 15 years, real Fed Funds 2-year ahead were priced to be between -100 and -200 bps.That’s the bond market asking the Fed to be very accommodative given poor growth.This time, market-implied US real yields in 2025 are priced to be…positive?!

Again, that doesn’t square with the ‘‘bond market is pricing in a recession’’ mantra.

Inflation slowing down to 2.5% quickly, and the Fed cutting rates to neutral (and never below) is not recessionary pricing.

It’s immaculate disinflation pricing.

The credit market wholeheartedly agrees: a recession is not the base case.US high-yield credit spreads are trading barely above 400 bps, below the 20-year average and far away from median recessionary episodes (1000 bps).

Additionally, the default cycle is priced in to be very mild and downside protection in the broad credit market is not as expensive as it would be if a recession was base case.

Finally, the tails.Insurance is very expensive when the house is already on fire.

So, what tail risks are markets trying to insure against by December 2024?A recession with Fed cutting rates below neutral (say, to 1.5% - orange line) or higher-for-longer (say, Fed Funds above 4% - blue line)?

Using a 2-year horizon and option-implied probabilities, insurance on the Fed keeping rates higher-for-longer is more expensive than insurance on Fed cutting rates in a magnitude consistent with a recession.

The bond market’s base case is immaculate disinflation, not a recession.

A relaxed credit market, inflation rapidly declining to 2% and the Fed cutting rates back to neutral, forward real rates still expected in positive territory and the lack of aggressive insurance bid for recessionary cuts all point in that direction.

Recession: 20-25% probabilityImmaculate disinflation: 45-50% probabilityGrowth regime/higher-for-longer: 30% probability

The Equity Market - Soft Landing

The equity market’s base case has rapidly shifted towards soft landing.

There are three main angles to cover:- Earnings expectations - The internals of the stock markets - The tails

First, the more recessionary vibes.

Analysts are realizing their 2023 EPS estimates might have been too optimistic.The pace and breadth of negative revisions is in line with other recessionary episodes.Also, highly cyclical sectors like semiconductors are experiencing EPS slashes in the 30% area which are almost consistent with a recession.

Yet, 2023 EPS consensus at $225 implies roughly a 4% earnings growth this year.In recessionary episodes, the average EPS decline is instead -30%.

The Chinese reopening is obviously playing a role in boosting cyclical growth expectations around the world.

Countries with tight Chinese trade relationships like Germany or Australia have outperformed in a risk-adjusted way.Within sectors, US semiconductors and high-beta have been the market’s darling while defensive sectors like staples and utilities are lagging.

Soft landing vibes getting stronger, helped by the Chinese reopening.

What about tails?

If markets were truly worried about an earnings recession and a stubbornly higher-for-longer Fed, you’d expect some bid for deep out-of-the-money put options.

But given the absence of jump risks in 2022, the strong ‘‘Fed put’’ muscle memory and expectations for earnings to be weak but not in recessionary territory downside protection in the S&P 500 is at the cheapest levels in 2 years.

The implied volatility in 20% out-of-the-money SPX puts with a 3-month expiry are trading in the lowest 15th percentile on a 2-year history (chart below) and in the lowest 40th percentile on a 5-year history.

The stock market’s base case is that a broad recession will be avoided as the growth downturn is bottoming (also thanks to China) and that we are past peak Fed tightness.

Downside earnings revisions are happening, but EPS is expected to still grow which is not consistent with a recession.A cyclical growth boost is getting increasingly priced in, and cyclical sectors and countries are outperforming defensive.Finally, the option market shows investors have little to no appetite for buying heavy downside protection.

Recession: 15-20% probabilitySoft Landing: 60-70% probabilityGrowth regime: 15-20% probability

Conclusions

Neither the bond nor the equity markets are pricing a recession as a very high probability scenario.

Instead, the base case is an immaculate disinflationary episode leading to a period of below-trend growth.

How do investors navigate this rather binary macro outlook, with a gravitational pull force (nominal growth slowdown) opposed by a cyclical push force (Chinese reopening boosting growth expectations)?

The three best practices are:

* Rely on a data-driven macro process, and don’t get stuck in a narrative if data is not validating it;

* Use episodes of extreme market conviction in the prevalence of the pull or push dynamic to take advantage of macro opportunities;

* Look for allocations towards investments that have a positive expected value in both outcomes, or for exposure to idiosyncratic asset classes whose return profile is not solely dependent on calling this binary macro outcome right.

Finally, an important reminder.

From January 2023, getting access to the premium The Macro Compass content requires a paid subscription.

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Hi everybody, and welcome back to The Macro Compass!

Markets are front-loading the Fed pivot, and it’s a bad idea.

In this piece, we will:

* Have a look at the last US inflation report;

* Answer the big question: Powell pivoted in 2019, is he going for it again in 2023?

* Analyze what’s priced in for bonds and equity markets: a recession, Goldilocks or what regime exactly?

* Conclude by refreshing our market views and our actionable Macro ETF Portfolio

Yes, this time is different: front-loading the Fed pivot is a bad idea.

Last week’s US CPI report delivered good news: inflation is coming down, and fast. Fixed income traders are nodding to this trend, and expect YoY CPI to print at 2.50% (!) by late summer already.

Not only that, but Powell got exactly what he is looking for:

- Inflationary pressures are less broad: the share of CPI items whose MoM annualized price increases exceed 4% is now quickly heading back down to 50% from its 75% peak a few months ago;

- The momentum of sticky inflation is fading: the 3m moving average of MoM core services ex-shelter CPI has dramatically slowed down, and it’s now in line with a 2.5-3.0% annualized core inflation

Markets have a huge recency bias.

For the last 10 years, every time inflation and growth were slowing down you had to do one simple thing.

Buy every asset you can, and front-load the upcoming Fed pivot. So that’s exactly what markets did.

Junk bonds, Bitcoin, BBBY & Co to the moon. Implied volatilities crushed across the board.

My mentor used to tell me the most expensive 4 words in finance are ‘’This Time Is Different’’. Yet, I think the old adage is wrong here.

Let me show you why, what bond and stock markets are pricing in and how at TMC we position our macro ETF portfolio accordingly…

From January 2023, getting access to the premium The Macro Compass content will require a paid subscription.

Not only deep and unique macro insights but also ETF Portfolios, tactical trade ideas, interactive tools, courses and much more are available on the TMC platform.

Come join this vibrant community of macro investors, asset allocators and hedge funds - check out which subscription tier suits you the most using the link below.

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This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

Hi everybody, and welcome back to The Macro Compass!

The Three Main Themes of 2023

Last week’s macro data releases provided relevant support to our three most important thesis to start 2023:

1) US nominal growth is fast decelerating

Evidence was provided by sharply declining services PMI and lower momentum of Non-Farm Payrolls: the rate of change for real growth is negative.Moderating wage growth implies that the rate of change for inflationary pressures is negative too.

2) EUR core inflation keeps marching higher

Inflation is mostly the byproduct of excessive printing of real-economy money that will chase a relatively inelastic basket of goods and services whose supply can’t be easily adjusted.

Europe went ahead with a large amount of real-economy money printing (pandemic fiscal stimulus), so why does European core inflation lag US core inflation by roughly 6 months?

That’s because the European fiscal stimulus (via EU programs) was much more spread out over time in nature and the European labor market is much more rigid – it takes a bit longer for European core inflation to show up.

But it does, and it likely will continue to do so over the next 3-6 months.

This will force the ECB to be (mistakenly so) very hawkish.

3) The Chinese re-opening trade has legs

It’s simple: it takes time to climb a mountain, and it takes time to fully reprice the Chinese re-opening.

After all, how could it all be ‘’priced in’’ when all = the sudden complete re-opening of the second largest economy in the world boosted by 2022 pent-up stimulus waiting to be put at work by consumers?

To that, sum up the fact Emerging Markets fund managers couldn’t literally allocate to China last year: locked-down economy, massive clampdown on tech and real estate, CCP anti-investment behavior etc.

In 2022, most EM fresh money went to Latin America.

In 2023, if you are an EM fund manager you are forced to reallocate to China & co (e.g. Korea etc).

Macro push and pull forces keep dominating 2023.

The gravitational pull is coming from a fast deteriorating picture for global growth and inflation.The push force comes from the sudden reopening of the Chinese economy.

Wrestling with these macro cross currents, it’s important not to miss the forest for the trees.

What forest?

Let’s dig in.

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Welcome back to The Macro Compass - and happy 2023!Thank you for the amazing support last year.I wish you and your families the best for this upcoming year.

Tell Me - What Are The Macro Models Saying?

The two main forces driving global macro and markets are the rate of change of (nominal) growth and the monetary policy stance.

Real-economy money creation and leading macro indicators inform us on the path ahead for economic growth.Financial money creation and risk-free real yields are key to understand the Central Bank stance and its implications for markets.

The TMC Quadrant Asset Allocation model deploys a data-driven approach to assess where do we stand on both fronts, and it’s a useful tool to start our 2023 asset allocation journey.

In short: for both the US and Europe, we are sitting in Quadrant 4 – the trickiest quadrant for long-term macro investors.

Let’s quickly analyze both the x-axis (RoC of nominal growth) and the y-axis (MonPol stance).

The x-axis: nominal growth is set to rapidly decelerate in 2023.

A)     The pace of real-economy money creation as measured by our flagship TMC Global Credit Impulse index is very low.

This index measures the rate of change in the quantity of money (in real terms, as % of GDP) held by the non-financial private sector in the 5 largest economies in the world.In other words: whether the real spending power of households and corporates is accelerating or decelerating.

As per preliminary October 2022 data, the -3.5% reading is by far the worst in 10 years and in line with the GFC levels.

The TMC Global Credit Impulse index (black, LHS) leads earnings growth (blue, RHS) and inflation (orange, LHS) by 4-6 quarters.

As a result, nominal growth is set to dramatically slow in 2023.

B) Other leading macro indicators point to a rapid deterioration of the job market.

The Global Credit Impulse is only one of the many forward-looking macro indicators in TMC’s data-driven macro and portfolio strategy approach.Amongst many others, the dramatic tightening of US Financial Conditions in 2022 sets the stage for a much weaker labor market in 2023.

After all, it’s how the economic cycle works.

Higher rates, wider credit spreads, lower equity multiples, higher US Dollar => tighter financial conditions => companies cut discretionary spending => weaker growth and earnings => deleveraging: companies cut capex and labor.

Rapid deterioration in US Financial Conditions lead weaker hiring trends by roughly 3 quarters.By this measure, US Non-Farm Payrolls should quickly converge to zero in H1 2023.

Bottom line: both in Europe and in the US the real-economy printing press has stopped working, and leading macro indicators also point to a sharp deceleration in nominal growth.

We are sitting on the left side of the TMC Quadrant Asset Allocation model.

What about the other axis?

The y-axis: the monetary policy stance is very tight.

So far we talked about the real economy – credit, growth, inflation, the labor market.

The y-axis of the Quadrant model instead focuses on the monetary policy stance and the pace of financial money (i.e. bank reserves) creation.

A)     Risk-free real yields are much higher than equilibrium – and that’s a problem for risk assets

Are interest rates high or low?It’s all about relativity and equilibrium.

The US and European economies are both hyper-financialized, over-leveraged and grey-haired; perhaps to slightly different extents, but they are roughly in the same boat.That implies that the equilibrium real rate (r*) at which these economies can run smooth and deliver potential growth without overheating or falling into recession are very low – high private and public debt levels, stagnant productivity, and an ageing population are to be blamed.

R* is estimated to be at roughly +25 bps in the US and -50 bps in Europe.

Today, market-implied medium term real yields are much higher than these equilibrium levels both in the US and in Europe.

This has important implications.

Real yields much higher than equilibrium impair the private sector ability to borrow cheaply, and hence dampen growth prospects while providing a high risk-free return for investors.

Not a surprise to see that every time such a setup was prevalent in the US (2009-2010; 2013 taper tantrum; 2018 hikes and QT; today) and in Europe (2011-2012: Eurozone debt crisis) risk assets had a hard time.

B) The financial money printing press seems broken too: from BRRR to RRRB.

The rate of change of financial money (i.e. bank reserves) is the other important component necessary to gauge the overall monetary policy stance.When the amount of interbank money is rapidly increasing, banks tend to increase their appetite for riskier investments and provide more liquidity to financial markets.

But given the ongoing US QT, the newly announced European QT and the large amount of TLTRO repayments in Europe the 6-month rate of change of EU+US Bank Reserves is likely to hit its lowest level in 10 years during 2023.

Bottom line: real-economy money printing has come to a halt and nominal growth is set to quickly deteriorate in 2023, while the monetary policy stance remains tight and the global financial money printers are also broken.

So, how to invest in such an environment?

It’s now time to introduce the TMC Macro ETF Portfolio!

From January 2023, getting access to the premium The Macro Compass content will require a paid subscription.

Not only deep and unique macro insights but also ETF Portfolios, tactical trade ideas, interactive tools, courses and much more are available on the TMC platform.

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Hi all, and welcome back on The Macro Compass.

In this timely piece we are going to cover the recent Bank of Japan meeting and its implications for markets.

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Surprise, Surprise!

We all woke up to a major macro surprise: the Bank of Japan (BoJ) widened the allowed trading band for the 10-year Japanese government bonds (JGBs) by 25 bps - 10y JGBs can now trade between -50 bps and +50 bps.

While this doesn’t seem like a major change, it really is.To understand why, we need to take a small step back.

For years, Japan implemented an aggressively dovish monetary policy stance. Bank of Japan rates were effectively pinned at 0% for decades. Large-scale QE was standard practice, and a few years ago the BoJ switched to Yield Curve Control (YCC).

This was necessary as relentless QE purchases had led the BoJ to own >50% of the Japanese government bond market, and buying more bonds would seriously alter the functioning of the market. For days, there were basically no trades happening in the JGB market.

So to keep 10-year yields low, the Bank of Japan moved from targeting a quantity of bonds to buy (QE) to a qualitative measure (YCC).

It was a successful move: the charts below show how predictable the BoJ monetary policy was - front-end rates stuck at 0% for decades, and 10y JGBs constantly trading in the prescribed +/- 25 bps yield range for 6+ years.

Until today.

But Alf, the BoJ didn’t raise rates and they widened the 10y JGB trading band by a mere 25 bps: how can such a ‘‘small’’ move have worldwide macro implications?

It does because global macro is a giant interconnected puzzle - bear with me.

Japan is a huge exporter of capital.Since the '90s, Japanese investors are used to look abroad for opportunities to deploy their domestic excess savings.

For instance, as of July 2022 (left chart) Japanese investors are the largest holders of US Treasuries in the world - Japan accumulated over $1 trillion in USTs as it was a convenient way to recycle excess savings: yield differentials were positive, and often more than offsetting the cost of hedging USD/JPY risks.

The right chart below shows how convenient it was for Japanese investors to buy Treasuries and cover the FX risks. They would on average get a 100-150 bps additional return by purchasing USTs rather than simply buying Japanese government bonds.

The BoJ decision and the new direction of travel can significantly alter this flow of capital - one of the global macro impacts of today’s BoJ decision.

Said that, to really grasp the potential market implications and trade opportunities going forward we must answer two main questions.

#1: Why Now, And Will The BoJ Continue Along This Path?

The best macro investors are always keen to assess a crucial yet elusive variable: policymakers’ incentive schemes.

Here is my attempt at doing that for Japan.

Japan has a new Prime Minister (Kishida, who succeeded Abe) and in April 2023 BoJ Kuroda’s term will expire - hence, it will have a new Governor of the Bank of Japan too.

Abe and Kuroda worked together to try and pull Japan out of a deflationary spiral, and while it can be argued they didn’t succeed much so far Kuroda now has the chance to leave office with a ‘‘victory lap’’.Core inflation in Japan could soon stabilize around 2%, and while the BoJ has basically nothing to do with it Mr. Kuroda is likely to seize the opportunity.

The cherry on the cake would be to lay the foundations for a new (more hawkish) monetary policy path his successor could follow.

And that’s my answer to the ‘‘why now’’ question.

Will Kuroda’s successor continue along this path?I think so.

And that’s because core inflation is likely to keep trending towards 2% (left chart), and despite fixed income investors not being fully convinced (right chart) yet they are also expecting Japanese CPI to justify a more hawkish stance.

The ‘‘new sheriff in town’’ approach is relevant because it signals this is not a one-off move, but rather a sustained shift in the approach to monetary policy and inflation.

The second important question to grasp macro implications and potential trade ideas is: what are markets pricing in at this stage?

#2: What’s The Market Pricing In?

Tracking global market moves across their many dimensions and assigning the right relevance to each mover is very hard - but the Volatility Adjusted Market Dashboard (VAMD) will fix that for you.You’ll literally be able to screen the entire global macro universe in a fully customizable way, identify the biggest vol-adjusted moves and draw analytical charts to test your macro ideas.

The VAMD is telling us that:

* Despite the BoJ not raising deposit rates, markets are pricing in 30+ bps hikes in 2023 (1y1m OIS at +27 bps, spot in negative territory) and an additional 25 bps hikes in 2024 too;

* The yield curve dramatically flattened in the 5s30s segment, indicating bond markets expect this sudden hawkish shift to weigh on the already poor long-term nominal growth prospects in Japan;

* Bond volatility picked up aggressively across the board.

On top of that, USD/JPY dropped like a stone.

In other words, fixed income and FX markets are taking this seriously and extrapolating a hawkish BoJ reaction function well into 2023.This is not to be treated like a one-off small move.

P.S. The VAMD is available for All-Round Investor subscribers.

Another important macro implication is evident in the global fixed income market.

As said before, Japanese investors are heavily involved in foreign investments and in particular in purchasing highly-rated government bonds issued by the US, European countries, UK and Australia.By affecting JGB yields and the JPY, the Bank of Japan largely impacted the financials of these gigantic cross-border capital flows in the bond market.

The chart below shows how after today Japanese investors won’t find any additional yield by purchasing foreign bonds vis-à-vis JGBs unless they buy Spanish or Italian bonds - which will be under pressure as the ECB tightens policy and embarks in QT.

Now that Japanese investors are getting positively rewarded to keep their cash at home during a global economic slowdown and periods of high macro uncertainty... ...they probably will choose to do that more.

That strengthens the Yen, and negatively affects foreign assets.

So, what are the implications for trades and portfolios?

Conclusions & Portfolio Implications

Another day in 2022, another tectonic shift by a globally important Central Bank: this time the Bank of Japan.

Given the policymakers’ incentive schemes, this isn’t likely to be a small one-off adjustment but a new monetary policy approach to inflation which involves a more hawkish BoJ stance with important global macro implications for asset classes.

* I already liked the JPY, and on a medium-term basis I like it more now.I expect a global recession in 2023, and the Yen tends to strengthen in such an environment as yield differentials compress and Japanese investors are incentivized to bring money home rather than seeking risks in that tough macro environment.With the BoJ enhancing those incentive schemes via higher domestic rates, the Yen might appreciate even further.Long JPY exposure can be achieved via FX account, or via $LJPY ETF for US investors or $EUJP for European investors.

* When it comes to bonds, the already dwindling support of Japanese investors for European and US bond markets will shrink further.This in particular supports my short-term bearish thesis on European rates.

* Finally, as another Central Bank joins the ECB and the Fed in tightening policy and increasing risk-free rates this bodes negatively for global equities too on the margin.

And this was it for today, thanks for reading!If you enjoye…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

Hi all, and a warm welcome back!

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Introduction

The ECB really went for it.

Lagarde was as assertive and committed in her press conference as Draghi was in 2013.

The main difference is that Draghi was unequivocally committed in being dovish and using all the ECB powers to save the Euro.Lagarde was relentlessly hawkish in an attempt to show unwavering commitment to slaying the European inflation dragon.

Therefore, this was the most iconic ECB meeting since the Draghi era.

And it leaves macro and markets with crucial repercussions across asset classes both in the short and in the medium term.

In this article, we will:

* Break down the ECB meeting piece by piece, analyzing the 3 most important parts of the iconic press conference;

* Assess the broad impact for markets and discuss the resulting implications for tactical trade ideas and long-term portfolio allocations.

The Most Iconic ECB Meeting In A Decade

In my opinion, the reason why the ECB decided to go ballistic has to do with the nature and timing of the European inflationary shock.

As a reaction to the pandemic, both the US and Europe went ahead with large-scale fiscal stimulus - a ton of newly printed real-economy spendable money at a time when supply can’t adjust is obviously inflationary.

But there were two major differences.

The gigantic US fiscal stimulus was very much concentrated between Q12020 and Q12021, while the European stimulus was mostly implemented through the European Union programs and hence much more spread out over time.Think about this: a decent portion of the European fiscal stimulus will be reflected only into the 2023 and 2024 single states fiscal budgets.

Additionally, while the US labor market quickly adjusts to the ebbs and flows of the macro cycle the European job market is much more rigid - it takes a while for aggregate demand to reflect into wages.

The result is that European core inflation has lagged US core inflation by 6 months, and looking ahead that means inflationary pressures in Europe might well broaden and persist for another few quarters.

That’s a serious problem for the ECB!

And indeed the ECB still foresees core inflation at 4.2% by December 2023.Yes, you read that right.

Despite already incorporating the effect of a much tighter monetary policy in their projections, the ECB expects core inflation will be still at more than double (!) its 2% target in 1 year (!) from today.

This ‘‘a-ha’’ moment and its reflection in the updated ECB projections led to the most iconic ECB meeting since the Draghi era.

Lagarde’s hawkish strategy to slay the European inflation dragon revolves around two main pillars: (much) higher interest rates for longer, and QT.

Let’s go into it.

#1: The Inflation Dragon Is Not Slayed With Baby Steps

The chart below is one of the most important I ever produced.

Lagarde is French, and she must remember the sticky inflation experience France had to go through in the ‘90s.

Back then, core inflation averaged almost 4% for 2 years, and the Banque de France was called to tighten monetary policy - but by how much to slay the inflation dragon?

The tightness of monetary policy isn’t measured by looking at absolute interest rates, but at rates relative to equilibrium.In the ‘90s demographic trends were more promising, productivity slightly stronger and the amount of unproductive debt burdens much lower - in other words, equilibrium interest rates were higher than today (~4.5% in the ‘90s vs ~1.5% today).

So, how much tighter than 4.5% rates was Banque de France forced to go?

A lot: 5y French government bond yields averaged 8% (300+ bps above neutral) for 2 full years before French inflation finally came back to target.

The reason why this matters a lot to the ECB today is that Lagarde understands she might need to push rates as restrictive as 300+ bps above neutral again.

And that means an ECB deposit rate above 4% - oh gosh.

This was a true shock for markets.

You see, so far markets believed the ECB would push as hard as 3% terminal rates: roughly 150 bps above neutral is quite something, and you know - Europe has a lot of fragilities to deal with and they won’t risk it.

The problem is that when core inflation is above 5%, as a Central Banker you are losing control and most likely about to lose any credibility left.And credibility is the only true weapon a Central Banker has.Without that, rate hikes/cuts/QE/QT won’t matter much as markets won’t believe you.

So your incentive scheme pushes you to go all-in: this way, chances to get things under control are higher and if you cause a recession you won’t lose your job anyway.So you go for it.

Markets understood the message, but only partially so in my opinion.

Despite the tremendous post-ECB move in bond markets, today (orange curve) the new ECB terminal rate is priced to be at 3.4% in September 2023.

Why is that not enough?Because it’s 80 bps below the ECB’s own expectations for core inflation.

As any other Central Bank trying to fight inflation, the ECB feels it must bring nominal ECB rates 50-100 bps above (not below) the level of core inflation.

Some basic math for December 2023:

Expected core inflation: 4.2%Market-implied ECB deposit rate: 3.3%

This doesn’t square.And indeed, post ECB meeting ‘‘several sources’’ pointed to 3x50 bps hikes over the next 3 meetings.The ECB will indeed try to get to 4% rates as soon as possible.

4% risk-free rates in Europe begs the question: what about Italy & Co?

#2: QT…in Europe!

To answer this question, we need to talk about QT first.

Lagarde announced EUR 15 billion/month of QT starting in Q1-2023, with a clear intention to double the pace to EUR 30 billion/month from Q2-2023.Again, you read that right: QT in Europe!

To put this into context, please consider that:

* Europe doesn’t have any ‘‘reverse repo’’ facility, so no easy way to ‘‘sterilize’’ QT;

* The ECB is encouraging banks to repay the cheap pandemic loans (TLTRO), which will contribute to shrinking the ECB balance sheet even further;

Most importantly, consider that for the last 7 years the ECB bought the entire government bond issuance. All of it. In some years, it ended up buying even more than that!

But due to rising deficits and QT, in 2023 the situation will drastically change and private investors will instead need to absorb a record amount of bonds.

For countries like Italy, a combination of rapidly shrinking excess reserves and the need for private investors to step up and purchase their new bond issuance in 2023 might well prove very very tricky.

This is how it goes.

* Worse macroeconomic conditions lead investors to be more cautious;

* Yet, peripheral countries will require more private investors’ sponsorship for their bond issuance in 2023;

* But excess reserves will be shrinking, and hence banks (amongst the largest buyers of peripheral bonds) will be taking a more conservative stance;

* This lack of sponsorship exactly when needed will reflect into much wider credit spreads required to convince private investor to step in.

The chart below refers to the US and shows how a shrinking amount of reserves tends to require wider credit spreads for investors to sponsor riskier borrowers.

The same is likely to happen in Europe.Tough times ahead for weak borrowers.

Conclusions & Portfolio Implications

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(Audio file now fixed)

Hi all, and welcome back on The Macro Compass.

In this piece we are going to cover the Fed meeting and its implications for markets.

For free. One last time.

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The Fed Meeting Explained

To explain what happened today with the FOMC meeting, we need a short step back.

The latest US CPI release materially surprised on the downside: both headline and core inflation rose way below the expectations of 65 out of the 67 (!) economists surveyed by Bloomberg.

Powell recently divided inflationary pressures in 3 main categories:

- Core goods: supply bottlenecks combined with the pandemic-related binge spending led to hefty core goods inflation, but the Fed understands this category will suffer from disinflationary pressures ahead and it’s not where its focus lies;

- Housing-related: Powell knows negotiated rents are cooling down, but he also understands housing-related CPI will take a while to reflect these trends; the Fed likes shelter inflation lower, but it can only wait and see;

- Ex-housing core services: the stickiest inflationary components that the Fed can directly influence via a weaker labor market and lower wages = this is what must go convincingly down.

The latest CPI print showed ex-housing core services pricing cooling further: its annualized 3-month rate of change is now rapidly dropping towards 2%.Markets interpreted this as the ultimate dovish signal, and sent bond yields sharply lower and equity prices higher in a typical ‘‘Fed pivot’’ move.

After all, if the stickiest components of the CPI baskets are showing signs of cooling this must be a green light for the Fed to be more confident they’ll achieve their objectives and hence loosen up?

Instead, today the Fed comes with their updated economic projections showing Fed Funds at 5.125% (!) by December 2023 (!)…and core PCE still at 3.5% (!) by that time.

An incredibly restrictive Fed Funds rate for a very long period of time will only be able to slow core PCE down to…almost double (?!) the Fed mandate?

Let’s look at 3 important points from today’s Fed meeting.

#1: The Fed Believes The Labor Market Is Still Red Hot

I must stress out two concepts here.

A) The Fed is really opinionated about this, as much as forecasting the first time in history when the Sahm rule won’t apply: in their projections the 3-month moving average of unemployment rate would move way more than 50 bps above its last 12 month low, and yet this time ‘‘it will be different’’ and we won’t have a recession.

B) I disagree: this time is never different, and we will have a serious recession.

Powell believes the only way to convincingly bring ex-housing core services inflation is via weakening the labor market, which he believes to be ‘‘super strong, and incredibly out of balance’’.My estimates are that he spent at least 7-8 minutes of the press conference endlessly repeating how hot the labor market is.

But it’s not.

Forward-looking labor market indicators show US Non-Farm Payrolls are likely to slow to 0 (yes, zero) by March next year and turn negative (!) after that.Financial conditions and banks lending standards have tightened very aggressively in 2022, and they lead hiring patterns by 9 months.

Powell is setting policy looking in the rearview mirror, and he will lead the US into a recession with Fed Funds above 5%.Don’t fight the Fed.

#2: The Bond Market Is Calling The Bluff

Bond investors have made up their mind: the Fed can change the Dot Plot all they want, but at this point in the cycle there is no chance they’ll be able to keep rates above 5% for the entire 2023.

The left chart shows market-implied Fed Funds (blue) for 2023 implying net interest rate cuts towards the 4% area while the Fed Dot Plot (orange) points to further hikes above 5% and a long pause.

But the most interesting nuance in fixed income markets is how inflation swap traders are pricing YoY CPI to develop in the months ahead (right chart): from today’s 7%+ to basically 2.5% in only 8 months.

That’s a much more aggressive disinflationary trend than even the optimistic Fed expects, but there is a catch.

The bond market understands that if you tighten financial conditions like hell, and keep doing so by ignoring all forward-looking indicators you will definitely succeed in slowing down inflation.

But that’s because you’ll be causing a serious recession.

History shows us how a recession always succeeded in slowing down inflation very rapidly, and this time won’t be different.Don’t fight the Fed.

#3: Changing The 2% Inflation Mandate? Forget About It

'''Changing the inflation target is not something we are thinking about.And it's not something we are going to think about thinking about under any circumstances. Our inflation target is 2%. Full stop.''

It’s not about what the Fed should do, but about what they will do.

And while we may discuss whether raising the inflation target to 3-4% is a sensible policy choice, there is no way Powell will even entertain a discussion about it now.

Credibility is seriously at stake, and the only way to get it back is getting the job done.Not moving the goalpost and calling victory.

Conclusions & Portfolio Implications

Powell won’t even consider risking a premature loosening of financial conditions, as the experience from the ‘70s strongly cautions against that.

That literally means he’ll be watching the US walk into a recession and stubbornly keep monetary policy very tight hence further exacerbating the problem.

What’s the right portfolio strategy for such a macro environment?

The golden rule is you don’t want to fight the Fed.But you want to challenge it where it makes sense.

Medium term (6-12 months)

In an average recession, the Fed cuts by 300-400 bps in the 12-24 months immediately after the recession starts - the bond market is pricing a 20-30% probability of that happening, and my subjective probability for that oucome is higher.Also, in an average recession earnings drop by 30% and that’s not nearly priced in.

Hence, I find value in:

* 2-5y Treasuries (and mid-2024 Eurodollar or SOFR call spreads)

* Long Utilities or Staples (Defensive) against Financials or Industrials (Cyclical)

Short term (1-2 months)

Don’t underestimate markets’ muscle memory.For 10 years, any remote hint of a ‘‘Fed pivot’’ meant buy the dip hand over fist.The initial equity market reaction might well be similar, as we saw post the CPI release: bonds, gold, stocks, everything rallies in the short-term.

As inflation further slows down and the labor market cools off, unexperienced traders will be trying to put up ‘‘Fed pivot’’ trades by buying equities.

I’ll be patiently waiting for them to set up tactical SPX shorts.

Don’t fight the Fed.

And this was it for today, thanks for reading!If you enjoyed the piece, please click on the like button and share it with friends :)

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DISCLAIMER

The content provided on The Macro Compass newsletter …

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

Hi all, and welcome back on The Macro Compass.

As you know, from January 1st getting access to this content (and much more!) will require a paid subscription.

Today we have a big news: monthly subscriptions are now open!

Check out which subscription tier suits you the most, and come join this exciting macro learning journey.

Let’s step up your macro game!

Yes, But Is It Priced In Already?

This short article will focus on answering a very relevant question: ok, recession, but is it already priced in?

Over the last few weeks we kept hearing a recession has become consensus amongst analysts and market pundits, and onboarding consensus macro views at the wrong price in one’s portfolio can be a very expensive exercises.

But we can do much more than rely on hearsay.

Using different techniques, we can test to what extent a recession is priced in both in bonds and equity markets and derive actionable conclusions.

That’s what this macro piece will be all about.

A Cross-Asset Analysis of Recession Probabilities

Let’s start with a very telling chart.

The number of respondents in the US SPF (Survey of Professional Forecasters) now foreseeing a recession in 2023 hit 44%.

That’s by far the highest percentage of respondents expecting negative GDP growth in over 50 years.

A recession is definitely becoming the consensus view amongst economists and market pundits.

Yet, economists don’t take risks in markets.Investors do.

Hence, the most appropriate question is: what’s the probability of a recession being priced in by market participants across asset classes?

The answer to this question is very important when looking at asset allocation in 2023: once a view becomes market consensus, onboarding it in your portfolio at the wrong price can be very detrimental to returns in case that consensus view doesn’t materialize.

A bit like when the music stops in a very crowded dancing floor with a single tiny exit door - everybody wants out at the same time, and it can become tricky.

Let’s have a look at what the bond and equity markets are really pricing in.

The Bond Market

Over the last 30 years, the average recession led the Fed to cut rates by 300 bps in the first 12 months and by a cumulative 400 bps in the 24 months following the start of the recession.

Apart from the 2020 (green line below) C-19 flash recession the pattern of the Fed cutting cycle in 1990, 2001 and 2008 followed similar trajectories.

300 bps cuts in the first year.Followed by another 100 bps cuts in the second year.

So the question is: what’s priced in today?

To answer, we first need to determine a potential start date for the 2023 recession.My work suggests March-June 2023 is highly likely - to be conservative, let’s say a recession (net job losses, negative YoY earnings growth) starts in June 2023.

The chart below shows how the bond market is now pricing the most aggressive Fed cutting cycle immediately following a hiking cycle.

The closest example is 1990: Fed Funds (dotted blue) were raised to ~10% and the bond market smelled a recession and subsequent cutting cycle ahead, but they could only price in as much as 100 bps Fed cuts in the period going from the 6th and the 18th month ahead.

Today, the bond market has broken that record and it’s pricing almost 150 bps worth of Fed cuts between June 2023 and June 2024.

In other words: the bond market base case is definitely ‘‘a recession’’.

But.Let me explain why ‘‘a recession’’ is different from ‘‘a proper recession’’.

As we said before the average Fed cutting cycle during a proper recession is 300 bps in the first year since the start of the recession - which we postulate around June 2023.

One thing is to price in ‘‘a recession’’ as base case, the other is to price in ‘‘a proper recession’’ that involves cutting Fed Funds from 5% to 2% by June 2024.

The option-implied probability derived from Eurodollar contracts that bond investors are assigning to ‘‘a proper recession’’ is still below 20%.

In short: yes, the bond market definitely expects a sharp slowdown in growth and given the shape of the money market curves a recession is definitely base case.

But a mild recession, not a proper one.

The market-implied probability of 300 bps cuts between June 2023 and June 2024 sits around 20%, while that of 400 bps cumulative cuts until June 2025 sits in the 25% area.

Overall, the bond market prices a recession as a 40-45% probability event.But it prices a proper recession only as a 20-25% probability event.

The Stock Market

We also hear that ‘‘everybody is bearish’’, hence a recession must be fully discounted by the stock market.Well, let’s have a more scientific look shall we?

Over the last 60+ years, an average recession involved earnings declining for more than 5 consecutive quarters and by almost 30% from peak to trough.

Here is your garden variety of EPS contractions - different lengths and magnitudes:

The equity market isn’t all about earnings though, but also about multiples.

Historically, earnings and multiples don’t bottom together - why?

Because when earnings have fallen for a couple of quarters already, it means the economy is really weak and so is the labor market.This is generally a validating condition for the Fed to start easing monetary policy.As they do so, risk-free rates decline and stock valuations tend to get an initial boost even if earnings keep falling.

When looking at a potential definite low for the S&P500 in this bear market, we therefore have to look at combined assumptions for EPS and multiples in 2023.

My work shows that:

* Earnings could contract by 20% in 2023;

* The average equity risk premium (ERP) in a recession should be above 5%, which boils down to ~16.5x forward P/E (~6% earnings yield) if we assume long-dated real rates in the 0.5-1.0% area next year = ERP around 5%

Here is what this boils down to for the S&P500 next year:

Assuming by December 2023 earnings have contracted by 10-15% and the Fed has clearly shifted their stance to dovish to counter the ongoing recession, the S&P500 could bottom in Q4 next year around 3,200-3,300 (EPS $190 * 17 P/E).

So: what’s the market-implied probability of the S&P 500 trading at or below 3,200 by the end of the next year?

Roughly 16%.

For reference, markets generally price a 20% drawdown (from ~4,000 to ~3,200) from spot levels in one year as a 10-12% probability event.

In short: yes, analysts are slowly revising down earnings growth. And yes, investors are now pretty much aware we are in a bear market.

But stock market participants are discounting a < 20% probability of a S&P 500 price action that would fit a proper recession in 2023.

Conclusions & Portfolio Implications

Yes, ‘‘a recession’’ has arguably become conensus amongst economists.And one could argue it’s almost become a base-case scenario for bond market investors, and that equity investors are well aware of the current bear market conditions.

So, is it all priced in?Not really.

In an average recession, the Fed cuts 300-400 bps in 12-24 months and earnings decline for 5+ consecutive quarters and by around 30%.

That’s a ‘‘proper recession’’ that requires a proper Fed pivot.

Today, bond and equity markets are pricing roughly a 20% chance of a ‘‘proper recession’’ - and while macro investing is a probability game and we’ll never see markets pricing in a 100% probability of an exceptional event like a proper recession, 20% isn’t an incredibly high number.

For portfolios, that means that the ‘‘easy money’’ has been made: as markets quickly repriced ‘‘a recession’’ as their base case, bonds rallied aggressively while stocks didn’t follow suit as it should be.

But given ‘‘a proper recession’’ remains only mildly priced in, a macro portfolio construction that benefits from these relative mispricings can be still achieved.

Calling the time and magnitude of the recession is the main task ahead, and we will try to do that together on The Macro Compass in 2023.

And this was it for today, thanks for reading!If you enjoyed the piece, please click on the like button and share it with friends :)

Finally, an import…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com