Last Friday’s infamous Jackson Hole has officially sealed the end of the summer break and the lack of trade liquidity, thanks to Fed Chair Powell reassuring the market what it needed. The words “a significant amount of work remains to be done to reach our goals” was all the market needed to sell it back higher, eliminating the weakness that went into the meeting.
As of this year, the market and every sell-side house had boosted reflation/reopen trading as evidenced by their multiple upgrades after the Q4 rally. However, in the past quarter, this reflation trade almost came to an end as we saw iron ore fall 40%, copper 15% and oil 10%, just to name a few. The big debate in Jackson Hole was whether the Fed would announce a winding-down sooner or later.
One of the main goals of the Fed is to reach full employment pre-COVID levels and will keep their foot on the pedal until they reach that goal. Although they have rated their inflation rating higher, they maintain that it is transient and will soon moderate over the course of the year. They have to say that because they honestly don’t know, they just want to.
The problem is that the Fed has now made this liquidity bubble so big after the global financial crisis that it has become too big to fail. Given the amount of global debt in dollars, they cannot allow interest rates to rise too much or else they and other governments would be unable to pay their loans. The only other problem with this modern monetary theory is that interest rates are now close to zero and even negative, and they have no room to cut if something went wrong now. Every time they try to raise interest rates or cut QE, the markets throw a tantrum and financial assets collapse, which is related to the total intrinsic value and wealth of all Americans and consumer spending.
The US Federal Reserve’s balance sheet is above $8 trillion, and in recent months we have seen signs of a stabilization in US growth after the hasty reopening of 1H trading. All that money thrown into the system and now it’s still showing signs of slowing down, and one can only wonder how much the Fed will print on the next issue. That can be kicked further and further down the road.
The market has unwound most of the long reflation trade as commodity prices, especially those exposed to China, have taken a major blow following China’s deleveraging despite their fundamentally tight inventory balances. That is why macro is so important for both raw materials and micro. When China sneezes, the whole world catches a cold. This couldn’t be closer to the truth, literally and figuratively.
When we went into the Jackson Hole meeting, the market was more deflationary than inflationary. It must be remembered that the role of the Fed is a reactionary role, they only respond to emergencies, they do not anticipate. Presidents like Volcker are a rare breed of the past. Since Greenspan, every Fed official has followed the “Greenspan put” model because they wouldn’t have been paid to do so otherwise. It hasn’t failed, so why change it.
Inflation is a lot stickier than the Fed expects, but the fact that producer prices have stalled a bit here gives them room to keep their QE going, given the Delta variant and possibly more closings, and payroll growth even more always lagging behind. And that’s what they did on Friday, setting the markets on fire in a slightly deaf voice and driving up the price of copper, oil and all inflation-related assets. It’s Sod’s law and this is happening at a time when houses like UBS (UBS) are now depreciating cyclicals and upgrading healthcare after a 20%+ taper – such a value-added analysis.
Now we are waiting for Friday payroll numbers. Once full employment is achieved, it will be a much harder question to ask, and the Fed may need to address that by the fourth quarter. Will it be a repeat of December 2018 again? Time will tell. Given the change in global supply chains and massive money pressures, inflation is not likely to abate anytime soon. There has been a marked shift in global supply chains, as evidenced by container shipping rates and the price of food and consumer goods across the board. Inflation is not a myth, it is very much alive and real.
For now, Powell has not given a set timetable, only saying it would be open for winding down later this year. To put things in perspective, winding down can only mean cutting back a few billion in MBS or Treasury assets, not reducing the balance sheet as such. For now it remains a guessing game. So enjoy the free ride until then.
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