Why the Fed won't cut rates

There's a new storm on the horizon. But this is the kind of storm that brings relief on a hot summer evening. There is the scenario of a high for long soft landing on the horizon. A world in which rates stay high, but there's sufficient resilience in the economy to tolerate these high rates. About a 30% probability on this high for long soft landing, combined with the other scenarios of boil the frog with high rates as well, we see about a 75% chance that rates just stay higher than what is currently anticipated.

In terms of the CPI report from March, it obviously came in a bit firmer than expected. And so you're running at rates that are still, a bit uncomfortably high for the Fed. But more importantly, Fed officials had looked at the January and February numbers as maybe kind of an outlier, a bit of a one-off, probably a little bit stronger with underlying trend was. And so, another strong print for March certainly undermines that view and potentially shifts the Fed a little more cautious direction.

And obviously that's what's been reflected in market pricing and taking out some of the cuts that we've had. We're down to, atm, fewer than two cuts by year-end price for the market right now.

The two pieces the Fed had been kind of separating out between housing and the super core. Both of them have been firmer than expected. Housing is basically kind of moving sideways, 0.4 plus per month.

Investors have been expecting it to be gradually cooling a bit more. And the big one obviously is the super core. The three-month run rate of that thing is now above 8%.Thus that's a really strong signal that you've got some meaningful stickiness yet in services inflation. And that's just not the US.

Two points make a line, three points make a trend, and you've got strong growth, not much delinquency and Labor markets are super strong. Why shouldn't Powell just look at this and saying, you know what, the Fed's not done here.

At minimum, they should not be cutting at all. Maybe they should be even hiking. Is there even a counter to that?

Japan

Institutional clients have a very positive outlook on the Japanese economy because they believe that Japan exiting a deflationary era. And you're starting to see things like very tight labor market, higher wage pressure, so real inflationary forces come to the forefront.

Emerging Markets (Interesting counterbalance)

So investors did shift their bias from a bullish one to a more neutral one on both EM local bonds. And currencies off the back of yesterday's US CPI print. After arguing for some time that so long as the Fed is cutting rates, the timing didn't really matter all that much.

But if the market is confident of being in a gradual cutting cycle, that alone would be sufficient to help emerging market assets deliver decent positive returns. And that also explains why, despite a pretty decent repricing in the US yield curve lately. Back in January, markets were pricing in over 100 basis points of cuts.

And now it's far less. EM assets overall held in well on the view that the regime was still one of rate cuts and people can debate the details of timing and overall magnitude. But now, the US has had three consecutive upside surprises to CPI inflation.

That opens the door for a more bearish potential scenario and regime for fixed income assets more generally. So not saying that's the base case now, but clearly the probability of something like the market having to think about no cuts is increasing. So it makes sense to step aside a little bit and let the dust settle on this one.

At EM local bonds, if you look at them inflation adjusted, in real yield terms, those EM real yields are actually the highest since 2009 at the moment, given the lower relative EM inflation. EM currencies are also generally cheaper. If you look in long-term versus the dollar, looking at how EMs been lagging some of these global cyclical upturns at the moment, the valuation side of things is probably not in a bad place right now. And if you look at EMFX risk appetite index, which is good to follow, it's been sort of oscillating around zero (not as of 12 hours ago though lol when I started writing this. More on that below) as well, not showing any significant positions.

If you look at sort of global investors, if you just take flows as a metric of their sentiment and how they've been seeing the asset class, they really have not been putting any money into EM bond funds. In fact, quite the opposite. So far this year, there has been 10 billion of outflows. That's on the back of 34 billion of outflows last year.

And that was on the back of 90 billion of outflows in 2022. So it just doesn't feel like the global investor has been piling into EM. In fact, the opposite, they've, on the margin, been withdrawing money from the asset class.

So it's important to recognize that emerging markets have their own inflation story. It's no longer being driven by a common global factor, as was the case back in 21 or 22. And the contrast this week between the downside surprise in inflation in Mexico, which is the EM country with the greatest trade and economic linkages to the US versus the upside surprise here in the US, that was quite telling about the sort of independent monetary policy and inflation trajectories that we see in emerging markets.

So, in an environment where the market is questioning the Fed's ability to cut at all against the backdrop of firming global growth is not necessarily a bad one for credit markets as recession risks are being seen as fallen and certainly that's what US economists think. But it's going to depend which bit of the credit markets and that's been our theme for a long time. Fundamentally, there's also quite a lot of idiosyncratic driver in those, let's call them post-distressed EM sovereigns who are coming off the back of a couple of years of really special situations distress,[COVID and CHINESE BRI DEBT] some going through restructuring, some narrowly avoided it.

And those are drivers which are just, it's a very big cyclical driver coming off the back of a distress period, which is probably not going to be affected as much by even a rethink of this fed path as the market's going through.

What do I think?

So probably sticking with those post-distressed, very high yield type of countries in sovereigns is probably right. For the lower spread portion, you could see people start to look at it and ask and ask an environment where core rates are going to stay higher for longer, where the value proposition is in there.

EMFX with high yields as outflows increase as FED continues to hold rates still or maybe even hike is a good strategy. 70/30 is also good. 70 in US money markets, 30 in EMFX money markets.

Notes for further Study:

https://www.xtb.com/en/market-analysis/risk-appetite-sinks-as-risks-hit-the-market

2015 paper from Morgan Stanley: https://www.morganstanley.com/im/publication/insights/investment-insights/ii_emergingmarketattractive_en.pdf

https://www.bloomberg.com/news/articles/2024-04-12/emerging-market-currencies-hit-two-month-low-on-flight-from-risk

!math !r-slurs

Caution: ALL INVESTMENT ADVISE IS OPINION. MARKETS ARE RISKY. INVEST AT YOUR OWN RISK. I BEAR NO RESPONSIBILITY IN ANY OF YOUR INVESTMENTS.