Notes From Underground: ‘Twas the Week Before Christmas

Last week, the leaders of the world’s central banks were attempting to regain their souls. FEDERAL RESERVE Chair Jerome Powell told tales of woe as workers were suffering as inflation rose. Crush the evil inflation out of the system is the battle cry  in an effort to recreate the melodrama of Andrew Mellon in 1931: liquidate, liquidate, liquidate in an effort to Calvinize the evil from the economy by crushing demand. Powell did note that housing had weakened SIGNIFICANTLY and financial conditions HAVE TIGHTENED CONSIDERABLY but will have to be patient because monetary policy acts with a lag.

The key issue for the FED and its desires to continue raising rates is the LABOR MARKET REMAINS TIGHT. In response to the FED DOT PLOTS, which reflected higher for longer, S&Ps closed down 2.5% for the week, BONDS were HIGHER, precious metals slightly lower and the DOLLAR unchanged. But I caution two critical things as we head into 2023.

First, there is an argument between the FED and Wall Street as seen in Steve Liesman’s question to Chair Powell about the central bank being concerned about a “loosening of financial conditions,” which was in direct contravention of what Powell said in his opening comments. The FED believes that global/domestic conditions are tightening but Wall Street says not so. The battle is on but Powell’s position is MONETARY POLICY OPERATES WITH A LAG.

Second, Jerome Powell discussed the hawkishness of the DOT PLOTS several times in answer to several questions but I warn that this is the same chairman that at the June 2021 press conference said the DOT PLOT PROJECTIONS need to be taken with a “BIG GRAIN OF SALT.” As usual, the FED gets to determine its favorite economic data and then ride off to develop a convenient counterfactual for when it goes awry.

***For the US the yield curve — notably the 2/10 — going into 2023 will be of interest as concerns are arising everyday about the growing pile of US debt and the rapidly rising financing costs. It twists my brain to figure why investors would desire 10-year notes that yield far less than two-year notes. Yes, if recession sets in, 10s have been a safe haven and rallied into a slowing economy and falling inflation levels. BUT if the economy slow and the FED holds at 4.5%, won’t the budget deficit increase creating even greater financing problems for the US deficit? Remember, not all economic outcomes are the same. The 2/10 US curve had a wide range last week but after inverting by more than 80 basis points it closed close to the week’s lows. That’s something to watch as the budget battles grow.

The BOE, SNB and ECB all raised rates by 50 basis points — in line with the FED — but each CENTRAL BANK had different statements. The BOE had THREE DISSENTS among its nine voters as two wanted no change and one preferred raising UK rates 75 basis points. It is a great statement for the Brits that they were willing to discuss in full and voice independent decisions. The SNB has only three voters on its board. The vote was unanimous but the Swiss are in a far different monetary position as inflation is 3% and the Swiss Franc is up 4% on a trade-weighted basis.

As SNB President Thomas Jordan noted, “This appreciation has helped ensure that less inflation has been imported from abroad, thus curbing the rise in inflation.” Jordan added that the SNB would ”also consider selling foreign currency [buying Swiss] depending on the development of the exchange rate. Accordingly, we have sold foreign currency in recent months to ensure appropriate monetary conditions. We will also sell foreign currency in the future if this is appropriate from the monetary policy perspective. Conversely, we remain willing to buy foreign currency again if necessary, i.e. if there were to be excessive appreciation pressure.”

The SNB has been flexible and because its QE program was exorbitant but based on buying OTHER COUNTRIES STOCKS AND BONDS the Swiss have OPTIONALITY AND FLEXIBILITY.

ECB PRESIDENT CHRISTINE LAGARDE dreams of flexibility but as her press conference revealed she has little because the ECB is trapped by the hawks on the ECB board. The European Central Bank does not reveal the board VOTE but in the past Lagarde has proclaimed that decisions were unanimous. After this meeting she changed to a general consensus and agreement but not unanimity. It appears that there is a disagreement on TACTICS. But in an effort to keep the HAWKS (Germany, Dutch, Austria, Belgium and others) in place Lagarde stated several times, “interest rates will still have to rise significantly at a steady pace to reach levels that are sufficiently restrictive to ensure a timely return of inflation to the 2% medium-term target.” The critical issue for Lagarde is that the EUROPEAN DEBT MARKETS FRAGMENT as the ECB plans on starting QT in March 2023.

The ECB decided to let 15 billion roll off its balance sheet at a “predictable pace” as Lagarde noted that any QT is a new experience for the ECB. The German/Italian 10-year bond differential widened 30 basis points in the 36 hours post Lagarde press conference. The BOND spreads are critical to the entire ECB /EU edifice as very little EU DEBT exists in an EU BOND because there is no harmonized taxing authority. When Lagarde first assumed the ECB presidency she made a major FAUX PAS as she programmed the ECB “WAS NOT HERE TO CLOSE SPREADS, which resulted in an immediate collapse of Italian bond prices.

Madame Lagarde immediately backtracked but the outcome is that the FRAGMENTATION OF EUROPEAN SOVEREIGN DEBT MARKETS will prevent the ECB copying the FED’S  QT program. That’s why the critical tool for the ECB will have to be SIGNIFICANTLY HIGHER SHORT-TERM RATES. In response to diminished QT, Lagarde brought up the use of Transmission Protection Instrument (TPI) to prevent any disastrous FRAGMENTATION. TPI was added to the ECB’s toolkit earlier in the year to allow the central bank to buy discretionary amounts of debt in violation of the sacrosanct CAPITAL KEY. The EURO initially rallied on the SIGNIFICANTLY higher interest rates but corrected as the market had many issues to absorb. But as Lagarde maintained yet again that it would be ODIOUS to think that the ECB is merely following other banks rather than doing what is good for Europe. Hoped to have shed some LIGHT on the coming YEAR.

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6 Responses to “Notes From Underground: ‘Twas the Week Before Christmas”

  1. Dm Says:

    Who the F knows. So strange. What is it he gestalt of all this. And on what time frame?

  2. Trader 1 Says:

    Yra –
    Would it be possible for You + Bernard Connolly to do a podcast together – to discuss how the EU might play out with inflation + rising interest rates + QT – The EU post ERM has never been tested in this environment

  3. Asherz Says:

    Thank you Yra for a very “light shedding” piece on what is going on across the Atlantic. The details you provide are not easily discernible to laymen.
    But the Big Picture is there for all to see. The Central Bankers are presented with an insoluble problem of their own making . Pivoting and assume the dovish white feathers and you feed the maw of inflation and fiat currency destruction. Keep their black hawkish feathers 🪶 and you plunge the debt infested nations into the Greatest Depression.
    They wish they could say “Stop the world I want to get off” but there is “No Exit”.
    Soft landing? Not for this aviary.

  4. the limey Says:

    What I most enjoy about Yra’s writing is that it allows me to think about markets with a structure I can trust. My thoughts this time are that our CB’s are using atomic age tools in a quantum world.

    current technological initiatives are changing our societies, M/L and the effects of cv19 on everything should be changing the way that we view and manage economics but we don’t seem to be doing that. If the energy chaps are considering how to implement blockchain, smartcontracts using IOT capable production lines WHY aren’t we hearing more along these lines from the CB’s. If we are soon to be able to understand the fundamental building block of all investments, energy then we should have a better idea as to how the economy is performing.

  5. Yra Says:——-from this morning’s on line FT—-Bill Gross in a further discussion on the FED

  6. Chicken Says:

    We finally got our bear market.

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