Oil and Forex Analysis – Hawkish Fed Williams, Oil prices soar, Hong Kong as a Petri Dish and the Procession to Recession

Global Macro Analysis

A hawkish Fed Williams fusing with a sharp rise in oil prices sounded the inflation alarms, sending US yields higher and effectively turning the market for sale into the long weekend, snuffing out whatever positive remnants remained from the slightly soft but still hot US CPI print.

Indeed, the Russia-Ukraine conflict inflation effects are now more meaningful than direct military developments in a market sense. These consequences have fabricated an uncertain environment that could keep investors wary.

Also, the resulting excessive rates volatility probably prevents many passive investors from getting back into more attractively priced fixed income, which might be a factor weighing on stocks.

I think markets will likely debate peak CPI until the next critical inflation reading. Still, Wednesday’s PPI scorcher suggested that consumer prices in the US, topping or not, aren’t poised to converge to target anytime soon.

It should be a quiet session given the Good Friday holidays. But the dollar is strong after Fed Williams decided to change his tune by marking to market himself in terms of FOMC consensus.

There was not a great deal of new information in his Bloomberg TV interview other than confirmation that the Fed is unfalteringly hawkish at this point and is not going to change course based on one slightly less hot inflation number.

The Fed needs to bring inflation closer to target via the aggressive rate hike channel, which unfortunately could be painful in terms of higher unemployment and lower stock market performance. Still, those two calling cards don’t exactly scream US exceptionalism and are not great for the medium-term US dollar outlook.

With US yields bouncing to the drumbeat of a hawkish Fed, we could expect stock markets to rejoin the procession to recession.

Oil Fundametal Analysis

There are no surprises here as oil continues to march higher, with global supply shortage outweighing concerns about slower demand in China.

In addition, major international trading houses announced they are planning to cut purchases of Russian crude and oil products starting mid-May, following the EU’s sanctions on Russia’s financial activities.

Despite Germany not agreeing to a total oil embargo this week, the EU is still turning the screws on anyone who effectively pays for Russian energy in Roubles, suggesting any direct expiring contracts beyond the international trading houses with Russian entities will not get rolled over. There will likely be a total winding down of all purchases by year-end in fear of getting sanctioned by the EU and US. Importantly, it won’t be easy to envision these companies restarting purchases in any conditions.

Hong Kong confirmed on Thursday that it would ease some of the world’s most stringent Covid restrictions, allowing beauty parlours, cinemas, and gyms to reopen from Apr 21 as infections in the global financial hub hover below 2,000 per day. The results could lead to an easing of Covid restrictions on the Mainland and, at minimum rolling lockdowns, given that Omicron data profile is far less severe than Delta. I suspect Mainland regulators will use Hong Kong as a petri dish.

Given this view, an RRR cut today could support oil via the Mainland demand channel if China subtly moves off the zero Covid policy. But the optimistic take is that once these restrictions end sooner than later, the government will push spending hard and be like throwing jet fuel on the commodity rally.

FOREX Fundamental Analysis

EUR/USD

The market is now back to expecting just 50bp of ECB tightening this year, meaning zero rates will be reached by year-end (46bp by October). That, to me, makes sense. So, the most extreme hawkishness has been priced out now, rightly so given the economic tumult.

But Bloomberg and Reuters report that ECB sources say a July hike is still possible despite Thursday’s meeting. And at a minimum, this suggests that the hawks are not giving up yet on a July hike and would imply announcing that’s tricky to do but not impossible. Meaning the market might continue to price 50:50 until more transparent communication emerges. (range trade in the 1.08’s for a while)

A September 25bp hike must be the base case, though. So I suspect the market debate will likely shift to 50 bp in September. That seems a likely scenario when growth is slowing, and it would still remove the negative rate drag on the EURUSD. My view remains that while zero rates this year are a given, going above zero will be much more difficult. Hence, I believe the USD is the clear winner here on a rates differential view, and EURUSD could trade lower.

USD/JPY

Tokyo’s interest to sell USDJPY saw the pair trade from a high near 125.70 down to a low near 125.10, but dips were bought. We will likely need a more forceful break above the 2015 high of 125.80/90 to attract momentum players. Overall, the pair traded quite resilient relative to the fall in US yields yesterday. So, with US 10 Y yields back to 2.82% after a hawkish Fed, Williams USDJPY tests 126 again.

I wouldn’t chase this one higher, and I am more inclined to take profit now due to a possible stimulus package that could take a lot of heat out of rising energy prices at least from the consumer perspective.

As CPI inflation in Japan is expected to rise to around 2% (BoJ’s inflation target), many wonder whether the BoJ will change its monetary policy, especially with the BoJ/Fed divergence on policy and as the yen continues to weaken versus the dollar.

1. The BoJ believes JPY depreciation is a net positive for the economy.
2. There is a significant negative output gap as the economic recovery is still slow with Covid residual effect.
3. 2% CPI inflation is unstainable as the main drivers are food and energy, which is harmful to GDP
4. Current forward guidance on policy rates states the BoJ “expects short- and long-term policy interest rates to remain at their present or lower levels.”

The MoF oversees the currency policy. The sharp yen depreciation should be a concern due to the adverse effects on households via loss of purchasing power. Indeed, this would also likely lead to more pressure from the public to do something about the yen. Therefore, word on the street is PM Kishida is likely to announce a large fiscal stimulus package in June (before the Upper House election -on Jun 10) and emergency measures to help reduce the effects of rising energy and food prices.

When I was market making a $Yen book via Tokyo for a way too many decades, under these types of conditions I would keep my eyes peeled for Tokyo flows as local banks are much better in tune with policymakers.

For a look at all of today’s economic events, check out our economic calendar.