26.03.2024
Qi Scenario Spotlight: What if this is a Fed Error?
The debate has intensified on whether the Fed is making policy error. They are backing themselves into a corner. Is there a risk of disinflation now stalling?
Currently, there is a strong positive correlation between the dollar and inflation expectations. Warning signs would be flashing if we see this correlation sharply fall i.e. inflation expectations breaking out of their range alongside a weaker dollar.
We show the equity winners and losers from a scenario of higher inflation expectations and higher rate vol. Commodity-sensitive equities outperform – Energy, Materials, GDX. Financials, Real Estate, Technology underperform.
Qi’s signals on the three largest weights in the trade-weighted dollar suggest the risk-reward on the dollar is shifting with USD now looking expensive. The key driver is policy rate differentials => a major policy change/error would shift the low volatilty of the USD Fx crosses.
Qi's modern platform offers objective, quantified macro-on-market relationships that allow our clients to make purely evidence-based decisions.
Currently, there is a strong positive correlation between the dollar and inflation expectations. Warning signs would be flashing if we see this correlation sharply fall i.e. inflation expectations breaking out of their range alongside a weaker dollar.
We show the equity winners and losers from a scenario of higher inflation expectations and higher rate vol. Commodity-sensitive equities outperform – Energy, Materials, GDX. Financials, Real Estate, Technology underperform.
Qi’s signals on the three largest weights in the trade-weighted dollar suggest the risk-reward on the dollar is shifting with USD now looking expensive. The key driver is policy rate differentials => a major policy change/error would shift the low volatilty of the USD Fx crosses.
Qi's modern platform offers objective, quantified macro-on-market relationships that allow our clients to make purely evidence-based decisions.
- Is the risk now of disinflation stalling? In last week’s FOMC, the Fed left its dot plot unchanged but raised its inflation and growth forecast – could credibility become an issue for the Fed? Is the risk now of disinflation stalling - in the face of strong GDP growth, a tight labour market, credit spreads at tights, global manufacturing PMIs turning north of 50, energy and metals on the rise AND now 3 rate cuts on the horizon?
- The Fed may well have backed themselves into a corner. Markets are priced for 3 cuts and the Fed has not dissuaded that view. If they back out now, it would likely lead to an inconvenient sharp tightening in financial conditions at a critical juncture in the political calendar
- However, in the aftermath of the FOMC, bond yields have fallen and the dollar has strengthened. It is clearly not yet time for the bond vigilantes. The market believes the Fed – if the Fed is ready to cut, now is the last chance to still lock in 10yr yields with a 4-handle. US 10yr inflation expectations are still broadly anchored in the middle of their 12mth 2.3 – 2.8% range. There is no cause for alarm just yet that the Fed is losing the fight.
- Fed credibility loss would likely be reflected by:
- o Rising long term US inflation expectations with a threat un-anchoring o USD weakening in cognisance of this o Rising long-end rates and a bear-steepening of the yields curve o Re-widening of credit spredit spreads and general funding concerns o And finally rising cross-asset volatility
- For an early warning sign, we look for when the positive correlation between the dollar and inflation expectations starts falling sharply: The first chart below shows that over the last few months the correlation between the two has been high and high vs. history. When inflation expectations break out of their range alongside a weaker dollar, it would reflect this regime change. We also note the positive correlation between VIX and inflation expectations sitting at its highest level since 2009 in the second chart.
- Qi‘s S&P 500 macro beta impulse has fallen sharply – does this reflect complaceny? The macro beta impulse shows how the sensitivity of the S&P 500 to macro drivers is changing, using our short term model. Sensitivities to macro have collapsed of late. Indeed,the sensivitiy to real yields is almost positive. Similarly, the sensitivity to risk aversion has sharply diminished. Real yields were previously such a focal point (as a drag) from late last year into February. Equities are clearly in a reflationary mindset.
- We consider below the winners and losers from a scenario of higher inflation expectations alongside higher Fed QT expectations (a proxy for rate volatility). We screened sectors and sector RVs. While sensitivities would sharply change in the event of an actual policy error, there are some clear takeaways
- Commodity-sensitive equities outperform – Energy, Materials, GDX. Financials, Real Estate, Technology underperform. In other words, increase exposure to real assets if the dollar’s secular bull run come under threat. The scatterplot below shows the top 10 winners and top 10 losers sitting in their respective top-right and bottom-left quadrants. Energy relative to Financials is a stand-out. Screening major ETFs outright to higher rate vol and a weaker dollar, also reveal GDX and OIH as among the bigger winners. The list is also shown in the table below
- Qi’s signals on the three largest weights in the trade-weighted dollar suggests the risk-reward on the dollar is shifting: It has been surprising how well the dollar has held up the last few sessions given the Fed’s indications. On Qi, EURUSD now screens as 0.8 sigma (1.2%) cheap to model. Qi model value has risen to almost 1.10; spot EURUSD has sold off. Moreover, it is not just EURUSD. USDJPY sits 0.7 sigma (1.5%) rich to aggregate macro conditions on Qi. Recently, a BoJ official warned “the current weakening of the yen is not in line with fundamentals and is clearly driven by speculation”. Finally, GBPUSD is also screening -0.6 sigma (-1.1% cheap)
