Markets
Equities had a solid finish to the week as the reversion lower in yields created a meaningful tailwind for growth stocks. And given the market body language of late, I suspect long-term investors were more than happy to ride a sea of green for a change.
Indeed, it was an epic bear market bounce, especially as doom and gloom prophecies have recession storm clouds billowing vertically with the horizon.
We calculate the lack of selling was enough to explain some of the bounce as there was minimal buy flow from retail or otherwise bankrolling this rotation rally.
On bonds, we think the street will wait until we are closer to the next CPI release to re-enter shorts as seasonal factors support the duration rally, so there might be more breathing room for stocks amid this fragile détente.
University of Michigan's final release revised the 5-10y inflation expectation to 3.1% from 3.3%. And the 1y inflation expectation was adjusted to 5.3% from 5.4%.
On the surface, it suggests it was unreasonable for the Fed to decide on monetary policy with a backward-looking approach. With 5y5y breaks still in check, many now think it was unnecessary to hike 75bp based on one data survey. So, the softer Fed Funds curve on Friday was due to the more faded inflation reprint.
I would ignore it for a straightforward reason. Higher oil prices are inflation's enemy number one for the Fed. And lower gasoline prices are at the top of the Biden administration's election plan ahead of the November midterms.
With the Fed focusing on headline over core, US monetary policy is increasingly captive to oil prices. That observation implies higher volatility around the Fed's reaction function. Hence with oil and gasoline prices staying high, the Fed will keep the rate hike pedal to the metal.
In addition, any hot data prints will provide room for higher repricing in front meetings, especially with a narrow window for the Fed to sprint to the finish line and hit the end-of-year terminal rates target. In that view, the risk-reward for further front-loading of hikes is attractive.
We think the next multiple legs lower in the S&P 500 will come from a de-rating in earnings. Last week I suggested there was no need to risk a career mistake selling blocks of SPX 3700 at +30 VIX.
Indeed, institutional sellers will need a lot more confidence that the earnings deterioration is happening now and that the consumer has stopped spending. Both go hand in hand; declining consumer spending does represent the main threat to earnings for big-ticket items—especially in the case of a recession.
And, of course, with the most significant pension month-end and quarter-end rebalancing buy estimate since March 2020 laying in wait, folks are less inclined to step in front of a month-end bounce.
Energy equities were under enormous pressure until Friday's reversal, consistent with the broad draw down across the commodity complex driven by growing recession and demand concerns. And that should remain a pressure point.
Hence, I suspect commodity markets will remain in focus, particularly oil, given the extent to which energy inflation fears have driven risk this year.
Oil Prices
Price action will soon tell us if the latest dive was a function of demand destruction or crowded positioning? But one thing is sure: the oil complex is not nearly as impervious as many had thought.
After getting hammered most of last week due to recession and fuel demand destruction concerns, oil prices rallied into the weekend on the back of physical demand. Those global economic worries were seemingly offset by higher China demand for "real world barrels."
Indeed, energy demand in Northern, Central and Northwestern China hit record levels as millions turned on the AC to escape the oppressive heatwave, which likely created the Domino effect. Record-high electricity impacts not only fuel-intensive industry production but also oil prices.
There could have been some element of the tail (time spreads) wagging the dog (spot), in the curve in heavy backwardation for a while, but when word starts spreading that China is a premium for prompt barrels, it's more than enough to spook shorts.
Although oil is a spot asset usually driven by supply and demand fundamentals, it is not unusual for the complex to trade like an anticipatory asset (stocks and forex) driven by the broader economic growth rate of demand, which is slowing if the PMI data are dependable.
Our view has been unwavering; in the absence of fresh supply, it will be challenging to see Brent trading below 100 as Ukraine - Russia war escalation will continue to drive energy price fears.
On the other hand, it is a fallacy to think Brent Crude could stay +$120 given the amount of central bank-induced slowdown likely to be seen later in the year. The Fed and other inflation-fighting central banks want lower commodities, which is what they are explicitly trying to engineer.
Gold
G-7 countries will make it official that they have stopped buying Russian gold. Since Russian Bars have been considered politically tainted in the West following the country's invasion of Ukraine, I doubt making it official will have much impact on the gold market as it was assumed that Russia would keep domestic production at home to soak up surplus USD and prevent excessive appreciation of the ruble. But there could be some headline bounce at the open.
Forex
G-10
Last week's Eurozone PMIs added to a laundry list of reasons to be suspicious about chasing the euro higher. From the Ukraine War to China's lockdowns, economic activity looks bleak.
At the same time, this would typically be enough to send the EUR/USD shuffling towards parity on the back of a hawkish Fed. However, the street is conflicted with the ECB on the brink of a momentous policy pivot while setting the springboard to exit negative rates.
I do not think the street wanted to be short euro ahead of this week's Sintra meeting that could cement expectations for an impending exit from negative rates and possibly rolling out a functional anti-fragmentation "backstop."
On another counter-trend trade, we still think the yen offers attractive skew due to rising US recession risks and the prospect of a change in monetary policy in Japan itself. And with intervention rhetoric picking up, Tokyo could be guarded about buying dollars up here.
Asia FX
As usual, the ringgit continues to be driven by external factors while underperforming the terms of trade improvement due to its high beta to CNH weakness, outflows from domestic investors, and exporters unwilling to convert USD due to the hawkish Fed.
However, with global risk sentiment improving and the yuan rallying, we could see follow-through below 4.40 early in the week if US yields continue to trade soft.