Macro

Reviewing key themes after a break.

The key theme for 2022 was a surprising central bank reaction to an inflation backdrop that looked primed for a continued overshoot. The Fed & Co. lost patience and the political risk of an angry voter base trumped what was likely to be a temporary boost in prices of an unknown duration. Recall that Joe Manchin singlehandedly stopped domestic stimulus to the ire of many fellow democrats in order to maintain his seat in congress by putting inflation first. When Russia entered Ukraine and commodity prices rocketed, central banks were forced to arguably overreact as a further rise in these prices seemed reasonable. My, how things change.

The coming year is one that will likely see a transition from a focus on inflation, a lagging indicator, to growth which will also become a political focal point before long. Jeremy Siegel made this point in his must watch interview last week. How much of an appetite does the Fed have for a meaningful rise in unemployment if inflation is clearly on the decline? There is real risk that inflation overshoots to the downside much like most other data series that have already mean reverted and are following the classic boom-bust scenario.

Recently, falling prices have become the norm. This boosts the case that the return to “normal” might start out with an overshoot to the downside. Most of the series that are contracting have rarely seen such a dramatic decline in price so quickly, and never outside of a recession.

Meanwhile, In the last several weeks news of a reopening in China boosted reflation plays like commodities and equities while interest rates have continued to decline.

In time, if the bounce from China is sustained there will be a meaningful boost for export led nations like those that comprise the euro area. Before then, the focus will likely shift to what could be meaningful GDP declines in the US in the first half of 2023. As growth goes negative or flirts with near zero, as it often does after a period of expansion, the backdrop will be one of falling prices and flat to contracting growth. Typically, the Federal reserve is cutting interest rates in this environment.

What makes this so complicated is that normally one would also expect the dollar to rise in such a scenario. This time around, the dollar has already rallied meaningfully on the back of high and widening rate differentials. If rate differentials collapse during a period of recession will the dollar smile as it has in past recessions?

This is probably the most important question going forward. If the typical relationship holds, then the initial move lower in the dollar on mean reversion of Fed exceptionalism is likely to fade over time as contracting liquidity and withdrawal of financing boosts the greenback. The yen might once again reign supreme as money comes home to countries that finance the rest of the world. The starting point is not kind to EM and commodity currencies which are likely to fall down the other side of the commodity shortage mountain.