The Three Things Note: Policy is not uncertain. Traders are.

Mon 10 Jul 2023

Alexander the Great was the first of the world’s great conquerors. Originally intent to exact revenge from Persia (modern-day Iran), he turned his adventure into global conquest and exploration. He marched his Greeks from Macedonia to modern-day Turkey, Georgia, Armenia, Syria, Lebanon, Israel, Jordan, Egypt, then back up to Iraq, finally conquering modern-day Iran. He then pushed further to the east, through the mountains of what is now Turkmenistan, Afghanistan, Tajikistan, and Pakistan, ending his venture north of modern India. To this day, variations of his name, Alexander, like Sikander or Iskender, can be found all across this route as can roughly 12 great cities called Alexandria (and one Boukephala, after his… well… great horse). One thing that always struck me with this story is how Alexander’s soldiers, mostly illiterate youngsters from the villages of Macedonia, rebelled on many an occasion. Not because they were tired of combat. Their victories were famous and made them rich and legends back home. Even when Alexander died, they kept on fighting (with each other that is).

Instead, they had an innate fear, something much more basic. That the further they pushed to the east, the more likely they were to fall off the edge of the earth.

We now know this as “acrophobia”, fear of extremes.

It seems that a far more literate investment crowd may be suffering from the same ailment. Often, when markets have rallied, retail investors fear joining as they think ‘they have gone too far. It’s the same with interest rates. Many believe that interest rates are already too high, therefore the logical thing to do is to simply lower them. Markets seem to refuse to believe that, high as they are, rates can go higher.

Last Thursday, markets sold off sharply as ADP, a US company that processes private payrolls, announced a strong US employment number. Traders felt that a strong US labour market will enable the Fed to carry on with its threats to further tighten interest rates and sharply reduced equity positions. The US 10y-2y yield curve inverter significantly on Thursday, to tighten again on Friday, after the bigger Non-Farm Payrolls number came in weaker than feared.

Or so the narrative goes.

First, in my nearly eighteen years of analysing financial markets, I can hardly remember equity indices dropping significantly on an ADP number. The correlation between the ADP and the S&P 500 since 1970 is practically zero. The indicator is usually considered the lesser brother of the all-important Non-Farm Payrolls numbers that usually come out a couple of days later. Although the two should be correlated, they are in fact not. Only 2% of the movement of the Non-Farm Payrolls can be explained by the movement of the ADP. Matter closed, and a hint that ‘Greek Statistics’ may extend much more broadly than the confines of a small Mediterranean country.

Second, these movements tell us only one thing: markets are volatile. Investors complain that there’s policy uncertainty, after a year and a half of rate hikes. More likely than not, it is they are suffering from a case of acrophobia. Until September last year, investors were rather sanguine about where interest rates were headed. As the year came to a close, however, and especially after the banking crisis in March, markets started to disbelieve the Fed and pricing in rate cuts the central bank never promised, or even hinted.

We are faced with high and sticky core/services inflation, which will be difficult to get down to 2% from where it is today. We are also faced with significant policy divergence, the consequences of which remain unknown. The US, which was very aggressive in moving against rates, will have an easier time getting back to target. The EU, which benefits from higher unemployment and thus lower services inflation pressures, will follow by a few months, simply because it was the last to raise rates.

The UK, despite the early reaction by the BoE, is plagued by already slower growth and very high inflation as a result of the tight labour and housing market, as well as the efficiency by which each cohort passes on the inflation cost to another. The oligopolistic structure in banks (five banks have 65% of the market) and supermarkets (five supermarkets have 75% of the market), is adding to the pressures on consumers. The path will be much more difficult, and will likely result in a recession. Bloomberg forecasts a shallow recession, but it could turn out to be more severe than that.

Central banks, and the Fed especially, remain fixed. They keep telling us, in every way possible, that inflation is too high, growth is too persistent and they are not done with rate hikes yet. Last week’s FOMC minutes attest to that. The central bank chorus in Sintra also confirmed it. And even when they are done, conditions should remain constrictive for some time. The largest US banks are set to report their biggest jump in loan losses since the pandemic, and what they are seeing in their balance sheet is, at best, the effect of last autumn’s rate hikes. And it is still more likely than not that central banks will end up over-tightening, i.e. constricting the economy more than they need to. Why? Because the economic equilibrium is a myth. No equilibrium can exist if the variables that create it are in constant motion. Thus, no one can get interest rates ‘just right’. The moving parts of the economy are too many to pre-calculate. So pushing the economy into a recession, and then taking the opposite action to restore demand, is the most probable course of action for central bankers.

Last week’s volatility wasn’t about the jobs market. Partly it was about taking some profit from the AI-driven rally. Partly it was a -welcome- return to the reality of higher interest rates and lower growth in the months to come.

George Lagarias – Chief Economist