The soft landing scenario that the market is currently pricing is an unstable equilibrium that can be undermined by good data or a run of bad data. The more it is priced as a central case, the greater the asymmetry if it is invalidated and data over December and January will be central for shaping the outlook ahead.
If inflation was the key driver of the market regime over the last 12 months, it is increasingly clear that growth and central banks’ reaction function to weakening growth will drive the coming quarters.
Price action displays the market’s desire to trade a scenario of falling growth and falling inflation, with policy responses that will ease financial conditions in response. Data which supports this scenario is eliciting a much stronger price response than data which does not. Part of this is the unwind of long held positions in USD and rates, but substantively a gradual deflating of G4 economies, policy support via cuts, coupled with a Q1/Q2 reopening of China is a soft landing and very different from zero-COIVD and an unbounded right tail of short term rates.
Last week’s price action displayed this market dynamic. Despite societal unrest and weak data, China proxies had a sharp rally as policy makers continued to gradually ease lockdown policy. CNH had a 3 stdev weekly move stronger vs the USD, HK shares rose by 2.5 weekly stdevs (+14%) and industrial base metals rose. In developed markets, Powell’s speech on Wednesday was not hawkish and, in some senses, dovish, however it lead to an outsized market reaction, including a 2.8 stdev daily move lower in short term US interest rates (1y1y rates fell by 35bps high low), the Nasdaq rising by 4% on the day and the USD falling by 2.3 stdev between Wednesday and Friday.
Finally, despite a very strong US employment report relative to expectations (263,000 jobs added, average hourly earnings 0.6% mom vs 0.3% expected) US rates finished the day lower than where they entered this data print.
These types of market moves are clearly impacted by the level of positioning that had been built over this year. In this context, we think there are two specific elements at play. Firstly, the duration and degree of trends resulted in large CTA positioning that, as anecdotal evidence suggests, is still being unwound. Secondly, the right tail of continued Fed hawkishness combined with rising inflation (and idiosyncratic risks) has likely resulted in large USD over hedges by real money accounts. The speed of the regime shift has meant that these positions still need to be unwound. Given the time of the year, these flows are having an outsized impact on markets.
The medium term outlook, however, is much more uncertain. Yes, there is growing evidence of a slowdown in global growth / global recession and peaking of inflation. Actions taken from Chinese policy makers do point to a shift away from zero-COVID. Powell and the Fed want to pause to allow the cumulative effect of tightening to take hold, but did not explicitly push back on the easing of financial conditions that have resulted from a dovish interpretation of this shift. Other central bankers have shifted more explicitly to an increased focus on growth, especially where property markets are contracting.
However, nominal inflation remains very high. The US labor market remains resilient despite some signs of slowing in the economy. There are limited signs of an offramp in the Ukraine war and a China reopening would add significant upside pressure to commodity prices into a tight market. Fed policy rates are likely to remain at or around 5% for at least another 6 months.
The path to the soft landing that is currently priced is via a fall in demand enough to bring down inflation, creating a shallow recession, enabling policy to be eased but without a significant labor market contraction or, in certain countries, a major property crash in the interim.
Right now that is where we are in the data but that scenario can be invalidated if either data is stronger than expected or weaker than expected and as such it is an unsustainable equilibrium for risk assets. This dynamic explains the driver of much of the recent market volatility.
Overall, from our perspective it is much too early for a soft (recession driven) landing to be a strong central case. Indeed, what characterized the inflation shock post COVID was a sequencing issue whereby extraordinary stimulus created a bullwhip effect in labor and goods supply. It seems plausible that the opposite could occur. In response to policy, rates have risen at the fastest rate in decades and the economy may contract much quicker than inflation can ease, pressuring policy makers to keep policy tight until a hard landing is unavoidable. Indeed a China reopening may support demand over time but in the short term exacerbate inflationary problems globally.
Therefore, the next few months' data will be key. The market is giving central bankers the benefit of the doubt that soft landings can be achieved, policy rates can be cut and the path forward is more positive for risk assets. This is certainly possible, but it is a narrow path that requires much more evidence to support it. The desire for the market to believe in this scenario, however, creates opportunities as the more it is priced as a central case, the greater the asymmetry in asset prices if it is invalidated.