Markets pricing in a US recession

The second day of Jerome Powell’s semi-annual testimony on Capitol Hill passed without incident, in contrast with the frenzy on Wednesday. He reiterated an unconditional commitment to fight inflation by the Federal Reserve, but markets instead continued to price in a recession, stopping rate hikes in their tracks much sooner. US yields fell once again, equities firmed once again, cryptos crept higher, while currency markets did almost nothing unless we are talking about USD/JPY.

Assuming that the Fed will have to change course sooner than late 2023 isn’t an unreasonable assumption. The Fed and a procession of central banks around the world got inflation completely wrong and have been scrambling to reverse the mistake. Given their track record, assuming they are going to be wrong the other way is completely reasonable in that context.

The commodity space is also pricing in the recession outcome. Copper prices plummeted overnight, and that has been the case recently with most industrial metals. Even soft commodity prices have fallen, and I’ve even seen a few headlines here in Indonesia about small palm oil farmers’ incomes taking a hit. Oil has taken a bath this week as well, and the increase in natural gas inventories overnight from the EIA data saw US natural gas prices fall as well.

Still, I remain unconvinced that inflation will magically just stop in its tracks just because Mr Powell mentioned the word recession. Oil futures curves on both Brent crude and WTI remain in backwardation, which tells us prompt supplies are tight. The curves moved down in totality but didn’t really change shape. We are getting plenty of headlines from around the world about potential blackouts as energy supplies and power generation capacity remain under stress. Russian oil and gas production will decrease as well as they run out of Western parts to maintain production. Most significantly, Germany activated phase two of its emergency energy plan overnight, as Russian gas flows continued slowing. If Europe is heading to international markets at short notice to hunt for supplies, energy prices aren’t going to fall much further.

The moves this week could still turn out to be the result of a financial market genetically pre-programmed to buy dips in equity and bond prices, thanks to two decades of central bank largesse. It could also be a bear market correction as the stampede for the exit door got overdone in the short term, leading to a short-squeeze. Maybe next week’s PMIs will give markets a better clue, or perhaps the July Non-Farm Payrolls and JOLTS data. It would be foolish to price out geopolitical stresses related to Ukraine/Russia conflict either, particularly in relation to European energy or Ukrainian food exports. The FOMC meeting on the 26-27^th of July may as well be next year at present; we can expect a lot more volatility between now and then.

Yesterday, the central banks of Indonesia and the Philippines sprung no surprises. BI kept policy rates unchanged thanks to a benign inflation landscape for now. BSP hiked by 0.25% as expected. The Indonesian rupiah eased overnight, but overall volatility in the Asian FX space was flatlined.

Today has a Friday feel to it with an extremely light data calendar in Asia. Japan Inflation is already out, with the headline for May unchanged at 2.50%, and core unchanged at 2.1% YoY. That is the second month above the BOJ’s 2.0% target for headline inflation. But before we all get excited, that’s two months after trying to achieve it for over 20 years. Nobody should expect it to prompt a sudden change of direction in monetary policy, especially as much of the increase is due to higher imported PPI inflation, and a weaker yen.

Malaysian Inflation is expected to remain benign at 2.60% YoY, while Singapore Industrial Production should remain steady at 6.0% YoY. Neither will move the needle in volatility terms today in Asia. China’s Final Current Account for Q1 this afternoon is already old news. This afternoon’s UK Retail Sales and German IFO Business Climate survey both have downside risks. And given the escalation of the energy situation in Germany, both Euro and Sterling could go into the weekend looking shaky once again. US New Home Sales and Michigan Consumer Sentiment also have downside risks. Weaker than expected numbers do not provide a fertile ground for stock market exuberance, lower interest rates or not. If the data is disappointing, US equities could unwind some of this week’s gains.

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