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Business Cycle Watch #2: Demand accelerates, supply-chain problems persist

Second month of 2022 may be the turning point of the global recovery. There are signs of a slowing pace of economic growth, however demand is strongest in the last two years despite prolonged supply chain problems.

The main themes of 2021 will continue and further intensify in the coming months. Inflation will persist. Disruptions in the manufacturing aren't going anywhere yet, and some commodities may hit an all-time high.

Risk up, yields down

Everyone is waiting for the Fed to hike, and bets on the future policy rate had gone very optimistic in the first half of February. After publishing the latest, mostly surprising, CPI numbers and a very hawkish Volker-style speech of James Bullard, the idea of a 50 bps hike in March was much more than just plausible. One week later, the market has realized that it had exaggerated a bit. Two weeks later, chances of a 50 point increase in fed funds target became negligible. As of 1st March, according to the CME measure, probability of a 50 bps increase in the fed funds rate is 0%.

The Treasury yield curve continues to flatten, and the eurodollar curve continues to invert. Some analysts have been worrying that 2s10s is heading towards zero, others think that 2s10s is not important as no (shadow) bank finances at 2-year duration. Who's right, then? Well... they're both kind of right.

The difference between Treasury 2s and 10s is very often used as an indicator of steepening or flattening yield curve, however, that particular spread does not have a clear interpretation. 10-year and 3-month Treasury spread is much more in indicative. 3m/10y is simple, it's money versus bonds (or, technically speaking, notes). Fixed income (FI) securities with maturity of 3 months are money market instruments, and that is what non-banks creditors typically use for financing. Furthermore, 3M LIBOR and now 3M Repo are used to price a wide variety of FI instruments, from mortgages to IRS. In short, 3m/10y is much closer to banks' balance sheet realities than any other spread.

Having said that, we shall not completely ignore 2y/10y spread or any other for that matter. Treasury 2s follow policy rate expectations, and 10s can be viewed as a composition of long-term real growth and inflation. In theory, the latter should follow the prior, and in that case we would get a nice steeping curve. Yet, long-term yields don't react much to the Fed's forward guidance, and thus reaction to actual rate hikes will not be substantial, as future fed funds rate is already very aggressively priced in the markets (ff futures, short-end of the Treasury curve, stock market...). In other words, the 3m/10y spread's future path can be seen in the existing 2y/10y spread, given that the Fed's rate hikes realize.

The next worrying sign is the eurodollar curve, which went from slightly inverted to completely inverted in less than four weeks. Eurodollar futures rates indicate that there is a disagreement between the Fed and the markets about the future real growth prospects. Just as Reynolds said

It's as if traders in the eurodollar futures market think the Fed is going to overdo it next year and then have to reverse course and push rates back down.

The eurodollar curve has a good record of predicting trouble, so it would be wise to watch it together with the financing spread very closely. Just as the Treasury term-structure, eurodollars have predicted the GFC and the 2018-19 "global synchronized growth slowdown". Below, you can see two of the past rate "disagreements" about the prospective growth and inflation in the Treasury market. Red is the short-term rate that tracks the Fed's monetary policy, blue is the long-term rate that tracks the real economy.

Demand picks up the pace

In the US, core retail trade (ex food, gas and auto) grew at 3.8% m/m (11.8% y/y), from -3.16% last month. The last time retail sales growth was this high was in August, during the vacation season.

It seems that in January, something has changed in consumers' behavior. Retail demand increased rapidly. The two most probable explanations are: shift in the approach to the pandemic or/and inflation-induced spending.

High infection pace and almost non-existent mortality of omicron variant has prompted some governments around the world to eliminate almost all the restrictions. That happened in February. Omicron itself, though, happened three months earlier and people most likely reacted to the information one-month prior to the officials, hence, possibly, strong January sales numbers. 9.2% m/m (10-month-high) increase in department store sales indicates that the pandemic may, indeed, be ending. Another evidence would be the retail oversees, especially in the UK. British total retail index ex gas rose 1.96% m/m, from -3.08% in Dec '21. Furthermore, in the last nine months, retail sales growth in both countries followed each other very closely.

Another explanation comes from asset allocation perspective. Elevated consumer prices are a kind of tax on savings, and when prices of most asset classes are sinking (non-decreasing bonds yields and negative stock returns), the best optimal decision may be to increase present consumption. Two data points that support this narrative are the growth in non-store retail that reached 14.5% m/m (12-month high), which shows that retail was even stronger "at home", and core CPI that has now expanded by 6% y/y.

High retail numbers don't come out of nowhere. The strongest retail sales digits in the last 12 months were in March '21, and there was one specific reason for the buying spree to happen - Biden's approval of $1.9 trillion economic stimulus bill. It is difficult to specify an exact reason for the shopping surge in January, but pandemic and inflation narratives give some idea of the current demand-side state of commerce.

Vigorous consumption can be also observed in the personal saving rate. During the two years of the pandemic, many households have increased their savings, most probably, due to the high level of economic uncertainty. The fourth quarter of 2021 reversed that tendency, and now the saving rate is at 6.4%, below its long-term average of 8.3%.

Inflation will persist

High consumer prices are going to last for much longer than we would like them to, and that's not only because of the forthcoming chaos in the crude market. Supply-chain problems are expected to stay. In the latest Philly Fed Manufacturing Survey, correspondents weren't very optimistic about the future delivery time, the index was at -22.3, two times lower than March '20 figures. Delivery issue was also mentioned in the most recent IHS Markit PMI report:

Delivery delays were the least severe since last May. Firms often noted that although material shortages eased, transportation and logistics delays extended lead times.

Generally, all February's Markit PMIs were very strong for the US. Robust manufacturing and accelerating services demand. Although, in the Eurozone, manufacturing slightly declined to 58.7 (down 0.5 points). When we take into account other surveys, like the mentioned Philly Manufacturing, then the positive global picture of the industrial sector is doubtful.

If issues in logistics won't be solved quickly, we will get a combination of long delays, high energy prices (consequence of the war in Ukraine), and thus also expensive raw materials. Additionally, Russia and Ukraine together export more than 25% of the world's wheat, plus, Russia alone exports about 13% of world's fertilizers and about 40% of the EU's natural gas supply.

The coming supply-driven inflation can be already seen not only in commodity prices, but also in inflation-linked bond yields. US Treasury inflation breakevens surged tremendously since the beginning of the war. 5-year breakevens increased almost 40 bps in February. German inflation-linked bobls show the same thing.

The war has changed the inflation profile dramatically. This year, consumer price growth will most likely be at the level of, or even exceed, the one of 2021. The EU is in the worst position due to the reliance on the Russian gas. Troubles will come especially in Fall, when the heating season begins.

Implications of the war today

The ongoing Russian invasion on Ukrainian soil will change the structure of commodity and material markets in the near future. However, some economic consequences were instant, and are already here.

The first major effect is the outflow of capital from the eastern EU countries to the safest region possible, i.e. USD denominated assets. The conflict has triggered a flight to safety that happens in currency, bond and equity markets. Euro to Polish zloty and to Hungarian forint went parabolic in the last week. EUR also dropped quite significantly, as there are many countries to the east of Berlin that also trade in euros. From 22nd Feb, EURUSD fell 4%. Additionally, every index of major currency is in red, except the US dollar. DXY rose 3.5% only in the last week.

Poland, Hungary, Slovakia, Romania. All of these countries experienced a sudden increase in bond yields and volatility of stocks. At the same time, 10-year bond yields of western developed countries dropped. This observation is important because a spillover of the war in the Eastern Europe, right now, pushes Central European countries into financial instability, especially Poland and Hungary, which are not in the EU monetary union. A fast decline in zloty and forint may trigger those countries to pursue an even more aggressive monetary policy, which could create "perfect" conditions for a recession in that region. The longer the war lasts, the higher chances that the credit premium on sovereign bonds will continue to increase, and the higher chances of a financial crisis in the region. Let's not forget that since 1973 the frequency of financial crisis doubled, and that increase was driven by currency crises.

A second imminent problem that the global economy has to confront is the chaos in commodity markets. Energy got expensive. Since 21st of February, the price of gas traded in the Netherlands increased by over 200%, Newcastle coal is up 79% and Brent Crude grew 24%.

Industrial materials also spiked to a dangerous level. Nickel, just in the last week, increased twofold. Copper is rising as well. Palladium, that is so crucial in the automotive manufacturing, is at its all-time high, up 28% since the beginning of the war.

Many hoped that this year will see the end of the material supply and logistics difficulties. Notwithstanding, the war has changed it all. The recent surge in commodity prices, and its volatility has killed the notion of a falling growth in consumer prices, with the Western Europe being most susceptible to economic costs of the Russian gamble.