Tense Climate and Equities at the Top

FX

US

This week, the candidate for the Fed Chair position, Kevin Warsh, was heard by the Senate (Banking Committee), in order to clarify his abilities to govern the American central bank. The central idea to retain is the “change of course” announced and assumed by Trump’s favorite (K. Warsh), as well as the criticism directed at the Fed regarding the post-Covid inflationary wave. He mentioned a balance-sheet reduction via large-scale asset sales (on the order of 100 billion dollars, per month or per sequence). In the context of quantitative tightening (QT), the decline in the stock of assets held by the Fed generally exerts upward pressure on long-term rates, potentially contributing to a steepening of the curve rather than a flattening of its short end.

This diagnosis fits a context where US data and yields remain firm. Under an inflation-targeting regime, an upside surprise on activity (retail sales, production) coupled with an oil shock argues against an imminent rate cut. Because, as we know, the Fed’s mandate breaks down into two important parts: inflation and the tracking of full employment. If full employment remains robust and inflation accelerates, the Fed’s reaction function (Taylor-rule type) retains a restrictive (hawkish) bias in order to anchor expectations, even if the exact magnitude and timing of adjustments remain dependent on upcoming releases and official communication.

As for the dollar in general, it still keeps its role as a safe-haven asset. With equities in great shape and geopolitical tensions still predominant, the greenback keeps the pace — but for how much longer? Employment data will be decisive for the coming weeks, even if the main concerns revolve around the imminent oil-driven inflation shock, already present in certain industries.

EUR

As for the US zone, sales and production data are above forecasts. The inflation shock will start to be felt on selling prices in the euro area, more significantly than in the US zone, because we have no energy sovereignty. So this energy inflation is likely to strike at the very heart of our economic zone’s activity.

Indeed, an asymmetric supply shock on the euro area could result in a period of stagflation, with GDP stabilizing or even declining, but ever-higher consumer prices…

European companies’ margins could decline rapidly over a short span and thus prolong this stagflationary period, because capital could migrate toward more profitable zones… the USA…

The economy shows no sign of notable slowdown, but the data are always worth monitoring in a climate as tense as ours. As for EURUSD, it varies according to the US president’s tweets and developments concerning the situation in the Middle East.

JPY

The same debate, again and again… is the carry trade still under threat? Well yes, the yen is still subject to these hypotheses, because, as we know, many trading and investment strategies base their logic on the interest-rate differential between two monetary zones.

Japan is a net energy-importing country… you see where I am going… Given the energy crisis that has already begun to strike, the country will be victim to strong inflation. The BoJ, which is accustomed to keeping relatively accommodative policies, could once again raise its rates, and thus reduce the US–JPY rate differential. This action would have the consequence, as we have already discussed in a previous article, of appreciating the yen in the short term. The yen being massively used as a funding currency, a narrowing of the yield gap reduces the profitability of arbitrage strategies. This forces investors to buy back yen to close their short positions, creating buying pressure on the Japanese currency.

Equities

As already said at the start, the equity market pierces highs and tech stocks soar. This is due to the fact that the US market is much more resilient than the others, but also that US tech companies are not very impacted by the war, given the country’s energy sovereignty and imports that are not extremely influential on production.

But be careful nonetheless: markets are tense, and all-time highs day after day while global geopolitical tensions keep rising bode nothing good. I would tend to use a comparison between the S&P 500 and an elastic band… careful not to stretch it too far, because the snap-back could be brutal. Hedge yourselves.