Daily Analysis 20 January 2022 (10-Minute Read)

Hello there,

A terrific Thursday to you as markets continue to turn red on a growing crowd of voices that have declared interest rates will keep heading higher this year.

In brief (TL:DR)

  • U.S. stocks were lower Wednesday with the Dow Jones Industrial Average (-0.96%), the S&P 500 (-0.97%) and the Nasdaq Composite (-1.15%) all in the red as the selloff continues in earnest and yields show no signs of slowing down.

  • Asian stocks mostly rose Thursday, shaking off a tumble in U.S. shares, as traders evaluated the latest reduction in Chinese borrowing costs against monetary policy tightening in the U.S.

  • Benchmark U.S. 10-year Treasury yields declined two basis points to 1.84% (yields fall when bond prices rise) as some traders took to buying.

  • The dollar edged lower.

  • Oil retreated with February 2022 contracts for WTI Crude Oil (Nymex) (-0.53%) at US$86.50.

  • Gold was around a two-month high with February 2022 contracts for Gold (Comex) (-0.15%) at US$1,842.70.

Bitcoin (-1.40%)fell to US$41,781 alongside other risk assets as risk-off sentiment continues to put downward pressure on the benchmark cryptocurrency.

In today's issue...

  1. Can the U.S. Federal Reserve Play Dice with the Markets?

  2. What to make of policy tightening forecasts?

  3. 2022 Could be the Year of Crypto Regulation


Market Overview

The dominant theme for markets remains prospective Fed rate hikes and the possible reduction of its holdings in Treasuries starting later in 2022 (also known as runoff).

But with almost a week to go before the Fed meets for this month, anything could theoretically happen.

The withdrawal of outsized stimulus threatens to inject more volatility across a range of assets and there's little doubt that the Fed is taking note, even as inflation continues to put pressure on policymakers to take decisive action.

U.S. President Joe Biden said it’s the Fed’s job to rein in the fastest inflation in decades, and backed the central bank’s plans to scale back stimulus, even while his administration struggles to bring its US$2 trillion economic plan across the line.

Chinese lenders lowered borrowing costs again after the central bank cut policy loan rates and pledged more easing for an economy struggling with a property slowdown and partial shutdowns as part of its zero-tolerance pandemic approach.

In Asia, markets were mostly higher Thursday with Tokyo's Nikkei 225 (+0.89%), Seoul's Kospi Index (+0.53%) and Hong Kong's Hang Seng (+2.21%) up, while Sydney’s ASX 200 (-0.15%) was down.



1. Can the U.S. Federal Reserve Play Dice with the Markets?

  • Policymakers shrugged off rising inflation for close to a year and whether they’ll have the appetite to get tough now and stick with intended rate rises should markets start to waver is far from clear.

  • Raise rates aggressively and risk destabilizing financial markets, potentially triggering a recession, or do nothing and allow for runway inflation.

While God may not play dice, the U.S. Federal Reserve may be as it attempts to run one of the most challenging gauntlets of all – Goldilocks monetary policy – withdrawing enough stimulus to curb inflation, but not so much that it destabilizes financial markets.

And although corporate earnings and economic growth of necessity matter to investors, the factor that is keeping them up on edge at the moment is the direction of interest rates.

Policymakers shrugged off rising inflation for close to a year and whether they’ll have the appetite to get tough now and stick with intended rate rises should markets start to waver is far from clear.

To be sure, there are a lot more retail participants in the market (especially in the U.S.) than there were before the pandemic and that could have a significant impact on consumer sentiment.

And let’s not forget, raising rates recklessly (try saying that quickly three times) would also hurt the political masters who appoint policymakers.

Take Europe for instance, where the European Central Bank’s monetary support doesn’t just keep borrowing cheap, its support of the bond market is crucial to holding the euro currency area together.

And while the Fed may appear to have more leeway due to the dollar’s reserve currency role, crashing the markets could spark off a recession, a legacy that even the most hawkish policymaker doesn’t have the appetite for.

Consider also that public debt in the U.S. was just 60% of national output in 2007, but is well over 100% today, thanks in no small part to the massive fiscal largesse from the coronavirus pandemic.

What this also means is that a huge slice of predicted GDP growth could be erased by higher benchmark interest rates that raise debt servicing costs.

While some more speculative corners of the market have already stumbled this year – specifically cryptocurrencies and tech stocks – the impact has not been felt across markets more broadly.

But that could change in a heartbeat.

The rotation to “value” stocks, in particular financials, now appears somewhat premature as earnings from the last quarter have fallen short of estimates.

And while lenders are expected to do better in a higher rate environment, the rate of default is also likely to go up, especially from those companies that were already on the edge, forcing for higher loan provisions to be made.

Job growth in the U.S. was also well below estimates in December, despite a strong increase in wages.

Against this backdrop, the Fed, and perhaps every other major central bank, is left with only unpalatable options.

Raise rates aggressively and risk destabilizing financial markets, potentially triggering a recession, or do nothing and allow for runway inflation.

The third possibility, the one that central bankers haven’t yet considered would be the worst outcome – stagflation – low growth coupled with soaring inflation, for which there are no good solutions.

Let’s not forget that not so long ago in 2018, U.S. Federal Reserve Chairman Jerome Powell suggested that the central bank was on “automatic pilot” towards regular rate rises, triggering tremors across global stocks, only to walk back his line to urge greater patience in raising borrowing costs, capitulating to market pressures.



2. What to make of policy tightening forecasts?

  • Given that at the last Fed policy meeting, the ultimate decision was to do nothing on rates, where are all these predictions coming from and why should investors care?

  • And when the Fed doesn’t eviscerate the markets by hiking rates as much as expected? Well, no bother, cause all of the “smart money” has positioned for the sharp rebound by picking up on the cheap.

Two times, four times, eight times – of late there’s been no shortage of predictions on how the U.S. Federal Reserve will react to the highest levels of U.S. inflation in four decades, with scenarios ranging from the sublime to the ridiculous.

Given that at the last Fed policy meeting, the ultimate decision was to do nothing on rates, where are all these predictions coming from and why should investors care?

At this stage in the market cycle, earnings and profits matter less than monetary policy.

The prospect of easy money days being in the rearview mirror has roiled everything from tech stocks to cryptocurrencies, but the biggest question that investors need to ask themselves is who are they betting against?

Are they betting against the plethora of talking heads showing up on the likes of CNBC and Bloomberg or are they betting on the resolve of policymakers?

This is where sifting the wheat from the chaff is essential.

It’s not just investors who are reading the Financial Times and Bloomberg, but policymakers as well – they don’t operate in ivory towers.

In which case, it suits Wall Street’s purposes to shake out markets by talking up the doom and gloom of severe policy tightening, eight interest rate hikes in 2022? Get real.

No Fed policymaker has the stomach for tanking an increasingly shaky recovery with a full-on market crash against a backdrop of inflation, declining consumer sentiment and labor shortages.

But it’s important that the talking heads keep yakking up doomsday scenarios of financial Armageddon. Why?

Because it puts the fear of God into policymakers to act more cautiously on rates and balance sheet runoff.

Repeat a lie often enough and it becomes the truth – this is a standard propaganda trick – just ask Goebbels.

By getting enough of Wall Street declaring that 4 or 8, heck why not 9 rate hikes this year of 1% a-piece from March onwards, risk assets start to correct dramatically, allowing Wall Street’s insiders to soak them up on the cheap.

And when the Fed doesn’t eviscerate the markets by hiking rates as much as expected? Well, no bother, cause all of the “smart money” has positioned for the sharp rebound by picking up on the cheap.

Rinse and repeat – thank you for attending Wall Street theater.



3. 2022 Could be the Year of Crypto Regulation

  • Given how cryptocurrencies have had an abysmal start to the year, you’d think that regulators would lean back on their well-appointed leatherbound chairs and kick the crypto regulation bucket down the road.

  • Cryptocurrency industry participants railed against the prospect of being regulated like traditional securities, which would put them at the mercy of gatekeepers on Wall Street with the wherewithal to properly police and package offerings.

If 2021 was the year of cryptocurrency adoption (debatable), then 2022 could be the year of cryptocurrency regulation.

Given how cryptocurrencies have had an abysmal start to the year, you’d think that regulators would lean back on their well-appointed leatherbound chairs and kick the crypto regulation bucket down the road.

But as any seasoned crypto trader will tell you, 24 hours is an eternity in the crypto markets and regulators aren’t waiting for the next bull cycle to scramble to either get a piece of the action or stake (no pun intended) a portion of the regulatory landscape.

Of the several market watchdogs in the U.S., the Securities and Exchange Commission appears poised to strike first, with Chairman Gary Gensler declaring yesterday that he’s hopeful trading platforms will take steps in the coming months to be more directly regulated by Washington.

Gensler can rely on a lot more than hope though.

As cryptocurrencies grow increasingly mainstream and institutional investors wade into the waters, the additional regulatory scrutiny is crucial for greater participation, so that investors receive the same protections that are typical for other assets.

At a virtual press conference, Gensler said,

“I’ve asked staff to look at every way to get these platforms inside the investor protection remit. If the trading platforms don’t come into the regulated space, it’d be another year of the public being vulnerable.”

Last year Gensler rattled the crypto industry by arguing that tokens were akin to securities and ought to be subject to the SEC’s tough rules.

Cryptocurrency industry participants railed against the prospect of being regulated like traditional securities, which would put them at the mercy of gatekeepers on Wall Street with the wherewithal to properly police and package offerings.

If the purpose of cryptocurrencies was to provide a frictionless means to transact value or manage software, then the idea of having trusted third parties undermines their entire value proposition.

Nevertheless, a middle ground may be possible.

Of all the different financial watchdogs in Washington, Gensler may be the best equipped to find some sort of hybrid approach that embraces innovation without exposing investors to inordinate amounts of risk.

Prior to his current appointment, Gensler taught blockchain technology at the MIT Sloan School of Management and he understands the technological potential underpinning cryptocurrencies.

Crypto proponents can also recognize that for greater mainstream adoption, at least some degree of protection is necessary, especially given the abundance of scams, manipulation and other fraudulent behavior that have come to be accepted as the inherent risks of dealing in the opportunities provided by the nascent digital asset class.

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