GLOBAL CREDIT BULLETS | Monday, 19th September 2022

Federal Reserve – Last stop 4% 
Lower headline inflation driven by lower energy prices is not enough to make the Fed turn dovish. Last week’s increase in core inflation, resilient retail sales and continued tightness of the labour market reinforce the narrative of a continued steep tightening path for the Fed.

Year-on-year US headline CPI data last week came at 8.3%, slightly lower than the July reading of 8.5%. However, this was widely anticipated as it was driven down by lower energy prices. Cause for concern came from core inflation, which came in at 6.3%, versus the previous reading of 5.9%.

Headline retail sales came in at 0.5% m-o-m vs a previous reading of 0%, whilst retail sales ex-auto and gas came in slightly lower at 0.3% vs 0.7% in July (revised down to 0.3%). Data fail to suggest an easing in retail sales, reinforcing our view of a hawkish Fed this week.

Leading indicators leave us a bit more hopeful. Supply chains bottlenecks continue to ease, with time to delivery decreasing and inventories building up in the industrial sector. Airfares and used cars prices are expected to see a drop in the coming months. Rent inflation continues to stay elevated but higher mortgage rates should start affecting the housing sector too, as permits data start showing. Inflation thus should start coming down over the next few months, just the signs are not affecting current prints yet.

In this environment, the Fed will need to continue delivering a hawkish message, as the level of inflation is high and the pace of the recent turn is not strong enough. 

On Wednesday, we think the Fed will hike 75bp, throwing on the table the idea of comparable or larger hikes shall inflation pressure continue. The decision will come together with a strong upward revision of forecasts, and signaling of a terminal rate closer to 4% in 2023. The good news is that markets are already there. Rates are pricing 78bp for the meeting, 10bp higher vs 1 week ago implying a policy rate in the 3-3.25% range. Year-end expectations are of a c.4.3% policy rate level, 192bp higher than where we are today. The Fed may deliver a hawkish message, but most of the news is already in the price following the strong inflation print last week.

Asia FX – under pressure
Broad USD strength is increasing pressure on Asia currencies. Last week saw the Japanese Yen reaching multi-decade lows versus the US dollar. In China, the Renminbi broke the 7-level versus the US dollar for the first time since mid-2020.

In Japan, the BOJ conducted “rate-checking” in foreign exchange markets last week, a move viewed as a lead-up to an actual intervention. However, the Ministry of Finance must coordinate with the U.S. Treasury on any intervention, and it’s uncertain whether Washington would agree to dollar sales.

The 24-year lows in JPY comes ahead of the BOJs policy meeting this Wednesday/Thursday. Given the lack of effective tools the government has to support the currency, the BOJ might come under increasing political pressure to shift its policy bias from easing to neutral if USDJPY goes above 150. We think the BOJ might worry that this shift could be interpreted as a move away from their easy policy stance. While it may tweak forward guidance for policy rates, we believe it is likely to maintain its easing bias on policy.

Similarly, the Renminbi has reached close to 2019/20 covid lows versus the US dollar, breaking 7 for the first time since mid-2020. However, we think PBOC’s main concern will continue to be around the pace of depreciation but not the overall direction of the move in USD-RMB.

Whilst China is showing signs of economic recovery on the back of PBOC stimulus/liquidity injection, fundamentals seem to favour a weaker Renminbi given weaker exports, ongoing property sector turbulence and still intact zero-Covid policy. Hence, we believe there is still some room for further Renminbi downside. The move in CNH ytd closely tracks the adjustment in EUR/USD, offering little reason to the PBOC to intervene more forcefully. Cooling exports and reduced interest gap vs the US will thus most probably mean higher chances of more pressure on the currency.

Ukraine war – No respite in sight
On September 24^th, it will be 7 months since the Russia invasion of Ukraine in late February. We take stock of the situation, which is markedly more fluid and complicated than the Russian military expected earlier this year.

Recent Ukrainian counteroffensive moves enabled them to regain Russian-controlled land and were followed by fresh new aid from the US, which on Thursday last week provided another round of military aid to Ukraine, amounting to $600 million.

This month, Kyiv’s forces have retaken dozens of settlements and more than 3,500 square miles of Russian-controlled ground in the northeastern Kharkiv region, where Ukrainian authorities have found another mass burial site of 440 unmarked graves, close to Izyum.

As Russian forces appear to have regained their footing after having been forced to retreat, the kremlin has to address domestic setbacks as there is growing criticism on how Russia has been dealing with the war, albeit still at contained levels.

On the battlefield over recent weeks, Russia has lost hundreds of heavy military vehicles, including over 100 tanks, according to open-source intelligence reports. It also lost several pieces of classified electronic-warfare equipment that are now in the hands of Western-allied forces.

Recent successful Ukrainian counterattacks have been allegedly acknowledged by Russian media, who are crediting most of the successes to the US intelligence and western weapons.

However, despite Ukraine’s recent battlefield successes, Russia still retains significant forces deployed in and around Ukraine and vast stores of weaponry and ammunition, giving it the potential to react and hit back. Further, Ukrainin forces might now face more resistance when attacking Russian-controlled regions.  Kyiv’s recent gains near Kharkiv, in the northeast, were achieved using surprise and by finding weak points in Russia’s long and thinly protected front line and achieving similar results using the same tactics might prove to be difficult.

Russia will probably struggle to update or replace the lost equipment because Western sanctions are limiting Moscow’s access to advanced electronics. And if word spreads that Russia’s advanced defenses have been compromised, its prospects of selling such gear in export markets will likely diminish, further weakening its arms industry.

To put things into context, as of the end (24th) of August:

• 5,587 Ukrainian civilians were confirmed dead, with the real number believed to be in the tens of thousands;
• More than 6.5mn refugees;
• Military losses: 9,000 Ukrainians and about 25,000 Russians;
• The war has already cost Ukraine at least $113.5bn, and it is expected for them to need more than $200bn to rebuild;
• Prior to the latest round of $600mn in aid from the US, donor nations pledged to give around $85bn to Ukraine.

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Algebris Investments’ Global Credit Team