The US Federal Reserve
is definitely going to continue to tighten its monetary policy. Beijing is definitely going to do everything it can to keep the Chinese economy on track. If markets accept those two propositions, there are profound implications across asset classes that are not yet properly reflected in pricing.
First, recent comments from Fed policymakers have only underpinned the notion that, in the US central bank’s attempts to curb elevated consumer price inflation, it will continue to raise interest rates
and do so at pace. A further 0.75 per cent rise on July 27 is very possible, with further increases to follow once the Fed reconvenes in September.
When the Fed seeks to flag the likelihood of such rate increases in advance so as not to surprise markets, as is arguably the case now, the accepted logic is that such pre-warning informs market pricing.
In the current context, last week saw part of the US government bond market become inverted
, with the nominal yield on the two-year US Treasury above that of the benchmark 10-year bond. This development is consistent with the idea the market fears that the pace of Fed tightening will tip the US economy into recession.
Such concerns also surely help explain why industrial metal prices – including copper, which is often seen as an economic bellwether – have recently been under pronounced downward pressure.
Markets appear to have concluded that the US monetary policy tightening, currently underpinning US dollar strength
in general, will also result in the destruction of real economic demand, which justifies a substantive marking down of the prices of such commodities.
Yet, as was again in evidence in robust US jobs and average hourly earnings data on Friday, the Fed has every reason to continue to raise interest rates swiftly in an attempt to bring down headline inflation and, even more importantly, avoid an unanchoring of inflation expectations in the US.
The problem for those positioning for a US recession is that it becomes hard to reconcile an inverted US yield curve
and lower industrial metals prices when US job creation and average hourly earnings are still showing no signs of rolling over, despite the Fed already having started to tighten monetary policy.
In the case of the industrial metals
complex, the situation is further complicated by the fact that Beijing looks set to flex its fiscal muscles again in its attempts to keep the pace of economic growth on track, even as it continues with policies to contain the Covid-19 pandemic.
Last Thursday, Bloomberg reported that China’s Ministry of Finance is considering allowing local governments to sell 1.5 trillion yuan (US$224 billion) of special bonds in the second half of 2022, bringing forward the sales from next year in an attempt to front-load economic stimulus, with the proceeds earmarked for new infrastructure projects
Such economic stimulus would be in addition to measures already announced. Local governments in China sold a record 1.94 trillion yuan
worth of bonds in June alone, representing a year-on-year increase of 143.27 per cent, according to analysis by Great Wall Securities.
There will be those who feel that, against the backdrop of Beijing’s zero-tolerance approach to Covid-19, not even the roll-out of new infrastructure projects on the scale suggested will guarantee China achieves its 2022 growth target of “ around 5.5 per cent
”. From a markets perspective, though, it’s the impact of such investment on sentiment that really matters.
Given the size of China’s economy, any indications that its already-prodigious appetite for commodities is set to increase further – coupled with the fact China has the financial means to enter commodity markets at will to procure the raw materials and energy it requires – should give pause to any market participants positioned for lower commodity prices.
Speculating on lower copper prices, for example, is likely to prove costly if Beijing is ramping up infrastructure projects that would require the use of large amounts of the metal.
There are no signs yet that tighter US monetary policy is resulting in large numbers of American workers being thrown into unemployment. So, with US inflation remaining high and the risk that inflation expectations become unanchored, the Fed has no reason to stop raising interest rates.
Meanwhile, the roll-out of China’s infrastructure plans can surely only mean greater demand for commodities. This combination of factors does not bode well for recession bets.
Neal Kimberley is a commentator on macroeconomics and financial markets