by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our thoughts about a possible shift in Fed policy. Next, we discuss the rising angst in the European financial markets. Finally, the report reviews how the West is adapting to a changing geopolitical landscape.

 Are We There Yet? Stocks rose on Thursday due to speculation that a slowing economy could sway the Fed to moderate its policy stance.

• Weak economic data and a smaller-than-expected increase in the Bank of Canada’s policy rate buoyed expectations that the Fed could ease the pace of rate hikes. The trade deficit expanded for the first time in six months due to a decline in exports, while the number of home sales fell sharply in September. Higher rates make American goods more expensive for foreigners and home prices unaffordable for borrowers. Meanwhile, the Bank of Canada surprised the market by hiking rates 50 bps which was below the expectations of a 75 bps increase. The move by the BOC could pave the way for other central banks to curb future rate increases as well. American investors hope that the reports could possibly sway the Fed in future policy changes.
• Although the BOC news led to a brief rally in equities, weak third-quarter earnings brought investors back to reality. Facebook (F, $128.92 ) and Google’s parent company Alphabet (Googl, $94.93), reported a steep decline in sales. The disappointing report pushed NASDAQ down 2% and the S&P 500 down 0.7% on Wednesday. The drop in tech shares reflected investors’ skepticism that the market had already hit bottom. That said, optimism about policy moderation was visible in currency markets. The sterling, yen, and euro all strengthened against the dollar on Wednesday. If sustained, the depreciating greenback will provide a tailwind for the global economy as it should make dollar-priced commodities less expensive for users of other currencies.
• The Fed has consistently dampened expectations every time the market has priced in a policy change. When the markets responded positively to the Federal Open Market Committee (FOMC) minutes released last week, several Fed officials reiterated the bank’s commitment to raising rates until inflation falls. We are currently in a blackout period, and therefore, we will not hear from any Fed officials until after the FOMC meeting on November 1-2. As a result, we believe investors should wait to adjust their holdings until after the meeting concludes to avoid being caught flat-footed. At this time, we are still determining if the Fed will change tack while the economy is still showing signs of growth.

No Backing Down: Dysfunction within the European financial system is a growing problem as bonds continue to be a sore spot for their economies.

• The European Central Bank raised its three key policy interest rates by 75 bps on Thursday, in line with market expectations. In addition to increasing rates, the ECB altered the terms and conditions of its targeted longer-term financing operations (TLTRO), which will disincentivize bank lending to the real economy. As a result, the euro dipped to dollar parity as investors priced in the possibility of a worsening Eurozone recession. Although the bank reiterated its desire to continue hiking rates, it was noncommittal on its plans to implement quantitative tightening. Thus, the bank is still hesitant to remove policy stimulus altogether.
• The sharp rise in interest rates has threatened to clog up the Eurozone repo and money markets as traders struggle to find collateral to meet liquidity requirements. Concerns about a collateral shortage within the Euro banking system have led the International Capital Market Association to urge ECB officials to make changes to prevent a potential crisis. The association proposed that the bank provide the financial system with extra collateral and implement a Eurozone Treasury bill issuance program. It is unlikely that the ECB will make these changes soon; however, the letter could push officials to delay quantitative tightening.
• Investors are only partially sold on the new U.K. Prime Minister Rishi Sunak. British gilt yields rose after his Chancellor of the Exchequer, Jeremy Hunt, delayed the release of the government budget proposal to November 17. The sell-off in U.K. bonds reflects a growing angst as investors fret over how Hunt plans to resolve the country’s public financing shortfall of £35 billion caused by rising inflation and soaring interest rates. Although Hunt claimed that the delay was designed to fine-tune the plan, he is likely still working out the details. PM Sunak aims to regain market confidence after his predecessor’s stimulus package called into question the country’s willingness to fight inflation.
  • The new proposal will likely include multiple austerity measures, including tax hikes and budget cuts. Thus, there is a concern that Hunt’s plan could hurt the U.K. economy.

 A Group Rethink: Western allies are adjusting how they confront rising threats from Russia and China.

• The Biden Administration may dial down the plans to impose price caps on Russian oil. Initially, the White House wanted to establish a price range of $40-$60 a barrel; however, new reports suggest that the price could be closer to $63-64 a barrel. The price cap is designed to prevent Russia from raising revenue while still giving it the incentive to maintain production. So far, the U.S., EU, and some western allied countries such as South Korea and Australia are poised to join the price cap. However, China and India remain noticeable holdouts. If successful, the cap should allow Russian oil to sell on the open market and relieve price pressures.
• On a related note, warmer-than-expected weather conditions are likely to undermine Russian leverage over Europe. The higher temperatures have reduced demand for energy imports so much that there are concerns about countries having too much natural gas. The excess energy resources should weigh on commodity prices as countries rely more on their stockpiles as winter approaches. Prices of natural gas have already dropped 70% from their August high. The drop in commodity prices could cushion a potential slowdown in the global economy.
• Meanwhile, Western allies are mulling over how to counter an increasingly hostile Russia and China. On Wednesday, Russian President Vladimir Putin oversaw military drills that included a simulation of a nuclear strike. On the same day, U.S. Secretary of State Antony Blinken accused China of undermining the status quo in Taiwan. The rising threats have encouraged allies to mend grievances. German Chancellor Olaf Scholz and French President Emmanuel Macron met in Paris to iron out policy differences. If the West wants to bring China and Russia to heel successfully, they must ensure that the alliance stays on the same page. If the group effectively reins in the two countries, it could lead to a calmer market due to a reduced risk of conflict between major powers.
  • Moscow has warned that it could start targeting U.S. satellites in response to its support for Ukraine. Thus, there is still a risk for escalation between the U.S. and Russia.

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