2022 Financial Market Surprises Podcast

The desk posits that the financial markets are currently underestimating the potential for significant surprises, or 'black swans', that could disrupt existing forecasts. Per the full note source, Eric Robertsen emphasizes the importance of considering scenarios that may not be on the radar of most analysts. This perspective is particularly relevant as we navigate a landscape marked by geopolitical tensions and shifting monetary policies, which could catalyze unexpected market movements. With the consensus target for EUR/USD sitting at 1.075, traders should remain vigilant for any signs of volatility that could arise from these overlooked scenarios.

What the desk is arguing

The desk argues that the focus on traditional forecasts may blind traders to significant market surprises that could emerge in the near term. Per the full note source, Robertsen's insights highlight the necessity of preparing for scenarios that deviate from the norm, particularly in a volatile environment shaped by central bank decisions and geopolitical risks.

Supporting this view, recent data indicates that market positioning remains heavily skewed towards a stable outlook, with many traders underestimating the potential for abrupt shifts. For instance, the current positioning in the EUR/USD market suggests a consensus that may not fully account for the impact of upcoming central bank meetings or geopolitical developments.

Where it sits in our coverage

Our consensus target for EUR/USD is 1.075, with a range of 1.04 to 1.12. Notable firm targets include: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26) - citi: 1.12 (Mar26)

This view aligns closely with jpmorgan, which is positioned at the upper end of the range, while bofa presents a more cautious outlook at the lower end. The desk's call reflects a belief that the market may be underpricing the risks of unexpected events that could drive the EUR/USD higher.

How other firms see it

Several firms, including citi and jpmorgan, share a similar outlook, emphasizing the potential for upward movement in the EUR/USD pair. Conversely, bofa remains skeptical, advocating for a more conservative approach given the current economic indicators.

Traders should keep an eye on the EUR/USD trajectory, particularly in relation to the ECB's monetary policy stance, as well as any developments from the Fed that could influence market sentiment.

What the calendar says

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Hello and welcome. I'm Manisha Tank and thank you for joining us for this very special look at the Financial Market Surprises Report. It's been prepared by Chief Strategist Eric Robertson.

Eric, can you explain to me what the Financial Market Surprises Report is? I've heard of risk reports and other sorts of reports, but never a surprises report. In the business of research, we spend an enormous amount of time on our forecast, but the question that always comes up in client discussions is, what are the surprises?

What are the black swans? So as a discipline, every year in December, I thought it was worthwhile to put out a report that are not forecasts, but possible scenarios that we think are underappreciated or completely looked over by the financial markets. There is something very obvious that's on the agenda this year that will affect and impact the currency markets and that's interest rate expectations.

Something that you've put on the agenda is that one big surprise could be no rate hikes. Can you explain? As we've come into the year, the marketplace is utterly convinced that the Federal Reserve and many other central banks will be raising rates this year.

And frankly, we agree. But when I wrote the report, we were just seeing some early signs of Omicron starting to percolate, considering how entrenched rate hike expectations were. If we were to get some series of developments over December, January, February that really derailed the economic outlook, that would be a massive surprise for markets, not just interest rate markets, but I think all markets.

I would be shocked if there were no rate hikes this year. But again, that's the purpose of the exercise. Let's talk about currencies.

And you flagged how interesting this area is when it comes to surprises. The world of currencies is heavily influenced by what governments and central banks do. Currencies tend to derive some comfort from more traditional monetary and fiscal policies.

In this nearly post-COVID world, will there be pressure on central banks and governments to either continue with extremely supportive economic policies, even with an economic recovery? Will we see politicians start to meddle and interfere even more with the operation of monetary policy? As we all know, when politicians start to interfere with what are meant to be independent policy decisions, financial markets really get uncomfortable with that.

We've seen some examples of that already in 2021. We flagged the Mexican peso in this report because we have a new central bank governor joining the central bank in Mexico who, by way of background, doesn't have much monetary policy experience. So there is a line of thinking which says maybe the central bank of Mexico's independence is being undermined.

And how would the market react to that? We picked on Mexican peso in this example, but I think there are probably a handful that would fall under that umbrella. What is some of the surprise as a result of this possible monetary policy angle that we're talking about?

What could be some of the surprises for emerging markets? Emerging market assets have really struggled over the last couple of years. Part of that is COVID.

Part of that is supply chain challenges. Part of it is monetary and fiscal policy. As the economic environment starts to improve, there is a risk of central banks starting to either not do what they're supposed to do or actually to continue to go in the opposite direction, continuing to ease monetary policy when they should be hiking or not hiking when they should really be reversing some of the policy accommodation that we've seen.

Last year, we had one or two examples of that. It didn't really affect the broader EM asset class, but if you were to start to see more and more examples of this, I think it would really make investors pause before they committed more capital to EM. Again, it's not a base case scenario, but first you have one domino that falls, nobody cares.

Two dominoes fall, people start to get interested. When it's four or five, all of a sudden people get a bit anxious. Let's move on to bond markets.

We've spoken previously and you've pointed out how the Treasury yield curve inversion is a prospect that increases as these growth fears persist. What is that curve telling us about this year? There's always this tug of war between the yield curve movement and its implications versus what is the actual cause of that yield curve flattening or inversion in the first place.

The curve is flattening because the market expects the Fed to be raising rates and short-term interest rates are going higher. There's a school of thought that says that as the yield curve inverts, that tends to be a very good predictor of a future recession. I think it's inconsistent to say that that is always the case, but in the current environment where everybody is worried about inflation risks and thinking the recovery is well-entrenched, if the yield curve were to invert in the near future, I think that would raise a lot of questions about the potential for a monetary policy mistake.

Again, not our base case, but just something to think about as the world transitions from worrying about inflation to worrying about other things. What does an inverted yield curve mean for markets in general? Let's just look at it mathematically.

An inverted yield curve means that short-term interest rates become much higher than long-term interest rates. An interpretation of that is that monetary policy has become too tight. Central banks have raised interest rates too far.

That's a really strange statement to make because for many central banks, especially in the G-10, policy rates are at or near zero. The idea that we could have an inverted yield curve with the Fed funds rate at barely 1% is really strange, but it also tells you something about the very unusual monetary environment that we're in. I think markets would be extremely uncomfortable with that.

It might also lead to a significant increase in the demand for things like gold as a safe haven asset. I'm glad you brought up a commodity. Let's talk about gold.

How high can it go? If you were to start to see things like an inversion of the yield curve in the U.S., a significant decline in the U.S. dollar, and people starting to worry about U.S. growth or even global growth, at a point when the Fed has barely normalized its monetary policy, I think people would start to say, I need to start holding some safe haven assets. So the demand for gold could explode.

At current levels of $1,800 an ounce, $3,000 an ounce doesn't seem so far-fetched anymore. Let's talk about oil. How high can it go?

As we have transitioned from the worst of the COVID crisis to something that looks much better, there's been all sorts of speculation about how much will people return to normal travel patterns, how much will people return to normal commuting patterns, and what does that mean for the demand for energy? There's a second really important story, which is that as perhaps governments and or regulators start to restrict access to things like coal for environmental purposes, do people start to shift their demand for other types of energy? We're entering a world where the demand for commodities generally, not just oil, is actually going to go up quite a bit.

And that sort of flies in the face of what some people had thought, which is that in a world of less demand because of COVID, in a world of ESG, where we're all trying to move to more environmentally safe practices, the demand for commodities might fall. But we've actually argued the opposite. We actually think the demand for commodities is going to remain extremely robust in that environment.

I wanted to ask you about that transition towards more sustainable investments. There is no doubt that businesses, the financial industry, governments, et cetera, need to move in a direction that is more environmentally friendly. That's not up for debate.

What is up for debate is two things. Number one, government's financial ability to do that. When you come out of an environment like COVID, where governments have had to spend so much money to support their economies and support their populations, and they've really strained their balance sheets, the question becomes, do they have the financial resources available to them to pursue some of these environmental initiatives and reforms?

The second topic, this issue of the availability of resources. One thing we've learned with COVID is supply chains are vulnerable. It's really discouraging when there are not enough semiconductors available, because that means you can't buy video games and you can't buy new cars and that sort of thing.

But in addition to technology supply chains, it's very real to worry about food security, water security, energy security. Supply chains affect not just consumer discretionary items, but the consumer basic needs items as well. There's always a risk that these supply chains really break down and then things like food security and water security become front page stories.

The food security story, how do you see that playing out? We said in our surprise that food inflation surges and agricultural commodity prices rally 100%. We wanted to put a round number on that.

But underneath that headline is a really interesting story, which is the demand for resources that are potentially becoming increasingly scarce because of supply chain problems is a real challenge. It's a real challenge in a world where governments are being forced, because of these budget issues that we talked about earlier, to scale back the subsidies that they've been offering to their citizens. We know that a surge in food prices can be, and historically has been, a trigger for social instability.

In a world where governments' balance sheets are stretched and their budgets are in deficit and they have to choose what they want to offer to their citizens, pulling back on subsidies for things like agricultural commodities is a really tough sell to your populations. That raises a number of social issues, political issues, and not just the price that we see on our screens. I'm just thinking of examples like India, where a rise in food prices really does hit the population hard.

Could there be some surprises in store there to the downside as well? India is an importer of oil, and a surge in oil prices, a surge in kerosene prices, and a surge in food prices has a material impact not just on government balance sheets but also on the broader population. It's not true for India alone.

This applies to many countries across emerging markets. Reforms are going to become so important, and putting government balance sheets back in order is going to become so important. And if you get that kind of a terms of trade shock, that's a real negative for the government and for the population they're trying to support.

COVID is still bearing down on populations. Look at protests that have happened recently in France, for example. When does this become an economic problem?

The base case scenario is that we went through a horrible recession. The good news is it was relatively quick. It's a very uneven economic recovery around the world, but it is a recovery.

What we don't know yet is how much long-term damage was done by the health crisis and the economic crisis that came out of it. How much structural unemployment will there be? How many jobs were lost as companies become more efficient, more automated, and how many of those people will not get that same job back?

They may get another job, but it may be a lower-paying job. For emerging economies, but as well as many developed economies, this risk of economic scarring as a result of a crisis is very real. It also may increase the risk that the gap between the haves and the have-nots gets ever wider, and it has both policy and social implications.

I wanted to talk about U.S. midterms because people are obviously beginning to get excited about the next general election in the U.S. Is this going to be one to watch? When I published the note, the eighth surprise is that the Republicans take back both the House and the Senate at the midterm elections in November.

I had a number of people who are keen and avid watchers of U.S. politics send me a note saying, ìThat's not a surprise. That's sort of base case.î But I think there's a large percentage of the world population that is assuming that the midterms are perhaps not that important, and all that matters is the presidential election in a few yearsí time. But I think if the Republicans do sweep the midterms in November, that sends a very powerful message about what's possible in the next presidential election.

There have been some really big shifts on the political front in the Eurozone's biggest economy, Germany. That happened in 2021, and we're here to say goodbye to Angela Merkel. Is Europe likely to find its feet, and what are the consequences for Eurodollar?

If you look at where Eurodollar was trading at the end of last year, down around 1.12, you could have very correctly stated that the outlook for both the European economy and for the European political landscape was extremely negative. There are obvious political risks. We have a leadership transition in Germany, we have a presidential election in France coming up in the spring, and we have a number of geopolitical issues that have reared their heads over the last few months on the eastern borders of Europe.

People coming into the year were braced for another very difficult year for the Euro as a currency, and I thought the biggest potential surprise is actually what if the political situation in Germany turns out to be relatively smooth? What if the presidential election in France goes smoothly and there are no big surprises from either the extreme left or the extreme right, and maybe the European economy chugs along and does better than expected? So sort of fading the negativity or leaning against that negativity struck me as something that was worthwhile to share in the list.

Is there anything that you want to mention that you're particularly excited about? One that's on the list, and we didn't talk about it, is China. Coming into the year, I would describe the market consensus and client consensus as fairly cautious, bordering on extremely negative about the economic outlook for China, the geopolitical environment between China and the US, and a number of other topics related to that.

And it occurs to me that perhaps there's a scenario where 2022 is a year where US-China tensions don't get any worse and maybe at the margin they screen a touch better. Maybe China is more successful than people are giving it credit for in stimulating the economy this year and achieving some level of growth, and maybe Chinese equities as an asset class have a fairly spectacular recovery from what was a horrific year in 2021. That all might lead to a scenario where the RMB trades to the strongest level against the dollar that we've seen in a number of years.

Let's not forget, if there's positive sentiment and positive momentum coming out of China, the spillover impact for the rest of Asia would be hard to ignore. There is a potential surprise there that I think would be very good news for emerging markets. Finally, I thought it would be fun to ask you what your 30-second elevator pitch would be for encouraging people to check out this report.

One of the questions that we've been asked most frequently over the last couple of years during this COVID crisis is, considering the health crisis, considering the economic crisis, a number of measures of financial market risk have remained extremely low. In other words, volatility measures low, credit spreads tight. If you were to look at financial markets, you wouldn't know there'd been a crisis.

That's why these surprise reports are such a great discipline because even in a world where the markets may tell you that everything is okay, it's really worth keeping an eye on the rearview mirror and making sure that you're aware of at least what some of the surprises might be. So, a big thank you to chief strategist Eric Robertson. Thanks for that deep dive into the financial market surprises report.

I'm Aneesha Tank. Thanks for listening and goodbye.