Both Janet and Mario need
The market to pay them more heed
As prices inflate
They’re keen to frustrate
A chance of a market stampede
Dull continues to describe the FX market as volatility remains extremely low and traders have become inured to most of the political dramas ongoing around the world. Rather, the one thing that seems to excite the investing and trading community is inflation. While the overnight activity in FX has been very modest, the one exception is the Swedish krone, which has rallied 0.75%. The jump occurred immediately after the release of the November CPI data, which rose, surprisingly, to 1.9%. With inflation in Sweden clearly trending higher for the past two years and approaching their target while growth remains robust, it appears that the Riksbank will soon be sounding somewhat more hawkish. At least that is the FX market’s expectation based on today’s rally. In fact, I would argue that inflation has become the FX market’s key indicator at this point in time, and perhaps the key indicator for all markets.
This week we hear from the Fed, the ECB and the BOE, a rare occurrence when three of the four major central banks meet nearly synchronously. While expectations for all three are baked in, with the Fed almost certain to raise rates 25bps, while both the ECB and BOE remain on hold, all the attention will be focused on the statements that will accompany the meetings. In addition, this week we see CPI data from all three currency areas as well, so there will be one more data point on which they can hang their hat. And so the real question for the market is just how might the prevailing narrative change based on the newest data and any central bank comments.
The first data release, amongst these three, was today’s UK CPI which printed at 3.1%, slightly higher than expected and high enough to require Governor Mark Carney to write a letter of explanation to the Chancellor of the Exchequer. This quaint tradition is designed to insure that the BOE keeps its eye on the mandate, which is CPI inflation of 2.0%, + or – 1.0%. The thing is, inflation in the UK has been rising steadily ever since the Brexit vote last year and the subsequent sharp decline in the pound. Given the lag with which prices adjust, it is no surprise that we are seeing inflation peak so long after the fact. And keep in mind, since the pound bottomed in January, it has rallied more than 11%, thus removing some of the pressure from its initial decline. Virtually all forecasts are for CPI in the UK to start slipping back below the 3.0% level and eventually toward its target. Of course, that assumes the pound doesn’t fall sharply again. That remains a risk if the Brexit talks turn negative. Right now, given the impetus from the UK conceding every point regarding the exit process, there is hope that the trade talks will help bolster the UK economy and the pound. Given the history of trade talks, I would be a little bit wary of a happy ending on the timeline currently envisioned. However, I don’t believe anything is going to change the BOE policy picture in the short run and it will remain on hold through at least the end of next year. There is still far too much uncertainty in the process for the economy there to overheat.
This leads us to the US, where not only do we see the CPI data tomorrow morning, but the FOMC announces their policy decision and has a press conference tomorrow afternoon. The current forecast for CPI is 2.2% headline, 1.8% core, which if realized will help remove some of the mystery of low inflation. It means that the idiosyncratic features that have been mentioned, things like unlimited data plans for cell phones, will be ebbing out of the data while other things, like ongoing rises in housing and medical costs reassert themselves. There continues to be a dichotomy between goods and services, where goods prices have extraordinary difficulty being raised by merchants as the spread of on-line commerce pressures prices lower. This morning’s article in the WSJ about the Amazon effect was interesting, not so much for the article as much for the comments that accompanied it which focused on how much services, like eating out or going to the doctor have risen in price despite the fact that you can buy a screwdriver for less. While there is no question that the price of many goods, both durable and non-durable, have remained quite stable, there is also no question that we continue to see rising prices for services. And remember, services make up ~80% of the economy. I might argue that your personal CPI seems a bit higher than the measured version. At any rate, the question for markets is will there be a change of tone by Chair Yellen regarding the future trajectory of interest rates. And while the Fed follows PCE, which doesn’t get released until next week, I’m pretty sure that a surprise in CPI will not go unnoticed. But will it be enough to change the story? It will have to be quite large to do so.
Finally, the ECB meets Thursday with the Eurozone CPI measures officially released on Monday morning. However, I am quite certain that the ECB will have the data ahead of time and know the outcome when they meet. So this will really be the best opportunity for the narrative to change. The current expectation there is for a 1.5% headline print with core still hanging around below 1.0%. Given that these levels remain will below the ECB target of ‘close but below 2.0%’, it strikes me that the market is getting somewhat ahead of itself with the idea that the ECB will be taking a more aggressive tone at this meeting. I have read several articles where analysts are highlighting the ongoing positive growth story and pointing to Thursday’s meeting as a time when Signor Draghi is going to hint at an even faster reduction in QE, or a more definitive endpoint. Based on Mario’s history, I find it highly unlikely that he will do anything that will be seen as more hawkish here. And in fact, if the market responds to something he says in that manner, we will hear from at least three ECB members about how the market has misinterpreted the comments. My point is that there is no evidence that the ECB is ready to move faster than they have currently committed, and positioning for that outcome would be a mistake in my view.
Regarding inflation, however, there is one wildcard that is completely out of the hands of the central bankers, commodity prices. Prices in this segment of the economy have definitely lagged that of asset prices in the financial sector over the past several years, but seem to be picking up. When you consider the strengthening in the global economy, it should not be a real surprise that this happens. After all, more growth leads to greater demand for stuff. In the end, however, price pressures from this sector are not nearly sufficient to cause any of the central banks to act right away. And so while it may be a future concern, it seems unlikely to have any near term impact on markets.
In the end, I am strongly of the opinion that the status quo will be maintained, that the big three central banks will act exactly as expected and that there will be no changes to forecasts for 2018. In other words, as much as I believe a little volatility is actually a healthy thing for markets, I fear that neither Carney nor Yellen nor Draghi will add any to the mix this week.
While I was typing, US PPI was released at 0.4% with the ex food & energy reading at 0.3%. Both of these were 0.1% higher than expected and we have seen the dollar perk up a little in the aftermath. But we will need to see a much higher print from tomorrow’s CPI to get the Fed to change its tune. And to me, that seems pretty unlikely. In the end, the lack of volatility remains a hedger’s dream, so please don’t miss out!