So what did we learn from the Fed?
They’re thinking that tax cuts instead
Of low unemployment
Could give them enjoyment
By driving price rises ahead
“We’ll have to be guided by the data as they come in, that’s what will dictate the path of our policy.” These words from Jerome Powell at his Senate confirmation hearing back on November 28th will be tested as we go forward. Yesterday’s FOMC Minutes showed that
the committee remains quite comfortable with the current economic growth prospects, highlighting strength in numerous sectors domestically as well as global growth. Recall that the December meeting occurred before the tax reform legislation became law. However, several committee members did discuss the prospects for said legislation and the impact it might have on the economy, and by extension the rate of inflation. It is clear that the Fed has completely turned its focus to the inflation story, and rightly so, given the current robust employment situation. So the question going forward, and one of the key drivers of markets and the dollar this year, is how will inflation behave in 2018?
The first data of the year have shown that economic growth continues apace, with PMI data from around the world beating expectations for both manufacturing and services. This morning’s readings from Europe and the UK are the latest, with the Service and Composite readings both pushing to the highest levels seen since the financial crisis. As well, from the US we saw ISM Manufacturing yesterday with a robust outcome of 59.7, also pushing back near its highest levels since the crisis. Of more importance, however, was the ISM Prices Paid index, printing at a much firmer than expected 69.0, and indicating further that inflation pressures are growing in the US.
The mystery of low inflation continues to be the theme on which the Fed hangs its hat. It is why two members dissented on raising rates in December, and what every dove will cite as they make the case for retaining extraordinary monetary policy. But inflation is real, it is quickening, and it is coming to a screen near you. Not only are we seeing price pressures at the factory gate as products are shipped, but we are seeing commodity prices staging a strong rally. In addition, the dollar’s weakness speaks directly to a rise in import prices, and after all, we run a very substantial trade deficit every month. The final hiding place has been in wages, but there remains a disconnect between the growth in wages (which according to the Atlanta Fed Wage Growth Tracker has been running at >3.2% for the past two years) and Average Hourly Earnings (AHE) which continues to run at a surprisingly low 2.5%. The thing is, there is no reason that Core PCE, the Fed’s designated measure of inflation, cannot rise despite the lagging of AHE. In fact, I expect that is exactly what we will see as 2018 progresses. Add to this the prospect for a further boost to US economic growth from the initial impacts of the tax changes and you have a recipe for higher inflation. This will force the Fed’s hand going forward. After all, if Chairman Powell is true to his word, higher inflation will guide the Fed toward higher rates. And that is not something the current market valuations have priced in. Rather I would argue what current valuations have prices in is permanent low interest rates and inflation, a highly unlikely outcome!
On to the dollar, which continues its recent performance and has fallen somewhat further this morning. Versus its G10 brethren, the dollar is down against all but the yen, which is basically flat on the session. Despite a strong performance by the US economy, it appears that traders continue to bet on an even stronger performance by other nations’ economies. Even the UK has shown resilience in the face of Brexit related uncertainty and has rallied further this morning. Last year the dollar remained under pressure all year as the narrative evolved toward the Fed slowing its pace of tightening while other nations started to increase theirs. I have seen nothing to indicate the Fed is going to slow down, and in fact, expect it is far more likely that they raise rates at least four times this year, more than they themselves penciled in back in December, and far more than futures markets currently have assessed. It is that change which will drive a change in dollar sentiment during 2018.
The story in emerging markets overnight was the same, with the dollar falling against virtually all its counterparts, led by TRY’s 0.7% gain followed closely by ZAR’s 0.6%. The latter is easy to understand as commodities, notably precious metals, have been rallying, while the former saw a response to a report by the central bank that the inflation story there was improving slightly. Remember, Turkish interest rates remain amongst the highest in the world. Elsewhere in this space, the story was similar if less dramatic, with currency strength a function of the dollar’s overall weakness rather than any specific stories per se.
This morning’s data brings the following: ADP Employment (exp 190K) and Initial Claims (242K), with the former having potential for instigating a move. Any reading that could imply further labor market tightening should impact US yields and by extension the dollar. However, I would argue that a weak number would not likely have a large negative impact given the market’s underlying premise is already that inflation will remain low forever! At any rate, the reality is that tomorrow’s data is far more important, so it is hard to get overlay excited this morning. The St Louis Fed’s Bullard speaks this afternoon, but I would be surprised if he starts to change the message, especially with the imminent arrival of a new Fed chair so soon. Adding it all up leads me to believe that the dollar is unlikely to fall much further instead staying quite near current levels. Tomorrow, however, could be a different story.