Positive Signs

The world is a funny old place
Where confidence in growth’s fast pace
Is what undermines
The positive signs
In stocks and bonds, causing retrace (ment)

My personal outlook for the economy has strengthened since December. We’ve seen continuing strength in the labor market. We’ve seen some data that will, in my case, add some confidence to my view that inflation is moving up to target. We’ve also seen continued strength around the globe, and we’ve seen fiscal policy become more stimulative.” So said Jerome Powell to the House Financial Services Committee yesterday morning when answering a question specifically about the number of rate hikes the Fed may implement this year. And the market response was immediate, with both stock and bond prices falling sharply while the dollar rose on this ‘hawkish’ reply.

One cannot be surprised at this market reaction. We have spent the past several years in the ‘Goldilocks’ economy, where growth has been solid but inflation absent thus allowing the Fed, and truly most central banks around the world, to leave excessive monetary accommodation in the system. The result has been remarkably low interest rates for an economy growing reasonably well, and a boon to both equity and fixed income markets. But all good things must come to an end, and with the uber-dove Janet Yellen no longer occupying the Chairmanship, it was inevitable that this would occur.

My take on Chairman Powell’s testimony is that he is not likely to attempt to obfuscate his views in the manner of the more recent Fed Chairs. I believe he knowingly personalized his testimony, discussing his own views rather than the committees, and that his more forthright manner is likely to be welcomed by investors over time. But my view is likely a minority one. The evolution of policy under both Bernanke and Yellen had been such that they appeared overly sensitive to market movements. In other words, if either of them said something that upset the market’s ‘demand’ for continuing Fed largesse and resulted in a sharp decline in the stock market especially, Fed speakers were on the tape within hours to walk back the comments. I foresee much less of this behavior going forward. Instead, my sense is that markets will simply have to evaluate the data and adjust accordingly. Personally I see this as a healthy and long overdue change to policymaking. It is likely to increase the volatility in markets somewhat, especially since Powell is alone in this attitude. After all, the other main central banks continue under their previous leadership, so it is unlikely that either Signor Draghi or Kuroda-san are about to change their style. In the end, this is merely one more reason that I like the dollar to rebound as the year progresses.

But let’s look at the things impacting the dollar today. The buck is broadly stronger (EUR -0.1%, GBP -0.7%, JPY +0.3%) after not only the perceived hawkishness from Mr. Powell, but also from a swath of weaker than expected economic data from around the world. Chinese PMI data printed at its weakest level in nearly two years at 50.3. While there was no doubt that the Lunar New Year celebration had some impact, the underlying indices showed very consistent weakness. We also saw weakness in Japanese Construction Orders and Housing Starts to close out the Asia session.

European data then followed this trend with weaker than expected Finnish GDP (0.7%); German GfK Confidence (10.8); French inflation (1.4%); and Italian Inflation (0.7%); and that was after a weaker than expected German Inflation print yesterday (1.2%). The continuing lackluster inflation data remains Draghi’s driving impetus in his efforts to prevent the market from assuming the end of QE. So when the ECB meets at the end of next week, the latest set of data will show still limited progress on inflation, especially in the big three economies of Germany, France and Italy, and will allow the doves to continue to control the message. As I have consistently maintained, the market continues to underestimate coming Fed aggressiveness (although that is changing after Powell yesterday) and overestimate the probability that the ECB is going to tighten policy soon. Eurozone data from yesterday and today simply highlight my case and this is the crux of my argument that the dollar will rebound.

This morning brings a reprieve on the Powell front, with the Chair waiting until tomorrow to address the Senate. However, we get the second reading of Q4 GDP, originally showing growth of 2.6%, but forecast to decline to 2.5%. That adjustment appears to reflect expectations that Real Consumer Spending in Q4 was actually a touch lower at 3.7% (originally released at 3.8%). We also see Chicago PMI (exp 65.0), which would be a modest decline from last month, but still at nearly the highest levels since the late 80’s. In other words, it seems unlikely that the Chairman’s bullish view on the US economy is going to be called into question today. Ultimately, I continue to see the trajectory of US interest rates higher at a faster pace than elsewhere in the world, and I continue to see the dollar benefitting. Hedgers, keep that in mind.

Good luck

What He’ll Say

There is an old banker named Jay
Who’ll speak before Congress today
Most analysts doubt
New views he will spout
But all want to hear what he’ll say

Some days, there is just not much to discuss, and today is one of those days. Ahead of Chairman Powell’s testimony this morning, markets have been extremely quiet around the world. The one consistency has been that equity markets have seen a minor bout of profit-taking after their recent recovery rally, but trading volumes appear to be light across the board. As to the dollar, it is virtually unchanged this morning from yesterday’s closing levels, and in truth, has not shown much movement for the past week.

As such, a look at Powell’s testimony and how it may impact the FX and other markets seems to be in order. The biggest unknown is likely to be the style with which he addresses the House Financial Services Committee. Markets have grown accustomed to the combination of obfuscation and circumspection that has defined Fed testimony for the past thirty years (since Alan Greenspan was first appointed). In fact, the only time that a Fed Chair actually broke new ground in one of these events was in 2013, when Ben Bernanke hinted that QE would not last in perpetuity and that the Fed was considering when to stop buying more bonds. Of course the result of that was the Taper Tantrum, a virtual collapse in the price of bonds, and a sharp correction in the price of stocks. And that was the last time a serious discussion of policy was held. But Mr. Powell is not a PhD economist; rather he is a former investment banker and businessman who in his few public appearances thus far, including his confirmation hearings seems to speak a bit more plainly. While I applaud that in any person, there is no question that it opens the door for a bit more volatility in markets. Remember, too, that despite her best efforts, Chair Yellen made a few inadvertent comments in her first two appearances that had market impacts and were subsequently walked back by other Fed members.

So what can he say? It seems likely that in his prepared remarks he will need to discuss the improvement in the economy since the Fed last met in January. It is also likely that he will touch on the increased market volatility we have experienced since then, but I would be surprised if he says anything other than this is normal and of no concern to the FOMC. In other words, my sense is he will try to remove the Fed put from the dialog. He will almost certainly mention the new budget and its added fiscal stimulus in an effort to highlight the potential risks of inflation rising faster than currently anticipated. And I’m sure he will conclude by saying the economy is in great shape and that the Fed is doing a wonderful job meeting its mandates of full employment and stable prices.

Will he touch on the timing of specific policies? Almost certainly not. What about the number of rate hikes the Fed is likely to impose this year? That is a possibility in the context of the discussion about the improvement in the overall economy. I doubt he will even mention the reduction of the balance sheet as that is something the Fed is very keen to keep in the background.

Remember, too, that he will be asked a series of questions by the committee members, almost none of which will be of substance, but a few of which could be tricky. It is in this section of the event that there is the greatest chance for a market surprise. As we saw with both Yellen and Bernanke, sometimes they are ‘too’ honest in their answers and get away from the broad storyline they are trying to maintain.

The thing is, it seems that there are very few things likely to come from the testimony that lean dovish. Given the constant improvements in the economy, there is a growing sense from many members (Bullard and Kashkari excepted) that the Fed may be falling behind the curve in their efforts to moderate building inflationary pressures. If that attitude is displayed, then we could well see a more clearly hawkish result. In that event, look for the dollar to benefit, and both bonds and stocks to fall. But my sense is that Powell will do whatever he can to sound as neutral as possible. In the end, one can be certain that he will discuss data dependence regarding Fed actions. And so as we look ahead to the data tomorrow and Thursday, any further indication that inflation is rising faster than previously forecast ought to result in further pressure on equities and bonds and further strength in the dollar. But we will need to see that data to respond.

As to today’s data, Durable Goods (exp -2.0%, +0.4% ex transport) and Case Shiller Housing Prices (6.3%) are on the docket, but will likely not see much response given the Powell testimony. The market response today will be entirely dependent on what he says, and until then, there is likely to be little price action at all.

Good luck

Much More To See

This week there’ll be much more to see
It starts with Jay’s testimony
Then data galore
Will tell us much more
From ISM to PCE

Today I’m going to start with a brief history of what has been the most important monthly data release during the past thirty-nine years. These are not hard and fast dates, merely approximations.

1979 – 1984: M2 Money supply was the key data point (it is actually released weekly) based on the fact that Fed Chair Paul Volcker was a pretty strict monetarist. This was before press conferences and the Fed never announced rates, they simply acted in the money markets to drive the Fed funds rate to their desired level. Remember, too, that this period was one where inflation was significantly higher and the Fed’s goal was to bring it down to a more reasonable level. However, there was no specific target like today.

1984 – 1988: The Trade Balance became the key data as the deficit grew significantly while the dollar approached record highs during this period. Volcker’s willingness to run tight monetary policy while the US was in the midst of expansive fiscal policy underpinned the dollar, and made US goods quite expensive globally. Remember, too that despite the equity market crash in 1987, the economy did not enter a recession.

1988 – 2017: For the past twenty years, the payroll report has clearly become the critical monthly release, starting with Alan Greenspan and running on through to Chair Yellen. This was during the ‘Great Moderation’ when central bankers thought that they had figured out how to defeat the business cycle. The employment data was seen as the key marker of economic activity, especially as the bulk of this time was before the Fed set a specific inflation target in 2012. For the period here before the financial crisis, the Fed was still far more concerned about inflation running too hot rather that too low, although the financial crisis certainly changed viewpoints there.

2017 – ?: At this point, I would argue that Core PCE has become the critical data point. While the argument over whether CPI or PCE is the better measure of inflation has been ongoing for a long time, the market reality is that PCE is what the Fed plugs into its models, so that is the one that should drive their decision-making function. Combined with the fact that the nation’s employment situation is now considered extremely robust, inflation is the variable that has the Fed’s attention. It is unclear how long this will remain the case, but I imagine it will be so for at least another year or two. After all, it’s not as though the Fed can change inflation’s course at the drop of a hat. So get used to the inflation story being the driver for now. And while PCE is the Fed’s preferred number, we get at least a half dozen different readings each month, any of which are likely to impact markets if they surprise, especially to the high side.

With that in mind, let’s look at what is happening in markets right now. If I had to characterize the dollar broadly I would say it is under pressure but there is very little consistency to the movement. Amid the G10 set, the pound has been the best performer after a speech from Labour leader Jeremy Corbyn highlighted his view that the UK should remain in a customs union with the EU upon Brexit. This view, which aligns with the portion of the Tory contingent that wanted to remain in the EU, may well moderate the outcome of the Brexit negotiations, and at least prevent the worst case of a ‘hard’ outcome. Combining this news with comments from BOE member Dave Ramsden who was previously considered a dove, that rates would be rising sooner than many expect, It should not be surprising that the pound has benefitted, rallying 0.5% this morning.

However, away from that news, there has been scant other commentary or data to drive things. For instance, while EUR and JPY are a bit firmer, CAD and MXN are both weaker. Commodity prices show strength in metals but not energy. Bond yields are little changed, although they have fallen from last week’s highs, and equity prices continue to march higher. In other words, there is certainly no broad theme to which markets are responding. I continue to look for tomorrow’s testimony by Chairman Powell as the first key for the week, but we do get a lot more data to ponder:

Today New Home Sales 600K
Tuesday Durable Goods -2.0%
  -ex Transport +0.4%
  Int’l Trade in Goods -$71.3B
  Wholesale Inventories 0.3%
  Case Shiller Home Prices 6.3%
  Consumer Confidence 126.0
  Powell House Testimony  
Wednesday Q4 GDP 2.5%
  Q4 Consumer Spending 3.7%
  Chicago PMI 65.0
Thursday Initial Claims 230K
  Personal Income 0.3%
  Personal Spending 0.2%
  Core PCE 0.3% (1.5% Y/Y)
  ISM Manufacturing 58.6
Friday Michigan Sentiment 99.5

Powell testifies to the Senate on Thursday as well, and we also hear from Bullard, Quarles and Dudley this week, but it beggars belief that the market will care about them with Powell so prominent. The data, however, should be critical, because we get the latest reading on Core PCE on Thursday. Given the recent inflation readings, where every one of them has been surprising to the high side, it doesn’t seem hard to believe that we see something higher here as well. My take is that the inflation story is evolving far more rapidly this time than it has in the past, and that econometric models are not coping well with the change. Don’t forget there will be a Prices Paid component to the ISM data as well, so there is plenty of opportunity for the recent price pressures to be made more evident this week. My gut tells me that we will continue to see inflation readings move higher and surprises will be in that direction.

In the end, I have a feeling that the question of whether the Fed is behind the curve is going to be asked more frequently as we go forward, maybe even at this week’s Humphrey-Hawkins testimony, and that the answer is a resounding yes. Powell’s style in this forum is a complete unknown, but he has been more forthright in his commentary style than any of the past three Fed chairs, so it is quite possible that the market gets a little shock tomorrow in the Q&A. But for today, I expect that market participants will remain quiet as they await tomorrow’s testimony.

Good luck

Driving The Bus

Inflation continues to be
The issue that most people see
As driving the bus
When they all discuss
What’s next for the economy

When you think about it, it is remarkable that inflation is now the hottest topic in economics and markets. For the past nine years, central banks collectively have been trying to raise prices around the world and while they have certainly succeeded when it comes to the prices of assets, when looking at the measured prices of goods and services, their efforts have been wanting. Not only that, but investors had seemingly dismissed the idea that inflation would ever return (except for a few outlying voices) and were basing their portfolios on that fact. But suddenly, rising inflation is the topic du jour with investors and traders trying to judge just how quickly those same central banks are going to adjust their policies. And given that virtually all market movements in the past nine years have been driven by central bank policies, this is important stuff for those with hedging requirements. In fact, right now I would contend that the dollar’s near-term future is directly based on just how those policies change.

Since the beginning of February we have learned that wage pressures in the US are increasing, CPI, PPI and Import Prices are all rising faster than expected, and that the Fed has clearly recognized the improved economic situation in the US and the rest of the world. We have also learned that the ECB is contemplating further changes in policy, but remains on the slow track. We learned that the BOE has expressed real concern over the rising inflation levels in the UK (which they attribute to the pound’s sharp decline in the wake of the Brexit vote in June 2016), and apparently are poised to tighten policy further. We have learned that the PBOC is continuing its crackdown on excess leverage in the Chinese economy, tightening policy there. And we have even begun to suspect that the BOJ, despite virtually no signs that inflation is beginning to actually rise in Japan, is getting ready to adjust policy there. In sum, these first hints of rising inflation have been sufficient to get global central banks to finally change their tune.

Of course, nine years of extraordinary monetary policy around the globe has had other consequences, notably the eye watering valuations of both equity and bond prices in many markets. And so, as policies change, it is reasonable to expect these valuations are going to change as well. So for investors, at this point in time, caveat emptor are the most important two words to remember.

But how does this impact the dollar? In a nutshell, the dollar (and in fairness every currency) will be subject to movement based on market expectations of policy changes vs. the actual changes that are made and, most importantly, the sequence of those changes around the world. And this has been my thesis for the past year or more. The market continues to under price the probability that the FOMC is going to be more aggressive, while it is over pricing the probability that the ECB is going to be more aggressive. This has been the proximate cause for the dollar’s sustained weakness even in the face of the Fed having proven it is the far more aggressive actor when it comes to tightening policy. Remember, not only are they raising rates, but they are also allowing QE to slowly diminish. Meanwhile the ECB is working overtime to explain that they are going to be moving at a glacial pace, with the idea that QE in the Eurozone would end abruptly in September getting short shrift. And I believe them.

Remember one thing about Europe, Signor Draghi is Italian, and the Italian economy is arguably the weakest in the Eurozone. With his term coming to an end next year, he almost certainly has designs to go into politics back home, and he will not want to be remembered as the central banker who prevented the Italian economy from recovering by tightening policy too quickly! I continue to believe that the ECB is going to lag in their policy tightening for at least the rest of his tenor, which is a bit more than a year. In the meantime, Chairman Powell is just getting started, and the one thing that we have consistently heard from every Fed speaker is that they are unconcerned with recent gyrations in the markets. As inflation in the US rises rapidly during the next six months (almost guaranteed to happen based simply on the math), attitudes will be forced to change, expectations of a faster pace of Fed tightening will become the norm, and the dollar will rebound. That’s my story and I’m sticking to it!

As to the overnight session, the dollar is modestly stronger, but that simply is unwinding yesterday’s net modest weakness. Yesterday’s US data was quite strong, with the Initial Claims number demonstrating a still robust labor market, and the Leading Indicators figure pointing to faster growth ahead. But we continue to see market players doubt the Fed’s stomach for tighter policy.

We have seen one outlier this morning, the British pound jumped about 0.5% after a story hit the tape a short time ago that there seemed to be a growing chance that a vote to reverse Brexit could be forthcoming. Now I don’t know if that is even possible given the arcana of the EU construction and the fact that the UK did officially invoke Article 50 to begin the withdrawal process. However, based on the fact that the pound has clearly been undermined by Brexit, the market reaction does make sense. But away from that it is hard to get too excited about any other currency movement.

There is no US data today, although we have three Fed speakers, Dudley, Mester and Williams. It would be surprising if any of them altered the current Fed message, especially with Chairman Powell set to speak to Congress next week. I would expect that he would be the one to change any views. As such, it is hard to get excited about prospects for significant movement today. Next week brings far more new information, including the latest GDP and PCE readings that will get all the attention. Today, though, look for a lackluster session.

Good luck and good weekend


So what did we learn from the Fed?
They still think three hikes lie ahead
Investors, though, traded
Like they were persuaded
That four were more likely instead

The first thing to know about the FOMC Minutes is that it is a long, boring document. After all, they are the official record of a government institution’s two-day meeting. And while it may seem that not much gets done, I assure you much get’s said! Looking at yesterday’s release, after an initial modest uptick in both equity and Treasury prices, it seems that investors and traders finally read through to the point (on page 16!) where the FOMC hinted that policy tightening could quicken. The result was a sharp reversal in stock prices, with the major indices falling nearly 2% from their intraday highs, and Treasury yields pushing up to new highs for the move. (Arguably the latter was helped along by the massive amount of paper the Treasury has been auctioning this week, yesterday in the 5-year sector with yields there reaching their highest level since 2009 at 2.658%.

I believe the key paragraph was this one:
“Almost all participants continued to anticipate that inflation would move up to the Committee’s 2 percent objective over the medium term as economic growth remained above trend and the labor market stayed strong; several commented that recent developments had increased their confidence in the outlook for further progress toward the Committee’s 2 percent inflation objective. A couple noted that a step-up in the pace of economic growth could tighten labor market conditions even more than they currently anticipated, posing risks to inflation and financial stability associated with substantially overshooting full employment. [My emphasis] However, some participants saw an appreciable risk that inflation would continue to fall short of the Committee’s objective. These participants saw little solid evidence that the strength of economic activity and the labor market was showing through to significant wage or inflation pressures. They judged that the Committee could afford to be patient in deciding whether to increase the target range for the federal funds rate in order to support further strengthening of the labor market and allow participants to assess whether incoming information on inflation showed that it was solidly on a track toward the Committee’s objective.” FOMC Minutes released 21Feb2018
It is also key to remember that it has been three weeks since they last met and that we have seen a great deal of new information in the interim, notably a payroll report showing AHE rising at 2.9%, and every price gauge printing higher than forecast. It is not hard to understand why the market turned around yesterday afternoon. In short, the idea that the Fed was already leaning toward concern over stronger economic growth leading to inflation moving back to their target and the fact that the recent data was clearly even stronger than expected has investors on alert for a somewhat more aggressive Fed for the rest of this year. Quite frankly, much has been made about the term ‘gradual’ with regard to the pace of rate hikes this year, but if the Fed raises rates once each quarter, that doesn’t seem more than a gradual pace to me.

While there are a number of other Fed speakers on the schedule for the rest of the week, I think all eyes will be turning to next Tuesday morning, when Chairman Powell makes his first appearance before Congress in semi-annual testimony. At this point, it would be surprising if his message was substantially different than what Ms Yellen had been saying, but do not discount a change in style as having an impact. Also, as this is his first meeting, it would not be surprising for the market to react to some throwaway comment he makes in response to a question. If you recall, both Yellen and Bernanke in their first meetings made seemingly innocuous comments that had larger than expected market impacts. In the end, the story remains that the US economy continues to show growth and that price pressures are increasing. I continue to look for interest rates in the US to rise across the curve, and for the dollar to benefit accordingly.

Speaking of the dollar, a look at the overnight session tells us virtually nothing. It was a mixed performance with some currencies showing strength (JPY +0.4%) while others displayed weakness (GBP -0.25%). The most obvious catalyst for movement was in the UK, where GDP growth for Q4 was revised lower to 0.4% and Business Investment in January was actually flat rather than growing the expected 0.5%. Interestingly, Governor Carney was on the tape explaining that the BOE is increasingly concerned over inflation and despite lackluster growth seems more likely to increase rates. In fact, after his comments, the market bid up the probability of a BOE move in May to 85%. And yet the pound could find no solace. As to the yen’s strength, this seems more of a chicken and egg question, given the 1% decline seen in the Nikkei overnight. So did stocks drive the yen or the other way round? Perhaps we saw a bit of a safe haven bid after equity market weakness, but that is not a widespread situation.

However, looking at the dollar over the past week, it has exhibited a solid performance, gaining 1.5% against a broad index and looks like it may have bottomed for now. While the overwhelming majority of pundits continue to look for the dollar to resume its decline, it appears to me as though they are relying on the idea that the market will respond to tighter ECB policy or BOJ policy, but ignore tighter FOMC policy. And of course, that is entirely possible. However, I find it unlikely to be the case, and rather continue to see the dollar as an undervalued asset here. Consider this, with 10-year Treasury yields at 2.95%, which is 2.9% higher than JGB’s and 2.25% higher than Bunds, it is not hard to see the attraction of owning a higher yielding asset in a currency whose central bank is continuing to provide support.

On the data front today we see Initial Claims (exp 230K) and Leading Indicators (0.6%), neither of which is likely to have an impact. We also hear from NY Fed Prez Dudley this morning and Dallas’ Kaplan this afternoon. To me, those will be far more critical to see if there are any clues to how the Fed’s thinking is evolving. Hawkishness has to be creeping into their minds given the recent data releases. Next week’s PCE data will be quite interesting, and after the Powell testimony is likely to be the most important thing we see. But for today, I have a feeling that the dollar will continue to edge higher and both equities and Treasuries will remain under pressure.

Good luck

On The Brink

This afternoon promptly at two
The Fed will release for review
Details from last meeting
(Will they soon be Tweeting?)
Where traders search for the next clue

Will these Minutes lead us to think
The FOMC’s on the brink
Of changing their pace
And now their base case
Is four rate hikes while assets shrink?

The dollar continues to hold its own this week, edging higher yet again as the euphoria surrounding the Eurozone’s economic growth was dented by slightly disappointing PMI data at the same time that US interest rates continue to creep higher. Starting with the Eurozone, Flash PMI data was released with a resounding thud. Even though the data was pretty strong (Manufacturing 58.5, Services 56.7, Composite 57.5), all three releases were a full point beneath expectations. So as we have seen numerous times, it seems that the economists may be getting slightly ahead of themselves in their forecasts for economic growth, extrapolating trends that are now flattening. Don’t get me wrong, compared to what the Eurozone was doing just one year ago, this data is great, and still points to Q1 GDP growth of 0.8%, its just that the market was pricing in even more. In the end, traders have continued their recent sales of euros with the single currency down a further 0.2% this morning.

We also saw UK data, in this case on employment, which showed that wages were improving, rising 2.5% in January, and the claimant count fell, but that the growth in employment has moderated. It is also key to remember that CPI in the UK is running at 3.0%, so real wages continue to decline there. The market remains convinced that the BOE is going to raise rates in May, but I continue to be skeptical of that outcome. Given the ongoing uncertainty regarding the Brexit situation and how it will ultimately impact the UK economy, it seems unlikely to me that the BOE will want to tighten policy and find themselves having made a mistake because of a downturn. Net, the pound, too, has fallen this morning, and is lower by a pretty healthy 0.55% as I type.

But the reality is that the talk of the markets continues to be biased toward central bank activities and their evolution. This afternoon the Fed releases the Minutes of their January meeting. If you recall, the big news from that meeting was the addition of the word ‘further’ in their description of raising rates this year. In fact, since that meeting, based on the data we have seen showing increased inflation pressures, the market has adjusted its expectations for the number of rate hikes coming. Economists are now looking for four hikes, and even the futures market has a 20% probability priced in for four hikes. Remember, it was less than a month ago when the futures market wouldn’t even price in three hikes. Interestingly, as I discussed in my thought experiment yesterday, there is even talk of a fifth hike now, or perhaps a 50bp hike rather than every move being in 25bp increments. What is clear is that the market has a bias to see hawkish commentary from these Minutes, and that implies to me that the risk is they are far more benign than currently expected. It wouldn’t surprise me if there were a knee-jerk sell-off in the dollar following the release if the Minutes are simply neutral. At the end of the day, I continue to look for measured inflation to grow more rapidly than the market, and that as it becomes clear that the inflation genie is well and truly out of the bottle, the Fed will be forced to be more aggressive and the dollar will rebound.

I would be remiss if I didn’t highlight an important Bloomberg story this morning, discussing how a large Japanese insurer, Meiji Yasuda Life, has adjusted its investment strategy to take advantage of the simultaneous rise in the yen and rise in 10-year Treasury yields, to begin to purchase Treasuries on an unhedged basis. One thing I have learned over the years is that if one Japanese insurer is executing a strategy, than all Japanese insurers are executing that strategy. To me, this implies that we are going to see short and medium term support for USDJPY as funds flow in this direction, as well as a stabilizing bid in the Treasury market, which should slow the rise in yields there. Of course, counter to that bid is the fact that the Treasury is issuing record amounts of debt and almost certainly going to drive that yield higher. At this point, nothing has changed my view that the 10-year will be yielding 4.0% by the end of the year.

In fairness, we also get another data point this morning, Existing Home Sales (exp 5.63M) although that has not typically been an FX market mover. We hear from both Philly Fed President Harker and Minneapolis Fed President Kashkari today, with the former leaning toward the hawkish side of the spectrum and the latter the most dovish of the entire committee. In fact, it will be interesting to hear what Kashkari has to say, as he has been a strong proponent of pausing the tightening process. The thing is, since we last heard him speak, we have seen significantly higher inflation readings, so the question is will he modify his views or will he simply argue that allowing inflation to run hot is the best policy. My gut tells me that he will go with the latter, but if he were to moderate his language, that would really be news and the dollar would likely benefit as interest rates rose here in response. In the end, I think tomorrow’s comments by Dudley and Bostic will be of more importance to the market, but we shall see.

And that is really all for today. As I wrote above, my sense is that the market is anticipating real hawkishness from these Minutes, so anything less is likely to see the dollar suffer and a rebound in both equity and bond markets.

Good luck

A Brave New World?

Could it be the yen’s
Recent strength is testament
To a brave new world?

While the dollar is broadly stronger this morning, the ongoing zeitgeist remains one of future dollar weakness. After last year’s standout performance by the euro, it seems traders and investors are turning their sights now to the yen. And though the yen is weaker this morning by 0.5%, it has still gained more than 5.0% YTD. The question remains what, if anything, can derail the broad based view that the dollar is set for an even steeper decline as the year progresses?

Contemplate the following thought experiment. The situation is that the last three major inflation readings (CPI, PPI and Import Prices) have been far higher than expectations, and so have the price indices in both the Philly Fed and Empire Mfg. surveys. Now consider you are a member of the FOMC and it is March 21st. You look at the following current data: Core PCE 1.8%, Unemployment Rate 4.0%, GDP +3.0%, and S&P 500 2800.

This grouping has your preferred inflation target virtually met, as well as rising rapidly; an unemployment rate below your view of NAIRU; a growth rate above potential with a negative output gap; and record high equity market prices, implying easy financial conditions. Then you consider the current policy stances that you hold; Fed Funds at 1.50%, at least 125bps below your most recent estimate of the long term Funds rate and as much as 350bps below pre-financial crisis estimates, and a balance sheet that holds some $3+ trillion of bonds that you purchased via creation of excess reserves. Do you a) raise rates 25bps and continue to talk about gradualism going forward; b) raise rates 25bps and describe a faster pace of rate hikes as the economy steams forward; or c) raise rates 50bps since you finally have to admit you are behind the curve? Remember, your current policy stance was implemented as an “emergency measure” in the wake of the financial crisis and recession that followed…NINE YEARS AGO!

Now, clearly we have no idea where any of these data points will be come the day of the FOMC meeting, but the ones I have put forth are well within bounds, and would indicate an economy that has quite possibly left Goldilocks behind and is now on an official tear. Jay Powell is still an unknown quantity, but there is every indication that he is quite aware of the potential issues with allowing the economy to run too hot and watch inflation move rapidly higher, especially given the funding requirements of the US government as it adds to its deficits. What would you do? But more importantly, what can we expect the Fed to do?

The point I am trying to make is that when you lay out the current economic conditions, it is abundantly clear that US monetary policy is far too lax for the situation. I think it is pretty clear that the Fed understands this too, or at least most members do. But the real issue is if the data start to indicate inflation is rising even faster than currently anticipated, how long will it be before the Fed reacts more aggressively. Is it really that hard to accept they may choose to raise rates 50bps at a meeting? I mean, historically, it has happened many times in the past. Could that be the meaning of the addition of the word ‘further’ into the Fed statement? Could the Fed be signaling that the pace of tightening is going to increase going forward? Right now, only the Fed knows the answer to these questions, and I doubt they are clear. But these are not impossible outcomes. And I assure you that if the Fed becomes more aggressive; the dollar will find more support.

Now back to the markets. The President’s Day holiday saw relatively quiet trading elsewhere in the world, partly because much of Asia continues to celebrate the Lunar New Year, but also because the US markets weren’t around to add to the mix. As we walk in this morning, the euro has retreated more than 1% from its peak on Friday morning (-0.5% today) with other G10 currencies showing similar magnitude movements. What I am starting to sense is that the dollar is finding a broad bottom, and I don’t expect to see it decline sharply from these levels.

Specific news in G10 saw Swedish CPI disappoint (-0.9%, exp -0.7%), which has resulted in talk of the Riksbank continuing its ultra-easy monetary policy rather than beginning to tighten it on the back of solid economic growth. We also saw German ZEW Sentiment decline, but by slightly less than anticipated. In other words, the data from Europe was mixed, if sparse. There was a great deal of ink spilled regarding the yen, but none of it was policy related. Rather, there has been a significant increase in the discussion, as mentioned above, that the yen is set to replace the euro as the long currency position of choice. In fact, there was more discussion of market technicals as the rationale than any discussion of policy adjustments. That said, there are some who expect that the BOJ will begin to change its target on managing JGB yields, with a split between those looking for a higher cap, maybe 0.20% up from today’s 0.10%, and those looking for a change to targeting 5-year JGB yields rather than the current 10-year yield target. But those are analyst views with no input from anybody actually at the BOJ, so remain speculative.

In fact, this entire week is one with limited data releases although the FOMC Minutes are released tomorrow afternoon, and we do hear from seven Fed speakers across eight speeches during the week. Here is the entire list of releases of note:

Wednesday Existing Home Sales 5.65M
  FOMC Minutes  
Thursday Initial Claims 230K
  Leading Indicators 0.6%

This is hardly the stuff to generate excitement. So all eyes will be on the Minutes tomorrow afternoon, and ears will be tuned to the plethora of Fed speakers. My personal take is that things will sound more hawkish than the market expects and that we will see the 10-year Treasury touch 3.0% for the first time in more than 3 years. This is likely to put pressure on equity prices again (currently futures are pointing lower by 0.7%) and continue to help the dollar find a bottom.

Good luck

Hellfire and Damnation

There once was a time when inflation
Was cursed like hellfire and damnation
But these days it seems
Those were but bad dreams
Now central banks seek its creation

So this week the data has shown
That clearly their efforts have sewn
The seeds they desire
As prices catch fire
Soon high prices they will disown

Remember way back on Wednesday, when markets appeared to be concerned about rising inflation as a harbinger for higher rates and increased volatility which would cause the unwinding of so many trading strategies? Yeah, that was so 48-hours ago it’s not funny. Between then and now we have seen US CPI print much higher than expected, US PPI print higher than expected and the price indices for both the Philly Fed and Empire Manufacturing gauges rise to their highest levels in six years. And what has been the market response to this uptick in price pressures? It’s not even a collective yawn, but rather an aggressive embrasure of the data. Apparently any concerns that the Fed will become more aggressive in their policy tightening have completely disappeared. And my read is not that traders are dismissing the fact that tighter policy will occur, it’s that nobody seems to care anymore. After a very rocky week last week, the equity market has recouped 75% of those losses. While Treasury yields have touched their highest point (2.942%) since January 2014, it seems that higher yields are no longer seen as a concern regarding equities. And of course, yesterday I highlighted that higher yields were no longer seen as a benefit for the dollar, so it appears that the ‘narrative’ continues to be, whatever you do, make sure that you buy stocks and sell the dollar. And that is exactly what we are seeing in markets these days and I suppose for the foreseeable future. At some point, I’m pretty sure views will adjust to the negative realities that come along higher inflation, but right now, you have to go with the flow.

I don’t think there is anything else for me to say on that subject, so let’s take a look at the FX markets a bit more closely. Broadly, the dollar remains under pressure, although the overnight session has been fairly dull. In G10 space, the biggest mover has been the pound, which fell 0.4% after much weaker than expected Retail Sales data (actual 0.1%, exp 0.5%) was released. That seems to be weighing slightly on the euro, which is down about 0.25%, but in fairness, both of them were quite strong yesterday, so this seems to be a bit of position unwinding ahead of the weekend. The one constant in the space has been JPY, which continues to strengthen, and is now barely able to hold the 106 level. Last night we learned that Kuroda-san was reappointed as Governor of the BOJ, and the two Deputy Governors appointed are also strongly in the reflationist camp, so for the time being, it doesn’t seem like the BOJ is going to move away from its aggressive QQE policy. Interestingly, economists and traders continue to believe that they will be forced to do so as the BOJ balance sheet has already grown to be the same size as the Japanese economy, (for a comparison, the Fed balance sheet remains at about 22% of the US economy’s size) and there is a growing belief they will not be able to safely expand it any further. Of course, a couple of days ago there was a growing belief that quickly rising inflation in the US was going to be an issue for markets, and we can see how that was mistaken. I have a feeling that Kuroda and company will not be changing policy anytime soon, but that it won’t matter very much. I still see the yen strengthening from here despite the BOJ’s best efforts.

Turning to the emerging markets, South Africa continues to be in the spotlight, as President Zuma finally resigned and President Ramaphosa was sworn in. The rand, which has been the best performing currency for three months, actually sold off slightly, 0.4%, in what is clearly a profit-taking exercise. I expect that if Ramaphosa lives up to half of expectations, the rand has further to climb. Elsewhere, while MXN has barely moved overnight, it is worth pointing out that the current polls for this summer’s Presidential elections point to Andres Manuel Lopez Obrador (AMLO) well in the lead. Given that he is a leftist firebrand, talking about renationalization of energy assets, it is surprising that there is not more concern in evidence about an AMLO victory. But there has been no reaction and surveys of business leaders dismiss his chances despite the polls. I certainly have no idea whether or not he will win the election, but it seems to me that there is at least a fair probability that will be the case, and my impression is the market is not prepared for that outcome. As the election draws nearer, if he retains his lead in the polls, look for the peso to feel some pain.

As we wrap up the week, we have a bit more data to absorb, but this doesn’t seem like market moving stuff. We start with Housing Starts (exp 1.232M) and Building Permits (1.3M) at 8:30 alongside the final Inflation gauges, Import and Export prices (exp 0.6% and 0.3% respectively). Finally, at 10:00 is Michigan Sentiment (95.5). Given the lack of concern shown by markets over the data earlier this week, I can’t imagine today’s data will matter very much. And so, as we head into the weekend, it appears that the trends this week will remain intact, thus look for the dollar to remain under pressure, bonds as well, and the stock market to continue rebounding from the correction last week.

Good luck and good weekend

No Nuance

No nuance is needed to show
Price pressures are starting to grow
And as an aside
Poor Goldilocks died
For shareholders, look out below!

In the wake of yesterday’s surprisingly high CPI print, on both the headline and core measures, the immediate impact was equity futures sold off sharply. This made sense given the heightened concerns that the market has been showing with regard to inflation ever since the AHE number surprised on the high side two weeks ago. So the CPI was now the second piece of important inflation data that was pointing to the Fed being forced to raise rates faster than they currently assume (3x in 2018) and much faster than the market is currently pricing (~2x in 2018). In fact, a Bloomberg survey of economists now points to the median expectation of Fed rate hikes this year having moved up to four while the Fed Funds futures market has moved up to a 25% probability of a fourth rate hike this year.

However, by yesterdays close
The market, its fear did transpose
As rates keep on rising
It’s now emphasizing
How fast the economy grows

It seems, however, that the bulls will not be denied. By the time the equity markets closed yesterday afternoon, stock prices were up ~1%, the dollar had resumed its decline and commodity prices were rising; all while Treasury prices continued to fall. There seems to be a pretty big disconnect between the way asset markets are trading and the increasing probability that global QE is going to disappear sooner than expected. My friend Mike Ashton (follow him on Twitter at @inflation_guy), who really does seem to know everything about inflation, makes the point that because of the comparisons over the next six months, Core CPI is likely to be up to 2.5% or even higher come late summer. If that is the case, and it certainly seems reasonable based on the data, ask yourself how relaxed the FOMC will be about that gradual pace of rate increases. My view is that even the doves will be forced to admit that rates need to move higher if the data begins to show the Fed is truly behind the curve. And so, I continue to look at the current broad market price action and scratch my head. A perfect example is that the correlation between the yield on 2-year Treasuries and the dollar, which historically has run above 60%, has fallen to 23%. That is emblematic of the change in views we have seen. It is also ripe for a return to historical values as more stress builds in the market. After all, equity markets that have been built on unlimited free liquidity cannot sustain the same levels when liquidity shrinks and is no longer free. Last week was, I believe, just a taste of what we will see during the rest of the year.

But for now, the market continues to whistle past that graveyard and the narrative remains, gradual rate rises will not impact the synchronous global growth story, earnings will continue to be amazing, and equity prices, alongside commodity prices, will continue to rise.

And the dollar? Boy they hate the dollar. In fairness, there is a clear negative fundamental, the growing twin deficits (budget and current account), which ought to undermine the dollar’s value. And of course, given the recent breakdown in the correlation with interest rates, there is nothing to offset that right now. With this in mind, it is no surprise that the dollar remains under pressure and has fallen further overnight. Can it continue? My view remains that the dollar will find its footing as the year progresses, but right now that is a distinct minority position.

So let’s take a look at the overnight activity in FX. As mentioned, the dollar is down across the board. In the G10 space, the biggest gainer has been the pound, up 0.5% and back over 1.40, although the Swiss franc has had almost the same magnitude movement. Interestingly, there has been no specific news in either one, or comments from officials that would seem to drive things. In fact, the only comment of note overnight was from Japanese FinMin, Taro Aso, who said that recent yen movement has not been severe enough to consider intervention. Not surprisingly, the yen is firmer by 0.3% and is actually now at its strongest vs. the dollar in more than a year.

Moving to emerging markets, we have seen strength across the board here as well, with ZAR continuing to benefit from President Zuma’s finally having resigned, and the APAC bloc virtually all stronger vs. the dollar as they head into the Lunar New Year celebrations. Local equity markets have been rebounding from last week’s sell-off and it is clear that investors are actively buying those currencies to get back into the trade. With the holiday now upon us, I expect this bloc will see limited action for the next couple of days, but both EEMEA and LATAM are likely to continue to trade with the broad narrative. I’m not sure what will change this view, but I am increasingly confident that something will do so in the near future.

On the data front today, we have a bunch of stuff as follows: Initial Claims (exp 224K); Empire Mfg (17.2); Philly Fed (21.6); PPI (0.3%, 2.5% Y/Y); Capacity Utilization (78.0%); and IP (0.2%). Given the market response to yesterday’s data, I would think the only thing that can derail the bulls would be information that the economy is fading, so much weaker Empire or Philly data, or surprisingly weak IP. Of course, that would simply encourage the bulls to point to the lack of pressure for further rate hikes.

Chairman Powell has a challenging time ahead of him as the market seems almost to be daring him to raise rates more quickly than currently assessed. I have to say that we have not heard any concerns from the Fed that the recent increase in market volatility is an issue, and so my take is the Fed will pick up the pace as the data presents itself going forward, and that volatility will continue. And in the end, increased volatility equals risk-off equals a stronger dollar. It just may take a little more time to get there.

Good luck

Might Cause Dismay

The CPI data today
Could very well show us the way
The market will move
As things here improve
So strong data might cause dismay

It is remarkable to me that the CPI print today has garnered as much press as it has. For the past three decades, this attention has pretty much been entirely reserved for the payroll report. So perhaps this is a healthy turn of events, one signaling that investors are going to look more carefully at the entire economic data set rather than a single proxy. Of course, it’s early days to be making that claim, but one can be hopeful! At any rate, most markets have basically tread water for the past two sessions in anticipation of the print.

To reiterate, expectations are as follows: CPI (0.3%, 2.0% Y/Y) and CPI ex food & energy (0.2%, 1.7% Y/Y). One thing that is important to understand is that not all 0.3% rises are the same. While the release only has one decimal place showing, the actual calculation pushes to the second decimal place, so 0.26% and 0.34% both print at 0.3%. Street economists and analysts will be closely watching the more precise figure and markets will respond to that number. And there is one other thing to remember, CPI is an annual number, so it is comparing the current price index to last year’s data. If you recall, it was last February when the cell phone companies changed their pricing for unlimited data, which drove the March inflation number much lower. So starting next month, the comparisons are going to be with those lower numbers, therefore we are almost assured of higher numbers this year beginning in March. Of course, that says nothing about today. While I don’t know where this data is going to print, what seems quite likely is that any print on the high side of 0.3%, let alone a 0.4% print, will be seen as confirmation that the FOMC is going to pick up the pace of rate hikes, and is likely to see another wave of equity market turmoil.

Oh and there is one more thing about the Fed, a story this morning that the White House is considering Loretta Mester, currently Cleveland Fed president and one of the more hawkish members of the FOMC, for the role of Fed Vice-Chair. She is a well-respected economist, and if she becomes the highest-ranking economist on the Fed, I expect that the tone from the FOMC will turn even more hawkish. That, my friends, will have an immediate impact on markets if it is announced. In the end, what we are seeing is the ongoing dismantling of the ultra easy monetary policy of the past nine years. As that progresses, expect both equity and bond markets to underperform and volatility to head back toward more historic levels, which despite the past week’s activity, are still higher than currently seen.

How will the dollar fare through all this? For the past two sessions, it has clearly been under some pressure, albeit not excessively so. One interesting conundrum has been the yen, which is stronger again this morning by 0.4%. Despite the fact that equity markets have stabilized, and there are many calls that last week’s decline was overdone, a stronger yen has historically been a sign of removing risk. So the modestly higher equity prices this week don’t really fit with a much stronger yen. Now, it’s possible that FX traders were responding to the Japanese GDP data last night, which showed Q4 growth at a slower than expected 0.5% Y/Y. The Nikkei underperformed, falling 0.4%, but in a classic chicken and egg question, I’m not sure whether the weak data and Nikkei, in the guise of risk reduction, caused the yen to strengthen, or if the strong yen caused the Nikkei to weaken. What I do know is that there are more stories that PM Abe is set to reappoint Kuroda-san as BOJ Governor, which some take as proof that the BOJ is going to maintain its hyper aggressive monetary stance. But even he has questioned just how much more QQE (Japan’s terms for QE) can help the economy there. And there is one other thing to note. Japan’s population is actually shrinking, as well as aging rapidly. So any growth at all on a gross basis implies a much better rate of per capita growth. Quite frankly, I think Japan has been doing quite well, and I continue to expect the yen to strengthen further despite my views on the Fed. Par remains my year-end target.

Pivoting to Europe shows that Q4 GDP was released at the expected (0.6%, 2.7% Y/Y) level, with Germany and Italy coming in a bit weaker than expected, while the Netherlands, France and Spain all looked a bit better. However, given the overall pace of growth, traders continue to preach the narrative that the ECB is going to exit QE faster than Signor Draghi is willing to admit. While the euro is virtually unchanged overnight, it has been edging higher during the past week. Here, I continue to put more faith in the Fed to turn the tables and drive the dollar higher. Today will be a key input in that process I think.

In the emerging markets, once again South Africa remains the place with the most noise as the ANC voted to remove President Zuma, but he has not yet vacated the post. This vote, however, has been enough to encourage further active rand buying, and it is higher by another 1% this morning. The risk here is that given the delays in this transition, the economy remains under stress and there is no budget in place. Moody’s is on the cusp of downgrading South Africa to junk rating which would trigger a significant outflow by bond investors, and correspondingly, likely have a pretty negative impact on the rand. For those with hedging needs here, it is something to keep in mind.

Elsewhere in the EMG bloc, APAC currencies have been the best performers, following the yen higher with KRW higher by 0.65%, MYR by 0.5% and both INR and TWD by 0.3%. Overall, a strong performance ahead of a key US data point. But it appears that investors are getting set to shake off last week’s market action and dive back in to risk. Again, the conundrum is the yen showing strength while other markets seem to be embracing risk. One of these processes is going to change soon, so beware.

Alongside the CPI data we also get Retail Sales this morning (exp 0.3%, 0.5% ex autos) although with the focus on CPI, it will have to be a really big outlier to matter. There are no Fed speakers and no other news on the docket. With that in mind, it will be all about that CPI print. A strong number should lead to equity market declines alongside bond market declines and the dollar rallying. A weak number should see the opposite, and if it is right in line, I expect that we are likely to see a continued tentative rebound from last week’s price action.

Good luck