Economists shouting like Stentor*
Have put inflation front and center
Investors are edgy
And seeking a hedge-y
For new trades they’re now scared to enter
*Stentor – A mythic Greek herald whose voice was “as powerful as fifty voices of other men” according to Homer
You cannot read an article or listen to a commentator these days without the conversation turning toward inflation. With this in mind, let me recap the recent trajectory of that conversation. We all know that central banks have been (overly?) terrified of deflation ever since the Japanese economy was afflicted with it in the wake of their market crash back in the late 1980’s. Policy errors by the BOJ helped insure that prices couldn’t rise because they supported so many zombie-like companies and never allowed the requisite bankruptcies and losses that would have allowed the markets to clear. And don’t get me wrong; deflation can be difficult for central banks to address, certainly compared to inflation. At any rate, with the financial crisis of 2008-9, central banks, led by Benny the Beard, were hyper focused on deflation again and did all they could to prevent it from occurring. Hence, the creation of QE and ZIRP and NIRP. Of course, the problem with those policies was they didn’t directly address inflation as we know it, basically CPI, but rather served to inflate asset prices dramatically. This is how we had come to see both stock and bond markets at their most overvalued levels in history. And despite the impact those policies had on markets, central banks have all been singing from the same hymnal and doing everything they can think of to raise inflation. We have heard it from Yellen, Draghi, Kuroda, Carney, Poloz and every other central banker on the planet. Taken together, the lack of measured price inflation (and especially wage inflation) and the ongoing desires of central bankers to see it come about have been the keys to keeping monetary policy ultra accommodative.
Which brings us to the past few weeks. A look at price data more recently shows that there are finally signs that inflation is seeping into the economy. Clearly, the Fed has already begun to tighten policy, as has the BOE and BOC. The market narrative continues to expect the ECB to move in that direction and even though the BOJ denies any possibility of change soon, the market narrative has them starting to remove accommodation as well in the near future. But the market had been sanguine over the pace of this change, pricing a far flatter trajectory of rate rises than even the central banks themselves have been highlighting. So with this as a backgound (the shortest 30-year history you will ever read), we get to the US employment report a week and a half ago, where the Average Hourly Earnings data surprised sharply to the upside and printed at 2.9%. Suddenly, investors and traders figured out that perhaps things on the inflation front were moving more rapidly than they had been led to believe, and that the central banks would need to become more aggressive to fight inflation. With global growth synchronized and moving up, all the pieces were suddenly in place to allow central banks to roll back their extraordinary policies, and to do so more quickly than previously expected. You all know what happened to asset markets since then, and now the question is whether or not this was just a hiccup and long-overdue modest correction, or the beginning of something new, namely an unwinding of risk.
There are myriad arguments on both sides with the bulls pointing to the still strong economic growth and earnings data while the bears highlight the change in monetary policy as being sufficient to overwhelm that data. We shall see. But there is no question that the next chapter to the story will be Wednesday’s CPI print here. While the Fed targets PCE, which will be released at the end of the month, CPI remains the market perception of what inflation is all about. And so virtually every market commentary article, and this is no exception, has been focused on how that number will impact market sentiment, and by extension markets. It is a very simple equation, with a strong print, above 0.3% (1.9% Y/Y) having immediate negative consequences for both equities and bonds, and a weak number allowing the ‘buy the dip’ crowd to get back to business. Tomorrow should be fun.
But in the meantime, today is still ahead of us, and so we must look at what has been ongoing in FX markets so far. Broadly, the dollar is weak, significantly so against some currencies, as it appears market participants are ramping up their bets that the rest of the world will tighten faster than the Fed. Of course, if this is the case, you would expect equity markets to fall as well, and lo and behold, that has been the overnight price action, with APAC markets lower, EMEA markets lower and US futures pointing in the same direction. The most noteworthy data overnight was from the UK, where core CPI surprised on the high side (see a pattern here?) at 2.7%. This has served to encourage the rate hike story in the UK, with May now seen as a virtual certainty, and helped underpin the pound, which has rallied 0.5%. But the dollar’s decline is not really data based, I would argue, rather it is a sentimental move. Take a look at the yen, which despite no data or comments whatsoever, has rallied more than 1.0% overnight. This is more in line with a derisking rather than a rate story. As to the rest of the G10, the movement has been somewhat less aggressive than that of the pound, with modest strength in the 0.2% area the norm.
In the emerging markets, while the dollar is generally softer, the movement has also not been that significant. There is, however, one surprising outcome and that is the South African rand. A vote was taken by the ruling ANC party to remove President Zuma, something that the market has been clearly very keen to see, and something they have priced in as can be seen from the rand’s now 17% rally since mid-November. And the rand is firmer today by another 0.25%. BUT, President Zuma ignored the vote and did not step down! In fact, from what I have read he appears to be digging in his heels even deeper. I am no expert on the politics of South Africa, but one thing is certain, and that is that if Zuma somehow manages to remain in office for much longer, the rand is going to start to give up some of these gains. Markets and investors have already priced in a President Ramaphosa and are quite bullish on the idea. If that fails to come about, watch out!
But those are the only interesting currency stories of the day. Today’s only data point is the NFIB Small Business Optimism Index, which was just released at a slightly better than expected 106.9. This is a historically high level, and one that has indicated peak optimism in the past. We also here from Cleveland Fed President Mester this morning, but unless she is suddenly dovish, which I sincerely doubt, it will be difficult for her to change many opinions I think. So today will be another one where we follow the equity markets as we await tomorrow’s CPI data. If equity markets resume last week’s decline, I expect that the dollar will find support and likely rebound a bit. However, if the bulls regain the upper hand, then the dollar should suffer as well.