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