Quite Carefree

Inflation continues to be
The data that folks want to see
While recent releases
Have shown some increases
Investors remain quite carefree

After a period of weeks where there seemed to be something of real import in virtually every session, the overnight market has seen very little of interest across the board. At this point, it appears that most market participants are simply waiting for this morning’s CPI data to see if the Fed will continue to show increasing concern over the trajectory of prices in the US. Expectations are for a headline increase of 0.2% (2.2% Y/Y) and a core increase of 0.2% (1.9% Y/Y). Both of those annualized numbers represent an uptick from last month and are likely to be the beginning of a trend higher, at least through the early autumn. The question, as always, is how will the Fed respond to data showing rising inflation. Thus far, we have heard from both hawks and doves that “headwinds are turning into tailwinds” which is Fedspeak for expectations are growing that rates may need to rise more quickly still. At this point, it is a virtual certainty that when the FOMC meets next week they will raise the Fed Funds rate by 25bps. The key unknowns are whether they will continue their hawkish rhetoric, and whether the dot plot will reflect a more aggressive tightening cycle. At this point, I see no reason to believe they will back off from recent comments. This is especially true if this morning’s data surprises to the high side. But even a low print is unlikely to change things yet. They will need a series of low inflation prints to change their tune.

So what does this mean for markets? In the FX world, the reality is that the dollar has done very little over the past two months, trading in a range while consolidating its declines from last year. FX traders continue to try to parse the information from the ECB, where the default view remains that they will be tightening soon; from the BOJ, where the default view remains that they will be forced to reduce accommodation because it has become completely ineffective; and from the Fed, where the default view seems to be that even if they raise rates four times this year, it is still completely priced in and dovish. While I disagree with the default views, the reality is that we will need to see some very new information, likely in the way of data surprises, in order to change those views at all. At the same time, bigger picture issues like the increasing US budget deficit, the significant increase in US Treasury issuance, the prospect of a trade war and the ongoing Fed reduction in its balance sheet will only play out over a much longer timeframe.

Of these, I remain most concerned over the impact of the shrinkage of the balance sheet. In fact, there is one scenario where I could see a much weaker dollar, and that is as follows: increased supply of Treasuries to fund the deficit alongside decreased demand for Treasuries (by the only price insensitive buyer) as the Fed stops replacing maturing securities could lead to both a sharp decline in Treasury prices and a coincident decline in the dollar as investors shun the greenback amid sharply rising rates and a weak fiscal position. After a more substantial dollar decline, perhaps another 10%-15%, and with higher yields available (think 4.0% in the 10-year) to investors, I would expect to see flows return, but that still implies a sharp movement between here and there. And while that is not my base case, it is certainly a scenario that is finding adherents. Time will tell.

Looking at today’s FX movement, the dollar is modestly stronger with the yen being the biggest underperformer, falling 0.75%. Looking at the data released there overnight, it didn’t appear to be of a market-moving sort, with the Tertiary Index falling slightly more than expected and PPI there softening as well. Rather, it appears that the ongoing elementary school scandal regarding FinMin Taro Aso is the driver, as he refused to step down and has continued to receive support from both Kuroda and Abe. It seems that traders expect if he is forced out it will result in a less dovish Abe administration and even serve as a catalyst for USDJPY to head to par. I’m not sure I buy that story, but there is no question that yen sellers were out in force overnight. But in truth, away from the yen, the rest of the G10 is trading within a few basis points of yesterday’s closing prices.

Meanwhile, in the EMG markets there has been a bit more currency weakness as concerns grow over the significant size of outstanding USD debt held by EMG companies and countries. With US rates continuing to rise, repayment risk remains a serious concern, and it should be no surprise that this bloc is feeling a little pressure. But all told, the dollar’s overall rally has only been about 0.15%, hardly enough to really change things.

Aside from the CPI data, the only other release has been the NFIB Small Business Optimism Index which printed at a better than expected 107.6, demonstrating that there is still a great deal of confidence in the economy. Equity markets, which had a mixed session in the US yesterday, are edging higher ahead of CPI, but the movement is quite limited. Treasury yields continue to hover either side of 2.90% as the market looks forward to the new 30-year Treasury Bond after a good performance yesterday in both the 3-year and 10-year auctions. So fears over indigestion of too much supply are not yet rampant. And that’s really it for the day. If pressed, I continue to expect inflation data to print slightly higher rather than lower, but that will need to happen for several more months in a row before the Fed starts to get nervous. All told, I expect that the dollar will be able to maintain its modest overnight gains, but see no reason for significant movement until the FOMC next week.

Good luck


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