Hawks’ Dreams

Apparently Powell and friends
Have confidence in recent trends
Four hikes, it now seems
Can fulfill hawks’ dreams
More turmoil this now portends

The other thing causing concern
Is not difficult to discern
The Middle East threat
Has markets upset
And could presage the next downturn

There is no shortage of new information to keep markets on their toes recently as yesterday clearly showed. The CPI data released showed that, as expected, the Y/Y data increased by 2.4% on the headline and 2.1% on a core basis. These in-line prints were seen as generally benign, or at least expected, and the initial market impact was limited. However, as my friend, Mike Ashton, (@inflation_guy on Twitter) has pointed out repeatedly, the inflation data going forward is going to climb based on the arithmetic of the calculation. Core CPI could well be 2.5% by June, and even though it is expected, and was mentioned in the FOMC Minutes, it is still going to be an optical problem for the Fed as it might appear that they are falling behind the curve.

Speaking of the FOMC Minutes, the spin was somewhat hawkish, as they expressed a growing confidence in the economy and the probability that inflation would reach their 2.0% target soon. (As an aside, there is an outside chance Core PCE could print 2.0% at the end of the month, which is even sooner than they expect. But almost certainly it will do so in May.) In fact, apparently there was a great deal of discussion as to whether they should let the economy run ‘hot’ and thus allow inflation to rise beyond their target without acting more aggressively. The idea is that this would draw even more people into the labor market from the sidelines.

However, I would remind you all that inflation is not something that they can steer like a car, rather it is something that responds uncertainly with a significant time lag to their actions. This could be a huge risk as, especially if the Middle East situation starts to get hotter, the potential for a price spike in oil grows commensurately. And while the Fed would likely look through the transitory nature of the initial spike, higher energy costs seep into basic operations and tend to remain there. As an example, my trash collection bill continues to show a fuel surcharge, which was first implemented in 2014 when oil prices were above $100/bbl. My experience is that once companies get to raise prices, they are loathe to reduce them again! The point is that given the inexact science of monetary policy, choosing to run hot could result in bigger problems and market impacts.

Which brings us to the third, and ongoing, market concern, the escalating war of words involving Syria’s alleged use of chemical weapons last week. The US has threatened to respond, being egged on by the Europeans and those in the Middle East who would like to see Syrian President Assad removed. However, Russia and Iran are clearly poised for further response. And this is where things get tricky as both of those nations are key oil producers. This is why oil prices are trading at their highest levels since late 2014, in the midst of the oil price collapse, and it is why equity markets have been having difficulty of late. The early stages of a war tend to be pretty bad for markets.

With all this noise, how should we interpret things for the FX markets? Well the first thing I would highlight is that the trade issue, which had been THE story for the past several weeks, is getting almost no press today. It just goes to show how fickle markets are. But do not forget the issue because I am convinced it will come back in play again soon. Interestingly, China suddenly opened their market for foreign companies to take part in payment processing, something which they alleged they would do more than a year ago, but this is only a small piece of the US’s demands regarding access to the Chinese market. And while this is a good sign, I don’t think it will satisfy the president. In the end, I look for more concessions from both sides, and no actual trade war, but there will be plenty of inflammatory rhetoric on the way, all of which can impact the dollar.

But FX has been the least interesting market around despite the news. Yes, the dollar has edged lower this week, but while technically correct, it seems a bit disingenuous to call a four-day move of about 1% a significant decline. As I have pointed out repeatedly, while the dollar did, in fact, fall about 9% last year, and another 2% in Q1, all that has done is take it back to the center of its long term trading range. The dollar is neither strong nor weak at this time, at least not on a broad basis.

However, there are some currencies that have seen real movement. The biggest mover of late has been RUB, which fell more than 8% at the beginning of the week on the back of the US sanctions against several large Russian companies. However, this morning it has stopped falling, actually rebounding 1% as oil prices continue to climb. The other key EMG story has been HKD, which last night traded to the weak edge of its trading band at 7.8500, for the first time since 2005. This is largely being driven by the fact that the HKMA has not kept local interest rates in line with rising US rates, and so HKD has become a favored funding vehicle. However, there is no indication that the HKMA will allow further weakness nor adjust the band, rather they will intervene as necessary to maintain its integrity. And they have plenty of firepower with which to do it, so while interesting, it is unlikely to have a big impact.

As to the G10, SEK is today’s biggest loser, falling more than 1.1% after Swedish CPI printed at a lower than expected 1.9% in March, forcing investors to reconsider the idea that the Riksbank would be raising rates any time soon. But while that is the largest move, the dollar is generally higher vs. the entire bloc; with the euro giving back 0.25% of its recent gains and the yen 0.3%. But in the end, the FX markets remain generally calm, with only a limited response to all the ongoing stories. I’m not sure what it will take to change this, but until we see the euro trading outside its recent 1.21-1.25 range, it will be tough to get excited.

Data this morning includes Initial Claims (exp 230K) and Import and Export Prices (exp 0.2% and 0.3% respectively). Considering the ongoing inflation theme, it is good to remember that the Y/Y numbers for this series are now 3.5% and 3.3% respectively, so the idea that the US is importing inflation has some validity. In the end, I would argue that inflation remains the key long-term story, one that has the Fed’s focus and one that is going to continue to drive the discussion. All the other stuff will come and go, and while it can have short-term impacts, is not part of the big picture. So higher inflation leading to higher US rates and the dollar’s rebound remain my baseline scenario.

Good luck