The Fed must be thrilled while they’re meeting
‘Cause price rises aren’t just fleeting
Inflation is higher
As they all desire
But will it soon be overheating?

They must be dancing at the Mariner Eccles building this morning, as PCE inflation finally achieved the Fed’s target of 2.0%! Hooray!! I know I’m glad to see prices rising more rapidly for the things I buy every day, aren’t you?

But seriously, this probably represents a significant change in the mindset at the FOMC. For the past nine years they have been doing everything they could think of in order to drive inflation higher. In fact, deflation was their greatest concern for a number of years, although I would argue that threat passed shortly after the original bout of QE helped unfreeze markets in 2009. Regardless, we have seen inflation rise consistently for the past year, and now that the cell phone anomaly has passed out of the annual data, we are getting a truer reading of what prices are doing in real life. And as I’m sure you are all aware, they are rising. But potentially more important to the Fed than the fact that the price of a gallon of gas or milk is higher is the fact that wages are growing more rapidly. Friday’s ECI data highlighted that and is consistent with the ongoing wage and price sub-indices we have seen from ISM and PMI data for the past several months. The Beige Book highlighted the issue and there must be four stories in the WSJ alone today about labor shortages and the higher wages being offered. The upshot is that the Fed would have to be willfully blind to not recognize that both wages and prices are rising pretty robustly at this point.

So what will they do about it? Well, this is what the conversation is all about. The narrative that has driven markets for the past year has been focused on the idea that synchronous global growth would force the EU, UK, Japan and China to all tighten policy more aggressively than had previously been thought while at the same time the market had already priced in all the US activity. The problem for the narrative is that the data is not cooperating as evidenced most recently by this morning’s weaker than expected UK PMI data, down to 53.9 from a downwardly revised 54.7 and much worse than expected. Or by yesterday’s German CPI data, which fell to 1.4%, rather than holding at 1.5%. And these are just the latest two data points that are undermining the narrative adding to virtually everything that was released during Q1. The point is that the narrative is losing its luster, and instead, what we are beginning to see is a change in expectations. It is no longer an extreme outlying view to expect US rates to rise more than the market had been pricing, or to expect that the ECB backs away from ending QE this year. In fact, futures markets have been making those changes lately with the probability of a fourth Fed hike this year now up to 50% (personally, I think it is 100%) and the probability of the BOE raising rates next week essentially 0% with not even one full hike priced in for 2018 now.

The impact on the dollar has been dramatic, as it has rallied more than 3% in the past two weeks and all of those trading ranges having been broken toward a higher dollar. While this is no surprise to me, there are clearly many in the market that have been caught offside by the move as evidenced by the still massive short positions in the dollar that are recorded on the futures exchanges. As I wrote earlier, it is getting quite expensive to hold a short dollar position given the high and rising US rate situation compared to rates elsewhere in the world. I expect that we will continue to see position covering and the dollar will continue to rally going forward, at least for a while.

Not surprisingly, the pound is the worst performer overnight (-0.7%) as the PMI data has simply added to its recent woes. Yesterday it was a political question, this morning an economic one. Quite frankly, it is very difficult to look at the UK economy and consider that higher rates are the proper prescription to enhance growth there. The key will be the next inflation reading in three weeks’ time. If that continues the recent trend of softening, the market should completely discount any rate hikes by the BOE this year and the pound is likely to fall further. Of course next week we will hear from the BOE directly, and while they will be laying out their latest forecasts, I feel like the market will remain focused on the data.

But both the euro and the yen have been under pressure as well, as data in both places has done nothing to encourage the idea that either the ECB or the BOJ will actually be in a position to reduce accommodation soon. In both cases, there has been no consistent inflationary impulse to date and the question now starting to be asked is whether the ECB, in particular, will ever be able to end QE. I mean, if growth is heading back down to trend of around 1.0%-1.5% with QE, what does that say about prospects without QE. Meanwhile, Japan has been expanding its asset purchases for two decades with no obvious benefit. The question for both these central banks is what will they do if a recession arrives and they are already at negative interest rates? It won’t be pretty, and I’m pretty sure the dollar will be the beneficiary at that time. But that is not going to happen very soon, so no need to worry about that right now.

Pivoting to the emerging markets, the dollar is higher against virtually the entire bloc. Even Mexico, which had a blowout Q1 GDP reading of 1.1% (4.6% annualized) that was much better than expected, is softer this morning by 0.35%. Clearly the ongoing trade ructions are having a significant impact on this bloc of currencies, but so are higher US rates and broad-based USD strength. There is some irony in the fact that many of the things that the Trump administration has done (tax cuts, increased spending, regulatory reduction) have helped underpin the dollar despite a seeming desire to have a weaker currency. But for now, the dollar is king and is likely to remain so for a bit longer.

This morning’s data brings ISM Manufacturing (exp 58.6) and Construction Spending (0.5%). The FOMC meeting also begins this morning, but the statement isn’t released until tomorrow afternoon. There is no expectation for the Fed to change policy here, but I remain of the opinion that the statement could be somewhat more hawkish than benign. In fact, there is little that the Fed has seen of late that would imply dovishness is the appropriate stance. Look for the dollar to continue to benefit this week with the euro finally breaking back below 1.20 for the first time since early January.

Good luck