Nations Regress

When two weeks ago I last wrote
The narrative was to promote
A dollar decline
Which did intertwine
With hatred for Trump ere the vote

But since then the dollar’s rebounded
While experts galore are confounded
Poor Europe’s a mess
While nations regress
On Covid, where hope had been founded

I told you so?  Before my mandatory leave began, the market narrative was that the dollar was not merely falling, but “collapsing” as everything about the US was deemed negative.  The background story continued to be about US politics and how global investors were steadily exiting the US, ostensibly because of the current administration.  Adding to that was Chairman Powell’s speech at the virtual Jackson Hole symposium outlining average inflation targeting, which implied that the Fed was not going to respond to incipient inflation by raising rates until measured inflation was significantly higher and remained there sufficiently long to offset the past decade’s period of undershooting inflation.  In other words, if (when) inflation rises, US interest rates will remain pegged to the floor, thus offering no support for the dollar.  While there were a few voices in the wilderness arguing the point, this outcome seemed assured.

And the dollar did decline with the euro finally breeching the 1.20 level, ever so briefly, back on September 1st.  But as I argued before leaving, there was no way the ECB was going to sit by idly and watch the euro continue to rally without a policy response.  ECB Chief economist Philip Lane was the first to start verbal intervention, which was sufficient to take the wind out of the euro’s sails right after it touched 1.20.  Since then, the ECB meeting last week was noteworthy for not discussing the euro at all, with market participants, once again, quickly accepting that the ECB would allow the single currency to rally further.  But this weekend saw the second volley of verbal intervention, this time by Madame Lagarde, VP Guindos, Ollie Rehn and Mr Lane, yet again.  Expect this pattern to be repeated regularly, every euro rally will be met with more verbal intervention.

Of course, over time, verbal intervention will not be enough to do the job, which implies that at some point in the future, we will see a more intensive effort by the ECB to help pump up inflation.  In order of appearance look for a significant increase in QE via the PEPP program, stronger forward guidance regarding the timing of any incipient rate hikes (never!), a further cut to interest rates and finally, actual intervention.  In the end, there is absolutely no way that the ECB is going to allow the euro to rally very much further than it already has.  After all, CPI in the Eurozone is sitting at -0.2% (core +0.4%), so far below target that they must do more.  And a stronger euro is not going to help the cause.

Speaking of inflation, I think it is worth mentioning the US situation, where for the second straight month, CPI data was much higher than expected.  While many analysts are convinced that the Fed’s rampant asset purchases and expansion of the money supply are unlikely to drive inflation going forward, I beg to differ.  The lesson we learned from the GFC and the Fed’s first gargantuan expansion of money supply and their balance sheet was that if all that money sits in excess reserves on commercial bank balance sheets, velocity of money declines and inflation is absent.  This time, however, the new funds are not simply sitting on the banks’ collective balance sheets but are rather being spent by the recipients of Federal government largesse.  This is driving velocity higher, and with it, inflation.  Now, whatever one may think of Chairman Powell and his Fed brethren, they are not stupid.  The Jackson Hole speech, I believe, served two purposes.  First, it was to help investors understand the Fed’s reaction function going forward, i.e. higher inflation does not mean higher interest rates.  But second, and something that has seen a lot less press, is that the Fed has just moved the goalposts ahead of what they see as a rising tide of inflation.  Now, if (when) inflation runs hot over the next 12-24 months, the Fed will have already explained that they do not need to respond as the average inflation rate has not yet achieved 2.0%.  It is this outcome that will eventually undermine the dollar’s value, higher inflation with no monetary response, but we are still many months away from that outcome.

Turning to today’s activity, after two weeks of broad dollar strength, as well as some equity market pyrotechnics, we are seeing a bit of a dollar sell-off today.  It would be hard to characterize the markets as risk-on given the fact that European bourses are essentially flat on the day (DAX -0.1%, CAC +0.1%) while Asian equity markets showed only modest strength at best (Nikkei, Hang Seng and Shanghai all +0.6%).  Yes, US futures are pointing higher by 1.0%, but that seems more to do with the two large M&A deals announced than anything else.

In the meantime, bond markets have shown no indication of risk being on, with 10-year Treasury yields essentially unchanged since Friday at 0.67%, and effectively unchanged since I last wrote on August 28!  The same is largely true across European government bond markets, with, if anything, a bias for risk-off as most of those have seen yields slide one to two basis points.

And finally, the dollar’s specifics show GBP (+0.6%) to be the top G10 performer, which given its recent performance, down more than 4% since I last wrote, seems to be a bit of a breather rather than anything positive per se.  In the UK, today sees the beginning of the Parliamentary debate regarding PM Johnson’s proposed rewrite of aspects of Brexit legislation, which many think, if passed, will insure a hard Brexit.  As to the rest of the bloc, gains are mostly in the 0.25% range, with the most common theme the uptick in economists’ collective forecasts for economic prospects compared with last month.

Interestingly, in the EMG bloc, movement is less pronounced, with MXN (+0.4%) the biggest gainer, while RUB (-0.4%) is the laggard.  Clearly, as both are oil related, oil is not the driver.  However, when EMG currencies move less than 0.5%, it is hard to get too excited overall.

On the data front this week, the big story is, of course, the FOMC meeting on Wednesday, but we have a bunch of things to absorb.

Tuesday Empire Manufacturing 6.0
IP 1.0%
Capacity Utilization 71.4%
Wednesday Retail Sales 1.0%
-ex autos 1.0%
Business Inventories 0.2%
FOMC Rate Decision 0.00%-0.25%
Thursday Initial Claims 850K
Continuing Claims 13.0M
Housing Starts 1480K
Building Permits 1520K
Friday Leading Indicators 1.3%
Michigan Sentiment 75.0

Source: Bloomberg

What we have seen lately is the lagging indicators showing that the bounce after the reopening of the economy was stronger than expected, but there is growing concern that it may not be sustainable.  At the same time, the only thing interesting about the FOMC meeting will be the new forecasts as well as the dot plot.  After all, Jay just told us what they are going to do for the foreseeable future (nothing) two weeks ago.

Good luck and stay safe