Whom He Must Obey

The question is, what can he say?
You know, course, I’m talkin’ ‘bout Jay
Can he still, more, ease?
In order to please
The markets whom he must obey

Fed day has arrived, and all eyes are on the virtual Marriner Eccles Building in Washington, where the FOMC used to meet, prior to the current pandemic.  In the wake of Chairman Powell’s speech at the end of August, during the virtual Jackson Hole symposium, where he outlined the new Fed framework; analysts, economists and market participants have been trying to guess when there will be more details forthcoming regarding how the Fed plans to achieve their new goals.  Recall, stable prices have been redefined as ‘an average inflation rate of 2.0% over time’.  However, Powell gave no indication as to what timeline was considered, whether it was fixed or variable, and how wide a dispersion around their target they are willing to countenance.  So generally, we don’t know anything about this policy tweak other than the fact that, by definition, inflation above 2.0% will not be considered a sufficient reason to tighten monetary policy.  There are as many theories of what they are going to do as there are analysts propagating them, which is why this meeting is seen as so important.

As it is a quarterly meeting, we will also see new Fed economic forecasts and the dot plot will be extended to include the FOMC membership’s views of rates through 2023.  As to the latter, the working assumption is that virtually the entire committee expects rates to remain at current levels throughout the period.  Reinforcing this view is the futures market, where Fed Funds futures are essentially flat at current levels through the last listed contract in August 2023.  Eurodollar futures show the first full rise in rates priced for June 2024.  In other words, market participants are not looking for any policy tightening anytime soon.

Which begs the question, exactly what can Jay say that could be considered dovish at this point?  Certainly, he could explain that they are going to increase QE, but that is already defined as whatever is deemed necessary to smooth the functioning of markets.  Perhaps if he defines it as more than that, meaning it is supposed to help support economic activity, that would be interpreted as more dovish.  But isn’t infinite QE already as much as they can do?

It seems highly unlikely that the committee will give a fixed date as to when policy may eventually tighten.  But it is possible, though I think highly unlikely as well, that they define what level of inflation may require a change in policy.  The problem with that theory is there are too many potential paths down which inflation can wander.  For instance, if core PCE increased to 2.5% (a BIG if) and remained stable there for six months, would that be enough to force an adjustment to policy?  Would one year be the right amount?  Five years?  After all, core PCE has averaged 1.6% for the past ten years.  For the past twenty, the average has been 1.72%.  In fact, you have to go back over the past 32 years in order to calculate the average core PCE at 2.0%.  And of course, this is the problem with the Fed’s new framework, it doesn’t really tell us much about the future of policy other than, it is going to be ultra-easy for a long, long time.

It is with this in mind that the market has embraced the idea that the dollar must naturally fall as a consequence.  And that is a fair point.  If the Fed continues to out-ease all other central banks, then the dollar is quite likely to continue to soften.  But as we have seen already from numerous ECB speakers, and are likely to see from the BOE tomorrow, the Fed is not acting in a vacuum.  FX continues to be a relative game, as the differential in policies between currencies is the driving factor.  And while Madame Lagarde did say she was not concerned about the euro’s strength, you may recall that she also indicated, once upon a time, that it was not the ECB’s job to worry about Italian government bond yields.  That was her position for at least a day before the ECB figured out that was their entire job and created the PEPP.  My point is, if Jay comes across as more dovish somehow, you can be certain that every other central bank will double down on their own policy ease.  No country wants to be the one with the strong currency these days.

But for now, the market is still of the opinion that the Fed is out in the lead, and so the dollar continues to drift lower.  This morning, we see the dollar weaker against the entire G10 bloc with NOK (+0.6%) the leader on the back of oil’s 2.5% rally, although GBP (+0.5%) is also firmer after UK inflation data showed smaller declines than forecast, perhaps alleviating some of the pressure on the BOE to ease further.  At least that’s the thought right now.  But even the euro, after ultimately slipping yesterday, has rallied a modest 0.15% although it remains below 1.19 as I type.

Emerging market currencies are behaving in a similar manner, as the entire bloc is firmer vs. the greenback.  Once again ZAR (+0.95%) leads the pack on the combination of firmer commodity prices (gold +0.5%), the highest real yields around and faith that the Fed will continue to ease further.  But we are seeing MXN (+0.5%) gaining on oil’s rally and CNY (+0.35%) following up yesterday’s gains with a further boost as expectations grow that China’s economy is truly going to be back to pre-Covid levels before the end of the year.  Overall, it is a day of dollar weakness.

Other markets have shown less exuberance as Asian equity markets were essentially flat (Nikkei +0.1%, Hang Seng 0.0%, Shanghai -0.3%) and European bourses are also either side of flat (DAX -0.1%, CAC +0.1%, FTSE 100 -0.1%).  US futures, naturally, continue to rally, with all three indices looking at gains of 0.4%-0.6% at this time.

Government bond markets remain dull, with another large US auction easily absorbed yesterday and 10-year yields less than a basis point different than yesterday’s levels.  In Europe, actually, most bond yields have edged a bit lower, but only one to two basis points’ worth, so hardly a sign of panic.

As to the data story, yesterday saw a much better than forecast Empire Manufacturing number (+17.0) boding well for the recovery.  This morning brings Retail Sales (exp 1.0% headline, 1.0% ex autos) at 8:30, and then the long wait until the FOMC statement is released at 2:00pm.  Chairman Powell will hold his press conference at 2:30, and if he manages to sound dovish, perhaps we see further dollar declines and equity rallies.  But I sense the opportunity for some disappointment and perhaps a short-term reversal if he doesn’t invent a new dovish theme.  In that case, look for the dollar to recoup today’s losses at least.

Good luck and stay safe
Adf

Fear Has Diminished

From Asia, last night, what we learned
Was China, the corner, has turned
The lockdowns are finished
And fear has diminished
Thus spending, in spades, has returned

The major news overnight comes from China, where the monthly release of data on IP, investment and Retail Sales showed that the Chinese economy is clearly regaining strength.  Arguably, the most noteworthy number was Retail Sales, which while still lower by -8.6% YTD, has rebounded to be 0.5% higher than August of last year.  Anecdotally, movie theaters there have seen attendance return to ~90% of pre-Covid levels, obviously far above anything seen here or in most of Europe.  In addition to the Retail Sales data, IP there rose 5.6% Y/Y and Property Investment rose a greater than forecast 4.6% on a YTD basis.  Overall, while these numbers are still well below the data China had been reporting pre-Covid, they point to Q3 GDP growth in excess of 3.0%, with some analysts now expecting GDP to grow as much as 6% in the third quarter.

With this unalloyed good economic news, it should be no surprise that the renminbi has performed well, and in fact, CNY is one of the top performers today, rising 0.5% and trading to levels not seen since May of last year.  While there are still numerous concerns regarding different aspects of China’s economy, notably that its banking sector is insolvent amid massively underreported bad loans, on the surface, things look better than almost anywhere else in the world.  Perhaps what is more surprising is that the equity market in Shanghai, which rose 0.5% overnight, did not have a better day.

Down Under, the RBA noted
That Aussie, though not really bloated
Would be better off
In more of a trough
Thus, helping growth there be promoted

Meanwhile, the Minutes of the most recent RBA meeting showed that while they couldn’t complain that the Aussie dollar was overvalued, especially given the recent rebound in commodity prices, they sure would like to see it lower to help the export sector of the economy.  However, despite reaffirming they would continue to support the economy, and that yield curve control wasn’t going anywhere, they gave no indication they were about to increase their support.  As such, AUD (+0.6%) is the top G10 performer of the session, and it is now pushing back to the 2-year highs seen earlier this month.

Turning to Europe, the two stories of note come from the UK and the ECB.  In Parliament, PM Johnson had the first reading of his bill that is set to unilaterally rewrite the Brexit deal with the EU, and it passed handily.  It appears that Boris believes he needs even more leverage to force the EU to accede to whatever demands remain in the negotiations, and he is comfortable playing hardball to achieve his ends.  The Europeans, however, continue to believe they have the upper hand and claim they are prepared to have the UK leave with no deal.  Politics being what it is, I imagine we won’t know the outcome until the last possible date, which is ostensibly next month at the EU Summit.

In the meantime, the market is starting to get concerned that a hard Brexit is back on the table and that the pound has much more to fall if that is the outcome.  While the market is not at record long GBP position levels, it is still quite long pounds.  The options market has been pricing more aggressively, with implied volatility around 12% for year-end (compared to 3-month historic volatility of just 9%) and risk reversals 2.5 points for the GBP puts.  While the pound has fallen a bit more than 4% since its peak on September 1st, it is still well above levels seen when fears of a hard Brexit were more prevalent.  As this new bill makes its way through Parliament, I suspect the pound will have further to decline.

As to the ECB, we have had yet more verbal intervention, this time from Italian Executive Board member, Fabio Panetta, who repeated that the ECB needs to remain vigilant and that though they have done a great job so far, they still may need to do more (i.e. ease further) in order to achieve their inflation goals.  The euro, however, continues to drift higher, up another 0.25% this morning, as the market appears to be preparing for a more aggressive FOMC statement and implicit further easing by the Fed.  While I believe it is too early for the Fed to more clearly outline their explicit plans on how to achieve average inflation of 2.0%, clearly there are many market participants who believe the Fed will be the most aggressive central bank going forward and that the dollar will suffer accordingly.  We shall see, but as I have repeatedly indicated, and Signor Panetta helped reiterate, the ECB will not stand idly by and allow the euro to rally unabated.

And those are really today’s stories.  Risk appetite continues to be fed by perceptions of further easy money from all central banks and we have seen equity markets continue their rebound from the short correction at the beginning of the month.  While Asia was mixed, Europe is in the green and US futures are pointing higher as well.  Treasuries are a touch lower, with yields up about 1 basis point, but the reality here is that yields have been in a very tight range for the past month.  In fact, the idea that the Fed needs to introduce yield control is laughable as it appears to already be in place.

As to the rest of the FX market, the dollar is under pressure everywhere, although Aussie and cable are the two leaders in the G10 space.  Elsewhere, there appears to be less conviction, or at least less rationale to buy the currency aggressively.  In the EMG bloc, ZAR is the leader, rising 1.2% this morning, continuing its strengthening trend that began back in August and has seen a nearly 7% appreciation in the interim.  Otherwise, there has been less excitement, with more modest gains on the back of generic USD weakness.

For today, we see Empire Manufacturing (exp 6.9) this morning as well as IP (1.0%) and Capacity Utilization (71.4%).  Alas, with the Fed meeting tomorrow and all eyes pointed to Washington, it seems unlikely that the market will respond to any of this data.  Instead, with the market clearly comfortable selling dollars right now, I see no reason for the buck to do anything but drift lower on the day.

Good luck and stay safe
Adf

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
Adf