Inflation’s on everyone’s lips
As traders now need come to grips
With data still soft
But forecasts that oft
Point to pending a-pocalypse
Is inflation really coming soon? Or perhaps the question should be, is measured inflation really coming soon? I’m confident most of us have seen the rise in prices for things that we purchase on a regular basis, be it food, clothing, cable subscriptions or hard goods. And of course, asset price inflation has been rampant for years, but apparently that doesn’t count at all. However, the focus on this statistic has increased dramatically during the past several months which is a huge change from, not only the immediate post-pandemic economy, but in reality, the past thirty years of economic activity. In fact, ever since Paul Volcker, as Fed Chair, slew the inflationary dragon that lived in the 1970’s, we have seen a secular move lower in measured consumer prices alongside a secular move lower in nominal interest rates.
But the pandemic has forced a lot of very smart people (present company excluded) to reconsider this trend, with many concluding that higher prices, even the measured kind, are in our future. And this is not a discussion of a short-term blip higher due to pent up demand, but rather the long-term trend higher that will need to be addressed aggressively by the Fed lest it gets out of hand.
The argument for inflation centers on the difference between the post GFC financial response and the post Covid shock financial response. Back in 2009, the Fed cut rates to zero and inaugurated their first balance sheet expansion of note with QE1. Several more bouts of QE along with years of near zero rates had virtually no impact on CPI or PCE as the transmission mechanism, commercial banks, were not playing their part as expected. Remember, QE simply replaces Treasuries with bank reserves on a commercial bank balance sheet. It is up to the commercial bank to lend out that money in order for QE to support the economy. But commercial banks were not finding the risk adjusted returns they needed, especially compared to the riskless returns they were receiving from the Fed from its IOER program. So, the banking sector sold the Fed their bonds and held reserves where they got paid interest, while enabling them to have a riskless asset on their books. In other words, only a limited amount of QE wound up in the public’s pocket. The upshot was that spending power did not increase (remember, wages stagnated) and so pricing pressures did not materialize, hence no measured inflation.
But this time around, fiscal policy has been massive, with the CARES act of nearly $2 trillion including direct payments to the public as well as forgivable small business loans via the PPP program. So, banks didn’t need to lend the money to get things moving, the government solved that part of the equation. Much of that money wound up directly in the economy (although certainly some found its way into RobinHood accounts and Bitcoin), thus amping up demand. At the same time, the lockdowns around the world resulted in broken supply chains, meaning many goods were in short supply. This resulted in the classic, more money chasing fewer goods situation, which leads to higher prices. This helps explain the trajectory of inflation since the initial Covid impact, where prices collapsed at first, but have now been rising back sharply. While they have not yet reached pre-Covid levels, it certainly appears that will be the case soon.
Which leads us back to the question of, what will prevail? Will the rebound continue, or will the long-term trend reassert itself? This matters for two reasons. First, we will all be impacted by rising inflation in some manner if it really takes off. But from a markets perspective, if US inflation is rising rapidly, it will put the Fed in a bind with respect to their promise to keep rates at zero until the end of 2023. If the market starts to believe the Fed is going to raise rates sooner to fight inflation, that will likely have a very deleterious effect on equity and bond prices, but a very positive effect on the dollar. The combination of risk-off and higher returns will make the dollar quite attractive to many, certainly enough to reverse the recent downtrend.
Lately, we are seeing the beginnings of this discussion, which is why the yield curve has steepened, why stock markets have stalled and why the dollar has stopped sliding. Fedspeak this week has been cacophonous, but more importantly has shown there is a pretty large group of FOMC members who see the need for tapering policy, starting with reducing QE, but eventually moving toward higher rates. Yesterday, uber-dove Governor Lael Brainerd pushed back on that story, but really, all eyes will be on Chairman Powell this afternoon when he speaks. To date, he has not indicated a concern with inflation nor any idea he would like to taper purchases, so any change in that stance is likely to lead to a significant market response. Pay attention at 12:30!
With that as backdrop, a quick tour of the markets shows that risk appetite is moderately positive this morning. While the Nikkei (+0.85%) and Hang Seng (+0.9%) both did well, Shanghai suffered (-0.9%) despite data showing record export performance by China last year. Europe is far less exciting with small gains (DAX +0.2%, CAC +0.1% and FTSE 100 +0.7%) following Germany’s release of 2020 GDP data showing a full-year decline of “just” -5.0%, slightly less bad than expected. US futures are mixed at this hour, but the moves are all small and offer no real news.
Bond markets show Treasury yields higher by 2bps, while European bonds have all seen yields slip between 1.0 and 1.7bps, at least the havens there. Italian BTP’s are selling off hard, with yields rising 5.7bps, and the rest of the PIGS have also been under pressure. Oil prices are little changed this morning, still holding onto their gains since November. Gold prices are slightly softer and appear to be biding their time until the next big piece of news hits.
Finally, the dollar is somewhat mixed this morning, with the G10 basically split between gainers and losers, although the gains have been a bit larger (AUD +0.4%, SEK +0.3%) than the losses (CHF -0.2%, JPY -0.1%). But this looks like position adjustments and potential order flow rather than a narrative driven move. EMG currencies are also split, but there are clearly more gainers than losers here, with the commodity bloc doing best (ZAR +0.85%, RUB +0.65%, BRL +0.6%) and losses more random led by KRW (-0.25%) and CZK (-0.2%). If pressed, one needs look past oil and gold to see agricultural commodities and base metals still performing well and supporting those currencies. KRW, on the other hand is a bit more confusing given the growth in China, it’s main exporting destination. Again, position adjustments are quite viable given the won’s more than 11% gain since May.
This morning’s data slate includes only Initial Claims (exp 789K) and Continuing Claims (5.0M), which if far from expectations could wiggle markets, but seem unlikely to do so as everyone awaits Powell’s speech. Until then, I expect that the dollar will continue to remain supported, but if Powell reiterates a very dovish stance, we could easily see the dollar head much lower. Of course, if he gives credence to the taper view, look for some real market fireworks, with both bonds and stocks selling off and the dollar jumping sharply.
Good luck and stay safe