Fed staffers relayed their suspicions
That ease in financial conditions
Could lead to distress
Which could make a mess
For Powell and all politicians
But Jay heard the story and said
The risks when we’re looking ahead
Are growth is too slow
Inflation too low
So, money still pours from the Fed
Yesterday’s Fed Minutes left us with a bit of a conundrum as there appears to be a difference of opinion regarding the current state of the economy and financial markets between the Fed staffers and their bosses. The bosses, of course, are the 19 members of the FOMC, 7 governors including the Chair and vice-Chair and the 12 regional Fed presidents. The staffers are the several thousand PhD economists who work for that group and develop and run econometric models designed, ostensibly, to help better understand the economy and predict its future path. On the one hand, based on the Fed’s prowess, or lack thereof, in forecasting the economy’s future path, it is understandable how the bosses might ignore their staffers. When looking at past Fed forecasts, they are notoriously poor at determining how the economy is progressing, seemingly because the models upon which they rely do not represent the US economy very well. On the other hand, the willful blindness exhibited by the bosses with respect to the current financial conditions is disqualifying, in itself, of trusting their views. As I said, quite the conundrum.
This was made a little clearer yesterday when the FOMC Minutes showed that the staff had indicated the following:
The staff provided an update on its assessments of the stability of the financial system and, on balance, characterized the financial vulnerabilities of the U.S. financial system as notable. The staff assessed asset valuation pressures as elevated. In particular, corporate bond spreads had declined to pre-pandemic levels, which were at the lower ends of their historical distributions. In addition, measures of the equity risk premium declined further, returning to pre-pandemic levels. Prices for industrial and multifamily properties continued to grow through 2020 at about the same pace as in the past several years, while prices of office buildings and retail establishments started to fall. The staff assessed vulnerabilities associated with household and business borrowing as notable, reflecting increased leverage and decreased incomes and revenues in 2020. Small businesses were hit particularly hard. [author’s emphasis].
And yet, after hearing the staff reports, neither the FOMC statement nor Chairman Powell at the ensuing press conference referred to elevated asset values or financial system vulnerabilities. Rather, those, and most other concerns, were described as moderate, while explaining that downside outcomes to inflation still dominated their thinking. In the intervening 3 weeks, we have seen Treasury yields rise 30 basis points in the 10-year and inflation breakevens rise 22 basis points. In other words, it is beginning to appear as though the Fed and the market are watching two different movies. The risk to this scenario is that the Fed can fall dangerously behind the curve with respect to keeping the economy on their preferred path, and may be forced to dramatically shift policy (read raise rates) if (when) it becomes clear rising inflation is not a temporary phenomenon. Now, while it is likely to take the Fed quite a while to recognize this discrepancy, I assure you, when it occurs and the Fed feels forced to act, the market response will be dramatic. But for now, that is just not on the cards. If anything, as we continue to hear from various Fed speakers, there is no indication they are going to consider tighter policy for several years to come.
In the meantime, there is no reason to suspect that market participants will change their short-term behavior, so ongoing manias will continue. Just be careful with your personal accounts. Remember, when things turn, return OF capital is far more important than return ON capital!
Now to today’s session. Once again, the traditional risk memes are a bit confused this morning. Equity markets have not had a good session with Asia mostly lower (Nikkei -0.2%, Hang Seng -1.6%, although Shanghai reopened with a gain, +0.5%). European markets are also under pressure (DAX -0.1%, CAC -0.4%, FTSE 100 -0.9%) despite the fact that today marks the beginning of the disbursement of EU-wide support funded by EU-wide bond issuance. You may remember last July when, to great fanfare, the EU agreed a €750 billion joint debt issuance, to be backed by all members. Well, we are now seven months later, and they are finally starting to disburse the funds. And do not seek respite in US futures markets as they are all lower by between 0.25% (DOW) and 0.8% (NASDAQ).
What is interesting is that despite the equity market weakness, bond markets are falling as well. It appears that growing concerns over rising inflation are outweighing the risk aversion theme. Thus, 10-year Treasury yields are higher by 1.9bps this morning and we are seeing even larger rises in some European markets (Gilts +4.1bps, OATs +2.6bps, Bunds +1.8bps). So, I ask you, which market is telling us the true risk story today?
Perhaps if we look to commodities we will get a hint. Alas, the information here is muddled at best. Oil prices continue to rise, up another 0.3% this morning, as up to 4 million barrels of daily production in Texas and the Midwest have been shut in because of the winter storms. That is 36% of US production, and clearly making an impact. Meanwhile, base metals have been mixed with Aluminum higher and Copper lower. Precious metals? Mixed as well with gold (+0.4%) rebounding from a couple of really bad sessions while silver (-0.75%) continues to slide.
Thus far, making a claim as to the risk sense of markets is essentially impossible. So, now we turn to the dollar. If tradition is a guide, the dollar’s broad weakness, lower vs. all G10 counterparts and many EMG ones as well, would indicate a risk on session. But if investors are moving into risky assets, why are stocks under uniform pressure? Perhaps they are all moving their money into Bitcoin (+0.2% today, +11.2% in the past week).
But back to the fiat world where we see GBP (+0.6%) as the leading G10 gainer which appears to be a result of traders expecting the UK to recover much faster than Europe given the relative success of their Covid vaccination program. But even the worst performers, CAD and JPY are higher by 0.15% this morning. NOK (+0.4%) seems to be benefitting from the ongoing oil rally, and the rest of the bloc may be beginning to see the resumption of the dollar short trade.
EMG currencies are a bit more mixed, with most APAC currencies softening overnight, but LATAM and CE4 currencies benefitting from the dollar’s overall softness. CLP (+0.5%) leads the way on the strength of rising copper prices, with ZAR (+0.45%) following closely behind.
Yesterday’s US data was surprisingly good, with Retail Sales exploding higher by 5.3% on a monthly basis (I guess the most recent stimulus checks were spent!) and PPI jumping by a full percent, to a still low 1.7%, which may well foreshadow the future of CPI. We also saw strong IP and Capacity Utilization data. This morning brings Initial Claims (exp 770K), Continuing Claims (4.425M), Housing Starts (1660K), Building Permits (1680K) and Philly Fed (20.0) all at 8:30. We also have two more Fed speakers, the hyper dovish Lael Brainerd and a more middle of the road dove Rafael Bostic.
Wrapping it all up shows a weak dollar, weak bond prices and weak stock prices. It feels like at least one of these needs to adjust its trajectory for the day to make any sense, but as of now, I am not willing to bet which. As far as the FX market goes, we appear to be rangebound for now, although any eventual break still feels like it will be for a lower dollar.
Good luck and stay safe