Eight years ago, when Chairman Ben
Suggested t’was not if but when
The Fed would reduce
Its purchase, profuse,
Of bonds, traders sold bonds, bought yen
But these days when taper’s discussed
The bond market doesn’t seem fussed
The reason could be
There’s now nobody
The market invests with its trust
Yesterday’s CPI data printed a tick higher than forecast indicating that, yes, prices are rising relative to last year. The headline print of 2.6% was the beneficiary of a substantial rise in energy prices compared to last year, but the core price index indicated that both goods and services prices are rising in price. One data point is not enough to make any claims in either direction, but it will certainly keep the discussion going for a while. The market response was somewhat counterintuitive as by the end of the day, 10-year Treasury yields had fallen 6 basis points and the dollar was softer amid modestly firmer equity prices. While the link between the dollar and Treasuries remains intact, the question is why would bonds rally (yields decline) if inflation was rising?
One possible answer is that the market had gotten far ahead of itself with respect to pricing in rising inflation. Historically, inflation takes time to manifest itself as prices on many things are sticky, meaning they remain stable for a time amid broad pressures and then shift in a relatively large step, rather than a gradual daily or weekly increase. We are all familiar with the situation when an item regularly purchased suddenly rises in price to catch up to the broad underlying price pressures. But when taken over the totality of all goods purchased, while any given good or service may see prices rise in discrete steps, the index moves up in a relatively smooth manner. This fact is why yesterday’s data are interesting, because the headline jump of 0.6% M/M certainly tests the definition of smooth. Consider that a monthly increase of 0.6% would result in annual inflation of 7.4%, a level that even the Fed would consider too hot. FYI, yesterday’s core print, which was actually 0.34%, would represent 4.2% core CPI over a year. So, yes, the base effects were instrumental in the much higher Y/Y data, but the monthly increases were pretty high in any accounting.
And yet, the bond market ultimately rallied all day, having touched 1.7% in early European trading and closing the session at 1.615%. If this wasn’t a classic case of buy the rumor, sell the news, I don’t know what is. And, as we have seen consistently all year, the dollar dutifully followed yields lower while equity markets ultimately rallied, although the euphoria over the value trade seems to be waning.
Perhaps of more interest is the fact that we have now had 3 key central bankers, two from the ECB, Knot and Villeroy, and the Fed’s Bullard all start to discuss the idea of tapering bond purchases. This seems incongruous given the adamant claims on both sides of the pond that current monetary policy is necessary and appropriate to ensure the respective economies return to form. And yet each of these discussed how tapering of QE could begin before the year is out. You may recall that Bullard wanted to tie the idea of tapering to the level of vaccinations in the economy, indicating that when 75% of the population is vaccinated, it could be time to start slowing purchases with the implication being the economy would then be able to stand on its own two feet.
This morning, Banque de France Governor Villeroy de Galhau explained that there could be an evolution in monetary policy at the ECB, which while remaining accommodative would shift the burden back to the APP (the original QE plan) from PEPP, which will ostensibly run its course in March 2022. Last week, Knot, the Dutch Central Bank president expressed his view that the current expectations of robust growth in the second half of the year could be a signal to begin tapering asset purchases. Now, understand that there were members from both central bank committees pushing back on the idea, but the fact remains that there is some consideration of tapering. Today, we hear from Chairman Powell again, but we will not hear from Madame Lagarde until her press conference after the ECB meeting next week.
Adding up the disparate facts is quite difficult. On the one hand, we have the first trial balloons floated regarding tapering of asset purchases as a response to the forecasts for extremely robust growth this year. On the other hand, the market appears to have indicated that, at least for now, the idea of much faster growth leading to much higher inflation has run its course. It strikes me that the market is unlikely to worry too much about these trial balloons until they hear from Powell and/or Lagarde. Until then, it appears that a short period of higher inflation readings is on the cards and unless they really start to spike, that is unlikely to have a big impact on either equities or bonds.
Speaking of equities, yesterday saw the S&P 500 close at yet another new all-time high with the NASDAQ pushing back to within 1% of its February record. Clearly, there is no inflation scare there. Rather, all eyes are turning to the first earnings releases due today. Overnight saw the Nikkei slide (-0.4%) but elsewhere in Asia equities rallied (Hang Seng +1.4%, Shanghai +0.5%). European markets are mixed with the DAX (-0.1%) lagging while both the CAC (+0.4%) and FTSE 100 (+0.3%) continue to grind higher. Apparently, Villeroy’s comments about tapering have not been seen as a danger. US futures are modestly higher at this point, just 0.2% or so as the market bides its time ahead of Powell’s comments at noon.
In the bond market, after a big rally yesterday, the 10-year has seen yields back up slightly, by 1.1 bps, although European bonds are all looking at modest yield declines (Bunds -1.0bps, OATs -1.2bps, Gilts -0.3bps). It has become pretty clear that the rush higher in yields has stalled for now, with important implications for all the other markets, especially the dollar.
Oil prices are continuing their recent rebound, with WTI +1.6%, although the price action in the metals markets remains confusing. Precious metals rallied sharply yesterday but are little changed this morning. Base metals continue to trade both ways with Cu (+1.1%) leading the way higher, but Al (-0.3%) lagging. It all seems very much like a consolidation period ahead of the next leg higher.
As to the dollar, after sliding all day yesterday alongside Treasury yields, it is continuing lower this morning. The leading gainer is NZD (+0.8%) which has rallied based on the market’s interpretation that standing pat by the RBNZ last night was actually hawkish, which has helped drag AUD (+0.65%) higher as well. Oil is supporting NOK (+0.45%) but the rest of the moves are far less significant. EMG currencies are also performing well this morning, led by KRW (+0.85%) and TRY (+0.5%). The won was a beneficiary of the generally falling dollar as well as foreign inflows into the KOSPI. TRY, on the other hand, simply offers yields that are too high to resist for certain investors, despite rising inflation there.
The only data today is the Fed’s Beige Book, to be released at 2:00, but aside from Powell at noon, we hear from four other Fed speakers including vice-chairman Clarida at 3:45 this afternoon. Come Friday, the Fed will enter their quiet period ahead of the next FOMC meeting, so it seems everyone wants to get their thoughts aired ahead of that.
In the end, the dollar remains beholden to 10-year Treasury yields, so we could be in for a period of very limited movement, if Treasuries have found a new home. Unless we hear something new from the Chairman today, I expect we are looking at a period of quiet for the next two weeks. The calm before the storm.
Good luck and stay safe