QE Will Wane

Some pundits have come to believe
That sometime before New Year’s Eve
The Fed will explain
That QE will wane
Though others are sure they’re naïve

So, let’s listen to what the Fed
Has very consistently said
Without hard statistics,
Not simple heuristics,
The idea of tapering’s dead

As a new week begins, all eyes are turning to the central bank conclaves scheduled for the latest clues in monetary policy activity.  Recall last week, the Bank of Canada surprised almost everyone by explaining they would reduce the amount of QE by 25% (C$1 billion/week) as they see stronger growth and incipient inflationary pressures beyond the widely discussed base effects that are coming soon to a screen near you.  This has clearly inspired the punditry, as evidenced by a recent survey of economists carried out by Bloomberg, showing more than 60% of those surveyed expect the Fed to begin to taper QE before the end of this year.  When the same questions were asked in March, less than 50% of those surveyed expected a tapering this year.  Obviously, we have seen a run of very strong survey data, as well as a very strong payroll report at the beginning of this month.  In addition, the vaccine rate has increased substantially, with the combination of these things leading to significantly upgraded economic forecasts for the US this year.

And yet, everything we have heard from Chairman Powell and the rest of the FOMC has been incredibly consistent; they are not even thinking about thinking about tapering monetary policy and will not do so until substantial further progress toward their goals of maximum employment and average inflation of 2.0% are achieved.  In addition, Powell has promised to communicate very clearly, well in advance, that changes are in the offing.  While we have had two strong employment reports in a row, the combined job gains remain a fraction of the 10 million that Powell has repeatedly explained need to be regained.  Arguably, we will need to see NFP numbers north of 750K for the next 6-9 months before the Fed is even close to their target and will consider taking their foot off the proverbial accelerator.

Of course, there is one thing that could force earlier action by the Fed, inflation rising more quickly than anticipated.  As of now, the Fed remains unconcerned over price rises and have made it clear that while the data for the next several months will be rising quickly, it is a transitory impact from the now famous base effects caused by the Covid induced swoon this time last year.  Even then, given the new framework of average inflation targeting, rather than a hard numeric target, a few more months of above 2.0% core PCE will hardly dissuade them from their views as they have nearly a decade of lower than 2.0% core PCE to offset.

But what if inflation is more than a transitory event?  While the plural of anecdote is not data, it certainly must mean something when every week we hear from another major consumer brand that prices will be rising later this year.  Personal care products, food and beverages have all been tipped for higher prices this year.  The same is true with autos and many manufactured goods as the consistent rise in input prices (read commodities) is forcing the hands of manufacturers.  While it is true that, by definition, core PCE removes food & energy prices, to my knowledge, neither toothpaste nor Teslas are core purchases.

The medium-term risk appears to be that inflation runs, not only hotter than the Fed expects, but hot enough that they begin to become uncomfortable with its impact.  While the natural response would be to simply raise rates, given Jay’s effective promise not to raise rates until 2023, as well as the fact that the Treasury can ill afford higher interest rates (nor for that matter can the rest of the economy given the amount of leverage that is outstanding), the Fed may well find themselves in quite a bind later this year.  One cannot look at the price of copper (+1.9% today, 25.6% YTD), aluminum (+1.2%, 21.1%) or iron ore (+0.4%, 16.0%) without considering that those critical inputs, neither food nor energy, are going to drive price pressures higher.  And, by the way, food and energy prices have been rocketing as well (Corn +38% YTD, Wheat +13.1%, Soybeans +18.2%, WTI +26.1%).  Chairman of the Fed may not be that attractive a position by the time Powell’s term ends in February.

Turning to the markets, if I had to characterize them in a theme, it would be idle.  Equity markets are generally flat to lower with the odd exception in Asia (Nikkei +0.4%, Hang Seng -0.4%, Shanghai -1.0%) and Europe (DAX -0.2%, CAC 0.0%, FTSE 100 0.0%).  US futures are also noncommittal this morning, with the NASDAQ (-0.3%) the only one having really moved.

In the bond market, the rally we had seen over the past three weeks has stalled and is starting to cede some ground.  For instance, Treasuries (+3.7bps) are leading the way higher but we are seeing higher yields throughout Europe (Bunds +2.3bps, OATs +2.5bps, Gilts +3.0bps) and even saw gains overnight in Australia (+1.8bps) and Japan (+0.5bps).  Historically, that would have seemed to be a risk-on phenomenon, but given the lack of equity strength, this feels a lot more like an inflationary call.

While the metals space is strong today, oil is actually softer (-1.7%) as concerns over the rampant spread of Covid in India and other emerging markets undermines the vaccine news in the West.

As to the dollar, it is generally, but not universally, weaker this morning.  In the G10, AUD (+0.6%), NZD (+0.3%) and CAD (+0.3%) are the leaders, with all benefitting from the metals rally, which has been sufficient to offset weaker oil prices for the Loonie.  On the downside, NOK (-0.1%) is clearly feeling a bit of pressure from oil, although 0.1% hardly makes a statement.  EMG currencies are showing the same type of price action with TRY (+1.2%) the leading gainer as it rebounds from near-record lows amid hopes the tension with the US will be temporary.  Away from the lira, TWD (+0.5%) rallied on concerns that the Taiwanese government would be pressured by the US with respect to its currency and competition concerns.  We saw similar, but lesser pressure on KRW (+0.4%).  Meanwhile, the modest declines seen in HUF (-0.2%) and MXN (-0.1%) define the other side of the spectrum.

Clearly, the FOMC meeting is the highlight of the week, but there is other important data as well, including the BOJ tonight.

Today Durable Goods 2.5%
-ex transport 1.6%
Tuesday Case Shiller Home Prices 11.8%
Consumer Confidence 112.0
Wednesday FOMC Decision 0.00% – 0.25%
IOER 0.12%
Thursday Initial Claims 550K
Continuing Claims 3.59M
GDP Q1 6.9%
Personal Consumption 10.3%
Friday Personal Income 20.0%
Personal Spending 4.2%
Core PCE 1.8%
Chicago PMI 64.2
Michigan Sentiment 87.5

Source: Bloomberg

The end of the week is where all the action will be, assuming Chairman Powell doesn’t shake things up Wednesday afternoon.  Core PCE is forecast to print at its highest level since February 2020, but if you recall the CPI data, it was a tick higher than forecast as well.  Of course, for now, it doesn’t matter.  This is all transitory.

Nothing has changed my opinion with respect to the relationship between the dollar and the 10-year Treasury yield.  While it is not actually tick for tick, if yields do back up, I would look for the dollar to find its footing in the near term.  I know the dollar bears are back in force, but we need to see a break above the 1.2350 level in the euro to really turn the tide in my view.  Otherwise, we are simply at the bottom of the dollar’s range.

Good luck and stay safe
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