The Seeds of Inflation

Inflation continues to be
A topic where some disagree
The Fed has the tools
As well as the rules
To make sure it’s transitory

But lately, the data has shown
The seeds of inflation are sown
So later this year
It ought to be clear
If Jay truly has a backbone

Yet again this weekend, we were treated to a government official, this time Janet Yellen, explaining on the Sunday talk show circuit that inflation would be transitory, but if it’s not, they have the tools to address the situation.  It is no coincidence that her take is virtually identical to Fed Chair Powell’s, as the Fed and the Treasury have clearly become joined at the hip.  The myth of Fed independence is as much a victim of Covid-19 as any of the more than 3.2 million unfortunate souls who lost their lives.  But just because they keep repeating they have the tools doesn’t mean they have the resolve to use them in the event that they are needed.  (Consider that the last time these tools were used, in the early 1980’s, Fed Chair Paul Volcker was among the most reviled government figures in history.)

For instance, last Friday’s data showed that PCE rose 2.3% in March with the Core number rising 1.8%.  While both those results were exactly as forecast, the trend for both remains sharply higher.  The question many are asking, and which neither Janet nor Jay are willing to answer, is how will the Fed recognize the difference between sustained inflation and transitory inflation?  After all, it is not as though the data comes with a disclaimer.  Ultimately, a decision is going to have to be made that rising prices are becoming a problem.  Potential indicators of this will be a sharply declining dollar, sharply declining bond prices and sharply declining stock prices, all of which are entirely realistic if/when the market decides that ‘transitory’ is no longer actually transitory.

For now, though, this issue remains theoretical as there is virtually unanimous agreement that the next several months are going to show much higher Y/Y inflation rates given the base effects of comparisons to the depth of the Covid inspired recession.  The June data will be the first test as that monthly CPI print last year was a robust 0.5%.  Should the monthly June print this year remain at that level or higher, it will deepen the discussion, if not at the Fed, then certainly in the investor and trader communities.  But in truth, until the data is released, all this speculation is just that, with opinions and biases on full display, but with no way to determine the outcome beforehand.  In fact, it is this uncertainty that is the primary rationale for corporate hedging.  There is no way, ex ante, to know what prices or exchange rates will be in the future, but by hedging a portion of the risk, a company can mitigate the variability of its results.  FWIW my view continues to be that the inflation genie is out of the bottle and will be far more difficult to tame going forward, despite all those wonderful tools in the Fed’s possession.

This week is starting off slowly as it is the so-called “golden week” in both China and Japan, where there are holidays Monday through Wednesday, with no market activity ongoing.  Interestingly, Hong Kong was open although I’m guessing investors were less than thrilled with the results as the Hang Seng fell a sold 1.3%.  Europe, on the other hand, is feeling frisky this morning, with gains across the board (DAX +0.6%, CAC +0.45%. FTSE 100 +0.1%) after the final PMI data was released and mostly confirmed the preliminary signs of robust growth in the manufacturing sector.  In addition, the vaccine news has been positive with Germany crossing above the 1 million threshold for the first time this weekend while Italy finally got to 500,000 injections on Saturday.  The narrative that is evolving now is that as Europe catches up in vaccination rates, the Eurozone economy will pick up speed much faster than previously expected and that will bode well for both Eurozone stocks and the single currency.  Remember, on a relative basis, the market has already priced in the benefits of reopening for the US and UK, while Europe has been slow to the party.

Adding to the story is the bond market, where European sovereigns are softening a bit in a classic risk-on scenario of higher stocks and lower bonds.  So, yields have edged higher in Germany (Bunds +1.5bps) and France (OATs +1.3bps) although Gilts are unchanged.  Meanwhile, Treasury yields are creeping higher as well, +1.6bps, and remain a critical driver for most markets.  Interestingly, the vaccine news has inspired the latest comments about tapering PEPP purchases by the ECB, although it remains in the analyst community, not yet part of the actual ECB dialog.

Most commodity prices are also in a quiet state with oil unchanged this morning although we continue to see marginal gains in Cu (+0.4%) and Al (+0.2%).  The big story is agricultural prices where Corn, Wheat and soybeans continue to power toward record highs.  Precious metals are having a good day as well, with both gold (+0.55%) and silver (+0.85%) performing nicely.

It should be no surprise with this mix that the dollar is under pressure as the pound (+0.4%) and euro (+0.3%) lead the way higher.  Only JPY (-0.1%) and CHF (-0.1%) are in the red as haven assets are just not needed today.  Emerging market currencies are mostly stronger with the CE4 all up at least as much as the euro and ZAR (+0.55%) showing the benefits of dollar weakness and gold strength.  There was, however, an outlier on the downside, KRW (-1.0%) which fell sharply overnight after its trade surplus shrunk much more than expected with a huge jump in imports fueling the move.

As it is the first week of the month, get ready for lots of data culminating in the NFP report on Friday.

Today ISM Manufacturing 65.0
ISM Prices Paid 86.1
Construction Spending 1.7%
Tuesday Trade Balance -$74.3B
Factory Orders 1.3%
-ex transport 1.8%
Wednesday ADP Employment 875K
ISM Services 64.1
Thursday Initial Claims 540K
Continuing Claims 3.62M
Nonfarm Productivity 4..2%
Unit Labor Costs -1.0%
Friday Nonfarm Payrolls 978K
Private Payrolls 900K
Manufacturing Payrolls 60K
Unemployment Rate 5.7%
Average Hourly Earnings 0.0% (-0.4% Y/Y)
Average Weekly Hours 34.9
Participation Rate 61.6%
Consumer Credit $20.0B

Source: Bloomberg

As well, we hear from five Fed speakers, including Chairman Powell this afternoon.  Of course, since we just heard from him Wednesday and Yellen keeps harping on the message, I don’t imagine there will be much new information.

Clearly, all eyes will be on the payroll data given the Fed has explained they don’t care about inflation and only about employment, at least for now and the near future.  Given expectations are for nearly 1 million new jobs, my initial take is we will need to see a miss by as much as 350K for it to have an impact.  Anything inside that 650K-1350K is going to be seen as within the margin of error, but a particularly large number could well juice the stock market, hit bonds and benefit the dollar.  We shall see.  As for today, given Friday’s Chicago PMI record print at 72.1, whispers are for bigger than forecast.  While the dollar is under modest pressure right now, if we see Treasury yields backing up further, I expect to see the dollar eventually benefit.

Good luck and stay safe
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