It wasn’t all that long ago
When Powell and friends let us know
That prices might rise
But that in their eyes
T’was something we soon would outgrow
And lately it seems they were right
As chains of supply get more tight
But so far, they’re clear
The Fed has no fear
Inflation could rise overnight
Investors, though, don’t seem to share
That attitude, devil-may-care
Instead they’re rebelling
And stocks they are selling
While bond markets, too, they forswear
Perhaps as a prelude to tomorrow’s CPI data here in the US, last night we saw Chinese inflation data. Chinese data, though, has a very different meaning than US data. From China, markets care far more about PPI than about CPI, as China continues to be the world’s factory floor. So, a rising PPI in China may presage rising retail prices elsewhere in the world. Consider this when looking at the Chinese data, where PPI rose a more than expected 6.8%, it’s highest print since October 2017, while CPI there rose only 0.9%, a tick less than forecast. The proximate cause of the sharp rise in PPI has been the ongoing explosion higher in commodity prices. All their input costs are rising (iron ore, steel, copper, energy, etc.) thus producers are forced to raise their prices. While retailers have not yet passed through all the cost increases in China, manufacturers and retailers elsewhere in the world have not been so sanguine on the issue. Instead, the combination of rising commodity prices and shortages in key intermediate goods, like semiconductors, has been more than sufficient to push up prices.
It should be no surprise that markets, in general, are not applauding this outcome, and in fact, are concerned that this is just the beginning of the move in prices. On the one hand, we continue to hear from both the Fed and the ECB that there is no reason to consider tightening policy at this time as neither bank has achieved their policy aims. On the other, there is no sign that the supply side damage that was caused by the pandemic is anywhere close to being repaired. Reduced supply meeting ongoing artificially high demand is guaranteed to raise prices. I guess the Fed and ECB will soon be quite pleased with themselves for having created inflation. The rest of us? Not so much.
However, this policy
mistake action in the face of the current conditions is what is driving market prices, which today are wholly in the red, and in substantial size. Equity markets worldwide (Nikkei -3.1%, Hang Seng -2.1%, DAX -2.2%, CAC -2.0%, FTSE 100 -2.2%) have been under severe pressure ever since yesterday’s US tech slump, but bond markets, too, are seeing significant selling pressure, with Bunds, OATs and Gilts all seeing yields climb by 4 basis points this morning. In other words, investors are explaining they don’t want to hold financial assets in an inflationary environment. In fact, there is a great deal of buzz in the markets about some of the large interest rate bets that are being made in both Eurodollar and Euribor futures markets, where very large size option trades are being executed with the aggressor buying put options as part of large risk reversals. It seems there is very little concern over interest rates declining from current levels, and rightly so, but expectations for higher rates well before either the Fed or ECB has indicated they are considering changing tack are the new normal.
What, you may ask, has this done for the dollar? That is a much tougher question to answer as the outcome has been far less clear. I have been adamant that the 10-year Treasury yield has been the key driver of the dollar’s value for virtually all of 2021, and despite the sell-off in European sovereigns this morning, Treasury yields are unchanged at 1.60%. Heading into tomorrow’s CPI data, as well as another round of Treasury refunding starting with today’s 3-year auction of $40 billion (a total of $108 billion will be auctioned this week), it appears that investors and traders are not certain what to do. Despite economic data that points to quickening growth, we continue to hear from Fed speaker after Fed speaker that they are not even close to considering tapering QE, let alone raising interest rates. Well, except for the lone(ly) hawk, Dallas Fed President Robert Kaplan. But yesterday, both Chicago’s Mike Evans and SF’s Mary Daly were clear it is far too early to consider tapering QE. Today brings six more Fed speakers, none of whom have a history of hawkishness.
In the end, if inflation continues to rise while Treasury yields remain rangebound due to QE, as real yields decline, look for the dollar to follow. Breakeven inflation rates continue to trade at multi-year highs (5-year 2.73%, 10-year 2.53%) and are indicating a strong belief that inflation is picking up pace. While the Fed continues to tell us they “have the tools” necessary to combat any potential inflation, the only thing of which we can be sure is they not only “have the tools” required to support markets (and the economy by extension), but that they will use those tools. When it comes to fighting the inflation battle, though, not a single current FOMC member is battle tested. Given this asymmetry, it is not surprising that we are seeing an increase in market bets on higher interest rates.
Back to the dollar, which is actually under a bit of pressure this morning, along with all those other assets. In the G10, only CHF (-0.1%) is softer as we are seeing gains from the European bloc (NOK, SEK +0.4%, EUR +0.3%) leading the way. Arguably, this is on the back of the much better than expected German ZEW expectations index, which printed at its highest level in more than 10 years. Meanwhile, the pound (+0.1%) and commodity bloc here are having a much less interesting session.
In the emerging markets, Asian currencies felt pressure overnight on the tech stock decline with KRW (-0.5%), TWD (-0.4%) and MYR (-0.3%). On the other hand, the CE4 have all followed the euro higher and we are seeing strength in ZAR (+0.5%), RUB (+0.6%) and MXN (+0.5%), despite oil’s small slide (-0.8%).
All in all, today is shaping up as another one that will be driven by the yield story. In order for the dollar to really turn around its recent weakness, we will need to see a very significant risk-off event, with Treasuries rallying and fear abundant. But so far, the current equity decline has not been sufficient to get those juices flowing. As such, I still would err on the side of a weaker dollar.
Good luck and stay safe