There once was a Fed Reserve Chair
Whose minions explained with fanfare
Though prices were climbing
With all the pump priming
Inflation was not really there
Investors responded with glee
And bought everything they did see
So, risk was a hit
While yields fell a bit
As money remains largely free
Brainerd, Bostic and Bullard, though sounding like a law firm, are actually three FOMC members who spoke yesterday. In what has been a remarkably consistent performance by virtually every single member of the committee (Robert Kaplan excepted), they all said exactly the same thing: prices will rise due to bottlenecks and shortages in the near-term, but that this was a short-term impact of the pandemic response, and that soon those issues would abate and prices would quickly stabilize again. They pointed to ‘well-anchored’ inflation expectations and reminded one and all that they have the tools necessary to combat inflation in the event their version of events does not come to pass. You have to give Chairman Powell credit for convincing 16 ostensibly independent thinkers that his mantra is the only reality.
The market response was one of rainbows and unicorns, with rallies across all assets as risk was snapped up everywhere. After all, it has been nearly two weeks since the CPI print was released at substantially higher levels than anticipated raising fears amongst investors that the Fed was losing control. But two weeks of soothing words and relatively benign data has been sufficient to exorcise those inflation demons. In the meantime, the Fed continues to purchase assets and expand its balance sheet as though the economy is teetering on the brink of destruction while they await the “substantial progress” toward their goals to be met.
One consequence of the Fed’s QE program has been that high-quality collateral for short term loans, a critical part of the financial plumbing of the US (and global) economy has been in short supply. For the past two months, Treasury bill issues have been clearing at 0.00%, meaning the government’s cost of financing has been nil. This is due to a combination of factors including the Treasury running down the balances in the Treasury General Account at the Fed (the government’s checking account) and the ongoing Fed QE purchases of $80 billion per month. This has resulted in the Treasury needing to issue less T-bills while simultaneously injecting more funds into the economy. Banks, meanwhile, wind up with lots of bank reserves on their balance sheets and no place to put them given the relative dearth of lending. The upshot is that the Fed’s Reverse Repurchase Program (RRP) is seeing unprecedented demand with yields actually starting to dip below zero. This is straining other securities markets as well given the bulk of activity in markets, especially derivatives activity, is done on a margin, not cash, basis. While so far, there have not been any major problems, as the stress in this corner of the market increases, history shows that a weak link will break with broader negative market consequences. For now, however, the Fed is able to brush off any concerns.
The result of the constant commentary from Fed speakers, with three more on the schedule for today, as well as the fading of the memories of the high CPI print has been a wholesale reengagement of the risk-on meme. Growth continues to rebound, while zero interest rates continue to force investors out the risk curve to find a return. What could possibly go wrong?
Today, the answer is, nothing. Risk is back with a vengeance as evidenced by a strong equity session in Asia (Shanghai +2.4%, Hang Seng +1.75%, Nikkei +0.7%) and a solid one in Europe as well (DAX +0.8%, CAC +0.15%, FTSE 100 0.0%). The Chinese (and Hong Kong) rally seems to be a product of the PBOC focusing their attentions on the commodity market, not equities, as the source of imbalances and a potential target of interventionist policies thus allowing speculators there to run free. German equities are the beneficiary of better than expected ZEW data, with both the current conditions (95.7) and Expectations (102.9) indices leading the way. While yesterday’s US equity rally faded a bit late in the day, futures this morning are all pointing higher by about 0.3%.
Arguably, the FOMC trio had a bigger impact on the bond market, where 10-year Treasury yields are now back below 1.60%, down 1 basis point this morning and at their lowest level in more than two weeks. It is certainly hard to believe that the bond market is remotely concerned about inflation at this time. Remember, though, Friday we see the core PCE print, which is the number the Fed truly cares about, and while it is forecast to print above the 2.0% target, (0.6% M/M, 2.9% Y/Y) we also know that the Fed strongly believes this is transitory and is no reason to panic. Markets, however, if that print is even stronger, may not agree with that sentiment.
Commodity prices are having a less positive day as the ongoing concerns about Chinese actions to prevent price rises continues to weigh on sentiment. Oil has slipped just a bit (-0.3%) but we are seeing declines in Cu (-0.4%), Al (-1.1%) and Fe (-3.1%), all directly in the crosshairs of the Chinese government. Agricultural product prices are mixed today while precious metals remain little changed.
Finally, the dollar is mostly lower this morning with broad weakness seen in the EMG bloc, but less consistency in G10. While SEK (+0.5%) leads the way higher, the rest of the bloc has been more mixed. NOK (-0.2%) is clearly suffering from oil’s decline, while JPY (-0.2%) seems to be giving ground as havens are unloved. EUR (+0.25%) has been helped by that German ZEW data as well as the beginnings of a perception that the Fed is going to be more aggressively dovish than the ECB for a long time to come. In that event, the euro will certainly rise further, although it has a key resistance level at 1.2350 to overcome.
ZAR (+0.7%) leads the emerging market parade higher as concerns over inflation there abate, and South Africa continues to have amongst the highest real yields in the world. KRW (+0.4%) is next in line as consumer sentiment in South Korea rose to its highest level in 3 years. The other noteworthy move has been CNY (+0.2%) not so much for the size of the move as much as for the fact that it has breached the 6.40 level and the government has indicated they are going to be taking additional steps to open the FX market in China to help local companies hedge their own FX risks. The only laggard of note is TRY (-0.3%) which is suffering as President Erdogan has replaced yet another member of the central bank’s board, inviting concerns inflation will run higher with no response.
Data today shows Case Shiller Home Prices (exp +12.5%) as well as New Home Sales (950K) and Consumer Confidence (119.0), none of which are likely to change either Fed views or market opinions. As mentioned above, three Fed speakers will regale us with their sermon on transitory inflation, and I expect that the dollar will remain under pressure for the time being. In fact, until we see core PCE on Friday, it is hard to make a case that the dollar will turn around and only then if the number is higher than expected.
Good luck and stay safe