Yields Are Repressed

You have to be mighty impressed
The bond market’s not even stressed
Although CPI
Has reached a new high
One wonders if yields are repressed

Clearly, there is only one story of import these days, and that is whether or not inflation is transitory.  Chairman Powell and his minions have spent the last several months harping on this idea, and although there was a time when several FOMC members seemed to get nervous and wanted to discuss tapering QE, it seems highly likely that next week’s FOMC meeting will focus on the fact that “substantial progress” has not yet been made toward the Fed’s goals of maximum employment and 2% average inflation.  Well, at least on the goal of maximum employment.  It seems pretty clear that they have made some progress on the inflation front.

While the headline Y/Y print of 5.0% was clearly impressive, and the highest since August 2008, personally, I am more impressed with the core M/M print of 0.7% as that is not impacted by what happened during the pandemic.  And the fact that this followed last month’s 0.9% print could indicate that inflation is becoming a bit less transitory.  But the Fed has done a wonderful job of selling its story.  One has to believe that Chairman Powell could not have wanted a better outcome than yesterday’s market price action with the S&P 500 making new highs while the bond market rallied sharply with the 10-year yield falling 6 basis points to 1.43%.

For a moment, let us try to unpack this price action.  On the one hand, it is easy to understand the equity rally as the decline in nominal yields alongside the rising recorded inflation has led to a dramatic fall in real yields.  One view, which many utilize, is that real 10-year yields are simply the 10-year yield less the current headline CPI rate.  Of course, right now, that comes to -3.57%, a level only seen a handful of times in the past, all of which occurred during significant inflationary periods in the 1970’s and early 1980’s.  Negative real yields are a boon for stocks, but historically are awful for the dollar and yet the dollar actually rallied slightly yesterday.  It seems to me that a more consistent outcome would require the dollar to decline sharply from here.  After all, even using Bund yields, currently -0.284%, and Eurozone CPI (2.0%), one sees real yields in the Eurozone far higher (-2.284%) than here in the US.  Something seems amiss.

Something else to consider is bond positioning.  There continues to be a great deal of discussion pointing to the bond market rally as a massive short squeeze.  Last week’s CFTC data was hardly indicative of that type of movement, although we will learn more this afternoon.  However, there is another place where both hedge funds and retail investors play, the ETF market, and when it comes to bond speculation, TLT is the product of choice.  Interestingly, more than 37% of the shares outstanding have been shorted in this ETF, a pretty good indication that there were a lot of bets for a higher yield.  But the word is that a significant portion of these shorts were closed out yesterday, on the order of $7 billion in short covering in total, which would certainly explain the sharp rally in the bond market.  This begs the question, is the price action technical in nature rather than a reflection of the views that inflation is truly transitory?  The problem with this question is we will not be able to answer it with any certainty for at least another three to four months.  But for now, the Fed has the upper hand.  In fact, there doesn’t seem to be any reason for them to adjust policy next week at all.  Why taper if the current policy mix is working?

Speaking of policy mixes that seem to be working, I would be remiss if I didn’t mention that the ECB meeting yesterday resulted in exactly…nothing.  Policy was left unchanged, Madame Lagarde promised to continue to buy assets at a faster pace than the first quarter, and then she spent an hour in her press conference saying virtually nothing.  It may have been her finest performance in the role.

The bond market seems to have made up its mind that the Fed is correct although there remain many pundits who disagree.  I expect that we will be continuing this discussion all summer long and with every high CPI print, you can look for the punditry to pump up the volume of their critiques of the Fed. However, we need only see one dip in the data for the Fed to claim victory and move on from the inflation discussion.  Next month’s CPI report will truly be important as the base effects will have disappeared.  Last year, the June M/M CPI was 0.5%.  If inflation is truly with us, we need to see M/M in June 2021 to be at least that high, if not a repeat of the 0.6%-0.8% numbers we have been seeing lately.  Between now and then we will see a number of price indicators including the Fed’s favorite core PCE.  For the past several months, every price indicator has been high and surprising on the high side.  The next months’ worth of data will be very important to both the Fed and the markets.  Enjoy the ride.

With two of the three key near-term catalysts now out of the way, all eyes will turn to next Wednesday’s FOMC meeting.  But that leaves us 4 sessions to trade in the interim.  Right now, with the fed narrative of transitory inflation dominating, it is easy to expect continued risk-on market performance.  Interestingly, that was not actually the case in Asia as the Nikkei (0.0%) was flat and Shanghai (-0.5%) fell although the Hang Seng (+0.35%) managed to close higher on the day.  Europe, however, got the memo and is green across the board (DAX +0.4%, CAC +0.7%, FTSE 100 +0.5%).  US futures, too, are picking up buyers as they all trade 0.25% or so higher at this hour.  

Meanwhile, in the bond market, Treasury yields have backed up 1.3bps, which looks far more technical than fundamental.  After all, they have fallen 18 bps in the past week, a rebound is no surprise.  However, European sovereign markets were closed before the bond party really started yesterday afternoon and they are in catch up mode today.  Bunds (-2.0bps) and OATS (-2.1bps) are performing well, but nothing like Gilts (-4.6bps), nor like the PIGS, all of which are seeing yield declines of at least 4bps.

Commodity prices are generally higher led by oil (WTI +0.5%) with the industrial metals all performing well (Cu +1.9%, Fe +1.0%, Sn +0.6%) although despite the dramatic decline in yields, gold (-0.5%) continues to underperform.  That feels like it is going to change soon.

Finally, in FX markets, the dollar is king of the G10, rising against all of its counterparts here with NZD (-0.4%) and SEK (-0.4%) leading the way down.  While the kiwi price action appears to be technical after having seen a decent rally lately, Sweden’s krona continues to suffer from its lower CPI print yesterday, once again delaying any idea that they may need to tighten policy in the near term.  The rest of the bloc is softer, but the movement has been far less impressive.

What makes that price action interesting is the fact that EMG currencies have actually had a much better performance with IDR (+0.4%), KRW (+0.4%) and TRY (+0.4%) all showing modest strength.  In Turkey, FinMin comments regarding the divergence between CPI and PPI were taken somewhat hawkishly.  In Seoul, a BOK governor mentioned the idea that one or two rate hikes should not be seen as tightening given the current record low level of interest rates (currently 0.50%).  However, it seems the market would see 50bps of tightening as tightening.  And lastly, the rupiah continues to benefit from foreign buying of bonds with inflows rising for a third consecutive week.

Data this morning brings Michigan Sentiment (exp 84.4) and careful attention will be paid to the inflation expectation readings, with the 1yr expected at 4.7%.  Remember, the Fed relies on those well-anchored inflation expectations, so if they are rising here, that might cause a little indigestion in Washington.

At this stage, just as we are seeing the bond market rally ostensibly on short covering, my sense is the dollar is behaving in the same way.  The data and rates would indicate the dollar should fall, but it continues to grind higher right now.  In the end, “the fundamentals things apply, as time goes by”1, and right now, they all point to a weaker dollar.  

Good luck, good weekend and stay safe
Adf

1.	Apologies to Wilson Dooley 

Out of Gas

Though prices are forecast to rise
The Treasury market implies
That Jay has it right
And this is the height
Inflation will reach at its highs

Instead, once the base effects pass
Inflation will run out of gas
So there is no need
For Powell to heed
The calls to halt QE en masse

This morning we finally get to learn about two of the three potential market catalysts I outlined on Monday, as the ECB announces their policy decision at 7:45 EDT with Madame Lagarde speaking at a press conference 45 minutes later.  And, as it happens, at 8:30 EDT we will also see the May CPI data (exp 0.5% M/M, 4.7% Y/Y headline; 0.5% M/M, 3.5% Y/Y ex food & energy).  Obviously, these CPI prints are far higher than the Fed target of an average of 2.0% over time, but as we have been repeatedly assured, these price rises are transitory and due entirely to base effects therefore there is no need for investors, or anybody for that matter, to fret.

And yet…one cannot help but notice the rising prices that we encounter on a daily basis and wonder what the Fed, and just as importantly, the bond market, is thinking.  Perhaps the most remarkable aspect of the current inflation discussion is that despite an enormous amount of discussion on the topic, and anecdotes galore about rising prices, the one market that would seem to be most likely to respond to these pressures, the Treasury market, has traded in exactly the opposite direction expected.  Yesterday, after a very strong 10-year auction, where the coverage ratio was 2.58 and the yield fell below 1.50%, it has become clear that bond investors have completely bought into the Fed’s transitory story.  All of the angst over the massive increases in fiscal spending and huge growth in the money supply have not made a dent in the view that inflation is dead.

Recall that as Q1 ended, 10-year yields were up to 1.75% and forecasters were falling all over themselves to revise their year-end expectations higher with many deciding on the 2.25%-2.50% area as a likely level for 10-year yields come December.  The economy was reopening rapidly and expectations for faster growth were widespread.  The funny thing is that those growth expectations remain intact, yet suddenly bond investors no longer seem to believe that growth will increase price pressures.  Last week’s mildly disappointing NFP report is a key reason as it was the second consecutive report that indicated there is still a huge amount of labor slack in the economy and as long as that remains the case, wage rises ought to remain capped.  The counter to that argument is the heavy hand of government, which is both increasing the minimum wage and paying excessive unemployment benefits thus forcing private companies to raise wages to lure workers back to the job.  In effect, the government, with these two policies, has artificially tightened the labor market and historically, tight labor markets have led to higher overall inflation.

The last bastion of the inflationists’ views is that the recent rally in Treasuries has been driven by short-covering and that has basically been completed thus opening the way for sellers to reemerge.  And while I’m sure that has been part of the process, my take, also anecdotal, is that fixed income investors truly believe the Fed at this time, despite the Fed’s extraordinarily poor track record when it comes to forecasting literally anything.  

As an example, two weeks ago, I was playing golf with a new member of my golf club who happened to be a portfolio manager for a major insurance company.  We spent 18 holes discussing the inflation/deflation issue and he was 100% convinced that inflation is not a problem.  More importantly, he indicated his portfolio is positioned for that to be the case and implied that was the house view so his was not the only portfolio so positioned.  This helps explain why Treasury yields are at 1.49%, 25 basis points lower than on April 1.  However, it also means that while today’s data, whatever it is, will not be conclusive to the argument, as the summer progresses and we get into autumn, any sense that the inflation rate is not heading back toward 2.0% will likely have major market consequences.  Stay tuned.

As to the ECB, it seems highly unlikely that they will announce any policy changes this morning with the key issue being their discussion of the pace of QE purchases.  You may recall that at the April meeting, the key words were, “the Governing Council expects purchases under PEPP over the current quarter to continue to be conducted at a significantly higher pace than during the first months of the year.”  In other words, they stepped up the pace of QE to roughly €20 billion per week, from what had been less than €14 billion prior to that meeting.  While the data from Europe has improved since then, and reopening from pandemic induced restrictions is expanding, it would be shocking if they were to change their view this quickly.  Rather, expectations are for no policy change and no change in the rate of QE purchases for at least another quarter.  The inflationary impulse in the Eurozone remains far lower than in the US and even though they finally got headline CPI to touch 2.0% last month, there is no worry it will run away higher.  Remember, too, there is no way the ECB can countenance a stronger euro as it would both impair its export competitiveness as well as import deflation.  As long as the Fed continues to buy bonds at the current rate you can expect the ECB to do the same.

In the end, we can only wait and see what occurs.  Until then, a brief recap of markets shows that things have continued to trade in tight ranges as investors worldwide await this morning’s news.  Equity markets in Asia were very modestly higher (Nikkei +0.3%, Shanghai +0.5%, Hang Seng 0.0%) and in Europe the movement has been even less pronounced (DAX +0.1%, CAC -0.1%, FTSE 100 +0.3%).  US futures are mixed as well with the three major indices within 0.2% of closing levels.

Bond markets, after a strong rally yesterday, have seen a bit of profit taking with Treasury yields edging higher by 0.8bps while Europe (Bunds +1.0bps, OATs +1.6bps, Gilts +0.7bps) have moved up a touch more.  But this is trader position adjustments ahead of the news, not investors making wholesale portfolio changes.

Commodity markets are mixed with crude oil (+0.1%) barely higher while precious metals (Au -0.5%, Ag -0.4%) are under a bit of pressure.  Base metals, however, are seeing more selling pressure (Cu -1.5%, Al -0.2%, Sn -0.7%) while foodstuffs are mixed as wheat is lower though corn and soybeans have edged higher.

Finally, in the FX market, the G10 is generally mixed with very modest movement except for one currency, NOK (-0.5%) which has fallen sharply after CPI data came out much lower than expected thus relieving pressure on the Norgesbank to tighten policy anytime soon.  In the EMG bloc, ZAR (+0.6%) is the leading gainer after its C/A surplus was released at a much stronger than expected 5.0% indicating finances in the country are improving.  But away from that, things have been much less exciting as markets await today’s data and ECB statements.

In addition to the CPI data this morning, as it is Thursday, we will see Initial Claims (exp 370K) and Continuing Claims (3.65M).  Interestingly, those may be more important data points as the Fed is clearly far more focused on employment than on inflation.  But they will not be sensational, so will not get the press.  FWIW my money is on a higher than expected CPI print, 5.0% or more with nearly 4.0% ex food & energy.  However, even if I am correct, it is not clear how big a market impact it will have beyond a very short-term response.  In the end, if Treasury yields continue to fall, I believe the dollar will follow.

Good luck and stay safe
Adf


 


How Long Can They Wait?

While prices worldwide are all rising
Most central banks keep emphasizing
That they have no fear
And later this year
Their efforts will be stabilizing

But every time data’s released
It seems that inflation’s increased
How long can they wait
Ere they contemplate
It’s time QE should be deceased?

It has been another extremely dull day in financial markets as participants await the next catalyst, arguably coming tomorrow in the form of either a surprise from the ECB, a low probability event, or a surprise from the US CPI release, a higher probability event.  And yet, even if CPI surprises, will it really have much market impact?

For inspiration on the potential impact of a surprising outcome, let us quickly turn to China, where last night inflation data was released with PPI rising 9.0% Y/Y, its highest print since 2008, although CPI rose a less than expected 1.3%.  However, for the world overall, Chinese PPI is of much greater importance as it offers clues to what Chinese manufacturers may be charging for the many goods they sell elsewhere in the world.  If they start raising prices, you can be sure that prices elsewhere will be rising as well.  But the market response to this much higher than expected result was a collective yawn.  Chinese bond yields actually fell 1 basis point while the renminbi slipped 0.2%.  Chinese equities rose 0.3% in Shanghai to complete the triumvirate of markets demonstrating no concern over rising prices.

Is that what we can expect if tomorrow’s CPI data prints at a higher than expected number, perhaps even above 5.0%?  The first thing to note is that the Treasury market is certainly not demonstrating concern, at least in the classical sense of selling off into a rising inflationary situation.  In fact, yields are now back to their lowest level, 1.50%, since early March, the period during which yields were rising rapidly and eventually touched the early-April highs of 1.75%.  But here we are 25 basis points lower and the market seems to have completely bought into the Fed narrative of transitory inflation.  (As an aside, perhaps someone can explain to me why, if inflation is transitory and the Fed need not respond to the recent rises, there is a growing consensus that the Fed is going to start to taper QE purchases.  After all, the implication of transitory inflation is that current policy is fine as is, why change it and rock the boat?)

Another story that has been getting increasing play is about the growing short positions in Treasury bonds and how regardless of tomorrow’s data, we could see a short squeeze and lower yields.  Now, when I look at the CFTC data, I do see that last week open positions fell by nearly 50K contracts, but the overall outstanding position remains net long ~55K and there has been no discernible pattern of building short positions, so I’m not sure where that story has come from.  

So, when considering what we know about the current situation, near-term inflation pressures but central bank certitude it is transitory and recent price action indicating limited concern over inflation, it tells me that a high CPI print, currently forecast at 4.7%, will have no impact of note on the bond market.  As such, it seems unlikely that a high CPI print will have much impact on any market.  We will need to see a series of high prints, and they will need to continue at least through October or November before, it seems, anybody is going to believe that inflation may be more than a transitory phenomenon.  Unfortunately, we will all suffer equally due to the fact that prices are going to continue to rise, regardless of what the Fed or BLS tells us.

Turning to today’s session, price action has been generally similar to yesterday’s session, which means that there have been continued small movements in markets with strong trends difficult to identify.  For instance, equity markets overnight showed the Nikkei (-0.3%) and Hang Seng (-0.1%) both slipping a bit while Shanghai (+0.3%) managed to eke out a gain.  Hardly conclusive evidence of a theme.  Europe, however, is a bit softer, with the DAX (-0.5%) and FTSE 100 (-0.6%) both under a bit of pressure although the CAC (0.0%) has gone nowhere at all.  The German story is one of weaker than expected data, this time a smaller trade surplus with declines of both imports and exports indicating growth there is not quite so robust.  Meanwhile, Brexit issues between the EU and UK have arisen again over Northern Ireland, and this seems to be weighing on sentiment there.  As to US futures markets, they are very little changed at this hour.

Bond markets are clearly not concerned over inflation with Treasury yields down 2.7 basis points and similar declines in Europe (Bunds -2.6bps, OATs -3.0bps, Gilts -2.0bps).  Looking further afield, Italian BTPs have seen yields decline by 5 basis points with Spain and Portugal both falling 4bps or more.  It seems clear the market believes the ECB is going to continue to actively support the European government bond market.

On the commodity front, oil continues to rally with WTI (+0.4%) back over $70/bbl.  Something to consider regarding oil is that as ESG initiatives continue to grow in importance, and many of them are attacking the fossil fuel industry, seeking to prevent funding, there will be less and less exploration for and drilling of new oil sources.  But the transition to eliminating fossil fuels from the economy will take many years, (I’ve seen credible estimates of 30-50 years) meaning demand will not disappear, even if supply shrinks.  It seems pretty clear what will happen to the price of oil in this situation.  Do not be surprised if the previous high of $147/bbl is eclipsed in the coming years.

As to the rest of the commodity space, precious metals are a bit softer while base metals are more mixed today (Cu -0.9%, Al -0.15%, Ni +0.3%).  And finally, the grains are giving back some of their recent gains with all three down about 1.0%.

Finally, in FX, the dollar is broadly softer, but the movement has been very modest.  In G10 space, NOK (+0.3%) is the leader along side CAD (+0.3%) as they both follow oil’s rise.  After that, though, the movement is between 0.0% and 0.2%, with no stories to discuss.  In the Emerging Markets, HUF (+0.6%) is the big winner, as CPI continues to print above 5.0% and the central bank is tipped to raise rates at its meeting tomorrow.  But aside from that, there are more winners than losers although they are all just modest gains on the order of 0.1%-0.2%.  Weakness was seen in some APAC currencies overnight, but that, too, was very modest.

There is no important data to be released today, nor are there any Fed speakers, so my take is the market will continue to trade on the back of the Treasury market movement.  If yields continue to slide, look for the dollar to stay under some pressure.  If they reverse, I think the dollar will as well.

Good luck and stay safe
Adf





No Aberration

In Europe and in the US

The central banks have made a mess

The latter’s seen prices

Rise up to a crisis

The former is still in distress

But one thing the two of them share

Is neither believes in the scare

That higher inflation

Is no aberration

And tapering they’ll soon declare

We have seen another day of modest overnight activity as market participants across asset classes wait for the next key data inputs.  At this point, the three biggest things on the horizon are Thursday’s ECB meeting and US CPI print and then next Wednesday’s FOMC meeting.  Until those data points are known, tight ranges and lack of trading liquidity are likely to be the hallmarks of all markets.

One of the things that has been something of a mystery is the disconnect between the performance of the US Treasury market and the ostensibly rapid rise in inflationary pressures, with the former essentially discounting the latter completely.  In fact, I would argue this is the key question that must be answered in order to better understand the potential future outcomes.  Arguably, it is also this situation which has allowed the Fed to remain sanguine over the recent jumps in CPI and PCE.

Consider that the bond market is generally assumed to have the greatest sensitivity to future economic activity given its very nature.  After all, the meaning of fixed income is that regardless of future economic performance, bondholders get a stated amount of interest.  It is this feature that keeps bond investors so highly attuned to inflation and inflation expectations as these investors want to ensure the real value of their investments does not decline due to rising prices.  Historically, this has certainly been the case, with bond markets selling off before inflation really took off.  This is also the genesis of the term ‘bond vigilantes’, coined during the Clinton administration to describe the bond market’s unwillingness to fund hugely expansionary fiscal plans and run large government deficits.  My, how the world has changed!

But back then, the Federal Reserve was not in the business of QE.  In fact, while it may have been a theoretical concept, even the Japanese had not yet tried it on for size.  Two plus decades later, though, the role of the Fed has clearly changed given the economic stresses suffered in both the GFC and Covid induced crisis.  QE has gone from an emergency tool to address a unique situation to the go-to tool in the Fed’s (and ECB’s) toolkit.  Thus, have grown the central bank balance sheets and so there has been a lid on interest rates, even if not explicitly via yield curve control.

There is, however, another key change in the world since the bond vigilante days of the late 1990’s; the regulatory requirements for large banks known as GSIBs, (Global Systemically Important Banks) imposed after the GFC.  These 30 institutions are required to maintain additional capital buffers and hold them in so-called High-Quality Liquid Assets (HQLA) which, not surprisingly, include Treasury bonds as well as mortgages and excess reserves.  One of the things that all of these banks do is adjust that portfolio of HQLA to maximize the available revenue, which in a world where yields are zero and negative, is very hard to achieve.  While Treasury bills and IOER pay virtually nothing, Treasury securities out the curve do have positive nominal yields and are thus relatively attractive for the purpose.

This leads to a potential alternative reason for the seeming lack of concern by the Treasury market over future inflation; price insensitive demand for bonds required to be held by large banks.  If these banks are buying and holding more Treasuries than they otherwise would have done in an unfettered world, the price signal from those bonds is likely to be somewhat skewed.  In other words, what if the Treasury market is not telling us there is no fear of inflation, but rather telling us that there are so many price insensitive buyers of bonds, even the excess supply being issued is not enough to scare holders out of the market.  In that case, we will need to get our clues about inflation elsewhere, perhaps from commodity markets.  And of course, commodity prices have done nothing but rally sharply across every class for the past year.  While there is no doubt that the first part of that move was to make up for the severe price dislocations seen at the beginning of the Covid crisis, it is not hard to make the case that the more recent price movement is a response to rising demand meeting inelastic supply.  It is the latter that drives inflation.

The point here is that both the ECB and Fed have consistently maintained that there is no reason to worry over recent high inflation prints and that there is no reason for either of them to adjust their policy mix anytime soon.  If the bond market ‘meter’ is malfunctioning, though, both of these central banks may well find themselves on the wrong side of history, yet again.  Rapidly rising inflation could well come to dominate the policy discussion quite quickly in that case, and maximum employment may recede to a pleasant dream.  Food for thought.

As to market activity today, as mentioned above, we have seen modest movements in both directions amid modest trading volumes.  Starting with equities, Asia saw small losses across the board (Nikkei -0.2%, Hang Seng 0.0%, Shanghai -0.5%) while Europe has been very modestly firmer (DAX 0.0%, CAC +0.2%, FTSE 100 +0.3%).  US futures are mixed as well with DOW (-0.15%) suffering while NASDAQ (+0.3%) are a bit higher and SPX futures are essentially unchanged.  Not much new information here.

Bond markets are mostly a bit firmer this morning with Treasury yields (-1.5bps) falling furthest and European sovereigns all seeing yield declines of about 0.75bps.  With 10-year Treasury yields back to 1.55%, it appears, on the surface, that there is no concern about rising inflation.  But if my proposed thesis is correct, that number could be quite misleading.

Commodity prices are generally coming under pressure this morning, certainly not a sign of imminent inflation, but I would argue this is simple daily price volatility more than anything else.  For example, oil (-0.9%) is leading the pack lower but we are seeing weakness in precious metals (Au -0.2%, Ag -0.5%) and base metals (Cu -0.5%, Ni -0.7%, Fe -1.9%) with only grains continuing to rally as all three major ones are higher by about 1.0% this morning.

Turning to FX, it should be no surprise that there is really no story here this morning either.  The dollar is probably marginally higher overall, but really mostly mixed with small movements in virtually all currencies.  In the G10, NZD (-0.3%) is the biggest mover, but this move has simply taken it back to the middle of its trading range.  And the rest of the bloc has moved far less.  In emerging markets, we have seen two movements of some note with HUF (-0.4%) declining after weaker than expected IP data was released, putting a dent in the idea the central bank may tighten policy, while RUB (+0.4%) rose after yesterday’s higher than expected CPI print has traders believing the central bank is likely to raise rates further.  However, beyond those two moves, there is very little to discuss.

On the data front, the NFIB Small Business Optimism index was released at a disappointing 99.6, below expectations of 101.0 and actually below last month’s reading as well.  That seems to be a result of the difficulty small firms are having in hiring staff.  We also see the Trade Balance (exp -$68.7B) and then the JOLTS Job Openings report (8.2M) later this morning.  But as mentioned at the top, I don’t think anything will matter until Thursday, so look for more range trading until then.

Good luck and stay safe

Adf

A ZIRP Doctrinaire

The lady who once ran the Fed

And, Treasury, now runs instead

Explained higher rates

Right here in the States

Are something that she wouldn’t dread

But when she was Fed Reserve chair

And she had a chance to forswear

That rates should stay low

Her answer was, no

As she was a ZIRP doctrinaire

“If we ended up with a slightly higher interest rate environment it would actually be a plus for society’s point of view and the Fed’s point of view.  We’ve been fighting inflation that’s too low and interest rates that are too low now for a decade.  We want them to go back to a normal interest rate environment, and if this helps a little bit to alleviate things then that’s not a bad thing, that’s a good thing.”  So said Treasury Secretary Janet Yellen in a Bloomberg News interview as she was returning from the G7 FinMin meeting in London.

What are we to make of these comments?  Arguably, the first thing to note is that the myth of Fed independence is not merely shattered, but rather that the Treasury now explicitly runs both fiscal and monetary policy.  Can Chairman Powell resist a call for higher rates from his boss?  And yet this is diametrically opposed to everything we have heard from the majority of the FOMC lately, namely until “substantial further progress” is made toward achieving their key goal of maximum employment, policy is going to remain as is.  In other words, they are going to continue to buy $120 billion per month of Treasury and mortgage backed paper.  However, QE’s entire raison d’etre is to keep rates lower.  Does this mean tapering is going to begin soon?  Will they be talking about it at next week’s FOMC meeting?  Again, based on all we had heard up through the beginning of the quiet period, there was only a small minority of FOMC members who were keen to slow down the purchases.  Is Yellen a majority of one by herself?

The other thing that seems odd about this is that elsewhere in the interview she strongly backed the need for the proposed $4 trillion of additional government spending, which is going to largely be funded by issuing yet more Treasury debt.  I fail to understand the benefit, for the Treasury (or taxpayers) of spending more on debt service due to higher interest rates.  Or perhaps, Yellen was simply saying she thought spreads over Treasuries should rise, so others paid more, but the US still paid the least amount possible.  Somehow, though, I don’t believe the latter sentiment is what she meant.  (A cynic might assume she was short Treasuries in her PA after Friday’s data and was simply looking for a quick profit.  But, of course, no government official would ever seek to gain personally from their official role…right?)

Regardless of her motivation, the market took it to heart and 10-year Treasury yields have backed up 2.5 bps this morning, although that is after Friday’s very strong rally (yields fell more than 7 basis points) on the back of the weaker than expected NFP report convinced the market that tapering was now put off for much longer.

Which brings us to Friday’s data.  Once again, the NFP report missed the mark, with a gain of 559K, well below the 675K expected.  Interestingly, despite last month’s even bigger miss, revisions were miniscule, just 27K higher.  So, at least according to the BLS, job growth is not nearly as fast as previously expected/hoped.  What makes this so interesting was last week’s ADP data showed nearly 1 million new jobs were taken.  It appears that Covid has had a significant impact on econometric models as well as the economy writ large.  Of course, the stock market took this goldilocks scenario as quite bullish and we saw equity markets rally nicely on Friday.

In sum, Yellen’s comments seem a bit out of step with everything we had previously understood.  There is, though, one other possibility.  Perhaps Ms Yellen understands that inflation is not going to be transitory and that the Fed may well find itself forced to raise rates to address this situation.  If this is the case, then the fact that the Treasury Secretary has already explained she thinks higher rates would be “a good thing,” it leaves the Fed the leeway needed to address the coming inflationary wave.  One thing is certain, the inflation discussion is going to be with us for quite a while yet.

Market activity overnight has been fairly dull despite the Yellen comments, with equity markets mixed in Asia (Nikkei +0.3%, Hang Seng -0.45%, Shanghai +0.2%) although European markets have started to climb after a very slow start (DAX +0.2%, CAC +0.3%, FTSE 100 +0.3%).  US futures are mixed to slightly lower as NASDAQ futures (-0.35%) feel the force of potentially higher interest rates, while the other two indices are little changed.  (Remember, tech/growth stocks are akin to having extremely long bond duration, so higher interest rates tend to push these stocks lower.)

As mentioned, Yellen’s comments have led to Treasuries falling, and we have seen the same behavior in Europe with sovereigns there looking at yields higher by between 1.5 and 2.0 bps at this hour.  Higher interest rates have also had a negative impact on commodity prices with oil (-0.4%), gold (-0.25%), copper (-1.0%) and aluminum (-1.0%) all under pressure.  The one exception in the commodity space is foodstuff where the grains are all higher by at least 1.5% this morning.

Finally, the currency market is mixed although arguably leaning toward slight dollar weakness.  In the G10, the most notable mover is NOK (+0.5%) which is gaining despite oil’s weakness on the assumption that it will be the first G10 country to actually raise interest rates, with Q4 this year now targeted.  But away from that, the other 9 currencies are within 0.2% of Friday’s close with no stories of note.  In the emerging markets, MXN (+0.85%) is the runaway leader after yesterday’s elections handed AMLO a loss of his supermajority in the Mexican congress.  It seems investors are glad to see a check on his populist agenda of spending.  Beyond that, we see TRY (+0.5%) benefitting from hopes that President Biden’s meeting with Turkish President Erdogan will result in reduced tensions between the two countries.  And lastly, KRW (+0.3%) continues to see investment inflows drive the currency higher.

On the data front, there was nothing of note overnight, but this week has some important activities, namely US CPI and the ECB meeting.

Tuesday NFIB Small Biz Optimism 100.9
Trade Balance -$68.5B
JOLTS Job Openings 8.3M
Thursday ECB Meeting
CPI 0.4% (4.7% Y/Y)
-ex food & energy 0.4% (3.4% Y/Y)
Initial Claims 370K
Continuing Claims 3.7M
Friday Michigan Sentiment 84.2

Source: Bloomberg

Clearly, all eyes will be on CPI later this week as while widely expected to be rising again due to base effects, it is important to remember that it has risen far faster than even those expectations.  While the Fed remains quiet, the ECB is likely to reiterate that it is going to be keeping a ‘stepped up pace’ of asset purchases.  Although there is a great deal of belief in the dollar weakness story, I assure you, the ECB is not interested in the euro rallying much further.  Just like the Chinese, it appears most countries have had enough of a weak dollar.  Until the next cues, however, it seems unlikely that there will be large movement in the FX market.

Good luck and stay safe

Adf

Crucial Advice

The Chinese Department of Price

Is proffering crucial advice

Don’t think about hoarding

It won’t be rewarding

And don’t make us speak to you twice!

There really is such a thing as the Department of Price in China.  It is part of the National Development and Reform Commission, the Chinese economic planning agency, although I have to admit it sounds more like something from Atlas Shrugged than a real agency.  But soaring commodity prices during the past year have become quite the problem for China, resulting in rising inflation and shortages of inputs for their manufacturers.  Apparently, President Xi is not pleased with this result and so this obscure (absurd?) government agency is now tasked with preventing prices from rising across a range of commodities.  Their tactics include threats against buyers deemed to be hoarding, against speculators in commodity trading firms and against manufacturers for passing on rising input costs to their final customers.  While one cannot help but chuckle at the futility of this effort (prices of things in demand will rise or shortages will result) it also highlights just how much of a concern inflation is to the Chinese and helps explain the recent PBOC action regarding FX reserves in order to stop/reverse the renminbi’s recent strength.  While a stronger renminbi would help ease inflationary pressures, its impact on exports, especially with input prices rising, was just too much to take.  For the foreseeable future, you can expect USDCNY to rise in a slow and steady manner.

Along with the FOMC

Investors are anxious to see

The payroll release

With forecast increase

To offset last month’s perigee

Turning to today’s news, markets remain quiet and rangebound ahead of this morning’s NFP report.  Last month’s abysmal outcome, just 266K new jobs, hugely below the nearly one million expected has increased the concern today.  While yesterday’s ADP Employment report was spectacular at 978K, last month it was nearly 750K and we still got that huge surprise.  Estimates this morning range from 335K to 1000K which tells us that nobody really knows, and none of the econometric models out there are well tuned to the current economic circumstances.  Here are the current median forecasts according to Bloomberg:

Nonfarm Payrolls 674K
Private Payrolls 610K
Manufacturing Payrolls 25K
Unemployment Rate 5.9%
Average Hourly Earnings 0.2% (1.6% Y/Y)
Average Weekly Hours 34.9
Participation Rate 61.8%
Factory Orders -0.3%

Following yesterday’s ADP report, the dollar, which had been drifting higher, got a huge boost and rallied strongly versus all its counterparts.  In addition, we saw sharp declines in precious metals prices and more modest declines in bond prices (yields on the 10-year rose about 4bps).  Arguably, that is exactly what one would expect with news that the US economy is growing more rapidly than previously thought.  But that begs the question for today, has the market already priced in a much larger number and so become subject to some serious profit-taking on a ‘sell the news’ meme?  My sense is that we will need to see a very large number, something on the order of 1.3 million to continue yesterday’s price action in markets.  Anything less, even if above the median forecast, will likely be seen as toppish and given it is a summer Friday, traders will be quick to square up positions.

Obviously, the FOMC is watching this data closely.  Recall, their stated goal is maximum employment and they continue to harp on the 8.1 million jobs that have not yet been replaced due to the Covid shutdown as well as the 2 million jobs that would have otherwise been created based on trend growth prior to the shutdown.  The point is that, given the transitory inflation pressures theme that has been universally repeated by every FOMC member, the Fed seems very likely to maintain the current policy settings for a while yet.  So, while today’s number is important for the market’s understanding of the current situation, I don’t believe there is any number that will change Fed policy.  At least no large number.  On the flipside, a second consecutive weak number might just encourage discussion that the current QE is not sufficient.  It will certainly raise eyebrows and cause a great deal of angst at the next FOMC meeting in two weeks’ time.

At this point, however, there is nothing we can do but wait.  A recap of the overnight activity shows that equity markets had minimal movements with no major index moving more than 0.4% (Nikkei -0.4%) and US futures essentially unchanged at this time.  Bond markets are exhibiting the same lack of direction, with movements less than 1 basis point ahead of the release across Treasuries and European sovereigns.  Commodity prices, after yesterday’s spectacular declines in the precious metals of more than 2%, have stabilized with oil drifting slightly higher (WTI +0.3%), and metals and agricultural prices either side of unchanged.

Finally, the dollar has also been ranging with no G10 currency having moved more than 0.2% from yesterday’s closing level and an even spread of gainers and losers.  In other words, everyone is biding their time here.  EMG currencies have displayed a bit more weakness, but much of that is due to last night’s APAC session where most currencies fell in response to the ADP number, just like everything else did during yesterday’s NY session.  Looking at the EEMEA currencies, only PLN (-0.4%) is showing any type of noteworthy movement and that mostly appears to be a reaction to the fact it has been amongst the best performers over the past month, having gained more than 3.0%, and so is subject to more profit-taking.  In other words, every market is simply biding its time ahead of the release.

Away from the payroll report, Chairman Powell does speak this morning, but the focus is on climate change, not monetary policy, so it seems unlikely we will learn very much.  And after this, the Fed is in its quiet period ahead of the meeting, so we are left to our own devices to determine what will happen.

My sense is we will see a strong showing today, maybe 750K as well as a revision up to last month’s data, which was abnormally weak given other indicators, but I am hard pressed to see the dollar repeat yesterday’s gains.  Rather, consolidation into the weekend seems the most likely outcome.

Good luck, good weekend and stay safe

Adf

Filled with Frustration

The Beige Book explained ‘round the nation

That growth was up, as was inflation

As well, we all learned

Of job offers spurned

And businesses filled with frustration

Meanwhile, round the world, PMI’s

Of Services were no surprise

As nations reopen

Most people are hopin’

The world will, at last, normalize

Ahead of tomorrow’s NFP report in the US, one which given last month’s extraordinary miss will be closely scrutinized by both investors and the Fed, most markets appear to be biding their time in narrow ranges.  This was largely true yesterday and so far, remains the case in the Asian and European sessions.  This lull in activity offers an excellent time to consider the supporting data that we have received in the past twenty-four hours, as well as the remainder due this morning.

Starting with the Fed’s Beige Book yesterday, the report highlighted the features of the economy we have been hearing about for the past several months.  The lifting of Covid inspired restrictions has led to strong increases in demand for products and services ranging from houses and cars to hotels and restaurants.  Business owners indicated that a combination of supply chain bottlenecks and increased demand have been forcing prices higher and that they saw no reason for that to end soon.  They also continue to comment on their inability to hire the workers necessary to satisfy demand, especially in lower wage segments of the economy.  The anecdote I feel best illustrates the issue came from St Louis where a job fair held by a dozen restaurants to fill more than one hundred open positions drew only twelve candidates!  It certainly appears as though the ongoing extra Federal unemployment benefits being offered through September are discouraging a lot of people from going back to work.

One of the underlying beliefs regarding the Fed’s transitory inflation story is that supply chain interruptions will quickly resolve themselves.  And it is not just the Fed that believes this will be the case, but virtually every other economist as well.  But I wonder, what prompts their faith in that outcome?  After all, with available labor scarce, who is going to relink those chains?  Consider, as well, industries like mining and extraction of raw materials.  Shortages of copper and iron ore require the reopening of mines or excavating new ones.  One of the impacts of Covid was that not only were current operating mines closed, but capex was drastically cut, so there is a significant disruption in the exploration process.  Add to that the rise of ESG as a business objective, which will, at the very least slow, if not prevent, the opening of new sources of these raw materials, and it becomes quite easy to believe that these bottlenecks will remain for more than just a few months.  In fact, it would not be surprising if it was several years before the supply/demand balance in many commodities is achieved.  Given the current assessment is a lack of supply, you can be certain that prices will continue to rise far longer than the Fed will have you believe.

As to the overnight session, we were regaled with the Services PMI data from around the world.  In Asia we saw Australia solid, at 58.0, and right in line with last month, while Japan, 46.5, did show a marginal increase, but remains well below the growth-contraction line of 50.0.  China’s Caixin data, at 55.1, was disappointing vs. expectations as well as lower by 1.2 points compared to April’s reading.  Is the Chinese economy beginning to roll over?  That is a question that is starting to be asked and would also explain the PBOC’s sudden concern over a too-strong renminbi.  In a strong economy, a rising currency is acceptable, but if things are not as good, currency strength is an unwelcome event.  Finally, the last major Asian nation reporting, India, showed awful data, 46.4, demonstrating the huge negative impact the recent wave of Covid infections is having on the economy there.

The European story was a bit better overall, with Germany (52.8 as expected), France (56.6 as expected), Italy (53.1 better than expected) and the Eurozone (55.2 slightly better than expected) all demonstrating the recovery is underway on the continent.  As well, the UK continues to burn brightly with a 62.9 reading, more than a point higher than forecast.  And don’t forget, later this morning the US releases both the PMI data (exp 70.1) as well as ISM Services (63.2) both demonstrating that the US economy remains the global leader for now.  With that in mind, it is kind of odd that the dollar is so hated, isn’t it?

The other data coming this morning will give us our first hints at tomorrow’s NFP with ADP Employment (exp 650K) released 15 minutes before both Initial (387K) and Continuing (3.614M) Claims.  As well, at 8:30 we see Nonfarm Productivity (5.5%) and Unit Labor Costs (-0.4%), which on the surface would indicate there are no wage pressures at all but continue to be distorted by the past year’s data outcomes.

As to the market situation, while equity markets in Asia were mixed (Nikkei +0.4%, Hang Seng -1.1%, Shanghai -0.4%), Europe has turned completely red (DAX -0.5%, CAC -0.4%, FTSE 100 -0.9%) despite the solid PMI data.  This feels far more like some profit taking ahead of tomorrow’s data as well as the upcoming ECB meeting next week.  US futures are also under pressure, with all three major indices lower by between 0.5% and 0.75%.

What is interesting about the market is that despite the selloff in stocks, we are seeing a selloff in bonds as well, with Treasury yields higher by 1.5bps and European sovereigns all higher by at least 1 basis point (Bunds +1.1bps, OATs +1.4bps, Gilts +2.7bps).  This, of course, begs the question, if investors are selling both stocks and bonds, what are they buying?

The answer is not clear at this point.  Oil (WTI -0.1%) while outperforming everything else, is still down on the day, as are gold (-0.65%) and silver (-1.4%).  Base metals?  Well, copper (-1.0%) is clearly not the winner, although aluminum (+0.25%) is the only green spot on the screen.  Well, that and agricultural products with Soybeans (+1.25%), Wheat (+1.0%) and Corn (+0.85%) all quite strong this morning, punctuating the idea that food inflation is running at its highest level in more than a decade according to a just released UN report.  That is something I certainly see every week at Shop-Rite and I imagine so does everyone else.

Finally, a look at the FX market shows the dollar is having a pretty good day all around.  In the G10, the pound (+0.1%) is the only currency to hold its own vs. the greenback, with the rest of the bloc lower by between 0.2% and 0.4%.  Frankly, this simply looks like a risk-off session as investors are selling both stocks and bonds across the G10, and no longer need to hold the local currencies.  In the EMG bloc, the story is largely the same, with only INR (+0.25%) rising and the rest of the bloc under some pressure.  The rupee movement seems to be more technical as alongside weak PMI data, the RBI meeting, coming up tonight, is expected to see policy remain unchanged with a dovish bias given the ongoing Covid problems in the country.  On the downside, while most currencies are lower, aside from TRY (-0.5%) on slightly lower inflation, therefore less need to maintain high rates, the rest of the bloc’s declines are only on the order of -0.2%.  Finally, I would be remiss if I didn’t mention yesterday’s price action in LATAM currencies, where we saw significant strength in BRL (+1.5%) and CLP (+1.1%) which has been a broad continuation of funds flowing back into the region.

We have a few more Fed speakers today, but they all say exactly the same thing all the time, it seems, that they are thinking about considering starting a discussion on tapering.  In this vein, there was a big announcement yesterday that the Fed would be unwinding one of the emergency bond buying programs, the secondary market corporate program, and selling out the $13 billion of bonds and ETF’s they own.  Of course, that is such a tiny proportion of their balance sheet, and of that market in truth, it seems unlikely to matter at all.

My observation lately has been that NY tends to go against the prevailing trend for the day during its session, meaning on a day like today, when the dollar is well bid as NY arrives, I would look for a bit of dollar selling.  We shall see, but in fairness, all eyes are really on tomorrow.

Good luck and stay safe

Adf

Likely Too Soon

The narrative now seems to be
That tapering’s what we will see
The meeting in June
Is likely too soon
By autumn, though, Jay may agree

tran∙si∙to∙ry
adjective
not permanent.
“transitory periods of medieval greatness”

per∙sist∙ent
adjective
continuing to exist or endure over a prolonged period.
“persistent rain will affect many areas”

Forgive my pedanticism this morning but I couldn’t help but notice the following comment from former NY Fed President William Dudley.  “The recent spike in US inflation is likely transitory for now – but it could become more persistent in the coming years as more people return to work.”  Now, I don’t know about you, but I would describe the words ‘transitory’ and ‘persistent’ as antonyms.  And, of course, we all know that the Fed has assured us that recent rises in inflation are transitory.  In fact, they assure us multiple times each day.  And yet, here is a former FOMC member, from one of the most important seats, NY Fed president, explaining that this transitory phenomenon could well be persistent.  If you ever wondered why the term ‘Fedspeak’ was coined, it was because ‘doublespeak’ was already taken by George Orwell in his classic ‘1984’.  Apparently, one does not regain one’s intellectual honesty when leaving a government institution where mendacity is the coin of the realm.

However, let us now turn to today’s main story; tapering.  The discussion on tapering of QE continues apace and the market is settling on a narrative that the Fed will reduce the amount of its monthly purchases by the end of the year.  Certainly, there are a minority of Fed governors who want to get the conversation going in earnest, with St Louis’ James Bullard the latest.  And this idea fits smoothly with the concept that the US economy is expanding rapidly with price pressures, even if transitory, building just as rapidly.  Just yesterday, Elon Musk compared the shortage in microprocessors needed to build Teslas to the shortage of toilet paper at the beginning of the pandemic last year.  (As an aside, one, more permanent, result of that TP shortage is that prices in my local Shop-Rite are significantly higher today than pre-pandemic, at least 40% higher, even though the shortage was transitory no longer persists.)  

The point is that the combination of shortages of specific items, bottlenecks in shipping and dramatically increasing demand fed by massive government stimulus programs are all feeding into higher prices, i.e. inflation.  Even the most committed central bank doves around the world have noticed this situation, and while most are unwilling to alter policy yet, the discussion is clearly beginning.  Last night, the RBA omitted their promise “to undertake further bond purchases to assist with progress goals,” despite maintaining their YCC target of 0.10% for 3-year AGB’s.  As well, yesterday Fed Governor Lael Brainerd, arguably the most dovish FOMC member, explained, “while the level of inflation in my near-term outlook has moved somewhat higher, my expectation for the contour of inflation moving back towards its underlying trend in the period beyond the reopening remains broadly unchanged.”  Apparently, Lael attended the Alan Greenspan school of Fedspeak.

Add it all up and you get a market that is convinced that tapering is visible on the horizon and will begin before Christmas 2021.  While I don’t doubt it is appropriate, as I believe inflation is not actually transitory, I am also skeptical that the Fed is ready to alter its policy until it sees data showing the employment situation has reached its newly formed goals.  I fear that, as usual, the Fed will be late to the tightening party and the outcome will be a far more dramatic policy reversal and much bigger market impact (read stock market decline) than desired.

How, you may ask, has this impacted markets today?  The big winner has been the dollar, which is firmer against virtually all its counterparts this morning.  For instance, NZD (-0.5%) is the laggard in the G10 space after RBNZ comments explaining the balance sheet will remain large for a long time.  In other words, while they may stop buying new securities, they will replace maturing debt and so maintain a significant presence in their bond market.  Meanwhile, CHF (-0.5%) is under pressure after SNB Vice-president Zurbruegg explained that the bank’s expansive monetary policy, consisting of NIRP and FX intervention is still necessary.  The rest of the bloc is also softer, but not quite to that extent with AUD (-0.35%) under pressure from commodity price pullbacks and JPY (-0.35%) suffering after odd comments by a BOJ member that they would respond to any untoward JPY strength in the event the Fed does begin to taper.

Emerging market currencies have also been under pressure all evening led by TRY (-0.9%) and KRW (-0.65%).  The latter’s movement was a clear response to the PBOC setting its fixing rate for a weaker CNY than the market had anticipated, thus opening the way for a weaker KRW.  Given the fact that South Korea both competes aggressively in some markets with Chinese manufacturers, and has China as its largest market, the intricacies of the KRW/CNY relationship are many and complex.  But in a broad dollar on scenario, it is not too surprising to see both currencies weaken, and given KRW’s recent strong performance, it had much further to fall.  But currency weakness in this bloc is across EEMEA, APAC and LATAM, which tells us it is much more about the dollar than about any particular idiosyncratic stories.

In the rest of the markets, equities were mixed in Asia (Nikkei +0.45%, Hang Seng -0.6%, Shanghai -0.75%) while Europe is green, but only just (DAX +0.15%, CAC +0.3%, FTSE 100 +0.1%).  US futures are either side of unchanged at this hour as the market tries to digest the tapering story.  Remember, much of the valuation premium that exists in the US is predicated on lower forever interest rates.  If they start to climb, that could easily spell trouble.

Speaking of interest rates, they have edged lower in the session with 10-year Treasury yields down 0.3bps while in Europe, yields have fallen a bit faster (bunds -1.4bps, OATs -1.5bps, gilts -1.2bps).  Certainly, there is no keen inflationary scare in this market as of yet.

Interestingly, oil prices continue to rise, despite the stronger dollar, with WTI (+1.0%) trading to new highs for the move.  But the rest of the commodity space finds itself under pressure this morning as the dollar’s strength takes its toll.  Precious metals are softer (Au -0.25%, Ag -0.5%) as are base metals (Cu -0.8%, Al -0.5%) although the ags are holding up.  But if dollar strength is persistent, I expect that commodity prices will remain on the back foot.

On the data front, today brings only the Fed’s Beige Book this afternoon, as the ADP employment number is delayed due to the Memorial Day holiday Monday.  As well, we hear from four Fed speakers, including three, Harker, Kaplan and Bostic, who have been in the tapering camp for several weeks now.  However, until we start to see the Treasury market sell off more aggressively, I think tapering will be a nice talking point, but not yet deemed a foregone conclusion.  As such, that link between Treasury yields and the dollar remains solid, with the dollar likely to respond well to further discussions of tapering and higher yields.  We shall see if that is what comes to pass regardless of the current narrative.

Good luck and stay safe
Adf




Quite Premature

In Europe, to pundits’ surprise

The rate of inflation did rise

The ECB’s sure

It’s quite premature

To think prices will reach new highs

Meanwhile at the PBOC

They altered FX policy

Banks there must now hold

More money, we’re told

Preventing the yuan to run free

Two big stories presented themselves since we last observed markets before the Memorial Day holiday in the States; a policy change by the PBOC raising FX reserve requirements in order to encourage less renminbi buying dollar selling, and the release of Eurozone CPI showing that rising demand into supply bottlenecks does, in fact, lead to rising prices.  In line with the second story, let us not forget that Friday’s core PCE reading of 3.1%, was not only higher than anticipated but reinforced the idea that inflation is rising more rapidly than central bankers would have you believe.

But let’s start with China, where the renminbi has been appreciating very steadily since last May, rising more than 11% in that time.  initially, this was not seen as a concern as the starting point for USDCNY was well above 7.0, which is a level that had widely been seen as concerning for the PBOC with respect to excessive weakness.  But twelve months later, it has become clear that the PBOC now believes enough is enough.  Remember, the Chinese economy continues to be heavily reliant on exports for total activity, and an appreciation of that magnitude, especially for the low value items that are produced and exported, can be a significant impediment to growth.  Remember, too, that while a strong renminbi helps moderate inflation in China, it effectively exports that inflation to its customers. (We’ll get back to this shortly.)

Ultimately, China’s goal is to continue to grow their economy as rapidly as possible to insure limited unemployment and increased living standards for its population.  To the extent that a strengthening currency would disrupt that process, it is no longer a welcome sight.  Hence the PBOC’s move to reign in speculation for further CNY appreciation.  By raising the FX reserve requirement, they reduce the amount of onshore USD available (banks must now simply hold onto them) hence counting on the dollar to rise in value accordingly.  Or at the very least, to stop sliding in value.  Consider that China’s long-term stated goal is to further internationalize the renminbi, which means that direct intervention is an awkward method of control.  (International investors tend to shy away from currencies that are subject to the whims of a government or central bank).  This effort to change the FX reserve ratio, thus altering the supply/demand equation is far more elegant and far less intrusive.  Look for this ratio, now set at 7%, to rise further should the renminbi continue to appreciate in value.

As to the inflation story, this time Europe is the setting where prices are rising more rapidly than anticipated.  This morning’s CPI print of 2.0% is the first time it has printed that high since November 2018.  Now, price pressures in Europe are not yet to the level seen in the US, where Friday’s data was clearly an unwelcome surprise, but based on the PMI data releases, with the Eurozone composite rising to a record high of 63.1, and the fact that the latest spate of European lockdowns is coming to an end within the next week or two, it appears that economic activity on the continent is set to grow.  So, the demand side of the equation is moving higher.  meanwhile, the rising value of the CNY has raised input prices for manufacturers as well as retail prices directly.  While margins may be compressed slightly, the fact that Eurozone aggregate savings are at an all-time high suggests that there is plenty of money available to spend on higher priced items.  It is this combination of events that is set to drive inflation.

There is, however, a dichotomy brewing as bond markets, both in the US and Europe, do not seem to be indicating a great deal of concern over higher inflation.  Typically, they are the first market to demonstrate concern, usually forcing a central bank response.  But both here in the States, where Friday’s PCE data resulted in a collective yawn (Treasury yields actually fell 1 basis point) and  this morning in the Eurozone, where across major Eurozone countries, German bunds 0.1 bp rise is the only gain, with yields declining slightly elsewhere, the market is telling us that bond investors agree with the central banks regarding the transitory nature of the current rising inflation.  

Perhaps they are right.  While it is difficult to go to the store, any store, and not see that prices for many items have increased during the post-pandemic period, rising inflation means that those price rises will continue for a long time to come, not a simple one-off jump. Both the Fed and the ECB are certain that supply bottlenecks will be loosened soon, thus describing the temporary nature of their inflation views.  However, it is not as clear to me that is the case.  one of the defining features of the global economy during the past decade has been the adjustment of investment priorities at the corporate level, from investing and building new capacity to repurchasing outstanding shares.  This financialization of the economy is not well prepared to expand actual output.  I fear it may take longer than central banks anticipate to loosen those bottlenecks, which means price pressures are likely to be with us for a lot longer than central banks believe.  

A quick tour of markets this morning shows that regardless of Chinese activity or inflation concerns, risk is ON.  While Asia was mixed (Nikkei -0.2%, Hang Seng +1.1%, Shanghai +0.2%), Europe is a green machine (DAX +1.5%, CAC +0.9%, FTSE 100 +1.1%) after strong PMI data across the board.  US markets are not to be left out of this rally with futures in all three major indices rising by about 0.4% at this hour.

As mentioned above, the bond market is far less interesting this morning.  While Treasury yields have backed up 2bps, Europe is going the other way, save Gilts (+1.1bps).  Clearly there is no inflation concern there right now.  And this is despite the fact that oil prices are much higher (WTI +2.8%, Brent +2.1% and >$70/bbl) along with copper (+4.7%) although wedid see Aluminum slip (-0.6%).  Grains are rising as well as is Silver (+0.75%), although gold, which was higher earlier, is back to flat on the day.

The dollar, this morning, is mixed, with roughly an equal number of currencies higher and lower, although the gains are much greater than the losses.  For instance, NOK (+0.7%) is clearly responding to oil’s rise, while SEK (+0.5%) is benefitting from continued strong PMI data.  However, the rest of the G10 space is +/- 0.2% with the pound (-0.25%) the most noteworthy decliner after concerns were raised that a new Covid variant could delay the reopening of the economy.

In the EMG space, KRW (+0.4%) and THB (+0.3%) have been the best performers as both are thriving amid improving economic performance and anticipation that China’s recovery will help support them further.  Meanwhile, on the flipside, TRY (-0.5%) is the laggard followed by INR (-0.4%) and ZAR (-0.3%).  CNY (-0.2%) slipped in the wake of the PBOC action, while INR is suffering as Covid cases continue to surge.  The same is true in South Africa, and Turkey suffered after higher inflation readings than expected.

Data this week is big starting with ISM and culminating in the payroll report.

TodayConstruction Spending0.5%
 ISM Manufacturing60.9
 ISM Prices Paid89.0
WednesdayFed’s Beige Book 
ThursdayADP Employment650K
 Initial Claims395K
 Continuing Claims3.615M
 ISM Services63.0
FridayNonfarm Payrolls650K
 Private Payrolls600K
 Manufacturing Payrolls25K
 Unemployment Rate5.9%
 Average Hourly Earnings0.2% (1.6% Y/Y)
 Average Weekly Hours34.9
 Participation Rate61.8%
 Factory Orders-0.2%

Source: Bloomberg

In addition to this data we will hear from six more Fed speakers, including Chairman Powell on Friday.  All ears will be tuned toward the tapering debate and how this week’s speakers address the situation.  However, if you consider it, if inflation is transitory and growth is going well, why would they need to taper?  After all, they appear to have achieved the nirvana of  explosive growth with no inflation. 

Needless to say, not everyone believes that story.  However, the one story that is gaining credence everywhere is that the dollar is likely to decline going forward.  That was the consensus view at the beginning of the year, and after a quarter of concern, it appears to be regaining many adherents.  To date, the relationship between the dollar and 10-year Treasury yields has been very strong.  It has certainly appeared that the bond drove the dollar.  However, recent activity has been less conclusive.  I still believe that relationship holds, but will be watching closely.  That said, the dollar does feel heavy these days.

Good luck and stay safe

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