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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