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


 


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