At first, no one thought it could be
That Powell would lessen QE
But less than a week
Was needed to wreak
Destruction ‘pon his new decree
The bond market bears have retreated
With steepeners now all deleted
While stocks are unsure
If this is the cure
And just how this news should be greeted
Last week’s FOMC meeting continues to be the main topic of market discussion as many assumptions have been questioned, especially those of the inflationist camp. The change in the dot plot was clearly unforeseen and has been the talk of the market ever since. Arguably, there are two key questions that have arisen in the wake of the meeting; 1) what happened to the Fed’s insistence that they would not adjust policy preemptively based on forecasts? and 2) is maximum employment no longer deemed to be an Unemployment Rate near 3.5%?
What has been made very clear, however, is that the market still believes the Fed can address inflation, or at the very least, that the market buys the Fed’s transitory inflation narrative. Regarding the latter, it relies almost entirely on the idea that supply-side bottlenecks will be quickly addressed, thus forcing prices lower and reducing the inflationary threat. My question is, why do so many assume that restarting production can be accomplished so quickly? In many cases, businesses have closed, thus no longer manufacturing products. In others, businesses are running shorter or fewer shifts due to the inability to hire/retain staff to operate. Glibly, many say that those businesses can simply raise wages to attract staff. And while that may be true, you can be sure that will result in rising prices as well. So, if supply returns at a higher price point, is that not still inflationary?
Under the theory that a picture is worth a thousand words, I have created a decision matrix that outlines my sense of how things may play out over the coming months. Having observed the Fed and its reaction function to market situations for quite a long time, I remain convinced that despite all the rhetoric regarding maximum employment or inflation expectations, the single most important data point for the Fed is the S&P 500. History has shown that when it declines sharply, between 10%-20%, they will step in, ease policy in some manner and seek to assuage the investment community regardless of trivialities like inflation, GDP growth or unemployment. Thus far, nothing the Fed has done has changed that opinion.
Remember, these are my personal views and I assigned rough probabilities along with estimates of what could happen under the defined scenarios. Ultimately, the question that keeps haunting me is; if inflation is transitory, why would they need to taper policy easing? After all, the underlying assumption is that the current policy remains economically supportive without negative inflationary consequences, so why change? I believe the answer to this question belies the entire Fed narrative. But that’s just me. The highlighted area is the expected outcome in one year’s time based on Friday’s closing markets (BCOM = Bloomberg Commodity Index). Interestingly, the math worked out where I saw weaker stocks, higher yields, a weaker dollar and higher commodities. In truth, if inflation is in our future, that does not seem to be wrong.
As to markets this morning, while Asian equity markets were largely under pressure (Nikkei -3.3%, Hang Seng -1.1%, Shanghai +0.1%), still reeling from the Fed’s allegedly hawkish stance, Europe is modestly firmer (DAX +0.7%, CAC +0.3%, FTSE 100 +0.2%). Perhaps hawks only fly East. US futures are also higher this morning, by roughly 0.5%, as the early concerns over tighter policy have clearly been allayed, by what though, I’m not sure.
Of course, all the real action has been in the bond market, where yields worldwide have fallen sharply since the FOMC meeting. Not only have yields fallen, but curves have flattened dramatically as well with movement on both ends of the curve, shorter dated yields have risen under the new assumption that the Fed will be raising rates, while the bank end has rallied sharply with yields declining as investors ostensibly believe that inflation is, in fact, transitory. While the overnight session has seen minimal movement (Treasuries 0.0bps, Bunds =0.4bps, Gilts -0.3bps), the movement since Wednesday has been impressive. The $64 billion question is, will this new movement continue into a deeper trend, or reverse as new data is released.
Commodity prices have not yet abandoned the inflation story, at least some of them haven’t. Oil (+0.2%) continues to perform well as demand continues apace and supply remains in the crosshairs of every ESG focused investor. Precious metals have rallied on the back of declining yields, both real and nominal, but base metals have slipped as there is a growing belief that they were massively overbought on an inflation scare that has now been defused. Funnily enough, I always had the commodity/inflation relationship the other way around, with higher commodity prices driving inflation.
Finally, the dollar this morning is weaker from Friday’s levels, but still generally stronger from its levels post FOMC. The crosscurrents here are strong. On the one hand, transitory inflation means less reason for a depreciating currency while on the other, lower rates that come with less inflation make the dollar less attractive. At the same time, if risk is going to be back in vogue, the dollar will lose support as well.
On the data front, there is a fair amount of data this week, although nothing of note today.
|Tuesday||Existing Home Sales||5.71M|
|Wednesday||Flash PMI Manufacturing||61.5|
|Flash PMIM Services||70.0|
|New Home Sales||871K|
|Core PCE||0.5% (3.9% Y/Y)|
As well as all of this, we heard from ten different Fed speakers, including Chairman Powell testifying to Congress tomorrow afternoon. It would seem there will be a significant effort to fine tune their message in the wake of last week’s meeting and the market volatility.
The dollar’s strength had been predicated on the idea that US yields were increasing and if that is no longer the case, my sense is that the dollar is likely to retrace its recent steps higher. For those who with currency payables, keep that in mind.
Good luck and stay safe