Said Jay, “you must listen to me”

And not to the numbers you see

Do not be afraid

Inflation will fade

So, keep up the stock buying spree!

Last week’s FOMC meeting seems to have been an inflection point in the recent market narrative which has resulted in a great many conflicting thoughts about the future.  The dichotomy of the meeting was the virtual absence of discussion on current high inflation readings juxtaposed with the Dot Plot forecasts on interest rates rising in 2023.  Arguably, the Dot Plot reflects the participants’ growing concern that inflation is rising, and that the FOMC will need to address that situation.  One could argue that this dichotomy has been the underlying cause for the increased volatility evident in markets, with sharp gains and losses seen across bonds, equities and currencies.

This afternoon, Chairman Powell will once again regale us with his views as he testifies before the House Select Subcommittee on the Coronavirus Crisis.  His prepared testimony was released yesterday afternoon with some key comments.  “Inflation has increased notably in recent months.  As these transitory supply effects abate, inflation is expected to drop back toward our longer-run goal.”  That pretty much sums up the Fed view and confirms that there is very little concern about inflation over time.  

Yesterday we also heard from three other Fed speakers, NY’s Williams, Dallas’ Kaplan and St Louis’ Bullard, with slightly different messages.  Williams, a permanent voter, remains adamant that it is too soon to consider adjusting policy, although he is willing to discuss the idea of tapering.  Meanwhile, both Kaplan and Bullard, both non-voters, are far more interested in getting the tapering talk off the ground as both see the economy picking up pace and have evidenced concern about overheating areas in the economy.  One can surmise from these comments that both of them are amongst the ‘dots’ above 1.0% for 2023.  In fact, Bullard admitted that he was a 0.6% ‘dot’ for 2022 in comments last week.  

Looking ahead, we have a long list of Fed speakers this week, with Mester, a hawkish non-voter, and Daly, a dovish voter, also set to comment today.  It almost appears as though voting members have been given a set of marching (speaking?) orders to which they are to adhere that express no concern over prices and the need to continue with current policy for the foreseeable future, while non-voting members have no such restrictions.  This is a very different dynamic than what we have become used to seeing, where everybody on the committee was saying the same thing.  Perhaps this is Powell’s solution to being able to maintain the policy he wants while having the Fed overall avoid criticism for groupthink.  But groupthink remains the base case, trust me.

During this period of policy adjustments, or at least narrative adjustments, investors have found themselves without their previous strong signals that all asset prices will rise and that havens serve little purpose.  Instead, we have seen a much choppier market in both stock and bond prices as previously long-held convictions have come into question. The most notable change has been in the shape of the yield curve, which has flattened dramatically.  For instance, the 2yr-10-yr spread, which had reached a high above 160 basis points in early April has seen a decline from 137 to below 110 and a rebound back to 122 in the past three sessions.  Other than March 2020, during the initial Covid confusion, there has not been movement of that nature since President Trump was elected in 2016.  And that was a one-day phenomenon.  At this point, the volatility we are experiencing is likely to continue until a new narrative takes hold.  As to today’s session, so far, we are seeing a modest bond rally with yields softer in Treasuries (-1.7bps after a 5bp rally yesterday) and European sovereigns (Bunds -0.4bps, OATs -1.4bps, Gilts -0.5bps) all slightly firmer on the day.  

Meanwhile, equity markets are also somewhat confused.  Last night, for instance, the Nikkei (+3.1%) rebounded sharply after the BOJ explained they had restarted their ETF buying program on Monday, so all was right with the world.  The Hang Seng (-0.6%) didn’t get that message but Shanghai (+0.8%) did despite rising short-term interest rates in China.  Those climbing rates appear to be a function of quarter end demand for bank funding that is not being supplied by the PBOC.  My sense is once July comes those rates will drift back down.  Europe, has had a more mixed equity session after a nice rally yesterday, with both the DAX and CAC flat on the day and the FTSE 100 (+0.3%) rising a bit, but weakness in the peripheral markets of Spain and Italy, with both of those lower by about 0.5%.  US futures are virtually unchanged at this hour as market participants seem to be awaiting Mr Powell.

Commodity markets are following suit, with some gainers (Au +0.2%, Ag +0.2%, Al +0.1%), some losers (WTI -0.7%, Soybeans -0.7% and Fe -3.2%) and many with little overall movement.  In a market that has lost its direction with respect to both growth and inflation expectations, or at least one which is re-evaluating those expectations, it should be no surprise there is a hodgepodge of price movements.

The dollar, however, is broadly firmer on the day, with GBP (-0.35%) the weakest performer in the G10 as traders await Thursday’s BOE meeting and their latest discussion on the inflation situation in the UK.  This will be BOE Chief Economist Andy Haldane’s last meeting, and he is expected to make some hawkish noises, but thus far, the rest of the committee has not been aligned with him.  Right now, the market is not looking for him to receive any support, hence the pound’s ongoing weakness, but if we do hear some hawkishness from another member or two, do not be surprised if the pound jumps back up.  As to the rest of the G10, losses range from 0.1%-0.25% and are all a reflection of the dollar’s strength, rather than any idiosyncratic stories here.  

Emerging market currencies are also broadly softer this morning, with a mix of laggards across all three blocs.  HUF (-0.5%), ZAR (-0.5%, THB (-0.45%) and MXN (-0.35%) reflect that this is a dollar and Fed story, not an EMG one.  The one exception to this rule is TRY (+1.0%) as hopes for an early lifting of Covid restrictions and a modest rise in Consumer Confidence there has underpinned the lira.

On the data front, we see Existing Home Sales (exp 5.72M) this morning at 10:00, but that seems unlikely to excite the market.  Rather, I expect limited movement until Chairman Powell speaks this afternoon.  

For now, volatility is likely to be the norm as the market adjusts to whatever the new narrative eventually becomes.  The inflation debate continues to rage and when Core PCE is released later this week, there will be more commentary.  However, it will require high inflation readings into the autumn to change the Fed’s stance, in my view, and until then, the idea that the Fed is considering tighter policy is likely to support the dollar for now.  However, that doesn’t mean further strength necessarily, just not any real weakness.

Good luck and stay safe

Adf