While Powell and friends fail to see
Inflation rise dangerously
Down south of the border
They fear its disorder
And burden on society
So, Mexico shocked and raised rates
While Fedspeak back here in the States
Continues the story
It’s all transitory
And claiming Nirvana awaits
Mexico became the latest emerging market nation to raise interest rates when they surprised the analyst’s community as well as markets by raising their base rate by 0.25% yesterday afternoon to 4.25%. The FX market response was swift and certain with the peso gaining more than 1.0% in the first minutes after the announcement although that has since slightly abated. “Although the shocks that have affected inflation are expected to be of a transitory nature, given their variety, magnitude and the extended time frame in which they have been affecting inflation, they may pose a risk to the price formation process,” the Banxico board explained in their accompanying statement. In other words, although they are paying lip service to the transitory concept, when CPI rose to a higher than expected 6.02% yesterday, it was apparently a step too far. Expectations for further rate hikes have already been built into the markets while views on the peso are improving as well.
The juxtaposition yesterday of Mexico with the UK, where the BOE left policy rates on hold at 0.10% and maintained the QE program intact despite raising its inflation forecast to 3.0% for next year, is quite interesting. Historically, it was the emerging market central banks who would seek growth at any cost and allow inflation to run hot while trying to support the economy and the developed market central banks who managed a more disciplined monetary policy, working to prevent inflation from rising while allowing their economy’s to grow without explicit monetary policy support. But it seems that another symptom of the Covid-19 pandemic is that it has reversed the ‘polarity’ of central bank thinking. Mexico is the 4th major EMG nation (Russia, Brazil and Poland are the others) to have raised rates and are anticipated to continue doing so to combat rising prices. Meanwhile, when the Bank of Canada reduced the amount of its QE purchases, it was not only the first G10 bank to actually remove some amount of monetary largess, it was seen as extraordinary.
In the States, yesterday we heard from six more Fed speakers and it has become evident that there are two distinct views on the FOMC as to the proper course of action, although to a (wo)man, every speaker exclaimed that inflation was transitory. Several regional Fed presidents (Bullard, Bostic and Kaplan) are clearly in the camp of tapering QE and potentially raising rates by the end of next year, but the Fed leadership (Powell, Clarida, Williams) are adamantly opposed to the idea of tightening policy anytime soon. And the thing is, the hawks don’t even have a vote this year, although they do get to participate in the conversation. The upshot is that it seems highly unlikely that the Fed is going to tighten policy anytime at all this year regardless of inflation readings going forward. While ‘transitory’ has always been a fuzzy term, my take has always been a 2-3 quarter view, but yesterday we started to hear it could mean 2 years or more. If that is the case, then prepare for a much worse ultimate outcome along with a much weaker dollar.
As markets and investors digest the latest central bank dogma, let us peruse the latest price action. Yesterday’s equity market price action led to yet another set of new all-time highs in US indices and even Mexico’s Bolsa rose 0.75% after the rate hike! Overnight saw a continuation of that view with the Nikkei (+0.65%), Hang Seng (+1.4%) and Shanghai (+1.15%) all rallying nicely. Perhaps a bit more surprisingly this morning has seen a weaker performance in Europe (DAX -0.15%, CAC -0.1%, FTSE 100 +0.1%) despite slightly better than expected Confidence data out of Germany and Italy. As vaccinations proceed apace on the continent, expectations for a renewed burst of growth are rising, yet today’s stock markets seem unimpressed.
At the same time, despite all the Fedspeak and concern over inflation, the 10-year Treasury yield has basically been unchanged all week and seems to have found a new home at 1.50%, right where it is now. Since it had been a harbinger for markets up until the FOMC meeting last week, this is a bit surprising. As to Europe, bonds there are actually under some pressure this morning (Bunds +1.7bps, OATs +2.9bps, Gilts +1.2bps) although given equity market performance, one is hard-pressed to call this a risk-on move. Perhaps these markets are responding to the better tone of data, but they are not in sync with the equity space.
In commodity markets, prices are mixed this morning. While oil (-0.25%) is softer, gold (+0.5%) and silver (+1.0%) are looking awfully good. Base metals, too, are having a better session with Cu (+0.4%), Al (+1.5%) and Sn (+0.2%) all performing well. Crop prices are also rising, between 0.25% and 0.5%. Fear not for oil, however, as it remains firmly ensconced in its uptrend.
And lastly, in FX markets, the dollar is under modest pressure across most of the G10, with the bulk of the bloc firmer by between 0.1% and 0.2%, and only GBP (-0.2%) softer. While we did see a slightly weaker than expected GfK Consumer Confidence number for the UK last night (-9 vs. expected -7) we also just saw CBI Retail Sales print at a much better than expected level. In the end, it is hard to ascribe the pound’s movement, or any of the G10 really, to data. It is far more likely positions being adjusted into the weekend.
In the emerging markets, the dollar is having a much tougher time with ZAR (+1.0%) and KRW (+0.6%) the leading gainers, but a number of currencies showing strength beyond ordinary market fluctuations. While the rand’s move seems outsized, the strength in commodity prices is likely behind the trend in ZAR lately. As to KRW, it seems that as well as the general risk on attitude, the market is pricing in the first policy tightening in Seoul and given the won’s recent mild weakness, traders were seen taking advantage to establish long positions.
We have some important data today led by Personal Income (exp -2.5%), Personal Spending (0.4%) and Core PCE (0.6% M/M, 3.4% Y/Y). Then at 10:00 we see Michigan Confidence (86.5). I want to believe the PCE data is important, but I fear that regardless of where it prints, it will be ignored as a product of base effects and so not a true reflection of the price situation. Yesterday, Claims data was a bit worse than expected as was Durable Goods. This is not to say things are collapsing, but it is growing more and more apparent, at least based on the data, that the peak in the economy has already been seen. In fact, the Atlanta Fed GDPNow model has fallen back below 10.0% and appears to be trending lower. The worst possible outcome for the economy would be slowing growth and rising inflation, and I fear that is where we may be heading given the current fiscal and monetary policy settings.
That combination will be abysmal for the dollar but is unlikely to be clear before many more months have passed. For now, I expect the dollar will revert to its risk profile, where risk-on days will see weakness and risk-off days see strength. Today feels far more risk-on like and so a little further dollar weakness into the weekend seems a reasonable assumption.
Good luck, good weekend and stay safe