As prices worldwide start to rise
And central banks, rates, normalize
Poor Madame Lagarde
May soon find it hard
To ably, her goals, realize
Let me start by saying that I will be out of the office starting tomorrow, returning July 6th.
Despite the fact that the markets in the US are showing only limited signs that the Fed is actually considering tightening, the punditry continues to believe that tapering asset purchases is next up on the Fed’s agenda. In fact, the discussion is becoming granular with respect to which assets they should consider addressing. The two current theses are; reduce purchases of both Treasuries and Mortgages at a similar rate, or just reduce Mortgage purchases given the bubble the Fed has blown in the housing market. And there are FOMC members on both sides of that argument although it cannot be surprising that the more dovish members continue to insist that buying $40 billion / month of Mortgage-backed securities is having absolutely no impact on the housing market. But the point is that the analyst community is fully on board with the idea the Fed is going to be reducing its asset purchases soon.
I highlight this because when combined with the fact that so many other countries are more definitively moving past unlimited policy ease, with some already tightening, it becomes interesting to consider which nations are not considering any policy changes. And this is where the ECB comes into view.
As of now, the ECB (and BOJ) insist that there are no plans to change their policy mix anytime soon. And yet, they seem to have the opposite problem of the Fed, the market is pricing in rate increases there, currently a 0.10% hike by the end of Q3, and bond yields have been rising steadily with German bund yields almost back up to 0.00%. (As an aside, it continues to be remarkable to me that one can make the statement, back up to 0.00%!) Given the slower trajectory of growth thus far in Europe, especially with respect to inflation readings, Madame Lagarde and her cadre of central bankers certainly have their work cut out for them to maintain the policy stance they desire and believe is necessary to support the economy there. Will the ECB be forced to ease further in some manner, like extending PEPP in order to achieve their aims?
In contrast, despite the fact that the Fed is talking about talking about tapering, and the dot plot indicated a majority of FOMC members believe they will be raising rates by the end of 2023, the bond market remains sanguine over the prospect of either higher inflation or higher interest rates. Go figure.
So, who do we believe when surveying the current situation? On the one hand, it is always tough to argue with the market. Whether or not we understand the actual drivers, the collective intelligence of investors tends to be exceptionally accurate at recognizing trends and future outcomes. On the other hand, the phrase, ‘don’t fight the Fed’ has been around for a long time because it has proven to be an effective input into any investment thesis. The problem is, when those two indicators are at odds with each other, choosing the likely outcome is extraordinarily difficult, more so than normal.
One way to think about it is that both can be right if you consider they may have differing timelines. For instance, the market tends to discount actions in the 9 month to 1year timeframe while the Fed may well be considering more immediate actions. However, in this case, I feel like the Fed is looking at a similar timeline as the market. Ultimately, as I’ve mentioned before, it appears the Fed remains completely reactive to market movement. Thus, right now, regardless of their rhetoric, my take is if the market demands easier policy, they will make it known via a sell-off in equities that will result in the Fed stepping in with support. If, on the other hand, the market is comfortable with the current situation, a continued benign rise in equities is on the cards. As the Fed has put themselves in the position of reactivity, my money is on the market this time, not the Fed. We shall see.
As I was quite delayed this morning, a very quick recap of the overnight session shows that risk was under pressure in Asia but that Europe has responded very well to much stronger than expected confidence indicators for manufacturing and consumers across the continent. So while all three main Asian indices fell about 1.0%, Europe has seen gains of at least 0.6% with the DAX up 1.2%.
As it happens this morning, Treasury prices have edged a bit lower with the 10-year yield rising 2bps, but that was after a nice rally yesterday, so we continue to trade right around 1.50%. Big picture here is nothing has changed. European sovereigns are softer as risk appetite improves on the continent, with 2.0bp rises in the major markets.
While oil prices (+0.5%) are a bit firmer, the metals complex is under pressure this morning with gold and silver both down sharply (-1.4%) and base metals also falling (Cu -1.0%, Al -0.7%).
The metals’ movement is more in sync with the dollar, which has rallied against all its G10 peers and most EMG currencies. AUD (-0.7%) and NZD (-0.7%) are the laggards here with NOK (-0.6%) next in line. Obviously, oil is not the driver, although Aussie and Kiwi would suffer from metal price declines. However, it appears that Covid continues to haunt many countries and the market seems to be responding to perceptions that growth will be slowing rather than continuing its recent uptrend.
In EMG, RUB (-0.8%), PLN (0.65%) and ZAR (-0.6%) are amongst the worst performers with ruble and rand clearly impacted by metals prices while the zloty seems to be suffering from a more classical interpretation of inflation’s impact on a currency, as higher inflation expectations are leading to a weaker currency.
On the data front, Case Shiller House Prices rose 14.88%, higher than expected and continuing the trend that has been in place for more than a year. Later we get Consumer Confidence exp (119.0) although it seems unlikely with payrolls coming on Friday, that the market will pay much attention.
Only Thomas Barkin from Richmond speaks on behalf of the Fed today, but there is no reason to believe that it will change any views. The narrative is still the same.
The dollar is feeling quite strong this morning and seems likely to maintain those gains as the day proceeds. If the market truly believes the Fed is going to taper, we should see the evidence in the bond market with higher yields. But for now, the dollar’s strength feels more like short-covering than a change in the long-term view of ultimate dollar weakness. However, this can persist for a while (just like inflation 😊)
Good luck, and have a great holiday weekend. I will be back on the 6th.