The bond market’s making it clear
Inflation, while higher this year,
Is likely to fade
Just like Jay portrayed
While bottlenecks soon disappear
The data though’s yet to support
Inflation’s rise will be cut short
Next week will supply
The data the Fed does purport
For the past month, virtually every price indicator in the G20 has printed higher than forecast, which continues a multi-month trend and has been a key support of the inflationist camp. After all, if the actual inflation readings continue to rise more rapidly than econometric models indicate, it certainly raises the question if there is something more substantial behind the activity. At the same time, there has been a corresponding increase of commentary by key central bank heads that, dammit, inflation is transitory! Both sides of this debate have been able to point to pieces of data to claim that they have the true insight, but the reality is neither side really knows. This fact is made clear by the story-telling that accompanies all the pronouncements. For instance, the transitory camp assures us that supply-chain bottlenecks will soon be resolved as companies increase their capacities, and so price pressures will abate. But building new plant and equipment takes time, sometimes years, so those bottlenecks may be with us for many months. Meanwhile, the persistent camp highlights the idea that the continued rise in commodity prices will see input costs trend higher with price rises ensuing. But we have already seen a significant retreat from the absolute peaks, and it is not clear that a resumption of the trend is in the offing. The problem with both these stories is either outcome is possible so both sides are simply talking their books.
While I remain clearly in the persistent camp, my take is more on the psychological effects of the recent rise in so many prices. After all, even the Fed is focused on inflation expectations. So, considering that recency bias remains a strongly inbred human condition, and that prices have risen recently, there is no question many people are expecting prices to continue to rise. At the same time, one argument that had been consistently made during the pre-pandemic days was that companies could not afford to raise prices due to competition as they were afraid of losing business. But now, thanks to multiple rounds of stimulus checks, the population, as a whole, is flush with cash. As evidenced by the fact that so many companies have already raised prices during the past year and continue to sell their wares, it would appear that the fear of losing business over higher prices has greatly diminished.
And yet…the bond market has accepted the transitory story as gospel. This was made clear yesterday when both Treasury and Gilt yields tumbled 8 basis points while Bund and OAT yields fell 6bps. That is not the behavior of a bond market that is worried about runaway inflation.
So, which is it? That, of course, is the $64 trillion question, and one for which nobody yet has the answer. What we can do, though, is try to determine how markets may move in either circumstance.
If inflation is truly transitory it would seem that we can look forward to a continued bull flattening of yield curves with the level of rates falling alongside the slope of the yield curve. Commodity prices will arguably have peaked as new production comes online and equity markets will benefit significantly from lower interest rates alongside steady growth. As to the dollar, it seems unlikely to change dramatically as lower yields alongside lower inflation means real yields will be stable.
On the other hand, if prices rise persistently for the next quarters (or years), financial markets are likely to respond very differently. At some point the bond market will become uncomfortable with the situation and yields will start to rise more sharply amid a steeper yield curve as the Fed will almost certainly remain well behind the curve and continue to suppress the front end. Commodity prices will have resumed their uptrend as they will be a key driver in the entire inflationary story. Energy, especially, will matter as virtually every other product requires energy to be created, so higher energy prices will feed into the economy at large. Equity markets may find themselves in a more difficult situation, especially the high growth names that are akin to very long duration bonds, although certain sectors (utilities, staples, REITs) are likely to hold their own. And the dollar? If, as supposed, the Fed remains behind the curve, the dollar will suffer significantly, as real yields will decline sharply. This will be more evident if we continue to see policy tightening from the group of countries that have already begun that process.
In the end, though, we are all just speculating with no inside knowledge of the eventual outcome. It is for this reason that hedging is so important. Well designed hedge strategies help moderate the outcome regardless of the eventual results, and that is a worthy goal in itself. Hedging can reduce earnings/cash flow volatility.
Onward to today’s markets. Starting with bonds, after yesterday’s huge rally, we continue to see demand as, though Treasury yields are unchanged, European sovereign yields have fallen by between 0.3bps (Gilts) and 1.5bps (Bunds), with the rest of the major nations somewhere in between.
Equity markets have been more mixed but are turning higher. Last night saw the Nikkei (-1.0%) and Hang Seng (-0.4%) follow the bulk of the US market lower, but Shanghai (+0.7%) responded positively to news that the PBOC may soon be considering cutting rates to support what is a clearly weakening growth impulse in China. (Caixin PMI fell to 50.3 in Services and 51.3 in Manufacturing, both far lower than expected in June.) European markets have been in better stead with the DAX (+0.9%) leading the way and FTSE 100 (+0.5%) putting in a solid performance although the CAC (+0.1%) is really not doing much. The big news here was the European Commission publishing their latest forecasts for higher growth this year and next as well as slightly higher inflation. Finally, US futures markets are all pointing higher with the NASDAQ (+0.5%) continuing to lead the way.
Commodity prices are definitely higher this morning with oil (+1.5%) a key driver, but metals (Au +0.6%, Ag +1.0%, Cu +2.0% and Al +0.3%) all finding strong bids. Agricultural products are also bid this morning and there is more than one analyst who is claiming we have seen the bottom in the commodity correction with higher prices in our future.
As to the dollar, it is somewhat mixed, but arguably, modestly weaker on the day. In the G10, NZD (+0.4%), NOK (+0.3%) and AUD (+0.3%) are the leaders with all three benefitting from the broad-based commodity rally. SEK (-0.25%) is the laggard as renewed discussion of moderating inflation pressures has investors assuming the Riksbank will be late to the tightening party thus leaving the krona relatively unattractive.
In the EMG bloc, ZAR (+0.5%), MXN (+0.35%) and RUB (+0.25%) are the leading gainers, with all three obviously benefitting from the commodity story this morning. CNY (+0.25%) has also gained after investor inflows into the Chinese bond market supported the renminbi. On the downside, KRW (-0.7%) and PHP (-0.6%) fell the most although the bulk of those moves came in yesterday’s NY session as the dollar rallied across the board and these currencies gapped lower on the opening and remained there. Away from these, though, activity has been less impressive with few stories to drive things.
Two pieces of data today are the JOLTS Job Openings (exp 9.325M) and the FOMC Minutes this afternoon. The former will simply serve to highlight the mismatch in skills that exists in the US as well as the fact that current policy with enhanced unemployment insurance has kept many potential workers on the sidelines. As to the Minutes, people will be focused on any taper discussion as well as the conversation on interest rates and why views about rates changed so much during the quarter.
Our lone Fed speaker of the week, Atlanta Fed President Bostic, will be on the tape at 3:30 this afternoon. To date, he has been in the tapering sooner camp, so I would expect that will remain the situation.
Yesterday’s dollar rally was quite surprising given the decline in both nominal and real yields in the US. However, it has hardly given back any ground. At its peak in early April, the dollar index traded up to 93.4 and the euro fell to 1.1704. We would need to break through those levels to convince of a sustained move higher in the dollar. In the meantime, I expect that the odds are the dollar can cede some of its recent gains.
Good luck and stay safe