Flames of Concern

While Fed commentary is banned
Inflation has certainly fanned
The flames of concern
And soon we’ll all learn
If prices are acting as planned

Meanwhile transitory’s the word
Jay’s used to describe what’s occurred
But most people feel
Inflation is real
And denial is naught but absurd

It is CPI day in the US today and recently the results have gained nearly as much attention as the monthly payroll data.  This seems reasonable given that pretty much every other story in the press touches on the subject, although as is constantly highlighted, the Fed pays attention to PCE, not CPI.  Nonetheless, CPI is the data that is designed to try to capture the average rate of increases in price for the ordinary consumer.  As well, virtually all contracts linked to inflation are linked to CPI.  So Social Security, union wage contracts and TIPS all use CPI as their benchmark.

Of course, the reason inflation is the hot topic is because it has been so hot over the past nine months.  Consider that since Paul Volcker was Fed Chair and CPI peaked at 14.8%, in 1980, there has been a secular decline for 40 years.  Now, for the first time since 1990, we are likely to have four consecutive Y/Y CPI prints in excess of 5.0%.  Although Powell and the FOMC have been very careful to avoid defining ‘transitory’, every month that CPI (and PCE) prints at levels like this serves to strain their credibility.

This is evidenced by a survey conducted by the New York Fed itself, which yesterday showed that the median expectation for inflation in one year’s time has risen to 5.2% and in three years’ time to 4.0%.  Both of these readings are the highest in the survey’s relatively short history dating back to 2013.  But the point is, people are becoming ever more certain that prices will continue rising.  And remember, while inflation may be a monetary phenomenon, it is also very much a psychological one.  If people believe that prices will rise in the future, they are far more likely to increase their demand for things currently in order to avoid paying those future high prices.  In other words, hoarding will become far more normal and expectations for higher prices will become embedded in the collective psyche.

In fact, it is this exact situation that the Fed is desperately trying to prevent, hence the constant reminders that inflation is transitory and so behavioral changes are unnecessary.  This is what also leads to absurdities like the White House trying to explain that except for the prices of beef, pork and poultry, food prices are in line with what would be expected.  Let’s unpack that for a minute.  Beef, pork and poultry are the three main protein sources consumed in this country, if not around the world, so the fact that those have risen in price makes it hard to avoid the idea that prices are rising.  But the second half of the statement is also disingenuous, “in line with what would be expected” does not indicate prices haven’t risen, only that they haven’t risen as much as beef etc.  I’m sure that when each of you heads to the supermarket to stock up for the week, you have observed the price of almost every item is higher than it was, not only pre-Covid, but also at the beginning of the year.  Alas, at this point, there is no reason to expect inflation to slow down.

Median expectations according to Bloomberg’s survey of economists show that CPI is forecast to have risen 0.4% in August with the Y/Y increase declining to 5.3% from last month’s 5.4% reading.  Ex food and energy, the forecasts are +0.3% and 4.2% respectively.  Now, those annual numbers are 0.1% lower than the July readings, which have many economists claiming that the peak is in, and a slow reversion to the lowflation environment we experienced for the past twenty years is going to return.  Counter to that argument, though, is the idea that the economy is cyclical and that includes inflation.  As such, even if there is an ebb for now, the next cycle will likely return us to these levels once again, if not higher.  PS, if the forecasts are accurate, as I mentioned before, this will still be the fourth consecutive month of 5+% CPI, a fact which makes it much easier for the masses to believe inflation has returned.  You can see why Powell and the entire FOMC continue to harp on the transitory concept, they are desperate to prevent expectations from changing because, as we’ve discussed before, they cannot afford to raise interest rates given the amount of leverage in the system.

Keeping all this in mind, it is easy to understand why the CPI data release has gained so much in importance, even to the Fed, who ostensibly focuses on PCE.  We shall see what the data brings.

In the meantime, the markets overnight have been mostly quiet with a few outlying events.  China Evergrande, the massively indebted Chinese property company has hired two law firms with expertise in bankruptcy.  This is shaking the Chinese markets as given the massive amount of debt involved (>$300 billion of USD debt) there is grave concern a bankruptcy could have significant knock-on repercussions across all sub-prime markets.  It should be no surprise that Chinese equity markets fell last night with Shanghai (-1.4%) and the Hang Seng (-1.2%) both under continued pressure.  However, the Nikkei (+0.7%) rose to its highest level since 1990, although still well below the peak levels from the Japanese bubble of the late ‘80s.  Europe is also mixed with the DAX (+0.1%) managing to eke out some gains while the rest of the continent slides into the red (CAC -0.4%, FTSE 100 -0.3%). US futures are basically unchanged this morning as we all await the CPI data.

Interestingly, despite a lot of equity uncertainty and weakness, bonds are also under pressure with yields rising across the board.  Treasuries (+1.2bps), Bunds (+1.9bps), OATs (+1.6bps) and Gilts (+3.8bps) have all sold off, with only Gilts making some sense as UK employment data was generally better than expected and indicative of a rebound in growth.

In the commodity markets, oil (WTI + 0.6%) continues to rebound as another hurricane hits the Gulf Coast and is shutting in more production.  But metals prices are under pressure led by copper (-1.25%) and aluminum (-1.0%).

As to the dollar, mixed is the best description I can give this morning.  In the G10, AUD (-0.5%) is the laggard after RBA Governor Lowe questioned why market participants thought the RBA would be raising rates anytime soon despite potential tapering in the US and Europe.  Australia is in a very different position and unlikely to raise rates before 2024.  On the plus side, NOK (+0.4%) continues to benefit from oil’s rebound and the rest of the bloc has seen much more modest movement, less than 0.2%, in either direction.

EMG markets are a bit weaker this morning, seemingly responding to the growing risk off sentiment as we see ZAR (-0.65%) and RUB (-0.5%) both under a fair amount of pressure with a long list of currencies declining by lesser amounts.  While declining metals prices may make sense as a driver of the rand, the ruble seems to be ignoring the oil price rally, as traders await the CPI data.  On the plus side, KRW (+0.45%) was the best performer as positions locally were adjusted ahead of the upcoming holiday there.

And that’s really the story as we await the CPI release.  The dollar, while softening slightly from its best levels recently, continues to feel better rather than worse, so I suspect we could see modest further strength if CPI is on target.  However, a miss in the print can have more significant repercussions, with a high print likely to see the dollar benefit  initially.

Good luck and stay safe
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