A Fad that is Passing

Said central banks, stop your harassing
Inflation’s a fad that is passing
By next year we see
(Or by ‘Twenty-three)
More bonds you will all be amassing

But lately some central bank hawks
Explained that the recent price shocks
Could well last much longer
With wage growth much stronger
And that might not be good for stocks

As we walk in on this Columbus Day holiday, where US banks and the Federal Reserve are closed, although equity markets remain open, the most notable price movement has been in oil where WTI (+2.8%) has rallied to its highest price since October 2014 and now sits well above the $80/bbl level.  Fortunately, we’ve been constantly reassured that this is a temporary transitory phenomenon by numerous central bankers around the world, most frequently by Chairman Powell and ECB President Lagarde.  The claim continues to be that the only reason prices keep rising is as a result of constricted supply chains amid a massive recovery (due to their actions) from the Covid pandemic economy-wide shutdowns.  Soon enough, they also exhort, these supply chain snafus will have been corrected and then shortages of stuff will be a distant memory as we revert to the steady growth and low inflation economies we have all come to know and love.  It’s such a nice, neat story and I’m confident that they both tell themselves constantly that it is true.

Alas, reality has a nasty way of intruding upon a good storyline and recent energy price action is pretty clearly pointing to a different story than the one being peddled by Powell and Lagarde.  In fact, some of their own colleagues, as well as brethren from other key central banks like the BOE, are singing a different tune, one much more in line with reality.  For instance, last night, Klaas Knot, the Dutch Central bank president and ECB member warned investors not to underestimate inflation risks, “This risky behavior [excessive leverage] is only sustainable at low inflation and interest rates.  From the perspective of healthy risk management, it is also important to take other scenarios into consideration.”  I wonder what other scenarios he is considering.  Refreshingly, he followed that comment with this, “There is more in the inflation process we don’t understand than we do understand,” as humble a comment as one can ever expect from a central banker!

However, given Knot’s constant hawkish rhetoric, markets did not really react to his comments, as they were not terribly new.  Of more interest were comments from two separate BOE members, Governor Andrew Bailey and Michael Saunders, the most hawkish member of the MPC.  In both cases, they commented that the market was quite right to begin pricing in higher interest rates as inflation was becoming more problematic and could be “very damaging” if policymakers don’t act.  Traders did not need much prompting beyond this to reprice interest rate futures such that a first hike of 15 basis points (to 0.25%) is now expected by December, while by the end of 2022, the market is pricing a base rate of 0.75%, so two more hikes after that.  Given that UK CPI is forecast to hit 4.0% in Q4 this year, that still seems awfully far behind the curve, but then compared to the US, where inflation is already well above 4%, even on the PCE measure, and Fed Funds remained pegged at 0.00%-0.25%, that counts as tight policy.  When the comments were first published, the pound did jump as much as 0.45%, however, that has already largely faded and as I type, the pound is only 0.1% higher on the day.

Perhaps these are the first real signs that the central bank community is recognizing inflation may not be as transitory as their models (and political needs) had indicated was likely (and necessary) respectively.  Instead, its persistence is becoming more evident, even to them, and calls for tighter monetary policy to address inflation are likely to grow.  Of course, given the extraordinary levels of leverage in the global monetary system, higher rates are going to be very difficult to achieve without an ensuing dramatic decline in asset prices.  This is the corner into which the Fed (and the ECB) have painted themselves.  (As I’ve said before, if I were Chairman Powell, I would be happy to step down allowing my successor to deal with the mess that is surely coming.)  Even if the Fed does begin to taper QE purchases, they will remain behind the curve for a very long time, and those vaunted ‘tools’, which they keep describing as available, will likely not be used to full effect.  Not only is inflation going to continue to rise, but central banks are going to continue to remain behind the curve for a long time to come.  Be prepared.

Ok, with that in mind, let’s look at markets overnight.  Equities in Asia had a pretty good session, with the Nikkei (+1.6%) and the Hang Seng (+2.0%) both performing well, although Shanghai was unchanged on the day.  Europe (DAX -0.5%, CAC -0.4%), on the other hand, is a little less optimistic.  The outlier here is the UK (FTSE 100 +0.15%) where it seems investors are happy to hear of a central bank willing to address incipient inflation.  US futures are all pointing lower, however, led by the NASDAQ (-0.7%) but -0.4% losses elsewhere.

The Treasury bond market is closed in the US today, but in Europe, the trend is clear, higher yields across the board, which is exactly what we saw in Asia as well.  So, Bunds (+3.5bps), OATs (+3.0bps) and Gilts (+5.0bps) are all selling off sharply with similar movement seen across the continent.  Asia, too saw sharp declines in bond prices with Australia (+8.0bps) leading the way but even China (+6.0bps) falling sharply despite ordinary efforts to prevent volatility in that market.

In the commodity space, while oil is leading the way, pretty much everything except gold is higher with NatGas (+3.8%), copper (+1.4%) aluminum (+2.3%) and the agricultural products all firmer on the day.  Remember this, the longer food and energy prices continue to climb, the more likely those price rises bleed into “core” inflation and drive that higher as well.

Turning to the dollar, the biggest loser today is JPY (-0.6%) as the widening yield differential in favor of the dollar has reached a point where Japanese investors have started to move money more actively into USD investments on an unhedged basis.  At this point, there doesn’t seem to be much reason for JPY to rally, so a test of 115 seems to be far more likely in the near term.  After that, we shall see.  On the plus side, AUD (+0.5%) has been the biggest beneficiary of the commodity rally while surprisingly, neither NOK nor CAD, both unchanged on the day, have seen a boost from the much higher oil prices.

In the EMG bloc, INR (-0.5%) and PHP (-0.4%) are the laggards of note with RUB (+0.3%) the only notable gainer.  Oil is obviously supporting the ruble while the rupee and peso both suffer on the same story, as both India and the Philippines are major oil importers.

On the data front, nothing is released today due to the holiday, but we get some important things this week:

Tuesday NFIB Small Biz Optimism 99.5
JOLTS Job Openings 10.934M
Wednesday CPI 0.3% (5.3% Y/Y)
-ex food & energy 0.2% (4.1% Y/Y)
FOMC Minutes
Thursday Initial Claims 320K
Continuing Claims 2686K
PPI 0.6% (8.7% Y/Y)
-ex food & energy 0.5% (7.1% Y/Y)
Friday Empire Manufacturing 25.0
Retail Sales -0.2%
-ex autos 0.5%
Business Inventories 0.6%
Michigan Sentiment 73.5

Source: Bloomberg

Aside from critical CPI and Retail Sales data, we hear from ten different Fed speakers across more than a dozen events this week, including Governor Brainerd on Wednesday, someone we should be listening to very closely given the rising probability she is named the new Chair.

Right now, the dollar is consolidating its recent gains, but showing no signs of giving any of them back.  I expect that we will see another leg higher in the near future as there is no evidence that either inflation or US yields are going to decline soon.  And right now, I think those are the drivers.  At some point, inflation may become detrimental to the dollar, but for now, buy dollars on dips.

Good luck and stay safe
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