Monthly Archives: November 2021

Before Omicron

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There once was a narrative told
Explaining the Fed still controlled
The market’s reaction
Preventing contraction
Thus, making sure stocks ne’er got sold

But that was before Omicron
Evolved and put more pressure on
The future success
Of Fed’ral largesse
With no real conclusion foregone

So, later this morning we’ll hear,
When Janet and Jay both appear,
In front of the Senate
If they’ve still the tenet
That all will be well by next year

Perhaps all is not right with the world.  At least that would be a conclusion easily drawn based on market activity this morning.  Once again, risk is being shed rapidly and across the board.  Not only that, but the market is completely rethinking the idea of tighter monetary policy by the Fed with the growing conclusion that it is just not going to happen, at least not on the timeline that had been assumed a few short days ago.

It seems that the Omicron variant of Covid is proving to be a bigger deal in investor’s eyes than had been originally assumed.  When this variant was first identified by South African scientists, the initial belief was it was more virulent but not as acute as the Delta variant.  So, while it was spreading quite rapidly, those who were infected displayed milder symptoms than previous variants.  (If you think about the biology of this, that makes perfect sense.  After all, every organism’s biologic goal is to continue to reproduce as much as possible.  If a virus is so severe that its host dies, then it cannot reproduce very effectively.  Thus, a more virulent, less severe strain is far more likely to remain in the world than a less virulent, more deadly strain, which by killing its hosts will die off as well.)

In the meantime, financial markets have been trying to determine just what type of impact this new strain is going to have on economies and whether it will induce another series of lockdowns slowing economic activity, or if it will be handled in a different manner.  And so far, there is no clear conclusion as evidenced by the fact that we saw a massive sell-off in risk assets Friday, a major rebound yesterday and another sell-off this morning.  If pressed, I would expect lockdowns to come back into vogue as despite questions over their overall efficacy, their imposition allows government officials to highlight they are ‘doing something’ to prevent the spread.  Additional bad news came from the CEO of Moderna, one of the vaccine manufacturers, when he indicated that the nature of this variant would likely evade the vaccines’ defense.

So, story number one today is Omicron and how this new Covid variant is going to impact the global economy.  Ironically, central bankers around the world must be secretly thrilled by this situation as the focus there takes the spotlight off their problem, rapidly rising inflation.

For instance, after yesterday’s higher than expected CPI prints in Spain and Germany, one cannot be surprised that the Eurozone’s CPI printed this morning at 4.9%, the highest level since the Eurozone was born in 1997, and far higher than any of the 40 economist forecasts published.  Madame Lagarde wasted no time explaining that this was all temporary and that by the middle of next year inflation would be back to its pre-pandemic levels, but it seems fewer and fewer people are willing to believe that story.  Do not mistake the run to the relative safety of sovereign bonds as a vote of confidence in the central bank community.  Rather that is simply seen as a less risky place to park funds than the equity market, which by virtually every measure, remains significantly overvalued.

This leads to the third major story of the day, the upcoming testimony by Chairman Powell and Treasury Secretary Yellen in front of the Senate Banking Committee.  The pre-released opening comments focus on Omicron and how it can be a risk for both growth and inflation thus once again trying to divert attention from Fed policies as a problem by blaming exogenous events beyond their control.  Of course, this story will resolve itself starting at 10:00, so we will all listen in then.

Ok, with all that as prelude, a quick tour of markets shows just how much risk is in disfavor this morning.  Overnight in Asia we saw broad weakness (Nikkei -1.6%, Hang Seng -1.6%) although once again Shanghai was flat.  Europe is completely in the red (DAX -1.45%, CAC -1.25%, FTSE 100 -1.0%) and US futures are also pointing lower (DOW -1.2%, SPX -1.0%, NASDAQ -0.5%).

Meanwhile, bond markets are ripping higher with Treasuries (-5.1bps) leading the way as yields fall back to levels last seen in early September.  In Europe, Bunds (-2.1bps), OATs (-2.2bps) and Gilts (-4.0bps) are all seeing demand pick up with the rest of the Continent all looking at lower yields despite rising inflation.  Fear is clearly a powerful motivator.  Even in Asia we saw JGB’s (-1.9bps) rally as did Australian and New Zealand paper.

Commodity markets are having quite a day with some really mixed outcomes.  Oil (-2.5%) is back in the red after yesterday’s early morning rebound faded during the day, and although oil did close higher, it was well of the early highs.  NatGas (-5.0%) is falling sharply, which at this time of year is typically weather related.  On the other hand, gold (+0.5%) is bouncing from yesterday and industrial metals (Cu +1.4%, Al +1.6%, Sn +2.7%) are in clear demand.  It seems odd that on a risk-off day, these metals would rally, but there you have it.

Finally, the dollar can only be described as mixed this morning, with commodity currencies under pressure (NOK -0.4%, CAD -0.25%) while financial currencies (EUR +0.5%, CHF +0.5%, JPY +0
4%) are benefitting on receding expectations for a tighter Fed.  PS, I’m sure the risk off scenario is not hurting the yen or Swiss franc either.

Emerging market currencies are demonstrating a broader based strength with TRY (-1.6%) really the only major loser as further turmoil engulfs the central bank there and expectations for lower interest rates and higher inflation drive locals to get rid of as much lira as possible.  Otherwise, PLN (+0.8%) is leading the way higher as expectations for the central bank to raise rates grow with talk now the rate hike will be greater than 50 basis points.  But MYR (+0.8%) and CZK (+0.75%) are also showing strength with the ringgit simply rebounding after a 10-day down move as bargain hunters stepped in, while the koruna has benefitted from hawkish comments from the central bank governor.  It appears that most EMG central banks are taking the inflation situation quite seriously and I would look for further rate hikes throughout the space.

Aside from the Powell/Yellen testimony, this morning brings Case Shiller House Prices (exp 19.3%), Chicago PMI (67.0) and Consumer Confidence (111.0).  As well, two other Fed speakers, Williams and Clarida, will be on the tape, but it is hard to believe they will get much notice with Powell front and center.

The dollar appears to be back following the interest rate story, which means that if expectations of Fed tightening dissipate, the dollar will likely fade as well, at least versus the financial currencies.  Commodities have a life of their own and will continue to dominate those currencies beholden to them.  The tension between potential slower growth and rising inflation has not been solved, and while my view is the Fed will allow inflation to burn still hotter, keep in mind that if they do act to tighten policy, the dollar should find immediate support.

Good luck and stay safe
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Future Pratfalls

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In Germany, and too, in Spain
The people are feeling the pain
Of prices exploding
And therefore corroding
Their standards of living again

Meanwhile from the ECB’s halls
The comments from those know-it-alls
Show lack of concern
As each of them spurn
The idea of future pratfalls

In trading, ‘the trend is your friend’ is a very common sentiment and an idea backed with strong evidence.  One can think of this as analogous to Newton’s first law, i.e. a body in motion stays in motion.  So, when the price action in some market has been heading in one direction over time, it tends to continue in that direction.  This is the genesis of the moving average as a trading tool as the moving average is what defines the trend.  I highlight this because the concept is not restricted to trading but is also evident in many other price series, notably inflation.  When one looks at the history of inflation, it tends to trend in one direction for quite some time with major reversals relatively infrequent.  That is not to say a reversal cannot occur, but if one does, it tends to be the result of a long period of adjustment, not a quick flip of direction.

And yet, when listening to both Fed and ECB speakers lately, they would have you believe that the currently entrenched trend higher for prices is the aberration and that in a matter of months they will be back to their old concerns about deflation being the biggest problem for the economy.  One has to wonder at what evidence they are looking to come to that determination as certainly the recent data does not point in that direction.  Just this morning Spanish CPI (5.6%) printed at the highest level since 1992 while Italian PPI (25.3%) printed at the highest level in its history.  From Germany, we have seen CPI prints from several of its states (Hesse 5.3%, Baden Wuerttemberg 4.9%, Bavaria 5.3%, Saxony 5.0%) with the national number (exp 5.5%) due at 8:00 this morning.

Still, none of this seems to be having an impact on the thoughts of ECB members with Lagarde, Schnabel, Villeroy and de Cos all out explaining that this is a temporary phenomenon and that by the middle of next year CPI will be back at their 2.0% target or lower.  Maybe it will be so, but as Damon Runyon so aptly explained, “The race is not always to the swift, nor the battle to the strong; but that is the way to bet.”  In other words, looking at the current trends, it seems far more likely that inflation remains high than suddenly turns around lower.  The biggest problem the central banks have now is that it has become common knowledge that inflation is rising, which means that individual behaviors are adjusting to a new price regime.  And if you listen to the central bank thesis that inflation expectations are a critical input, then they are really in trouble as inflation expectations are clearly rising.

At least the Fed has begun to discuss the idea of removing accommodation, although the Omicron variant of Covid may given them pause, but in Europe, it is not even on the table.  A discussion point that has been raised numerous times lately is the idea of a central bank policy error, either raising rates prematurely to battle phantom inflation or waiting too long to tighten policy and allowing inflation to become more entrenched.  While my money is on the latter, it is very clear that the ECB, at least, and still many Fed members, are far more concerned with the former.  Perhaps they are correct, and all these rising prices will quickly dissipate, and that would be great.  However, I am not counting on that outcome, nor should anyone else at this point until there is ANY proof the Fed or ECB are correct.

Meanwhile, Friday’s dramatic events seem to have been erased from memory as while there are still headlines regarding the Omicron variant, the collective market view appears to be that it is not going to result in another wave of lockdowns and therefore the economic impact will be relatively minor.  As such, we are seeing a reversal of fortune across most markets from their Friday price action.  It should be no surprise that the biggest change comes from oil (+4.75%) which has recouped about one-third of its losses and seems set to continue rebounding.  After all, if the consensus is that Omicron is not going to have much of an impact, then the supply/demand story hasn’t changed and that bodes well for oil prices moving higher.  Elsewhere in the commodity space NatGas (+7.4%) is rising sharply on the back of colder than normal weather, while metals prices (Au +0.1%, Ag +0.5%, Cu +1.7%, Al +1.2%) are all rebounding as well.

In the equity markets, Asia never got a chance to sell off like Europe and the US on Friday so caught up (down?) with the Nikkei (-1.6%) leading the way although the Hang Seng (-1.0%) also suffered.  Shanghai traded flat for the day.  Europe, however, which sold off sharply on Friday, with many markets down more than 4%, has rebounded somewhat this morning (DAX +0.7%, CAC +1.1%, FTSE 100 +1.2%) although these markets are obviously well lower than Thursday’s closing levels.  Finally, US equities sold off sharply in Friday’s abbreviated session, with all three indices down about 2.3% but this morning futures are all rebounding as well, up between 0.6% and 0.8%.

Bonds saw the most dramatic move on Friday, with Treasury yields tumbling 16 basis points while European yields all fell as well, albeit less dramatically.  This morning, with risk back in vogue, bonds are back under pressure with Treasuries (+6.8bps) leading the way but all of Europe (Bunds +2.7bps, OATs +1.5bps, Gilts +3.9bps) also seeing higher yields.

It should come as no surprise that the dollar is also reversing some of Friday’s price action with the commodity bloc doing well (SEK +0.4%, CAD +0.3%, AUD +0.3%) while the financials are under modest pressure (EUR -0.2%).  This movement is nothing more than a reaction to the Friday movement.  EMG currencies are seeing similar price action with the best performers the commodity bloc here (RUB +0.9%, ZAR +0.7%) while weakness has been seen in TRY (-3.45%) and CLP (-0.7%).  The former continues to suffer from President Erdogan’s comments about never raising interest rates to fight inflation while the peso is reacting to early polls showing the leftist, Gabriel Boric, leading ahead of the runoff presidential election in 3 weeks.

It is a week full of data culminating in Friday’s payroll report although it starts out slowly.

Tuesday Case Shiller Home Prices 19.35%
Chicago PMI 67.0
Consumer Confidence 110.7
Wednesday ADP Employment 525K
Construction Spending 0.4%
ISM Manufacturing 61.1
ISM Prices Paid 85.8
Fed Beige Book
Thursday Initial Claims 250K
Continuing Claims 2000K
Friday Nonfarm Payrolls 535K
Private Payrolls 525K
Manufacturing Payrolls 45K
Unemployment Rate 4.5%
Average Hourly Earnings 0.4% (5.0% Y/Y)
Average Weekly Hours 34.7
Participation Rate 61.7%
ISM Services 65.0
Factory Orders 0.5%

Source: Bloomberg

In addition to all that data, we hear from Chairman Powell (and Secretary Yellen) in front of the Senate and House on Tuesday and Wednesday as well as eight more Fed speakers during the week.  If I were a betting man, I would expect that the broad message will continue to be that while inflation is not a long-term problem, it is appropriate to continue to normalize monetary policy now.  And that will be the message right up until markets force them to make a choice by either selling off sharply and forcing an end to policy tightening or running to new highs dragging inflation expectations, as well as inflation, along with them.

Meanwhile, the dollar remains beholden to the latest whims.  If tightening is back on the table, then look for the dollar to resume its uptrend.  However, if Omicron, or something else, causes a change in the message, the dollar seems likely to pull back smartly.

Good luck and stay safe
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The Kicker

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Whatever we all used to think
‘Bout how growth might rapidly shrink
If Covid spread quicker
Prepare for the kicker
A new strain that spreads in a blink

While the plan was to let you all digest your Thanksgiving meals in peace, unfortunately, the news cycle is not prepared to cooperate.  Risk is waaaayyyyy off this morning as news of a new strain of Covid, B.1.1.529, has been identified in South Africa, but also in Botswana and Israel, albeit only a literal handful of cases so far, but whose attributes may be that it is not going to be able to be addressed by vaccines.  So the market reaction has been to sell any risk asset they hold, which has resulted in a serious risk-off session with equity markets around the world much lower (Nikkei -2.5%, Hang Seng -2.7%, Shanghai -0.6%, DAX -3.0%, CAC -3.75% and the FTSE 100 -2.9%), bond markets ripping higher with yields tumbling (Treasuries -9.6bps, Bunds -5.5bps, OATs -5.1bps, Gilts -10.5bps and even JGBs -1.5bps) and oil getting trashed (-5.3%).  Aside from bonds, the only other things higher this morning are gold (+1.0%) and the yen (+1.1%).  That’s not strictly true, the euro has performed better than you might have expected, rallying 0.7%, although most EMG currencies are under real pressure, as are the commodity linked G10 currencies like CAD (-0.9%), AUD (-0.55%) and NOK (-0.4%).

US futures are also pointing sharply lower (DOW -2.0%, SPX -1.6%, NASDAQ -1.0%), so be prepared for some red on the screens here as well.  The emerging consensus is that lockdowns are coming back, with Belgium imposing some overnight already, and travel bans are back with Israel and the UK already banning flights from South Africa.

Aside from the obvious health concerns that we will all be reevaluating; the point of this note is to discuss the impact on markets.  Well, the idea that the Fed is going to be raising rates more rapidly has been tossed aside, with talk that tapering is not only not going to accelerate, but potentially stop.  So, they will have reduced purchases by $15 billion/month and that will be it.  Recall, just Wednesday there were two 25 basis point rate hikes priced into Fed funds futures curves by the end of 2022, with a third due for February 2023.  Already one of those rate hikes has been priced out and if the news doesn’t improve soon, I would look for the others to go away as well.  If we are entering a new phase of Covid restrictions, the question will be how much more money governments around the world are going to throw at the problem, not when they are going to start removing accommodation.

So, the quick analysis is that inflation will quickly fall to the wayside as a concern around the world as governments everywhere react to this latest medical risk.  Of course, at this point, it no longer matters why prices are rising, it is simply the fact they are rising and that expectations for them to continue get further entrenched that is the problem.  Reading through comments from various companies in their recent earnings calls shows that most of them are anticipating raising prices to cover costs as frequently as quarterly.  Once again, this implies that holding ‘stuff’ rather than paper assets is going to be the best protection one can have for a while yet.

It is still too early to estimate how this new Covid strain will ultimately impact economies which is entirely dependent on government responses.  But if recent history is any guide, I would expect that the playbook remains; more fiscal spending, more monetizing of debt and higher inflation amidst platitudes of just how much those governments care about you, their citizens.

Also, do not be surprised if all those best laid plans of companies returning to offices get waylaid once again.

In the end, the reason companies hedge their FX exposure is to help reduce the variance in earnings, whether by moderating cash flow swings or balance sheet revaluation.  It is because markets respond to news of this nature in such extreme measures that hedging makes sense and that is not about to change.

But also, B.1.1.529 is yet another nail in the coffin of just-in-time manufacturing processes.  Just-in-case is going to become the new normal, with higher inventories in order that manufacturers and retailers can satisfy client demand, and that is a permanent change in pricing.  Any thoughts that inflation is going to go back down to sub 2% for an extended period are going to run headlong into reality over the next year, and it won’t be pretty.

To sum it up; risk is worthless today, hold havens.  As to all the tomorrows, prices will tend higher for a much longer time regardless of what bond markets seem to indicate.  Those markets no longer offer signals as in the past due to central bank interference.

And with those cheery thoughts, enjoy Black Friday and a full edition will be out on Monday.

Good luck, good weekend and stay safe
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Unchecked

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In Europe, the maximum nation
Is facing the scourge of inflation
And so, they are calling,
To help it start falling,
For less money accommodation

But others in Europe reject
The idea inflation’s unchecked
T’would be premature
To tighten, they’re sure
As QE they want to protect

It appears there is a growing rift in the ECB as we are beginning to hear more opposing views regarding the nature of inflation and correspondingly as to the prescription to address the issue.  On the one hand, the hawks have been sharpening their talons with Germany’s Schnabel, Slovenia’s Vasle and Spain’s de Guindos having all warned of inflation’s surprising persistence and explaining that the risk is to the upside for higher inflation still.  Meanwhile, this morning we had an erstwhile Hawk, Austria’s Holzmann, and an uber-dove, Italy’s Panetta pushing back on that view and insisting that the inflation that has been afflicting Europe is being driven by “purely temporary factors” and that premature withdrawal of stimulus would be a mistake.

The surprising feature of this discussion is that the Spanish voice is hawkish while the Austrian is dovish.  Perhaps what that tells us is that, just like in the US, inflation has become a bigger political problem in Spain and the Socialist PM, Pedro Sanchez, is feeling the heat from the population there.  This would not be surprising given inflation is running at 5.4%, the highest level since the introduction of the euro in 1999.  Arguably, the fact that Robert Holzmann seems to be siding with the transitory camp is also quite the surprise, but as they say, politics makes strange bedfellows.  In the end, as long as Madame Lagarde remains at the helm, the doves remain in control.  As such, these comments sound very much like posturing for particular audiences.

Turning to other news, Germany is at the center of the most interesting stories today as local politics (the formation of a new government…finally) as well as data (IFO Expectations fell to 94.2) seem to be driving the euro bus, and with the euro, the rest of the markets.  A brief look at the proposed government shows a coalition of the Social Democrats (SPD), the Greens and the Free Democratic Party (FDP) which is a pro-growth, free markets group.  This unprecedented grouping of 3 parties remains tenuous, at best, if only because the underlying belief sets are very different.  It remains unclear how a party whose focus is on less government (FDP) is going to work effectively with a party whose focus is on bigger government (SPD).  Olaf Scholz will be the new PM, a man with long experience in politics and a widely respected name.  As I said before, politics makes strange bedfellows!

On the economic side, this morning’s IFO data was quite disappointing, with Expectations falling back to levels seen in the beginning of the year and reaching a point that foretells of a recession coming.  Adding this to the imminent lockdown scenario (Germany’s Covid caseload jumped by 54K yesterday, with a significant surge ongoing), leaves quite the negative impression for the German economy.  In fact, given this news, it becomes harder for the hawks to make their case as the central bank model continues to believe that slowing growth will slow inflation.  (And while that would be true for demand-pull inflation, the whole cost-push framework is different.)  At any rate, the result is a day where risk is being shed and havens sought.  This is especially so in Germany, where the DAX (-0.6%) is the weakest performer in Europe, while Bunds (-1.7bps) have rallied despite a terrible auction outcome as investors adjust asset mixes.  And the euro?  Down a further 0.3%, trading just above 1.1200, although it appears that there is further to run.

What about the rest of markets?  Well, the Nikkei (-1.6%) fell sharply as investors in Japan expressed concern that the Fed would begin to tighten, and it would have negative impacts throughout the world.  At least that is what they claim.  China, on the other hand saw much less movement with the Hang Seng (+0.1%) and Shanghai (+0.1%) seeing a mix of gainers and losers internally thus offsetting for the index as a whole.  The rest of Europe is generally softer (CAC -0.2%, Spain’s IBEX -0.3%), although the FTSE 100 is basically unchanged on the day.  And after a mixed day yesterday, US futures are pointing modestly lower, -0.2% or so across the board.

As to the rest of the bond market, Treasuries (-2.4bps) are finally rallying after seeing a dramatic 12 basis point rise in the past three sessions.  We have also seen OATs (-0.7bps) rally slightly and Dutch bonds (-1.6bps) all the havens.  It should not, however, be surprising that Italian BTPs (+1.2bps) and Greek bonds (+3.9bps) are being sold as they remain risk assets in full.

On the commodity front, oil, which has been suffering from the SPR release story, seems to have absorbed that risk and after rebounding yesterday is flat this morning.  While still below $80/bbl, my sense is this has further to run higher.  NatGas (-0.25%) is a touch lower in the US as is gold (-0.1%).  However, the industrial metals are performing far better (Cu +0.7%, Al +0.7%, Sn +0.4%).

Lastly, the dollar is generally having a good day again, as risk appetite wanes.  NZD (-0.6%) is the weakest G10 currency after the market was disappointed in their actions last night, only raising the base rate by 0.25% while the whisper number was 0.5%. SEK (-0.4%) is the next laggard, with the krona continuing to suffer on the view that the Riksbank will remain reluctant to tighten policy at all in the face of actions by the Fed and potentially the BOE.  The rest of the bloc is generally softer with only the haven, JPY (+0.1%), showing any strength.

In the EMG space, we need to look away from TRY (+5.6%) which is retracing some of yesterday’s remarkable decline, as it is destined for extreme volatility in the near future.  But elsewhere, there is actually a mixed result with BRL (+0.6%) and PHP (+0.5%) leading the gainers while THB (-0.7%) and RUB (-0.3%) lag the space.  The real is benefitting from the central bank announcement it will be auctioning off 14K contracts in the FX markets, part of their intervention process, while the Philippine peso has benefitted from further investment inflows to the local stock market.  On the flipside, the baht seems to be suffering from concerns that the lockdowns in Europe will reduce tourism there during the high season, while the ruble continues to suffer from concerns over potential military activity and the further negative impacts of sanctions that could follow.

Given tomorrow’s Thanksgiving holiday, all the rest of the week’s data will be released today:

Initial Claims 260K
Continuing Claims 2033K
GDP Q2 2.2.%
Durable Goods 0.2%
-ex Transport 0.5%
Personal Income 0.2%
Personal Spending 1.0%
Core PCE 0.4% (4.1% Y/Y)
Michigan Sentiment 67.0
New Home Sales 800K
FOMC Minutes

Source: Bloomberg

As the GDP data is a revision, it will not garner much attention.  Rather, all eyes will be focused on Core PCE, as if recent form holds, it will print higher than expectations, further forcing the Fed debate.  And of course, the Minutes will be parsed intently as traders try to divine just how quickly things may change next month, especially since Chairman Powell and Governor Brainerd have both been clear that inflation is their primary concern now.

At this point, there is nothing to stand in the way of the dollar and I expect that it will continue to grind higher for a while.  The hallmark of the move so far this month, where the single currency has fallen 3.0%, is that it has been remarkably steady with a majority of sessions showing modest declines.  That pattern seems likely to continue for now unless there is a change from either the Fed or the ECB, neither of which seems likely.  Hedge accordingly.

Have a wonderful Thanksgiving holiday and poetry will return on Monday November 29th.

Good luck, good weekend and stay safe
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Sang the Blues

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The President’s finally decided
That Lael and Jay have now divided
The tasks at the Fed
And both of them said
Inflation just won’t be abided

The bond market took in the news
And quickly adjusted its views
Thus, interest rates rose
While gold felt the throes
Of pain as goldbugs sang the blues

By now, we all know that Chairman Powell has been reappointed to his current role as Fed Chair and Governor Brainerd has been elevated to Vice-Chair.  The underlying belief seems to be that the Biden administration was not prepared for what would likely have been a much more difficult confirmation fight to get Brainerd as Chair and decided to husband whatever political capital they still have left to fight for their spending legislation.  Arguably, the most interesting part of the process was that both Powell and Brainerd, in their remarks, indicated that fighting inflation was a key priority.  As Powell said, “We will use our tools both to support the economy and strong labor market, and to prevent higher inflation from becoming entrenched.”  Now that is a wonderful sentiment, and of course, directly in line with the Fed’s Congressional mandate to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.”  Alas for them both, the tools necessary for the different pieces of the mandate tend to be opposite in their nature.

However, the market response was clear as to its broad belief that tighter Fed policy is on the horizon.  Between those comments and what we heard last week from Governor Waller, vice-Chair Clarida and St Louis Fed President Bullard, it seems clear that the meeting in December is going to be all about the timing of the tapering.  While the progressive wing of the Democratic party remains steadfast in their belief in the power of MMT to deliver prosperity for all, it appears that the reality on the ground, namely that inflation is exploding higher, has become too big a problem to ignore for President Biden.

Here’s the thing.  The traditional tool for fighting rising inflation is to raise interest rates above the rate of inflation to create positive real yields.  Now, depending on how you define inflation; CPI, PCE, the core version of either, or the trimmed mean version of either, given where all of those measures currently stand, the minimum amount of rate increases is going to be 300 basis points, with a chance that it could be 400 or more.  Now, ask yourself how an economy that is leveraged to the hilt (total debt/GDP > 895%) will respond to interest rates rising by 300 or 400 basis points.  How about the stock market, with its current Shiller CAPE (cyclically adjusted P/E) above 39 compared to a median of 15.86 over the past 150 years?  How do you think that will respond to the interest rate curve rising by 300 or 400 basis points?  The picture is not pretty.

It remains to be seen just how much pain the Fed and the Administration can stand if the Fed actually does start to tighten policy more aggressively in the face of rapidly rising inflation.  Consider that in Q4 2018, the last time the Fed was trying to ‘normalize’ policy by allowing the balance sheet to run down slowly while also raising interest rates, stocks fell 20% and the result was the ‘Powell Pivot’ on Boxing Day that year, where the Chairman explained that tightening policy wasn’t actually that critical at the time and would end immediately.  At that time the same measure of debt/GDP was ‘merely’ 763% and the CAPE was 29.  We have much further to fall today, and I expect that when/if that starts to happen, the Fed will not blithely continue tightening policy to fight inflation.  Remember the idea that the Fed has painted themselves into a corner?  Well, this is the corner in which they have painted themselves.  They need to raise rates to fight inflation but doing so is likely to provoke a severely negative market, and potentially economic, reaction.

Now, while we are all waiting for that shoe to drop, let’s take a look at how markets responded to the news.  The first thing to note is the bond market, where 10-year yields rose 9 bps yesterday and that trend has continued this morning with yields higher by another 2.3bps.  With the 10-year currently yielding 1.65%, all eyes are on the 1.75% level, the peak seen in March, and the level many see as a critical technical level, a break of which could open up much higher yields.  It should not be surprising that we have seen higher yields elsewhere as well, with European sovereigns (Bunds +5.9bps, OATs +5.7bps, Gilts +4.8bps) responding to three factors this morning; the US market movement, better than expected preliminary PMI data across the continent and hawkish comments from both Isabel Schnabel and Klaas Knot, two ECB members. You may recall last week when I described some Schnabel comments as apparently dovish, and a potential capitulation of the remaining hawks on the ECB.  Apparently, I was mistaken.  Today she was much clearer about the risks of inflation being to the upside and that they must be considered.  If the hawks are in flight, bonds have further to decline.

In the equity markets, yesterday’s news initially brought a rally in the US, but by the end of the day, as bond yields rose, the NASDAQ, which is effectively a very long duration asset, fell 1.25%, although the rest of the US market fared far better.  The overnight session saw a more modest reaction with the Nikkei (+0.1%) and Shanghai (+0.2%) edging higher although the Hang Seng (-1.2%) suffered on weaker consumer and pharma stocks.  Europe has rebounded from its worst levels but is still lower (DAX -0.7%, CAC -0.25%, FTSE 100 0.0%) despite (because of?) the PMI data.  I guess hawkish monetary policy trumps good economic data, a harbinger of what may be on the horizon.  At this hour, US futures are little changed, so perhaps there is good news in store.

News that the Biden administration is releasing 30 million barrels of oil from the SPR along with releases by India and South Korea has weighed on oil prices (WTI -1.5%) although NatGas (+4.8%) is not following along for the ride.  Gold (-0.5%) got clobbered yesterday and is down 2.7% from Friday’s closing levels.  Clearly, inflation fighting by the Fed is not seen as a positive.  As to the rest of the metals complex, it is generally higher as expectations grow that demand around the world is going to pick back up.

Finally, in the FX market, the truly notable mover today is TRY (-11.2%!) which appears to be starting to suffer from a true run in the wake of President Erdogan’s praise of the recent interest rate cut and claiming that Turkey is fighting an “economic war of independence.”  It seems he’s losing right now.  Relative to that movement, nothing else seems substantial although MXN (-0.8%) is feeling pressure from declining oil prices while other EMG currencies slid on the broad strong dollar theme.  In the G10, NZD (-0.5%) is the weakest performer as long positions were cut ahead of the RBNZ meeting next week, but the bulk of the bloc is modestly lower as US interest rates continue to power ahead.

On the data front, we see the preliminary PMI data (exp 59.1 Mfg, 59.0 Services) and that’s really it.  Yesterday’s Existing Home Sales were better than expected, but really, today’s markets will continue to be driven by interest rates and views on how the Fed is going to behave going forward.  Taking Powell at his word means that tighter policy is coming which should help the dollar amid a broader risk-off sentiment.  Plan accordingly.

Good luck and stay safe
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Somewhat Weak

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In China, the PBOC
Whose policy, previously
Consisted of planks
Instructing the banks
To buy more and more renminbi

Has seemingly now changed its mind
With prop trading now much maligned
Instead, what they seek
Is yuan, somewhat weak
And banks that object will be fined

Let’s face it, constantly harping on inflation is getting tiresome.  While it remains the biggest topic in the market, we have discussed it extensively, and in fact, until there is some clarity as to the next Fed chair, it is very difficult to even try to determine how the Fed will respond going forward.  The word is that President Biden will be revealing his nomination tomorrow at which point we can game out potential future scenarios.

In the meantime, we have seen large movements in some emerging market currencies, and we have heard about some potential changes in policies underlying one of the less volatile ones, the Chinese renminbi.  One of the more surprising features of the dollar’s rally since summertime has been the fact that the renminbi has actually strengthened about 0.6% while the euro has declined nearly 8%.  In fairness, the euro has many self-inflicted problems that have been underlying its recent weakness, but the dollar, as measured by the Bloomberg dollar index, has risen by nearly 6%, implying there has been a lot of broad-based dollar strength.  This begs the question, why hasn’t the renminbi followed suit?

There are several potential answers to this question with the likelihood that each has been a part of the process.  Remember, for a mercantilist economy like China’s, a weaker currency tends to be the goal in an effort to improve the competitiveness of its exporters.  So, acceptance of a stronger currency demonstrates other priorities.

If nothing else, China plays the long game, historically willing to sacrifice short-term economic performance for the sake of a longer-term goal, often a political one.  And one of the things China is very keen to achieve is de-dollarization of its economy.  Given the growing antagonism between the US and China, President Xi has determined his nation is better served by an alternative to the US dollar in as many areas as possible.  One of those areas is in trade with other developing nations.  To the extent that the Chinese can convince other Asian, Middle Eastern or African nations to accept renminbi in exchange for their products, rather than dollars, it both strengthens Xi’s grip on those nations’ economies as well as reduces his reliance on the US led SWIFT system thus preventing any interference by the US.  As such, it is incumbent upon Xi to insure that CNY is a strong and stable currency, the exact words the PBOC uses to describe the renminbi in almost every press release.

Now, while this may have been at odds with short-term potential benefits, Xi understood the long-term benefits of removing as much of the Chinese economy from the dollar’s global sphere of influence as possible.  And it seems, that a major tool used to help maintain the renminbi’s strength has been the encouragement of local Chinese banks prop trading desks to continue to buy the currency.  There have long been stories of the PBOC whispering in the ear of Chinese banks to do just that, with the implication that the PBOC would prevent any significant weakness.

But that was then.  It seems now that the ongoing malaise in the Chinese economy, where growth forecasts continue to slide and expectations for another 50 basis point RRR cut are growing, has the PBOC apparently cracking down on prop desks buying too much CNY.  They have been instructed to monitor client activity and keep it at more ‘normal’ levels.  Some see that as a tacit admission that the previous policy, which was never explicit, was in fact a reality.  In addition, much will be made of the fixing, which last night was printed 0.2% weaker than expected.  Now, while 0.2% may not seem like much, in a currency with historical volatility around 3%, it is a signal.  In addition, the PBOC indicated that it would be ready to allow a “more flexible currency”, their code for weakness.  This is not to say the CNY is going to collapse, just that the unusual strength we have seen over the past six plus months is likely coming to an end.  Be warned.

Turning to the rest of the market this morning, the situation is somewhat mixed, with equity markets showing both gains and losses, although bond markets are under universal pressure.  Starting with equities, Asia gave no directional cues with the Nikkei (+0.1%) little changed while the Hang Seng (-0.4%) and Shanghai (+0.6%) gave confusing signals.  It seems that there is a very large sell order making the rounds in Evergrande stock, which is weighing on HK, while Shanghai responded to the first hints of easing by the PBOC.  Europe, which was modestly higher earlier in the session, has drifted to a mixed performance as well with the DAX (-0.1%) and CAC (-0.2%) both a touch softer although the FTSE 100 (+0.1%) has eked out a gain.  In the absence of any data releases, it seems that traders are biding their time for the next big thing.  US futures, on the other hand, are all firmer by about 0.35%, despite talk of a faster taper by more Fed speakers late last week.

Bond markets, though, are having a rougher time of things with Treasuries (+3.3bps) leading the way, but Bunds (+1.3bps) and Gilts (+2.5bps) both following along.  OATs are unchanged on the day, although have spent the bulk of the session with modestly higher yields.  The thing about yields, though, is that they remain range-bound and have shown little impetus to trend in either direction.  This is a market waiting for the next central bank discussion.

In the commodity space, oil continues under pressure as the thought of SPR releases in a coordinated manner from a number of nations continues to dog the price.  NatGas (-5.4%), interestingly, has tumbled after a larger than expected build in inventories, something US homeowners will welcome.  In the metals space, gold (-0.2%) is slightly softer and copper (-0.6%) is feeling a bit more strain.  However, aluminum (+0.6%) and nickel (+2.1%) show that this is not a universal issue.

As to the dollar, in the G10 the story is mixed with AUD (+0.3%) the best performer while SEK (-0.4%) is the worst.  However, these appear to be flow related movements as there has been no data or commentary from either nation.  The rest of the bloc has barely moved, +/- 0.1% for most of them, as traders await the next big idea.  In the emerging markets, CLP (+3.0%) is the big gainer as yesterday’s presidential election resulted in the conservative candidate performing far better than expected and investors now hoping that the country will maintain its investment friendly policies.  On the downside, RUB (-1.3%) and HUF (-0.6%) are in the worst shape with the former feeling pain based on concerns recent troop movements near the Ukraine border will result in an invasion and potential further sanctions, while the forint is suffering despite a more aggressive central bank as inflation there continues to ramp higher.  Expectations are growing for yet another rate hike as the fear is they are falling further behind the curve.

With the holiday before us, data is all crammed into the first three days this week, and most of it is on Wednesday:

Today Existing Home Sales 6.18M
Tuesday Manufacturing PMI 59.1
Services PMI 59.0
Wednesday Initial Claims 261K
Continuing Claims 2052K
GDP 2.2%
Durable Goods 0.2%
-ex Transport 0.5%
Personal Income 0.2%
Personal Spending 1.0%
Core PCE 0.4% (4.1% Y/Y)
New Home Sales 800K
Michigan Sentiment 66.9
FOMC Minutes

Source: Bloomberg

Consider that on the day before Thanksgiving, we are going to see some of the most important data of the month, and there will be relatively few people around.  If there is any surprise, we could see significant volatility.  In fact, for the week as a whole, the lack of liquidity is likely to result in a choppier market.  Keep that in mind if you need to execute anything of substance, but overall, the dollar’s recent rally seems likely to continue.

Good luck and stay safe
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Risk’s In Retreat

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In Germany, Covid’s widespread
And lockdowns seem likely ahead
But that hasn’t stopped
Inflation which popped
To levels the people there dread

The upshot is risk’s in retreat
As equities, traders, excrete
But bonds and the buck
Are showing their pluck
And havens now look mighty sweet

While Covid has obviously not disappeared, for a time it seemed much less important to investors and traders and so, had a lesser impact on price action.  But that was then.  During the past few weeks, Covid has once again become a much bigger problem despite the inoculation of large portions of the population in most developed countries.  Exhibit A is Austria, where they have imposed a full-scale vaccine mandate and have the police checking papers randomly to insure that anyone outside their home is vaccinated.  If you are found without papers, the penalty is prison.  However, Germany seems determined to catch up to Austria on this count, as the infection rate there climbs rapidly, and the healthcare system is getting overwhelmed.  There is talk that a nationwide lockdown is coming there as well, and soon.

Of course, what we learned during the first months of Covid’s spread was that when lockdowns are imposed, economic activity declines dramatically.  After all, in-person services all but end, and without government financial support, many people are unable to maintain their levels of consumption.  As such, the prospect of the largest economy in Europe going into a total lockdown is a pretty negative signal for future economic activity.  Alas for the authorities, the one thing that does not seem to be in retreat is inflation.  While Germany is contemplating a national lockdown, this morning it released its latest PPI data and in October, Producer Prices rose 3.8%, which takes their year-on-year rise to…18.4%!  This is the highest level since 1951 and obviously greatly concerning.  While some portion of these increased costs will be absorbed by companies, you can be sure that a substantial portion will be passed on to customers.  CPI is already at 4.6% and there is no indication that it is about to retreat.

And folks, this is Germany, the nation that is arguably the most phobic regarding inflation of any in the developed world.  Sure, Turkey and Argentina and Venezuela have bigger inflation problems right now.  So does Brazil, for that matter.  And many of these latter nations have long histories of inflation ruling the roost.  But ever since 1924, when the newly established Rentenbank helped break the Weimar hyperinflation, sound money and low inflation have been the hallmarks of German policy and politics.  So, the idea that any price index is printing in double digits, let alone nearly at 20% per annum, is extraordinary.  In fact, this is what makes yesterday’s comments from Isabel Schnabel, a German PhD economist and member of the ECB’s Executive Board, so remarkable.  For any German with sway over monetary policy to pooh-pooh the current inflation levels is unprecedented.  Even more remarkably, with Jens Weidmann leaving the role of Bundesbank President, Schnabel is on the short list to replace him.

This drama in Germany matters because if the Bundesbank, traditionally one of the most hawkish central banks, and the biggest counterweight to the ECB as a whole, is turning dovish, then the implications for the euro, as well as Eurozone assets, are huge.  If the Bundesbank will not be holding back Madame Lagarde’s push to do more, we can expect an expansion in QE from here and overall higher inflation going forward.  Both bonds and stocks will rally, as will the price of commodities in euros, while the euro itself will fall sharply.  In fact, this may be enough to offset any incipient dovishness from the Fed should Lael Brainerd wind up as Fed Chair.  It would certainly change medium and long-term views on the EURUSD exchange rate.  And you thought that the week before Thanksgiving would be quiet.

And so, it is a risk-off type day today.  While Asian equity markets managed more winners than losers (Nikkei +0.5%, Hang Seng -1.1%, Shanghai +1.1%), Europe is completely in the red (DAX -0.2%, CAC -0.3%, FTSE 100 -0.5%) and US futures are pointing down as well, with DJIA futures (-0.6%) leading the way.

Bond markets are behaving exactly as would be expected on a risk-off day, with Treasury yields falling 4.6bps while European Sovereigns (Bunds -5.5bps, OATs -5.4bps, Gilts -5.8bps) have rallied even further.  In fact, German 30-year bunds have fallen into negative territory again for the first time since August.

If you want to see risk being shed, look no further than oil (-3.1%) which is lower yet again and seems to have found a short-term top.  It seems the news of SPR releases as well as slowing growth prospects has been enough to halt the inexorable rally seen since April 2020.  Interestingly, a number of other commodities are performing quite well with NatGas (+1.1%), copper (+0.9%) and aluminum (+0.7%) all nicely higher.  Gold (+0.2%) continues to edge up as well, with more and more inflows given its haven status.  Somewhat surprisingly, Bitcoin (-4.7%, -10.5% in the past week) is not similarly benefitting, although the narrative of it being digital gold remains strong.  Perhaps it was simply massively overbought!

Finally, the dollar is clearly king this morning, rallying strongly vs all its G10 peers except the yen (+0.35%), with NOK (-1.1%) the biggest laggard on the back of oil’s decline, although the SEK (-0.9%) and EUR (-0.7%) are no slouches either.  The funny thing about the euro was it spent all day yesterday climbing slowly after touching new lows for the move.  However, this morning, it is below 1.13 and pressing those lows from Wednesday with no end in sight.

EMG currencies are also under pressure across the board with HUF (-1.6%) the worst performer as it has unwound the gains seen from yesterday’s surprising large rate hike, and is now suffering as Covid spreads rapidly and it may soon be a restricted zone for travel from Europe.  CZK (-1.1%) is next in line, as it too, is in the crosshairs of authorities to prevent travel there due to Covid.  In fact, the entire CE4 is the worst bloc, but we are also seeing further weakness in TRY (-0.6%) after yesterday’s rate cut, and RUB (-0.5%) with oil’s slide as the cause.

There is no data to be released today and only two Fed speakers, Waller and Clarida, with the latter losing his clout as he will soon be exiting the FOMC.  There continues to be a wide rift between the hawks and doves on the Fed, but as long as Powell, Brainerd and Williams remain dovish, and they have, the very modest steps toward tapering are all we are likely to see.  The problem is that while we are all acutely aware of inflation and the problems it brings, the FOMC is lost in its models and sees a very different reality.  Not only that, inflation diminishes the real value of the US’s outstanding debt and so serves an important purpose for the government.  While there continues to be lip service paid to inflation as a problem, policy actions show a willingness to tolerate higher inflation for a much longer time.  Alas, it will be topic number one with respect to markets for a long time to come.

For now, the dollar is performing well against all the major currencies, but there are many potential twists in our future.  As I have said before, payables hedgers should be picking levels to add to their hedges.

Good luck, good weekend and stay safe
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Prices Keep Rising

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In Europe, though prices keep rising
The central bank is emphasizing
No rate hikes are near
In this or next year
So, traders, their views, are revising

Meanwhile in the States the reverse
Is true with inflation much worse
Now traders believe
The Fed’s on the eve
Of trying to tighten their purse

It cannot be surprising that inflation remains topic number one in the markets as its existence is driving virtually every narrative.  For instance, the choice for next Fed Chair is seen as having a direct impact on inflation based on the relative dovishness of Lael Brainerd vs. Jay Powell.  Too, as oil prices have risen so sharply over the past year, driving up the price of gas at the pump and inflation in general, the Biden Administration is now exhorting all nations to release oil from their strategic reserves in order to damp down those price pressures.  And what about wages, you may ask?  As per the WSJ this morning, here is the latest on the just agreed wage deal at Deere & Co, whose workers had been on strike for the past 5 weeks,

“Deere workers returning to assembly plants and warehouses will get an immediate 10% raise, and each worker will receive an $8,500 bonus. Additional 5% pay raises will be provided in 2023 and 2025, and lump-sum bonuses amounting to 3% of workers’ annual pay will be awarded in the three other years.
The deal approved Wednesday also will increase the base pay level for Deere’s continuous-improvement program by about 4%, giving workers more weekly pay from the program if their productivity meets the company’s goals. About two-thirds of UAW-represented Deere workers receive production-based compensation on top of their regular wages, according to the company.”

Apparently, the cost of the settlement is on the order of $3.5 billion, a very substantial portion of their forecast 2021 earnings estimates of $5.8 billion.  It strikes that either Deere is going to be raising prices (likely) to offset that margin compression, or its earnings numbers are going to diminish (also likely) thus putting pressure on its stock over time.  Recall, Chairman Powell has been adamant, and we have heard from numerous other Fed speakers as well, that wage inflation is not imminent and thus recent price rises are likely to be temporary.  This appears to be one more data point that makes the Fed story less plausible.

In Europe, however, there is a full-court press by ECB members to convince the investment and trading communities that they are not going to raise rates anytime soon as inflation there, too, is still transitory.  While it should be no surprise that Mario Centeno, the Portuguese central bank head and ECB member is all-in for never raising rates again, it is a huge surprise that Germany’s Isabel Schnabel is talking about the need to avoid premature tightening as deflation risks still haunt the Eurozone.  Her comments come despite CPI in Germany running at 4.5%, the highest since the reunification in the early 90’s and causing significant domestic strife.  If one was looking for a sign that the ECB doves have coopted the hawks to their side, there is no better indication than this!  As such, traders, who had been pricing for a 10bp rise in the deposit rate by the end of 2022 have pushed that view back nearly 12 months.

In sum, the battle between the central bank narratives and reality continues apace with the central banks, remarkably, holding their own in the face of growing evidence to dispute their claims.  And it is this battle that will continue to drive markets and help maintain volatility as each data point or comment has the ability to alter things at the margin.

So, as we look at markets this morning, remember the backdrop remains, Inflation, friend or foe?

Ok, how has risk appetite been affected by the latest news?  Well, US equities all moved lower yesterday and that carried over into Asia with the Nikkei (-0.3%), Hang Seng (-1.3%) and Shanghai (-0.5%) all in the red.  Part of that is because the Chinese property sector continues to weigh on sentiment there with the latest news that several large property companies, including Evergrande, are set to unload stakes in other companies to raise cash.  While these sales will be at great losses, the imperative for the cash is obvious.  Not surprisingly, selling large stakes of publicly held companies tends to weigh on their stock price and thus the market as a whole.

In Europe, the picture is more mixed (DAX +0.1%, CAC +0.2%, FTSE 100 -0.2%) with the UK seeming to suffer from growing concerns the Johnson government may invoke Article 16 from the Brexit deal which would suspend part of the Northern Ireland solution and could quickly evoke retaliation by the EU.  As to US futures, given it appears to be illegal for two consecutive down days in the equity markets, it should not be surprising that futures are pointing higher by between 0.2% and 0.5% at this hour.

Bond market price action is a very clear result of the central bank narrative as European sovereigns have all seen rallies (lower yields) while Treasuries remain under pressure as investors anticipate higher rates in the States.  This morning the 10-year Treasury yield is higher by 1 basis point while in Europe (Bunds -0.9bps, OATs -1.3bps, Gilts -2.7bps) the entire continent has seen demand pick up and yields decline.  Clearly, if the ECB remains full-bore on QE, it will support these prices for a long time.

Turning to the commodity markets, pretty much the entire space is softer today led by oil (-0.5%), gold (-0.2%) and copper (-0.7%).  But there is weakness across the rest of the industrial and precious metal space as well.  In fact, the only gainers on the day are NatGas (+1.8%) which looks very much like a rebound from its recent sharp sell-off, and the agricultural space, where the big 3 products are all firmer by a bit.

Turning to the FX markets, the dollar is under a bit of pressure this morning, which mostly seems like a pull-back from its recent strength.  Technically, it does seem overbought.  In the G10, NZD (+0.7%) is far and away the leading gainer after the RBNZ published their inflation expectations survey at the highest level in a decade and traders began to price in another 25 basis point rate hike at their meeting next week.  However, after that, the rest of the bloc has seen much more modest strength except for NOK (-0.1%) which is suffering from oil’s recent travails, and JPY (-0.1%) which may be reacting to news that the Kishida government is discussing yet more fiscal stimulus, this time to the tune of ¥78.9 trillion.

Emerging market currencies have a more mixed tone with the outlier continuing to be TRY (-2.1%) as the central bank remained true to form and cut its base rate to 15.0% despite runaway inflation.  Next worst is CLP (-0.7%) which has fallen as the finance ministry has stopped its regular dollar sales to maintain cash balances, but pulling support from the currency, and then we see both MXN (-0.55%) and ZAR (-0.5%) suffering on the back of commodity weakness.  On the plus side, HUF (+0.7%) is the big winner after the central bank raised rates by a more than expected 0.70% in their efforts to fight inflation.

On the data front this morning comes weekly Initial (exp 260K) and Continuing (2120K) Claims as well as the Philly Fed (24.0) and Leading Indicators (0.8%).  The Fed speaker onslaught slows a bit today with only four speakers, although despite yesterday’s plethora of speakers, it doesn’t appear we learned anything new.

For now, the broad narrative remains the Fed is going to be the first large central bank to tighten and that is driving the dollar higher.  While today we seem to be pausing for a bit, this story does not yet appear to have run its course.  Hence, I reiterate for payables hedgers, pick your levels and take advantage of the dollar’s strength for now.  orders are an excellent way to manage this risk.

Good luck and stay safe
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Quite Insane

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There once was a concept, inflation
That frightened the heads of each nation
As prices would rise
They could not disguise
The fact it was just like taxation

But now, though it seems quite insane
Most governments try to explain
No need for dismay
Inflation’s okay
There’s no reason you should complain

The latest example is from
The UK, where people’s income
Continues to lag
Each higher price tag
And prospects for growth are humdrum

It certainly is becoming more difficult to accept the idea that the current inflationary surge being felt around the world is going to end anytime soon.  I keep trying to imagine why any company would cut prices in the current macroeconomic environment given the amount of available funds to spend held by consumers everywhere.  So called ‘excess’ savings, the amount of savings that are available to consumers above their long-term trend, exceed $3 trillion worldwide, with more than $2 trillion of that in the US alone.  If you run a company and are being faced with higher input costs (energy, wages, raw materials, etc.) and there has been no reduction in demand for your product, the most natural response is to continue to raise prices until you find the clearing price where demand softens.  It is a pipe dream for any central bank to expect that the current situation is going to resolve itself in the near future.

And yet…the major central banks (Fed, ECB, BOE and BOJ) continue to be committed to maintaining ultra-easy monetary policy.  For instance, today’s inflation data from the UK is a perfect case in point.  CPI rose a more than expected 4.2% Y/Y, more than double the BOE’s price target.  Core CPI rose 3.4%, also more than expected and RPI (Retail Price Index, the price series that UK inflation linked bonds track), rose 6.0%, the highest level since 1991.  And yet, the BOE is seemingly no closer to raising rates.  You may recall that despite what appeared to be clear signaling by the BOE they would be raising interest rates at their meeting earlier this month, they decided against doing so, surprising the market and leading to significant volatility in UK interest rate markets.  In fact, BOE Governor Bailey fairly whined afterwards that it was not the BOE’s job to manage the economy.  (If not, what exactly is their job?)  At any rate, the growing concern in the UK is that growth is slowing more rapidly while prices continue to rise.  This has put the BOE in a tough spot and will likely force a decision as to which issue to address.  The problem is the policy prescriptions for each issue are opposite, thus the conundrum.

The bigger problem is that this conundrum exists in every major economy.  The growth statistics we have seen have clearly been supported by the massive fiscal and monetary policy expansion everywhere.  In the US, that number is greater than $10 trillion or 40% of the economy.  The fear is that organic growth, outside the stimulus led measures, is much weaker and if policy support is removed too early, economies will quickly fall back into recession.  In fact, that is the most common refrain we hear from policymakers around the world, premature tightening will be a bigger problem.  Ultimately, a decision is going to need to be made by every central bank as to which policy problem is more important to address immediately.  For the past four decades, the only policy issue considered was growth and how to support it.  But now that inflation has made a comeback, it is a much tougher choice.  We shall see which side the major central banks choose over the coming months, but in the meantime, the one thing which is abundantly clear is that prices are going to continue to rise.

A reasonable question would be, how have markets responded to the latest data and comments?  And the answer is…no change in attitude.  Risk appetite remains relatively robust as the money continues to flow from central banks, although certain risk havens, notably gold, are finding new supporters as fears of significantly faster inflation grow.

So, let’s survey today’s markets.  Equities have had a mixed session with Asia (Nikkei -0.4%, Hang Seng -0.25%, Shanghai +0.45%) and Europe (DAX +0.1%, CAC +0.1%, FTSE 100 -0.3%) all, save China, remaining near all-time highs (in the case of the Nikkei they are merely 31 year highs from after the bubble there), but certainly showing no signs of backing off.  US futures are showing similar price action with very modest movement either side of flat.

Bonds, as well, are little changed and mixed on the day with Treasuries (-0.5bps) catching a modest bid after having sold off sharply over the past week.  In Europe, the price action is similar with Bunds (-0.3bps), OATs (+0.2bps) and Gilts (-0.5bps) all within a few tics of yesterday’s closing levels.  I would have expected Gilts to suffer somewhat more given the UK inflation data, but these days, it appears that inflation doesn’t have any impact on interest rates.

Commodity prices are softer this morning led by oil (-1.3%) and NatGas (-1.75%), although European NatGas is higher by more than 7.3% this morning as Russia continues to restrict flows to the continent.  (I have a feeling that the politicians who made the decision to rely on Russia for a critical source of power are going to come under increasing pressure.)  In the metals markets, industrials are mostly under pressure (Cu -1.0%, Sn -0.1%, Zn -0.8%) but we are seeing a slight rebound in aluminum (+0.6%) and precious metals are doing fine (Au +0.6%, Ag +1.1%).  It seems that inflation remains a concern there.

As to the dollar, it has outperformed a few more currencies than not, with TRY (-1.25%) the biggest loser as the central bank there has clearly made the decision that growth outweighs inflation and is expected to cut interest rates further despite inflation running at nearly 20%.  Elsewhere in the EMG bloc, the losers are less dramatic with MYR (-0.3%) and CLP (-0.3%) the next worst performers.  On the plus side, RUB (+0.8%) is the clear leader, shaking off the decline in oil prices as inflows to purchase Russian bonds have been enough to support the ruble.  Otherwise, there are a handful of currencies that have edged higher, but nothing of note.

In the G10, the picture is also of a few more losers than gainers but no very large moves at all.  surprisingly, GBP (+0.1%) has done very little in the wake of the CPI data and actually SEK (+0.35%) is the best performer on the day.  However, given the krona’s recent performance, where it has fallen more than 4% in the past week, a modest rebound should not be much of a surprise.  Overall, the dollar has retained its bid as evidenced by the euro (-2.8%) and the yen (-2.0%) declining during the past week with virtually no rebound.  It appears that the market continues to believe the Fed is going to be the major central bank that tightens policy fastest and the dollar is benefitting accordingly.

This morning’s data brings Housing Starts (exp 1579K) and Building Permits (1630K), neither of which seem likely to move markets.  Yesterday’s Retail Sales and IP data were much stronger than expected, which clearly weighed on bond markets a bit, and supported the dollar, but had little impact elsewhere.  We hear from seven! Fed speakers today, as they continue to mostly double down on the message that they expect inflation to subside on its own and so it would be a mistake to act prematurely.  There is a growing divide between what the market believes the Fed is going to do and what the Fed says they are going to do.  When that resolves, it will have a large market impact, we just don’t know when that will be.

For now, you cannot fight the dollar rally, but I will say it is getting a bit long in the tooth and a modest correction seems in order during the next several sessions.  Payables hedgers should be picking spots and layering into hedges because the longer-term situation for the dollar remains far more tenuous.

Good luck and stay safe
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Hawks Now Despair

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The imminent news of the day
Is President Joe will convey
His choice for Fed chair
As hawks now despair
Lael Brainerd will soon lead the way

Her bona fides highlight her views
More policy ease she would choose
Inflation? No worry
But she’s in a hurry
For banks to put under the screws

The word from Washington is that President Biden will be announcing his selection for Fed chair imminently.  The very fact that the news was released using that phraseology implies to some (this author included) that we will have a new Fed Chair going forward, Lael Brainerd.  It is widely known that the President interviewed both Brainerd and Powell last week and ostensibly, Ms Brainerd accorded herself quite well.  It is also widely known that the progressive wing of the Democratic Party, which continues to gain sway over policy decisions, hates Chairman Powell and believes that not only would a Chairwoman Brainerd maintain policies to pay for their wish list, but that she would also be much tougher on the banking industry on a regulatory basis.

Of course, the key question is, can Brainerd win approval from a split Senate?  However, it is not clear that Powell could win approval either.  In Brainerd’s case, the vote would almost certainly be a straight party-line vote with Vice-president Harris casting the tiebreaker if necessary, although, it is quite possible that one or two of the very centrist Republican senators vote yea for her.  Powell, on the other hand, has enemies on both sides of the aisle, as there is a contingent of Republicans who believe he is to blame for the current inflation, while we also know there is a contingent of Democrats, led by Senator Warren, who despise him.  In other words, it doesn’t appear either is a slam dunk despite the fact both are currently on the Fed board and have been approved in the past.

Given we already know how markets have responded to the Powell Chairmanship, let us consider how a Chair Brainerd might be viewed.  Whether it is true or not, the current narrative is that Ms Brainerd would be more dovish than Powell, far less likely to complete the current tapering initiative and potentially seek reasons to further expand the Fed’s balance sheet.  If that were to be the case, one would have to be bullish financial assets with both stocks and bonds benefitting from that policy mix.  In addition, given the current inflationary impulse, and the likelihood that a Chair Brainerd continues to believe in the transitory theory, commodity prices are likely to continue their climb higher.  As to the dollar, based on this thesis, the dollar’s recent rise would likely come to an end, as the ongoing decline in real rates would undermine its value proposition.  You may wonder why bond prices would perform well despite rising inflation and the answer is simple, the ongoing QE purchases would support them, and a change in view regarding the timing of any tightening would likely see the short end of the curve rally, driving rates there much lower as well.

Of course, this is speculation regarding speculation of a particular outcome.  However, based on the market’s previous responses to these types of policy stimuli, I would contend they are reasonable.  Regardless, this all depends on any announcement.

One thing to note is that the case for a dollar decline is relatively strong in the event the market perception changes regarding further Fed policy tightness.  The dollar has been benefitting from the perception that the Fed is leading the way among the major central banks, with respect to removing policy ease.  If that perception were to change, so will the trajectory of the greenback.

Turning to the markets this morning, after a lackluster day in the US yesterday, where the major indices barely moved, we saw a mixed performance in Asia (Nikkei +0.1%, Hang Seng +1.3%, Shanghai -0.3%) as China continues to feel downward pressure from the real estate sector there.  Europe, on the other hand, is having a better day (DAX +0.5%, CAC +0.4%, FTSE 100 +0.2%) despite growing concerns over NatGas supplies due to some delays in NordStream 2 approvals.  It seems that a combination of ongoing dovish comments from Madame Lagarde and a new analysis by Capital Economics indicating interest rates in Europe will not rise before 2025, have inspired more risk-taking.  Meanwhile, US futures, which had been lower earlier in the session, have now edged back to essentially unchanged on the day.

In the bond market, yesterday saw some very aggressive selling with Treasury yields rising 5 basis points and pretty much dragging the entire space with them.  This morning, however, things have reversed with Treasury yields (-1.9bps) down along with Bunds (-1.9bps), OATS (-2.0bps) and Gilts (-2.0bps).  As long as there is belief in the QE process, bonds will retain a bid.  As an aside, there was an interesting article yesterday from MNI reporting on the fact that Italy and the other PIGS are seeking a permanent change in EU lending rules to insure that they get more money with less strings, as has been occurring during the Covid inspired emergency.  This has all the signs of a new policy that will be enacted, permanently increasing the amount of support that Southern Europe receives from the EU, and likely, over time to build tensions.  I would look for PIGS spreads vs. Bunds to narrow on this conversation, but it will not help the euro.

As to commodities, this morning most are in the green led by oil (+0.4%) which is continuing yesterday’s late day rally although prices are still much lower on the week.  NatGas (+2.8%) is clearly rising in concert with the European story on Nordstream 2 while gold (+0.6%) and silver (+0.85%) continue to confound by rising sharply alongside the dollar.  Ags are a little softer as are base metals (Al -1.6%, Zn -0.9%), so the message from this market is just not clear.

Turning to the dollar, it is broadly stronger this morning with SEK (-0.3%) and CHF (-0.3%) the laggards in the G10 although GBP (+0.25%) and NOK (+0.2%) are both firmer.  Going backwards, NOK is clearly being supported by oil prices while the pound is benefitting from modestly positive employment news amid a spate of releases there.  As to the losers, there is really no news in either currency which implies the general dollar bullish framework continues to be the key driver.  In the emerging markets, TRY (-1.4%) is today’s worst performer as investors fear further rate cuts despite rapidly rising inflation.  Interestingly, RUB (-0.5%) is also under pressure despite oil’s rebound as concerns over rising inflation in Russia are also impacting investment decisions.  CLP (-0.5%) is the other laggard here as a combination of broad dollar strength and concerns over inflation seem to be undermining the peso.

On the data front, we see Retail Sales (exp 1.5%, 1.0% ex autos) as well as IP (0.9%) and Capacity Utilization (75.9%) this morning.  We get the Fed train rolling with five speakers this morning ranging from the most hawkish (George) to the most dovish (Daly).  However, I believe all eyes will be on the Chairmanship story, not comments from underlings.

The dollar broadly continues to rally with the euro having traded to its lowest level since July 2020 and there is nothing that indicates this trend is going to change soon.  While there are good reasons to expect the dollar to eventually decline, right now, higher is the direction of travel so keep that in mind for your hedging.  However, for those with a longer-term view, looking into 2023 and 2024, current levels may well look attractive if payables are the exposure.

Good luck and stay safe
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