The Minutes revealed that the Fed
When pondering their views ahead
Are no longer all
Completely in thrall
With hiking til more ink is red

However, they also revealed
That some felt a still higher yield
Was proper for June
And want more hikes soon
To make sure inflation’s fate’s sealed

Yesterday’s FOMC Minutes were interesting for the fact that after more than a year of the committee remaining completely in sync, it appears we have finally reached the point where there is a more robust discussion of the next steps.  The hawkish pause skip was very clearly an uneasy compromise between those members who thought it was appropriate, after 10 consecutive rate hikes, to step back and see if things were actually playing out in the manner their models predicted and those that remained adamant it was inappropriate to delay their process as there has been far too little progress on the reduction in services inflation.  Remember, the Fed’s models are entirely Keynesian in that they assume higher interest rates reduce demand by forcing financing costs higher.  It is why Chairman Powell has repeatedly explained that in order to achieve their goals, a little pain is going to be required.

 

But consider the nature of the current bout of inflation.  Was this driven by excess money being created in the banking sector and spent on business investment, or even share buybacks?  Or was this inflation driven by excess money being created, and then handed directly to the public in order to help everyone during the government-imposed lockdowns, thus spent immediately on goods, and eventually on services once the lockdowns were lifted?

 

I would argue that the latter is a more accurate representation of the current situation, one more akin to the post WWII economy than the 1970’s oil embargo led economy.  If this is the situation, then perhaps continuing to raise interest rates may not be the best solution to the problem.  In fact, as Lynn Alden indicates in her most recent piece, it could well be counterproductive.  If this inflation is fiscally (meaning government led) driven rather than monetarily (meaning bank lending led) driven, higher interest rates simply add to the amount of money available to spend by the public.  In fact, this process becomes circular as higher interest rates increase the amount of interest paid to bondholders adding to their disposable incomes, while simultaneously increasing the size of the fiscal deficit, thus increasing debt issuance, and driving interest rates higher still.  This is an unenviable place for the Fed to find itself, especially since its models don’t really accept this premise.  Rather, they continue to fight the 1970’s inflation via the Volcker playbook, which may only exacerbate the situation.

 

My growing concern is that the Fed is fighting the wrong enemy, and in fact, has no tools to fight the excessive fiscal spending which is currently the key driver of demand.  As such, it is very realistic to expect inflation, whether measured as PCE or CPI, is going to remain elevated on a core basis for quite a while yet.  When combining this thesis with both deglobalization and incremental labor shortages, the case for higher inflation for longer becomes even more compelling.  We have already seen that the housing market has not behaved at all in the manner expected by the Fed’s (or anybody’s) models, with prices holding up far better than anticipated given the dramatic rise in interest rates over the past 18 months.  It is not hard to believe that other variables in the Fed’s models are equally wrong.  In the end, this is further confirmation, to me, that the Fed will be fighting its inflation battle for a very long time.

 

How have markets reacted to this new information?  Not terribly well with financial assets falling in value around the world.  This is true in equities, where yesterday’s modest US declines were followed by much sharper falls in Asia and Europe with the Hang Seng (-3.0%) the laggard but all of Europe down by more than -1.0% today.  US futures are also under pressure, down about -0.4% as I type (7:30).

 

But despite the fall in equity markets, bond prices are tumbling as well with yields rising around the world.  Treasury yields are actually the best performers, rising only 4bps this morning, although that has taken them tantalizingly close to the 4.00% level which has proven to be a more significant hurdle for equities in the recent past.  But in Europe and the UK, bond yields are screaming higher with Gilts (+10bps) leading the way, but all Continental sovereigns seeing yields rise by at least 6bps.  This is interesting given the fact that the only data released today was Construction PMI data which was incredibly weak across all of Europe and the UK.  Clearly, the prospect of higher Fed funds is one of the driving forces here as higher for longer gets more deeply embedded in the market belief set.

 

Speaking of higher Fed funds, the market is currently pricing an 85% probability of a hike later this month and then only a slight chance of a second one, despite the Fed’s comments.  In Europe, the situation is similar, with a 90% probability priced for July but only one more hike in total by the end of the year.  And remember, the ECB is 125bps behind the Fed in terms of the level of rates, and inflation remains higher in the Eurozone than in the US.  It feels like there will be more changes to come in these markets.

 

Oil prices, meanwhile, continue to be supported with the rationale being the Saudi’s continued production cuts.  While there is a story that Iran has been pumping more oil into the market, the price action has certainly been a bit more bullish lately.  Structurally, there is still going to be a shortage of oil over time, but for now, that doesn’t seem to matter.  Meanwhile, base metals are edging lower this morning, after the weak construction data, and gold remains stuck in its consolidation.

 

As to the dollar, it is generally, though not universally, lower this morning with the yen (+0.6%) the leading gainer on fading risk sentiment, although there is also a building story that Ueda-san is going to be making some adjustments in the near future in order to mitigate the recent weakness.  While it has been relatively slow and steady, as it approaches 145, it clearly seems to be generating some discomfort.  But in the G10, the weakness is broad.  However, in the EMG bloc, the dollar has had a much better showing rising against a majority of the group with ZAR (-0.9%) the laggard on the weaker metals’ prices, but weakness throughout APAC and LATAM currencies as well.  If we continue to see US rates climb higher, I expect that the dollar will be dragged along for the ride.

 

On the data front today, there is a lot of stuff, starting with ADP Employment (exp 225K) and followed by the Trade Balance (-$69.0B), Initial Claims (245K), Continuing Claims (1734K), JOLTS Job Openings (9885K) and finally ISM Services (51.2) at 10:00.  I saw a story that there has been a seasonal adjustment issue with the Claims data because of the Juneteenth holiday, which is quite new, and so not necessarily properly accounted for in the release.  Over time, these things will smooth out, but do not be surprised if today’s Claims print is higher than expected.  And of course, this all leads up to tomorrow’s NFP report, something I will discuss then.  Dallas’s Lori Logan speaks today, but she is not currently a voter.  Next week, however, we hear from a lot of Fed speakers, so perhaps some fireworks are on the horizon.

 

Overall, I think there is a case to be made that the Fed is looking in the wrong direction and that they will continue to raise the Fed funds rate and drive all yields higher without having the desired disinflationary impact.  In that scenario, I think the dollar still looks the best of the bunch.

 

Good luck