Inflation is clearly passé
As traders and markets display
Remarkable trust
The Fed will adjust
The path of rate hikes come what may

The upshot is there’s a new meme
A landing so soft it would seem
No jobs will be lost
And there is no cost
Alas I fear it’s just a dream

I’m not sure if you saw the announcement yesterday, but everything is beautiful!  Inflation is a thing of the past, the economy continues to tick over quite nicely with employment remaining robust and the idea of recession is just a figment of the permabears’ imagination.  At least that’s what it seems like based on market movements of late.

Yes, PPI printed lower than forecast, which after the somewhat softer CPI and the known base effects, was not hugely surprising.  Perhaps a bit more surprising was that the Claims data, both on an Initial and Continuing basis, printed lower than expected.  The implication here is that the labor market remains quite robust with those folks who have been laid off able to find new employment quite rapidly.  While there is still plenty of data pointing to a manufacturing recession (ISM, IP, Factory Orders), the Services situation remains far better with increased activity and rising wages still apparent.  So, perhaps the optimists have it nailed, and believe Chairman Powell has managed to create a soft landing, where inflation comes back to target without having to cause a recession.

However, it feels like it is still a little early to take that victory lap.  After all, the inflation data was literally one data point driven largely by base effects and regardless of your view, one data point does not a trend make.  Certainly, the equity market is all-in on the soft-landing scenario.  The Treasury market, at least since the CPI print on Wednesday has rallied dramatically (another 10bps yesterday) and is now 29bps lower over the past week.  In fact, the 2yr Treasury has rallied even further, with yields there falling by 35bps over the same period.  To say that the market has adjusted its views on the Fed’s future activities would be an understatement.   There is still a 91% probability priced into a 25bp rate hike this month, but there are no more hikes after that priced at this stage and the first cut is seen in either March or May next year, at least according to the Fed funds futures market.

And what of the dollar?  While it is bouncing a little today, that is clearly modest position adjustment amid profit-taking as it is sharply lower on the week against all its G10 counterparts and almost all its EMG brethren.  

There is, of course, one fly in the ointment, oil prices, and commodities in general.  One of the key features of markets over time is that they tend to be self-correcting.  The saying, the solution to high prices is high prices is trying to explain the idea that high prices result in additional supply coming to market (to take advantage of those high prices) which results in prices falling back to earlier, lower levels.  The same process occurs with low prices as well, where low prices inspire increased demand and reduced supply thus driving prices higher again.  

Well, oil is exhibit A for this process.  Since oil continues to be priced and traded largely in dollars, when the dollar is strong, non-dollar countries (basically everybody else) finds that oil is expensive and so demand wanes a bit resulting in softening oil prices.  However, when the dollar declines, as we have seen in the past week, that opens the door for oil, and most commodities which are priced in dollars, to rally sharply.  Of course, if you are the Fed and continue to try to dampen price pressures, the last thing you want is a weak dollar and high commodity prices as both lead directly to rising inflation.  In fact, one reason that US inflation did not reach the levels seen in Europe and the UK is that the dollar remained quite strong throughout this period thus reducing inflationary pressures.  But right now, that dynamic is reversing with the dollar under pressure and commodity prices rising.  That bodes ill for continued declines in CPI and PPI which is certainly not part of the new narrative.  

(As an aside, it is this very feature that drives the de-dollarization narrative as you can easily understand why China, who is the largest importer of oil in the world, would like to see the dollar dethroned so they can pay for their imports with their own currency (printed as necessary) rather than have to earn dollars elsewhere to pay for their oil and other commodity imports.)

At any rate, I feel it is very important for everyone to remember that it is never the case when all signals point in the same direction.  It is only the case that the market responds to a group of signals that reinforce their underlying view, happily ignoring the rest.  As another saying accurately makes clear, nothing matters until it matters.

Ok, as we head into the weekend with a week’s worth of euphoria behind us, what is today shaping up to be?  Well, equity markets are muddling about with most ever so slightly higher but some sliding after the previous two days’ strong rallies.  US futures are also lackluster at this hour (8:00) barely higher as traders prepare for another summer weekend.  

Bond markets, too, are quiet after a raucous week, with yields little changed on the day in the US and throughout Europe and in Japan.  One cannot be surprised by the market response to the CPI data and now that this new narrative of rainbows, unicorns and lollipops is making its way around to every corner of the market, there is no reason to think that much will change in the near term.  Arguably, even if inflation is beaten and is heading back to 2%, a big IF, there is precious little reason for 10-year yields to fall very far as they would currently be offering a 1.75% real yield, a very normal situation throughout history.  Although, there would certainly be cause to believe the 2yr is set to see yields decline further and the yield curve normalize.  But again, I believe it is very early to take that as gospel.

Commodity markets are following the same pattern here, consolidation after a week of strong rallies in all the major commodities so the question is, will those rallies continue next week?  Or have we reached the end.  This story is true of the dollar as well, which is intimately linked to the commodity story.

Will today’s Michigan Sentiment (exp 65.5) change any views?  I doubt it although if the reading is quite strong, and given the growing bullish zeitgeist, it could certainly pump risk assets further.  However, a soft reading seems unlikely to derail the current risk attitude at this point.  With the Fed commentary under wraps until the FOMC meeting, today is likely to be entirely equity focused.  To that end, the big banks have been reporting Q2 earnings this morning and so far, they have all beaten (dramatically reduced) forecasts.  I expect that is all that is needed for risk to retain its luster, so do not be surprised to see the dollar continue its recent slide and stocks and commodities finish higher on the day.

Good luck and good weekend
adf