Author Archives: fxpoet

Deflation’s Emerged

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Inflation in China is sliding
Which now has some pundits deciding
Elsewhere round the globe
The deeper you probe
DEFLATION’s emerged from its hiding

For equity bulls it’s a sign
That US rates soon will decline
But thus far Chair Jay
Keeps pounding away
That higher for longer is fine

By far the story that has gotten the most press from the overnight session has been the Chinese inflation readings.  For good order’s sake, they showed that the Y/Y CPI rate fell to 0.0%, down 2 ticks from last month and 2 ticks below expectations, while the Y/Y PPI rate fell to -5.4%, far below last month’s -4.6% reading and the lowest level since the end of 2015.

 

There have been numerous takes on the implications of this data.  In the short-term column, we have seen weakness in AUD (-0.7%) and NZD (-0.5%) as the narrative explains the falling inflation indicates falling demand and slowing growth in China, thus reducing the need for Antipodean exports.  Interestingly, this take does not effectively explain commodity price movements as although oil (-0.7%) is a bit lower this morning, both copper (+1.3%) and aluminum (+0.8%) are having quite a solid session.  Of course, the entire China reopening is bullish for the global economy and inflation story has been a disappointment from the get-go, so it is not clear why this is suddenly changing any opinions.

 

However, if you listen to the longer-term takes on this data, pundits are implying this is proof that the inflation genie is getting stuffed back into its lamp, and that soon, as inflation tumbles in the US, the Fed will finally pivot, and stock prices will run to new highs.  Quite frankly, I have a much harder time accepting the long-term take than the equity bulls seem to have.

 

A key part of this narrative is that come Wednesday, CPI in the US will be declining sharply to 3.1%, at least according to the current median Bloomberg estimate.  It is widely known this decline is due to the base effect as expectations are for a M/M outcome of 0.3%.  However, -ex food & energy, CPI is still forecast to print at 5.0%, well above the Fed’s target, and the number that Chairman Powell has been highly focused on of late.  It seems that the current narrative, at least in the equity world, is that China’s falling inflation will soon spread around the world and allow interest rates to head lower again thus supporting stock prices. 

 

The thing is, this is an equity market narrative, not a bond market one.  Turning to the bond market shows that yields remain quite firm with the 10-year still solidly above 4.00% (currently 4.05%, -1bp on the day), and the 2yr right near 5.0%.  Fed funds futures markets continue to price in a rate hike at the end of July with a 50% chance of another one by the November meeting, and no thoughts of a rate cut until June 2024.  In other words, while the equity cheerleaders are extrapolating from weak Chinese inflation to weak US (and global) inflation right away, the bond market continues to see the world quite differently.  This dichotomy in world view has been extant for many months now and eventually will be resolved.  The key question is, will the resolution be a sharp decline in bond yields?  Or a sharp decline in equity prices?  And that, of course, is the $64 billion question.

 

For what it’s worth, and it may not be much, I continue to lean toward an eventual equity market correction rather than a reversal of Fed policy and much lower US yields.  Well, I guess what I expect is that the air will come out of the equity bubble as the long-awaited recession finally arrives at which point the Fed will indeed feel cutting rates is appropriate.  However, there is just no indication this part of the cycle is imminent.  Remember, that on a long-term basis, equity multiples remain well above average and a reversion to the mean, at least, ought not be surprising.  As the earnings season for Q2 kicks off soon, there is ample opportunity for disappointment and the beginnings of a change of heart.  I couldn’t help but notice that Samsung, the largest chipmaker in the world, reported a 96% decline in profits in Q2 on Friday, hardly a sign of ongoing strength, AI be damned.  And while one company is not a trend, this one is certainly a tech bellwether and should not be ignored.

 

The point is that a correction in equity markets ought not be a huge surprise based on the ongoing, and rising, interest rate structure in the US, along with the very clear manufacturing recession in which the US, and most of the world, finds itself. 

 

Adding to this less optimistic view would be Friday’s NFP report which saw a weaker than expected headline print for the first time in more than a year, with significant revisions lower for the past two months.  The underlying metrics were not terrible, and on the inflation front, Average Hourly Earnings remain at 4.7%, well above the level the Fed believe is appropriate to allow them to achieve their 2% inflation target.  In other words, nothing about this report screams the Fed is done.  In fact, just the opposite, as those earnings numbers continue to pressure inflation higher.  Concluding, I believe it is premature to expect any Fed policy change and I am beginning to sense that we are observing the first cracks in the bull market thesis.  We shall see.

 

As to the rest of the market picture overnight, Friday’s US weakness was matched in Japan (-0.6%) and Australia, but Chinese shares rallied by a similar amount.  It seems there is growing belief that the Chinese government is going to offer more support for the economy there.  European bourses are in the green this morning, on the order of 0.5%, while US futures are essentially unchanged at this hour (8:00).  At this point, all eyes are on Wednesday’s CPI report so don’t be surprised if we have a couple of quiet sessions until then.

 

As to the rest of the bond market, European sovereigns have all sold off slightly with yields edging higher by between 1bp and 2bps although there has been no data of note released.  Perhaps more interesting is the fact that JGB yields are creeping higher, up 3bps overnight and now at 0.454%, much closer to the YCC cap of 0.50% than we have seen since April, immediately after Ueda-san took the helm.  There has been a lot of chatter about Japan doing something as they are ostensibly becoming uncomfortable with the yen’s ongoing weakness, so this is something to keep on the radar.

 

Speaking of the yen, while it is unchanged overnight, there has been no continuation from Friday’s sharp rally in the currency which was built on rumors of a BOJ policy adjustment or perhaps direct intervention.  But this is an area that must be watched closely as recall, last October, the BOJ was actively selling dollars to halt the yen’s slide then.  Elsewhere, though, the dollar is ever so slightly firmer on the day, with both gainers and losers in the EMG bloc, although none having moved very far.  Here, too, I feel like the market is awaiting the CPI data for its next catalyst.

 

A look at the data for this week shows the following:

 

Today

Consumer Credit

$20.0B

Tuesday

NFIB Small Biz Optimism

89.9

Wednesday

CPI

0.3% (3.1% Y/Y)

 

-ex food & energy

0.3% (5.0% Y/Y)

 

Fed’s Beige Book

 

Thursday

Initial Claims

250K

 

Continuing Claims

1720K

 

PPI

0.2% (0.4% Y/Y)

 

-ex food & energy

0.2% (2.6% Y/Y)

Friday

Michigan Sentiment

65.5

Source: Bloomberg

 

In addition to the CPI and PPI data, we hear from seven Fed speakers across nine events this week, with this morning being particularly busy as four different speakers will be on the tape between 10 and noon.  If you recall, there seemed to be the beginnings of dissent based on the Minutes we saw last week, so perhaps the message will get mixed, but as of now, I see no reason to believe that Powell will wait before hiking again.  In fact, the June 2022 M/M inflation print was the highest of the cycle at 1.2%, hence the base effect issue for this month.  Meanwhile, the July M/M reading will be compared to last July’s 0.0% reading, so I expect next month’s CPI will be much higher on Y/Y basis.  This will not be lost on Powell and the Fed. 

 

In the end, there has been nothing to change my view that the Fed is going to stay on course and that they will continue to drive the currency world overall with the dollar likely still the biggest beneficiary over time.

 

Good luck

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Much Wronger

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There once was a theory on rates
Explaining, that, here in the States
Recession would cause
Chair Powell to pause
And end all soft-landing debates

But data of late has been stronger
Encouraging ‘higher for longer’
At this point it seems
Recessionist dreams
Could not have been very much wronger

Which leads to today’s NFP
The data point all want to see
If once more it’s high
Look for yields to fly
If low, look for stocks filled with glee

Recently, the US data releases have been anything but benign as they show continued economic strength in the face of many headwinds.  Yesterday’s numbers were overwhelmingly positive with the ADP Employment Change +497K, more than twice expectations and the highest since February 2022.  There is certainly no indication from this data series that companies are cutting back on their hiring.  As well, the ISM Services results were firmer than expected, with the headline jumping to 53.9, up nearly 3 points on the month and more than 2 points higher than forecast.  But more impressively, both the Employment and New Orders readings were much higher than last month indicating a more robust economy than many had been both describing and expecting.

 

But this is all simply a leadup to today’s NFP report, the data point upon which I have been most highly focused as the key for understanding the Fed’s reaction function.  As I have consistently highlighted, if NFP continues to grow and the Unemployment rate remains low, the Fed has ample cover to continue to tighten policy via both higher interest rates and balance sheet reduction (QT) without concern over political blowback.  After all, if jobs remain plentiful and wages continue to grow, complaints of overtightening will have no credibility.

 

Heading into the number, here are the latest consensus forecasts according to Bloomberg:

 

Nonfarm Payrolls

230K

Private Payrolls

200K

Manufacturing Payrolls

5K

Average Hourly Earnings

0.3% (4.2% Y/Y)

Average Weekly Hours

34.3

Participation Rate

62.6%

 

While the headline is, of course, just that, the number that will get the most press, it is worthwhile watching the Weekly Hours data which, as can be seen in the below Bloomberg chart, has been declining steadily since early 2021.  The key, though, is to recognize that the only time we have been below 34.3 is during the past two recessions, so a continuation lower in the recent trend may bode ill for future economic activity.  The thesis here is that companies will reduce the hours of their staff before actually firing them given the expense of bringing on and training new staff in the next up cycle.

 

In the meantime, investors and traders are taking their cues from the data already seen and are increasingly accepting of the higher for longer thesis the Fed has promulgated for the past year.  Yesterday’s price action was dramatic with Treasury yields surging through 4.0% in the 10-year and 5.0% in the 2-year.  This morning that trend continues with yields higher by another 3bps and you can be sure that if the overall employment report is strong, they will go higher still.

 

At the same time, equity markets are starting to feel a little pressure after what has been a remarkable rally in the first half of 2023, as the 4.0% level in 10-year Treasury yields has led to the breakage of things consistently during this cycle.  It started with the UK pension problems and Gilt market collapse in September 2022, was followed by the BOJ being forced to intervene to prevent the yen’s collapse in October 2022, then the FTX collapse in November 2022 and finally Silicon Valley Bank’s demise in March 2023.  In each of these cases, the 10-year yield traded above 4.0% ahead of the problem and was taken back down in the wake of the outcome.  This chart from the Gryning Times makes the case eloquently:

As such, it should be no surprise that equity markets fell yesterday in the US and overnight in Asia as we are clearly reaching a pain point in the market.

 

Of course, the question is, will this time be different?  Have investors priced in higher yields already and still comfortable paying extremely high multiples for stocks?  History has shown that this time is never different when it comes to investor behavior.  Euphoric predictions are followed by reality setting in and eventually prices adjust lower, reverting to long-term means, especially with respect to earnings mulitples.  But that is not to say things will be unable to defy gravity for longer.  As Keynes famously told us all, markets can remain irrational longer than you can remain solvent.

 

Based on all the data we have seen recently, there is no reason to believe that today’s NFP number is going to be weak, nor that the Unemployment Rate is going to rise sharply.  Rather, a higher than consensus number seems quite viable as a baseline expectation.

 

Remember, too, that the Fed continues to hammer home its message of higher for longer with Dallas Fed President Lorie Logan the latest to say so yesterday, “I remain very concerned about whether inflation will return to target in a sustainable and timely way.  I think more restrictive monetary policy will be needed to achieve the Federal Open Market Committee’s goals of stable prices and maximum employment.”  There is nothing ambiguous about that language, that is for sure.

 

Perhaps the most surprising thing about markets this morning is the fact that despite the rise in Treasury yields, the dollar is mixed at best, and arguably slightly lower.  Certainly, versus its G10 counterparts, it is broadly softer with the yen the biggest gainer, 0.5%.  This behavior is somewhat incongruous given the close relationship the dollar has had to US yields.  The dollar-yield relationship is much clearer in the EMG bloc where the greenback is stronger vs. virtually the entire segment.  And I expect that we are going to see a continuation of the dollar gains if US yields continue higher. 

 

But for now, all we can do is sit back and await the data.

 

Good luck and good weekend

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Inflation’s Fate’s Sealed

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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

In For a Bruising

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The data’s still somewhat confusing
As hard numbers claim growth is cruising
But surveys keep showing
That growth should be slowing
And bears think we’re in for a bruising

Another month, another series of weaker than expected PMI/ISM data with limited corresponding weakness in the ‘hard’ numbers.  On Monday, ISM Manufacturing fell to 46.0, basically a point worse than last month and expectations.  The sub-indices were no better with weakness across Prices, Employment and New Orders.  This is hardly the sign of a strong economy.  In fact, we are at levels consistent with recession.  The same story has been playing out internationally, with weakness across virtually the entire Eurozone and weakness in China as well.  In fact, this morning’s bearish risk tone seems to have been driven by the weakness in the Caixin PMI overnight which fell to 52.5 on much weaker Services activity.  At least that is the current story making the rounds.

 

The confusion comes from the fact that the hard data, measurement of actual activity and output rather than surveys of what people or businesses are planning or expecting, remains far better than the Survey data implies.  Consider that the average reading of the regional Fed manufacturing surveys in June was -9.86, a pretty clear indication that manufacturing is in recession territory.  Meanwhile, the Citi Economic Surprise Index remains at a solidly positive 57.5, which is a level consistent with solid GDP growth.

 

So, which is it?  Has the Fed achieved its objective of a soft landing, with inflation heading back to the 2% target while growth continues apace?  Or is the survey data truly descriptive of the future with a more dramatic slowing of growth soon to appear on our screens?

 

Alas, it is very difficult for me to view the total picture and see the soft landing as anything but a tiny probability.  The term ‘long and variable lags’ was created because they are just that, long and variable.  There is no consistency as to the time between the Fed’s policy actions and their impact on the economy, with examples of the adjustment being anywhere between 9 and 27 months.  Arguably, this time we have seen some unusual timing given the starting point of the economy and all the unique policies that were a consequence of the pandemic response.  And as of today, we are 15 months into the tightening cycle, so plenty of time yet to remain within the historical landscape here.

 

For instance, the dramatic rise in interest rates were assumed to have been devastating to the housing market and home builders yet that has not been the case.  Instead, the result that was generally unforeseen, was that the supply of existing homes on the market shrank dramatically as people are now ‘locked into’ extremely low mortgage rates (having refinanced during the ZIRP period) and either cannot afford to, or simply will not give them up.  The result is that housing demand is largely being satisfied by new homes, thus home builders are killing it while consistent housing demand results in higher prices.

 

Similarly, fiscal policy has been pumping money into the economy at a far faster rate than during previous recessions with Congress passing the ironically named Inflation Reduction Act, as well as the CHIPS act and various other spending measures.  At the same time, the student loan forbearance has resulted in millions of people having much greater disposable income than they otherwise would have been able to spend, thus supporting demand.  However, it appears that the student loan situation may be changing after the recent Supreme Court ruling and the debt ceiling deal also included some spending reductions.  The point is that the taps may be slowly turning off in two areas that have been broadly economically supportive thus reducing overall demand and correspondingly economic activity.

 

This week, however, we get some of the most important ‘hard’ data with both the Trade Balance and the employment report.  In fact, I have maintained that NFP is the single most important piece of data currently as its continued strength has been the key reason the Fed has been able to defend its policy choices.  As long as Unemployment remains low, Chairman Powell can point to that and rightly claim that the economy can withstand higher interest rates and the Fed will continue their quest to drive inflation to their 2% target.  This is not an argument for their policies, just an observation that they will not change until there is a sufficient catalyst to do so.  Hence, I continue to watch the weekly Initial Claims data as crucial.  It has already started to move higher, with the 4-week moving average having risen to 257.5K from a low point of 190.5K back in September 2022.  While this number is not recessionary in its own right, the trend is clearly a concern.

 

Ultimately, I remain in the camp that the widely forecast recession is still coming down the tracks, it has just taken the scenic route.  In the meantime, a quick look at the overnight session shows risk is under pressure everywhere with Asian equity markets all in the red and Europe seeing the same thing.  As mentioned above, today’s narrative is about the Caixin PMI printing a weak number, but we also saw weakness throughout Europe in today’s PMI releases.  US futures are also under pressure at this hour (8:00), currently down about -0.5%.

 

Bonds are seeing some haven demand with yields sliding a bit across the continent, somewhere in the 1bp-2bps area, although Treasury yields are essentially unchanged this morning, maintaining the gains from the much higher than expected GDP print last week.  If we continue to see strong economic data, I expect that Treasury yields can head higher still.  The yield curve inversion is now at -105bps, its lowest point during this period and an indication that the market is more accepting of the Fed’s higher for longer comments.  Remember, this remains a very powerful recession indicator as well, and it has been inverted for just over a year at this point.

 

Oil prices have rebounded 2% this morning and are back above $70/bbl after Saudi Arabia indicated they were going to continue at their recently reduced production level and there is word that the Biden administration may tender for more oil to start refilling the SPR.  Remember, though, oil remains far lower than it has been in the past year, so there is plenty of room for it to move higher.  Metals prices are mixed this morning with gold rejecting a sell-off below $1900/oz and both copper and aluminum still trending lower.

 

Finally, the dollar is broadly stronger today but in truth is mixed since I last wrote on Friday.  In the G10, the commodity bloc is suffering most with AUD (-0.45%) and NOK (-0.4%) the laggards although all currencies are softer on the day.  In the EMG bloc, HUF (-0.9%) and BRL (-0.5%) are the laggards with the forint responding to both budget cuts and expectations of central bank interest rate cuts, while the real appears to be tracking the broader risk-off sentiment.

 

On the data front, it is obviously an important week with the following on the docket:

 

Today

Factory Orders

0.8%

 

FOMC Minutes

 

Thursday

ADP Employment

223K

 

Initial Claims

245K

 

Continuing Claims

1750K

 

Trade Balance

-$69.0B

 

JOLTS Job Openings

9900K

 

ISM Services

51.3

Friday

Nonfarm Payrolls

225K

 

Private Payrolls

200K

 

Manufacturing Payrolls

5K

 

Unemployment Rate

3.6%

 

Average Hourly Earnings

0.3% (4.2% Y/Y)

 

Average Weekly Hours

34.3

 

Participation Rate

62.6%

Source: Bloomberg

 

While everybody will be looking forward to the payroll report, this afternoon’s FOMC Minutes should be interesting as well.  Given the entire skip/pause question, there is heightened interest as to how that conversation played out.  But ultimately, this is all about payrolls this week.  Aside from the Minutes, we hear from two other Fed speakers, NY’s Williams and Dallas’s Logan, with the market still trying to determine just how high higher for longer really means.

 

The funny thing about the FX market is that despite my growing belief that the US is still due a recession, I believe that the dollar may well hold up as Europe and many emerging markets find themselves in the same situation.  As such, the description of, the cleanest dirty shirt in the laundry still applies to the buck.

 

Good luck

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Growth Vs. Shrink

Posted on by 
The data continue to show
That things ain’t so bad, don’t you know
So why do folks feel
The bad stuff is real
With growth steady, though somewhat slow?

Apparently, there is a link
Twixt wage growth and what people think
As real wages fall
They cast a great pall
O’er viewpoints on growth versus shrink

That much anticipated recession seems like it will have to wait at least another quarter or two before landing as yesterday’s 3rd revision of the GDP data jumped to 2.0% annualized, much higher than forecast, with strength continuing to be seen in both personal and government consumption.  As well, the Initial Claims data fell to 239K, far below expectations and an indication that the steady drumbeat of layoffs may just be slowing down a bit.  It should be no surprise that equity markets rallied on the news, although the NASDAQ was the definitive laggard on the day.  It was not a tech story or an AI story, but a straight up growth story getting investors back into the game.  As today is quarter end, it is also important to remember that many investment managers who had been underweight equities were actively buying to achieve the appropriate window dressing for their clients.

 

Of more interest, in my view, was the bond market response where yields exploded higher by 15bps in the 10yr as traders priced in even higher for even longer than had been seen before the release.  Here, too, the recession call remains a mirage, or at least very uncertain in the mists.  The 2yr yield rose even further, 18bps, taking the curve inversion to -103bps.  Fed funds futures are now pricing an 85% chance of a rate hike next month, up from a 70% probability prior to the release as pretty much everyone is now on board the rate hike train.

 

One of the key conundrums is the idea that the Fed continues to tighten policy while equity markets continue to rally.  Historically, rate hikes of this speed and magnitude would have seen a very different reaction, but this time that is just not the case.  For those who remain suspect of the market’s euphoria, there seem to be a number of potential time bombs littering the landscape, notably commercial real estate (CRE) and housing.  In the case of CRE, there are two concerns.  First is that there is a huge overhang of debt that needs to be rolled over in the next 18 months, >$1.5 trillion, which currently has coupons far below today’s interest rate levels.  Adding to the concern is the WFH trend and how many of these buildings, especially office properties in big cities, are not generating the same cash flows as before.  So, higher rates with lower cash flows are a recipe for default and fears are growing that there are going to be many defaults on these outstanding loans.  The fact that the small regional banks have a large proportion of their assets in the CRE class also bodes ill for their ultimate situation.  So far, we have seen several high-profile buildings sell at extremely low valuations and we have also seen landlords walk away from several buildings, with two large hotels in San Francisco the current bellwethers.

 

Turning to housing, the overriding view has been that the Fed would kill the market given that mortgage rates have risen from ~3% to ~7% alongside higher prices thus more than doubling the average monthly cost of owning a home.  However, two things have conspired to prevent a collapse in this market so far.  First, is the fact that many people who refinanced to a 3% mortgage during ZIRP are simply unwilling to move thus reducing the supply of existing homes on the market, hence keeping prices elevated.  Second is that given the structural reduction in the labor force and the increased demand for construction workers for industrial activity (which has exploded on the back of the Inflation Reduction Act), the housing market remains far more robust than would have been expected.  Add to this the fact that builders are buying down mortgage rates (paying a part of the mortgage so the rate is more like 5% than 7%) and things are working just fine.  Again, it is possible that this time bomb has been defused.

 

So why the long faces everywhere?  The best explanation I have seen, which apparently has some academic workbehind it, indicates that the evolution of real wages very accurately tracks economic sentiment.  In other words, if real wages are rising, people remain relatively bullish on the economy whereas if they are falling (and they have been negative since April 2021), people tend to have a much more dour view of things.  Politically, if real wages rise it will change the entire population’s view on everything, so if I were in office, it would be the only thing I targeted.  This also explains why inflation is such a major problem for the administration in office.

 

So, with this as background, perhaps we have a better understanding of what the prospects are for the future, or maybe a roadmap to watch for key signals.

 

Meanwhile, the data continue to come out fast and the spin doctors are working overtime.  For example, in Europe this morning, CPI printed a tick lower than forecast (5.5% vs. 5.6%) with core CPI doing the same thing (5.4% vs. 5.5%), and people are raving about the better result.  But remember, the target is 2.0%, so there is no evidence they have improved things at all, nor that they are going to be able to slow the tightening process.  However, equity markets across Europe are all higher on the day, most by more than 1%.  Go figure.  The narrative remains the key, and as long as the central banks can control the narrative and get people to believe that things are getting better, markets will respond accordingly.

 

Bond yields in Europe did not move as far as in the US yesterday but are all modestly higher this morning as well, except for Gilts +8bps on a massive Current Account deficit result generating concerns over the UK’s finances.

 

As to commodities, oil bounced back toward $70/bbl yesterday and is holding those gains, although not adding to them, but the metals markets continue to suffer with both aluminum and copper falling again today.  Gold, too, is under pressure from higher yields.  Commodities remains the place where recession is seen looming.

 

Finally, the dollar can best be described as mixed this morning, with a 50:50 split in the G10 although no movers have even made it 0.25% away from yesterday’s close.  In the emerging markets, ZAR (-1.2%) is the lone outlier, falling on the back of the metal market weakness.  However, away from the rand, a split in performance without any outliers is the best description.  However, I must point out that USDCNH, the offshore renminbi, has traded above 7.28 and continues its slow march higher (to 7.50 and beyond!)

 

On the data front, there is a bunch of stuff today starting with Personal Income (exp 0.3%) and Spending (0.2%) along with core PCE (0.3% M/M, 4.7% Y/Y) at 8:30, then Chicago PMI (43.8) and Michigan Sentiment (63.9) later in the morning.  It seems that the Fed has begun their July 4th holiday weekend already with no speakers on the calendar until the 5th.  The market remains very data focused so more strong data should see higher US yields and a firmer dollar, although it depends on which data is strong as to how equities respond.  Strong spending and income data should help, but a high surprise on PCE will not.

 

And that’s really it heading into the long weekend.  I, too, will take Monday off so no poetry until Wednesday next week, ahead of the NFP report.

 

Good luck and good weekend

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Double Secret Inflation

Posted on by 
In Sintra, each central bank head
From Europe, Japan and the Fed
Explained all was well
Amongst their cartel
So, ideas of changing were dead

However, in Asia it seems
The PBOC’s latest schemes
To strengthen the yuan
Have failed to catch on
Look, now, for a change in regimes

The panel in Sintra that mattered had the three key central bank heads on the dais, Powell, Lagarde and Ueda, and each one held true to their recent word.  Both Powell and Lagarde insisted that inflation remains too high and that the surprising resilience in both the US and European (?) economies means that they would both be continuing their policy tightening going forward.  Powell hinted at a July hike and Lagarde promised one a few weeks ago.  At the same time, Ueda-san explained that while headline inflation was higher than their target, given the lack of wage growth, the BOJ’s ‘double-secret’ core inflation reading was still below 2% and so there would be no policy changes anytime soon.  He did explain that if this key reading moved sustainably above 2%, it would be appropriate to tighten monetary policy, but quite frankly, my take (and I’m not alone) is that all three of these central bank heads are very happy with the current situation.

 

Why, you may ask, are they happy?  Well, politically, inflation remains the biggest headache for both Powell and Lagarde, and quite frankly most of the rest of the world, while in Japan, recent rises in inflation have not raised the same political ire.  At the same time, as long as the BOJ continues YCC and QE with negative rates, the flood of liquidity into the market there helps offset the liquidity withdrawn by the Fed and ECB.  The result of this policy mix is a very gradual reduction in total global liquidity along with an ongoing demand for US and European sovereign issuance.  It should be no surprise that Japan is now the largest holder of US Treasuries outside the Fed.  As well, the policy dichotomy has resulted in a continued depreciation of the yen which supports the mercantilist aspects of the Japanese economy.  And finally, higher inflation in Japan helps erode the real value of the 250% of GDP worth of JGBs outstanding, allowing eventual repayment of that debt to proceed more smoothly.  Talk about a win, win, win!  Until we see a material change in the macroeconomic statistics in one of these three areas, it would be a huge surprise if policies changed.

 

The upshot of this analysis is that it seems unlikely that we are going to see any substantive movement in yields, either up or down, given the relative offsets in policy, and that the yen is likely to continue to erode in value.  Last autumn, the yen fell very sharply, breaching 150 for a short time and generating serous angst at the BOJ and MOF.  We saw intervention and the idea was there was a line in the sand at that level.  However, my take is that as long as the move remains gradual, and it has been gradual as the yen has steadily, but slowly depreciated for the past 5 months, about 2%/month, we are likely to see more verbal intervention, but not so much in the way of actual activity.  In the end, unless policies change, actual intervention simply serves to moderate the move.

 

Speaking of failed intervention, we can turn to China which has a similar problem to Japan, weakening growth and low inflation.  As I have written before, a weak renminbi is the best outlet valve they have, and the market has been doing the job.  However, here the movement has been a bit faster than the PBOC would like thus resulting in more overt and covert intervention.  On the overt side, we continue to see the PBOC try to fix the onshore currency strong (dollar lower) than the market would indicate as they try to get the message across that they don’t want the currency to collapse.  On the covert side, there has been an increase in the number of stories regarding Chinese banks, like China Construction Bank and Bank of China, actively selling USDCNH, the offshore renminbi in an effort to slow the currency’s depreciation.  But the story that is circulating is that all throughout Africa and Asia, nations that were encouraged to accept CNY for sales of commodities are now quite unhappy with the CNY’s weakness and are quickly selling as much as they can in order to preserve their reserve’s value.  My sense is this process will continue as the dichotomy between a stronger than expected US economy and a weaker than expected Chinese one continues to push the renminbi lower.  PS, for everyone who was concerned about the dollar losing its reserve currency status to the renminbi or some theoretical BRICS backed currency, this should help remind you of why any change to the dollar’s global status is very far in the future.

 

And those are today’s stories.  Yesterday’s mixed US risk picture has been followed overnight with Chinese shares, both Mainland and Hong Kong, suffering but the Nikkei eking out a gain.  In Europe, the FTSE 100 is under pressure, but we are seeing strength on the continent despite what I would consider slightly worse than expected data prints in German State CPIs as well as Eurozone Confidence measures.  However, the one place where inflation slowed sharply was Spain, where headline fell to 1.9%!  While that was a touch higher than forecast, it is the first reading of any country in the Eurozone below the 2% level since early 2021.  Alas, what is not getting much press is the fact that core CPI there fell far less than expected to 5.9% and remains well above targets.  The ECB has a long way to go.

 

Bonds are under pressure across the board today, with yields higher by about 3bps-4bps in Treasuries and across Europe.  This seems to be a response to the idea that a) neither the Fed nor ECB is going to stop raising rates and b) inflation is not falling as quickly as hoped.  JGB yields, though, remain well below the YCC cap at 0.38% so there is no pressure on Ueda-san to change his tune.

 

Oil prices are creeping higher this morning but remain below $70/bbl and in truth have not done very much lately.  The big picture of structural supply deficits vs. concerns over shorter term demand deficits due to the coming recession continue to play out as choppy markets but no direction.  Copper has fallen sharply this morning and is down more than 5% in the past week.  Its recent rally appears to have been a short squeeze more than a fundamental view.  Gold, meanwhile, continues to consolidate just above $1900/oz.

 

Finally, the dollar is mixed on the day, with both gainers and losers across the EMG space although it is broadly lower vs the G10.  AUD (+0.5%) is the leading major currency after better-than-expected Retail Sales data was released overnight but the rest of the bloc, while higher, is just barely so.  In the EMG, PLN (+0.75%) is the best performer, but that is very clearly a position rebalancing after a week of structural weakness.  On the downside, KRW (-0.75%) is the worst performer after weaker Chinese data impacted the view of Korea’s future.  Otherwise, most currencies are relatively unchanged on the day.

 

We get some important data today starting with Initial Claims (exp 265K) and Continuing Claims (1765K) as well as Q1 GDP (1.4%).  Frankly, since this is the third look at GDP, I expect that the Claims data, which has been trending higher lately, is the most critical piece.  If we see another strong print, be prepared for the recession narrative to come back with a vengeance, but if it is soft, then there will be nothing stopping the Fed going forward.

 

Powell made some comments this morning in Madrid, but they were about bank stability not economic policy, and we hear from Bostic this afternoon.  But frankly, I see little reason for a change in sentiment anywhere on the Fed given the data continues to show surprising economic strength.  As such, I still like the dollar medium term.

 

Good luck

Adf

Inflation’s at Bay

Posted on by 
While waiting to hear more from Jay
Investors keep socking away
More assets that need
Low rates to succeed
With clues, now, inflation’s at bay

In Europe, the money supply
Although really still very high
Is starting to fall
As well, there’s a call
To start waving PEPP bonds bye-bye

Overall, it has been an uneventful session in the markets with risk assets generally performing well amid clues that all the central bank efforts to tame inflation may be starting to work.  The first sign was the release of lower-than-expected Italian CPI data at 6.7%, down sharply from last month’s 8.0% reading.  As well, Italian PPI continues its recent negative trend, printing at -6.8% Y/Y, widely seen as a harbinger of future CPI activity.  In addition, money supply data has continued to fall rapidly as per the below chart from the ECB, with M1 growth falling to -6.4%, its lowest reading ever.

Yesterday I mentioned the idea that the ECB was turning into a closet monetarist institution as they continue to see their balance sheet shrink and today’s data helps bolster that view.  In addition, there is increasing discussion at Sintra that the ECB should consider actually selling some of the bonds from their QE programs, APP and PEPP, rather than simply let them roll off without reinvesting.  Recall, that while the Fed is allowing $95 billion / month to mature without reinvestment, the ECB’s pace is a mere €15 billion / month.  Granted, the ECB also has the benefit of having a large slug of TLTRO loans maturing this week (approximately €500 billion) which has been the driving force behind their balance sheet’s decline, but whatever is driving the process, it seems like the ECB is tightening monetary policy more aggressively than the Fed. 

 

The big difference between the US and Europe, though, is that Europe is already clearly in a recession while the US, despite a widely anticipated slowdown, continues to perform quite well.  For instance, yesterday’s data releases were uniformly better than expected.  Durable Goods, Home Prices, New Home Sales, Consumer Confidence and the Richmond Fed Manufacturing Index all printed at better levels than expected.  This goes back to the Citi Surprise Index, which jumped nearly 17 points yesterday after the releases and sits firmly in positive territory in an uptrend.  Meanwhile, the same measure in the Eurozone is collapsing, deep in negative territory.  The below Bloomberg chart is normalized at 100 from one year ago.  It is quite easy to see the remarkable gap between the US (blue line) and Eurozone (white line) with respect to relative economic performance.

Arguably, one would expect that given the US economy’s seeming resilience, the Fed would be the more aggressive of the two central banks, but that is just not the case, at least based on the behavior of their respective balance sheets.

 

The big question is, can this dichotomy continue?  With the Eurozone already in a recession and showing no signs of coming out of it, can the ECB continue to tighten policy in the same manner they have to date?  As well, can the US equity market continue to perform well despite no indication that the Fed has any reason to pivot to easier money in the near future?  Logically, at least based on previous logic, one would have thought these conditions could not continue very long.  And yet, here we are with no obvious end in sight. 

 

My sense, and my fear, is that the ‘long and variable lags’ with which monetary policy impacts economic activity have not yet been felt in the US economy and that much more stress is still in the not-too-distant future.  If I had to select a particular weak spot it would be commercial real estate, especially the office sector, as already we have seen a number of high-profile mortgage defaults, and given the change in working conditions for so many people and companies, are likely to see many more.  The GFC was driven by the retail mortgage sector imploding.  It is not hard to imagine the next financial downturn being driven by the inability of commercial mortgage holders to refinance over the next year or two as they are currently upside down on their properties and cash flows are suffering dramatically to boot.  If this sector is the genesis of the problems, then given local and community banks are quite exposed to the sector all over the country, we are likely to be in for a rough ride, both in the economy and the stock market.  Be wary.

 

As to the overnight session, generally speaking, equity markets followed yesterday’s US rally with gains.  Japan was the leader with the Nikkei rallying 2% and only mainland China suffered as there was less clarity that the Chinese government was going to support the economy, and the currency.  European bourses are all nicely higher although US futures, especially the NASDAQ, are a bit softer after the Biden administration indicated further restrictions on semiconductor sales to China.

 

Bond yields are sliding a bit this morning but not too much, 2bp-3bp and quite frankly, all remain in a fairly narrow trading range.  Despite the Treasury issuance onslaught that has been proceeding since the debt ceiling was eliminated, yields have not moved very far at all.  It would seem that as issuance is pushed further out the maturity ladder, we would see higher yields, but that has not been evident yet.  Meanwhile, the yield curve remains massively inverted, right at -100bps this morning.

 

Oil prices are stabilizing this morning but have fallen more than 6% in the past week as this is the one market that truly believes the recession story.  Gold is also under pressure, falling further and pushing toward $1900/oz.  Higher yields continue to undermine the barbarous relic.  As to base metals, copper is under pressure, but aluminum is holding in reasonably well. 

 

Finally, the dollar is rebounding from a few days of softness with strength virtually across the board this morning.  Every G10 currency is weaker led by NZD (-1.3%) and AUD (-0.95%) as concerns over Chinese economic activity weigh on the antipodeans.  But the whole bloc is under pressure.  Meanwhile, in the EMG space, the picture is the same, virtual unanimity in currency weakness led by ZAR (-1.0%) and THB (-0.95%) with CNY (-0.3%) reversing course after the PBOC was absent from the market last night.  Despite hawkish comments from the SARB, the rand continues to suffer over concerns about the broader economy while the baht is suffering from political concerns.  This is an interesting story as Pita Limjaroenat was the surprise victor in recent elections but was not backed by the military.  Not surprisingly they are not happy, and he is having trouble putting a government together.

 

There is no major data today, so we are all awaiting Chairman Powell’s comments at 9:30 to see if he has any further nuance to impart.  At this point, I have to believe he will continue to push the higher for longer mantra as the data has certainly done nothing to dissuade him.  As such, I still like the dollar over time.

 

Good luck

Adf

Havoc We’ll Wreak

Posted on by 
Said Christine, we’ve not reached the peak
Of rate hikes, more pain we still seek
So, come this July
A hike we’ll apply
To see how much havoc we’ll wreak

The ECB summer retreat began this morning and ECB President Lagarde kicked things off with the following comments, “It is unlikely that in the near future the central bank will be able to state with full confidence that the peak rates have been reached.  Barring a material change to the outlook, we will continue to increase rates in July.”  That seems like a pretty clear signal that there is no pause on the horizon.  Remarkably, the OIS market in Europe is only pricing in a 90% probability of a hike, despite a virtual guarantee from Lagarde.  Overall, the market has two more hikes total priced in, with a terminal rate of ~3.90%.  If you think about it, that is remarkable considering that core CPI in the Eurozone currently sits at 5.3%!  There is an awful lot of belief that despite both lower interest rates and higher inflation readings compared to the US, the ECB is nearly done.

 

Working in Lagarde’s favor is the fact that Europe appears to be slipping into a recession with Germany already there and the overall data output of late consistently underperforming rapidly declining expectations.  In fact, a look at the Citi Surprise Index for the Eurozone shows a reading of -140.20, lower than anytime other than the Covid collapse and the GFC.  This is even lower than during the Eurozone bond crisis in 2011-12, which given the dire straits at the time, is really impressive.  So, maybe Lagarde and the ECB anticipate a deep recession that will help crush demand and price pressures as well.  Of course, she can never actually say that, but who knows what she actually believes.  Or…perhaps the ECB have become closet monetarists and are relying on the fact that, unlike the Fed, their balance sheet has actually fallen substantially in size this year, > €1.1 trillion and is tracking lower still.  Compare this to the Fed where the balance sheet has only fallen by half as much and perhaps there is hope yet for the ECB. 

 

At any rate, the overall market response to these comments has been nonplussed.  It has certainly not engendered concerns in the equity market as European bourses are essentially unchanged on the day.  It has not engendered concerns in the bond market as European sovereigns are less than one basis point different than yesterday’s closes, and as far as the currency markets, the euro has edged higher by 0.3%, continuing its recent trend of bouncing off its lows ever so slowly.  For the rest of the day, we hear from various ECB speakers and several BOE members, but Powell doesn’t speak until tomorrow, and as we can see from today’s price action, he remains THE man when it comes to moving markets.

In China, they’re getting annoyed
That analysts there have employed
Some logic and said
When looking ahead
That stock value will be destroyed

If you want to understand the dangers of recent efforts to censor mis- or disinformation, look no further than China, where last night, three prominent finance writers were banned suspended from their Weibo accounts (China’s version of Twitter) for spreading “negative and harmful information” about the stock market.  In other words, after a 20% decline since the beginning of the year and no indication that the government was going to do anything substantive to try to address a clearly slowing economy, they didn’t exhort the public to buy stocks, but rather seemingly indicated they could fall further.  Apparently, that analysis is not appropriate hence the banning.  At the same time, the PBOC fixed the onshore renminbi much higher (dollar lower) than expected in an effort to slow the ongoing decline in the currency.  Since January 16th, prior to last night, CNY had declined more than 8%, pretty much in a straight line.  As I have written consistently, with inflation remaining quite low on the mainland, the PBOC seemed fairly relaxed about the currency’s weakness, but I guess that started to get a little out of hand.  It remains to be seen if they are going to intervene more aggressively, but the pressures clearly remain for a weaker renminbi.  The interest rate differential significantly favors the dollar and that is not going to change anytime soon.  As such, given the significant carry advantage for the dollar, I continue to expect USDCNY to rally to 7.50 and beyond as the year progresses.

 

Otherwise, it’s been a fairly dull session with no other noteworthy news and no critical data.  Risk has had a mixed picture with China and Hong Kong rebounding from recent lows on rumors that China was going to add some support, but Japan is continuing its recent correction from a massive run up this year.  European bourses are edging a bit lower at this hour (8:00) while US futures are mixed, albeit not really having moved very much. 

 

Bond yields, as mentioned above, are little changed with Gilts (+2.2bps) the only outlier of note.  There has been no data from the UK, so I expect this movement is position related more than anything else.

 

In the commodity space, oil (-1.6%) is once again under pressure as it remains the only market that truly is pricing for declining growth, although most base metals are under pressure today as well.  Gold, however, seems to be forming a new bottoming pattern above the $1900/oz level, although given reduced geopolitical fears and, more importantly, still high and rising interest rates, it will be tough for the yellow metal to rise in the current environment.

 

Finally, the dollar is under pressure again with a bit more universal negativity today.  The euro, now +0.45%, leads the way with the rest of the G10 showing far less impetus higher and NOK (-0.1%) unable to shake oil’s weakness.  As to the EMG space, ZAR (+1.2%) is the leading gainer followed by PLN (+0.7%) and PHP (+0.7%) showing that the gains are widespread.  LATAM currencies are also firmer, but by much smaller amounts.  As to the drivers, some hawkish talk from the SARB has traders looking for higher rates for longer, with similar commentary from the Polish Central Bank a key support there.  Completing this trio, a change at Bangko Sentral Pilipinas has been coming but the outgoing governor expressed his view that policy would not change, thus keeping relative tightness there as well.  I sense a theme.  Higher for longer is the central bank mantra virtually everywhere in the world with just China and Japan not playing along.

 

On the data front, Durable Goods just printed at a much better than expected 1.7% with the ex Transport reading at 0.6%, also firmer than expected.  That is certainly a different story than the survey data we have been seeing for the past several months, but it is also going to be confirmation for the Fed that they need to continue to raise rates.  Later this morning we will see Case Shiller House Prices (exp -2.40%), New Home Sales (675K), Consumer Confidence (104.0) and Richmond Fed (-12).  There are no Fed speakers on the calendar, so I expect that we will take our cues from equities and anything surprising out of Sintra.  Right now, the dollar is under gradual pressure, but over time, I continue to believe it will find support on the back of a Fed which is likely to be the most hawkish of all.

 

Good luck

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Confusion Reigns

Posted on by 
Investors and traders are caught
Twixt data which shows that they ought
Be uber concerned
Although they have learned
That fighting momentum is fraught

And so, it’s confusion that reigns
Reminding us of Maynard Keynes
Though logic dictates
We’re in dire straits
That doesn’t prevent further gains

One of the remarkable things about the current situation across markets and macroeconomics is that every piece of new information seems to add to the confusion rather than any sense of clarity.  As such, both the bulls and the bears, or perhaps the hawks and the doves, have constant reinforcements for their views.  As John Maynard Keynes famously told us all in 1920, “the market can stay irrational longer than you can stay solvent,” and right now, there are many who are flummoxed by the seeming irrationality of the markets.

 

Data continues to print demonstrating economic weakness, with this morning’s German IFO results simply the latest.  Expectations fell sharply to 83.6, a level whose depths had only been plumbed in the past during the GFC, at the beginning of Covid and when Russia invaded Ukraine.  Too, the Business Climate fell to 88.5, mirroring the Expectations index in futility.  In other words, this is an indication that businesses in Germany are not merely in a recession currently but see no escape soon.  And why would they?  After all, Madame Lagarde promised another rate hike next month and there is talk of further hikes later.  So, it appears there will be no short-term relief for the citizens there.   And yet, despite a very modest amount of equity market selling at the end of last week, most equity markets remain solidly higher halfway through 2023.

 

This morning’s data begs the question, can the global economy, or really any industrialized nation’s economy, avoid a recession if the manufacturing sector is declining.  We are all aware that most of the G10 economies are services oriented, while we see much larger proportions of GDP driven by manufacturing in larger emerging markets.  The following table, with data from the World Bank shows what these proportions as percentages of GDP were in 2021 (latest data available):

 

Australia

6

Brazil

10

Canada

10

China

27

Germany

19

India

14

Ireland

35

Japan

20

Korea

25

Mexico

18

South Africa

12

Spain

12

Sweden

13

UK

9

US

11

 

It should be no surprise that China, given their mercantilist policies, are at 27%, nor that South Korea (25%) and Mexico (18%) have relatively large manufacturing sectors.  But both Germany (19%) and Japan (20%) are also quite manufacturing focused.  As such, it should not be that surprising they both had run large trade and current account surpluses given that’s what mercantilist policies generate.  The point is, if manufacturing is heading into a slump, or perhaps already in one, can the broader economy maintain overall growth? 

 

Arguably, there is a significant portion of the services economy that is highly dependent on manufacturing as well.  Consider things like financial services for those companies, transportation of manufactured goods as well as raw materials to factories and food and janitorial services at factories.  Those are not part of the equation, but if factories close down in ‘service oriented’ economies, all those services will shrink as well.  The point is even in the US, where manufacturing technically represents only 11% of GDP, a slump in that sector will have wide ranging impacts.   And what we have seen just this month is a litany of lousy data on the manufacturing side.  ISM Manufacturing (46.9), Kansas City Fed (-12), Philly Fed (-13.7), Dallas Fed (-29.1) and Chicago PMI (40.4) all point to severe weakness in the US manufacturing sector.  Can the US economy really grow strongly with a key sector under such pressure?  Can any economy?  Germany is already in a recession, and we know that their manufacturing sector is sliding.  China, too, has shown weaker data consistently and the government there is trying to figure out how to support the economy to prevent a severe slowdown.  These are the arguments for why an official recession is coming to the US and all of Europe and probably the world. 

 

And yet, equity market bullishness remains intact.  At least based on the major indices.  Despite the fastest set of interest rate hikes in history by the Fed, ECB and BOE amongst others, equity indices are higher throughout the G10 this year, led by the NASDAQ’s remarkable 29% rally.  In addition, as we approach month/quarter end this week investment managers who have not been willing to close their eyes and buy are finding themselves forced into that situation.  Meanwhile, inflation data, while slowing from its peak seen 6mo-9mo ago remains well above central bank targets indicating that there is further monetary policy tightening to come.

 

So, who do you believe?  The data that shows key sectors of the global economy are slowing?  Or the data that shows ongoing strong employment means overall economic activity is continuing to rise?  It is easy to understand why so many analysts are forecasting a recession.  It is also easy to understand why investors don’t respond that way as they watch market performance.  And this, of course, is why Keynes’ words were so prescient, right now, markets do not seem rational, but they are what they are.

 

Arguably the one thing that is not frequently discussed but has been shown to be true over time is that G10 governments do not like to see recessions at all and will do anything they can and spend any amount, to prevent one from occurring.  As long as central banks continue to monetize the debt required to do so, this structure can continue.  But at some point, the debt will overwhelm the system and a correction will occur.  It is anybody’s guess as to when that might happen, but it certainly feels like that day is slowly coming into view.  At some point, investors will ignore what the central banks say and there will be a very significant correction.  But there’s nothing to say it can’t wait five more years.  As I said, confusion reigns.

 

Turning to the market activity overnight, After Friday’s down session in the US, Asia continued that trend with Chinese equity markets the weakest of the bunch, but screens red across the region.  Europe, which had been uniformly negative earlier in the session has now seen a very modest bounce back to basically unchanged although US futures remain slightly in the red.

 

That risk-off feeling is being seen in bond markets with yields lower across the board this morning as both Treasuries and European sovereigns find themselves with yields sitting between 3bps and 4bps softer than Friday’s closing levels.  The 2yr-10yr yield curve inversion remains -102bps, certainly not a positive economic sign, and we are seeing European curves invert as well.  Even JGB yields are a touch lower this morning.

 

Oil prices are a touch higher this morning although WTI remains below $70/bbl and metals prices are also a bit firmer, bouncing off recent lows.  However, that seems more to do with dollar weakness than commodity strength.

 

Which is a bit odd as during a classic risk-off session, the dollar tends to do quite well, yet today it is softer vs. all its G10 counterparts led by NOK (+0.9%) and many EMG currencies.  Forgetting TRY (-2.7%), the other losers are CNY (-0.7%) which is catching up after a few days of Mainland holidays, and TWD (-0.3%).  However, there is a long list of gainers led by ZAR (+0.9%) and HUF (+0.6%).  Arguably, falling Treasury yields are hurting the dollar somewhat, but quite frankly, I’m not convinced that is the driver here.

 

On the data front, as it is the last week of the month, we will get updated GDP and PCE figures as well as an array of things:

 

Today

Dallas Fed

-20.0

Tuesday

Durable Goods

-0.9%

 

-ex transportation

0.0%

 

Case Shiller Home Prices

-2.60%

 

New Home Sales

675K

 

Consumer Confidence

103.8

Thursday

Initial Claims

264K

 

Continuing Claims

1772K

 

Q1 GDP

1.4%

Friday

Personal Income

0.3%

 

Personal Spending

0.2%

 

Core PCE Deflator

0.3% (4.7% Y/Y)

 

Chicago PMI

44.0

 

Michigan Sentiment

63.9

Source: Bloomberg

 

On the speaker front, the ECB has their summer confab in Sintra, Portugal this week with Powell, Lagarde, Ueda and Bailey all speaking on Wednesday and Thursday.  It will certainly be interesting to hear them all together as they try to convince themselves they are in control.

 

I remain skeptical as to the potential for further gains in risk assets, but I have been skeptical for months and been wrong.  As to the dollar, if yields are going to decline, I could see the dollar slide further, but if risk does get jettisoned, I expect the dollar to find a bid.

 

Good luck

Adf

No Longer Clear

Posted on by 
Inflation remains
Far higher than desired
Will Ueda-san blink?

Which one of these is not like the other?

 

Central Bank

Policy Interest Rate

Core CPI

Federal Reserve

5.25%

5.3%

ECB

4.00%

5.3%

BOE

5.00%

7.1%

Bank of Canada

4.75%

4.2%

RBA

4.10%

6.8% (headline)

BOJ

-0.10%

3.2%

Source: Bloomberg

 

Japanese inflation readings were released overnight, and they showed no signs of declining.  In fact, they were actually a tick higher than the median forecasts.  However, there has been zero indication that the BOJ is set to respond to the highest inflation in decades.  As everything economic is political, by its very nature, the reality seems to be that there is not yet any political price for PM Kishida to pay for rising inflation.  Recall, as inflation started to pick up sharply in the wake of the pandemic reopenings, the universal central bank response was, inflation is transitory and it will subside soon.  Politically, at that time, governments were keen to keep interest rates near (or below) zero as part of their belief that it would foster economic activity and recession was the big concern.

 

However, once it became so clear that even central banks understood this bout of inflation was not a transitory phenomenon, policy prescriptions changed rapidly leading to the very rapid rise in interest rates we have seen since early 2022.  Politically, inflation was the lead story in every media outlet with governments around the world and their central banks being blamed, so they had to respond.  (Whether their response has been effective is an entirely different story).  Except in one place, Japan.  As is abundantly clear from the table I constructed above, the BOJ has yet to alter their monetary policy stance despite core CPI remaining at extremely elevated levels far above the BOJ’s 2% target.  In fact, prior to the recent spike, you have to go back to 1981 to see Japanese core CPI this high.

 

Apparently, though, inflation is not making headlines in Japan as it has been throughout the rest of the G7 and so the BOJ is perfectly happy to continue on their path of infinite QE and YCC.  Remarkably, 10-year JGB yields fell further last night, now around 0.35%, as there is seemingly very little concern that a policy change is in the offing there.  Certainly, there has been no indication from any BOJ commentary nor from Kishida’s government.  As such, it can be no surprise that the yen continues to fall, declining 1% this week and more than 3% over the past month. 

 

Interestingly, there has definitely been an uptick in the buzz from market talking heads about the need for the BOJ to abandon YCC and that a change is imminent.  I have seen a number of analyses that foretell of the inevitable change and how the yen is likely to rise dramatically when it happens.  FWIW, which may not be that much, I agree that when the BOJ does change policy, we are likely to see the yen rally sharply.  The problem is, I see no indication that is going to happen anytime soon.  Show me the headlines in the Asahi Shimbun or the Nikkei Shimbum (major Japanese newspapers) that are focused on inflation and I will change my view.  But until it is a political problem, the BOJ is serving its current function of supplying the world’s liquidity with a correspondingly weaker yen as a result.

The messaging’s no longer clear
Regarding the rest of the year
While some at the Fed
See more hikes ahead
Some others feel ending is near

Once again yesterday we heard mixed messages from Fed speakers with some (Barkin) talking about evaluating their actions so far and waiting for more proof that further tightening was needed while others (Bowman, Waller) seeming pretty clear that more hikes are in the offing.  Powell’s Senate testimony was largely the same as the House testimony on Wednesday with more of the questions focused on bank capital rather than monetary policy.  Of course, the big question remains, are they done or not?  Fed funds futures are still pricing a 72% chance of a hike in July and a terminal rate of 5.33%, so one more hike from current levels.  But the arguments on both sides remain active.  It appears to me that as long as the employment situation remains robust, they will continue to hike until inflation falls closer to their target.  Yesterday’s Initial Claims data printed just a touch higher, 264K, and the trend certainly seems to be moving higher, but is not nearly at levels consistent with recession.  The NFP report in two weeks will be critical but until then, we are likely to be whipsawed by commentary.

 

As to the overnight session, risk is very definitely on its heels this morning with equity markets in the red around the world, with all of Asia falling by -1.5% or more although European bourses have not suffered quite as much, -0.3% to -0.8%.  US futures are also under pressure, down about -0.5% at this hour (8:00).

 

Bond markets, on the other hand, are performing their role as safe haven, with yields sharply lower this morning. Treasury yields, which had risen yesterday have given all that back and then some, down 6bps, while in Europe, sovereigns are down 12-13bps virtually across the board.  The latter seems to be a response to the Flash PMI data which was released showing slowing activity across the continent, especially in France where both Manufacturing and Services fell below 50 and where German Manufacturing PMI tumbled to 41.0.  If the Eurozone economy is truly performing so poorly, it is hard to believe that the ECB will continue on its current path much longer.  One other rate story is the short-term GBP rates which are now pricing a terminal rate by the BOE at 6.13%, pricing another 5 rate hikes into the curve by the middle of next year.

 

However, on this risk off day, it is the dollar that is truly king of the world, rallying vs every one of its counterparts in both the G10 and EMG.  NOK (-2.2%) is the G10 laggard on the back of general risk aversion as well as the fact that oil prices are tumbling again, down a further -1.25% this morning on the recession fears.  But the weakness is pervasive with AUD (-1.0%) weak and the euro (-0.7%) giving up chunks of its recent gains in short order.  Interestingly, the yen (-0.1%) is the best performer in the G10.  The picture in the emerging markets is similar, with substantial losses across the board led by TRY (-1.3%) and ZAR (-1.1%).  Of course, Turkey’s lira is destined to continue collapsing given the dysfunctional monetary policy there, but ZAR is feeling the pressure of declining metals prices, especially gold, which is down again this morning and now pressing $1900/oz.  Meanwhile, China’s renminbi continues to slide, trading to new lows for this move with the dollar marching inexorably higher.

 

On the data front, today brings Flash PMI data (exp 48.5 Manufacturing, 54.0 Services, 53.5 Composite) and that’s it. Two more Fed speakers, Bullard and Mester, are due to speak and both have been leading hawks so we know what to expect.  So, looking at the rest of the session, I suspect that the dollar will maintain most of its gains, but do not be surprised to see a little sell off as we head into the weekend and positions are reduced.

 

Good luck and good weekend

Adf