A Gordian knot

Now, what if inflation is not
As transit’ry as Powell thought?
And what if there’s slowing
Instead of more growing?
Would that be a Gordian knot?

Well, lately the bond market’s view
Appears to be, in ‘Twenty-two
Inflation will soar
Much higher before
The Fed figures out what to do

The Fed has been pushing the transitory inflation narrative for quite a while now, but lately, they have been struggling to get people to accept it at face value.  You can tell this is the case because pretty much every third story in any newsfeed is about rising prices in some product or service.  Commodities are particularly well represented in these stories, especially energy, as oil, NatGas and coal have all seen dramatic price rises in the past month or so.  It is also important to understand that despite the durm und strang regarding the continued use of coal as an energy source, it remains the largest source of electricity worldwide.  I bring this up because the situation in China is one where the country is restricting energy use due to a lack of coal available to burn.  (Perhaps one of the reasons for this is the Chinese, in a snit over Australia calling them out as to the origins of Covid-19, banned Australian coal imports.)

From an inflation perspective, this has the following consequences: less coal leads to less electricity production which leads to restrictions on electricity use by industry which leads to reduced production of everything.  Given China’s importance in the global supply chain for most products, less production leads to shortages and, presto, higher prices.  And this is not going to end anytime soon.  Much to the Fed’s chagrin, they can print neither coal nor NatGas and help mend those broken supply chains.  Thus, despite their (and every other central bank’s) efforts to repeal the laws of supply and demand, those laws still exist.  So, just as April showers lead to May flowers, less supply leads to higher prices.

The difference in the past week or so is that bond markets worldwide have started to cotton on to the idea that inflation is not transitory after all.  Yields have been rising and curves steepening, but even the front end of yield curves, where central banks have the most impact, have seen yields rise.  So, a quick look at global bond markets today shows yields higher in every major market around the world.  Treasuries (+1.1bps) have not moved that far overnight but are higher by 12bps in the past week.  Gilts (+4.8bps) on the other hand, have seen real selling in today’s session, also rising 12bps in the past week, but on a lower base (10-year Gilts yield 1.125% vs. 1.58% for Treasuries.)  And the same situation prevails in Bunds (+2.6bps, +6.6bps in past week), OATs (+2.5bps) and the rest of Europe.  Asia is not immune to this with even JGB’s (+1.2bps, +4bps in past week) selling off.  The point is that bond investors are starting to recognize that inflation may be more persistent after all.  And if the Fed loses control over their narrative, they have much bigger problems.  Forward guidance remains a key monetary policy tool, arguably more important that the Fed Funds rate these days, so if that is no longer effective, what will they do?

Needless to say, risk attitudes are starting to change somewhat as concern grows that almost the entire central banking community, certainly the Fed and ECB, will be too slow to react to very clear inflation signals.  In this situation, financial assets will definitely suffer.  Keep that in mind as you look ahead.

OK, next we need to look to this morning’s NFP report as that has been a key element of the recent market inactivity.  Investors are looking for confirmation that the Fed is going to begin tapering next month and have certainly been encouraged by both the ADP Employment number as well as yesterday’s much lower than expected Initial Claims data.  Here’s what current median forecasts look like:

Nonfarm Payrolls 500K
Private Payrolls 450K
Manufacturing Payrolls 25K
Unemployment Rate 5.1%
Average Hourly Earnings 0.4% (4.6% Y/Y)
Average Weekly Hours 34.7
Participation Rate 61.8%

Source: Bloomberg

Powell explained that as long as this report was not terrible, he felt the tapering would begin.  Interestingly, the range of forecasts is 0K to 750K, a pretty wide range of disagreement as to how things might play out.  Certainly, a number like last month’s 235K could throw a wrench into the tapering process.  Personally, my take is slightly weaker than median, but not enough to change the taper idea.

On a different note, I cannot help but look at the Average Hourly Earnings forecasts and wonder how any Fed speaker can argue that wages aren’t growing rapidly.  Absent the Covid induced gyrations, 4.6% is the highest number in the series by far going back to early 2007.  Again, this speaks to persistent inflationary pressures, not transient ones.

But we will know shortly how things turn out, so a quick recap before then shows that equity markets had a good session in Asia (Nikkei +1.3%, Hang Seng +0.55%, Shanghai +0.7%) but are less giddy in Europe (DAX -0.1%, CAC -0.4%, FTSE 100 0.0%).  Meanwhile, US futures are essentially unchanged ahead of the data.

We’ve already discussed the bond market selloff and cannot be surprised that commodity prices are mostly higher led by oil (+0.8%) and NatGas (+0.1%), but also seeing strength in gold (+0.3%).  Industrial metals are having a rougher go of it (Cu -0.3%, Al -0.4%) and Ags are a bit firmer this morning with all three major grains higher by about 0.55%.

As to the dollar, it is mixed this morning ahead of the data with the largest gainer NOK (+0.4%) on the back of oil’s strength, while SEK (+0.3%) is also firmer although with no clear driver other than positioning ahead of the data.  On the downside, JPY (-0.15%) continues under pressure as higher US yields continue to attract Japanese investors.

EMG currencies have seen a more negative session with PLN (-0.6%), TRY (-0.5%) and RUB (-0.5%) all under pressure and the APAC bloc mostly falling, albeit not quite as far.  The zloty story seems to be concerns over a judicial ruling that puts Poland further at odds with the EU which has been sufficient to offset the boost from yesterday’s surprise rate hike.  In Turkey, a story that President Erdogan is “cooling” on his view toward the central bank governor seems to have markets nervous while in Russia, rising inflation and limited central bank response has investors concerned despite oil’s rally.

There are no Fed speakers on the calendar today so it will all be about the NFP number.  Until then, don’t look for much, and afterwards, there is typically a short burst of activity and a slow afternoon.  I don’t think the big trend of dollar strength has ended by any means, but it is not clear today will see much of a gain.

Good luck, good weekend and stay safe
Adf

Risks They Have Wrought

It’s not clear why anyone thought
The ECB ever would not
Continue to buy
More bonds as they try
To safeguard ‘gainst risks they have wrought

So, when PEPP, next March, does expire
A new plan we’ll get to admire
As Christine will ne’er
Be set to foreswear
Her drive to push bond prices higher

If ever anyone was talking their own book, it was Greek central bank president Yannis Stournaras this morning on the subject of the ECB’s potential actions post-PEPP.  “Asset purchases aim at favorable financing conditions, at smooth transition of monetary policy to prevent any kind of fragmentation in jurisdictions in the euro area.  I’m sure that the Governing Council will continue to aim at this.” [author’s emphasis] These comments were in response to a report that the ECB is considering instituting a new asset purchase program when the emergency PEPP expires in March.  This is certainly no surprise as I posited this exact outcome a month ago (Severely Distraught – Sep 7) and the idea has gained credence since then.

One of the features of the ECB’s APP (original QE program from 2015) is that they are required to purchase bonds based on the so-called capital key in order to give the illusion they are not monetizing national debt.  This means that they must buy them in proportion to the relative size of each economy.  Another feature is that the bonds they purchase must be investment grade (IG).  This rules out Greek debt which currently is rated BB-, 3 notches below IG.  The PEPP, however, given the dire emergency created by governments shutting down their economies when Covid-19 first appeared, did away with those inconveniences and was empowered to buy anything deemed necessary.  Not surprisingly, purchases of bonds from the PIGS was far above their relative economic weight which has served to narrow credit spreads across the entire continent.  If the PEPP simply expires and is not replaced, it is unambiguous that PIGS’ debt would fall sharply in price with yields rising correspondingly, and those nations would find themselves in far worse fiscal shape.  In fairness, the ECB can hardly allow that to happen to just a few nations so they will continue their PEPP purchases in some manner or other.  And I assure you they will continue to purchase Greek debt regardless of its credit rating.

It is useful to compare this future to that of the Fed, where Chairman Powell has indicated that as long as the payroll number this Friday is not a complete disaster (currently expected 500K), a reduction in the pace of QE is appropriate. On the surface, it would be quite reasonable to expect the euro to decline further given what is likely to be a divergence in relative yields.  Yesterday’s ADP Employment report (568K) was better than expected and certainly seems to be of sufficient strength to support the Chairman’s view of continued strength in the labor market.  Thus, if the Fed does begin to taper while the ECB discusses its next version of QE, I would look for the euro’s recent decline to continue.

Of course, the big question is, will the Fed continue to taper if the economic situation in the US starts to show much less impetus?  For instance, the Atlanta Fed’s GDPNow forecast is estimating Q3 GDP growth at 1.333%, MUCH weaker than it had been in the past and a MUCH sharper slowdown than the Fed’s own forecasts.  While the number may well be higher than that, it does speak to a run of weaker than expected economic data in the US.  Inflation, meanwhile, shows no signs of abating soon.  The Fed looks set to find themselves in a very uncomfortable position with the following choices: tighten into slowing growth or let inflation run much hotter than targeted for much longer than anticipated.  (If I were Powell, given the trainwreck that is approaching, I don’t think I would accept the offer of reappointment should it be made!)

In sum, while the decision process in Europe is much easier with slower growth and lower inflation, extending monetary largesse still seems appropriate, in the States, some tough decisions will need to be made.  The problem is that there is not a single person in any Federal position who appears capable of making (and owning) a tough decision.  In fact, it is this lack of demonstrated decision-making prowess that leads to the idea that stagflation is the most likely outcome going forward.

But it is still a few weeks/months before these decisions will need to be made and, in the meantime, Buy Stonks!  Well, at least, that seems to be the investor mindset as fleeting fears over contagion from China Evergrande’s slow motion bankruptcy and comments from Vladimir Putin that Russia would, of course, supply the necessary NatGas for Europe, have been sufficient to remind the equity crowd that a 5% decline from an all-time high price level is an amazing opportunity to buy more stocks.  Hence, yesterday morning’s fears have abated and all is once again right with the world.

(As an aside, it strikes me that relying on a key geopolitical adversary to supply the life’s blood of your economy is a very risky strategy.  But Putin would never use this as leverage for something else, would he?  I fear it could be a very long cold winter in Europe.)

OK, with that in mind, let’s look at markets this morning.  Equity markets are green everywhere ranging from the Nikkei (+0.5%) to the Hang Seng (+3.1%) with all of Europe in between (DAX +1.2%, CAC +1.35%, FTSE 100 +1.0%) while China remains closed.  US futures are also firmer, currently pointing to a 0.75% rise on the open.

Bond markets are in pretty good shape as well.  Yesterday, after substantial early session weakness, they rebounded, and this morning are continuing on that trend.  While Treasuries are only lower by 0.2bps, in Europe we are seeing much better buying (Bunds -1.7bps, OATs -2.1bps, Gilts -1.2bps) with PIGS bonds (Italy -5.1bps, Greece -3.0bps) showing even more strength.

Commodity prices are consolidating after what has been a significant run higher with oil (-1.6%) and NatGas (-2.0%) both off highs seen yesterday morning.  Gold is unchanged on the day while copper (+1.1%) has bounced along with other base metals.  Ags, too, are a bit firmer this morning.

This positive risk attitude has seen the dollar cede some of its recent gains with AUD (+0.35%) leading the way in the G10 on the back of stronger commodity prices, followed by SEK (+0.3%) and NZD (+0.3%) both benefitting from better risk appetite as well.  Only NOK (-0.1%) is under pressure on the back of the oil price decline.  EMG currencies are universally stronger led by ZAR (+0.7%), PHP (+0.6%) and RUB (+0.5%).  ZAR is clearly benefitting from the commodity rally while PHP was higher on some positive growth comments from the central bank there.  The ruble seems to be benefitting from the view that a higher than expected CPI print there will force the central bank to raise rates more than previously anticipated.

On the data front, today brings only Initial (exp 348K) and Continuing (2762K) Claims.  Given tomorrow is payroll day, these are unlikely to move the market.  We also hear from Cleveland Fed president Mester, one of the more hawkish voices, discussing inflation, but my sense is all eyes are on tomorrow’s NFP to make sure that the taper is coming.  As such, today is likely to continue to see risk appetite with higher stock prices and a soft dollar.  But large moves seem unlikely.

Good luck and stay safe
Adf

Narrative Drift

Today it is more of the same
As energy traders proclaim
No price is too high
For NatGas, to buy
With policy blunders to blame

As such it is not too surprising
Inflation concerns keep on rising
Prepare for a shift
In narrative drift
Which right now CB’s are devising

Perhaps the most interesting feature of markets since the onset of the Covid-19 pandemic is the realization that prices for different things, be they equities, bonds, commodities, or currencies, can move so much faster and so much further than previously understood.  The simple truth is that markets as a price discovery mechanism are unparalleled in their brilliance.  Recall, for instance, back in April 2020, when crude oil traded at a negative price.  The implication was that crude oil holders were willing to pay someone to take it off their hands, something never before seen in a physical commodity market.  (Of course, in the interest rate markets, that had become old hat by then.)  Well, today European natural gas markets have gone the other way, rising 40% in both Amsterdam and London and taking prices to levels previously unseen.  Now, much to the chagrin of European policymakers, there is no upper limit on prices.  As winter approaches, with NatGas inventories currently just 74% of their long-term average, and with most of the EU reliant on Russia for its gas supplies, it is not hard to foresee that these prices will go higher still.

The first issue (a consequence of policy decisions) is that deciding to allow a geopolitical adversary to control your energy supply is looking to be a worse and worse decision every day.  Gazprom’s own data shows that they have reduced the flow of gas to Europe via Belarus and Poland by 70% and via Ukraine by 20% in the past week.  It cannot be surprising that prices in Europe continue to rise.  And the knock-on effects are growing.  You may recall two weeks ago when a fertilizer company in the UK shuttered two plants because the NatGas feedstock became so expensive it no longer made economic sense to produce fertilizer.  One consequence of that was there was a huge reduction in a byproduct of fertilizer production, pure CO2, which is used for refrigeration and has impaired the ability of food processors to ship food to supermarkets and stores.  Empty shelves are a result.  Just today, a major ammonia producer shuttered its plants as the feedstock is too expensive for profitable production as well.  The point is that NatGas is used as more than a heating fuel, it is a critical input for many industrial processes.  Shuttering these processes will have an immediate negative impact on economic activity as well as push prices higher.  If you are wondering why there are concerns over stagflation returning, look no further.

The bigger problem is that there is no reason to believe these prices will sell off anytime soon.  Arguably, we are witnessing the purest expression of supply and demand working itself out.  As a consequence of these earlier decisions, the EU will now be forced to respond by spending more money and reducing tax income in order to support their citizens and businesses who find themselves in more difficult financial straits due to the sharp rise in the price of NatGas.

Now, a trading truth is that nothing goes up (or down) in a straight line, so there will certainly be some type of pullback in prices in the short run.  However, the underlying supply-demand dynamic certainly appears to point to a supply shortage and consistently higher prices for a critical power source in Europe.  Slower economic growth and higher prices are very likely to follow, a combination that the ECB has never before had to address.  It is not clear that they will be very effective at doing so, quite frankly, so beware the euro as further weakness seems to be the base case.

The other main story of note
Concerns a new debt ceiling vote
Majority wailing
The other side’s failing
May yet, a default, soon promote

Alas, we cannot avoid a quick mention of the debt ceiling issue as the clock is certainly winding down toward a point where a technical default has become possible.  Political bickering continues and shows no sign of stopping as neither side wants to take responsibility for allowing more spending, but neither do they want to be responsible for a default.  (Perhaps that sums up politicians perfectly, they don’t want to take responsibility for anything!)  This is more than a technical issue though as financial markets are failing to see the humor in the situation and starting to respond.  Hence, today has seen a broad sell-off in virtually every asset, with equities down worldwide, bonds down worldwide and most commodities lower (NatGas excepted).  In fact, the only thing that has risen is the dollar, versus every one of its main counterparts.

The rundown in equities shows Asia (Nikkei -1.05%, Hang Seng -0.6%, Shanghai closed) failing to take heart from yesterday’s US price action.  European investors are very unhappy about the NatGas situation with the DAX (-2.2%), CAC (-2.15%) and FTSE 100 (-1.8%) all sharply lower.  It certainly hasn’t helped that German Factory Orders fell a much worse than expected -7.7% in August either.  US futures are currently lower by about 1.25% as risk is clearly not today’s flavor.

Funnily enough, bond markets are also under pressure today, with Treasuries (+1.6bps), Bunds (+1.6bps), OATs (+2.2bps) and Gilts (+3.0bps) all seeing heavy selling.  It seems that inflation concerns are a more important determinant than risk concerns as the evidence of rising prices being persistent continues to grow.

In the commodity space, pretty much everything, except NatGas (+0.6% to $6.33/mmBTU) is lower as well, although this appears to be consolidation rather than the beginning of a new trend.  So, oil (-0.6%), gold (-0.5%), copper (-1.0%) and aluminum (-0.85%) are all under pressure.  Given the dollar’s strength, this should not be that surprising, although overall, I continue to expect a rising dollar and rising commodity prices.

As to the dollar, it is king today, rising 1.1% vs NZD, despite a 0.25% interest rate increase by the RBNZ last night, 1.0% vs. NOK and 0.85% vs SEK with the latter seeing a negative monthly GDP outcome in a huge surprise, thus marking down growth expectations significantly for the year.  But the rest of the G10 is much softer save JPY, which is essentially unchanged on the day.  Meanwhile, the euro has fallen a further 0.5% and is now approaching modest support at 1.1500.  Look for further declines there.

As to emerging market currencies, all that were open last night or today are lower with MXN (-1.2%) leading the way on a combination of lower oil and higher inflation, but HUF (-0.9%), ZAR (-0.8%) and CZK (-0.8%) all suffering on either weaker commodity prices are concerns over insufficient monetary tightening in an inflationary economy.  Even INR (-0.7%) is feeling the heat from rising inflationary pressures.  It is universal.

On the data front, only ADP Employment (exp 430K) is due this morning and there are no Fed speakers scheduled.  Right now, it feels like the dollar is primed to continue to move higher regardless of the data, or anything else.  Fear is growing among investors and they are searching for the safest vehicles they can find.  The steepening of the yield curve indicates the demand is in the 2yr, not the 10yr space, which makes sense, as in an inflationary environment, you want to hold the shortest duration possible.  Beware the FAANG stocks as they are very long duration equivalents.  Instead, it feels like the dollar is a good place to hang out.

Good luck and stay safe
Adf

Prices Ascend

As energy prices ascend
More problems they seem to portend
Inflation won’t quit
While growth takes a hit
When will this bad dream ever end?

Another day, another new high in the price of oil.  We have now reached price levels not seen in seven years and there is no indication this trend is going to end anytime soon.  Rather, given the supply and demand characteristics in the marketplace, it is not hard to make a case that we will be seeing $100/bbl oil by Q1 2022, if not sooner.  OPEC+ just met and, not surprisingly, decided that they were quite comfortable with rising oil prices thus saw no reason to increase production at this time.  Meanwhile, Western governments continue to do everything in their power to prevent the expansion of energy production, at least the production of fossil fuels.  This combination of policies seems likely to have some serious side effects, especially as we head into winter.

For instance, while I have highlighted the price of energy in Europe and Asia, which remains far higher than in the US, it is worth repeating the story.  Natural gas in Europe is now trading at $37.28/mmBTU, compared with just under $6/mmBTU in the US.  Storage levels are at 74% of capacity which means that any cold snap is going to put serious pressure on the Eurozone economy as NatGas prices will almost certainly rise further in response.  In addition, Europe remains highly dependent on Russia as a supplier which seems to open them to some geopolitical risk.  After all, Vladimir Putin may not be the friendliest supplier in times of crisis.

China, too, is having problems as not only has the price of oil risen sharply, but so, too, has the price of thermal coal (+5.25% today, +200% YTD).  China still burns a significant amount of coal to produce electricity throughout the country with more than 1000 plants still operating and nearly 200 more under construction.  It is this situation which causes many to question President Xi Jinping’s commitment to reining in carbon emissions.  Unsurprisingly, the inherent conflicts in the desire to reduce carbon, thus capping coal production, while trying to generate enough electricity for a growing economy have resulted in the Chinese abandoning the carbon issues.  Last week, Xi ordered coal mines to produce “all they can” rather than adhere to the strict quotas that had been put in place.  Right now, there is a power crisis as utilities have cut back electricity production reducing service to both industrial and residential users.  Again, winter is coming, and insufficient electricity is not going to be acceptable to President Xi.  When push comes to shove, you can be sure that the primary goal is generating enough electricity for the economy not reducing carbon emissions.

Ultimately, this story is set to continue worldwide, with the tension between those focused on economic activity and growth continually at odds with those focused on carbon dioxide.  Until nuclear power is accepted as the only possible way to create stable baseload power with no carbon emissions, nothing in this story will change.  The implication is that energy prices have further, potentially much further, to run given the inelasticity of demand for power in the short-term.  And this matters for all other markets as it will impact both growth and inflation for years to come.

Consider bond markets and interest rates.  While the Fed and other central banks may choose to ignore energy prices in their policy decisions, the market does not ignore rising energy prices.  The ongoing increase in inflation around the world is going to result in higher interest rates around the world.  While central banks may cap the front end, absent YCC, back end yields will rally.  A rising cost of capital is going to have a negative impact on equity markets as well, as both future earnings are likely to suffer and the discount factor for those who still consider DCF models as part of their equity analysis, is going to reduce the current value of those future cash flows.  The dollar, however, seems likely to benefit from rising oil and energy prices, as most energy around the world (in wholesale markets) is priced in USD.  Essentially, people will need to buy dollars to buy oil or gas.  Adding all this up certainly has the appearance of a more substantial risk-off period coming soon.  We shall see.

This morning, however, that is not entirely clear.  While Asian equity markets saw more red than green (Nikkei -2.2%, Sydney -0.4%, Hang Seng +0.3%, Shanghai closed), Europe is feeling positively giddy with gains across the board (DAX +0.35%, CAC +0.8%, FTSE 100 +0.65%) as PMI data showed more winners than losers although it also showed the highest price pressures seen since 2008, pre GFC.  US futures, after markets had a tough day yesterday, are pointing higher at this hour, with all three main indices higher by about 0.35%.

Bond markets are a bit schizophrenic this morning as Treasury (+1.9bps) and Gilt (+2.0bps) yields climb while we see modest declines in Europe (Bunds -0.2bps, OATs -0.3bps).  While yields remain low on a historic basis, and real yields remain extremely negative, it certainly appears that the trend in yields is higher.  There is every possibility that central banks blink when it comes to fighting inflation and ultimately do prevent yields from rising much further, but so far, they have not felt compelled to do so.  This is something we will be watching closely going forward.

Turning to commodities, oil (WTI +1.05%) shows no signs of slowing down.  Nor does NatGas (+3.0%) or coal (+5.25%).  Energy remains in demand.  Precious metals, on the other hand, continue to flounder with both gold (-0.85%) and silver (-0.7%) under pressure.  Copper (-1.75%) too, is feeling it today along with the rest of the industrial metal space save aluminum (+0.6%).  Ags are softer as well.

The dollar, however, is having a much better day, rallying against most of its major counterparts.  For instance, JPY (-0.3%) continues to suffer as the market demonstrates a lack of excitement over the new PM and his team.  Meanwhile, EUR (-0.2%) has reversed its consolidation gains and appears set to resume its recent downtrend.  Technically, the euro looks pretty bad with a move toward 1.12 quite realistic before the end of the year.  AUD (-0.2%) found no support from the RBA’s message last night as they continue to look toward 2024 before interest rates may start to rise.  On the plus side, only NOK (+0.2%) on the back of oil’s gains, and GBP (+0.2%) on the back of a stronger than expected PMI release are in the green.

EMG currencies have also seen many more laggards than gainers led by HUF (-0.5%) and PLN (-0.3%) both high beta plays on the euro, and MXN (-0.2%) and RUB (-0.2%) both of which are somewhat surprising given oil’s continued rise.  The bulk of the APAC currencies also slid, albeit only in the -0.1% to -0.2% range, with several simply adjusting after several days with local markets closed.  ZAR (+0.35%) is the only gainer of note as the Services PMI data printed at a better than expected 50.7.

On the data front, the Trade Balance (exp -$70.8B) and ISM Services (59.9) are on the slate and we hear from Vice-Chair Quarles on LIBOR transition.  In other words, not much of note here.  While I believe oil prices remain the key driver right now, there is certainly some focus turning to Friday’s payroll data as that is the last big data point before the Fed’s November meeting.

The dollar’s trend remains higher and I see no reason for anything to halt that for now.  My take is the modest correction we saw Friday and Monday is all there is for now, and a test of the recent highs is coming soon to a screen near you.

Good luck and stay safe
Adf

The Ceiling for Debt

To traders, the ceiling for debt
Is starting to grow as a threat
As Yellen explained
She’ll soon be constrained
From paying our bills, just not yet

Some folks claim an alternate way
Exists which could help save the day
To quickly influx
A cool trillion bucks
Just mint a new coin to help pay

In addition to all the Congressional drama over the Biden spending agenda, the US is also being buffeted by the debt ceiling drama.  We’ve all seen this movie before, where US law requires Congress to approve the amount of debt that can be issued by the Treasury in order to pay for the spending that Congress mandates.  (A little-known fact is that the debt ceiling was not enacted to impose discipline on Congress, in fact it was the opposite.  Prior to the debt ceiling’s implementation, Congress was required to vote on the funding for each spending bill they enacted on an individual basis.  The debt ceiling was created to allow Treasury to fund the Congressional spending mandates in a smoother and more efficient manner.  My how things have changed!)  But back to our story… the current situation is that the debt ceiling has been reached and the Treasury is not empowered to issue any new debt (it can roll over maturing debt) in the current situation.  While the Treasury does have some cash on hand, and can move funds around in its various accounts, by most measures, it appears that there are about 2 weeks of funding left before the government will have to default on paying some bills on a timely basis.

Now default was never contemplated by the Founding Fathers, with them going so far as to explain in Section 4 of the 14th Amendment of the Constitution:

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void. [author’s emphasis]

It is this confluence of events which has led to a somewhat creative thought regarding how the government can overcome their problem, minting a trillion-dollar platinum coin.  One thing that is clear is that the Treasury has the legal right to mint coinage, which is why despite the talk of the Fed printing money, the actual money printer is the Treasury department.  Those $20 bills in your wallet are printed at the US Mint, a part of the Treasury.  And the right to print money is fiercely protected by every nation as it is a good source of revenue (known as seignorage).  Consider, they print money and can use it to buy real stuff, whether tanks, or medicines or anything else.  All of those things cost far more than the paper that money is printed on.  As well, paper money is considered part of the Treasury’s coinage capability.

Now, in economic terms, $20 bills are actually zero-coupon perpetual bonds.  A claim on a fixed notional of assets with no interest rate paid and no maturity date.  The same is true with quarters and dimes and nickels, no maturity date, no interest rate, some ascribed value.  This has led to the idea that the Treasury can mint a coin with a notional value of $1 trillion (made of platinum to denote its high value), deliver it to the Fed and get $1 trillion of spending power in their general account.  This idea was first mooted in 2011 as a similar split in Congress brought the US government very close to an actual default.  Ten years later, as the concept of MMT has become more widely accepted as a viable path forward (it’s NOT), the idea is once again gaining traction.  It certainly solves some problems, notably it prevents a default, but more importantly to the Democrats in Congress, it prevents a distasteful political vote that can be used as a cudgel by Republican opponents in the next election.

Of course, my question is, why would they stop at $1 trillion?  After all, if current spending plans are for $5 trillion, why not mint five coins, or ten so they have some spare change?  You can see the danger of this slippery slope, especially in the current economic environment where inflation is already running rampant.  The addition of $1 trillion or $5 trillion more into the economy without the creation of new products or services would really turbocharge inflation.

While thus far, it seems this idea remains at the margin, given the dysfunctionality of Congress these days, and the shrinking timeline for action, it cannot be ruled out.  My sense is that while it could have a short-term positive impact on the dollar and markets, it would relatively quickly be understood to be a massively inflationary action with both bonds and the dollar suffering accordingly.

OK, with that food for thought, let us take a look at market activity today.  The first thing to note is that China is in the midst of its Golden Week holidays, which means there are no markets there until next week.  Hong Kong (-2.2%) and Tokyo (-1.1%), however, were both open, although neither had a very positive session.  Hong Kong suffered as they halted trading in Evergrande shares and other real estate companies fell sharply.  Europe, on the other hand has edged slightly higher this morning, (DAX +0.0%, CAC +0.2%, FTSE 100 +0.2%) although it is hard to get too excited over the movement.  US futures, on the other hand, are all pointing a bit lower, on the order of -0.4% at this hour.

Bond markets are seeing some selling this morning with 10-year Treasury yields higher by 3.5bps, although since the very sharp move last week, they have been consolidating either side of 1.50% yields.  European sovereigns are also under some pressure with yields there moving up (Bunds +1.8bps, OATs +1.6bps, Gilts +2.0bps), although there has been precious little news on which to trade.

In the commodity market, oil prices continue to trade higher (WTI +0.3%) as does Nat Gas (+2.3%).  While precious metals are under some pressure (Au -0.6%), industrial metals are firm this morning (Cu +1.35%, Al +0.6%) and agricultural prices are mixed in slow trading.

As to the FX market, the dollar is definitely under some pressure this morning with CHF (+0.45%) leading the way higher in the G10 with NOK (+0.4%) and GBP (+0.4%) next in line.  The only laggard today is JPY (-0.15%) which is confusing given the Swiss franc’s performance as otherwise, one could consider this a somewhat risk-on day.  But US equity futures are not helping that story either.  In the EMG space, things are a little clearer as the CE4 (HUF +0.75%, PLN +0.6%, CZK +0.3%) are the top performers as all of them continue to get supported by central bank comments regarding tighter monetary policy.  On the downside, MXN (-0.45%) is suffering the opposite as Banxico comments indicated that there would be no 50 basis point rate hikes anytime soon, something the market was beginning to price in.  Net, the dollar is probably slightly softer, but the recent uptrend remains intact.

Data this week is fairly slow up until Friday’s payroll report:

Today Factory Orders 1.0%
Tuesday Trade Balance -$70.6B
ISM Services 59.9
Wednesday ADP Employment 430K
Thursday Initial Claims 350K
Continuing Claims 2770K
Consumer Credit $17.5B
Friday Nonfarm Payrolls 470K
Private Payrolls 450K
Manufacturing Payrolls 25K
Unemployment Rate 5.1%
Average Hourly Earnings 0.4% (4.6% Y/Y)
Average Weekly Hours 34.7
Participation Rate 61.7%

Source: Bloomberg

A couple of things worth mentioning are that last week, the NFP forecast was 535K, so starting to slip.  Also, we continue to hear that there is no wage inflation, yet 4.6% Y/Y will be the highest non-Covid related level since before the GFC.  On the Fed speaker circuit, this week is far less noisy with only 4 speakers, none of whom are going to change the narrative.

As to the dollar overall, I believe we are in an uptrend for now, having broken through previous strong resistance, and I expect that we are likely to see this trend continue.  Use pullbacks to hedge, but they will not be large in my view.

Good luck and stay safe
Adf

At All Costs#

Ahead of the winter’s white frosts
The Chinese told firms, “at all costs”
Get oil and gas
And coal, so en masse
Our energy never exhausts

In Europe, as prices keep rising
For Nat Gas, most firms are revising
The prices they charge
Which has, by and large
Helped CPI keep on surprising

Ostensibly, the reason that the Fed, and any central bank, looks at prices on an -ex food & energy basis is because they realize that they have very little control over the prices of either one.  The only tool they have to control them is extremely blunt, that of interest rates.  After all, if they raise interest rates high enough to cause a recession, demand for food & energy is likely to decline, certainly that of energy, and so prices should fall.  Of course, precious few central bankers are willing to cause a recession as they know that their own job would be on the line.

And yet, central banks cannot ignore the impact of food & energy prices on the economy.  This is especially so for energy as it is used to make or provide everything else, so rising energy prices eventually feed into rising prices for non-energy products like computers and washing machines and haircuts.  As has become abundantly clear over the past months, energy prices continue to rise sharply and alongside them, we are seeing sharp rises in consumer prices as well.

Protestations by Lagarde and Powell that inflation is transitory do not detract from the fact that energy prices are exploding higher and that those charged with securing energy for their country or company are willing to continue to pay over the odds to do so.  Yesterday, an edict from the Chinese government to all its major companies exhorted them to get energy supplies for the winter “at all costs.”  This morning, they followed up by telling their coal mining companies to produce at maximum levels and ignore quotas.  Clearly, there is concern in Beijing that with winter coming, there will not be enough energy to heat homes and run factories, an unmitigated disaster.  But this price insensitive buying simply drives the price higher.  (see Federal Reserve impact on bonds via QE for an example.)

And higher these prices continue to go.  Nat Gas, which is the preferred form of fossil fuel, continues to rise dramatically in both Europe and Asia.  In both geographies, it has risen to nearly $35.00/mmBTU, almost 6x as expensive as US Nat Gas.  On an energy equivalent basis, that comes out to $190/bbl of oil.  And you wonder why the Chinese want to dig as much coal as possible.  The problem they are already having, which is adding to their overall economic concerns, is that they have run into an energy shortage and have been restricting power availability to the industrial sector in order to ensure that households have enough.  Of course, starving industry is going to have a pretty negative impact on the economy, hence the call for obtaining energy at all costs.  But that has its own problems, as driving prices higher will divert spending to energy from both investment and consumption.  In other words, as is often the case, there is no good answer to this problem.

If you are wondering how this impacts foreign exchange, let me explain.  First, energy is priced in dollars almost everywhere in the world, at least at a wholesale level.  So, buying energy requires having dollars to spend to do so.  I would contend one reason we have seen the dollar maintain its strength recently, and break out of a medium-term range, is because countries are panicking over their winter energy needs and need dollars to secure supplies.  Second, as energy prices rise, so too does inflation.  And while Mr Powell continues to refuse to accept that is the case, the market is not so stubborn on the issue.  We have seen the yield curve steepen sharply over the past several weeks, something which is historically a dollar positive, and with expectations for the taper firmly implanted into the market’s collective conscience, the strong view is interest rates in the US are going higher.  This, too, is very dollar supportive.  While I remain unconvinced that the Fed will ultimately be willing to tighten policy in any significant manner, that remains the current market narrative.  We shall see how things evolve, but for now, the dollar has legs alongside interest rates and energy prices.

Ok, to today’s price action.  The notable thing is the reduction in risk appetite that has been evident for the past several sessions.  For instance, yesterday we finally achieved a 5% correction in the S&P 500 for the first time in more than 200 sessions.  While prices remain extremely overvalued on traditional measures, it is not yet clear if the ‘buy the dip’ mentality will prevail as we enter a new fiscal quarter.  We shall see.

Overnight, Asia was mostly lower (Nikkei -2.3%, Hang Seng -0.4%) but Shanghai (+0.9%) managed to rally.  Of course, remember, Shanghai has been massively underperforming for quite a while.  Other than China, though, the rest of Asia was all red.  Europe, too, is bright red this morning (DAX -0.8%, CAC -0.8%, FTSE 100 -1.0%) as the broad risk-off sentiment combines with modestly weaker than expected PMI data and higher than expected Eurozone CPI data.  As to the latter, the 3.4% headline print is the highest since Sept 2008, right at the beginning of the GFC.  Yesterday, German CPI printed at 4.1%, which is the highest level since the wake of the reunification in 1993.  For a culture that still recalls the Weimar hyperinflation, things must be pretty uncomfortable there.  It is a good thing this inflation is transitory!

Not surprisingly, with risk being jettisoned, bonds are in demand this morning and although Treasuries are unchanged in this session, they did rally all day yesterday with yields declining nearly 5bps.  As to Europe, Bunds (-3.2bps) and OATs (-3.2bps) are firmly higher with the rest of the continent while Gilts (-1.5bps) are not seeing quite as much love despite an underperforming stock market.  I think one reason is that UK PMI data was actually better than expected and higher than last month, an outlier versus the continent.

Commodity prices are mixed this morning as despite my opening monologue, oil (WTI -0.9%) and Nat Gas (-0.7%) are both under pressure.  Of course, both have been rallying sharply for months, so nothing goes up in a straight line.  Precious metals are little changed on the day, but industrial metals are strong (Cu +1.6%, Al +0.5%, Sn +1.2%).  Ags, on the other hand, are mixed with no pattern whatsoever.

As to the dollar, it is under modest pressure this morning in what appears to be a consolidation at the end of the week.  The one noteworthy mover in the G10 is NOK (+0.75%) which is rallying despite oil’s decline as the market reacted to a surprisingly large decline in the Unemployment rate there to 2.4%.  But otherwise, GBP (+0.3%) is the next best performer and the rest of the bloc is +/-0.2%, with CAD (-0.2%) the laggard on weak oil prices.

EMG currencies have many more gainers than losers this morning with only RUB (-0.6%) on oil weakness, and KRW (-0.35%) on a smaller than expected trade surplus, declining of note, while THB (+0.6%), PLN (+0.6%) and HUF (+0.4%) all have shown some strength.  In Bangkok, the central bank vowed to monitor the baht, which has been falling steadily over the past 9 months to its weakest point in more than 4 years.  PLN saw higher than expected CPI data (5.8%) which has the market looking for higher rates from the central bank, while HUF was the beneficiary of central bank comments that the monetary tightening campaign was “far from the end.”

There is a veritable trove of data to be released this morning starting with Personal Income (exp 0.2%), Personal Spending (0.7%) and the Core PCE (3.5%) at 8:30.  Then at 10:00 we see ISM Manufacturing (59.5) and Prices Paid (78.5) as well as Michigan Sentiment (71.0).  If the PCE number prints on plan, the Fed will be crowing about how it, too, is falling and has peaked.  However, that is crow they will ultimately have to eat, as the peak is not nearly in.

The underlying picture for the dollar remains quite positive on both a technical and fundamental basis, but it appears today is a consolidation day.  Perhaps, a good time to buy dollars still needed to hedge.

Good luck, good weekend and stay safe
Adf

A Beginning, a Middle and End

“A beginning, a middle and end”
Is how Powell outlined the trend
Of current inflation
Which has caused frustration
For central banks who overspend

As Ralph Waldo Emerson so notably observed, “A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines.”  I am reminded of this each time I read that (little statesman) Jay Powell or (the divine) Madame Lagarde explain that inflation is largely transitory.  Little-minded they certainly appear to be, no?  Every day the evidence grows that inflation is trending higher yet despite this information, they remain consistent in their belief (or at least in their comments) that all of this price appreciation will quickly pass.  Yesterday, at an ECB held virtual symposium, Powell expressed frustration that supply chain bottlenecks have not been resolved as quickly as the Fed’s models indicate they should be.  Or perhaps the frustration stems from the fact that they have been completely wrong about inflation and it is starting to have a serious impact on their idealized world.  Whatever the case, each time they try to gloss over the implications of inflation, they lose just a touch more credibility (to the extent they have any remaining) in the markets’ collective eyes.  While the Fed’s track record for forecasting has always been awful, the current situation appears to be one of either intransigence in the face of new evidence, or more likely, a recognition that a change in their narrative has the potential to lead to much worse outcomes.

Fortunately, they continue to explain that if inflation were to get out of hand, they have the tools to address the issue and they are not afraid to use them!  However, history indicates that is not the case.  Consider that those ‘tools’ consist of the ability to raise interest rates and tighten monetary policy.  We all recall that just 3 years ago, as the Fed was attempting to normalize its balance sheet, allowing purchased assets to mature without being replaced, as well as slowly move interest rates higher, the equity market tumbled 20% in Q4 2018.  This led to the Powell pivot, where he decided that a declining stock market was a negative for his personal balance sheet the economy and instead, the FOMC cut rates in January to mitigate the damage already done.  The situation today appears far more dangerous with market leverage and valuations at historic highs.  Tightening policy in this market condition is likely to result in at least a 20% revaluation of equities, something the Fed can clearly not countenance.  Hence, it is far easier to ignore inflation than to respond to it.  Meanwhile, Paul Volcker spins in his grave!

In the meantime, Eurozone inflation readings released thus far this morning have shown virtually every one at the highest levels since before the GFC, at the very least, if not the highest readings in three decades.  For instance, French CPI printed at 2.7%, its highest print since June 2008.  Italian CPI, at 3.0%, is merely its highest since 2012, but in fairness, prior to the euro’s creation, Italian CPI regularly ran at much higher levels resulting in a continuing depreciation of the lire. Shortly we will see German inflation, with some of its States already reporting levels above 4.2%, their highest prints since the mid 1990’s, which is also the current forecast for the nation as a whole.  The point is, there is absolutely no evidence that inflation is peaking, and while Powell and Lagarde twiddle their thumbs, things are going to get worse before they get better.

So, what does this mean for markets?  Well, we have already seen yield curves steepen in the US and throughout Europe as there is a strong belief that despite rising inflation, neither the Fed nor ECB is going to respond.  Yes, the Fed said they would think about tapering come November, but if anything, that is likely to simply steepen the curve further as the price-insensitive buyer of last resort reduces its purchases.  The real question is, at what point will the Fed decide that yields are too high and adjust policy to rein them in?  SMBC’s house forecast is for 1.80% by the end of the year, which is in line with much of the Street.  The conundrum, however, is that Street forecasts are for continued higher prices in equities as well, and it seems to me that the two scenarios are unlikely to be achieved simultaneously.  If rates do continue higher, while I think the short-term impact will be USD positive, I fear the equity market may not be quite as sanguine.

Overnight, markets continue to wrestle with the conflicting ideas of rising inflation and central bank sanguinity on its transitory nature.  While we have seen a sharp rise in yields over the past week, last night was a consolidating session with bond market movement quite limited.  Treasury yields have edged higher by 1.2bps, but at 1.53% remain a few ticks below the peak seen Monday.  We have seen similar, modest, price action on the continent (Bunds +0.5bps, OATs +0.4bps) although Gilts (+2.4bps) have responded to better-than-expected GDP results for Q2, which showed year on year growth of 23.6%.  Not surprisingly, this has helped the pound as well, which is firmer this morning by 0.1%.

Equity markets have also had mixed reviews with Asia (Nikkei -0.3%, Hang Seng -0.4%, Shanghai +0.9%) not giving consistent direction and Europe following suit (DAX -0.2%, CAC 0.0%, FTSE 100 +0.2%).  US futures are higher by about 0.5% at this hour as traders await this morning’s data releases.

While oil prices have slipped a bit this morning (WTI -0.8%) the same cannot be said for NatGas (+2.7%) as the energy situation remains fraught in Europe and the UK (and Asia).  The rest of the commodity space is generally under pressure as well with copper (-1.7%) and aluminum (-0.4%) both falling while the precious sector is essentially unchanged on the day.

The dollar, while mixed in the overnight session, saw significant strength yesterday which has seen the euro fall below 1.1600 for the first time since July 2020, and looking for all the world like it has further to run.  Unless yields in the US stop rising, my take is we could well see 1.12 before long.  But in the past two days we have seen some sharp declines; NOK (-1.5%), NZD (-1.3%) and EUR (-0.9%) have all suffered.  Even the yen (-0.45%) is declining here despite some evidence of risk mitigation.  In fact, it has weakened to its lowest point since the beginning of the Covid situation in February 2020, and here, too, looks as though it as room to run.  115 anyone?

EMG currencies have shown similar price behavior, falling sharply yesterday with a more mixed overnight session.  But the breadth of the decline is indicative of a dollar story, not any idiosyncratic issues in particular countries.  While those clearly exist, they are not driving the market right now.

This morning’s data calendar brings the weekly Initial (exp 330K) and Continuing (2790K) Claims data as well as the third look at Q2 GDP (6.6%).  Then at 9:45 we see Chicago PMI (65.0).  While the GDP data contains inflation information, it is not widely followed or used in models.  However, it is interesting to note that the Core PCE calculation there is at 6.1%, which happens to be the highest print since Q3 1983!  Perhaps this is why it is ignored.

We also hear from six Fed speakers in addition to Powell and Yellen sitting down in front of the House Financial Services Committee.  Of course, Powell has made clear his views on the transitory nature of inflation and I’m confident no question from a Congressman will get him to admit anything different.  Rather, I expect a staunch defense of the two disgraced Fed regional presidents who resigned after their insider trading was made known, and both he and Yellen to beseech Congress to raise the debt ceiling and not allow the government to shut down.  In other words, nothing new will occur.

The dollar has pretty clearly broken out of its recent range and I expect that this move has some legs.  I would be buying dollars on dips when the opportunity arises.  For payables hedgers, pick your spots and lock in comfortable rates.  The trend is now your friend.

Good luck and stay safe
Adf

Raring to Spend

Japan’s new PM
Fumio Kishida is
Raring to spend yen

The LDP elected Fumio Kishida as its new president, thereby assuring him of the job of Japan’s 65th Prime Minister.  Relacing Yoshihide Suga, Kishida-san has a tall task ahead of him in leading the nation back to a growth trajectory.  In addition, he must face the voters by November as well as rally his supporters in an upper house election next year.  Apparently, his plan is…spend more money!  He has promised to spend tens of trillions of yen (hundreds of billions of dollars equivalent) in order to help resuscitate the Japanese economy and bolster the middle class.

As refreshing as it is to have a new administration, it seems as though the policy playbook continues to consist of a single page…spend more yen.  Perhaps something will change in Japan, but it seems unlikely.  Rather, the nation will continue to struggle with the same macroeconomic issues that have plagued it for the past decades; excess debt driving slower growth amid an aging population.  The yen (+0.1%) has stabilized this morning but appears to be trending pretty sharply lower.  While support (USD resistance) is strong at 111.65-85, should we breech that level, a move toward 115.00 appears quite reasonable as well as likely.

As energy prices rise higher
Most governments seek a supplier
Of power that will
Completely fulfil
The orders that they all desire

In other news, it is becoming abundantly clear that the combination of energy policies that have been enacted recently are not having the desired outcome, assuming that outcome is to develop clean energy in abundance.  This is made evident by the dramatically rising prices of things like natural gas in Europe (+400% since 1Mar21) and the US (+130% YTD) and coal (+160% YTD).  Of course, the latter is rarely considered ‘clean’ but it is reliable.  And that is the crux of the matter.  Reliability of both wind and solar power has been called into question lately and reliance on baseload power sources like coal, which Europe, China, and India have in abundance, and NatGas, which they don’t, is driving policy decisions.

For instance, China is mulling energy price hikes for industry in an effort to reduce demand.  And if that doesn’t work, they will raise prices for residential users.  Go figure, a communist nation using price signals to adjust behavior!  At any rate, the immediate impact is likely to be downgraded growth prospects for China’s economy as rising energy prices will lead to rising export prices, lower exports, and lower growth.  We have already seen Chinese equity markets under pressure recently as the energy situation worsens.  Shanghai (-1.8%, -5.5% in past two weeks) is leading the way lower amid growing concern that Evergrande is not the biggest problem impacting China.  At some point, I expect the renminbi is going to suffer a bit more than its recent price action has shown.  Slowing growth and continued monetary expansion are going to add a great deal of pressure to the currency as it may be the only outlet available for the economy.  I fear it could be a “long cold lonely winter” in China this year.

Of course, it’s not just China where energy prices are rising, they are higher everywhere.  I’m sure you see it when you refill your gas tank, or when you pay your electric bill.  And this is a problem for economic growth as higher energy costs feed into product and service pricing directly, as well as reduce the amount of disposable income available for spending by the population.  Higher prices and slower growth (i.e. stagflation) are a very real risk, and by some measures have already arrived.

Beyond the direct discomfort we all will feel from its impacts, the policy questions are critical.  Consider, last time stagflation was upon us, then Fed Chairman Paul Volcker raised interest rates sharply in order to attack the inflation issue driving the US economy into a severe double-dip recession.  Oh yeah, the S&P 500 fell nearly 30% over the two-year period.  But ask yourself if, given the current zeitgeist as well as the current makeup of the Fed, there is any possibility that Chairman Powell (or his successor) will attack inflation in the same way.  It seems highly unlikely that would be the case.  Rather, it is a virtual certainty that the focus will be on the ‘stag’ part of the term and more money printing and spending will be recommended.  After all, given the increasing acceptance of the MMT mindset, that’s all that needs to be done.  Remember, policies matter, and if policies are designed to achieve short-term goals at the expense of longer-term needs, the ultimate outcome tends to be poor.  As in China, the currency is likely to be the relief valve for the economy which is what informs my view of longer-term USD weakness.  However, for now, the dollar is following 10-year Treasury yields, which seem to be trending higher, albeit not today when they have fallen 4.2 basis points.

Summing it all up, rising energy prices are starting to have deleterious effects on all parts of the global economy and the financial market implications are only going to grow.  In addition, the policy actions going forward are critical, and the chance of a policy error seem to grow daily.  The idea of short-term pain for long-term gain is obsolete in the year 2021.  Be prepared for more problems in the future.

Ok, a quick run around markets shows that after yesterday’s sharp US equity sell-off, Japan (Nikkei -2.1%) followed suit as did Shanghai although the Hang Seng managed to rally 0.7%.  Europe, on the other hand has decided that central banks will come to the rescue, as we are seeing a nice rebound from yesterday’s price action (DAX +1.1%, CAC +1.2%, FTSE 100 +1.0%).  US futures, too, are higher led by the NASDAQ (+1.0%) as declining yields are helping out.

But are yields really declining?  The fact that the bond market has bounced slightly after a dramatic 1-week decline is hardly a sign of a rebound.  Rather, it is normal trading activity.  While the trend remains for higher yields, today, all of Europe has seen yields slide on the order of 2 basis points alongside the Treasury yield declines.  This feels very much like a lull in the action, not a top/bottom in the market.

Commodity prices are behaving in a similar manner as oil (-0.8%) and NatGas (-1.2%) are leading the way lower, consolidating what has been an impressive rally.  Metals prices are mixed with gold (+0.6%) rebounding but base metals (Cu -0.4%, Al -0.2%, Sn -0.6%) all sliding.  Agricultural prices are mixed as the overall session seems to be one of position adjustments after a big move.

As to the dollar, it is mixed, albeit slightly firmer if anything.  In the G10, NOK (-0.35%) is falling alongside oil prices with NZD (-0.3%) the next worst performer on weakening commodity prices.  JPY (+0.1%) and CHF (+0.1%) are both modestly firmer, but here, too, things seem more position oriented than trend worthy.  EMG currencies are mixed with an equal number of gainers and losers, but the notable thing is that the biggest movers have only seen price adjustments of 0.3% or less.  In other words, there are precious few stories here to think about.

There is no data of note this morning, but we do hear from a lot of central bankers, notably Chairman Powell alongside Lagarde, Kuroda and Bailey (BOE) at an ECB forum.  We also hear from Harker, Daly and Bostic, but the narrative remains tapering is coming in November, and none of these three will be able to change that narrative.

In truth, I would have expected the dollar to soften today given the bond market, so the fact it remains reasonably well bid is a sign that there is further strength in this move.  The euro is pushing to critical technical support at 1.1650, a break of which is likely to see a much sharper decline.  Hedgers, keep that in mind.

Good luck and stay safe
Adf

QE Galore

With Kaplan and Rosengren out
The hawks have lost much of their clout
This opens the door
For QE galore
With tapering now more in doubt

As well, has Jay’s rep now been stained
So much that he won’t be retained
As Chair of the Fed
With Brainerd, instead
The one that progressives ordained?

All the action is in the bond market these days as investors and traders focus on the idea that the Fed is going to begin tapering its asset purchases in November.  Not surprisingly, demand for Treasuries has diminished on these prospects with the yield curve bear steepening as 10-year and 30-year yields climb more rapidly than the front end of the curve.  In fact, this morning, 10-year Treasury yields have risen a further 3.5 basis points, which makes 22bps since the FOMC meeting, and is now trading at 1.52%, its highest level since June.  Yields are rising elsewhere in the world as well, just not quite as rapidly as in the US.  For instance, Bunds (+3.2bps today, +13bps since Wednesday), OATs (+3.1bps today, 15bps since Wednesday) and Gilts (+4.8bps today, +20bps since Wednesday) are also under severe pressure.  While the BOE has absolutely discussed the idea of tapering, the same is not true with the ECB, which instead is discussing how it is going to replace PEPP when it expires in March 2022.

By the way, there is another victim to these rate rises, the NASDAQ, (futures -1.6%) where the tech sector lives and whose valuations have moved to extraordinary heights based on their long duration characteristics.

But let us consider how recent, sudden, changes in the makeup of the Fed may impact the current narrative.  It seems that two of the more hawkish Regional Fed presidents, Boston’s Rosengren and Dallas’ Kaplan, were actively trading their personal accounts at the same time they were privy to the inside discussions at the FOMC.  I can’t imagine more useful information short of knowledge of an acquisition, with respect to how to position my personal portfolio.  When this news broke last week, there was an initial uproar and then a slow boil rose such that both clearly felt pressured to step down.  (Of course, they had already sold out their positions ahead of the tapering discussion, so don’t worry, they kept their gains!)

There are a couple of things here which I have not yet seen widely discussed, but which must be considered when looking ahead.  First, the two of them were amongst the more hawkish FOMC members, with Kaplan the first to talk about tapering and Rosengren climbing on that bandwagon several months ago with vocal support.  So, will their replacements be quite as hawkish?  It would not surprise if Dallas goes for another hawk but given the progressivity of the bulk of New England, the new Boston Fed president seems far more likely to lean dovish in my view.  So, the tone of the FOMC seems likely to change.

Perhaps of more importance, though, is that this went on under Chairman Powell’s nose with no issues raised until it became public.  That is hardly a sign of strong leadership, and the very idea that two FOMC members were trading their personal accounts on the back of inside information is a huge black mark on his chairmanship.  You can be certain that when he sits down before the Senate Banking Panel today, Senator Warren is going to be tenacious in her attacks.  The point is, the idea that Powell will be reappointed may just have been squashed.  This means that Lael Brainerd, currently a Fed governor, may well get the (poison) chalice.  Governor Brainerd, just yesterday, explained that she was not nearly ready to taper, rather that the labor market was still “a bit short of the mark” of the “substantial further progress” threshold.  In fact, she is convinced that the economy will revert to its pre-pandemic characteristics soon after the delta variant dissipates.

If you consider the implications of this new information, we could well wind up with a more dovish FOMC generally with a much more dovish Fed chair.  Ask yourself if that scenario is likely to produce a consensus to taper asset purchases?  While Jay may get the process started, assuming economic activity holds up through November, they will never end QE with that type of FOMC bias.  In fact, it would not be surprising if the Biden administration nominated someone like Professor Stephanie Kelton, the queen of MMT, for one of the open governorships.

Summing up, recent surprising actions have now opened the door for a much more dovish Fed going forward.  This means that the fight against inflation, which even Powell has begun to admit could last a bit longer than initially anticipated, is of secondary, if not tertiary, importance.  For now, the dollar is following US rates higher as spreads widen in the dollar’s favor, but if the Fed gets reconstructed in a more dovish manner, which seems far more likely this morning than last week, I would expect the dollar to find a top sooner rather than later.

However, that is all prognostication of what may happen.  What is happening right now is that yields are rising on the taper talk and risk is being jettisoned as a result.  So, equity markets are generally under pressure.  Last night saw the Nikkei (-0.2%) slip a bit while the bulk of the rest of the region suffered more acutely (Australia -1.5%), although Shanghai (+0.5%) and the Hang Seng (+1.2%) were the positive outliers.  However, that seemed more like dip buying than fundamentally led activity.  Europe is really under the gun (DAX -1.15%, CAC -1.75%, FTSE 100 -0.5%) as yields, as discussed above, rise everywhere.

Commodity prices continue to show mixed behavior as oil (WTI +0.95%) and Nat Gas (+7.5%), rise sharply on supply concerns while metals (Au -0.9%, Cu -1.3%) all suffer on the back of concerns over economic growth and the dollar’s strength.

Speaking of the dollar, it is universally higher this morning against both G10 and EMG counterparts.  NZD (-0.8%) and GBP (-0.7%) are the downside leaders this morning, with kiwi feeling pressure from falling iron ore prices while the pound turned tail recently on position adjustments as traders await a dovish BOE speaker’s comments later in the session.  But, AUD (-0.6%) is also feeling the pressure from declining metals prices and in a more surprising outcome, NOK (-0.5%) is floundering despite rising oil prices and the fact that the Norgesbank was the First G10 central bank to actually raise rates!  As well, don’t forget JPY (-0.4%) which is now pushing to its highest levels of the year and not far from multi-year highs.  Remember, high energy prices are a distinct yen negative.

EMG currencies are being led lower by ZAR (-1.0%) on weaker metals prices and THB (-0.75%) which is continuing to feel pressure from its fiscal accounts.  But here too, the weakness is widespread (KRW -0.65%, MXN -0.6%, PLN -0.6%) as the dollar is simply in substantial demand on the back of the yield benefit.

On the data front, yesterday’s Durable Goods numbers were much stronger than expected, clearly helping the rate/dollar story.  This morning brings Case Shiller House Prices (exp 20.0%) as well as Consumer Confidence (115.0) and the Advanced Goods Trade Balance (-$87.3B).  But the feature event will be the 10:00am sit down by Powell and Yellen at the Senate.  We do hear from four other FOMC members, but none will garner the same attention.  It will be interesting to hear how he parries what are almost certain to be questions about the insider trading scandal as well as more persistent inflation.  Stay tuned!

The correlation of the dollar to the 10-year yield has risen sharply in the past several sessions and is now above 60%.  I see no reason for that to change, nor any reason for yields to stop climbing right now.  While I doubt we even get back to the March highs of 1.75%, that doesn’t mean we won’t see some more fireworks in the meantime.

Good luck and stay safe
Adf

More Price Inflation

The story of civilization
Is growth due to carbonization
But fears about warming
Have started transforming
Some policies ‘cross most each nation

Alas, despite recent fixation
On policy coordination
Alternatives to
Nat Gas are too few
Resulting in more price inflation

Perhaps there is no greater irony (at least currently) than the fact that governments around the world must secretly be praying for a very warm winter as their policies designed to forestall global warming have resulted in a growing shortage of fuels for heating and transportation.  Evergrande has become a passé discussion point as the overwhelming consensus is that the Chinese government will not allow things to get out of hand.  (I hope they’re right!)  This has allowed the market to turn its attention to other issues with the new number one concern the rapidly rising price of natural gas.  One of the top stories over the weekend has been the shuttering of petrol stations in the UK as they simply ran out of gasoline to pump.  Meanwhile, Nat Gas prices have been climbing steadily and are now $5.35/mmBTU in the US, up 4.2% today and 110% YTD.  As to the Europeans, they would kill for gas that cheap as it is currently running 3x that, above $16.00/mmBTU.

Apparently, policies designed to reduce the production of fossil fuels have effectively reduced fossil fuel production.  At the same time, greater reliance on less stable energy sources, like wind and solar power, have resulted in insufficient overall energy production.  While during the initial stages of Covid shutdowns, when economic activity cratered, this didn’t pose any problems, now that economies around the world are reopening with substantial pent-up demand for various goods and services, it has become increasingly clear that well-intentioned policies have resulted in dramatically bad outcomes.  While Europe appears to be the epicenter of this problem, it is being felt worldwide and the result is that real economic activity will decline across the board.  Hand-in-hand with that outcome will be even more price pressures higher throughout the world.  Policymakers, especially central bankers, will have an increasingly difficult time addressing these issues with their available toolkits.  After all, central banks cannot print natural gas, only more money to chase after the limited amount available.

The important question for market observers is, how will rising energy prices impact financial markets?  It appears that the first impacts are being felt in the bond markets, where in the wake of the FOMC meeting last week, yields have been climbing steadily around the world.  In the first instance, the belief is that starting in November, the Fed will begin reducing its QE purchases, which will lead to higher yields from the belly to the back of the curve.  But as we continue to see yields climb (Treasuries +3.3bps today), you can be sure the rationale will include rising inflation.  After all, our textbooks all taught us that higher inflation expectations lead to higher yields.

The problem for every government around the world, given pretty much all of them are massively overindebted, is that higher yields are unaffordable.  Consider that, as of the end of 2020, the global government debt / GDP ratio was 105%, while the total debt /GDP ratio was 356% (according to Axios).  That is not an environment into which central banks can blithely raise interest rates to address inflation in the manner then Fed Chair Volcker did in the late 1970’s. In fact, it is far more likely they will do what they can to prevent interest rates from rising too high.  This is the reason I continue to believe that while the Fed may begin to taper at some point, tapering will not last very long.  They simply cannot afford it.  So, while bond markets around the world are under pressure today (Bunds +1.8bps, OATs +2.8bps, Gilts +2.9bps), and by rights should have significant room to decline, this movement will almost certainly be capped.

Equity markets, on the other hand, have room to run somewhat further, as despite both significant overvaluation by virtually every traditional metric, as well as record high margin debt, in an inflationary environment, a claim on real assets is better than a claim on ‘paper’ assets like bonds.  While Asian markets (Nikkei 0.0%, Hang Seng +0.1%, Shanghai -0.8%) have not been amused by the rise in energy prices, European bourses are behaving far better (DAX +0.6%, CAC +0.4%, FTSE 100 +0.2%).  As an aside, part of the German story is clearly the election, where the Social Democrats appear to have won a small plurality of seats, but where there is no obvious coalition to be formed to run the country.  It appears Germany’s role on the global stage will be interrupted as the nation tries to determine what it wants to do domestically over the next few weeks/months.  In the meantime, early session strength in the US futures markets has faded away with NASDAQ futures (-0.4%) now leading the way lower.

Turning to the key driver of markets today, commodity prices, we see oil (WTI +1.25%) continuing its recent rally, and pushing back to $75/bbl.  We’ve already discussed Nat Gas and generally all energy prices are higher.  But this is not a broad-based commodity rally, as we are seeing weakness throughout the metals complex (Au -0.1%, Cu -0.3%, Al -0.2% and Sn -4.8%).  Agricultural prices are slightly softer as well.  It seems that the idea energy will cost more is having a negative impact everywhere.

Finally, the dollar is a beneficiary of this price action on the basis of a few threads.  First, given energy is priced in dollars, they remain in demand given higher prices.  Second, the energy situation in the US is far less problematic than elsewhere in the world, thus on a relative basis, this is a more attractive place to hold assets.  So, in the G10 we see SEK (-0.5%) as the laggard, followed by the traditional havens (CHF -0.25%, JPY -0.2%), as the dollar seems to be showing off its haven bona fides today. In the EMG bloc, THB (-0.8%) leads the way lower followed by ZAR (-0.7%) and PHP (-0.7%), with other currencies mostly softer and only TRY (+0.5%) showing any strength on the day.  The baht has suffered on traditional macro issues with concerns continuing to grow regarding its current account status, with the Philippines seeing the same issues.  Rand appears to have reacted to the metals complex.  As to TRY, part of this is clearly a rebound from an extremely weak run last week, and part may be attributed to news of a Nat Gas find in the Black Sea which is forecast to be able to provide up to one-third of Turkey’s requirements in a few years.

As it is the last week of the month, we do get some interesting data, although payrolls are not released until October 8th.

Today Durable Goods 0.6%
-ex Transportation 0.5%
Tuesday Case Shiller Home Prices 20.0%
Consumer Confidence 115.0
Thursday Initial Claims 330K
Continuing Claims 2805K
GDP Q2 6.6%
Chicago PMI 65.0
Friday Personal Income 0.2%
Personal Spending 0.6%
Core PCE 0.2% (3.5% Y/Y)
Michigan Sentiment 71.0
ISM Manufacturing 59.5
ISM Prices Paid 77.5

Source: Bloomberg

Naturally, all eyes will be on Friday’s PCE data as the Fed will want to be able to show that price pressures are moderating, hence their transitory story is correct (it’s not.) But I cannot help but see the House Price index looking at a 20.0% rise in the past twelve months and think about how the Fed’s inflation measures just don’t seem to capture reality.

Rising yields in the US seem to be beginning to attract international investors, specifically Japanese investors as USDJPY has been moving steadily higher over the past two weeks.  The YTD high has been 111.66, not far from current levels.  Watch that for a potential breakout and perhaps, the beginning of a sharp move higher in the dollar.

Good luck and stay safe
Adf