While Jay and the FOMC
Are certain it’s transitory
Has forced some to pare
Their policy stance by degree
Thus none of us ought be amazed
That yesterday Banxico raised
Its overnight rate
As they cannot wait
Til prices (and people) get crazed
Last week the central bank of Brazil raised its overnight rate by 1.0%, taking it back to 5.25%, and promised to continue raising rates until they get inflation back under control. This seems pretty reasonable since the latest inflation reading there was 8.99%. Currently, the market is pricing in a 1.25% rate hike next month. Yesterday afternoon, Mexico’s central bank raised the overnight rate by 25 basis points for the second consecutive meeting, taking it up to 4.50%. Given that the latest reading on inflation there is 5.81%, it seems they, too, have further to raise rates in order to tame rising prices.
In fact, this is a scenario we are witnessing around the world in emerging markets, where inflation has been rising quite rapidly and the monetary authorities, recognizing that they don’t have infinite capacity to borrow in either their local currency or in dollars, find themselves in a very uncomfortable position. Either attack inflation now by raising rates and earning the wrath of their government, or let it rip and watch the country descend into more dire straits, akin to Argentina, Turkey, or worst of all, Venezuela.
But that the Fed would respond to inflation in the same manner. Instead, we continue to get high inflation readings (yesterday’s PPI jumped to 7.8%, 6.2% ex food & energy) and a steady stream of pablum about the transitory nature of inflation in the US. While only time will actually tell if higher inflation is truly here to stay, there certainly seems to be a lot of evidence that is the case. One cannot open a newspaper (or perhaps scroll a newsfeed) without immediately seeing a story about how fast food restaurants, or food manufacturers or…fill in the blank, are raising prices because of a combination of higher input and shipping costs. Perhaps, what is more surprising is that these companies have gained confidence that higher prices will not scare off their customers, meaning these price rises will stick.
On the wage front, this morning’s story of how newly minted college graduates taking (getting?) a job at Evercore Securities will now be paid a starting salary of $120,000 per year seems a pretty good indication that wages are rising. Given the JOLTS data showing there are over 10 million open positions in the country, it is not surprising that ‘finding qualified people to hire’ remains the top problem of small businesses according to the NFIB survey. The implication is wages are going to continue to rise and prices alongside them.
Speaking of shipping costs, we continue to see record rises in shipping rates as well as huge delays in timing. China closed one-quarter of its Ningbo port, the third largest in China, because of concerns over the spread of the delta variant of Covid. While US ports have not yet closed because of this, the backlog of ships waiting to unload continues to run near record high levels, and now delays from China will result in even bigger logistical and supply chain problems. All in all, it remains difficult for this author to see a future, at least a near future, where prices do anything but go much higher.
Into that environment we continue to see the key Fed leadership remain sanguine over the prospects of inflation, maintaining the narrative that any price rises are transitory. Apparently, this has come to mean prices will stop going up so rapidly but are unlikely to come back down. While there is a growing chorus of FOMC members, mostly regional presidents, that believe it is coming time to taper QE purchases, until we hear that from Powell or Williams or Brainerd, I think it remains a 50:50 proposition at best. But even if they do start to taper, given their history of responding to asset valuations, any stock market decline, which would seem likely given the current valuations are entirely built on the ‘lower forever’ interest rate scenario, would almost certainly see them stop quickly. Painting a picture where real yields do anything but fall deeper into negative territory continues to be a difficult thing. And that, ultimately, is going to be a negative for the dollar.
But when is ultimately? It is still a little ways off. Until then, it appears that the market is set up for the dollar to strengthen somewhat further. The dollar’s relationship with 10-year yields, which had been strong in Q1 and broke in Q2, seems to be back on track. All the taper talk has bond traders looking for a further backup in yields, and correspondingly, a further rise in the dollar. While today it is drifting lower vs. most of its counterparts, this can easily be explained by the fact that it is a summer Friday and traders are paring positions going into the weekend. But the medium-term view needs to be that higher US yields will support the dollar.
As to the rest of the markets, Asian equity markets continue to struggle as the spread of the delta variant accelerates and more countries in the region consider more drastic responses. Last night saw losses in all the major markets (Nikkei -0.15%, Hang Seng -0.5%, Shanghai -0.25%) and as long as these nations have difficulty managing the resurgence of infections, investors seem to believe that the growth story will be negatively impacted. Europe, on the other hand, is all green this morning (DAX +0.4%, CAC +0.35%, FTSE 100 +0.35%) as there is a greater belief that Covid issues are under better control. Vaccination rates have risen quite rapidly and so while infection rates may be rising, hospitalizations are not, just like in the US. Many analysts continue to believe European equity markets, writ large, are undervalued vs. their US counterparts, and while there is tapering talk here, there is absolutely no indication whatsoever that the ECB is going to do anything but continue to print money.
Treasury yields have drifted lower by 1.3bps this morning, which helps explain the dollar’s modest decline, but they remain right at 1.35% and show no signs of retracing last week’s sharp move higher. European sovereigns, on the other hand, are a bit softer this morning, classic risk-on behavior, with Bunds (+0.9bps) and OATs (+1.4bps) slipping into the weekend. Gilts are essentially unchanged, as it happens.
The commodity market is showing no clear directional bias of late, with both oil (-0.35%) and gold (+0.4%) having retraced a portion of major price declines over the past two weeks, but neither showing signs of either a break higher or the next leg down. Rather, they are both a bit choppy right now.
Finally, the dollar is mostly softer against its G10 counterparts, with NOK (+0.3%) the leader and the euro pushing up 0.25%. Frankly, both of these appear to be trading moves, as both had shown weakness all week, so positions are likely being pared into the weekend.
In the emerging market space, KRW (-0.65%) continues to be the bloc’s biggest laggard, falling for the fifth consecutive day as the combination of the record level of Covid infections, and concerns over the semiconductor space in the KOSPI have seen sellers come out of the woodwork for both stocks and the currency. Away from the won, weakness was evident throughout the APAC currencies, albeit to a much lesser extent, as the Covid spread story is regionwide. On the plus side, both CE4 and LATAM currencies are performing well, with MXN (+0.4%) the leader on the back of Banxico’s rate hike, and RUB (+0.4%) seeing position unwinding after a particularly weak trading period this week.
Data this morning brings Michigan Sentiment (exp 81.2) as well as some further secondary price indices, Import and Export prices, which have been running well above 10% each. The point is there is inflationary pressure everywhere.
It is not surprising that after a week where the dollar was broadly stronger, it softens on Friday, but nothing has changed the short-term view that modestly higher US yields will lead to further dollar strength. Keep an eye on the 1.1704 level in EURUSD, which I believe can be a catalyst for a much larger move higher in the dollar if it breaks.
Good luck, good weekend and stay safe