Transitory is Dead

Said Jay, transitory is dead
And now when we’re looking ahead
To our consternation
It seems that inflation
Has climbed up to levels we dread

The market heard this and was stunned
Thus, equities quickly were shunned
The dollar was bought
And everyone thought
They’re better off buying the Bund

Finally!  It only took Chairman Powell 9 months to accept the reality on the ground that inflation is not likely to disappear anytime soon.  He officially ‘retired’ the word transitory as a description and confessed that inflation has been more persistent than he and the Fed had forecast.  The question that was not addressed is why the Fed thought that the supply chain bottlenecks were going to be short-lived to begin with.  After all, the primary use of ultra-cheap funding by the corporate community has been capital structure rebalancing (i.e. share repurchases) as that was the most efficient way to improve company valuations.  At least their stock market valuations.  Thus, there was never any evidence that investment was flowing toward areas that were bottle(necke)d up.

Ironically, this was partly Powell’s fault as his continued confidence that inflation was transitory, and bottlenecks would ease discouraged any company from making the investments to ease those very same bottlenecks.  Consider this, why would a company spend money to increase capacity if the benefits to be gained would be so short-lived?  And so, investments were not made, capacity remained the same and the bottlenecks persisted.

But now the Fed has acknowledged that inflation is a problem and Mr Powell has indicated that the pace of tapering QE ought to be increased.  The market read this as a doubling of the pace and so QE is now set to end in March, at least according to the punditry.  We will find out more precisely come the FOMC meeting in two weeks’ time.

Ultimately, the problem for Powell and the Fed is that a more aggressive timeline to tighten policy could potentially have a fairly negative impact on both stock and bond markets.  If that is the case, and there is no reason to believe it won’t be, Mr Powell may find himself in a similar situation as Q4 2018, when comments regarding the fact that the Fed was “nowhere near neutral” interest rates, which implied further tightening, resulted in a 20% decline in the S&P 500 Index and led to the infamous Powell Pivot on Boxing Day, when the Fed stopped tightening and began to ease policy.  Can Powell withstand a 20% decline in the S&P 500 today?  I doubt it.  10%?  Even that will be tough.  In essence, Powell now finds himself caught between President Biden’s growing concerns over inflation and the market’s likely concerns over tighter policy.  If nothing else, we should finally learn the Fed’s true master as this plays out.

So, with that in mind, let’s take a look at how markets have responded overnight.  While yesterday saw an immediate rejection of risk assets, the first bargain hunters have returned and equity markets were largely in the green overnight and on into this morning.  The Nikkei (+0.4%), Hang Seng (+0.8%) and Shanghai (+0.35%) all managed to rally amid mixed data (Japan’s PMI rising to 54.5, China’s Caixin PMI falling to 49.9) and despite ongoing concerns the omicron variant would lead to further lockdowns.

European bourses (DAX +1.4%. CAC +1.3%, FTSE 100 +1.3%) are all much firmer after the PMI data there was generally better than expected.  This is despite the fact that the OECD released its latest forecasts, slightly downgrading global growth for 2021 although maintaining its 2022 global growth forecast of 4.5%.  Pointed comments about the risks of the omicron variant accompanied the release as all the work was done before that variant became known.  Perhaps investors are looking at omicron and assuming it will delay tightening further, thus support equity values.  Finally, US futures are all pointing sharply higher this morning, at least 1.0% with NASDAQ futures +1.5% at this hour.

It should be no surprise, given risk is back in vogue, that bonds are selling off again.  The one thing that has been evident is that volatility in markets has increased and shows no signs of abating until there is a more coherent story and clarity on ultimate central bank policy.  This morning, Treasury yields (+3.6bps) have jumped as have Bunds (+2.7bps), OATs (+3.1bps) and Gilts (+5.6bps).  Perhaps more surprising is that Italian BTPs (+6.5bps) have been the worst performer on the continent as during a risk-on session, these bonds tend to outperform.  Asian bond markets performed in a similar manner as yields rallied everywhere there.

Commodity prices are at least making sense today as we are seeing strength virtually across the board.  Oil (+4.5%) is leading the energy space higher, although NatGas (-3.4%) remains disconnected and is the sole outlier.  Metals are firmer as both precious (Au +0.7%, Ag +0.2%) and industrial (Cu +0.45%, Al +0.7%, Sn +0.3%) see buying interest and agricultural prices are firmer as well.

The dollar, though, has less direction today with the G10 seeing commodity currencies stronger (NZD +0.35%, AUD +0.3%, CAD +0.25%) while financials are under modest pressure (CHF -0.2%, JPY -0.15%, EUR -0.15%).  Now, in fairness, none of these moves are that large and most likely they represent position adjustment more than anything else.  In the emerging markets, TRY (+1.8%) remains the most volatile, rising sharply (more than 8.5% at its peak) after the central bank announced they were intervening due to “unhealthy price formations” in the market.  It seems those price formations have been the result of President Erdogan continuing his campaign to lower interest rates in the face of soaring inflation.  But there were other gainers of note including MXN (+0.9%) backed by oil’s rebound, KRW (+0.8%) on the strength of stronger than forecast output data and CLP (+0.7%) on the rise in copper prices.

Data this morning brings ADP Employment (exp 525K), ISM Manufacturing (61.2) and Prices Paid (85.5) and at 2:00 this afternoon, the Fed releases the Beige Book.  Chairman Powell and Secretary Yellen testify to the House Financial Services Committee starting at 10:00, and remember, that was when the fireworks started yesterday.  I doubt we will see the same type of movement but be alert.

The dollar story has lost its conviction as previously, the thought of a more aggressive Fed would have led to a much firmer dollar.  However, we are not witnessing that type of price action here.  While I still believe that will impact the currency’s near-term movement, right now it appears that many currencies are trading on their own idiosyncratic issues without the benefit of the big picture.  If the Fed does taper more quickly and begin to raise rates, I do expect the dollar will benefit and we can see 1.10 or lower in the euro as there is absolutely no indication the ECB is going to follow suit.  However, I suspect that equity market pain will become too much for the Fed to tolerate, and that any dollar strength will be somewhat short-lived.  Payables hedgers should take advantage over the next few weeks/months, but if you are a receivables hedger, I think patience may be a virtue here.

Good luck and stay safe
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More Duration

A governor, Fed, name of Waller
Who previously had been a scholar
Remarked that inflation
Might have more duration
Which could cause a weakening dollar

As well, he explained that his view
Was rate hikes just might soon ensue
Were that to transpire
Then yields would move higher
While equity losses accrue

In what can only be termed a bit surprising, Fed governor Chris Waller, the FOMC member with the shortest tenure, explained yesterday that he is “greatly concerned abut the upside risk that elevated inflation will not prove temporary.”  While refreshing, that is certainly a far cry from the narrative that the Fed has been pushing for many months.  Of course, if one simply looks at the inflation data, which has been trending sharply higher, it seems apparent that transitory is not an apt description.  As well, he is the first Fed member to be honest in the discussion about bottlenecks and supply chain issues as he commented, “bottlenecks have been worse and are lasting longer than I and most forecasters expected, and an important question that no one knows the answer to is how long these supply problems will persist.” [emphasis added].

During the entire ‘transitory inflation’ debate, the issue with which I most disagreed was the working assumption that these transportation bottlenecks and supply chain disruptions would quickly work themselves out.  It was as though the central bank community believed that because economic models explain that higher prices lead to increased production of those goods or services, the result was a magical appearance of additional supply to push prices back down.  Meanwhile, in the real world filled with regulations, restrictions and skill and resource mismatches and misallocations, these things can take a long time to correct themselves.  There is no little irony that government regulations regarding truck drivers have significantly reduced the supply of available truckers which has led to those very bottlenecks that are now bedeviling the economy (and government).  Alas, in the great Rube Goldberg tradition, rather than simplify processes to open up supply chains, it appears that government will be adding new regulations designed to offset the current ones which will almost certainly have other negative consequences down the road.

Finally, Governor Waller was refreshingly honest in his view of things like core inflation and trimmed-mean CPI or PCE calling them, “a way of manipulating data.”  Of course, that is exactly what they are.  Central banks have relied on these lower numbers as a rationale for continuing extraordinarily easy monetary policy despite the very clear rise in inflation.   And despite Mr Waller’s comments, the Powell/Yellen narrative remains inflation is not that high and anyway it’s transitory.

As it happens, though, the bond market seems to have been listening to Waller’s comments as it sold off pretty aggressively yesterday with yields backing up 4 basis points to their highest level since May.  While this morning Treasury yields are unchanged, it is becoming clear that a trend higher in yields is manifesting itself with the market clearly targeting the highs seen in March at 1.75%.

A fair question would be to ask if this price action is occurring elsewhere in the world and the answer would be a resounding yes.  For instance, UK Gilts, which today have actually fallen 3.1bps, are trending sharply higher over the past two months and are at their highest levels since early 2019.  Today’s UK CPI report showed inflation at 3.1%, which was a tick lower than forecast, but still well above their 2.0% target.  In addition, virtually the entire MPC has acknowledged that CPI is likely to rise above 4.0% by December with a very uncertain timeline to fall back.  Governor Bailey has made it clear that they will be raising interest rates at their next meeting in early November and there has been no pushback regarding the market pricing in 3 more rate hikes in 2022.

The upshot of all this is the carefully curated narrative by the Fed and its brethren is being destroyed by events on the ground and in addition to damage control, they are trying very hard to establish the new narrative.  However, it is not clear the market is going to be so willing to go along this time.  Too, all this price pressure is occurring with a backdrop of softening economic data, with yesterday’s Housing data the latest numbers to fall both from the previous month and below forecasts.  As I’ve written before, were I Chairman Powell, I wouldn’t accept renomination even if it is offered.  The Fed chair, when things hit the fan, will not have a very good time.

On the flip side of all this distress there is the equity market, which continues blithely along the trail of rallying on every piece of news, whether good or bad.  Now that we have entered earnings season, with expectations for a strong Q2 (after all, GDP grew at 6.8%), algorithms investors remain ready to buy more of whatever is hot.  Yesterday saw solid gains across all three US indices and we continue to see more strength than weakness overseas.  In Asia, for instance, the Nikkei (+0.15%) edged higher while the Hang Seng (+1.35%) had quite a good day although Shanghai (-0.2%) continues to suffer under the ongoing pressure from the Chinese real estate market.  Today another Chinese real estate developer, Sinic, defaulted on a bond and by the end of the week the 30-day grace period for Evergrande will end and we will see if there are more ramifications there.

As to the rest of the world, both Europe (DAX +0.1%, CAC -0.1%, FTSE 100 +0.1%) and US futures are essentially flat this morning.  The investor question is, can strong earnings offset tighter monetary policy?  While we shall see over the course of the next few weeks, I suspect that a more hawkish Fed, if that is what shows up, will be very difficult to offset for the broad indices.

Commodities have taken a breather today with oil (-1.2%) and NatGas (-1.3%) slipping and dragging most other things down with them.  So, copper (-1.3%) and aluminum (-1.1%) are feeling that pain although gold (+0.7%) and silver (+1.25%) are both benefitting from either the inflation narrative or the fact that the dollar is arguably somewhat softer.

Speaking of the dollar, it is best described as mixed today, with a range of gainers and losers versus the greenback.  In the G10, NOK (-0.45%) is the worst performer, clearly suffering on the back of oil’s decline, with the pound (-0.3%) next in line after CPI printed a tick lower than expected and some thought that might dissuade the BOE from raising rates (it won’t).  But other than those two, everything else is +/- 0.15% which is indicative of nothing happening.

EMG currencies are also mixed with the biggest winners INR (+0.6%) and KRW (+0.4%) both benefitting from equity market inflows amid hopes for stronger growth.  After that, the gainers have been modest at best with nothing really standing out.  On the downside, RUB (-0.2%) following oil and CNY (-0.2%) have been the worst performers.  China is interesting as the PBOC set the fix for a much weaker than expected renminbi as it is clearly becoming a bit uncomfortable with the currency’s recent appreciation (+1.9% in past two months before last night).  Remember, for a mercantilist economy like China, excessive currency strength is an economic problem.  Look for the PBOC to continue to push against further strength.

On the data front, only the Fed’s Beige Book is released this afternoon, but we do hear from 5 more FOMC members.  Remember, nobody expected Waller’s comments to be market moving, so we must keep our antenna up for something else.

In fact, my sense is that the Fed is going to try very hard to reestablish the narrative they want regarding inflation and the future of interest rates.  That implies we are going to hear more and more from Fed speakers.  The risk is that the divide at the Fed between hawks and doves will widen to a point where no consistent narrative is forthcoming.  At that point, markets are likely to pay less attention to the comments and more to the data and expectations.  If forward guidance loses its strength, the Fed will be in a much worse position and market volatility is likely to increase substantially.  However, we have not yet reached that point.  In the meantime, the dollar is searching for its next catalyst.  Until then, consolidation of recent gains continues to be the most likely outcome.

Good luck and stay safe
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Likely to Fade

The bond market’s making it clear

Inflation, while higher this year,

Is likely to fade

Just like Jay portrayed

While bottlenecks soon disappear





The data though’s yet to support

Inflation’s rise will be cut short

Perhaps CPI

Next week will supply

The data the Fed does purport

For the past month, virtually every price indicator in the G20 has printed higher than forecast, which continues a multi-month trend and has been a key support of the inflationist camp.  After all, if the actual inflation readings continue to rise more rapidly than econometric models indicate, it certainly raises the question if there is something more substantial behind the activity.  At the same time, there has been a corresponding increase of commentary by key central bank heads that, dammit, inflation is transitory!  Both sides of this debate have been able to point to pieces of data to claim that they have the true insight, but the reality is neither side really knows.  This fact is made clear by the story-telling that accompanies all the pronouncements.  For instance, the transitory camp assures us that supply-chain bottlenecks will soon be resolved as companies increase their capacities, and so price pressures will abate.  But building new plant and equipment takes time, sometimes years, so those bottlenecks may be with us for many months.  Meanwhile, the persistent camp highlights the idea that the continued rise in commodity prices will see input costs trend higher with price rises ensuing.  But we have already seen a significant retreat from the absolute peaks, and it is not clear that a resumption of the trend is in the offing.  The problem with both these stories is either outcome is possible so both sides are simply talking their books.

While I remain clearly in the persistent camp, my take is more on the psychological effects of the recent rise in so many prices.  After all, even the Fed is focused on inflation expectations.  So, considering that recency bias remains a strongly inbred human condition, and that prices have risen recently, there is no question many people are expecting prices to continue to rise.  At the same time, one argument that had been consistently made during the pre-pandemic days was that companies could not afford to raise prices due to competition as they were afraid of losing business.  But now, thanks to multiple rounds of stimulus checks, the population, as a whole, is flush with cash.  As evidenced by the fact that so many companies have already raised prices during the past year and continue to sell their wares, it would appear that the fear of losing business over higher prices has greatly diminished.

And yet…the bond market has accepted the transitory story as gospel.  This was made clear yesterday when both Treasury and Gilt yields tumbled 8 basis points while Bund and OAT yields fell 6bps.  That is not the behavior of a bond market that is worried about runaway inflation.  

So, which is it?  That, of course, is the $64 trillion question, and one for which nobody yet has the answer.  What we can do, though, is try to determine how markets may move in either circumstance.

If inflation is truly transitory it would seem that we can look forward to a continued bull flattening of yield curves with the level of rates falling alongside the slope of the yield curve.  Commodity prices will arguably have peaked as new production comes online and equity markets will benefit significantly from lower interest rates alongside steady growth.  As to the dollar, it seems unlikely to change dramatically as lower yields alongside lower inflation means real yields will be stable.

On the other hand, if prices rise persistently for the next quarters (or years), financial markets are likely to respond very differently.  At some point the bond market will become uncomfortable with the situation and yields will start to rise more sharply amid a steeper yield curve as the Fed will almost certainly remain well behind the curve and continue to suppress the front end.  Commodity prices will have resumed their uptrend as they will be a key driver in the entire inflationary story.  Energy, especially, will matter as virtually every other product requires energy to be created, so higher energy prices will feed into the economy at large.  Equity markets may find themselves in a more difficult situation, especially the high growth names that are akin to very long duration bonds, although certain sectors (utilities, staples, REITs) are likely to hold their own.  And the dollar?  If, as supposed, the Fed remains behind the curve, the dollar will suffer significantly, as real yields will decline sharply.  This will be more evident if we continue to see policy tightening from the group of countries that have already begun that process.

In the end, though, we are all just speculating with no inside knowledge of the eventual outcome.  It is for this reason that hedging is so important.  Well designed hedge strategies help moderate the outcome regardless of the eventual results, and that is a worthy goal in itself. Hedging can reduce earnings/cash flow volatility.

Onward to today’s markets.  Starting with bonds, after yesterday’s huge rally, we continue to see demand as, though Treasury yields are unchanged, European sovereign yields have fallen by between 0.3bps (Gilts) and 1.5bps (Bunds), with the rest of the major nations somewhere in between.

Equity markets have been more mixed but are turning higher.  Last night saw the Nikkei (-1.0%) and Hang Seng (-0.4%) follow the bulk of the US market lower, but Shanghai (+0.7%) responded positively to news that the PBOC may soon be considering cutting rates to support what is a clearly weakening growth impulse in China.  (Caixin PMI fell to 50.3 in Services and 51.3 in Manufacturing, both far lower than expected in June.)  European markets have been in better stead with the DAX (+0.9%) leading the way and FTSE 100 (+0.5%) putting in a solid performance although the CAC (+0.1%) is really not doing much.  The big news here was the European Commission publishing their latest forecasts for higher growth this year and next as well as slightly higher inflation.  Finally, US futures markets are all pointing higher with the NASDAQ (+0.5%) continuing to lead the way.

Commodity prices are definitely higher this morning with oil (+1.5%) a key driver, but metals (Au +0.6%, Ag +1.0%, Cu +2.0% and Al +0.3%) all finding strong bids.  Agricultural products are also bid this morning and there is more than one analyst who is claiming we have seen the bottom in the commodity correction with higher prices in our future.

As to the dollar, it is somewhat mixed, but arguably, modestly weaker on the day.  In the G10, NZD (+0.4%), NOK (+0.3%) and AUD (+0.3%) are the leaders with all three benefitting from the broad-based commodity rally.  SEK (-0.25%) is the laggard as renewed discussion of moderating inflation pressures has investors assuming the Riksbank will be late to the tightening party thus leaving the krona relatively unattractive.

In the EMG bloc, ZAR (+0.5%), MXN (+0.35%) and RUB (+0.25%) are the leading gainers, with all three obviously benefitting from the commodity story this morning.  CNY (+0.25%) has also gained after investor inflows into the Chinese bond market supported the renminbi.  On the downside, KRW (-0.7%) and PHP (-0.6%) fell the most although the bulk of those moves came in yesterday’s NY session as the dollar rallied across the board and these currencies gapped lower on the opening and remained there.  Away from these, though, activity has been less impressive with few stories to drive things.

Two pieces of data today are the JOLTS Job Openings (exp 9.325M) and the FOMC Minutes this afternoon.  The former will simply serve to highlight the mismatch in skills that exists in the US as well as the fact that current policy with enhanced unemployment insurance has kept many potential workers on the sidelines.  As to the Minutes, people will be focused on any taper discussion as well as the conversation on interest rates and why views about rates changed so much during the quarter.

Our lone Fed speaker of the week, Atlanta Fed President Bostic, will be on the tape at 3:30 this afternoon.  To date, he has been in the tapering sooner camp, so I would expect that will remain the situation.  

Yesterday’s dollar rally was quite surprising given the decline in both nominal and real yields in the US.  However, it has hardly given back any ground.  At its peak in early April, the dollar index traded up to 93.4 and the euro fell to 1.1704.  We would need to break through those levels to convince of a sustained move higher in the dollar.  In the meantime, I expect that the odds are the dollar can cede some of its recent gains.

Good luck and stay safe

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