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