The central banks of the G10
Are starting to realize the ‘when’
Of interest rate rises
To forestall a crisis
Is sooner than they thought back then
Inflation breakevens keep rising
While companies are proselytizing
That they’re not to blame
As costs are aflame
Thus CB’s, their plans, are revising
It is difficult to scan a news source these days without seeing a story of how some company or another is raising their prices by X% due to increased shipping/raw material costs/labor costs. And the reporter doesn’t really have to look that hard for the typical anecdotes that accompany this type of story since the situation has become increasingly prevalent. Just this morning I read about Unilever, WD-40 and P&G all explaining that prices have not only already risen but would be rising further in the months ahead. Obviously, this does not bode well for the transitory narrative, which is in its death throes. That being said, it is still not the universal opinion of all Fed members. For instance, yesterday NY Fed president John Williams exclaimed that long-term inflation expectations have risen to levels “consistent with the 2% goal.” Now, I’m not sure what long-term expectations he is looking at, but yesterday, the 5-year/5-year inflation rate in the US Treasury market closed at 2.915%, its highest level since the series began in 2002. The 19-year history of this measure shows an average of 1.85%, which seems more in line with Williams’ comments. But one must be willfully blind to look at the chart of this series and claim inflation expectations remain sedate.
The risk for the central banks that maintain inflation is not a growing issue is loss of whatever credibility they have remaining. And the upshot is, markets are not listening to them anymore and have begun to price in more aggressive rate hikes around the world. In the US, the first rate hike is priced for next July, right about the time the Fed previously expected to finish tapering. And there is a second hike priced in before the end of 2022. In the UK, the first hike is priced for this December with three more expected by next September. Even in the Eurozone, a full hike is priced in by the end of next year, something that not a single ECB banker has expressed, and in fact, several have categorically denied.
At the same time, longer term yields are rising as well, with 10-year Treasuries up to 1.68% even after having fallen 2.1 bps in the overnight session. German bunds, while still negative (-0.09%) are at their highest level since May 2019, which was the last time their yield was at 0.0%. And we are seeing similar price action across Gilts, OATs and Australian GBs. (The latter despite the fact that the RBA remains adamant that they will not be raising interest rates until 2024. Methinks they will have some crow to eat on that subject.)
The problem for central banks, and their respective governments, is that given the extraordinary amount of debt outstanding, higher yields can quickly become a problem. So, ask yourself how can a central bank prevent rising yields without raising front end rates or expanding their balance sheets further? You will not like this answer but here is a taste of what could be coming our way; regulatory changes that force institutions to buy government bonds. Consider the ease with which central banks could require commercial banks to expand the ratio of government bonds in their asset portfolio, or insurance companies or pension funds or all three. Financial repression can take form in many ways, and this would likely be the first step. After all, for the average person, this is a relatively esoteric process and would not likely be widely understood hence would not cause an uproar. Of course, all those insurance company and pension fund portfolios that needed to replace stock holdings with bonds would result in some pretty big selling pressure in the equity market, which would get a little more press. But central banks wouldn’t get the blame as they are one step removed from the process. In their eyes, this would be a win-win.
The implication is not that this is imminent, just that it is a possible pathway in the future, and one that seems more and more likely as inflation drives yields higher. However, for now, the market is still of the belief that central banks will be forced to raise rates and are pricing accordingly. Given the widespread nature of this belief set, the relative impact on currencies remains muted. However, if US rates continue to lead the way higher, I think the dollar will continue to see the most support.
Ok, a quick look at today shows that despite the gathering inflation clouds, risk is in vogue with equities generally higher and bonds generally softer. Last night saw modest gains in the Nikkei (+0.35%) and Hang Seng (+0.4%) although Shanghai (-0.35%) continues to feel the pain of the property situation in China. (As an aside, Evergrande made a surprise partial payment on the USD bond coupon that had been overdue and was about to trigger a default. So, it lives to default another day.) Europe, too, is having a generally positive session with the CAC (+1.1%) leading the way higher but strong gains in the DAX (+0.7%) and FTSE 100 (+0.55%). Here, the data released was the preliminary PMI data, which was best described as mixed compared to forecasts, but broadly softer compared to last month, and continues to trend lower. The outlier here was the UK, which had stronger PMI data, but much weaker than expected Retail Sales data, so perhaps offsetting news. As to US futures markets, the are either side of unchanged at this hour after this week’s rally.
Bond markets throughout the continent are seeing selling pressure with yields rising (Bunds +1.7bps, OATs +1.6bps) but Gilts (-0.8bps) have a bid along with Treasuries (-2.1bps). The trend, though remains for higher yields as investors respond to rising inflationary forecasts. Central banks have their work cut out for them if they want to maintain control of these markets.
In the commodity markets, oil (+0.4%) and NatGas (+0.8%) are back in the green as are copper (+0.75%) and gold (+0.55%). In fact, pretty much the entire complex including industrial metals and agricultural products are all firmer this morning.
Finally, the dollar is softer across the board in the G10, with AUD (+0.45%) the leading gainer on the back of the commodity picture, followed by SEK (+0.35%) and NOK (+0.35%) which are similarly well situated. The pound (+0.05%) is the laggard as the Retail Sales data seems to have undermined some bullish views. In the emerging markets, there are two outliers, one in each direction. The only loser of the day is TRY (-1.0%) which continues to suffer from yesterday’s surprising 200bps rate cut. Meanwhile, RUB (+1.4%) has been the leading gainer after the Bank of Russia surprised the market with a 75bp rate hike, much larger than the 25bp-50bp that had been forecast. Adding that to the price of oil has been an unalloyed positive. Away from those two, however, gains are modest with ZAR (+0.35%) the next best performer following commodity prices higher.
Preliminary PMI data is the only thing on the docket data wise this morning, but Chairman Powell speaks at 11:00 as the final speaker before the quiet period begins. Given the differences we heard from Williams and Waller, it will be very interesting to see if Powell is more concerned about inflation or employment.
As such, I expect a muted morning ahead of Powell’s comments and then the opportunity for some activity if he substantially changes the narrative. My sense is that any change would be hawkish and therefore a dollar positive.
Good luck, good weekend and stay safe
PS, I will be out of the office next week so no poetry again until November 1st.