Dire Straits

The Vice-Chair explained he foresees
A time when the Fed, by degrees
Will taper their buying
Of bonds while they’re trying
To offset the spread of disease

Soon after they finish that deed
Most members already agreed
To raise interest rates
Unless dire straits
In markets don’t let them succeed

Fed Vice-Chair Richard Clarida certainly surprised markets yesterday with his speech as he laid out his reasoning that the tapering of the Fed’s current QE purchases will occur sooner than many had previously expected.  While he started out with the caveat that the Fed will not be responding to forecasts, but rather to actual economic outcomes, he then proceeded to forecast the exact sequence of events that will occur and create the proper environment for the Fed to first, taper bond purchases and second, eventually raise interest rates.  The market response was immediate, with the bond market selling off sharply, the dollar rallying and equity markets ceding early gains alongside most commodity prices.  After all, a tighter Fed is not nearly as supportive of risk assets, but neither does it imply lower interest rates.  It is also worth noting that coincident with the release of the text of his speech was the release of the ISM Services number which printed at a much higher than expected, and record level, 64.1.  So, a positive data print and a hawkish Fed speaker were sufficient to change a lot of opinions.

But not this author’s, at least not yet.  My baseline view continues to be that the Fed remains in an extremely difficult position where inflation continues at much higher levels than which they expected or with which they are comfortable, but the employment market remains far away from their restated goal of maximum employment.  As well, as Clarida noted yesterday, and as has been repeated by numerous other Fed speakers, they promise they are not going to move on forecasts or survey data, but instead wait for actual numbers (read the NFP data and core PCE) to achieve their preferred levels before altering policy.  This means that tomorrow’s NFP data will be scrutinized even more closely than usual, as Clarida’s comments yesterday imply that even more FOMC members are ready to move.

One problem with the early taper thesis is that the data may not meet the FOMC’s requirements, at least not in the near term.  For instance, yesterday’s ADP Employment release printed at 330K, less than half the expected 690K and basically one-third of the forecasts for NFP tomorrow.  While the month to month correlation between the two data points is not perfect (0.784 over the past 5 years) it is certainly high enough to imply a strong relationship between the two.  The point is that if tomorrow’s NFP number disappoints, which cannot be ruled out, and assuming that the Fed is true to their word regarding waiting for actual data to reach their preferred levels, it would certainly suggest a delay to the tapering story.  Keep in mind, as well, that the Citi Economic Surprise Index, which measures actual releases vs. forecasts, remains in negative territory, implying that the economy is slowing further rather than extending gains seen earlier in the year.  In fact, after the much worse than expected GDP print last week, it appears that growth is already slipping back toward pre-Covid trends of 1.5% – 2.0%.  Oh yeah, none of this includes the impact of the delta variant, which has resulted in numerous lockdowns around the world and augers still slower growth.

On the flip side, though, is the fact that we have seen an increasing number of FOMC members start to accept the idea that tapering will soon be appropriate.  In addition to Clarida, yesterday we also heard from SF Fed President Daly, an avowed dove, who said, “Fed will do something on asset purchases end ’21 / early ’22.”  By my count, that makes at least six different FOMC members who have indicated tapering is coming soon.  Of this group, Clarida is by far the most important, but if even the doves like Daly are coming round to that view, tapering cannot be ruled out.

To taper or not remains the $64 trillion question for all markets, and while the recent trend of the narrative seems to be pushing in that direction, without support from ongoing improvements in employment data (after all, inflation is well through their target), it will still come to naught.

One last thing on inflation.  As the Fed tries to retake the narrative from the market, be prepared for a new description of inflation.  No longer will it be transitory, but rather, perhaps, tolerable.  In other words, they will accept that it is running hotter than their target and make the excuse that it is far more important to get the nation back to work first, at which point they can use those vaunted tools they frequently mention to address rapidly rising prices.

With all this in mind, the next question is, how will these changes impact the markets?  Yesterday’s price action is likely to be a very good case study if the data continues to support an early tapering of purchases.  Any interruption in the flow of money into the capital markets will be felt by both equities and bonds in the same way, they will fall in price, while the dollar is very likely to find a lot of support vs. both G10 and EMG counterparts.  As to commodities, my inclination is that the past year’s rally will pause, at the very least, but given they remain massively undervalued vs. other asset classes, they likely still have some upside.

On to today.  Overnight price action was mixed with the Nikkei (+0.5%) rising somewhat while Chinese shares (Hang Seng -0.8%, Shanghai -0.3%) were under pressure as stories about the next sectors to feel the wrath of regulators (sin stocks) were rampant with those falling and dragging the indices with them.  fortunately, they represent a much smaller portion of the market than the tech sector, so will have a smaller negative impact if that is, indeed, the situation.  Europe is mixed this morning (DAX +0.1%, CAC +0.35%, FTSE 100 -0.2%) as the morning data was inconclusive and investors there are far more concerned with the Fed than anything else.  As to US futures, they are all modestly higher this morning, about 0.2%.

Bond markets are showing the difference between central bank policy this morning with Treasuries consolidating yesterday’s declines and unchanged on the day, while European sovereigns (Bunds -1.0bps, OATs -1.2bps) continue to see support from an ECB that is nowhere near tightening policy.  Gilts (+2.0bps) on the other hand, are selling off a bit as the BOE meeting, just ending, revealed several things.  First, they are prepared to go to negative interest rates if they need to.  Second, they will continue their current QE pace of £3.4 billion per week, and third, that they expect inflation to reach 4.0% in Q4 of this year.  They did, however, explain that if things proceed as expected, some tightening, read higher interest rates, may be appropriate.  while the initial move in the GBP was a sharp jump higher, it has already retraced those steps and at +0.2% is only modestly up on the day.

Commodity prices are mixed with oil consolidating after yesterday’s rout and unchanged on the day.  In fact, the same is true of precious and most base metals, as traders are trying to figure out their next move, so likely waiting for tomorrow’s data.

And the dollar, interestingly, is modestly softer vs. the G10 this morning, but that is after a strong rally yesterday in the wake of the Clarida speech.  The commodity bloc is leading the way (AUD +0.35%, NOK +0.3%, NZD +0.25%) despite the lack of commodity price action.  And this also sems to ignore the 6th lockdown in Melbourne since the pandemic began last year, as the delta variant continues to wreak havoc around the world.  The rest of the G10 though, has seen much less movement.  In the emerging markets, PHP (-1.0%) was by far the worst performer overnight as the covid caseload soared to record numbers and concerns over growth expanded.  After that, TRY (-0.6%) is the next worst, as President Erdogan came out with calls for a rate cut despite rampant inflation.  However, away from those two currencies, movement has been on the order of +/- 0.2%, indicating nothing very special.  Essentially, these markets have ignored Clarida.  One last thing to note here is yesterday, the central bank of Brazil raised its SELIC rate by 1.0% to 5.25%, as inflation is exploding there.  However while BRL has been modestly stronger over the past several sessions, this was widely priced in so there was no big movement.

Data-wise, today brings Initial Claims (exp 383K), Continuing Claims (3255K) and the Trade Balance (-$74.2B), none of which seem likely to change any opinions.  Rather, at this point, all eyes are on tomorrow’s NFP data.  We also hear from two Fed speakers, Governor Waller and Minneapolis President KashKari, who is arguably the most dovish of all.  certainly if he starts talking taper, then the die is cast.  We shall see.

As I said, if tapering is on the cards, the dollar will likely test its highs from March/April, so be prepared.

Good luck and stay safe
Adf

High Tide

The dollar continues to slide
But is risk approaching high tide?
Last night t’was the Kiwis
Who hinted that their ease
Of policy may soon subside

As well, from the Fed yesterday
Three speakers had two things to say
It soon may be time
To change paradigm
Inflation, though, ain’t here to stay

There will come a time in upcoming meetings, we’ll be at the point where we can begin to discuss scaling back the pace of asset purchases.”  So said, Fed Vice-Chairman Richard Clarida yesterday.  “We are talking about talking about tapering,” commented San Francisco Fed President Mary Daly in a CNBC interview yesterday.  And lastly, Chicago Fed President Charles Evans explained, “the recent increase in inflation does not appear to be the precursor of a persistent movement to undesirably high levels of inflation.  I have not seen anything yet to persuade me to change my full support of our accommodative stance for monetary policy or our forward guidance about the path for policy.”

The Fed’s onslaught of forward guidance continues at full speed as virtually every day at least two or three Fed speakers reiterate that policy is perfect for the current situation, but in a nod to the growing chorus of pundits about higher inflation, they are willing to indicate that there will come a time, at some uncertain point in the future, when it may be appropriate to consider rolling back their current policy initiatives.

But ask yourself this; if inflation is going to be transitory, that implies that the current policy settings are not a proximate cause of rising prices.  If that is the case, why discuss tapering?  After all, high growth and low inflation would seem to be exactly the outcome that a central bank wants to achieve, and according to their narrative, that is exactly what they have done.  Why change?

This is just one of the conundra that is attendant to the current Fed policy.  On the one hand, they claim that their policy is appropriate for the current circumstance and that they need to see substantial further progress toward their goals of maximum employment and average 2% inflation before considering changing that policy.  On the other hand, we have now heard from five separate FOMC members that a discussion about tapering asset purchases is coming, which implies that they are going to change their policy.  Allegedly, the Fed is not concerned with survey data, but want to see hard numbers showing they have achieved their goals before moving.  But those hard numbers aren’t here yet, so why discuss changing policy?

The cynical answer is that the Fed actually doesn’t focus on unemployment and inflation, but rather on the equity markets foremost and the bond market secondarily.  Consider, every time there has been a sharp dislocation lower in stocks, the Fed immediately cuts rates to try to support the S&P.  This has been the case since the Maestro himself, Alan Greenspan, responded to the 1987 stock market crash and has served to inflate numerous bubbles since then.

A more charitable explanation is that they have begun to realize that they are in an increasingly untenable position.  Since the GFC, the Fed has consistently been very slow to reduce policy accommodation when the opportunity arose and so the history shows that rates never regain their previous peak before the next recession comes along.  Recall, the peak in Fed funds since 2009 was just 2.50%, reached in December 2018 just before the Powell Pivot in the wake of a 20% drawdown in the S&P 500.  In fact, since 1980, every peak in Fed Funds has been lower than the previous one.  The outcome of this process is that the Fed will have very little room to cut rates to address the next recession, which is what led to QE in the first place and more importantly has served to reduce the Fed’s influence on the economy.  Arguably, then, a major reason the Fed is keen to normalize policy is to retain some importance in policymaking circles.  After all, if rates are permanently zero, what else can they do?

It is with this in mind that we turn our attention elsewhere in the world, specifically to New Zealand, where the RBNZ signaled that its Official Cash Rate (Fed funds equivalent) may begin to rise in mid-2022.  This is a full year before previous expectations and makes the RBNZ the 3rd G10 central bank to talk about tightening policy sooner than thought.  The Bank of Canada has already started to taper QE purchases and the BOE has explained they will be starting next year as well.  It should be no surprise that NZD (+1.15%) is the leading gainer in the FX market today, nor that kiwi bonds sold off sharply with 10-year yields rising 8bps.

Do not, however, mistake this for a universal change in policy paradigm, as not only is the Fed unwilling to commit to any changes, but the BOJ remains in stasis and the ECB, continues to protest against any idea that they will be tightening policy soon.  For instance, just this morning, ECB Executive Board Member and Bank of Italy President, Fabio Panetta, said, “Only a sustained increase in inflationary pressures, reflected in an upward trend in underlying inflation and bringing inflation and inflation expectations in line with our aim, could justify a reduction in our purchases.  But this is not what we projected in March.  And, since then, I have not seen changes in financing conditions or the economic outlook that would sift the inflation path upward.”

Investors and traders have been moving toward the view that the ECB would be tapering purchases before 2023 as evidenced by the rise in the euro as well as the rise in European sovereign yields.  But clearly, though there are some ECB members (Germany, the Netherlands) who would be very much in favor of that action, it is by no means a universal view.  Madame Lagarde will have her hands full trying to mediate this discussion.

For now, the situation remains that the central bank narrative is still the most important one for markets, and the fact that we are seeing a split amongst this august group is a key reason FX volatility remains under pressure.  The lack of an underlying theme to drive the dollar or any bloc of currencies in one direction or the other leaves price action beholden to short-term effects, large orders and the speculator community.  We need a new paradigm, or at least a reinvigoration of the old one to get real movement.

In the meantime, the dollar continues to drift lower as US yields continue to drift lower.  Right now, the bond market appears to have faith in the Fed narrative of transitory inflation, and as long as that is the case, then a weaker dollar and modestly higher stock prices are the likely outcome.

Today’s price action, NZD excepted, showed that to be the case, with APAC currencies performing well, but otherwise a mixed bag.  Equity markets are marginally higher and bond yields have largely fallen in Europe, although Treasuries are little changed after a 4bp decline yesterday.  Gold is actually the biggest winner lately, having traded back above $1900/oz as investors watch the slow destruction of fiat currency values.  But in the FX space, the USD-Treasury link remains the most important thing to watch.

Good luck and stay safe
Adf

Gazumped

While measured inflation has jumped
And stock markets, Powell has pumped
The dollar is queasy
As money this easy
Has bulls concerned they’ll get gazumped

But its not just Powell who’s saying
That QE and ZIRP will be staying
Almost to a man
The Fed’s master plan
Is printing and buying…and praying

Once again, yesterday, we heard from several FOMC members and each of them highlighted that the data has not yet come close to describing the “substantial progress” they are seeking with respect to reduced unemployment and so it is not nearly time to begin even thinking about tapering.  Well, except for the lone quasi-hawkish voice of Dallas Fed President Robert Kaplan, who did express concern that the Fed’s actions were part of the reason that asset prices are so high.  But not to worry, Mr Kaplan will not be a voter until 2023, so will not even be able to officially register his disagreement with policy for two more years.  In other words, based on everything we continue to hear, we can expect a series of 9-0 votes every six weeks to maintain current policy.

It is this ongoing messaging, which comes not only from the Fed but from the ECB and BOJ as well, that continues to drive the narrative as well as market prices.  Inflation?  Bah, it’s transitory and while 2021 may see some higher readings, it will all disappear by 2022.  Bubbles?  Bah, central banks cannot detect them and, even if they could, it is not their job to deflate them.  It has become abundantly clear that the three big central banks have jointly decided that the only thing that matters is the unemployment rate, and until that data is back at record low levels, regardless of what else is happening in the economy, the current state of QE and ZIRP/NIRP is going to remain in place.

Thus, it cannot be that surprising this morning that the dollar has begun to slide a bit more in earnest, while risk appetite, as measured by equity prices remains robust.  A very large segment of the punditry continue to harp on concerns over rising inflation and how the Fed and other central banks will be forced to adjust their policy to prevent it from getting out of hand.  But simply listening to virtually every central banker tells us that nothing is going to change.

Through that April employment report, we have not made substantial further progress,” said Fed Vice-Chair Richard Clarida yesterday.  Meanwhile, from the ECB, Francois Villeroy de Galhau explained this morning, “Today there’s no risk of a return of lasting inflation in the euro area, and so there’s no doubt that the ECB’s monetary policy will remain very accommodative for a long time.  I want to say that very clearly.”  I don’t know about you, but it seems pretty clear that the concept of tapering QE purchases, let alone raising interest rates, is not even on the table.

Now, smaller central banks have changed their tune, notably the Bank of Canada and Sweden’s Riksbank, with the former actually reducing QE purchases while the latter has promised to do so shortly.  As well, the Bank of England has begun the discussion about reducing policy support as the economy there continues to open rapidly, and growth picks up.  As such, it should not be that surprising that those three currencies (GBP +2.75%, CAD +2.1%, SEK +1.9%) are the leading gainers vs. the dollar so far this month.

Perhaps what is also interesting is that the euro is strengthening so clearly vs. the dollar despite the strong words by ECB members regarding the maintenance of easy money.  It appears that the market has a stronger belief in the Fed’s willingness to ignore the repercussions of their policy choices than that of the ECB.  Remember, in the end, Europe remains reliant on Germany as its engine of growth and largest economy, and German DNA, ever since the Weimar hyperinflation in the 1920’s favors tighter policy, not looser.  Madame Lagarde will have a tougher battle to maintain easy policy if the data starts to point higher than will Chairman Powell.  Right now, however, that is all theoretical regarding both banks.  Easy money is here for the foreseeable future, which means that risk appetite is likely to remain strong, driving up stock and commodity prices while the dollar sinks.

What about bonds, you may ask?  Haven’t they been the key driver?  The answer is that they have been the key driver,  but a close look at statistics like inflation breakevens, and more importantly, the shape of the breakeven curve, offer indications that even though near-term expectations are for much higher inflation, more and more investors are buying the transitory story.  If that is, in fact, the case, then there is ample room for bonds to rally as well, which would be quite the shock to all the inflationistas out there.

This morning is exhibit A regarding the impact of increased risk appetite.  Equity markets around the world are higher with Asia (Nikkei +2.1%, Hang Seng +1.4%, Shanghai +0.3%) putting in some very strong performances while Europe (DAX +0.25%, CAC +0.2%, FTSE 100 +0.4%) are all green, but have come off their best levels of the morning.  US futures are also pointing higher, with gains ranging from 0.2% (Dow) to 0.7% (Nasdaq).

The bond market, meanwhile, is directionless, with yields for Treasuries (-0.5bps) and European sovereigns (Bunds 0.0bps, OATs -0.7bps, Gilts +0.7bps) all trading in narrow ranges.  If you consider that given the increase in risk appetite as evidence by stocks, commodities and the dollar, the very fact that bonds are not selling off is actually a bullish sign.

Speaking of commodities, Brent crude (+0.6%) traded above $70/bbl for the first time since November 2018 this morning and WTI is firmer by a similar amount.  Metals prices continue to rally (Au 0.0%, Ag +0.8%, Cu +1.0%, Al +0.7%), as do foodstuffs (Soybeans +0.6%, Wheat +0.75%, Corn +1.7%).  While it is not clear how much longer commodity prices will rally, it seems abundantly clear, based on their price action, that the rally has more legs.

And finally, the dollar, which as mentioned above is under pressure, is having a really bad day.  Versus its G10 counterparts, the dollar is softer across the board with NZD (+0.7%), NOK (+0.6%) and CHF (+0.55%) leading the way.  But the euro (+0.45%) is also much firmer and now trading above 1.22 for the first time since early February.  If you recall, 1.2350 was the high seen the first week of January, and in order to truly change opinions, the euro will have to trade through that level.  With the dollar so weak, it certainly seems like there is a good chance to get there soon.

EMG markets are also seeing pretty uniform gains with ZAR (+0.7%), HUF (+0.65%) and PLN (+0.6%) leading the way, the former on the back of commodity price strength while the two CE4 currencies are benefitting from the belief that both central banks may be tightening policy shortly as well as the euro’s strength.  But we saw strength overnight in the APAC currencies as well (KRW +0.4%, SGD +0.4%, TWD +0.35%) as they all are responding to the broad-based dollar weakness.

On the data front, today brings Housing Starts (exp 1702K) and Building Permits (1770K), with both simply showing that the housing market remains on fire.  Meanwhile, only Robert Kaplan is scheduled to speak, but we already know what he thinks (tapering needs to start soon) and we also know his is a lone voice in the wilderness.  It would not surprise me if we had a surprise series of comments from another FOMC member just to counter his views.

Looking ahead to the session, there is no reason to believe that the dollar’s weakness is going to change anytime soon.  Unless Treasury yields start to back up smartly, risk appetite is the dominant story today, and that bodes ill for the dollar.

Good luck and stay safe
Adf

Don’t Get Carried Away

The data released yesterday
Had Fed speakers try to downplay
The idea that prices
Are causing a crisis
They said, don’t get carried away

But markets worldwide have all swooned
As traders are highly attuned
To signals inflation
In every location
Will quickly show that it’s ballooned

Wow!  That’s pretty much all you can say about the CPI data yesterday, where, as I’m sure you are by now aware, the numbers were all much higher than expected.  To recap, headline CPI rose 0.8% M/M which translated into a 4.2% Y/Y increase.  Ex food & energy, the monthly gain was 0.9%, with the Y/Y number jumping to 3.0%.  To give some context, the core 0.9% gain was the highest print since 1981.  It appears, that at least for one month, the combination of unlimited printing of money and massive fiscal spending did what many economists have long feared, awakened the inflation dragon.

The Fed was in immediate damage control mode yesterday, fortunately having a number of speakers already scheduled to opine, with Vice-Chair Richard Clarida the most visible.  His message, along with all the other speakers, was that this print was of no real concern, and in truth, somewhat expected, as the reopening of the economy would naturally lead to some short-term price pressures as supply bottlenecks get worked out.  As well, they highlighted the fact that much of the gain was caused by just a few items, used car prices and lodging away from home, neither of which is likely to rise by similar amounts again next month.  That may well be true, but the elephant in the room is the question regarding housing inflation and its relative quietude.

House prices, at least according to the Case Shiller Index, are screaming higher, up 12% around the country in the past 12 months and showing no signs of slowing down.  The pandemic has resulted in a significant amount of displacement and as people move, they need some place to live.  The statistics show that there is the smallest inventory of homes available in decades.  As well, the rocketing price of lumber has added, apparently, $34,000 to the price of a new house compared to where it was last year, which given the median house price in the US is a touch under $300,000, implies a more than 10% rise in price simply due to the cost of one material.  And yet, Owners Equivalent Rent, the housing portion of the CPI data, rose only at 0.21% pace.  A great source of inflation information is Mike Ashton (@inflation_guy), someone you should follow as he really understands this stuff better than anyone else I know.  As he explains so well, this is likely due to the eviction moratorium that has been in place for more than a year, so rents paid have been declining.  However, that moratorium has just been overturned in a court decision and so we should look for the very hot housing market to soon be reflected in CPI.  That, my friends, will be harder to pass off as transitory.

The reason all this matters is because the entire Fed case of maintaining ZIRP in their efforts to achieve maximum employment, is based on the fact that inflation is not a problem, so they have no reason to raise rates.  However, if they are wrong on this issue, which is the only issue on which they focus, it results in the Fed facing a very difficult decision; raise rates to fight inflation and watch securities prices deflate dramatically or stay the course and let inflation continue to rise until it potentially gets out of control.  While we all know they have the tools, the decision to use them will be far more challenging than I believe most of them expect.

The market’s initial reaction to the data was a broad risk-off session, as equity prices fell sharply in Europe and the US yesterday and then overnight in Asia (Nikkei -2.5%, Hang Seng -1.8%, shanghai -1.0%) they followed the trend. Europe this morning (DAX -1.4%, CAC -1.1%, FTSE 100 -2.0%) is still under pressure as the global equity bubble is reliant on never-ending easy money.  Rising inflation is the last thing equity markets can abide, so these declines can not be surprising.  The question, of course, is will they continue?  A one- or two-day hiccup is not really a problem, but if investors start to get nervous, it is a completely different story.  It is certainly true that valuations for equities, at least as measured by traditional metrics like P/E and P/S are at extremely high levels.  A loss of confidence that the past is prologue could well see a very sharp correction.

Despite the risk off nature of the equity market price action, bonds were also sold aggressively yesterday and in the overnight session.  It ought not be surprising given that bonds should be the worst performing asset in an inflationary spike, but still, the 10-year Treasury jumped more than 7 basis points yesterday, a pretty big move.  While this morning it is essentially unchanged, the same cannot be said for the European sovereign market where yields have risen again, between 1.5bps (Bunds) and 5.1bps (Italian BTPs) with the rest of the continent sandwiched in between.  Nothing has changed my view that the 10-year Treasury yield remains the key market driver, at least for now, thus if yields continue to rally, look for more downward pressure on stocks and commodities and upward pressure on the dollar.

Speaking of commodities, they are under pressure across the board this morning with WTI (-2.1%) leading the way lower but Cu (-1.7%) having its worst day in months.  The entire base metal complex is lower as are virtually all agriculturals, although the precious metals are holding up as a bit of fear creeps into the investor psyche.

Finally, the dollar, which rallied sharply yesterday all day in the wake of the CPI print, is more mixed this morning gaining against the G10’s commodity bloc (NOK -0.3%, AUD -0.2%) while suffering against the European bloc (CHF +0.25%, EUR +0.1%) although the magnitude of the movements have been small enough to attribute them to modest position adjustments rather than an overriding narrative.  We are seeing a similar split in the EMG currencies, with APAC currencies all under pressure (THB -0.5%, KRW –0.4%, TWD -0.2%) while the CE4 hold their own (PLN +0.3%, HUF +0.3%, CZK +0.2%).  At this time, LATAM currencies, which all suffered yesterday, are either unchanged or unopened.

This morning’s data brings Initial Claims (exp 490K) and Continuing Claims (3.65M) as well as PPI (0.3% M/M, 5.8% Y/Y) headline and (0.4% M/M, 3.8% Y/Y ex food & energy).  Of course, with the CPI already out, this is unlikely to have nearly the impact as yesterday.  In addition, we get three more Fed speakers to once again reiterate that yesterday’s CPI data was aberrational and that any inflation is transitory.  I guess they hope if they say it often enough, people may begin to believe them.  But that is hard to do when the prices you pay for stuff continues to rise.

Treasuries remain the key.  If yields rally again (and there is a 30-year auction today) then I expect the dollar to take another leg higher.  If, on the other hand, yields drift back lower, look for the dollar to follow as equity buyers dip their toes back into the water.

Good luck and stay safe
Adf

We’ll Be Behind

The Chair and the Vice-Chair both said
Before we raise rates at the Fed
We’ll taper our buying
While we’re verifying
If growth can keep moving ahead

So, don’t look at forecasts ‘cause we
Care only for hard stats we see
Thus, we’ll be behind
The curve, but you’ll find
Inflation we’ll welcome with glee

The Fed has made clear they are driving the bus looking only in the rearview mirror.  This is a pretty dramatic change in their modus operandi.  Historically, given the widespread understanding that monetary policy works with a lag of anywhere from 6 months to 1 year, the Fed would base policy actions on their forecasts of future activity.  This process was designed to prevent inflation from rising too high or allowing growth to lag too far from trend.  One of the problems they encountered, though, was that they were terrible forecasters, with their models often significantly understating or overstating expectations of future outcomes.

So, kudos to Chairman Powell for recognizing they have no special insight into the future of the economy.  It is always difficult for an institution, especially one as hidebound as the Federal Reserve, to recognize its shortcomings.  This does beg the question, though, if they are going to mechanically respond to data with policy moves, why do they even need to be involved at all?  Certainly, an algorithm can be programmed to make those decisions without the added risk of making policy errors. Instead, the Fed could concentrate on its role as banking supervisor, an area in which they have clearly fallen behind.  But I digress.

Back in the real world, this change, which they have been discussing for some time, is truly important.  It seems to be premised on the idea that measured inflation remains far below their target, so running the economy ‘hot’ is a desirable way to achieve that target.  And running the economy hot has the added benefit of helping to encourage maximum employment in the economy, their restated goal on that half of the mandate.  It also appears to assume that they have both the tools, and the wherewithal to use them, in case inflation gets hotter than currently expected.  It is this last assumption that I fear will come back to haunt them.  But for now, this week’s CPI data did nothing to scare anybody and they are feeling pretty good.

One other thing they both made clear was that the timing of any rate hike was absolutely going to be after QE purchases are completed.  So, the tapering will begin at some point, and only when they stop expanding the balance sheet will they consider raising the Fed Funds rate.  Right now, the best guess is late 2023, but clearly, since they are data driven, that is subject to change.

There is a conundrum, though, in the markets.  Despite this very clear policy direction, and despite the fact that bond investors are typically quite sensitive to potential inflation, Treasury yields have seemingly peaked for the time being and continue to slide lower.  Certainly, the auctions this week, where the Treasury issued $120 billion in new debt were all well received, so concerns over a buyer’s strike were overblown.  In fact, overnight data showed that Japanese buyers soaked up nearly $16 billion in bonds, the largest amount since last November.  But, depending on how you choose to measure real interest rates, they remain somewhere between 0.0% and -1.0% based on either Core or Headline CPI vs. the 10-year.  Traditionally, headline has been the measure since it represents everything, and for a bond investor, they still need to eat and drive so those costs matter.

Summing this all up tells us 1) the Fed is 100% reactive to data now, so overshooting in their targets is a virtual given; 2) interest rates are not going to rise for at least another two years as they made clear they will begin tapering their QE purchases long before they consider raising interest rates; and 3) the opportunity for increased volatility of outcomes has grown significantly with this new policy stance since, by definition, they will always be reactive.  To my mind, this situation is one where the current market calm is very likely preceding what will be a very large storm.  If central banks handcuff themselves to waiting for data to print (and remember, hard data is, by definition, backwards looking, generally at least one month and frequently two months), trends will be able to establish themselves such that the Fed will need to respond in a MUCH greater manner to regain control.  Markets will not take kindly to that situation.  But that situation is not yet upon us, so the bulls can continue to run.

And run they have, albeit not as quickly as they have been recently.  In Asia overnight, it was actually a mixed performance with the Nikkei (+0.1%) eking out a small gain while the Hang Seng (-0.4%) and Shanghai (-0.5%) both stumbled slightly.  Europe, on the other hand, is all green with gains ranging between 0.2% and 0.4% across the major markets.  US futures are actually looking even better, with gains of 0.45%-0.6% at this hour.  Earnings season started yesterday, and the big banks all killed it in Q1, helping the overall market.

Bond yields, meanwhile, are continuing to slide, with Treasuries (-1.9bps) continuing to show the way to virtually all Western bond markets.  Bunds (-1.6bps), OATs (-2.0bps ) and Gilts (-2.7bps) are rallying as well despite the generally upbeat economic news.  There was, however, one negative release, where the German economic Institutes have cut their GDP forecast by 1.0%, to 3.7%, after the third wave and concomitant lockdowns.

Oil prices, which have had a huge runup this week, have slipped a bit, down 0.5%, but the metals markets are all in the green with Au (+0.6%), Ag (+0.6%), Cu (+1.5%) and Al (+0.25%) all in fine fettle.

It can be no surprise that with Treasury yields lower and commodity prices generally higher, the dollar is under further pressure this morning.  In the G10, the commodity bloc is leading the way with NZD (+0.25%), CAD (+0.2%) and AUD (+0.2%) all performing well.  There are a few laggards, but the movement there is so small, it is hardly a sign of anything noteworthy.  The euro, for instance, is lower by 0.1%, truly unremarkable.  In the EMG bloc, RUB (-1.2%) is the biggest mover, suffering on the news that the Biden Administration is slapping yet more sanctions on Russia for their election meddling efforts.  After that, HUF (-0.4%) has suffered as the central bank maintains its rate stance despite quickening inflation readings.  On the plus side, ZAR (+0.65%) and MXN (+0.3%) are the leading gainers, both clearly benefitting from the commodity story today.

One thing to watch here is the technical picture as despite the slow-motion decline in the dollar since the beginning of the month, it is starting to approach key technical support levels with many traders looking for a breakout should we breach those levels.  We shall see, but certainly if Treasury yields continue to slide, the dollar is likely to slide further.

We have a bunch of data today led by Initial Claims (exp 700K), Continuing Claims (3.7M), Retail Sales (+5.8%, +5.0% ex autos) and then Empire Manufacturing (20.0), Philly Fed (41.5), IP (2.5%) and Capacity Utilization (75.6%).  The Retail Sales data is based on the second stimulus check being spent, and the Claims data is assuming strength based on the NFP from last month.    We also hear from a bunch more speakers, but Powell and Clarida are done, so it would be surprising to see anything new from this group of three.

All told, nothing has changed my view that as goes the 10-year Treasury yield, so goes the dollar.  That will need to be proven wrong consistently before we seek another narrative.

Finally, I will be taking a few, very needed, days off so there will be no poetry until I return on Thursday April 22.

Good luck, good weekend and stay safe
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Perfect Right Here

Said Harker, by end of this year
A taper could be drawing near
But Mester explained
No cash would be drained
As policy’s perfect right here

Ahead of this morning’s payroll report, I believe it worthwhile to recap what we have been hearing from the FOMC members who have been speaking lately.  After all, the Fed continues to be the major force in the market, so maintaining a clear understanding of their thought process can only be a benefit.

The most surprising thing we heard was from Philadelphia Fed president Harker, who intimated that while he saw no reason to change things right now, he could see the Fed beginning to taper their asset purchases by the end of 2021 or early 2022.  Granted, that still implies an additional $1 trillion plus of purchases, but is actually quite hawkish in the current environment where expectations are for rates to remain near zero for at least the next three years.  Given what will almost certainly be a significant increase in Treasury issuance this year, if the Fed were to step back from the market, we could see significantly higher rates in the back end of the curve.  And, of course, it has become quite clear that will not be allowed as the government simply cannot afford to pay higher rates on its debt.   As well, Dallas Fed President Kaplan also explained his view that if the yield curve steepened because of an improved growth situation in the US, that would be natural, and he would not want to stop it.

But not to worry, the market basically ignored those comments as evidenced by the fact that the equity market, which will clearly not take kindly to higher interest rates in any form, rallied further yesterday to yet more new all-time highs.

At the same time, three other Fed speakers, one of whom has consistently been the most hawkish voice on the committee, explained they saw no reason at all to adjust policy anytime soon.  Regional Fed presidents from Cleveland (Loretta Mester), Chicago (Charles Evans) and St Louis (James Bullard) were all quite clear that it was premature to consider adjusting policy as a response to the Georgia election results and the assumed increases in fiscal stimulus that are mooted to be on the way.

Recapping the comments, it is clear that there is no intention to adjust policy, meaning either the Fed Funds rate or the size of QE purchases, anytime soon, certainly not before Q4.  And if you consider Kaplan’s comments more fully, he did not indicate a preference to reduce support, just that higher long-term rates ought to be expected in a well-performing economy.  Vice-Chairman Clarida speaks this morning, but it remains difficult to believe that he will indicate any changes either.  As I continue to maintain, the government’s ability to withstand higher interest rates on a growing amount of debt is limited, at best, and the only way to prevent that is by the Fed capping yields.  Remember, while the Fed has adjusted its view on inflation, now targeting an average inflation rate, they said nothing about allowing yields to rise alongside that increased inflation.  Again, the dollar’s performance this year will be closely tied to real (nominal – inflation) yields, and as inflation rises in a market with capped yields, the dollar will decline.

Turning to this morning’s payroll release, remember, Wednesday saw the ADP Employment number significantly disappoint, printing at -123K, nearly 200K below expectations.  As of now, the current median forecasts are as follows:

Nonfarm Payrolls 50K
Private Payrolls 13K
Manufacturing Payrolls 16K
Unemployment Rate 6.8%
Average Hourly Earnings 0.2% (4.5% Y/Y)
Average Weekly Hours 34.8
Participation Rate 61.5%
Consumer Credit $9.0B

Source: Bloomberg

These numbers are hardly representative of a robustly recovering economy, which given the cresting second wave of Covid infections and the lockdowns that have been imposed in response, ought not be that surprising.  The question remains, will administration of the vaccine be sufficient to change the trajectory?  While much has been written about pent up demand for things like travel and movies, and that is likely the case, there has been no indication that governments are going to roll back the current rules on things like social distancing and wearing masks.  One needs to consider whether those rules will continue to discourage those very activities, and thus, crimp the expected recovery.  Tying it together, a slower than expected recovery implies ongoing stimulus

But you don’t need me to explain that permanent stimulus remains the basic premise, just look at market behavior.  After yesterday’s US equity rally, we have seen a continuation around the world with Japan’s Nikkei (+2.35%) leading the way in Asia, but strength in the Hang Seng (+1.2%) and Australia (+0.7%), although Shanghai (-0.2%) didn’t really participate.  Europe, too, is all green, albeit in more measured tones, with the DAX (+0.8%) leading the way but gains in the CAC (+0.5%) and FTSE 100 (+0.2%) as well as throughout the rest of the continent.  And finally, US futures are all pointing higher at this hour, with all three indices up by 0.25%-0.35%.

The Treasury market, which has sold off sharply in the past few sessions, is unchanged this morning, with the yield on the 10-year sitting at 1.08%.  In Europe, haven assets like bunds, OATs and gilts are little changed this morning, but the yields on the PIGS are all lower, between 1.6bps (Spain) and 3.9bps (Italy).  Again, those bonds behave more like equities than debt, at least in the broad narrative.

In the commodity space, oil continues to rally, up another 1.3% this morning, and we continue to see strength in base metals and ags, but gold is under the gun, down 1.1%, and clearly in disfavor in this new narrative of significant new stimulus and growth.  Interestingly, bitcoin, which many believe as a substitute for gold has continued to rally, vaulting through $41k this morning.

And lastly, the dollar, which everyone hates for this year, is ending the week on a mixed note.  In the G10, NOK (+0.3%) is the best performer, as both oil’s rise and much better than expected IP data have investors expecting continued strength there.  But after that, the rest of the bloc is +/- 0.2% or less, implying there is no driving force here, rather that we are seeing position adjustments and, perhaps, real flows as the drivers.

In the emerging markets, ZAR (+1.2%) and BRL (+0.6%) are the leading gainers, while IDR (-0.8%) and CLP (-0.6%) are the laggards.  In fact, other than those, the bloc is also split, like the G10, with winners and losers of very minor magnitude.  Looking first at the rand, today’s gains appear to be position related as ZAR has been under pressure all week, declining more than 5.6% prior to today’s session.  BRL, too, is having a similar, albeit more modest, correction to a week where it has declined more than 5% ahead of today’s opening.  Both those currencies are feeling strain from weakening domestic activity, so today’s gains seem likely to be short-lived.  On the downside, IDR seems to be suffering from rising US yields, as the attractiveness of its own debt starts to wane on a relative basis.  As to Chile, rising inflation seems to be weighing on the currency as there is no expectation for yields to rise in concert, thus real yields there are under pressure.

And that’s really it for the day.  We have seen some significant movement this week, as well as significant new news with the outcome of the Georgia election, so the narrative has had to adjust slightly.  But in the end, it is still reflation leads to higher equities and a lower dollar.  Plus ça change, plus ça meme chose!

Good luck, good weekend and stay safe
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