QE’s Paradigm

Said Daly, this “pop” was expected
But basically, we have projected
This only will last
A few months, then pass
Thus, higher rates we have rejected

Said Bullard, it may well be time
To alter QE’s paradigm
By end of this year
It ought to be clear
That tapering is not a crime

And finally, today Chairman Jay
Is like to have something to say
‘Bout why rising prices
Do not mean a crisis
Is brewing and soon on the way

The one thing about writing this note on a daily basis is that you really get to see the topic du jour.  In fact, arguably, that is the purpose of the note.  When Brexit happened in 2016, it was likely the topic of 75% of my output.  Covid dominated last year for at least 3 months, where virtually every discussion referenced its impact.  And now we are onto the next topic which just will not go away.  In fact, if anything it is growing in importance.  Of course, I mean inflation.

By now you are all aware that June’s CPI reading was 5.4% on a headline basis and 4.5% ex food & energy with both readings substantially higher than forecasted by the punditry.  The monthly gains in both series was 0.9%.  Now my rudimentary math skills tell me that if I annualized 0.9%, I would wind up with an inflation rate of 11.4%.  I don’t know about you, but to me that number represents some real problems.  Of course, despite the reality on the ground, the FOMC cannot possibly admit that their policies are driving the economy into a ditch, so they continue to spin a tale of transitory price gains that are entirely due to short-term impacts on supply chains and gains relative to last year’s extremely depressed prices on the back of Covid inspired lockdowns.  And while, last year’s Covid-inspired lockdowns did have a major negative impact on prices, the idea that supply chain disruptions are short-term are more an article of faith, based on economic textbook theories, than a description of reality.

In addition, the other key leg of the Fed thinking is that inflation expectations remain ‘well-anchored.’  Alas, I fear that anchor may have come loose and is starting to drift with the current of inflation prints to a higher level.  This was made evident in the NY Fed’s survey of inflation expectations released on Monday showing that people expected inflation to be 4.8% in one year’s time.  The Fed also likes to point to inflation breakevens in the market (the difference between nominal Treasury yields and their TIPS counterparts) and how those have fallen.  It is true, they are lower than we saw at the peak in mid-May (2.56%), but in the past week, they have risen 15 basis points, to 2.37%, and appear to be headed yet higher.

And this is not merely a US phenomenon.  For instance, just this morning CPI in the UK printed at 2.5%, rising a more than expected 0.4% from last month, and we have seen this occur around the world, as both developed countries (e.g. Germany, Canada and Spain) and developing nations (e.g. Brazil, India and Mexico) have all been suffering from prices rising faster than expected.  Now, there are some nations that are addressing the issue with monetary policy by tightening (Brazil, Mexico and Hungary being the latest).  But there are others that continue to whistle pass this particular graveyard and remain adamant there is no problem (US, UK Europe).

Chairman Powell testifies to the House today (my apologies for mistakenly explaining it would be yesterday) and it has the opportunity to be quite interesting.  While there will not doubt be a certain amount of fawning by some members of the committee, at least a few members have a more conservative bent and may ask uncomfortable questions.  I keep waiting to hear someone ask, ‘Chairman Powell, can you please explain why you believe my constituents are better off when paying higher prices for the items they regularly purchase?  After all, isn’t that what Fed policy to raise inflation is all about?’  Alas, I don’t expect anyone to be so bold.

In the end, based on a lot of history, Powell will never directly answer a question on inflation other than to say that it is transitory and that the current monetary policy settings are appropriate.  If pressed further, he will explain the Fed “has the tools” necessary to combat inflation, but it is not yet time to use them.  While it is possible he has a Freudian slip and reveals his true thinking, he has become pretty polished in these affairs and the audience is generally not sharp enough to throw him off his game.

To sum it all up, inflation is screaming higher rising rapidly and the Fed remains sanguine and unlikely to adjust their policies in the near future.  While Daly and Bullard, two doves who spoke yesterday, indicated that tapering QE would likely be appropriate at some point, there was no evident hurry in their views.  Consumer prices are going higher from here, count on it.

There are some nations, however, that are willing to address inflation.  We already see several raising rates and last night, the RBNZ explained they would be ending QE by next week.  This was quite a surprise to the market and so we saw 10-year yields in New Zealand jump 7.3 basis points while NZD (+1.0%) has been the best performing currency in the world as expectations are now that the RBNZ will begin raising rates by the end of the summer.  But that the Fed had this type of common sense.

Ok, enough ranting on inflation.  Let’s see how this string of higher CPI prints has been impacting markets.  On the equity front, it has not been a happy period.  Yesterday saw US markets sell off, albeit only in the 0.3%-0.4% range. But Asia was far worse (Nikkei -0.4%, Hang Seng -0.6%, Shanghai -1.1%) and Europe is entirely in the red as well (DAX -0.2%, CAC -0.25%, FTSE 100 -0.6%) with the UK leading the way lower after that CPI print.  US futures, though, have had enough of the selling and are very modestly higher at this time.  Perhaps they think Powell will save the day.

Did I mention the 30-year bond auction was a disaster yesterday?  Apparently, with inflation running at 5.4%, locking in a yield of 1.975% for 30-years does not seem very attractive to investors.  Hence, the abrupt move to 2.05% after the auction announcement, with a long tail.  While yields are a touch lower this morning (10-year -2.0bps, 30-year -2.6bps) that has more to do with the jettisoning of equity risk than a desire to earn large negative real returns.  In Europe, it should be no surprise that Gilt yields are higher, +3.6bps, after the CPI print, but the continent is largely unchanged on the day.

Oil prices have backed off a bit, falling 0.8% this morning, but WTI remains just below $75/bbl and the trend is still firmly higher.  Gold is perking up a bit as declining real yields always helps the barbarous relic and is higher by 0.5% with silver +0.8%.  Base metals, however, are in a different place with Cu (-0.75%) and Al (-0.5%) leading the way lower.  Foodstuffs are generally higher, which of course explains the ongoing unrest in a growing list of developing countries.

As to the dollar, it is broadly weaker vs. its G10 counterparts, with kiwi far and away the leader while the rest of the bloc is firmer by between 0.1%-0.3%.  That feels much more like a dollar consolidation than any other stories beyond NZD and GBP’s inflation print.  In the EMG bloc, the picture is more mixed with PHP (-0.6%) the laggard as capital continues to flow out of the country amid foreign reserve levels sinking.  The rest of the APAC bloc was also soft, but much of that came yesterday in NY’s session with little adjustment from those levels.  On the plus side, MXN (+0.3%) is the leading gainer and the CE4 are all higher by about 0.2%, but this remains dollar consolidation after a run higher.

Somewhat anticlimactically we are going to see PPI this morning (exp 6.7%, 5.1% ex food & energy), but given the CPI has already been released, it will have to be really special to have an impact.  The Fed’s Beige Book is released at 2:00 but the highlight will be the Chairman at noon.  Frankly, until then, I don’t expect very much at all, but the market will be hanging on every word he speaks.

Broadly, the dollar remains well bid.  Yesterday saw the market anticipate the Fed being forced to tighten sooner than previously expected.  Powell has the opportunity to squelch that view or encourage it.  While I believe he will lean toward the former, that is the key market risk right now.  If I were a hedger, I would think about getting things done this morning, not this afternoon.

Good luck and stay safe
Adf

Like Tides in the Sea

Though Jay and the FOMC
Refuse to accept it can be
Most prices worldwide
Can be certified
As rising like tides in the sea

Back in 2011, wedged between the GFC and the European debt crisis, the world witnessed the Arab Spring.  This was a series of populist protests throughout the Middle East and North Africa that were triggered by a confluence of events including a desire for more freedom and democracy by a group of populations that had been oppressed by kleptocratic and authoritarian rulers.  But one of the key issues that was apparent in each of the nations involved was the fact that inflation, specifically food prices, were rising rapidly and the impoverished citizenry of many of these nations could no longer afford to feed themselves or their families.  Ultimately, while there was much angst at the time about changes in ruling regimes and much hope that the siren song of freedom would be heard in heretofore brutal dictatorships, very little changed except the name of the authoritarian and kleptocratic leader.

From our perspective in the markets, the importance of this lesson is the potential impact that sharply rising food prices can have on both financial markets and political outcomes.  This appears topical given the rioting that has begun in two very different countries, Cuba and South Africa.  In Cuba, the list of complaints could have been written in Tunisia in 2011, as the people there are growing tired of the conditions under which they are forced to live by Raul Castro and Miguel Diaz-Canel, the heirs to the Fidel Castro regime.  The economy is in tatters and food shortages are rampant with little hope of change as long as the government remains in place.  South Africa, meanwhile, has had a different catalyst, the imprisonment of former president Jacob Zuma, but the conditions on the ground, where inflation is rising sharply, and growth has been lagging are not dissimilar to what precedes this behavior anywhere.

While two countries don’t yet make a trend, it will be important to pay close attention to other EMG nations who are experiencing the same types of pressures.  Remember, just because the Fed, ECB and BOJ are not ready to raise rates as they studiously ignore rising inflation, the same has not been true in a number of emerging markets like Brazil, Hungary and Mexico, whose central banks are responding to the obvious rise in price pressures by raising their policy rates.  Inflation is insidious as it impacts all that we do and eventually weighs on how we approach our everyday tasks.  Yesterday, the NY Fed released its monthly survey of inflation expectations and it jumped to 4.8% in the one-year category, the highest level since the survey began.  While inflation is frequently described as a monetary phenomenon, it is also a psychological one.  When you expect prices to rise, you tend to err on the side of buying things sooner rather than waiting.  And that behavior drives prices as well.  As the evidence of more persistent price rises continues to increase, there will come a denouement between the Fed and reality.  It is at that point that we could see some cracks in the current narrative of “stonks to the moon!”  Remember, being hedged ahead of a significant policy change makes a great deal of sense, so don’t wait until it’s too late.

Meanwhile, the market story today is one of a modest continuation of recent trends with no substantial outliers.  It appears investors are waiting for more information from the ECB on their new policy framework next week, as well as this morning’s testimony by Chairman Powell at the House of Representatives.

After yesterday’s late day rally in the US, Asian equity markets were all in the green (Nikkei +0.5%, Hang Seng +1.6%, Shanghai +0.3%) with the big data release Chinese trade numbers showing their exports climbed more than forecasts, clearly a positive sign for both China and global growth.  Europe has been a bit more mixed with extremely modest movement either side of unchanged and no story or data to discuss while US futures show the NASDAQ (+0.35%) continuing to power ahead although the other two main indices have done nothing.

Bond markets are rallying ever so slightly with Treasury yields lower by 0.8bps and similar declines throughout Europe (Bunds -0.7bps, OATs -1.5bps, Gilts -1.1bps).  As to commodity markets, they are mixed this morning with oil (+0.1%) marginally higher along with gold (+0.1%), while copper (-1.1%) is lagging.  The long-term trend for most commodities remains higher, although we continue to see short-term consolidation.

In the FX market, the most notable mover has been ZAR (-1.35%) which is continuing to suffer on the back of the rioting in the country and the likely negative impact it will have on the economy.  Other laggards in the EMG bloc are HUF (-0.5%), PLN (-0.5%) and MXN (-0.4%), as traders respond to differing issues in each nation.  Poland’s central bank has hinted that they will extend QE at a moment’s notice in the event the delta variant of Covid becomes a bigger problem, while Hungary seems to be suffering for its unwillingness to agree to a global corporate tax rate.  As to Mexico, the nominee for central bank governor, Arturo Herrera, explained he would not expect Banxico to begin a tightening cycle, despite the fact they have already raised rates once.  On the plus side, RUB (+0.4%) leads the way as traders anticipate future gains in the oil price.

In the G10 space, while the dollar is broadly firmer, the biggest movers have been GBP (-0.3%) and NOK (-0.3%), hardly the stuff of excitement.  Arguably, what we continue to see is short USD covering as positions remain overly short, albeit somewhat reduced from where things stood at the beginning of the quarter.

This morning, in addition to the Powell testimony, we see CPI (exp 4.9%, 4.0% ex food & energy), which ought to be quite interesting.  If the forecast is correct, it would be the first time that the Y/Y data fell since last November.  As well, if this is the case, Chair Powell will almost certainly point to the outcome in his comments today as a strong sign the Fed’s transitory inflation story playing out exactly as they anticipate.  Of course, a higher than expected print will require a bit more tap dancing on Powell’s part.

The FX market continues to consolidate with no large trend driving things currently.  Now that the relationship between the dollar and Treasuries has seemingly broken, traders are looking for new short-term drivers and waiting for clarification as to how the next trend will derive.  In other words, we are likely to continue to see somewhat choppy and directionless trading for the next several weeks unless we get something of real note.  So, paraphrasing Samuel Beckett, it appears we are ‘Waiting for Powell.”

Good luck and stay safe
Adf

Getting Upset

The Chinese are getting upset

Commodity prices, as yet

Continue to rise

As shrinking supplies

Now pose, to their model, a threat

So, naturally, what did they do?

They ordered state firms to eschew

Stockpiling provisions

As now all decisions

Will come from Beijing ‘pon review

With the FOMC meeting on virtually everyone’s mind this morning, market activity overall has been muted.  However, the one place in the world that doesn’t revolve around the Fed is China, and news from there last night is quite interesting.  You may recall my quick story about the Department of Price two weeks’ ago and how that ‘august’ institution warned commodity hoarders and speculators to stop what they were doing.  Well, apparently, not enough people listened to those warnings as last night two more Orwellian entities in China joined the conversation regarding commodity prices.  The State-owned Assets Supervision and Administration Commission (SASAC) ordered companies under its purview, the SOE’s, to “control risks and limit their exposure to overseas commodities markets”.  This was clearly the stick to accompany the carrot dangled by the National Food and Strategic Reserves Administration, which has indicated it will soon release state stockpiles of copper, aluminum and zinc amongst other metals.

It is obvious that China has figured out that rising commodity prices may soon start to pass through from the factory to the consumer and drive CPI higher on the mainland.  President Xi is clearly concerned that rising prices could lead to some political unrest given that the bargain he has made with his citizens is to enhance their lives economically so he can control all the levers of power.  Thus, if inflation starts to rise more seriously, the population may call his leadership into question.

The problem for China, however, is that while in the past, they had been the marginal buyer of virtually all commodities as they grew their economic capacity dramatically, that situation no longer holds.  Yes, they still have an impact, but in this post-Covid environment where the rest of the world is rebounding very quickly, demand for commodities outside of China is growing rapidly.  But perhaps more importantly, because the previous decade saw commodity prices lag financial prices, investment in the sector was greatly reduced.  This has led to reduced supplies of many critical things and now that demand is resurgent, not surprisingly the prices of copper, steel and other commodities have been rising rapidly even if China isn’t buying as much as they used to.

Adding to this dynamic is the great conundrum of ESG.  On the one hand, ESG’s goals are to reduce environmental impact of economic activity which has largely played out as trying to substitute electricity for fossil fuels as a power source.  On the other hand, in order to electrify economies, the amount of metals like steel and copper required to achieve the stated goals is dramatically higher than the current model.  So, reducing investment in commodity producers results in much higher prices for the very commodities needed to achieve ESG goals in the long run.  While this is not the only argument to rebut the Fed’s transitory inflation story, it is an important part of the inflationists’ views.  China’s actions will only have a very temporary impact on the prices of the commodities in question, but the long-term demand is here to stay.  Until investment in extraction of commodities increases sufficiently to bring more capacity online, odds are that commodity prices will continue to rise, whether Xi Jinping likes it or not.  And if input prices continue to rise, at some point soon, so will prices of end products.  We have been witnessing the beginnings of that trend, but I fear it has much further to go.

Interestingly, despite all the sturm und drang in Beijing about metals prices, after a sharp decline yesterday, this morning they are edging higher (Cu +0.2%, Al +0.1%, Fe +0.5%, Steel +2.8%) although not nearly reversing yesterday’s moves.  If you ever wanted proof that China no longer calls the shots in commodities, here is exhibit A.

Today Chairman Jay will expound

On growth and its stunning rebound

But do not expect

That he will project

Some changes will shortly gain ground

The other story today, really the biggest for our session, is the FOMC meeting.  Broadly speaking, expectations are that the Fed will not make any policy changes of note, although there will clearly be some tweaking to the statement.  They cannot ignore the 5.0% CPI reading, I think, and they will certainly focus on the idea that the employment situation isn’t improving as rapidly as they would like.  And ultimately, for now, it is the latter issue that will continue to inform policy choices.  So tapering is not going to be on the menu, and when Powell is asked in the press conference, as he surely will be, I expect a response along the lines of, substantial further progress needs to be made before they will change things.

If I were to assess the risks, it feels like there is more risk of a hawkish outcome than a dovish one as the inflation story will not go away.  But that implies to me that the market is according a hawkish twist some real probability, so the big surprise to markets would be if they were excessively dovish.  However, I think Powell will do everything he can to be as nondescript as possible, stay on message and there will be very little movement.

A brief recap of markets overnight shows that Asian equities suffered, led by Shanghai (-1.1%).  Not only are they dealing with rising commodity prices, but the data released (Retail Sales, IP and Fixed Asset Investment) all disappointed vs. expectations.  China’s negativity bled into the Nikkei (-0.5%) and Hang Seng (-0.7%) as well.  Europe, on the other hand, has gone nowhere ahead of the Fed, with virtually every equity index within 0.1% of yesterday’s closes.  It should be no surprise that US futures markets are also essentially unchanged ahead of the Fed.

As to the bond market, we are beginning to see a touch of strength with yields declining ever so slightly.  Treasuries are lower by 0.5bps, while Bunds (-1.1bps), OATs (-0.9bps) and Gilts (-0.7bps) are also performing reasonably well ahead of this afternoon’s announcements.  It remains remarkable to me that with inflation rising universally, bond yields continue to ignore the situation.  One has to give credit to the central banks for selling their transitory story.

In the FX markets, the picture is mixed with gainers and losers evenly split in the G10.  AUD and NZD (+0.3% each) lead the way higher, although there does not appear to be a clear catalyst implying this is a positioning issue.  GBP (+0.25%) has gained on the back of slightly higher than expected CPI readings (2.1% vs. 1.9% expected), as traders look for more concrete tightening of policy there.  On the downside, both NOK and SEK have fallen by 0.35%, despite oil’s modest gains and a lack of other news.  Again, this feels more technical than fundamental.

EMG currencies are also little changed overall, with a touch of weakness seen in the APAC bloc overnight, but only on the order of -0.1%, while RUB (+0.3%) and MXN (+0.25%) are the leaders, clearly helped by oil’s ongoing gains, but also seeming to benefit from some political stories.

Data this morning bring Housing Starts (exp 1630K) and Building Permits (1730K), but they will not be noticed with the Fed story coming later this afternoon.  Yesterday’s data was mixed at best with Retail Sales disappointing for May but seeing large positive revisions in April to offset, while PPI once again printed at much higher than expected levels (6.6%).  But let’s face it, today is Fed day and we are unlikely to see much movement until at least 2:00 when the statement is released if not until 2:30 when Chairman Powell starts to speak.  At this time, any hawkishness is very likely to support the dollar with the opposite true as well, a dovish tilt will lead to a dollar decline.

Good luck and stay safe

Adf

Yields Are Repressed

You have to be mighty impressed
The bond market’s not even stressed
Although CPI
Has reached a new high
One wonders if yields are repressed

Clearly, there is only one story of import these days, and that is whether or not inflation is transitory.  Chairman Powell and his minions have spent the last several months harping on this idea, and although there was a time when several FOMC members seemed to get nervous and wanted to discuss tapering QE, it seems highly likely that next week’s FOMC meeting will focus on the fact that “substantial progress” has not yet been made toward the Fed’s goals of maximum employment and 2% average inflation.  Well, at least on the goal of maximum employment.  It seems pretty clear that they have made some progress on the inflation front.

While the headline Y/Y print of 5.0% was clearly impressive, and the highest since August 2008, personally, I am more impressed with the core M/M print of 0.7% as that is not impacted by what happened during the pandemic.  And the fact that this followed last month’s 0.9% print could indicate that inflation is becoming a bit less transitory.  But the Fed has done a wonderful job of selling its story.  One has to believe that Chairman Powell could not have wanted a better outcome than yesterday’s market price action with the S&P 500 making new highs while the bond market rallied sharply with the 10-year yield falling 6 basis points to 1.43%.

For a moment, let us try to unpack this price action.  On the one hand, it is easy to understand the equity rally as the decline in nominal yields alongside the rising recorded inflation has led to a dramatic fall in real yields.  One view, which many utilize, is that real 10-year yields are simply the 10-year yield less the current headline CPI rate.  Of course, right now, that comes to -3.57%, a level only seen a handful of times in the past, all of which occurred during significant inflationary periods in the 1970’s and early 1980’s.  Negative real yields are a boon for stocks, but historically are awful for the dollar and yet the dollar actually rallied slightly yesterday.  It seems to me that a more consistent outcome would require the dollar to decline sharply from here.  After all, even using Bund yields, currently -0.284%, and Eurozone CPI (2.0%), one sees real yields in the Eurozone far higher (-2.284%) than here in the US.  Something seems amiss.

Something else to consider is bond positioning.  There continues to be a great deal of discussion pointing to the bond market rally as a massive short squeeze.  Last week’s CFTC data was hardly indicative of that type of movement, although we will learn more this afternoon.  However, there is another place where both hedge funds and retail investors play, the ETF market, and when it comes to bond speculation, TLT is the product of choice.  Interestingly, more than 37% of the shares outstanding have been shorted in this ETF, a pretty good indication that there were a lot of bets for a higher yield.  But the word is that a significant portion of these shorts were closed out yesterday, on the order of $7 billion in short covering in total, which would certainly explain the sharp rally in the bond market.  This begs the question, is the price action technical in nature rather than a reflection of the views that inflation is truly transitory?  The problem with this question is we will not be able to answer it with any certainty for at least another three to four months.  But for now, the Fed has the upper hand.  In fact, there doesn’t seem to be any reason for them to adjust policy next week at all.  Why taper if the current policy mix is working?

Speaking of policy mixes that seem to be working, I would be remiss if I didn’t mention that the ECB meeting yesterday resulted in exactly…nothing.  Policy was left unchanged, Madame Lagarde promised to continue to buy assets at a faster pace than the first quarter, and then she spent an hour in her press conference saying virtually nothing.  It may have been her finest performance in the role.

The bond market seems to have made up its mind that the Fed is correct although there remain many pundits who disagree.  I expect that we will be continuing this discussion all summer long and with every high CPI print, you can look for the punditry to pump up the volume of their critiques of the Fed. However, we need only see one dip in the data for the Fed to claim victory and move on from the inflation discussion.  Next month’s CPI report will truly be important as the base effects will have disappeared.  Last year, the June M/M CPI was 0.5%.  If inflation is truly with us, we need to see M/M in June 2021 to be at least that high, if not a repeat of the 0.6%-0.8% numbers we have been seeing lately.  Between now and then we will see a number of price indicators including the Fed’s favorite core PCE.  For the past several months, every price indicator has been high and surprising on the high side.  The next months’ worth of data will be very important to both the Fed and the markets.  Enjoy the ride.

With two of the three key near-term catalysts now out of the way, all eyes will turn to next Wednesday’s FOMC meeting.  But that leaves us 4 sessions to trade in the interim.  Right now, with the fed narrative of transitory inflation dominating, it is easy to expect continued risk-on market performance.  Interestingly, that was not actually the case in Asia as the Nikkei (0.0%) was flat and Shanghai (-0.5%) fell although the Hang Seng (+0.35%) managed to close higher on the day.  Europe, however, got the memo and is green across the board (DAX +0.4%, CAC +0.7%, FTSE 100 +0.5%).  US futures, too, are picking up buyers as they all trade 0.25% or so higher at this hour.  

Meanwhile, in the bond market, Treasury yields have backed up 1.3bps, which looks far more technical than fundamental.  After all, they have fallen 18 bps in the past week, a rebound is no surprise.  However, European sovereign markets were closed before the bond party really started yesterday afternoon and they are in catch up mode today.  Bunds (-2.0bps) and OATS (-2.1bps) are performing well, but nothing like Gilts (-4.6bps), nor like the PIGS, all of which are seeing yield declines of at least 4bps.

Commodity prices are generally higher led by oil (WTI +0.5%) with the industrial metals all performing well (Cu +1.9%, Fe +1.0%, Sn +0.6%) although despite the dramatic decline in yields, gold (-0.5%) continues to underperform.  That feels like it is going to change soon.

Finally, in FX markets, the dollar is king of the G10, rising against all of its counterparts here with NZD (-0.4%) and SEK (-0.4%) leading the way down.  While the kiwi price action appears to be technical after having seen a decent rally lately, Sweden’s krona continues to suffer from its lower CPI print yesterday, once again delaying any idea that they may need to tighten policy in the near term.  The rest of the bloc is softer, but the movement has been far less impressive.

What makes that price action interesting is the fact that EMG currencies have actually had a much better performance with IDR (+0.4%), KRW (+0.4%) and TRY (+0.4%) all showing modest strength.  In Turkey, FinMin comments regarding the divergence between CPI and PPI were taken somewhat hawkishly.  In Seoul, a BOK governor mentioned the idea that one or two rate hikes should not be seen as tightening given the current record low level of interest rates (currently 0.50%).  However, it seems the market would see 50bps of tightening as tightening.  And lastly, the rupiah continues to benefit from foreign buying of bonds with inflows rising for a third consecutive week.

Data this morning brings Michigan Sentiment (exp 84.4) and careful attention will be paid to the inflation expectation readings, with the 1yr expected at 4.7%.  Remember, the Fed relies on those well-anchored inflation expectations, so if they are rising here, that might cause a little indigestion in Washington.

At this stage, just as we are seeing the bond market rally ostensibly on short covering, my sense is the dollar is behaving in the same way.  The data and rates would indicate the dollar should fall, but it continues to grind higher right now.  In the end, “the fundamentals things apply, as time goes by”1, and right now, they all point to a weaker dollar.  

Good luck, good weekend and stay safe
Adf

1.	Apologies to Wilson Dooley 

Out of Gas

Though prices are forecast to rise
The Treasury market implies
That Jay has it right
And this is the height
Inflation will reach at its highs

Instead, once the base effects pass
Inflation will run out of gas
So there is no need
For Powell to heed
The calls to halt QE en masse

This morning we finally get to learn about two of the three potential market catalysts I outlined on Monday, as the ECB announces their policy decision at 7:45 EDT with Madame Lagarde speaking at a press conference 45 minutes later.  And, as it happens, at 8:30 EDT we will also see the May CPI data (exp 0.5% M/M, 4.7% Y/Y headline; 0.5% M/M, 3.5% Y/Y ex food & energy).  Obviously, these CPI prints are far higher than the Fed target of an average of 2.0% over time, but as we have been repeatedly assured, these price rises are transitory and due entirely to base effects therefore there is no need for investors, or anybody for that matter, to fret.

And yet…one cannot help but notice the rising prices that we encounter on a daily basis and wonder what the Fed, and just as importantly, the bond market, is thinking.  Perhaps the most remarkable aspect of the current inflation discussion is that despite an enormous amount of discussion on the topic, and anecdotes galore about rising prices, the one market that would seem to be most likely to respond to these pressures, the Treasury market, has traded in exactly the opposite direction expected.  Yesterday, after a very strong 10-year auction, where the coverage ratio was 2.58 and the yield fell below 1.50%, it has become clear that bond investors have completely bought into the Fed’s transitory story.  All of the angst over the massive increases in fiscal spending and huge growth in the money supply have not made a dent in the view that inflation is dead.

Recall that as Q1 ended, 10-year yields were up to 1.75% and forecasters were falling all over themselves to revise their year-end expectations higher with many deciding on the 2.25%-2.50% area as a likely level for 10-year yields come December.  The economy was reopening rapidly and expectations for faster growth were widespread.  The funny thing is that those growth expectations remain intact, yet suddenly bond investors no longer seem to believe that growth will increase price pressures.  Last week’s mildly disappointing NFP report is a key reason as it was the second consecutive report that indicated there is still a huge amount of labor slack in the economy and as long as that remains the case, wage rises ought to remain capped.  The counter to that argument is the heavy hand of government, which is both increasing the minimum wage and paying excessive unemployment benefits thus forcing private companies to raise wages to lure workers back to the job.  In effect, the government, with these two policies, has artificially tightened the labor market and historically, tight labor markets have led to higher overall inflation.

The last bastion of the inflationists’ views is that the recent rally in Treasuries has been driven by short-covering and that has basically been completed thus opening the way for sellers to reemerge.  And while I’m sure that has been part of the process, my take, also anecdotal, is that fixed income investors truly believe the Fed at this time, despite the Fed’s extraordinarily poor track record when it comes to forecasting literally anything.  

As an example, two weeks ago, I was playing golf with a new member of my golf club who happened to be a portfolio manager for a major insurance company.  We spent 18 holes discussing the inflation/deflation issue and he was 100% convinced that inflation is not a problem.  More importantly, he indicated his portfolio is positioned for that to be the case and implied that was the house view so his was not the only portfolio so positioned.  This helps explain why Treasury yields are at 1.49%, 25 basis points lower than on April 1.  However, it also means that while today’s data, whatever it is, will not be conclusive to the argument, as the summer progresses and we get into autumn, any sense that the inflation rate is not heading back toward 2.0% will likely have major market consequences.  Stay tuned.

As to the ECB, it seems highly unlikely that they will announce any policy changes this morning with the key issue being their discussion of the pace of QE purchases.  You may recall that at the April meeting, the key words were, “the Governing Council expects purchases under PEPP over the current quarter to continue to be conducted at a significantly higher pace than during the first months of the year.”  In other words, they stepped up the pace of QE to roughly €20 billion per week, from what had been less than €14 billion prior to that meeting.  While the data from Europe has improved since then, and reopening from pandemic induced restrictions is expanding, it would be shocking if they were to change their view this quickly.  Rather, expectations are for no policy change and no change in the rate of QE purchases for at least another quarter.  The inflationary impulse in the Eurozone remains far lower than in the US and even though they finally got headline CPI to touch 2.0% last month, there is no worry it will run away higher.  Remember, too, there is no way the ECB can countenance a stronger euro as it would both impair its export competitiveness as well as import deflation.  As long as the Fed continues to buy bonds at the current rate you can expect the ECB to do the same.

In the end, we can only wait and see what occurs.  Until then, a brief recap of markets shows that things have continued to trade in tight ranges as investors worldwide await this morning’s news.  Equity markets in Asia were very modestly higher (Nikkei +0.3%, Shanghai +0.5%, Hang Seng 0.0%) and in Europe the movement has been even less pronounced (DAX +0.1%, CAC -0.1%, FTSE 100 +0.3%).  US futures are mixed as well with the three major indices within 0.2% of closing levels.

Bond markets, after a strong rally yesterday, have seen a bit of profit taking with Treasury yields edging higher by 0.8bps while Europe (Bunds +1.0bps, OATs +1.6bps, Gilts +0.7bps) have moved up a touch more.  But this is trader position adjustments ahead of the news, not investors making wholesale portfolio changes.

Commodity markets are mixed with crude oil (+0.1%) barely higher while precious metals (Au -0.5%, Ag -0.4%) are under a bit of pressure.  Base metals, however, are seeing more selling pressure (Cu -1.5%, Al -0.2%, Sn -0.7%) while foodstuffs are mixed as wheat is lower though corn and soybeans have edged higher.

Finally, in the FX market, the G10 is generally mixed with very modest movement except for one currency, NOK (-0.5%) which has fallen sharply after CPI data came out much lower than expected thus relieving pressure on the Norgesbank to tighten policy anytime soon.  In the EMG bloc, ZAR (+0.6%) is the leading gainer after its C/A surplus was released at a much stronger than expected 5.0% indicating finances in the country are improving.  But away from that, things have been much less exciting as markets await today’s data and ECB statements.

In addition to the CPI data this morning, as it is Thursday, we will see Initial Claims (exp 370K) and Continuing Claims (3.65M).  Interestingly, those may be more important data points as the Fed is clearly far more focused on employment than on inflation.  But they will not be sensational, so will not get the press.  FWIW my money is on a higher than expected CPI print, 5.0% or more with nearly 4.0% ex food & energy.  However, even if I am correct, it is not clear how big a market impact it will have beyond a very short-term response.  In the end, if Treasury yields continue to fall, I believe the dollar will follow.

Good luck and stay safe
Adf


 


How Long Can They Wait?

While prices worldwide are all rising
Most central banks keep emphasizing
That they have no fear
And later this year
Their efforts will be stabilizing

But every time data’s released
It seems that inflation’s increased
How long can they wait
Ere they contemplate
It’s time QE should be deceased?

It has been another extremely dull day in financial markets as participants await the next catalyst, arguably coming tomorrow in the form of either a surprise from the ECB, a low probability event, or a surprise from the US CPI release, a higher probability event.  And yet, even if CPI surprises, will it really have much market impact?

For inspiration on the potential impact of a surprising outcome, let us quickly turn to China, where last night inflation data was released with PPI rising 9.0% Y/Y, its highest print since 2008, although CPI rose a less than expected 1.3%.  However, for the world overall, Chinese PPI is of much greater importance as it offers clues to what Chinese manufacturers may be charging for the many goods they sell elsewhere in the world.  If they start raising prices, you can be sure that prices elsewhere will be rising as well.  But the market response to this much higher than expected result was a collective yawn.  Chinese bond yields actually fell 1 basis point while the renminbi slipped 0.2%.  Chinese equities rose 0.3% in Shanghai to complete the triumvirate of markets demonstrating no concern over rising prices.

Is that what we can expect if tomorrow’s CPI data prints at a higher than expected number, perhaps even above 5.0%?  The first thing to note is that the Treasury market is certainly not demonstrating concern, at least in the classical sense of selling off into a rising inflationary situation.  In fact, yields are now back to their lowest level, 1.50%, since early March, the period during which yields were rising rapidly and eventually touched the early-April highs of 1.75%.  But here we are 25 basis points lower and the market seems to have completely bought into the Fed narrative of transitory inflation.  (As an aside, perhaps someone can explain to me why, if inflation is transitory and the Fed need not respond to the recent rises, there is a growing consensus that the Fed is going to start to taper QE purchases.  After all, the implication of transitory inflation is that current policy is fine as is, why change it and rock the boat?)

Another story that has been getting increasing play is about the growing short positions in Treasury bonds and how regardless of tomorrow’s data, we could see a short squeeze and lower yields.  Now, when I look at the CFTC data, I do see that last week open positions fell by nearly 50K contracts, but the overall outstanding position remains net long ~55K and there has been no discernible pattern of building short positions, so I’m not sure where that story has come from.  

So, when considering what we know about the current situation, near-term inflation pressures but central bank certitude it is transitory and recent price action indicating limited concern over inflation, it tells me that a high CPI print, currently forecast at 4.7%, will have no impact of note on the bond market.  As such, it seems unlikely that a high CPI print will have much impact on any market.  We will need to see a series of high prints, and they will need to continue at least through October or November before, it seems, anybody is going to believe that inflation may be more than a transitory phenomenon.  Unfortunately, we will all suffer equally due to the fact that prices are going to continue to rise, regardless of what the Fed or BLS tells us.

Turning to today’s session, price action has been generally similar to yesterday’s session, which means that there have been continued small movements in markets with strong trends difficult to identify.  For instance, equity markets overnight showed the Nikkei (-0.3%) and Hang Seng (-0.1%) both slipping a bit while Shanghai (+0.3%) managed to eke out a gain.  Hardly conclusive evidence of a theme.  Europe, however, is a bit softer, with the DAX (-0.5%) and FTSE 100 (-0.6%) both under a bit of pressure although the CAC (0.0%) has gone nowhere at all.  The German story is one of weaker than expected data, this time a smaller trade surplus with declines of both imports and exports indicating growth there is not quite so robust.  Meanwhile, Brexit issues between the EU and UK have arisen again over Northern Ireland, and this seems to be weighing on sentiment there.  As to US futures markets, they are very little changed at this hour.

Bond markets are clearly not concerned over inflation with Treasury yields down 2.7 basis points and similar declines in Europe (Bunds -2.6bps, OATs -3.0bps, Gilts -2.0bps).  Looking further afield, Italian BTPs have seen yields decline by 5 basis points with Spain and Portugal both falling 4bps or more.  It seems clear the market believes the ECB is going to continue to actively support the European government bond market.

On the commodity front, oil continues to rally with WTI (+0.4%) back over $70/bbl.  Something to consider regarding oil is that as ESG initiatives continue to grow in importance, and many of them are attacking the fossil fuel industry, seeking to prevent funding, there will be less and less exploration for and drilling of new oil sources.  But the transition to eliminating fossil fuels from the economy will take many years, (I’ve seen credible estimates of 30-50 years) meaning demand will not disappear, even if supply shrinks.  It seems pretty clear what will happen to the price of oil in this situation.  Do not be surprised if the previous high of $147/bbl is eclipsed in the coming years.

As to the rest of the commodity space, precious metals are a bit softer while base metals are more mixed today (Cu -0.9%, Al -0.15%, Ni +0.3%).  And finally, the grains are giving back some of their recent gains with all three down about 1.0%.

Finally, in FX, the dollar is broadly softer, but the movement has been very modest.  In G10 space, NOK (+0.3%) is the leader along side CAD (+0.3%) as they both follow oil’s rise.  After that, though, the movement is between 0.0% and 0.2%, with no stories to discuss.  In the Emerging Markets, HUF (+0.6%) is the big winner, as CPI continues to print above 5.0% and the central bank is tipped to raise rates at its meeting tomorrow.  But aside from that, there are more winners than losers although they are all just modest gains on the order of 0.1%-0.2%.  Weakness was seen in some APAC currencies overnight, but that, too, was very modest.

There is no important data to be released today, nor are there any Fed speakers, so my take is the market will continue to trade on the back of the Treasury market movement.  If yields continue to slide, look for the dollar to stay under some pressure.  If they reverse, I think the dollar will as well.

Good luck and stay safe
Adf





No Aberration

In Europe and in the US

The central banks have made a mess

The latter’s seen prices

Rise up to a crisis

The former is still in distress

But one thing the two of them share

Is neither believes in the scare

That higher inflation

Is no aberration

And tapering they’ll soon declare

We have seen another day of modest overnight activity as market participants across asset classes wait for the next key data inputs.  At this point, the three biggest things on the horizon are Thursday’s ECB meeting and US CPI print and then next Wednesday’s FOMC meeting.  Until those data points are known, tight ranges and lack of trading liquidity are likely to be the hallmarks of all markets.

One of the things that has been something of a mystery is the disconnect between the performance of the US Treasury market and the ostensibly rapid rise in inflationary pressures, with the former essentially discounting the latter completely.  In fact, I would argue this is the key question that must be answered in order to better understand the potential future outcomes.  Arguably, it is also this situation which has allowed the Fed to remain sanguine over the recent jumps in CPI and PCE.

Consider that the bond market is generally assumed to have the greatest sensitivity to future economic activity given its very nature.  After all, the meaning of fixed income is that regardless of future economic performance, bondholders get a stated amount of interest.  It is this feature that keeps bond investors so highly attuned to inflation and inflation expectations as these investors want to ensure the real value of their investments does not decline due to rising prices.  Historically, this has certainly been the case, with bond markets selling off before inflation really took off.  This is also the genesis of the term ‘bond vigilantes’, coined during the Clinton administration to describe the bond market’s unwillingness to fund hugely expansionary fiscal plans and run large government deficits.  My, how the world has changed!

But back then, the Federal Reserve was not in the business of QE.  In fact, while it may have been a theoretical concept, even the Japanese had not yet tried it on for size.  Two plus decades later, though, the role of the Fed has clearly changed given the economic stresses suffered in both the GFC and Covid induced crisis.  QE has gone from an emergency tool to address a unique situation to the go-to tool in the Fed’s (and ECB’s) toolkit.  Thus, have grown the central bank balance sheets and so there has been a lid on interest rates, even if not explicitly via yield curve control.

There is, however, another key change in the world since the bond vigilante days of the late 1990’s; the regulatory requirements for large banks known as GSIBs, (Global Systemically Important Banks) imposed after the GFC.  These 30 institutions are required to maintain additional capital buffers and hold them in so-called High-Quality Liquid Assets (HQLA) which, not surprisingly, include Treasury bonds as well as mortgages and excess reserves.  One of the things that all of these banks do is adjust that portfolio of HQLA to maximize the available revenue, which in a world where yields are zero and negative, is very hard to achieve.  While Treasury bills and IOER pay virtually nothing, Treasury securities out the curve do have positive nominal yields and are thus relatively attractive for the purpose.

This leads to a potential alternative reason for the seeming lack of concern by the Treasury market over future inflation; price insensitive demand for bonds required to be held by large banks.  If these banks are buying and holding more Treasuries than they otherwise would have done in an unfettered world, the price signal from those bonds is likely to be somewhat skewed.  In other words, what if the Treasury market is not telling us there is no fear of inflation, but rather telling us that there are so many price insensitive buyers of bonds, even the excess supply being issued is not enough to scare holders out of the market.  In that case, we will need to get our clues about inflation elsewhere, perhaps from commodity markets.  And of course, commodity prices have done nothing but rally sharply across every class for the past year.  While there is no doubt that the first part of that move was to make up for the severe price dislocations seen at the beginning of the Covid crisis, it is not hard to make the case that the more recent price movement is a response to rising demand meeting inelastic supply.  It is the latter that drives inflation.

The point here is that both the ECB and Fed have consistently maintained that there is no reason to worry over recent high inflation prints and that there is no reason for either of them to adjust their policy mix anytime soon.  If the bond market ‘meter’ is malfunctioning, though, both of these central banks may well find themselves on the wrong side of history, yet again.  Rapidly rising inflation could well come to dominate the policy discussion quite quickly in that case, and maximum employment may recede to a pleasant dream.  Food for thought.

As to market activity today, as mentioned above, we have seen modest movements in both directions amid modest trading volumes.  Starting with equities, Asia saw small losses across the board (Nikkei -0.2%, Hang Seng 0.0%, Shanghai -0.5%) while Europe has been very modestly firmer (DAX 0.0%, CAC +0.2%, FTSE 100 +0.3%).  US futures are mixed as well with DOW (-0.15%) suffering while NASDAQ (+0.3%) are a bit higher and SPX futures are essentially unchanged.  Not much new information here.

Bond markets are mostly a bit firmer this morning with Treasury yields (-1.5bps) falling furthest and European sovereigns all seeing yield declines of about 0.75bps.  With 10-year Treasury yields back to 1.55%, it appears, on the surface, that there is no concern about rising inflation.  But if my proposed thesis is correct, that number could be quite misleading.

Commodity prices are generally coming under pressure this morning, certainly not a sign of imminent inflation, but I would argue this is simple daily price volatility more than anything else.  For example, oil (-0.9%) is leading the pack lower but we are seeing weakness in precious metals (Au -0.2%, Ag -0.5%) and base metals (Cu -0.5%, Ni -0.7%, Fe -1.9%) with only grains continuing to rally as all three major ones are higher by about 1.0% this morning.

Turning to FX, it should be no surprise that there is really no story here this morning either.  The dollar is probably marginally higher overall, but really mostly mixed with small movements in virtually all currencies.  In the G10, NZD (-0.3%) is the biggest mover, but this move has simply taken it back to the middle of its trading range.  And the rest of the bloc has moved far less.  In emerging markets, we have seen two movements of some note with HUF (-0.4%) declining after weaker than expected IP data was released, putting a dent in the idea the central bank may tighten policy, while RUB (+0.4%) rose after yesterday’s higher than expected CPI print has traders believing the central bank is likely to raise rates further.  However, beyond those two moves, there is very little to discuss.

On the data front, the NFIB Small Business Optimism index was released at a disappointing 99.6, below expectations of 101.0 and actually below last month’s reading as well.  That seems to be a result of the difficulty small firms are having in hiring staff.  We also see the Trade Balance (exp -$68.7B) and then the JOLTS Job Openings report (8.2M) later this morning.  But as mentioned at the top, I don’t think anything will matter until Thursday, so look for more range trading until then.

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

Far From our Goals

Said Brainerd, “we’re far from our goals”
Of helping to max out payrolls
So, patience is needed
Else we’ll be impeded
And Biden might drop in the polls
Thus, we must maintain the controls

There is a single hymnal at the Marriner Eccles Building in Washington, DC and every FOMC member continues to read from that gospel.  In short, the current view is that things are getting better, but there is still a long way to go before the economy can continue to grow without Fed support, therefore, the current policy mix is appropriate and will be for a long time to come.  On the subject of inflation, when it was even mentioned by any of the six Fed speakers yesterday, it was pooh-poohed as something of no concern, widely recognized that it will rise in the short-term, but universally expected to be ‘transitory’.  I don’t know about you, but it certainly makes me feel much better that a group of 6 individuals, each extremely well-paid with numerous perks accorded to their office, and each largely out of touch with the world in which the rest of us live, are convinced that they can see the future.  After all, the Fed’s forecasting record is unparalleled…in its futility.

However, that is the situation as it currently stands, the Fed remains adamant that there is no need to taper its QE program, no need to raise interest rates anytime soon and that the current policy mix will address what ails the US economy.

The problem with this attitude is that it seems to ignore the reality on the ground.  Exhibit A is the news today that average gasoline prices across the nation crossed above $3.00/gallon for the first time since 2014.  In fairness to the Fed, some portion of this is a result of the shutdown of the Colonial Pipeline, where a number of states on the East Coast find themselves with no gasoline to pump.  But do not be mistaken, as I’m sure everyone is aware, gasoline prices have been rising sharply for the past 6 months, at least.  At issue now is just how much higher they can go before having more deleterious effects on the economy, let alone on many individuals’ personal situation.

It is not just gasoline, but pretty much all commodities that have been rallying sharply since the pandemic induced lows of April 2020.  Since its nadir, for example, the GSCI has more than doubled, but that merely brings it back to its level of the prior five years, when there was no concern over commodity driven inflation.  The difference this time is that due to a combination of the Covid-induced breakdown in supply chains and a massive reduction in Capex by the mining and extraction sector, the prospect of equilibrium in this space in the near term is limited.  There is a growing belief that we are embarking on a so-called commodity super-cycle.  This would be defined as a long-term period where commodity demand outstrips supply and commodity prices rise continually, generally doubling or tripling from the previous lows.

This discussion is an excellent prelude to this morning’s CPI release, where the analyst community is looking for a 0.2% M/M rise which translates into a 3.6% Y/Y rise.  Ex food and energy, expectations are for 0.3% M/M and 2.3% Y/Y.  The sharp rise in the annual headline rate is exactly what the Fed has been discussing as base effects, given this time last year, the economy was seeing price deflation on the back of the economy’s shutdown, with transportation, hospitality and leisure prices collapsing due to a forced lack of demand.  As such, the market seems entirely prepared for a very large number.  From my vantage point, the Y/Y number is not so important today, but the M/M number is.  Consider that a 0.3% reading, if strung over twelve months, comes to an annual inflation rate of more than 3.6%, considerably above the Fed’s target.

We continue to hear one Fed speaker after another explain that while the economy is improving, they must still maintain ultra-easy monetary policy.  We continue to hear them explain that any inflation readings will be transitory.  And maybe they are correct.  However, if they are not, and inflation embeds itself more deeply into the national psyche, the Fed will find themselves in an unenviable position; either raise interest rates to combat inflation (you know, the tools they have) and watch the financial markets fall sharply; or let inflation run hot, and allow the dollar to fall sharply while eventually watching financial markets fall sharply.  Talk about a Hobson’s Choice!

Now to markets, which after yesterday’s selloff in the US equity space, albeit with a close that was well off session lows, we saw a mixed Asian session (Nikkei –1.6%, Hang Seng +0.8%, Shanghai +0.6%) and are seeing a similar performance in Europe (DAX +0.25%, CAC 0.0%, FTSE 100 +0.35%).  US futures, on the other hand, are uniformly pointing lower at this hour, down between 0.35% (DOW) and 0.6% (NASDAQ).

Bond markets, after yesterday’s worldwide rout, have seen a small rebound with Treasury yields edging lower by 0.5bps, although still hanging around the 1.60% level.  There is an overwhelming consensus that 10-year Treasury yields are set to rise substantially, but so far, that has just not been the case.  European markets are seeing yield declines of between 1bp (Bunds and OATs) and 2bps (Gilts).  Today brings two critical data points, first the US CPI data shortly and then the US 10-year Treasury auction will be closely scrutinized to determine if there is a crack in demand for our seemingly unlimited supply of Treasury paper.

Commodity prices are broadly higher led by oil (WTI +1.3%) with base metals continuing to climb as well (Cu +0.7%, Al +0.5%, Ni +1.0%).  The same cannot be said of the precious metals space, though, with both gold (-0.2%) and silver (-0.8%) seeing some selling on profit taking.

The dollar is in fine fettle this morning, rallying against 9 of its G10 counterparts with only CAD (+0.1%) holding its own.  NZD (-0.6%) and AUD (-0.5%) are in the worst shape as both respond to weaker than expected Chinese monetary growth which implies that the Chinese economy may not be growing as quickly as previously thought.  However, the European currencies are all modestly softer as well on worse than expected Eurozone IP data (0.1% vs. 0.8% expected).  EMG currencies are also under pressure this morning, with the APAC currencies feeling it the worst.  KRW (-0.45%), THB (-0.4%) and SGD (-0.25%) are leading the way lower, also on the back of the Chinese monetary data.  Interestingly, TWD (-0.03%) is barely changed despite an equity market rout (TAIEX -4.1%) and concerns about growth in China.

Other than the CPI data and the Treasury auction, there is no other news or data.  Well, that’s if you exclude the continuing parade of Fed speakers, with today’s roster of 4 positively sparse compared to what we have seen lately.  The one thing we know is that they are unlikely to change their tune.

Which brings us back to the 10-year Treasury.  It continues to be the market driver in my view, with higher yields leading to a stronger dollar and vice versa.  I suspect that this morning’s CPI data may print higher than forecast, but it is not clear to me if that will truly have an impact.  My bigger fear is that broad risk appetite may be waning given the leadership of the equity rally has been suffering of late.  In this situation, we could easily go back to a classical risk-off framework of lower stocks, higher bond prices (lower yields) and a stronger dollar.  Just beware.

Good luck and stay safe
Adf

Devil-May-Care

It wasn’t all that long ago
When Powell and friends let us know
That prices might rise
But that in their eyes
T’was something we soon would outgrow

And lately it seems they were right
As chains of supply get more tight
But so far, they’re clear
The Fed has no fear
Inflation could rise overnight

Investors, though, don’t seem to share
That attitude, devil-may-care
Instead they’re rebelling
And stocks they are selling
While bond markets, too, they forswear

Perhaps as a prelude to tomorrow’s CPI data here in the US, last night we saw Chinese inflation data.  Chinese data, though, has a very different meaning than US data.  From China, markets care far more about PPI than about CPI, as China continues to be the world’s factory floor.  So, a rising PPI in China may presage rising retail prices elsewhere in the world.  Consider this when looking at the Chinese data, where PPI rose a more than expected 6.8%, it’s highest print since October 2017, while CPI there rose only 0.9%, a tick less than forecast.  The proximate cause of the sharp rise in PPI has been the ongoing explosion higher in commodity prices.  All their input costs are rising (iron ore, steel, copper, energy, etc.) thus producers are forced to raise their prices.  While retailers have not yet passed through all the cost increases in China, manufacturers and retailers elsewhere in the world have not been so sanguine on the issue.  Instead, the combination of rising commodity prices and shortages in key intermediate goods, like semiconductors, has been more than sufficient to push up prices.

It should be no surprise that markets, in general, are not applauding this outcome, and in fact, are concerned that this is just the beginning of the move in prices.  On the one hand, we continue to hear from both the Fed and the ECB that there is no reason to consider tightening policy at this time as neither bank has achieved their policy aims.  On the other, there is no sign that the supply side damage that was caused by the pandemic is anywhere close to being repaired.  Reduced supply meeting ongoing artificially high demand is guaranteed to raise prices.  I guess the Fed and ECB will soon be quite pleased with themselves for having created inflation.  The rest of us?  Not so much.

However, this policy mistake action in the face of the current conditions is what is driving market prices, which today are wholly in the red, and in substantial size.  Equity markets worldwide (Nikkei -3.1%, Hang Seng -2.1%, DAX -2.2%, CAC -2.0%, FTSE 100 -2.2%) have been under severe pressure ever since yesterday’s US tech slump, but bond markets, too, are seeing significant selling pressure, with Bunds, OATs and Gilts all seeing yields climb by 4 basis points this morning.  In other words, investors are explaining they don’t want to hold financial assets in an inflationary environment.  In fact, there is a great deal of buzz in the markets about some of the large interest rate bets that are being made in both Eurodollar and Euribor futures markets, where very large size option trades are being executed with the aggressor buying put options as part of large risk reversals.  It seems there is very little concern over interest rates declining from current levels, and rightly so, but expectations for higher rates well before either the Fed or ECB has indicated they are considering changing tack are the new normal.

What, you may ask, has this done for the dollar?  That is a much tougher question to answer as the outcome has been far less clear.  I have been adamant that the 10-year Treasury yield has been the key driver of the dollar’s value for virtually all of 2021, and despite the sell-off in European sovereigns this morning, Treasury yields are unchanged at 1.60%.  Heading into tomorrow’s CPI data, as well as another round of Treasury refunding starting with today’s 3-year auction of $40 billion (a total of $108 billion will be auctioned this week), it appears that investors and traders are not certain what to do.  Despite economic data that points to quickening growth, we continue to hear from Fed speaker after Fed speaker that they are not even close to considering tapering QE, let alone raising interest rates.  Well, except for the lone(ly) hawk, Dallas Fed President Robert Kaplan.  But yesterday, both Chicago’s Mike Evans and SF’s Mary Daly were clear it is far too early to consider tapering QE.  Today brings six more Fed speakers, none of whom have a history of hawkishness.

In the end, if inflation continues to rise while Treasury yields remain rangebound due to QE, as real yields decline, look for the dollar to follow.  Breakeven inflation rates continue to trade at multi-year highs (5-year 2.73%, 10-year 2.53%) and are indicating a strong belief that inflation is picking up pace. While the Fed continues to tell us they “have the tools” necessary to combat any potential inflation, the only thing of which we can be sure is they not only “have the tools” required to support markets (and the economy by extension), but that they will use those tools. When it comes to fighting the inflation battle, though, not a single current FOMC member is battle tested.  Given this asymmetry, it is not surprising that we are seeing an increase in market bets on higher interest rates.

Back to the dollar, which is actually under a bit of pressure this morning, along with all those other assets. In the G10, only CHF (-0.1%) is softer as we are seeing gains from the European bloc (NOK, SEK +0.4%, EUR +0.3%) leading the way.  Arguably, this is on the back of the much better than expected German ZEW expectations index, which printed at its highest level in more than 10 years.  Meanwhile, the pound (+0.1%) and commodity bloc here are having a much less interesting session.

In the emerging markets, Asian currencies felt pressure overnight on the tech stock decline with KRW (-0.5%), TWD (-0.4%) and MYR (-0.3%).  On the other hand, the CE4 have all followed the euro higher and we are seeing strength in ZAR (+0.5%), RUB (+0.6%) and MXN (+0.5%), despite oil’s small slide (-0.8%).

All in all, today is shaping up as another one that will be driven by the yield story.  In order for the dollar to really turn around its recent weakness, we will need to see a very significant risk-off event, with Treasuries rallying and fear abundant.  But so far, the current equity decline has not been sufficient to get those juices flowing.  As such, I still would err on the side of a weaker dollar.

Good luck and stay safe
Adf