Somewhat Misleading

The latest inflation’ry reading
Showed price rises kept on proceeding
But bond markets jumped
While dollars were dumped
This movement seems somewhat misleading

The two market drivers yesterday were exactly as expected, the CPI report and the FOMC Minutes.  The funny thing is it appears the market’s response to the information was contrary to what would have been expected heading into the session.

Starting with CPI, by now you are all aware that it continues to run at a much hotter pace than the Fed’s average 2.0% target.  Yesterday’s results showed the M/M headline number was a tick higher than forecast at 0.4%, as was the 5.4% Y/Y number.  Ex food & energy, the results were right on expectations at 4.0%, but that is cold comfort.  Here’s a bit of bad news though, going forward for the next 5 months, the monthly comps are extremely low, so the base effects (you remember those from last year, right?) are telling us that CPI is going to go up from here.  Headline CPI is almost certain to remain above 5.0% through at least Q1 22 and I fear beyond, especially if energy prices continue to rise.  The Social Security Administration announced that benefits would be increased by 5.9% next year, the largest increase in 20 years, but so too will FICA taxes increase accordingly.

The initial market movement on the release was perfectly logical with the dollar bouncing off its lows while Treasury yields backed up.  Given the current correlation between those two, things made sense.  However, that price action was relatively short-lived and as the morning progressed into the afternoon, the dollar started to slip along with yields.  Thus, leading up to the Minutes’ release, the situation had already turned in an unusual direction.

The Minutes explained, come November,
Or possibly late as December
The time will have come
Where QE’s full sum
Ought fade like a lingering ember

The Minutes then confirmed what many in the market had expected which was that the taper is on, and that starting in either mid-November or mid-December the Fed would be reducing its monthly asset purchases by $15 billion ($10 billion less Treasuries, $5 billion less mortgages).  This timeline will end their QE program in the middle of next year and would then open the way for the Fed to begin to raise rates if they deemed it necessary.

Oddly enough, the bond rally really took on legs after the Minutes and the dollar extended its losses.  So, while the correlation remains intact, the direction is confusing, at least to this author.  Losing the only price insensitive bond buyer while the government has so much debt to issue did not seem a recipe for higher bond prices and lower yields.  Yet here we are.  The best explanation I can offer is that investors have assessed that less QE will result in slowing growth and reduced inflationary pressures, so much so that there is the beginning of talk about a recession in the US early next year.  Alas, while I definitely understand the case for slowing growth, and have been highlighting the Atlanta Fed’s GDPNow trajectory lower, there is nothing about the situation that I believe will result in lower inflation, at least not for quite a while yet.  Thus, a bond market rally continues to seem at odds with the likely future outcome.

Of course, there is one other possible explanation for this behavior.  What if, and humor me here for a moment, the Fed doesn’t actually follow through with a full tapering because equity prices start to fall sharply?  After all, I am not the only one to have noticed that the Fed’s reaction function seems to be entirely based on the level of the S&P 500.  Simply look back to the last time the Fed was trying to remove policy accommodation in 2018.  You may recall the gradual reduction in the size of their balance sheet as they allowed bonds to mature without replacing them while simultaneously, they were gradually raising the Fed funds rate.  However, by Christmas 2018, when the equity market had fallen 20% from its highs, Chairman Powell pivoted from tightening to easing policy thus driving a reversal higher in stocks.  Do you honestly believe that a man with a >$100 million portfolio is going to implement and maintain a policy that will make him poorer?  I don’t!  Hence, I remain of the belief that if they actually do start to taper, still not a given in my mind, it won’t last very long.  But for now, the bond market approves.

Thus, with visions of inflation dancing in our heads, let’s look at this morning’s market activity.  Equity markets are clearly of the opinion that everything is under control, except perhaps in China, as we saw the Nikkei (+1.5%) put in a strong performance and strength throughout most of Asia.  However, the Hang Seng (-1.4%) and Shanghai (-0.1%) were a bit less frothy.  Europe, though, is all in on good news with the DAX (+0.8%), CAC (+0.9%) and FTSE 100 (+0.7%) having very positive sessions.  This has carried over into the US futures market where all three major indices are higher by at least 0.6% this morning.

Bonds, meanwhile, are having a good day as well, with Treasury yields sliding 0.7bps after a nearly 5bp decline yesterday.  In Europe, given those markets were closed during much of the US bond rally, we are seeing a catch-up of sorts with Bunds (-3.7bps), OATs (-3.1bps) and Gilts (-1.6bps) all trading well as are the rest of Europe’s sovereign markets.

On the commodity front, pretty much everything is higher as oil (+1.25%), NatGas (+2.1%) and Uranium (+21.7%!) lead the energy space higher.  Metals, too, are climbing with gold (+0.4%), copper (+0.7%) and aluminum (+3.4%) all quite firm this morning.  Not to worry, your food is going up in price as well as all the major agricultural products are seeing price rises.

As to the dollar, it is almost universally lower this morning with only two currencies down on the day, TRY (-0.9%) and JPY (-0.15%).  The former is suffering as President Erdogan fired three more central bankers who refuse to cut interest rates as inflation soars in the country and the market concern grows that Turkey will soon be Argentina.  The yen, on the other hand, seems to be feeling the pressure from ongoing sales by Japanese investors as they seek to buy Treasury bonds with much higher yields than JGBs.  However, away from those two, the dollar is under solid pressure against G10 (SEK +0.9%, NOK +0.8%, CAD +0.55%) and EMG (THB +0.7%, IDR +0.7%, KRW +0.6%).  Broadly speaking, the story is much more about the dollar than about any of these particular currencies although commodity strength is obviously driving some of the movement as is positive news in Asia on the Covid front where some nations (Thailand, Indonesia) are easing restrictions on travel.

On the data front, this morning brings the weekly Initial (exp 320K) and Continuing (2.67M) Claims numbers as well as PPI (8.7%, 7.1% ex food & energy).  PPI tends to have less impact when it is released after CPI, so it seems unlikely, unless it is a big miss, to matter that much.  However, it is worth noting that Chinese PPI (10.7%) printed at its highest level since records began in 1995 while Korean import and export prices both rose to levels not seen since the Asian financial crisis in 1998.  The point is there is upward price pressure everywhere in the world and more of it is coming to a store near you.

We hear from six more Fed speakers today, but it would be quite surprising to have any change in message at this point.  To recap the message, inflation is proving a bit stickier than they originally thought but will still fade next year, they will never allow stock prices to fall, inflation expectations remain anchored and tapering will begin shortly.

While I still see more reasons for the dollar to rally than decline, I believe it will remain linked to Treasury yields, so if those decline, look for the dollar to follow and vice versa.

Good luck and stay safe
Adf

Prices Will Grow

As markets await CPI
It’s funny to watch the Fed try
Explaining inflation
Will lack the duration
To send expectations sky-high

But even their own surveys show
That most people already know
Inflation is here
And well past next year
The level of prices will grow

Each month the Federal Reserve Bank of New York publishes the results of a survey of consumer expectations on inflation.  Yesterday, they published the September results and, lo and behold, the data showed that 1-year inflation expectations rose to 5.31%, by far the highest point since the survey began in 2013.  The 3-year data rose to its highest ever level of 4.19%, also well above the Fed’s 2.0% target.  And yet somehow, the authors of the report explained that inflation expectations remain well anchored.  Their claim is that if you look at the 5-year expectations, they remain near the levels seen before the pandemic, indicating that there should be no concern.  I don’t know about you, but 3 years of inflation running above 4.0% seems a lot longer than transitory.

Of course, it’s not just the analysts at the NY Fed who are unwilling to admit to the increasingly obvious situation, we continue to hear the same from other officials.  For instance, Treasury Secretary Janet Yellen, in a televised interview yesterday remarked, “I believe it’s [inflation] transitory, but I don’t mean to suggest these pressures will disappear in the next month or two.”  She then raised the specter of shortages by commenting, “There’s no reason for consumers to panic over the absence of goods they’re going to want to acquire at Christmas.”  Now, don’t you feel better?

In fairness, however, there are several Fed members who have finally admitted that the transitory emperor has no clothes.  Atlanta Fed President Raphael Bostic explained yesterday, “It is becoming increasingly clear that the feature of this episode that has animated price pressures – mainly the intense and widespread supply-chain disruptions – will not be brief.  By this definition, then, the forces are not transitory.”  As well, we heard from St Louis Fed President James Bullard, “I have to put some probability on a scenario where inflation stays high or even goes higher.”

At this point, it’s fair to ask, which is it?  Clearly there is a split at the Fed with some regional presidents recognizing that inflation has risen sharply and has all the appearances of being persistent, while Fed governors seem more likely to lean toward the transitory fable.  Perhaps what explains this split is the regional presidents have a far different constituency than do the Fed governors.  The Fed presidents are trying to address the issues extant in their respective geographies, so rising inflation matters to them.  Meanwhile, the governors, despite the claim that the Fed is apolitical, serve their masters in Congress and the White House, who believe they need to continue QE and ZIRP forever to continue spending money in unconscionable sums while not suffering from the slings and arrows of the bond market vigilantes.  But remember this too, every Fed governor votes at every meeting while only a handful of regional presidents vote (granted, Bostic is one of those right now.)  I fear we will continue to hear transitory for a while yet.

All this is a prelude to two key pieces of information today, this morning’s CPI release (exp 5.3% headline, 4.0% core) and the FOMC Minutes from the September meeting to be released at 2:00pm.  The one thing that has been very clear lately is that interest rate markets are beginning to buy into the persistence of inflation.  While Treasury yields have edged lower by 1.6bps this morning, in the past 3 weeks, those yields have risen 26 basis points.  And this is a global phenomenon with Bund yields, for instance, having risen 20 basis points over the same period despite a 4.1bp decline today.  Investors are starting to pressure the central bank community with respect to interest rates, driving them higher as fears of rising inflation abound worldwide.  While some, central banks have recognized the reality on the ground (Norway, New Zealand, numerous EMG nations) and others have paid lip service to the idea of raising rates (the UK, Canada), the two biggest players, the Fed and ECB, will not even discuss raising rates, although the Fed continues to tease us with talk of tapering.

However, I will ask again, do you believe the Fed will taper (tighten) policy if GDP growth is more clearly abating?  My view remains that they may actually start to taper, but that it will be a short-lived process as weak GDP growth will dissuade them from doing anything to worsen that side of the ledger.  While eventually, weaker GDP growth will result in demand destruction and reduced price pressures, that is likely to take a very long time.  Hence, the idea of stagflation remains very viable going forward.

Now it’s time to look at markets.  Equities have had a mixed session thus far with Asia (Nikkei -0.3%, Hang Seng -1.4%, Shanghai +0.4%) seeing both gainers and losers and Europe (DAX +0.7%, CAC +0.25%, FTSE 100 -0.1%) seeing similar mixed price action.  UK data showed August GDP was a tick lower than forecast and is clearly slowing from its previous pace, arguably weighing on the FTSE.  As to US futures, they are edging higher ahead of the data with gains in the 0.1%-0.3% range after yesterday’s modest declines.

We’ve already discussed bonds so a look at commodities shows that oil (-0.6%) is retreating for the moment as is NatGas (-1.5%), while we are seeing strength in gold (+0.7%) and copper (+1.7%).  In fact, the entire metals complex is stronger today as apparently, weaker energy prices are good for industrial activities.

As to the dollar, it is under some modest pressure today across the board.  In the G10, SEK (+0.35%) and CHF (+0.35%) lead the way with JPY (0.0%) the laggard.  However, there are no specific stories that seem to be driving things, rather this is a broad-based dollar correction from recent strength.  The same situation holds in the EMG bloc with ZAR (+0.75%) the leader followed by much lesser movement of KRW (+0.4%), CZK (+0.35%) and PLN (+0.35%).  The won has responded to comments from the central bank that it is closely watching the exchange rate and will not be afraid to step in if it becomes destabilized.  That is a euphemism for much weaker, as the currency had fallen nearly 9% in the previous four months.  As to the others, recent weakness seems to merely being consolidated with nothing new driving price action.

While the Fed may not care much about CPI, the rest of us do care.  And really, so do they, but it doesn’t tell their story very well.  At any rate, while it is entirely reasonable that we see a continued flatlining of price rises, the risks remain to the upside as at some point, housing inflation is going to show up in the data.  And that, my friends, is going to be significant and persistent!  Ahead of the number, don’t look for much.  If we see a high print, expect the dollar to regain this morning’s losses, though, as the market will become that much surer the taper is on its way.

Good luck and stay safe
Adf

At All Costs#

Ahead of the winter’s white frosts
The Chinese told firms, “at all costs”
Get oil and gas
And coal, so en masse
Our energy never exhausts

In Europe, as prices keep rising
For Nat Gas, most firms are revising
The prices they charge
Which has, by and large
Helped CPI keep on surprising

Ostensibly, the reason that the Fed, and any central bank, looks at prices on an -ex food & energy basis is because they realize that they have very little control over the prices of either one.  The only tool they have to control them is extremely blunt, that of interest rates.  After all, if they raise interest rates high enough to cause a recession, demand for food & energy is likely to decline, certainly that of energy, and so prices should fall.  Of course, precious few central bankers are willing to cause a recession as they know that their own job would be on the line.

And yet, central banks cannot ignore the impact of food & energy prices on the economy.  This is especially so for energy as it is used to make or provide everything else, so rising energy prices eventually feed into rising prices for non-energy products like computers and washing machines and haircuts.  As has become abundantly clear over the past months, energy prices continue to rise sharply and alongside them, we are seeing sharp rises in consumer prices as well.

Protestations by Lagarde and Powell that inflation is transitory do not detract from the fact that energy prices are exploding higher and that those charged with securing energy for their country or company are willing to continue to pay over the odds to do so.  Yesterday, an edict from the Chinese government to all its major companies exhorted them to get energy supplies for the winter “at all costs.”  This morning, they followed up by telling their coal mining companies to produce at maximum levels and ignore quotas.  Clearly, there is concern in Beijing that with winter coming, there will not be enough energy to heat homes and run factories, an unmitigated disaster.  But this price insensitive buying simply drives the price higher.  (see Federal Reserve impact on bonds via QE for an example.)

And higher these prices continue to go.  Nat Gas, which is the preferred form of fossil fuel, continues to rise dramatically in both Europe and Asia.  In both geographies, it has risen to nearly $35.00/mmBTU, almost 6x as expensive as US Nat Gas.  On an energy equivalent basis, that comes out to $190/bbl of oil.  And you wonder why the Chinese want to dig as much coal as possible.  The problem they are already having, which is adding to their overall economic concerns, is that they have run into an energy shortage and have been restricting power availability to the industrial sector in order to ensure that households have enough.  Of course, starving industry is going to have a pretty negative impact on the economy, hence the call for obtaining energy at all costs.  But that has its own problems, as driving prices higher will divert spending to energy from both investment and consumption.  In other words, as is often the case, there is no good answer to this problem.

If you are wondering how this impacts foreign exchange, let me explain.  First, energy is priced in dollars almost everywhere in the world, at least at a wholesale level.  So, buying energy requires having dollars to spend to do so.  I would contend one reason we have seen the dollar maintain its strength recently, and break out of a medium-term range, is because countries are panicking over their winter energy needs and need dollars to secure supplies.  Second, as energy prices rise, so too does inflation.  And while Mr Powell continues to refuse to accept that is the case, the market is not so stubborn on the issue.  We have seen the yield curve steepen sharply over the past several weeks, something which is historically a dollar positive, and with expectations for the taper firmly implanted into the market’s collective conscience, the strong view is interest rates in the US are going higher.  This, too, is very dollar supportive.  While I remain unconvinced that the Fed will ultimately be willing to tighten policy in any significant manner, that remains the current market narrative.  We shall see how things evolve, but for now, the dollar has legs alongside interest rates and energy prices.

Ok, to today’s price action.  The notable thing is the reduction in risk appetite that has been evident for the past several sessions.  For instance, yesterday we finally achieved a 5% correction in the S&P 500 for the first time in more than 200 sessions.  While prices remain extremely overvalued on traditional measures, it is not yet clear if the ‘buy the dip’ mentality will prevail as we enter a new fiscal quarter.  We shall see.

Overnight, Asia was mostly lower (Nikkei -2.3%, Hang Seng -0.4%) but Shanghai (+0.9%) managed to rally.  Of course, remember, Shanghai has been massively underperforming for quite a while.  Other than China, though, the rest of Asia was all red.  Europe, too, is bright red this morning (DAX -0.8%, CAC -0.8%, FTSE 100 -1.0%) as the broad risk-off sentiment combines with modestly weaker than expected PMI data and higher than expected Eurozone CPI data.  As to the latter, the 3.4% headline print is the highest since Sept 2008, right at the beginning of the GFC.  Yesterday, German CPI printed at 4.1%, which is the highest level since the wake of the reunification in 1993.  For a culture that still recalls the Weimar hyperinflation, things must be pretty uncomfortable there.  It is a good thing this inflation is transitory!

Not surprisingly, with risk being jettisoned, bonds are in demand this morning and although Treasuries are unchanged in this session, they did rally all day yesterday with yields declining nearly 5bps.  As to Europe, Bunds (-3.2bps) and OATs (-3.2bps) are firmly higher with the rest of the continent while Gilts (-1.5bps) are not seeing quite as much love despite an underperforming stock market.  I think one reason is that UK PMI data was actually better than expected and higher than last month, an outlier versus the continent.

Commodity prices are mixed this morning as despite my opening monologue, oil (WTI -0.9%) and Nat Gas (-0.7%) are both under pressure.  Of course, both have been rallying sharply for months, so nothing goes up in a straight line.  Precious metals are little changed on the day, but industrial metals are strong (Cu +1.6%, Al +0.5%, Sn +1.2%).  Ags, on the other hand, are mixed with no pattern whatsoever.

As to the dollar, it is under modest pressure this morning in what appears to be a consolidation at the end of the week.  The one noteworthy mover in the G10 is NOK (+0.75%) which is rallying despite oil’s decline as the market reacted to a surprisingly large decline in the Unemployment rate there to 2.4%.  But otherwise, GBP (+0.3%) is the next best performer and the rest of the bloc is +/-0.2%, with CAD (-0.2%) the laggard on weak oil prices.

EMG currencies have many more gainers than losers this morning with only RUB (-0.6%) on oil weakness, and KRW (-0.35%) on a smaller than expected trade surplus, declining of note, while THB (+0.6%), PLN (+0.6%) and HUF (+0.4%) all have shown some strength.  In Bangkok, the central bank vowed to monitor the baht, which has been falling steadily over the past 9 months to its weakest point in more than 4 years.  PLN saw higher than expected CPI data (5.8%) which has the market looking for higher rates from the central bank, while HUF was the beneficiary of central bank comments that the monetary tightening campaign was “far from the end.”

There is a veritable trove of data to be released this morning starting with Personal Income (exp 0.2%), Personal Spending (0.7%) and the Core PCE (3.5%) at 8:30.  Then at 10:00 we see ISM Manufacturing (59.5) and Prices Paid (78.5) as well as Michigan Sentiment (71.0).  If the PCE number prints on plan, the Fed will be crowing about how it, too, is falling and has peaked.  However, that is crow they will ultimately have to eat, as the peak is not nearly in.

The underlying picture for the dollar remains quite positive on both a technical and fundamental basis, but it appears today is a consolidation day.  Perhaps, a good time to buy dollars still needed to hedge.

Good luck, good weekend and stay safe
Adf

Dissatisfaction

The Chinese would have us believe
Their growth targets, they will achieve
Alas, recent data
When looked at pro rata
Shows trust in their words is naïve

Meanwhile, in the UK, inflation
Is rising across that great nation
The market’s reaction
Is dissatisfaction
Thus, Gilts have seen depreciation

Just how fast is China’s GDP growing?  That is the question to be answered after last night’s data dump was distinctly worse than expected.  The big outlier was Retail Sales, which grew only 2.5% Y/Y in August, down from 8.5% in July and far below the expected 7.0% forecast.  But it was not just the Chinese consumer who slowed down their activity, IP rose only 5.3% Y/Y, again well below the July print of 6.4% and far below the forecast of 5.8%.  Even property investment was weaker than forecast, rising 10.9%, down from 12.7% in July and below the 11.3% forecast.  So, what gives?

Well, there seem to be several issues ongoing there, some of which may be temporary, like lockdowns due to the spreading delta variant of Covid, while others are likely to be with us for a longer time, notably the fallout from the bankruptcy of China Evergrande on the property market there.  The Chinese government is walking a very fine line of trying to support the economy without overstimulating those areas that tend toward speculation, notably real estate.  This is, however, extraordinarily difficult to achieve, even for a government that controls almost every lever of power domestically.  The problem is that the Chinese economy remains hugely reliant on exports (i.e. growth elsewhere in the world) in order to prosper.  So, as growth globally seems to be abating, the impact on China is profound and very likely will continue to detract from its GDP results.

Adding to the Chinese government’s difficulties is that the largest property company there, Evergrande, is bankrupt and will need to begin liquidating at least a portion of its property portfolio.  Remember, it has more than $300 billion in USD debt and the government has already said that interest and principal payments due next week will not be made.  A key concern is the prospect of contagion for other property companies in China, as well as for dollar bonds issued by other Chinese and non-US entities.  History has shown that contagion from a significant bankruptcy has the ability to spread far and wide, especially given the globalized nature of financial markets.  While we will certainly hear from Chinese officials that everything is under control, recall that the Fed assured us that the subprime crisis was under control, right before they let Lehman Brothers go under and explode the GFC on the world.  The point is, there is a very real risk that investors become wary of certain asset classes and risk overall which could easily lead to a more severe asset price correction.  This is not a prediction, merely an observation of the fact that the probability of something occurring has clearly risen.

Speaking of things rising, the other key story of the morning is inflation in the UK, which printed at 3.2%, its highest level since March 2012, and continues to trend higher.  This cannot be surprising given that inflation is rising rapidly everywhere in the world, but the difference is the BOE may have a greater ability to respond than some of its central bank counterparts, notably the Fed.  For instance, the UK debt/GDP ratio, while having risen recently to 98.8%, remains well below that of the rest of the G7, notably the Fed as the US number has risen to around 130%.  As such, markets have begun to price in actual base rate hikes by the BOE, looking for the base rate to rise to 0.50% (from 0.10% today) by the end of next year with the first hike expected in May.  While that may not seem like much overall (it is not really), it is far more than anticipated here in the US.  And remember, our CPI is running above 5.0% vs. 3.2% in the UK.

The upshot of the key stories overnight is that taking risk is becoming harder to justify for investors all over the world.  While there has certainly not yet been a defining break from the current ‘buy the dip’ mentality, fingers of instability* seem to be developing throughout financial markets globally.  The implication is that the probability of a severe correction seems to be growing, although the timing and catalyst remain completely opaque.

So, how has the most recent news impacted markets?  Based on this morning’s price action, there is clearly at least some concern growing.  For example, equity markets in Asia were all in the red (Nikkei -0.5%, Hang Seng -1.8%, Shanghai -0.2%) as the fallout of slowing Chinese growth and the China Evergrande story continue to weigh on sentiment there.  In Europe, the continent is under some pressure (DAX -0.1%, CAC -0.5%) although the UK (FTSE 100 +0.1%) seems to be shaking off the higher than expected CPI readings.  As to US futures, as I type, they are currently marginally higher, about 0.2% each, but this follows on yesterday’s afternoon sell-off resulting in lower closes.  Nothing about this performance screams risk-on, although it is not entirely bad news.

The bond market seems a bit more cautious as Treasury yields have fallen further and are down 1.3bps this morning after a 4bp decline yesterday.  This is hardly the sign of speculative fever.  In Europe at this hour, yields are essentially unchanged except in Italy, where BTP yields have risen 1.6bps as concerns grow over the amount of leeway the Italian government has to continue supporting its economy.

Commodity markets show oil prices continuing to rise (WTI +1.35%) after inventory numbers continue to show drawdowns and Gulf of Mexico production remains reduced due to the recent hurricane Nicholas.  While gold prices are little changed on the day, both copper (+0.6%) and aluminum (+1.6%) are firmer on supply questions.  Certainly nothing has changed my view that the price of “stuff” is going to continue higher in step with the ongoing central bank additions of liquidity to markets and economies.

Finally, the dollar is under pressure this morning, which given the risk-off sentiment, is a bit unusual.  But against its G10 brethren, the greenback is lower across the board with NOK (+0.85%) the clear leader on the strength of oil’s rally, although we are seeing haven assets CHF (+0.4%) and JPY (+0.4%) as the next best performers.  The rest of the bloc has seen much lesser gains, but dollar weakness is clear.

The same situation obtains in the EMG markets, where the dollar is weaker against all its counterparts, although the mix of gainers is somewhat unusual.  ZAR (+0.5%) is the top performer on the back of strengthening commodity prices and it is no surprise to see RUB (+0.4%) doing well either.  But both HUF (+0.45%) and CZK (+0.4%) are near the top of the list as both have seen higher than forecast inflation readings recently and both central banks are tipped to raise rates in the next two weeks.  As such, traders are trying to get ahead of the curve there.  The rest of the bloc is also firmer, but the movement has been much less pronounced with no particular stories to note.

On the data front this morning, Empire Manufacturing (exp 17.9), IP (0.5%) and Capacity Utilization (76.4%) are on the docket, none of which are likely to change many opinions.  The Fed remains in their quiet period until the FOMC meeting next week, so we will continue to need to take our FX cues from other markets.  Right now, it appears that 10-year yields are leading the way, so if they continue to slide, look for the dollar to follow suit.

Good luck and stay safe
Adf

*see “Ubiquity” by Mark Buchanan, a book I cannot recommend highly enough

Flames of Concern

While Fed commentary is banned
Inflation has certainly fanned
The flames of concern
And soon we’ll all learn
If prices are acting as planned

Meanwhile transitory’s the word
Jay’s used to describe what’s occurred
But most people feel
Inflation is real
And denial is naught but absurd

It is CPI day in the US today and recently the results have gained nearly as much attention as the monthly payroll data.  This seems reasonable given that pretty much every other story in the press touches on the subject, although as is constantly highlighted, the Fed pays attention to PCE, not CPI.  Nonetheless, CPI is the data that is designed to try to capture the average rate of increases in price for the ordinary consumer.  As well, virtually all contracts linked to inflation are linked to CPI.  So Social Security, union wage contracts and TIPS all use CPI as their benchmark.

Of course, the reason inflation is the hot topic is because it has been so hot over the past nine months.  Consider that since Paul Volcker was Fed Chair and CPI peaked at 14.8%, in 1980, there has been a secular decline for 40 years.  Now, for the first time since 1990, we are likely to have four consecutive Y/Y CPI prints in excess of 5.0%.  Although Powell and the FOMC have been very careful to avoid defining ‘transitory’, every month that CPI (and PCE) prints at levels like this serves to strain their credibility.

This is evidenced by a survey conducted by the New York Fed itself, which yesterday showed that the median expectation for inflation in one year’s time has risen to 5.2% and in three years’ time to 4.0%.  Both of these readings are the highest in the survey’s relatively short history dating back to 2013.  But the point is, people are becoming ever more certain that prices will continue rising.  And remember, while inflation may be a monetary phenomenon, it is also very much a psychological one.  If people believe that prices will rise in the future, they are far more likely to increase their demand for things currently in order to avoid paying those future high prices.  In other words, hoarding will become far more normal and expectations for higher prices will become embedded in the collective psyche.

In fact, it is this exact situation that the Fed is desperately trying to prevent, hence the constant reminders that inflation is transitory and so behavioral changes are unnecessary.  This is what also leads to absurdities like the White House trying to explain that except for the prices of beef, pork and poultry, food prices are in line with what would be expected.  Let’s unpack that for a minute.  Beef, pork and poultry are the three main protein sources consumed in this country, if not around the world, so the fact that those have risen in price makes it hard to avoid the idea that prices are rising.  But the second half of the statement is also disingenuous, “in line with what would be expected” does not indicate prices haven’t risen, only that they haven’t risen as much as beef etc.  I’m sure that when each of you heads to the supermarket to stock up for the week, you have observed the price of almost every item is higher than it was, not only pre-Covid, but also at the beginning of the year.  Alas, at this point, there is no reason to expect inflation to slow down.

Median expectations according to Bloomberg’s survey of economists show that CPI is forecast to have risen 0.4% in August with the Y/Y increase declining to 5.3% from last month’s 5.4% reading.  Ex food and energy, the forecasts are +0.3% and 4.2% respectively.  Now, those annual numbers are 0.1% lower than the July readings, which have many economists claiming that the peak is in, and a slow reversion to the lowflation environment we experienced for the past twenty years is going to return.  Counter to that argument, though, is the idea that the economy is cyclical and that includes inflation.  As such, even if there is an ebb for now, the next cycle will likely return us to these levels once again, if not higher.  PS, if the forecasts are accurate, as I mentioned before, this will still be the fourth consecutive month of 5+% CPI, a fact which makes it much easier for the masses to believe inflation has returned.  You can see why Powell and the entire FOMC continue to harp on the transitory concept, they are desperate to prevent expectations from changing because, as we’ve discussed before, they cannot afford to raise interest rates given the amount of leverage in the system.

Keeping all this in mind, it is easy to understand why the CPI data release has gained so much in importance, even to the Fed, who ostensibly focuses on PCE.  We shall see what the data brings.

In the meantime, the markets overnight have been mostly quiet with a few outlying events.  China Evergrande, the massively indebted Chinese property company has hired two law firms with expertise in bankruptcy.  This is shaking the Chinese markets as given the massive amount of debt involved (>$300 billion of USD debt) there is grave concern a bankruptcy could have significant knock-on repercussions across all sub-prime markets.  It should be no surprise that Chinese equity markets fell last night with Shanghai (-1.4%) and the Hang Seng (-1.2%) both under continued pressure.  However, the Nikkei (+0.7%) rose to its highest level since 1990, although still well below the peak levels from the Japanese bubble of the late ‘80s.  Europe is also mixed with the DAX (+0.1%) managing to eke out some gains while the rest of the continent slides into the red (CAC -0.4%, FTSE 100 -0.3%). US futures are basically unchanged this morning as we all await the CPI data.

Interestingly, despite a lot of equity uncertainty and weakness, bonds are also under pressure with yields rising across the board.  Treasuries (+1.2bps), Bunds (+1.9bps), OATs (+1.6bps) and Gilts (+3.8bps) have all sold off, with only Gilts making some sense as UK employment data was generally better than expected and indicative of a rebound in growth.

In the commodity markets, oil (WTI + 0.6%) continues to rebound as another hurricane hits the Gulf Coast and is shutting in more production.  But metals prices are under pressure led by copper (-1.25%) and aluminum (-1.0%).

As to the dollar, mixed is the best description I can give this morning.  In the G10, AUD (-0.5%) is the laggard after RBA Governor Lowe questioned why market participants thought the RBA would be raising rates anytime soon despite potential tapering in the US and Europe.  Australia is in a very different position and unlikely to raise rates before 2024.  On the plus side, NOK (+0.4%) continues to benefit from oil’s rebound and the rest of the bloc has seen much more modest movement, less than 0.2%, in either direction.

EMG markets are a bit weaker this morning, seemingly responding to the growing risk off sentiment as we see ZAR (-0.65%) and RUB (-0.5%) both under a fair amount of pressure with a long list of currencies declining by lesser amounts.  While declining metals prices may make sense as a driver of the rand, the ruble seems to be ignoring the oil price rally, as traders await the CPI data.  On the plus side, KRW (+0.45%) was the best performer as positions locally were adjusted ahead of the upcoming holiday there.

And that’s really the story as we await the CPI release.  The dollar, while softening slightly from its best levels recently, continues to feel better rather than worse, so I suspect we could see modest further strength if CPI is on target.  However, a miss in the print can have more significant repercussions, with a high print likely to see the dollar benefit  initially.

Good luck and stay safe
Adf

Nothing Will Thwart

Inflation continues to be
The problem the Fed will not see
The latest report
Shows nothing will thwart
Their views that it’s transitory

Perspective is a funny thing; it has the ability to allow different people to see the same events in very different ways.  For example, yesterday’s CPI report, which printed at 5.4% headline and 4.3% ex food & energy, was fodder for both those with an inflationary bias and those who are in the transitory camp.  As predicted here yesterday morning, any number that was not higher than the June report would be touted as proof inflation is transitory.  And so it has been.  The highlighted facts are the month on month reading was ‘only’ 0.5%, much lower than the previous three months’ readings of 0.9%.  Of course, that is true, but it ignores the fact that a monthly rate of 0.5% annualizes to 6.16%, still dramatically higher than the target.  As well, there was much ink spilled on the fact that used car prices, which had admittedly been rising remarkably quickly due to the unusual circumstances of the semiconductor shortage impeding new car production, fell back to a more normal pace of growth.  The problem with that story is despite one of the ostensible key reasons inflation had been misleadingly higher, used car prices, ceasing to be an issue, inflation still printed at 5.4%!  Clearly there are other things at work here.

Another aspect of perspective comes in the form of the averaging concept, which is the Fed’s latest ruse in rationalizing higher inflation.  For instance, those in the transitory camp, which seems to include the entire FOMC, but also much of the punditry, remain hostile to the idea of inflation settling in at a rate of 1.8%, slightly below the Fed’s target, but are entirely sanguine about that same statistic running at 2.8% for a while to help make up for lost time.  It is this distorted lens that seems to drive the description of inflation as ‘too-low’.  From up here in the cheap seats, inflation cannot be too low.  The idea that we are all better off with prices rising is wrong on its face.

And the idea that wage increases drive inflation also needs to be reconsidered.  After all, if that were the case, we would all be rooting for inflation as that means our wages would be rising quickly.  However, as we know simply by living our lives, and as has been demonstrated by the data, wage increases are broadly lagging inflation.  In fact, yesterday, as part of the Bureau of Labor Statistics data dump, Real Average Hourly and Weekly Earnings showed Y/Y declines of -1.2% and -0.7% in July.  It is no secret that inflation destroys the real value of your earnings, and yet the Fed continues to target a higher level of inflation than had been seen during the past decade and remains comfortable that the current sharply higher numbers are inconsequential in the long run.

However, in the end, whether we agree or disagree with the Fed’s current policy stance and its impacts, the reality is we are not going to have any say in the matter.  All we can do is strive to understand their reaction functions and manage our risks accordingly.  Ultimately, I continue to see the biggest risk as a significantly higher rate of inflation in the US, which will eventually drive nominal yields somewhat higher and real yields still lower than current levels.  That cannot be good for the dollar but will likely help the prices of ‘stuff’.  In the end, be long anything on the periodic table, as that will maintain its value.

The summer doldrums continue as market movement remains fairly limited across equities, bonds, commodities and currencies.  This is not to say there aren’t individual things that move or are trending, just that the broader picture is one of a decided lack of activity.

Last night, for instance, Asian equity markets (Nikkei -0.2%, Hang Seng -0.5%, Shanghai -0.2%) were all lower, but only just.  European markets are more mixed, with both gainers (DAX +0.4%, CAC +0.2%) and losers (FTSE 100 -0.1%) but as can be seen, the movements are not terribly exciting.  This morning saw the release of a plethora of UK data led by Q/Q GDP (+4.8%) and then many of its details showing Consumption by both the government and the population at large grew dramatically, while businesses slowed down somewhat, with IP and Construction both lagging estimates.  I guess investors were generally unimpressed as both the stock market and the pound (-0.1%) have edged somewhat lower after the reports.  Finally, US futures are either side of unchanged again, with the NASDAQ continuing to lag in the wake of the recent rise in US 10-year yields.

Speaking of yields, after the very sharp rise seen in the previous five sessions, yesterday’s Treasury price action was far less exciting and this morning we see the 10-year yield higher by just 1.0 basis point after a decline of similar magnitude Wednesday.  European sovereigns show Bunds (+0.8bps) and OATs (+0.7bps) modestly softer while Gilts (+2.5bps) seem to believe that the UK data was actually better than other market impressions.

Commodity prices are mixed this morning as oil (-0.2%) has given up early gains, along with gold (-0.1%) and the agricultural space.  Copper, however, is bucking the trend and higher by 0.8%.

Lastly, the dollar can only be characterized as mixed this morning, with some weakness in AUD and NZD (-0.25% each) and some strength in NOK (+0.2%) and otherwise a lot of nothing in between.  It is hard to make a case that there is much market moving news in any of these currencies as the UK was the only country with significant new information.

Emerging market currencies are also split, with KRW (-0.4%) continuing to lag the rest of the space as concern grows over the semiconductor manufacturing sector leading to continued equity market outflows and currency sales.  I would imagine that the recent rantings by Kim Jong-Un’s little sister about increased nuclear activity cannot be helping the situation there, but it is not getting headline press in financial discussions.  Otherwise, PLN (-0.3%) is the next weakest currency in the bloc today which seems to be a reaction to some legislation passed that would ostensibly restrict media and speech in the country.  On the plus side, TRY (+1.0%) is today’s champion as traders and investors respond to the central bank’s moderately more hawkish than expected statement after leaving interest rates unchanged (at 19.0%!) as widely expected.  Otherwise, there is nothing noteworthy in the space.

Data today brings the weekly Initial Claims (exp 375K) and Continuing Claims (2.9M) data as well as PPI (7.2%, 5.6% ex food & energy).  However, with CPI already having been released, this data seems relatively insignificant.  There are no scheduled Fed speakers as most FOMC members seem to be going on vacation ahead of the Jackson Hole conference in two weeks’ time.

For now, the dollar seems to be tracking yields pretty well, so if we see movement in the bond market, look for the dollar to follow.  Otherwise, we are likely to remain rangebound for the time being.

Good luck and stay safe
Adf

Nowhere Near

Charles Evans, on Tuesday, explained
Inflation can well be contained
In fact, his concern
Is prices could turn
Back lower ere targets are gained

“I’m going to be very regretful if we sort of claim victory on averaging 2% and then we find ourselves in 2023 with about a 1.8% inflation rate, sustainable, going forward. That would be a challenge for our long-run framework,” he [Evans] said. “We ought to be willing to average inflation above 2%—frankly, well above 2%. [author’s emphasis]”

One cannot overstate the hubris associated with the above quote from Chicago Fed President Charles Evans.  The fact that he legitimately believes the Fed’s powers are such that they can fine-tune a $24 trillion economy to the point that measured estimates of particular features of that economy are able to be managed to a decimal place of an annualized percentage outcome is extraordinary.  It is the perfect illustration of the fact that the Fed is completely out of touch with the economy in which you and I live and completely ensconced in a model driven framework where data represents reality.  But it is exactly this hubris that has resulted in the policy decisions that have brought the world negative interest rates and a defense of debt monetization.  As long as central bankers, notably the Fed, continue to believe that their models are the economy, rather than a simplified representation of the economy, they are likely to continue to make decisions with significant unintended consequences from which we all will suffer.

This morning the market awaits
The latest inflation updates
What’s patently clear
Is they’re nowhere near
An outcome to end the debates

Speaking of inflation, this morning brings the latest CPI data with expectations running as follows: Headline (0.5%, 5.3% Y/Y) and ex food & energy (0.4%, 4.3% Y/Y).  Both of those forecasts are slightly lower than the prints seen in July, and if realized, you can be sure that we will hear a chorus of FOMC members highlighting the transitory nature of inflation.  Of course, if the outcomes are higher than forecast, something we have seen in each of the past twelve reports, we will also hear a chorus of FOMC members explaining that this remains a temporary phenomenon and that inflation is transitory.  [Perhaps when Ralph Waldo Emerson wrote in 1841, “a foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines,” he was anticipating the Fed.]  However, financial markets may not be quite as sanguine over the results, especially if they continue their year-long streak of outperforming the median estimate.

Markets, of late, have been starting to discern between those products that will benefit from altered policy and those products that will suffer.  Nowhere is this clearer than in the US equity markets where we have seen the NASDAQ underperform its brethren indices.  Recall, given the NASDAQ’s strong bias toward high growth (and low profit) companies that benefit greatly from extremely low interest rates, the index behaves very much like a very long-duration bond.  So, in a scenario where inflation is rising and market expectations are for tapering of asset purchases to begin soon(ish), it should be no surprise that the NASDAQ falls alongside the price of bonds.  At the same time, if the implication is that rising inflation is being caused by rebounding growth, rather than supply-chain blockages, there is an opportunity for more mundane, value-type companies to outperform.  Hence, the differing performance of the DOW vs. the NASDAQ.
Of course, the place where inflation is likely to have the most direct effect is the bond market, where long-term yields are theoretically supposed to reflect inflation expectations.  And while we have certainly seen yields rise over the past week, there is no way they currently reflect those expectations.  They cannot do so as long the Fed continues to buy all the new issuance, and then some, thus artificially driving up prices and driving down yields.  Ask yourself this, does it make sense that US 10-year yields are at 1.36% if inflation is at 5.4%?  Of course, the answer to that is a resounding ‘No!’  Yet, that is the current situation.  To observe the bond market and believe it is not artificially inflated (everywhere in the world, mind you) is akin to believing that the moon is made of green cheese.  It just ain’t so!

At any rate, ahead of this morning’s CPI release, investors have generally been biding their time as they wait to determine if they need to adjust their world view.  Equity markets are generally a bit firmer as Asia mostly eked out some gains (Nikkei +0.6%, Hang Seng +0.2%, Shanghai 0.0%) with Europe following suit (DAX 0.0%, CAC +0.3%, FTSE 100 +0.5%).  US futures are split with the NASDAQ (-0.2%) slipping following yesterday’s losses, while the other two main indices are essentially unchanged.  All in all, it appears that there is some hope that CPI prints on the low side to allow the Fed narrative to continue apace, and therefore to allow rates to remain lower for longer.

Bond markets, though, are starting to get a bit antsy these days with Treasury yields edging higher again (+1.7bps) with similar type gains seen throughout Europe (Gilts +1.4bps, OATs +1.8bps, Bunds +0.8bps).  At this point, 10-year Treasury yields have risen 0.25% in the space of a week, which is a very substantial move, especially when considering that the base at the beginning was just 1.12%.  One has to believe the Fed is watching extremely closely as they do not want to see the market run too far ahead of their mooted tapering and create Taper tantrum #2 inadvertently.  It is here where a higher than forecast CPI print could have quite an impact and which may force the Fed to reconsider the idea of tapering.  After all, they cannot afford for 10-year yields to rise to 2.0% while they are still purchasing $120 billion per month of paper.

Commodity prices are mixed today with oil (-1.1%) feeling the pressure of higher yields while gold (+0.5%) seems to be ignoring that same pressure.  Of course, gold was just subject to a significant sell-off, so this could easily be a simple trading bounce.  As it happens, both agricultural and base metal prices are showing a mixture of gainers and losers and no real underlying theme.

Finally, the dollar is definitely stronger again this morning.  While the movement vs. its G10 brethren has not been large, it is unanimous, with all currencies in the red today.  A particular shout-out goes to the euro, which is trading just pips from the key support level of 1.1704.  Watch that carefully as a break there is likely to open up much lower levels.  In the emerging markets, KRW (-0.6%) has been the laggard, followed by TRY (-0.5%) and HUF (-0.4%).  The won has been suffering from a combination of rising covid cases, with a record high 2200 reported yesterday, which has been encouraging the liquidation by foreign investors of Korean equities.  Meanwhile, TRY is under pressure as traders are concerned the President Erdogan will once again interfere in the central bank’s business and prevent them from raising rates at tomorrow’s meeting.  Finally, the forint seems to be suffering for the sins of its neighbors as concerns over German growth, a key market, and Polish politics, a close neighbor, have encouraged selling.

And that’s really it for today.  All eyes will be on the CPI at 8:30. More than just watching the tape, I always pay attention to @inflation_guy on Twitter as he does an excellent job breaking down the drivers of the number and offering insight into how things may evolve.  I highly recommend following him.

As to the dollar, the slow grind higher continues and as long as US rates are rising, I think so will the dollar.  If we break the 1.1704 level in the euro, look for a bit of an acceleration.  But don’t be surprised if we reject the move given it is the first test of the support level since it was established back in March.

Good luck and stay safe
Adf

Resolute

The narrative is resolute
That though prices did overshoot
They’re certain to fall
And that, above all,
The Fed’s in control, absolute

However, concern is now growing
That growth round the world’s started slowing
Though Friday’s report
On jobs was the sort
To help the bull market keep going

Clearly, my concerns over a weak payroll report were misplaced as Friday’s data was strong on every front, although perhaps too strong on some.  Nonfarm payrolls grew a robust 943K with net revisions higher of 119K for the past two months.  The Unemployment Rate crashed to 5.4%, down one-half percent, and Average Hourly Earnings rose 4.0% Y/Y.  It is the last of these that may generate some concern, at least from the perspective of the transitory inflation story.

While it is unambiguously good news for the working population that their wages are rising, something that has been absent for the past two decades, as with Newton’s first law (every action has an equal and opposite reaction) the direct result of rising wages tends to be rising prices.  So, while getting paid more is good, if the things one buys cost more, the net impact may not be as positive.  And in fact, consider that while the 4.0% annual rise is the highest (excluding the distortions immediately following the  Covid-19 lockdowns) in the series since at least the turn of the century, when compared to the most recent CPI data (you remember, 5.4%) we find that the average employee continues to fall behind on a real basis.

When discussing inflation, notice that the Fed harps on things like used car prices or hotel prices as the key drivers of the recent rise in the data.  They also tend to explain that commodity prices play a role, and that is something they cannot control.  But when was the last time Chairman Powell talked about rapidly rising wages or housing prices as an underlying cause of inflation?  In fact, when asked about whether the Fed should begin tapering mortgage-backed securities purchases sooner because of rapidly rising house prices, he claimed the Fed’s purchases have no impact on house prices, but rather it was things like the temporary jump in lumber prices that were the problem.  Oh yeah, and see, lumber prices have fallen back down so there is nothing to worry about.

Of course, wages are not part of CPI directly.  Rising wages are reflected in the rising prices of everything as companies both large and small find it necessary to raise prices to maintain their profitability.  Certainly, there are some companies that have more pricing power than others and so are quicker to raise prices, but in the end, rising wages result in one of two things, higher prices or lower margins, and oftentimes both.  In the broad scheme of things, neither of these outcomes is particularly positive for generating real economic growth, which is arguably the goal of all monetary policies.

Consider, to the extent rising wages force companies to raise the price of their product or service, the result is an upward bias in inflation that is independent of the price of oil or lumber or copper.  In fact, one of the key features of the past 40 years of disinflation has been the fact that labor’s share of the economic pie has fallen substantially compared to that of capital.  This has been the result of the globalization of the workforce as the addition of more than 1 billion new workers from developing nations was sufficient to keep downward pressure on wages.

Arguably, this has also been one of the key reasons corporate profit margins have risen and stock prices along with them.  Now consider what would happen if that very long-term trend was in the process of reversing.  There is a likelihood of rising prices of goods and services, otherwise known as inflation.  There is also a likelihood of a revaluation of equity prices if margins start to decline. And nothing helps margins decline like rising labor costs.

Consider, also, this is the sticky type of inflation, exactly the opposite of all the transitory claims.  This is the widely (and rightly) feared wage-price spiral.  I am not saying this is the current situation, at least not yet, but that things are falling into place that could easily result in this outcome.

Now put yourself in Chairman Powell’s shoes.  Prices have begun rising more rapidly as companies respond to rising wage pressures.  The employment situation has been improving more rapidly so there is less concern over the attainment of that part of your mandate.  But…the amount of leverage in the system is astronomical with government debt running at record high levels (Federal government at 127%) and all debt, including household and corporate at 400% of GDP.  Do you believe that the economy can withstand higher interest rates of any substance?  After all, in order to tackle inflation, real rates need to be positive.  What do you think would happen if the Fed raised rates to 6%?  And this is my point as to why the Fed has painted themselves into the proverbial corner.  They cannot possibly respond to inflation with their “tools” because the negative ramifications would be far too large to withstand.  It is also why I don’t’ believe the Fed will make any substantive policy changes despite all the tapering talk.  They simply can’t afford to.

Ok, on to the markets.  One of the notable things overnight was the flash crash in the price of gold, which tumbled $73 as the session began on a huge sell order in the futures market, although has since regained $54 and is currently down 1.1% from Friday’s close.  The other things was the release of Chinese CPI (1.0%) and PPI (9.0%), both of which printed a few ticks higher than expected.  Obviously, there is not nearly as much pass-through domestically from producer to consumer prices in China, but that tends to be a result of the fact that consumption is a much smaller share of the Chinese economy.  However, higher prices on the production side, despite the government’s efforts to stop commodity speculation and hoarding, does not bode well for the transitory story.  And while discussing EMG inflation readings, early this morning we saw Brazil (1.45% M/M) and Mexico (5.86% Y/Y) both print higher than forecast results.  Certainly, it is no surprise that both central banks are in tightening mode.

A quick peak at equity markets showed Asia performed reasonably well (Nikkei +0.3%, Hang Seng +0.4%, Shanghai +1.0%) although Europe has been struggling a bit (DAX -0.2%, CAC -0.1%, FTSE 100 -0.4%).  US futures, meanwhile, are either side of unchanged with very modest moves.

Treasury yields have given back 2 basis points from Friday’s post-NFP surge of 7.5bps, although there are many who continue to believe the short-term down trend has been ended.  European sovereigns are also rallying a bit, with Bunds (-1.3bps), OATs (-1.3bps) and Gilts (-3.5bps) leading a screen that has seen every European bond rally today.

Commodity prices are perhaps the most interesting as oil prices have fallen quite sharply (-4.0%) with WTI back to $65.50/bbl, its lowest level since late May.  This appears to be a recognition of the growth of the Delta variant and how more and more nations are responding with another wave of lockdowns and restrictions on movement, thus less travel and overall economic activity.  As such, it should be no surprise that copper (-1.5%) is lower or that the metals space as a whole is under pressure.

Interestingly, the dollar is not showing a clear trend at all today, with gainers and losers about evenly mixed and no particularly large moves.  In the G10, NOK (-0.3%) is the laggard, clearly impacted by oil’s decline, but away from that, the mix is basically +/- 0.1%, in other words, no real change.  In the emerging markets, ZAR (+0.3%) is the leader, although this appears more to be a response to its sharp weakness last week than to any specific news.  And that is the only EMG currency that moved more than 0.2%, again, demonstrating very little in the way of new information.

Data this week brings CPI amongst a bunch of lesser numbers:

Today JOLTS Jobs Openings 9.27M
Tuesday NFIB Small Biz Optimism 102.0
Nonfarm Productivity 3.2%
Unit Labor Costs 0.9%
Wednesday CPI 0.5% (5.3% Y/Y)
-ex food & energy 0.4% (4.3% Y/Y)
Thursday Initial Claims 375K
Continuing Claims 2.88M
PPI 0.6% (7.1% Y/Y)
-ex food & energy 0.5% (5.6% Y/Y)
Friday Michigan Sentiment 81.2

Source: Bloomberg

At this point, the response to the CPI data will be either of the following; a high number will be ignored (transitory remember), and a low number will be proof they are correct.  So, while we may all be suffering, the narrative will have no such problems!

There are a handful of Fed speakers this week as well, with the two most hawkish voices (Mester and George) on the calendar.  Right now, the narrative has evolved to tapering is part of the conversation and Jackson Hole will give us more clarity.  The market is pricing the first rate hike by December 2022 based on the recent commentary.  We shall see.  Until then, I don’t anticipate a great deal as many desks will be thinly staffed due to summer vacations.  Just be careful if you have a large amount to execute.

Good luck and stay safe
Adf

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
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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
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