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 Reprieve

Said Boris to Angela, Hon
When this year is over and done
There’ll be no reprieve
The UK will leave
The EU and start a great run

Will somebody please explain to me why every nation seems to believe that if they do not have a trade deal signed with another nation that they must impose tariffs.  After all, the WTO agreement merely defines the maximum tariffs allowable to signatories.  There is no requirement that tariffs are imposed.  And yet, to listen to the discussion about trade one would think that tariffs are mandatory if trade deals are not in place.

Consider the situation of the major aircraft manufacturer in Europe, a huge employer and key industrial company throughout the EU.  As it happens, they source their wings from the UK, which, while the UK was a member of the EU, meant there were no tariff questions.  Of course, Brexit interrupted that idea and now their wing source is subject to a tariff.  BUT WHY?  The EU could easily create legislation or a regulation that exempts airplane wings from being taxed upon importation.  After all, there’s only one buyer of wings.  This would prevent any further disruption to the manufacturer’s supply chain and seem to be a winning strategy, insuring that the airplanes manufactured remain cost competitive.  But apparently, that is not the direction that the EU is going to take.  Rather, in a classic example of cutting off one’s nose to spite their face, the EU is going to complain because the UK is not willing to cut a deal to the EU’s liking while imposing a tariff on this critical part for one of their key industrial companies.  And this is just one of thousands of situations that work both ways between the UK and the EU.  I never understand why the discussion is framed in terms of tariffs are required, rather than the reality that they are voluntarily imposed by the importing country for political reasons.

This was brought to mind when reading about the meeting between British PM Johnson and German Chancellor Merkel, where ostensibly Boris explained that he would like a deal but the EU will need to compromise on key areas like fishing rights and the influence, or lack thereof, of EU courts in UK laws, or the UK is prepared to walk with no deal.  Negotiations continue but the clock is well and truly ticking as the deadline for an extension to be agreed has long passed.

It cannot be surprising that this relatively negative news has resulted in the pound giving up some of its recent gains, although at this point of the session it is only lower by 0.2% compared to yesterday’s closing levels, a modest rebound from its earlier session lows.  The euro, on the other hand is essentially unchanged at this hour as traders look over the landscape and determine that there is very little to drive excitement for the day.

dol·drums

/ˈdōldrəmz,ˈdäldrəmz/

noun

  1. a state or period of inactivity, stagnation, or depression.

In the late 1700’s, sailors would get stuck crossing the Atlantic at the equator during the summer as the climactic conditions were of high heat and almost no wind.  This time became known as the summer doldrums, a word that came into use as a combination of dull and tantrums, or, essentially, unpredictable periods of dullness.

Well, the doldrums have arrived.  And, as the summer progresses, it certainly appears that, despite the ongoing Covid-19 emergency, the FX market is heading into a period of even greater quiet.  This is somewhat ironic as one of the favored analyst calls for the second half of the year is increasing volatility across markets.  And while that may well come to pass in Q4, right now it seems extremely unlikely.

Let’s analyze this idea for a moment.  First off, there is one market that is very unlikely to see increased volatility, Treasury notes and bonds.  For the past month, the range on 10-year yields has been 10 basis points, hardly a situation of increased volatility.  And given the Fed’s ever-increasing presence in the market, there is no reason to believe that range will widen anytime soon.  Daily movement is pretty much capped at 3 basis points these days.

Equity markets have shown a bit more life, but then they have always been more volatile than bonds historically.  Even so, in the past month, the S&P has seen a range of about 7% from top to bottom and historic volatility while higher than this time last year, at 25% is well below (and trending lower) levels seen earlier this year.  After the dislocations seen in March and April, it will take some time before volatility levels decline to their old lows, but the trend is clear.

Meanwhile, FX markets have quickly moved on from the excitement of March and April and are already back in the lowest quartile of volatility levels.  Again, looking at the past month, the range in EURUSD has been just over 2 big figures, and currently we are smack in the middle.  Implied volatility, while still above the historic lows seen just before the Covid crisis broke out, are trending back lower and have fallen in a straight line for the past month.  And this pattern has played out even in the most volatile emerging market currencies, like MXN, which while still robustly in the mid-teens, have been trending lower steadily for the past three months.

In other words, market participants are setting aside their fears of another major dislocation in the belief that the combination of fiscal and monetary stimulus so far implemented, as well as the promise of more if deemed ‘necessary’ will be sufficient to anesthetize the market.  And perhaps they are correct, that is exactly what will happen, and market activity will revert to pre-Covid norms.  But risk management is all about being prepared for the unlikely event, which is why hedging remains of critical importance to all asset managers, whether those assets are financial or real.  Do not let the lack of current activity lull you into the belief that you can reduce your hedging activities.

If you haven’t already figured this out, the reason I waxed so long on this issue is that the market is doing exactly nothing at this point.  Overnight movement was mixed and inconclusive in equities, although I continue to scratch my head over Hong Kong’s robust performance, while bond markets remain with one or two basis points of yesterday’s levels.  And the dollar is also having a mixed session with both gainers and losers, none of which have even reached 0.5%.  In fact, the only true trend that I see these days is in gold, which as breeched the $1800/oz level this morning and has been steadily climbing higher since the middle of 2018 with a three-week interruption during March of this year.  I know that the prognosis is for deflation in our future, but I would be wary of relying on those forecasts.  Certainly, my personal experience shows that prices have only gone higher since the crisis began, at least for everything except gasoline, and of course, working from home, I have basically stopped using that.

Not only has there been no market movement, there is essentially no data today either, anywhere in the world.  The point is that market activity today will rely on flows and headlines, with fundamentals shunted to the sidelines.  While that is always unpredictable, it also means that another very quiet day is the most likely outcome.

Good luck and stay safe

Adf