Jay Powell’s Story

This weekend the Chinese reported
That PMI growth has been thwarted
This likely implies
They’ll increase the size
Of stimulus, when all is sorted

Meanwhile, as the week doth progress
Investors will need to assess
If Jay Powell’s story
About transitory
Inflation means more joblessness

The conventional five-day work week clearly does not apply to China.  On a regular basis, economic data is released outside of traditional working hours as was the case this past weekend when both sets of PMI data, official and Caixin (targeting small companies), were reported.  And, as it happens, the picture was not very pretty.  In fact, it becomes easier to understand why the PBOC reduced the reserve requirement for banks several weeks ago as growth on the mainland is quite evidently slowing.  The damage can be seen not only in the headline manufacturing numbers (PMI 50.4, Caixin 50.3) but also in the underlying pieces which showed, for example, new export orders fell to 47.7, well below the expansion/contraction line.

While it is one of Xi’s key goals to wean China from the dominance of exports as an economic driver, the reality is that goal has come nowhere near being met.  China remains a mercantilist, export focused economy, where growth is defined by its export sector.  The fact that manufacturing is slowing and export orders shrinking does not bode well for China’s economy in the second half of the year.  To the extent that the delta variant of Covid is responsible for slowing growth elsewhere in the world, apparently, China has not escaped the impact as they claim.

However, in today’s upside-down world, weakening Chinese growth is seen as a positive for risk assets.  The ongoing ‘bad news is good’ meme continues to drive markets and this weaker Chinese data was no exception.  Clearly, investors believe that the Chinese are going to add more stimulus, whether fiscal or monetary being irrelevant, and have responded by snapping up risk assets.  The result was higher equity prices in Asia (Nikkei +1.8%, Hang Seng +1.1%, Shanghai +2.0%) as well as throughout Europe (CAC +0.8%, FTSE 100 +0.95%, DAX +0.1%) with the DAX having the most trouble this morning.  And don’t worry, US futures are all higher by around 0.5% as I type.

But it was not just Chinese equities that benefitted last night, investors snapped up Chinese 10-year bonds as well, driving yields lower by 5bps as expectations of further policy ease are widespread in the investment community there. That performance is juxtaposed versus what we are witnessing in developed market bonds, where yields are actually slightly firmer, although by less than 1 basis point, as the risk-on attitude encourages investors to shift from fixed income to equity weightings.

Of course, all this price action continues to reflect the fact that the Fed, last week, was not nearly as hawkish as many had expected with the tapering question remaining wide open, and no timetable whatsoever with regard to rate movement.  And that brings us to the month’s most important data point, Non-farm Payrolls, which will be released this Friday.  At this early point in the week, the median forecast, according to Bloomberg, is 900K with the Unemployment Rate falling to 5.7%.

Given we appear to be at an inflection point in some FOMC members’ thinking, I believe Friday’s number may have more importance than an August release would ordinarily demand.  Recall, the recent trend of US data has been good, but below expectations.  Another below expectations outcome here would almost certainly result in a strong equity and bond rally as investors would conclude that the tapering story was fading.  After all, the Fed seems highly unlikely to begin tapering into a softening economy.  Last week’s GDP data (6.5%, exp 8.5%) and core PCE (3.5%, exp 3.7%) are just the two latest examples of a slowing growth impulse in the US.  That is not the time when the Fed would historically tighten policy, and I don’t believe this time will be different.

There is, however, a lot of time between now and Friday, with the opportunity for many new things to occur.  Granted, it is the beginning of August, a time when most of Europe goes on vacation along with a good portion of the Wall Street crowd and investment community as a whole, so the odds of very little happening are high.  But recall that market liquidity tends to be much less robust during August as well, so any new information could well lead to an outsized impact.  And finally, historically, August is one of the worst month for US equities, with an average decline of 0.12% over the past 50 years.

Keeping this in mind, what else has occurred overnight?  While bad news may be good for stock prices, as it implies lower rates for even longer, slowing growth is not an energy positive as evidenced by WTI’s (-1.8%) sharp decline.  Interestingly, gold (-0.25%) is not benefitting either, as arguably the reduced inflation story implies less negative real yields.  More surprisingly, copper (+0.7%) and Aluminum (+0.6%) are both firmer this morning, which is a bit incongruous on a weaker growth story.

As to the dollar, it is broadly weaker, albeit not by much, with G10 moves all less than 0.2% although we have seen some much larger gains in the EMG space.  On top of that list sits ZAR (+1.15%) and TRY (+1.1).  The former is quite surprising given the PMI data fell by a record amount to 43.5, 14 points below last month’s reading as rioting in the wake of the Zuma arrest had a huge negative impact on business sentiment and expectations.  Turkey, on the other hand, showed a solid gain in PMI data, which bodes well for the economy amid slowing growth in many other places.  After those two, the gains were far more modest with HUF (+0.5%) and RUB (+0.35%) the next best performers with both the forint and the ruble benefitting from more hawkish central bank comments.

Obviously, it is a big data week as follows:

Today ISM Manufacturing 60.9
ISM Prices Paid 88.0
Construction Spending 0.5%
Tuesday Factory Orders 1.0%
Wednesday ADP Employment 650K
ISM Services 60.5
Thursday Initial Claims 382K
Coninuing Claims 3260K
Trade Balance -$74.0B
Friday Nonfarm Payrolls 900K
Private Payrolls 750K
Manufacturing Payrolls 28K
Unemployment Rate 5.7%
Average Hourly Earnings 0.3% (3.9% Y/Y)
Average Weekly Hours 34.7
Participation Rate 61.7%
Consumer Credit $22.0B

Source: Bloomberg

Beyond the data, surprisingly, we only hear from three Fed speakers as many must be on holiday.  But at this point, the market is pretty sure that it is only a matter of time before the Fed starts to taper, so unless they want to really change that message, which I don’t believe is the case, they can sit on the sidelines for now.  of course, that doesn’t mean they are going to taper, just that the market expects it.

While the dollar is opening the week on its back foot, I don’t expect much follow through weakness, although neither do I expect much strength.  I suspect many participants will be biding their time ahead of Friday’s report unless there is some exogenous signal received.

Good luck and stay safe
Adf

The Tapering Walk

For those who expected a hawk
When Powell completed his talk
T’was somewhat depressing
That Jay was professing
They’d not walk the tapering walk

Then last night, from China, we learned
A falling stock market concerned
The powers that be
Thus, they did agree
To pander to those who’d been burned

Apparently, the Fed is not yet ready to alter its policy in any way.  That is the message Chairman Powell delivered yesterday through the FOMC statement and following press conference.  Though it seems clear there was a decent amount of discussion regarding the tapering of asset purchases, in the end, not only was there no commitment on the timing of such tapering, there was no commitment on the timing of any potential decision.  Instead, Chairman Powell explained that while progress had been made toward their goals, “substantial further progress” was still a ways away, especially regarding the employment situation.

When asked specifically about the fact that inflation was currently much higher than the FOMC’s target and whether or not that met the criteria for averaging 2%, he once again assured us that recent price rises would be transitory.  Remember, the dictionary definition of transitory is simply, ‘not permanent’.  Of course, the question is exactly what does the Fed mean is not going to be permanent?  It was here that Powell enlightened us most.  He explained that while price rises that have already occurred would likely not be reversed, he was concerned only with the ongoing pace of those price rises.  The Fed’s contention is that the pace of rising prices will slow down and fall back to levels seen prior to the onset of the Covid pandemic.

Of course, no Powell Q&A would be complete without a mention of the “tools” the Fed possesses in the event their inflation views turn out to be wrong.  Jay did not disappoint here, once again holding that on the off chance inflation seems not to be transitory, they will address it appropriately.  This, however, remains very questionable.  As the tools of which they speak, higher interest rates, will have a decisively negative impact on asset markets worldwide, it is difficult to believe the Fed will raise rates aggressively enough to combat rising inflation and allow asset markets to fall sharply.  In order to combat inflation effectively, history has shown real interest rates need to be significantly positive, which means if inflation is running at 5%, nominal rates above 6% will be required.  Ask yourself how the global economy, with more than $280 Trillion of debt outstanding, will respond to interest rates rising 600 basis points. Depression anyone?

At any rate, the upshot of the FOMC meeting was that the overall impression was one of a more dovish hue than expected going in, and the market response was exactly as one might expect.  Equity markets rebounded in the US and have continued that path overnight.  Bond markets rallied a bit in the US, although with risk appetite back in vogue, have ceded some ground this morning.  Commodity prices are rising and the dollar is under pressure.

Speaking of risk appetite, the other key story this week had been China and the apparent crackdown on specific industries like payments and education.  While Tuesday night’s comments by the Chinese helped to stabilize markets there, that was clearly not enough.  So, last night we understand that the China Securities Regulatory Commission gathered a group of bankers to explain that China was not seeking to disengage from the world nor prevent its companies from accessing capital markets elsewhere.  They went on to explain that recent crackdowns on tech and educational companies were designed to help those companies “grow in the proper manner”, a statement that could only be made by a communist apparatchik.  But in the end, the assurances given were effective as equity markets in Hong Kong and China were sharply higher and those specific companies that had come under significant pressure rebounded on the order of 7%-10%.  So, clearly there is no reason to worry.

Now, I’m sure you all feel better that things are just peachy everywhere.  The combination of Chairman Powell removing any concerns over inflation getting out of hand and the Chinese looking out for our best interests regarding the method of growth in its economy has led to a strongly positive risk sentiment.  As such, it should be no surprise that equity prices are higher around the world.  Asia started things (Nikkei +0.75%, Hang Seng +3.3%, Shanghai +1.5%) and Europe has followed suit (DAX +0.45%, CAC +0.7%, FTSE 100 +0.9%).  US futures have not quite caught the fever with the NASDAQ (-0.2%) lagging, although the other two main indices are slightly higher.

In the bond market, investors are selling as they no longer feel the need of the relative safety there, with Treasury yields higher by 3bps, while Bunds (+2bps), AOTs (+1bp) and Gilts (+2.7bps) are all under pressure.  But remember, yields remain at extremely low levels and real yields remain deeply negative, so a few bps here is hardly a concern.

Commodity prices have waived off concerns over the delta variant slowing the economy down and are higher across the board.  Oil (+0.25%), gold (+0.85%), copper (+1.1%) and the entire agricultural space are embracing the renewed growth narrative.

Finally, the dollar, as would be expected during a clear risk-on session and in the wake of the Fed explaining that tapering is not coming to a screen near you anytime soon, is lower across the board.  In the G10 space, NZD (+0.6%) and NOK (+0.55%) are leading the way higher, which is to be expected given the movement in commodity prices.  CAD (+0.45%) is next in line.  But even the yen (+0.1%) has edged higher despite the positive risk attitude.  One could easily describe this as a pure dollar sell-off.

In the emerging markets, HUF (+0.85%) is the leader as traders are back focused on the hawkishness of the central bank and an imminent rate hike, now ignoring the lack of EU funding that remains an open issue.  ZAR (+0.8%) is next on the commodity story with KRW (+0.7%) in the bronze medal position as exporters took advantage of the weakest won in nearly a year to sell dollars and then Samsung’s earnings blew away expectations on the huge demand for semiconductors, and funds flowed into the equity market.

We get our first look at Q2 GDP this morning (exp 8.5%) with the Consumption component expected to rise 10.5% on a SAAR basis.  We also see Initial Claims (385K) and Continuing Claims (3183K).  Recall, last week Initial Claims were a much higher than expected 419K, so weakness here could easily start to cause some additional concern at the Fed and delay the tapering discussion even further.  With the FOMC behind us, we can look forward to a great deal more Fedspeak, although it appears many of the committee members are on vacation, as we only have two scheduled in the next week, and they come tomorrow.  I imagine that calendar will fill in as time passes.

Putting it all together shows that any Fed hawks remain in the distinct minority, and that the party will continue for the foreseeable future.  Overall, the dollar has been trading in a range and had been weakly testing the top of that range.  It appears that move is over, and we seem likely to drift lower for the next several sessions at least, but there is no breakout on the horizon.

Good luck and stay safe
Adf

Christine Lagarde’s Goal

This morning, Christine Lagarde’s goal
Is focused on how to cajole
The market to see
That her ECB
Has total command and control

Ahead of the ECB statement and the subsequent press conference this morning, markets are mostly biding their time.  Monday’s risk-off session is but a hazy memory and everyone is completely back on board for the reflation trade despite rising numbers of Covid cases as well as newly imposed lockdowns by governments throughout the world.  While that may seem incongruous, apparently, the belief is that any such lockdowns will be for a much shorter period this time than we saw last year, and so the impact on economic activity will be much smaller.

With a benign backdrop, it is worthwhile, I believe, to consider what we are likely to see and hear from the ECB and how it may impact markets.  We already know that they have changed their inflation target from, “close to, but below 2.0%” to ‘2.0%’.  In addition, we have been told that there is a willingness to accept a period of time where inflation runs above their target as the ECB seeks to fine-tune both the message and the outcome.  Of course, when you think about what CPI measures, it is designed to measure the average rate of price increases for the population as a whole, the idea of fine-tuning something of this nature is ridiculous.  Add to that the extreme difficulty in measuring the data (after all, what exactly makes up the consumer basket? and how does it change over time?  and isn’t it different for literally every person?) and the fact that central banks are concerned if inflation prints at 1.7% or 2.0% is ludicrous.  As my friend @inflation_guy (you should follow him on Twitter) always explains, you cannot reject the null hypothesis that 1.7% and 2.0% are essentially the same thing in this context.  In other words, there is no difference between 2.0% inflation, where central bankers apparently feel comfortable, and 1.7% inflation, where central bankers bemoan the impending deflationary crisis.

As well, the ECB is going to explain their new asset purchase process.  Currently, there are two programs, the Public Sector Purchase Program (PSPP) which is the original QE program and had rules about adhering to the capital key and not purchasing more than 33% of the outstanding debt of any nation in order to prevent monetizing that debt.  Covid brought a second program, the Pandemic Emergency Purchase Program (PEPP), which had no such restrictions regarding what was eligible and how much of any particular nation’s bonds could be acquired but was limited in size and time.  Granted they both expanded the size of the program twice and extended its maturity, but at least they tried to make believe it was temporary.  The recent framework review is likely to allow PEPP to expire in March 2022, as currently planned, but at the same time expand the PSPP and its pace of purchases so that there will be no difference at all to the market.  In other words, though they will attempt to describe their policies as ‘new’, nothing is likely to change at all.

Finally, they apparently will be altering their forward guidance to promise interest rates will remain unchanged at current levels until inflation is forecast to reach or slightly surpass 2% and remain there for some time within the central bank’s projection period of two to three years.  Given the decades long lack of inflationary impulse in the Eurozone due to anemic underlying economic growth and ongoing high unemployment, this essentially means that the ECB will never raise rates again.  The ongoing financial repression being practiced by central banks shows no sign of abating and the ECB’s big framework adjustment will do nothing to change that outcome.

Will any of this matter?  That is debatable.  First, the market is already fully aware of all these mooted changes, so any price impact has arguably already been seen.  And second, have they really changed anything?  I would argue the answer to that is no.  While the descriptions of policies may have changed, the actions forthcoming will remain identical.  Interest rates will not move, and they will continue to purchase the same number of bonds that they are buying now.  As such, despite a lot of tongue wagging, I expect that the impact on the euro will be exactly zero.  Instead, the single currency will remain focused on the Fed’s (remember the FOMC meets next week), interest rate policy and the overall risk appetite in the market.

Turning to markets ahead of the ECB announcement we see that risk remains in vogue with strong gains in Asia (Hang Seng +1.85, Shanghai +0.35%, Nikkei closed) and Europe (DAX +0.9%, CAC +0.8%) although the FTSE 100 is barely changed on the day.  US futures are all green and higher by about 0.2% at this hour.

Bond markets have calmed down after a few very choppy days with Treasury yields backing up 1bp and now back to 1.30%, nearly 18 basis points above the low print seen Monday.  European sovereigns are mixed with Gilts seeing yields edge up by 0.8bps, while OATs have seen yields slide 0.8bps and Bunds are unchanged on the day.  Of course, with the ECB imminent, traders are waiting to see if there is any surprise forthcoming so are being cautious.

Oil prices continue their sharp rebound from Monday’s virtual collapse, rising another 0.6% and now firmly back above $70/bbl.  It turns out that Monday was a great opportunity to buy oil on the cheap!  Precious metals continue to disappoint with gold (-0.4%) slipping back below $1800/oz, although really just chopping around in a range.  Copper is firmer by 0.8% this morning but the rest of the non-ferrous group is slightly softer.

As to the dollar, it is under pressure virtually across the board this morning as there is certainly no fear visible in markets.  In the G10, NOK (+0.9%) is the leader on the back of oil’s rebound with the rest of the bloc seeing broad-based, but shallow, gains.  In the emerging markets, HUF (+0.55%) is the leader after recent comments from a central banker that they will be raising rates until their inflation goal is met.  (So old school!)  Meanwhile, overnight saw strength in APAC currencies (PHP +0.45%, IDR +0.4%, KRW +0.35%) as positive risk sentiment saw foreign inflows into the entire region’s stock markets.

We do get some data this morning starting with Initial (exp 350K) and Continuing (3.1M) Claims at 8:30 as well as Leading Indicators (0.8%) and Existing Home Sales (5.90M).  Fed speakers remain incommunicado due to the quiet period so as long as the ECB meets expectations the dollar should continue to follow its risk theme, which today is risk-on => dollar lower.

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
Adf

Covid’s Resurgence

Covid’s resurgence Has begun to detract from Asia’s second spring

It seems the global economic rebound is starting to falter.  At least, that is what one might conclude from the run of data we are seeing from virtually every nation, as well as the signals we are starting to get from the global central banking community.  For instance, on the data front, this morning’s UK numbers showed that growth, while still quite positive, is not quite living up to expectations.  May’s GDP reading was 0.8%, a very good number (it would annualize to nearly 10% GDP growth) but far below analysts forecasts of 1.5%.  Similarly, IP also printed at 0.8%, again well above last month’s data but falling far short of the 1.4% expectations.  The point is that economists’ views of the reopening burst seem to have been a bit overexuberant.  The UK is hardly alone in this situation with Italy also showing disappointing IP data for May (-1.5% vs. +0.3% expected).  And we saw the same thing from both Germany and France earlier this month.  In a nutshell, it appears that the European economy, while certainly growing more robustly than Q1, may well have seen its best days.

Meanwhile, in Asia, the delta variant of Covid-19 has become a much larger problem, with Japan, South Korea, Indonesia and Thailand particularly hard hit.  You have probably heard that the Olympics will be spectatorless this year in Tokyo as the Suga government has implemented yet another emergency lockdown order that is not due to expire until the end of August.  In South Korea, infections are rising as well and the government has increased curbs on gatherings of more than 5 people, while Thailand has once again closed ‘non-essential’ businesses to prevent the spread of the disease.  Vaccination rates throughout Asia have been much lower than elsewhere, with most of Europe and the US having seen between 40% and 50% of the population vaccinated while Asian countries are in the 5% – 10% range.  The issue is that while the virus continues to spread, economic activity will continue to be impaired and that means that markets in those economies are going to feel the pain, as likely will their currencies.

Of course, the US has not been immune from this run of disappointing data as virtually every reading in the past month has failed to meet expectations.  Two broader indicators of this slowdown are the Atlanta Fed’s GDPNow number, which is currently at 7.78%, obviously a strong number, but down from 13.71% two month’s ago.  As well, the Citi Economic Surprise index has fallen from 270 a year ago to essentially 0.0 today.  This measures actual data vs. median expectations and is indicative of the fact that data continues to miss its targets in the US as well as throughout the rest of the world.

Arguably, it is this downturn in economic activity that has been the key driving force in the bond market’s remarkable rally for the past two months, although this morning, it appears that some profit taking is underway as Treasury yields have backed up 4.8bps.  Keep in mind, though, that yields had fallen more than 25bps at their lowest yesterday in just the past two weeks, so a reprieve is no real surprise.  

The question at hand has become, is this just a pause in activity, or have we already seen the peak and now that fiscal stimulus is behind us, growth is going to revert to its pre-pandemic trend, or worse?  My sense is the latter is more likely and given the extraordinary amount of debt that was issued during the past year, the growth trend is likely to be even worse than before the pandemic.  However, slowing growth is not necessarily going to be the death knell for inflation by any means.  Lack of investment and shortages of key inputs will continue to pressure prices higher, as will the demand from consumers who remain flush with cash.  The worst possible outcome, stagflation, remains entirely realistic as an outcome.

And on that cheery note, let’s survey markets quickly.  While yesterday was a clear risk-off session, this morning it is just the opposite, with equity markets rebounding and bonds under some pressure.  While the Nikkei (-0.6%) failed to rebound, we did see the Hang Seng (+0.7%) pick up some while Shanghai (0.0%) was flat.  The big news in China was the PBOC reduced the RRR for banks by 0.5%, to be implemented next week.  Remember, the Chinese continue to try to fight the blowing up of bubbles in markets, both financial and real estate, but are looking for ways to loosen policy.  Remember, too, that inflation in China remains quite high, at least at the factory gate, with PPI released last night at 8.8% Y/Y.  This reading was exactly as forecast and a touch lower than last month’s reading.  But it is still 8.8%!  If this starts to trend lower over the coming months, that will be a strong signal regarding global inflationary concerns, but we will have to wait to see.

European markets, though, are uniformly stronger, led by the CAC (+1.75%) although the DAX (+0.9%) and FTSE 100 (+0.7%) are both doing well this morning despite the weaker data.  It appears that investors remain comforted by the ECB’s continued commitment to supporting the economy and their commitment to not withdraw that support if inflation readings start to tick higher.  As to US futures, while the NASDAQ is unchanged at this hour, both SPX and DOW futures are higher by around 0.5%.

It is not only Treasuries that are selling off, but we are seeing weakness in Gilts (+3.8bps), Bunds (+1.1bps) and OATs +0.5bps) as well.  After all, every bond market rallied over the past weeks, so profit-taking is widespread.

On the commodity front, oil continues to trade in a hugely volatile manner, currently higher by 1.15% after rebounding more than 3% from its lows yesterday.  Base metals are also moving higher (Cu +1.7%, Al +0.6%, Sn +0.1%) although gold (-0.2%) continues to range trade around the $1800/oz level.

As to currencies, the picture is mixed with commodity currencies strong this morning alongside the commodity rally (NOK +0.8%, AUD +0.55%, NZD +0.3%) while the yen (-0.3%) is giving up some of yesterday’s haven related gains.  EMG currencies are behaving in a similar manner with RUB (+0.75%), ZAR (+0.6%) and MXN (+0.3%) all benefitting from higher commodity prices.  However, we are also seeing HUF (+0.85%) rise sharply as inflation surprised to the high side at 5.3% Y/Y and encouraged traders to bet on tighter monetary policy given its resurgence.  On the downside, the Asian bloc suffered the most (PHP -0.4%, THB -0.4%, KRW -0.3%) as traders sold on the negative Covid news.

There is no data today nor any Fed speakers.  That means that FX markets will be looking to equities and bonds for it’s cues, with equity markets seeming to have the stronger relationship right now.  The bond/dollar correlation seems to have broken down lately.    While the dollar is soft at this time, I see no reason for a major sell-off in any way.  As it is a summer Friday, I would look for a relatively quiet session with a drift lower in the dollar as long as risk assets perform well.

Good luck, good weekend and stay safe

Adf

Likely to Fade

The bond market’s making it clear

Inflation, while higher this year,

Is likely to fade

Just like Jay portrayed

While bottlenecks soon disappear





The data though’s yet to support

Inflation’s rise will be cut short

Perhaps CPI

Next week will supply

The data the Fed does purport

For the past month, virtually every price indicator in the G20 has printed higher than forecast, which continues a multi-month trend and has been a key support of the inflationist camp.  After all, if the actual inflation readings continue to rise more rapidly than econometric models indicate, it certainly raises the question if there is something more substantial behind the activity.  At the same time, there has been a corresponding increase of commentary by key central bank heads that, dammit, inflation is transitory!  Both sides of this debate have been able to point to pieces of data to claim that they have the true insight, but the reality is neither side really knows.  This fact is made clear by the story-telling that accompanies all the pronouncements.  For instance, the transitory camp assures us that supply-chain bottlenecks will soon be resolved as companies increase their capacities, and so price pressures will abate.  But building new plant and equipment takes time, sometimes years, so those bottlenecks may be with us for many months.  Meanwhile, the persistent camp highlights the idea that the continued rise in commodity prices will see input costs trend higher with price rises ensuing.  But we have already seen a significant retreat from the absolute peaks, and it is not clear that a resumption of the trend is in the offing.  The problem with both these stories is either outcome is possible so both sides are simply talking their books.

While I remain clearly in the persistent camp, my take is more on the psychological effects of the recent rise in so many prices.  After all, even the Fed is focused on inflation expectations.  So, considering that recency bias remains a strongly inbred human condition, and that prices have risen recently, there is no question many people are expecting prices to continue to rise.  At the same time, one argument that had been consistently made during the pre-pandemic days was that companies could not afford to raise prices due to competition as they were afraid of losing business.  But now, thanks to multiple rounds of stimulus checks, the population, as a whole, is flush with cash.  As evidenced by the fact that so many companies have already raised prices during the past year and continue to sell their wares, it would appear that the fear of losing business over higher prices has greatly diminished.

And yet…the bond market has accepted the transitory story as gospel.  This was made clear yesterday when both Treasury and Gilt yields tumbled 8 basis points while Bund and OAT yields fell 6bps.  That is not the behavior of a bond market that is worried about runaway inflation.  

So, which is it?  That, of course, is the $64 trillion question, and one for which nobody yet has the answer.  What we can do, though, is try to determine how markets may move in either circumstance.

If inflation is truly transitory it would seem that we can look forward to a continued bull flattening of yield curves with the level of rates falling alongside the slope of the yield curve.  Commodity prices will arguably have peaked as new production comes online and equity markets will benefit significantly from lower interest rates alongside steady growth.  As to the dollar, it seems unlikely to change dramatically as lower yields alongside lower inflation means real yields will be stable.

On the other hand, if prices rise persistently for the next quarters (or years), financial markets are likely to respond very differently.  At some point the bond market will become uncomfortable with the situation and yields will start to rise more sharply amid a steeper yield curve as the Fed will almost certainly remain well behind the curve and continue to suppress the front end.  Commodity prices will have resumed their uptrend as they will be a key driver in the entire inflationary story.  Energy, especially, will matter as virtually every other product requires energy to be created, so higher energy prices will feed into the economy at large.  Equity markets may find themselves in a more difficult situation, especially the high growth names that are akin to very long duration bonds, although certain sectors (utilities, staples, REITs) are likely to hold their own.  And the dollar?  If, as supposed, the Fed remains behind the curve, the dollar will suffer significantly, as real yields will decline sharply.  This will be more evident if we continue to see policy tightening from the group of countries that have already begun that process.

In the end, though, we are all just speculating with no inside knowledge of the eventual outcome.  It is for this reason that hedging is so important.  Well designed hedge strategies help moderate the outcome regardless of the eventual results, and that is a worthy goal in itself. Hedging can reduce earnings/cash flow volatility.

Onward to today’s markets.  Starting with bonds, after yesterday’s huge rally, we continue to see demand as, though Treasury yields are unchanged, European sovereign yields have fallen by between 0.3bps (Gilts) and 1.5bps (Bunds), with the rest of the major nations somewhere in between.

Equity markets have been more mixed but are turning higher.  Last night saw the Nikkei (-1.0%) and Hang Seng (-0.4%) follow the bulk of the US market lower, but Shanghai (+0.7%) responded positively to news that the PBOC may soon be considering cutting rates to support what is a clearly weakening growth impulse in China.  (Caixin PMI fell to 50.3 in Services and 51.3 in Manufacturing, both far lower than expected in June.)  European markets have been in better stead with the DAX (+0.9%) leading the way and FTSE 100 (+0.5%) putting in a solid performance although the CAC (+0.1%) is really not doing much.  The big news here was the European Commission publishing their latest forecasts for higher growth this year and next as well as slightly higher inflation.  Finally, US futures markets are all pointing higher with the NASDAQ (+0.5%) continuing to lead the way.

Commodity prices are definitely higher this morning with oil (+1.5%) a key driver, but metals (Au +0.6%, Ag +1.0%, Cu +2.0% and Al +0.3%) all finding strong bids.  Agricultural products are also bid this morning and there is more than one analyst who is claiming we have seen the bottom in the commodity correction with higher prices in our future.

As to the dollar, it is somewhat mixed, but arguably, modestly weaker on the day.  In the G10, NZD (+0.4%), NOK (+0.3%) and AUD (+0.3%) are the leaders with all three benefitting from the broad-based commodity rally.  SEK (-0.25%) is the laggard as renewed discussion of moderating inflation pressures has investors assuming the Riksbank will be late to the tightening party thus leaving the krona relatively unattractive.

In the EMG bloc, ZAR (+0.5%), MXN (+0.35%) and RUB (+0.25%) are the leading gainers, with all three obviously benefitting from the commodity story this morning.  CNY (+0.25%) has also gained after investor inflows into the Chinese bond market supported the renminbi.  On the downside, KRW (-0.7%) and PHP (-0.6%) fell the most although the bulk of those moves came in yesterday’s NY session as the dollar rallied across the board and these currencies gapped lower on the opening and remained there.  Away from these, though, activity has been less impressive with few stories to drive things.

Two pieces of data today are the JOLTS Job Openings (exp 9.325M) and the FOMC Minutes this afternoon.  The former will simply serve to highlight the mismatch in skills that exists in the US as well as the fact that current policy with enhanced unemployment insurance has kept many potential workers on the sidelines.  As to the Minutes, people will be focused on any taper discussion as well as the conversation on interest rates and why views about rates changed so much during the quarter.

Our lone Fed speaker of the week, Atlanta Fed President Bostic, will be on the tape at 3:30 this afternoon.  To date, he has been in the tapering sooner camp, so I would expect that will remain the situation.  

Yesterday’s dollar rally was quite surprising given the decline in both nominal and real yields in the US.  However, it has hardly given back any ground.  At its peak in early April, the dollar index traded up to 93.4 and the euro fell to 1.1704.  We would need to break through those levels to convince of a sustained move higher in the dollar.  In the meantime, I expect that the odds are the dollar can cede some of its recent gains.

Good luck and stay safe

Adf

Nirvana Awaits

While Powell and friends fail to see

Inflation rise dangerously

Down south of the border

They fear its disorder

And burden on society





So, Mexico shocked and raised rates

While Fedspeak back here in the States

Continues the story

It’s all transitory

And claiming Nirvana awaits

Mexico became the latest emerging market nation to raise interest rates when they surprised the analyst’s community as well as markets by raising their base rate by 0.25% yesterday afternoon to 4.25%.  The FX market response was swift and certain with the peso gaining more than 1.0% in the first minutes after the announcement although that has since slightly abated.  “Although the shocks that have affected inflation are expected to be of a transitory nature, given their variety, magnitude and the extended time frame in which they have been affecting inflation, they may pose a risk to the price formation process,” the Banxico board explained in their accompanying statement.  In other words, although they are paying lip service to the transitory concept, when CPI rose to a higher than expected 6.02% yesterday, it was apparently a step too far.  Expectations for further rate hikes have already been built into the markets while views on the peso are improving as well.

The juxtaposition yesterday of Mexico with the UK, where the BOE left policy rates on hold at 0.10% and maintained the QE program intact despite raising its inflation forecast to 3.0% for next year, is quite interesting.  Historically, it was the emerging market central banks who would seek growth at any cost and allow inflation to run hot while trying to support the economy and the developed market central banks who managed a more disciplined monetary policy, working to prevent inflation from rising while allowing their economy’s to grow without explicit monetary policy support.  But it seems that another symptom of the Covid-19 pandemic is that it has reversed the ‘polarity’ of central bank thinking.  Mexico is the 4th major EMG nation (Russia, Brazil and Poland are the others) to have raised rates and are anticipated to continue doing so to combat rising prices.  Meanwhile, when the Bank of Canada reduced the amount of its QE purchases, it was not only the first G10 bank to actually remove some amount of monetary largess, it was seen as extraordinary.  

In the States, yesterday we heard from six more Fed speakers and it has become evident that there are two distinct views on the FOMC as to the proper course of action, although to a (wo)man, every speaker exclaimed that inflation was transitory.  Several regional Fed presidents (Bullard, Bostic and Kaplan) are clearly in the camp of tapering QE and potentially raising rates by the end of next year, but the Fed leadership (Powell, Clarida, Williams) are adamantly opposed to the idea of tightening policy anytime soon.  And the thing is, the hawks don’t even have a vote this year, although they do get to participate in the conversation.  The upshot is that it seems highly unlikely that the Fed is going to tighten policy anytime at all this year regardless of inflation readings going forward.  While ‘transitory’ has always been a fuzzy term, my take has always been a 2-3 quarter view, but yesterday we started to hear it could mean 2 years or more.  If that is the case, then prepare for a much worse ultimate outcome along with a much weaker dollar.

As markets and investors digest the latest central bank dogma, let us peruse the latest price action.  Yesterday’s equity market price action led to yet another set of new all-time highs in US indices and even Mexico’s Bolsa rose 0.75% after the rate hike!  Overnight saw a continuation of that view with the Nikkei (+0.65%), Hang Seng (+1.4%) and Shanghai (+1.15%) all rallying nicely.  Perhaps a bit more surprisingly this morning has seen a weaker performance in Europe (DAX -0.15%, CAC -0.1%, FTSE 100 +0.1%) despite slightly better than expected Confidence data out of Germany and Italy.  As vaccinations proceed apace on the continent, expectations for a renewed burst of growth are rising, yet today’s stock markets seem unimpressed.

At the same time, despite all the Fedspeak and concern over inflation, the 10-year Treasury yield has basically been unchanged all week and seems to have found a new home at 1.50%, right where it is now.  Since it had been a harbinger for markets up until the FOMC meeting last week, this is a bit surprising.  As to Europe, bonds there are actually under some pressure this morning (Bunds +1.7bps, OATs +2.9bps, Gilts +1.2bps) although given equity market performance, one is hard-pressed to call this a risk-on move.  Perhaps these markets are responding to the better tone of data, but they are not in sync with the equity space.

In commodity markets, prices are mixed this morning.  While oil (-0.25%) is softer, gold (+0.5%) and silver (+1.0%) are looking awfully good.  Base metals, too, are having a better session with Cu (+0.4%), Al (+1.5%) and Sn (+0.2%) all performing well.  Crop prices are also rising, between 0.25% and 0.5%.  Fear not for oil, however, as it remains firmly ensconced in its uptrend.

And lastly, in FX markets, the dollar is under modest pressure across most of the G10, with the bulk of the bloc firmer by between 0.1% and 0.2%, and only GBP (-0.2%) softer.  While we did see a slightly weaker than expected GfK Consumer Confidence number for the UK last night (-9 vs. expected -7) we also just saw CBI Retail Sales print at a much better than expected level.  In the end, it is hard to ascribe the pound’s movement, or any of the G10 really, to data.  It is far more likely positions being adjusted into the weekend.

In the emerging markets, the dollar is having a much tougher time with ZAR (+1.0%) and KRW (+0.6%) the leading gainers, but a number of currencies showing strength beyond ordinary market fluctuations.  While the rand’s move seems outsized, the strength in commodity prices is likely behind the trend in ZAR lately.  As to KRW, it seems that as well as the general risk on attitude, the market is pricing in the first policy tightening in Seoul and given the won’s recent mild weakness, traders were seen taking advantage to establish long positions.

We have some important data today led by Personal Income (exp -2.5%), Personal Spending (0.4%) and Core PCE (0.6% M/M, 3.4% Y/Y).  Then at 10:00 we see Michigan Confidence (86.5).  I want to believe the PCE data is important, but I fear that regardless of where it prints, it will be ignored as a product of base effects and so not a true reflection of the price situation.  Yesterday, Claims data was a bit worse than expected as was Durable Goods.  This is not to say things are collapsing, but it is growing more and more apparent, at least based on the data, that the peak in the economy has already been seen.  In fact, the Atlanta Fed GDPNow model has fallen back below 10.0% and appears to be trending lower.  The worst possible outcome for the economy would be slowing growth and rising inflation, and I fear that is where we may be heading given the current fiscal and monetary policy settings.  

That combination will be abysmal for the dollar but is unlikely to be clear before many more months have passed.  For now, I expect the dollar will revert to its risk profile, where risk-on days will see weakness and risk-off days see strength.  Today feels far more risk-on like and so a little further dollar weakness into the weekend seems a reasonable assumption.

Good luck, good weekend and stay safe

Adf

Feeling Upbeat

The last central bank set to meet

This month is on Threadneedle Street

No change is expected

Though some have projected

The hawks there are feeling upbeat

Market focus this morning will be on the Bank of England’s policy meeting as it is the last of the major central banks to meet this month.  We have already had a tumultuous time between the ECB’s uber dovishness and the Fed’s seeming turn toward the hawkish side of the spectrum.  Of course, the Fed has largely tried to walk that idea back, but it remains firmly implanted in the market dialog.  As to the UK, growth there, despite more draconian lockdown measures still being imposed in the face of the delta variant of Covid, has been expanding rapidly according to the GDP readings while PMI data points to a continuation of that trend.  Not surprisingly, given the supply side constraints that are evident elsewhere in the world, the UK is also dealing with that issue and so prices have been rising apace.  In fact, the CPI data released last week showed the highest print in more than two years.  Of course, that print was 2.1%, hardly a number to instill fear in anyone’s heart.

And yet, the amount of talk about the need to tighten monetary policy in the UK is remarkable.  At least in the US, we are looking at exceptionally high CPI data, with numbers not seen in decades.  In contrast, CPI in the UK averaged nearly 3.0% for all of 2017, well above the most recent reading.  Not only that, but it was only at the last meeting that the BOE reaffirmed that QE was necessary to support the economy.  The idea that in 6 weeks things have changed that much seems fanciful.  That’s not to say that the committee won’t be discussing potential tightening down the road, especially if recent economic trends continue, but I find it hard to believe that given the ongoing disruptions that are still extant, there can be any serious considerations of change.  As it stands, the market is currently pricing a 15 basis point hike by next June, which would take the base rate back up to 0.25%.  

Arguably, the fact that the market is this focused on what should be a non-event is a good indication of the lack of interesting stories at the moment.  With the ECB and Fed behind us, and with both central banks furiously trying to drive the narrative to their preferred story of transitory inflation and no reason to worry, traders are looking for any opportunity to make a buck.  Some of the previous ideas, whether Bitcoin or meme stocks, have largely lost their luster.  The inflation trade, too, is having a harder time as so many commodity prices have retreated from their early Spring highs.  In this situation, it is not unusual for traders to focus on any potential catalyst far in excess of its importance.  I would contend, that is exactly what we are seeing here and that when the BOE announcement comes, it will have nothing to add to the story.

It can be no surprise, then, that market activity overnight has been extremely quiet overall.  As traders and investors look for the next big thing, volumes tend to decrease, and volatility can abate for a short period of time.  For instance, equity markets in Asia showed almost no pulse with both the Nikkei and Shanghai indices unchanged on the day while the Hang Seng managed to eke out a 0.25% gain.  Europe, on the other hand, is having a go of it, with gains in the DAX (+0.8%) and CAC (+1.0%) after much stronger than forecast confidence data was released.  The FTSE 100 (+0.3% ahead of the BOE) seems to want to join the party but is awaiting the BOE release before really moving.  And, after several desultory sessions with very limited movement in the US, futures this morning are higher by 0.5% across the board.

Bond markets are similarly quiet with modest price declines in Treasuries (+0.8bps), Bunds (+0.9bps) and OATs (+0.9bps) seen at this hour.  Gilts are essentially unchanged, clearly awaiting the BOE meeting before traders are willing to get too involved.

Commodity prices started the session with a mix of gainers and losers, but at this hour, most have turned lower.  Oil (-0.2%) is just backing off slightly but remains in a strong uptrend.  While precious metals (Au +0.2%, Ag +0/6%) stick out for being a bit higher on the day, we are seeing weakness in Copper (-0.2%), Aluminum (-0.4%) and most of the ancillary metals as well as the agricultural space with the three main crops all lower by at least 1.0%.

As to the dollar, it is a bit softer this morning with NOK (+0.4%) the leading gainer despite oil’s reversal from early morning gains.  But there is strength in SEK (+0.3%), NZD (+0.25%) and essentially the entire G10 bloc, albeit only modest in size.  It is difficult to point to specific catalysts for this movement, although Sweden’s PPI data did print much higher than forecast leading to some speculation, they too would soon be tightening policy.

***BOE leave policy unchanged, rates on hold***

The first reaction to the BOE news is a modest decline in the pound (-0.2%) although I expect it will remain choppy for now.

Quickly turning to the EMG bloc, the dollar is softer here almost universally with RUB (+0.45%) the leading gainer and PLN (+0.4%) right behind it.  The latter is benefitting from talk that rising inflationary pressures will lead to tighter monetary policy, while the ruble, along with the krone, seems to be maintaining its early gains despite oil’s pullback.  

On the data front, this morning brings the usual weekly Initial Claims (exp 380K) and Continuing Claims (3.46M) as well as Durable Goods (2.8%, 0.7% ex transport).  We also get the final look at Q1 GDP (6.4%) which is forecast to be unchanged from the previous reading.  Tomorrow we will see Core PCE, which is the Fed’s preferred inflation measure, but we can discuss that then.

Overall, it is shaping up to be a dull day.  Further comments from the BOE are highlighting the transitory nature of inflation there, with a statement indicating that while 3.0% inflation will be coming, it will not last very long.  As I continue to type, the pound continues to slide, now down 0.3%, and interest rate markets are adjusting as well, with the rate hike scenario being pushed further into the future.  

The one area where we could get some movement is from the Fed speakers, with six on today’s calendar.  Yesterday, Atlanta Fed president Bostic was the first since the FOMC meeting last week, to reiterate that tapering would be appropriate soon as well as higher rates.  But the preponderance of evidence remains that the Fed is uninterested in doing anything for a long while yet.  I think things will get more interesting for them later in the year if inflation figures continue to run hot, but for now, they remain confident they are in control.

As to the dollar, unless we start hearing a lot more hawkish rhetoric from the Fed speakers, my sense is that it will continue to drift slightly lower in its current trading range.

Good luck and stay safe

Adf

Bears Have Retreated

At first, no one thought it could be

That Powell would lessen QE

But less than a week

Was needed to wreak

Destruction ‘pon his new decree

The bond market bears have retreated

With steepeners now all deleted

While stocks are unsure

If this is the cure

And just how this news should be greeted

Last week’s FOMC meeting continues to be the main topic of market discussion as many assumptions have been questioned, especially those of the inflationist camp.  The change in the dot plot was clearly unforeseen and has been the talk of the market ever since.  Arguably, there are two key questions that have arisen in the wake of the meeting; 1) what happened to the Fed’s insistence that they would not adjust policy preemptively based on forecasts? and 2) is maximum employment no longer deemed to be an Unemployment Rate near 3.5%?

What has been made very clear, however, is that the market still believes the Fed can address inflation, or at the very least, that the market buys the Fed’s transitory inflation narrative.  Regarding the latter, it relies almost entirely on the idea that supply-side bottlenecks will be quickly addressed, thus forcing prices lower and reducing the inflationary threat.  My question is, why do so many assume that restarting production can be accomplished so quickly?  In many cases, businesses have closed, thus no longer manufacturing products.  In others, businesses are running shorter or fewer shifts due to the inability to hire/retain staff to operate.  Glibly, many say that those businesses can simply raise wages to attract staff.  And while that may be true, you can be sure that will result in rising prices as well.  So, if supply returns at a higher price point, is that not still inflationary? 

Under the theory that a picture is worth a thousand words, I have created a decision matrix that outlines my sense of how things may play out over the coming months.  Having observed the Fed and its reaction function to market situations for quite a long time, I remain convinced that despite all the rhetoric regarding maximum employment or inflation expectations, the single most important data point for the Fed is the S&P 500.  History has shown that when it declines sharply, between 10%-20%, they will step in, ease policy in some manner and seek to assuage the investment community regardless of trivialities like inflation, GDP growth or unemployment.  Thus far, nothing the Fed has done has changed that opinion.

Remember, these are my personal views and I assigned rough probabilities along with estimates of what could happen under the defined scenarios.  Ultimately, the question that keeps haunting me is; if inflation is transitory, why would they need to taper policy easing?  After all, the underlying assumption is that the current policy remains economically supportive without negative inflationary consequences, so why change?  I believe the answer to this question belies the entire Fed narrative.  But that’s just me.  The highlighted area is the expected outcome in one year’s time based on Friday’s closing markets (BCOM = Bloomberg Commodity Index).  Interestingly, the math worked out where I saw weaker stocks, higher yields, a weaker dollar and higher commodities.  In truth, if inflation is in our future, that does not seem to be wrong.

As to markets this morning, while Asian equity markets were largely under pressure (Nikkei -3.3%, Hang Seng -1.1%, Shanghai +0.1%), still reeling from the Fed’s allegedly hawkish stance, Europe is modestly firmer (DAX +0.7%, CAC +0.3%, FTSE 100 +0.2%).  Perhaps hawks only fly East.  US futures are also higher this morning, by roughly 0.5%, as the early concerns over tighter policy have clearly been allayed, by what though, I’m not sure.

Of course, all the real action has been in the bond market, where yields worldwide have fallen sharply since the FOMC meeting.  Not only have yields fallen, but curves have flattened dramatically as well with movement on both ends of the curve, shorter dated yields have risen under the new assumption that the Fed will be raising rates, while the bank end has rallied sharply with yields declining as investors ostensibly believe that inflation is, in fact, transitory.  While the overnight session has seen minimal movement (Treasuries 0.0bps, Bunds =0.4bps, Gilts -0.3bps), the movement since Wednesday has been impressive.  The $64 billion question is, will this new movement continue into a deeper trend, or reverse as new data is released.

Commodity prices have not yet abandoned the inflation story, at least some of them haven’t.  Oil (+0.2%) continues to perform well as demand continues apace and supply remains in the crosshairs of every ESG focused investor.  Precious metals have rallied on the back of declining yields, both real and nominal, but base metals have slipped as there is a growing belief that they were massively overbought on an inflation scare that has now been defused.  Funnily enough, I always had the commodity/inflation relationship the other way around, with higher commodity prices driving inflation.

Finally, the dollar this morning is weaker from Friday’s levels, but still generally stronger from its levels post FOMC.  The crosscurrents here are strong.  On the one hand, transitory inflation means less reason for a depreciating currency while on the other, lower rates that come with less inflation make the dollar less attractive.  At the same time, if risk is going to be back in vogue, the dollar will lose support as well. 

On the data front, there is a fair amount of data this week, although nothing of note today.

TuesdayExisting Home Sales5.71M
WednesdayFlash PMI Manufacturing61.5
 Flash PMIM Services70.0
 New Home Sales871K
ThursdayInitial Claims380K
 Continuing Claims3481K
 Durable Goods2.9%
 -ex transport0.7%
 Q1 GDP6.4%
FridayPersonal Income-2.7%
 Personal Spending0.4%
 Core PCE0.5% (3.9% Y/Y)
 Michigan Sentiment86.5

Source: Bloomberg

As well as all of this, we heard from ten different Fed speakers, including Chairman Powell testifying to Congress tomorrow afternoon.  It would seem there will be a significant effort to fine tune their message in the wake of last week’s meeting and the market volatility.

The dollar’s strength had been predicated on the idea that US yields were increasing and if that is no longer the case, my sense is that the dollar is likely to retrace its recent steps higher.  For those who with currency payables, keep that in mind.

Good luck and stay safe

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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