A Wrong Turn

In Europe, the reading today
For CPI led to dismay
With prices still rising
Lagarde’s now revising
The timing for QE’s decay

Then later this morning we’ll learn
If Jay has a cause for concern
Should payrolls be strong
It will not be long
Til stock markets take a “wrong” turn

There seem to be three stories of note today with varying impacts on market behavior, and in the end, they are all loosely tied together.  Starting in Europe, CPI printed at a higher than forecast 5.0% in December, rising to a historic high for the Eurozone as currently constituted.  While energy prices were the largest driver of the data, even excluding those, CPI rose 2.6%, well above the current ECB target.  Given the series of remarkable energy policy blunders that have been made by the Europeans, one has to believe that it will be many more months before energy inflation has any chance of abating.  And as long as the continent remains reliant on Russia for its natural gas supplies, it will almost certainly be held hostage across other issues.  Remember, too, the more money spent on energy, where those funds leave the continent as they don’t really produce much of their own, the less money available for things like manufacturing and consumption of other goods.

The problem for the ECB is that the specter of slowing growth conflicts with their alleged desire to reduce QE and allow policy to “normalize”.  As we see in virtually every nation, the tension between addressing inflation and stifling growth is the crux of central bank decision making.  Madame Lagarde finds herself between the proverbial rock and hard place here.  As things currently stand, I fear the Eurozone is going to find itself in a position dangerously close to stagflation as the year progresses.  Do not be surprised if there are some major electoral changes this year.  PS, none of this is actually very good for the single currency, so keep that in mind as well.  While it has seemed to have stabilized over the past two months, another leg lower feels like it is still on the cards.  What Will Christine Do? History shows that central banks almost always err on the side of higher inflation, so do not be surprised if that is the case here as well.

Turning to the States, it is payroll day with the following forecasts:

Nonfarm Payrolls 447K
Private Payrolls 405K
Manufacturing Payrolls 35K
Unemployment Rate 4.1%
Average Hourly Earnings 0.4% (4.2% Y/Y)
Average Weekly Hours 34.8
Participation Rate 61.9%

Source: Bloomberg

With the market and investors still absorbing what seemed to be an even more hawkish set of FOMC Minutes than anticipated, where they extensively discussed QT, this has all the trademarks of a ‘good news is bad’ set-up, such that a strong print (>600K) will result in a bond and stock market sell-off as investors flee duration assets.  Remember, too, the ADP number printed at 807K, nearly double expectations and the highest since May21.  Since that release, forecasts have risen by about 50K and whispers even more.  The point is that if US data really starts to show significantly more strength, expectations are going to grow for more rate hikes this year as well as a quicker pace of allowing the balance sheet to shrink.  And that, my friends, will not be a good look for risky assets.

There once was a firm, Evergrande
In China, that bought tons of land
In order to build
Apartment blocks filled
With people, but now must disband

The problem for China is they
Explained, when this firm went astray
Twas under control
And they would cajole
Investors, their sales, to delay

Finally, before we move on to today’s markets, I would be remiss if I didn’t point out a change of tone from China overnight, one that was not officially announced but is true nonetheless.  You may remember back in September when we first heard about China Evergrande and the fact that the second largest property developer in that country, and the most indebted, was having trouble repaying its loans.  Initially there was talk by the doomsayers that this was China’s Lehman moment, and everything would unravel quickly.  Of course, that did not happen, although what we have seen since is a slower unraveling of that company and many others in the sector.  It turns out that when your business model is premised on borrowing excessive amounts of money to build apartment blocks in ghost cities, there could be problems down the line.

At any rate, the PBOC was adamant that everything was under control and that, anyway, China Evergrande’s borrowings weren’t that big compared to China’s GDP.  (That always sounded an awful lot like Bernanke’s comments regarding subprime mortgages.)  More recently, the PBOC imposed three ‘red lines’ regarding the ability of property developers to borrow money as they were really trying to squeeze the speculation out of the property market, but without causing the bubble to actually burst, simply deflate.  These rules, though, meant that Evergrande, and the other very weak companies in the space, suddenly had no source of funding.  Well, last night it was discovered that the PBOC has actually instructed banks to lend to property companies more aggressively.  Apparently the PBOC’s red lines have as much value as Qaddafi’s or Obama’s, in other words, none.  It can be no surprise that the PBOC has reversed course given the potential problems that exist in the Chinese property sector.  Just beware as things there remain opaque and in flux, although I doubt the renminbi is set to move dramatically soon.

Ok, quickly, after yesterday’s US equity fizzle, where markets slid slightly, Asia was mostly the same although the Hang Seng (+1.8%) did manage to rally sharply after it became clear Evergrande would get more funding.  Europe has done essentially nothing, despite a generally weak mix of data (German IP -0.2%, French IP -0.4%) as investors seem to be waiting for the payroll number to assess the Fed’s actions.  US futures are little changed at this hour as well.

We are seeing similar lack of activity in the bond market as here, too, investors await the payroll numbers.  Yesterday saw essentially no change in the 10-year Treasury yield although shorter maturity bonds did see yields rise a couple of ticks as the market continues to look for rate hikes sooner rather than later.  Europe is also biding its time to see what comes from NFP, with no major markets having moved even 1 basis point from yesterday’s levels.

Oil prices continue to rise (+0.75%) with WTI now above $80/bbl for the first time in two months.  But we are seeing strength throughout this space with NatGas (+1.4%) and Uranium (+3.5%) showing all energy is bid.  In fairness, the Uranium story is squarely on the back of the uprising in Kazakhastan where some 40% of global uranium is mined.)  On the metals front, both precious (Au +0.2%, Ag +0.2%) and base (Cu +0.3%, Al +0.5%, Zn +2.7%) are all in favor with only agricultural prices under pressure today.

As to the dollar, it is somewhat softer but not universally so.  SEK (+0.4%) and NOK (+0.3%) are the leading gainers in the G10 with oil helping the latter while the former continues to benefit from perceptions of still strong economic activity despite the latest wave of omicron.  However, other than these, movement is 0.1% or less in either direction, signifying absolutely nothing.  EMG currencies, though, have definitely seen more strength with ZAR (+0.7%), RUB (+0.7%) and CLP (+0.5%) all responding positively to the commodity rally.

And that is really it for the day.  My take on the NFP data is that good news (i.e. a strong print) will be a negative for risk assets as estimates will be that the Fed needs to move that much quicker to alleviate the inflation pressures.  That means a classic risk-off scenario of stronger dollar, stronger yen and weaker equities.  Bonds, however, are likely to see curve flattening more than higher rates, as the front end will be sold aggressively while the back lags appreciably.

Good luck, good weekend and stay safe
Adf

Slower than Planned

There once was a firm, Evergrande
Whose ethos was just to expand
But its wanderlust
Led it to go bust
When China grew slower than planned

The aftermath now seems to be
Impacting the PBOC
They cut RRR
And could well do more
Inverse to Fed ending QE

As we begin a new week, and arguably the second to last where market liquidity will be close to its ordinary levels, the news of the day centers on the PBOC reducing its Reserve Ratio Requirement (RRR), as foreshadowed by Premier Li Keqiang last week.  While the official comments are focused on the government’s efforts to insure stable growth amid concerns over the omicron variant’s spread, it appears the reality may reach a little deeper.  Of more importance to market participants than the virus is the status of China Evergrande and the entire property sector in China.  It now appears that there is going to be an total restructuring of that company’s debt as it defaults on its remaining obligations.  Recall, Evergrande is was the largest property developer in China, and the most highly leveraged having total debts in excess of $300 billion as it expanded its business from purely property development to interests as far flung as theme parks, a soccer club and electric vehicles.  As of last night, it has notified creditors that a restructuring is on its way and that clearly has the PBOC a little concerned.

Property is the largest sector of the Chinese economy, representing more than 30%, and a key revenue source for most provinces and cities as they sell land to fund operations.  Evergrande was one of the largest purchasers, and so its slow-motion demise is being felt throughout the nation.  It is for this reason that the PBOC finds itself in a situation where it feels the need to add more liquidity to the economy, hence the RRR cut.  Interestingly, the problems here have not stopped the Chinese government’s crackdown on its tech sector, at least on the personal tech sector, as Didi Chuxing is being forced to delist from the NYSE and looks to reestablish its shares in Hong Kong.

From a vantage point some 7000 miles away, it appears that President Xi Jinping is moving quite rapidly in his efforts to completely control all aspects of the Chinese economy.  Do not be surprised to see every Chinese company listed outside Shanghai or Hong Kong to wind up moving that listing, nor to see further declines in those equity markets.  Capitalism with Chinese characteristics turns out to be socialism/communism after all, at least from the definitional perspective of the state controlling the means of production.  Whether this results in faster growth, or whether the rest of the world will even be able to determine that remains to be seen.  However, classical economics would suggest that the more internalization and the stricter the business regulations, the slower will be future growth.

Why, you may ask, is this important?  Well, first off it is reasonable to expect that ongoing liquidity injections in the Chinese economy are likely to eventually weaken the renminbi.  Second, if the growth trajectory of the Chinese economy is flattening, one of the few things the Chinese will be able to do to address that is weaken the currency to make its exporters more competitive.  The point is, while recent PBOC policy has been to maintain a strong and stable currency, and we have seen the renminbi appreciate more than 11% since it bottomed post-pandemic, the case for that trend to end and a weakening trend to develop appears to be growing.  For asset and receivables hedgers, careful consideration must be given to managing that risk.

With that in mind, let us turn to this morning’s activity.  Friday’s NFP report was mixed, with a weaker than expected headline number for jobs growth, but a much better than expected outcome in the Unemployment Rate as it appears more and more people are leaving large organizations and striking out on their own.  The upshot is labor market tightness is still with us and unlikely to ease in the short run.  Investors decided that was an equity market negative as it would encourage the Fed to taper policy even more quickly hence Friday’s equity sell-off.  At the same time, concerns over tighter policy slowing growth seem to have bond traders flattening the curve rapidly as they fear a Fed policy mistake of raising rates into slowing growth.  In other words, it’s all a mess!

Ok, overnight saw weakness in Asia (Nikkei -0.4%, Hang Seng -1.8%, Shanghai -0.5%) following the US Friday narrative, while Europe has decided things are far better this morning with rallies across the board (DAX +0.3%, CAC +0.7%, FTSE 100 +0.9%).  On a relative basis these moves make sense given the terrible Factory Orders data from Germany (-6.9% in October) while UK Construction PMI surprisingly rose to 55.5.  Meanwhile, US futures are a bit schizophrenic this morning with the DOW (+0.6%) looking to rebound from Friday while the NASDAQ (-0.4%) seems set to continue to slide.

The bond market, which rallied sharply Friday (Treasury yields falling 10bps) is giving back some of those price gains with the 10-year yield higher by 5.2bps this morning.  European yields are also a higher, but by much less (Bunds +0.9bps, OATs +0.7bps, Gilts +1.2bps), which are also consolidative moves, just not quite as dramatic.

On the commodity front, oil continues to whipsaw with a sharp rebound today (+3.25%) although NatGas (-7.9%) is getting crushed on a combination of forecasts for warmer weather in the Northeast as well as lower LNG prices in Europe.  In the metals markets, gold (-0.2%) continues to trade just below $1800/oz, neither rallying alongside inflation nor collapsing.  Copper (+0.8%) seems to be following oil, but aluminum (-0.85%) and tin (-1.9%) both seem to be in a more fearful mode.

Turning to the FX markets, mixed is the best description as we have both substantial gainers and losers vs. the dollar.  In the G10, AUD (+0.5%), SEK (+0.5%) and NOK (+0.5%) are leading the way higher on the back of the better commodity sentiment.  Meanwhile, CHF (-0.5%) and JPY (-0.3%) are both under pressure on the same story plus the European risk appetite.  In the EMG bloc, ZAR (+0.7%) leads the way with CLP (+0.3%) next as the commodity story seems to be driving thing here too.  On the downside, TRY (-0.45%) continues its volatile trading while the other laggards are from both APAC and EEMEA but have not seen significant declines.

On the data front, it is inflation week with CPI on Friday the biggest number to watch.  Leading up to that is the following:

Tuesday Q3 Nonfarm Productivity -4.9%
Q3 Unit Labor Costs 8.3%
Trade Balance -$66.9B
Wednesday JOLTS Job Openings 10500K
Thursday Initial Claims 225K
Continuing Claims 1910K
Friday CPI 0.7% (6.7% Y/Y)
-ex food & energy 0.5% (4.9% Y/Y)
Michigan Sentiment 68.0

Source: Bloomberg

In addition to this data, we hear from the Bank of Canada on Wednesday, where expectations are for no rate movement although they have been amongst the most hawkish of the G10 central banks of late.  As to CPI, while it is not the Fed’s preferred gauge, Chairman Powell clearly feels the pressure and so next week we can expect to see just how much faster they are going to reduce QE purchases…at least for now.

There are so many cross-currents driving markets right now, it is very difficult to find a specific underlying theme in the short-term.  Longer term, nothing has changed my view that the Fed will halt their tapering/tightening script as soon as equity markets begin to decline a little more substantially.  At that point, I feel like the dollar may come under pressure, although during the decline, it should probably rally further.  Payables hedgers should be taking advantage of this relatively strong dollar as I don’t think it will last that long.

Good luck and stay safe
Adf

More Price Inflation

The story of civilization
Is growth due to carbonization
But fears about warming
Have started transforming
Some policies ‘cross most each nation

Alas, despite recent fixation
On policy coordination
Alternatives to
Nat Gas are too few
Resulting in more price inflation

Perhaps there is no greater irony (at least currently) than the fact that governments around the world must secretly be praying for a very warm winter as their policies designed to forestall global warming have resulted in a growing shortage of fuels for heating and transportation.  Evergrande has become a passé discussion point as the overwhelming consensus is that the Chinese government will not allow things to get out of hand.  (I hope they’re right!)  This has allowed the market to turn its attention to other issues with the new number one concern the rapidly rising price of natural gas.  One of the top stories over the weekend has been the shuttering of petrol stations in the UK as they simply ran out of gasoline to pump.  Meanwhile, Nat Gas prices have been climbing steadily and are now $5.35/mmBTU in the US, up 4.2% today and 110% YTD.  As to the Europeans, they would kill for gas that cheap as it is currently running 3x that, above $16.00/mmBTU.

Apparently, policies designed to reduce the production of fossil fuels have effectively reduced fossil fuel production.  At the same time, greater reliance on less stable energy sources, like wind and solar power, have resulted in insufficient overall energy production.  While during the initial stages of Covid shutdowns, when economic activity cratered, this didn’t pose any problems, now that economies around the world are reopening with substantial pent-up demand for various goods and services, it has become increasingly clear that well-intentioned policies have resulted in dramatically bad outcomes.  While Europe appears to be the epicenter of this problem, it is being felt worldwide and the result is that real economic activity will decline across the board.  Hand-in-hand with that outcome will be even more price pressures higher throughout the world.  Policymakers, especially central bankers, will have an increasingly difficult time addressing these issues with their available toolkits.  After all, central banks cannot print natural gas, only more money to chase after the limited amount available.

The important question for market observers is, how will rising energy prices impact financial markets?  It appears that the first impacts are being felt in the bond markets, where in the wake of the FOMC meeting last week, yields have been climbing steadily around the world.  In the first instance, the belief is that starting in November, the Fed will begin reducing its QE purchases, which will lead to higher yields from the belly to the back of the curve.  But as we continue to see yields climb (Treasuries +3.3bps today), you can be sure the rationale will include rising inflation.  After all, our textbooks all taught us that higher inflation expectations lead to higher yields.

The problem for every government around the world, given pretty much all of them are massively overindebted, is that higher yields are unaffordable.  Consider that, as of the end of 2020, the global government debt / GDP ratio was 105%, while the total debt /GDP ratio was 356% (according to Axios).  That is not an environment into which central banks can blithely raise interest rates to address inflation in the manner then Fed Chair Volcker did in the late 1970’s. In fact, it is far more likely they will do what they can to prevent interest rates from rising too high.  This is the reason I continue to believe that while the Fed may begin to taper at some point, tapering will not last very long.  They simply cannot afford it.  So, while bond markets around the world are under pressure today (Bunds +1.8bps, OATs +2.8bps, Gilts +2.9bps), and by rights should have significant room to decline, this movement will almost certainly be capped.

Equity markets, on the other hand, have room to run somewhat further, as despite both significant overvaluation by virtually every traditional metric, as well as record high margin debt, in an inflationary environment, a claim on real assets is better than a claim on ‘paper’ assets like bonds.  While Asian markets (Nikkei 0.0%, Hang Seng +0.1%, Shanghai -0.8%) have not been amused by the rise in energy prices, European bourses are behaving far better (DAX +0.6%, CAC +0.4%, FTSE 100 +0.2%).  As an aside, part of the German story is clearly the election, where the Social Democrats appear to have won a small plurality of seats, but where there is no obvious coalition to be formed to run the country.  It appears Germany’s role on the global stage will be interrupted as the nation tries to determine what it wants to do domestically over the next few weeks/months.  In the meantime, early session strength in the US futures markets has faded away with NASDAQ futures (-0.4%) now leading the way lower.

Turning to the key driver of markets today, commodity prices, we see oil (WTI +1.25%) continuing its recent rally, and pushing back to $75/bbl.  We’ve already discussed Nat Gas and generally all energy prices are higher.  But this is not a broad-based commodity rally, as we are seeing weakness throughout the metals complex (Au -0.1%, Cu -0.3%, Al -0.2% and Sn -4.8%).  Agricultural prices are slightly softer as well.  It seems that the idea energy will cost more is having a negative impact everywhere.

Finally, the dollar is a beneficiary of this price action on the basis of a few threads.  First, given energy is priced in dollars, they remain in demand given higher prices.  Second, the energy situation in the US is far less problematic than elsewhere in the world, thus on a relative basis, this is a more attractive place to hold assets.  So, in the G10 we see SEK (-0.5%) as the laggard, followed by the traditional havens (CHF -0.25%, JPY -0.2%), as the dollar seems to be showing off its haven bona fides today. In the EMG bloc, THB (-0.8%) leads the way lower followed by ZAR (-0.7%) and PHP (-0.7%), with other currencies mostly softer and only TRY (+0.5%) showing any strength on the day.  The baht has suffered on traditional macro issues with concerns continuing to grow regarding its current account status, with the Philippines seeing the same issues.  Rand appears to have reacted to the metals complex.  As to TRY, part of this is clearly a rebound from an extremely weak run last week, and part may be attributed to news of a Nat Gas find in the Black Sea which is forecast to be able to provide up to one-third of Turkey’s requirements in a few years.

As it is the last week of the month, we do get some interesting data, although payrolls are not released until October 8th.

Today Durable Goods 0.6%
-ex Transportation 0.5%
Tuesday Case Shiller Home Prices 20.0%
Consumer Confidence 115.0
Thursday Initial Claims 330K
Continuing Claims 2805K
GDP Q2 6.6%
Chicago PMI 65.0
Friday Personal Income 0.2%
Personal Spending 0.6%
Core PCE 0.2% (3.5% Y/Y)
Michigan Sentiment 71.0
ISM Manufacturing 59.5
ISM Prices Paid 77.5

Source: Bloomberg

Naturally, all eyes will be on Friday’s PCE data as the Fed will want to be able to show that price pressures are moderating, hence their transitory story is correct (it’s not.) But I cannot help but see the House Price index looking at a 20.0% rise in the past twelve months and think about how the Fed’s inflation measures just don’t seem to capture reality.

Rising yields in the US seem to be beginning to attract international investors, specifically Japanese investors as USDJPY has been moving steadily higher over the past two weeks.  The YTD high has been 111.66, not far from current levels.  Watch that for a potential breakout and perhaps, the beginning of a sharp move higher in the dollar.

Good luck and stay safe
Adf

Flames of Concern

The story is still Evergrande
Whose actions last night have now fanned
The flames of concern
‘Til bondholders learn
If coupons will be paid as planned

Though pundits have spilled lots of ink
Explaining there’s really no link
Twixt Evergrande’s woes
And fears of new lows
The truth is they’re linked I would think

It must be very frustrating to be a government financial official these days as despite all their efforts to lead investors to a desired outcome, regardless of minor details like reality, investors and traders continue to respond to things like cash flows and liquidity, or lack thereof.  Hence, this morning we find ourselves in a situation where China Evergrande officially failed to pay an $83.2 million coupon yesterday and now has a 30-day grace period before they can be forced into default on the bond.  The concern arises because China Evergrande has more than $300 billion in bonds outstanding and another $300 billion in other liabilities and it is pretty clear they are not going to be able to even service that debt, let alone repay it.

At the same time, the number of articles written about how this is an isolated situation and how the PBOC will step in to prevent a disorderly outcome and protect the individuals who are on the hook continue to grow by leaps and bounds.  The true victims here are the many thousands of Chinese people who contracted with Evergrande to build their home, some of whom prepaid for the entire project while others merely put down significant (>50%) deposits, and who now stand to lose all their money.  Arguably, the question is whether or not the Chinese government is going to bail them out, even if they allow Evergrande to go to the wall.  Sanguinity in this situation seems optimistic.  Remember, the PBOC has been working very hard to delever the Chinese property market, and there is no quicker way to accomplish that than by allowing the market to reprice the outstanding debt of an insolvent entity.  As well, part of President Xi’s calculus will be what type of pain will be felt elsewhere in the world.  After all, if adversaries, like the US, suffer because of this, I doubt Xi would lose any sleep.

But in the end, markets this morning are demonstrating that they are beginning to get concerned over this situation.  While it may not be a Lehman moment, given that when Lehman was allowed to fail it was truly a surprise to the markets, the breadth of this problem is quite significant and the spillover into the entire Chinese property market, which represents ~25% of the Chinese economy, is enormous.  If you recall my discussion regarding “fingers of instability” from last week (Wednesday 9/15), this is exactly the type of thing I was describing.  There is no way, ex ante, to know what might trigger a more significant market adjustment (read decline), but the interconnectedness of Chinese property developers, Chinese banks, Chinese shadow financiers and the rest of the world’s financial system is far too complex to parse.  However, it is reasonable to estimate that there will be multiple knock-on effects from this default, and that the PBOC, no matter how well intentioned, may not be able to maintain control of an orderly market.  Risk should be off, and it is this morning.

It ought not be surprising that Chinese shares were lower last night with the Hang Seng (-1.3%) leading the way but Shanghai (-0.8%) not that far behind.  Interestingly, the only real winner overnight was the Nikkei (+2.1%) which seemed to be making up for their holiday yesterday.  European shares are having a rough go of it as well, with the DAX (-0.8%), CAC (-1.0%) and FTSE 100 (-0.3%) all under the gun.  There seem to be several concerns in these markets with the primary issue the fact that these economies, especially Germany’s, are hugely dependent on Chinese economic growth for their own success, so signs that China will be slowing down due to the Evergrande mess are weighing on these markets.  In addition, the German IFO surveys were all released this morning at weaker than expected levels and continue to slide from their peaks in June.  Slowing growth is quickly becoming a market meme.  After yesterday’s rally in the US, futures this morning are all leaning lower as well, on the order of -0.3% or so.

The bond market this morning, though, is a bit of a head-scratcher.  While Treasuries are doing what they are supposed to, rallying with yields down 2.6bps, the European sovereign market is all selling off despite the fall in equity prices.  So, yields are higher in Germany (Bunds +1.4bps) and France (OATs +2.2bps), with Italy (BTPs +5.0bps) really seeing some aggressive selling.  Gilts are essentially unchanged on the day.  But this is a bit unusual, that a clear risk off session would see alleged haven assets sell off as well.

Commodity markets are having a mixed day with oil unchanged at this hour while gold (+0.75%) is rebounding somewhat from yesterday’s sharp decline.  Copper (+0.1%) has edged higher, but aluminum (-1.4%) is soft this morning.  Agricultural prices are all lower by between 0.25% and 0.5%.  In other words, it is hard to detect much signal here.

As to the dollar, it is broadly stronger with only CHF +0.1%) able to rally this morning.  While the euro is little changed, we are seeing weakness in the Antipodean currencies (AUD, NZD -0.4%) and commodity currencies (CAC -0.2%, NOK -0.15%).  Granted, the moves have not been large, but they have been consistent.

In the EMG bloc, the dollar has put on a more impressive show with ZAR (-1.3%) and TRY (-0.9%) leading the way, although we have seen other currencies (PHP -0.6%, MXN -0.4%) also slide during the session.  The rand story seems to be a hangover from yesterday’s SARB meeting, where they left rates on hold despite rising inflation there.  TRY, too, is still responding to the surprise interest rate cut by the central bank yesterday.  In Manila, concern seems to be growing that the Philippines external balances are worsening too rapidly and will present trouble going forward.  (I’m not sure you remember what it means to run a current account deficit and have markets discipline your actions as it no longer occurs in the US, but it is still the reality for every emerging market economy.)

On the data front, we see only New Home Sales (exp 715K), a number unlikely to have an impact on markets.  However, we hear from six different Fed speakers today, including Chairman Powell, so I expect that there will be a real effort at fine-tuning their message.  Three of the speakers are amongst the most hawkish (Mester, George and Bostic), but of this group, only Bostic is a voter.  You can expect more definitive tapering talk from these three, but in the end, Powell’s words still carry the most weight.

The dollar remains in a trading range and we are going to need some exogenous catalyst to change that.  An Evergrande collapse could have that type of impact, but I believe it will take a lot more contagion for that to be the case.  So, using the euro as a proxy, 1.17-1.19 is still the right idea in my view.

Good luck, good weekend and stay safe
Adf

Far From Surreal

The Fed explained that they all feel
A taper is far from surreal
The goal for inflation
Has reached satiation
While job growth ought soon seal the deal

Heading into the FOMC meeting, the consensus was growing around the idea that the Fed would begin tapering later this year, and the consensus feels gratified this morning.  Chairman Powell explained that, if things go as anticipated, tapering “could come as soon as the next meeting.”  That meeting is slated for November 2nd and 3rd, and so the market has now built this into their models and pricing.  In fact, they were pretty clear that the inflation part of the mandate has already been fulfilled, and they were just waiting on the jobs numbers.

An interesting aspect of the jobs situation, though, is how they have subtly adjusted their goals.  Back in December, when they first laid out their test of “substantial further progress”, the employment situation showed that some 10 million jobs had been lost due to Covid-19.  Since then, the economy has created 4.7 million jobs, less than half the losses.  Certainly, back then, the idea that recovering half the lost jobs would have been considered “substantial further progress” seems unlikely.  Expectations were rampant that once vaccinations were widely implemented at least 80% of those jobs would return.  Yet here we are with the Fed explaining that recovering only half of the lost jobs is now defined as substantial.  I don’t know about you, but that seems a pretty weak definition of substantial.

Now, given Powell’s hyper focus on maximum employment, one might ask why a 50% recovery of lost jobs is sufficient to move the needle on policy.  Of course, the only answer is that despite the Fed’s insistence that recent inflation readings are transitory and caused by supply chain bottlenecks and reopening of the economy, the reality is they have begun to realize that prices are rising a lot faster than they thought likely.  In addition, they must recognize that both housing price and rent inflation haven’t even been a significant part of the CPI/PCE readings to date and will only drive things higher.  in other words, they are clearly beginning to figure out that they are falling much further behind the curve than they had anticipated.

Turning to the other key release from the FOMC, the dot plot, it now appears that an internal consensus is growing that the first rate hike will occur in Q4 2022 with three more hikes in 2023 and an additional three or four in 2024.  The thing about this rate trajectory is that it still only takes Fed Funds to 2.00% after three more years.  That is not nearly enough to impact the inflationary impulse, which even they acknowledge will still be above their 2.0% target in 2024.  In essence, the dot plot is explaining that real interest rates in the US are going to be negative for a very long time.  Just how negative, though, remains the $64 trillion question.  Given inflation’s trajectory and the current school of thought regarding monetary policy (that lower rates leads to higher growth), I fear that the gap between Fed Funds and inflation is likely to be much larger than the 0.2% they anticipate in 2024.  While this will continue to support asset prices, and especially commodity prices, the impact on the dollar will depend on how other central banks respond to growing inflation in their respective economies.

Said China to its Evergrande
Defaulting on bonds is now banned
So, sell your assets
And pay dollar debts
Take seriously this command

CHINA TELLS EVERGRANDE TO AVOID NEAR-TERM DEFAULT ON BONDS

This headline flashed across the screens a short time ago and I could not resist a few words on the subject.  It speaks to the arrogance of the Xi administration that they believe commanding Evergrande not to default is sufficient to prevent Evergrande from defaulting.  One cannot help but recall the story of King Canute as he commanded the incoming tide to halt, except Canute was using that effort as an example of the limits of power, while Xi is clearly expecting Evergrande to obey him.  With Evergrande debt trading around 25₵ on the dollar, and the PBOC continuing in their efforts to wring leverage out of the system, it is a virtual guaranty that Evergrande is going under.  I wouldn’t want to be Hui Yan Ka, its Chairman, when he fails to follow a direct order.  Recall what happened to the Chairman of China Huarong when that company failed.

Ok, how are markets behaving in the wake of the FOMC meeting?  Pretty darn well!  Powell successfully explained that at some point they would begin slowing their infusion of liquidity without crashing markets.  No tantrum this time.  So, US equities rallied after the FOMC meeting with all three indices closing higher by about 1%.  Overnight in Asia we saw the Hang Seng (+1.2%) and Shanghai (+0.4%) both rally (Japan was closed for Autumnal Equinox Day), and we have seen strength throughout Europe this morning as well.  Gains on the continent (DAX and CAC +0.8%) are more impressive than in the UK (FTSE 100 +0.2%), although every market is higher on the day.  US futures are all currently about 0.5% higher, although that is a bit off the earlier session highs.  Overall, risk remains in vogue and we still have not had a 5% decline in the S&P in more than 200 trading days.

With risk in the fore, it is no surprise that bond yields are higher, but the reality is that they continue to trade in a pretty tight range.  Hence, Treasury yields are higher by 2.4bps this morning, but just back to 1.324%.  Essentially, we have been in a 1.20%-1.40%% trading range since July 4th and show no sign of that changing.  In Europe, yields have also edged higher, with Bunds (+1.6bps) showing the biggest move while both OATs (+0.9bps) and Gilts (+0.6bps) have moved less aggressively.

Commodity prices are mixed this morning with oil lower (-0.7%) along with copper (-0.25%) although the rest of the base metal complex (Al +0.6%, Sn +0.55%) are firmer along with gold (+0.3%).  Not surprisingly given the lack of consistency, agricultural prices are also mixed this morning.

The dollar, however, is clearly under pressure this morning with only JPY failing to gain, while the commodity bloc performs well (CAD +0.8%, NOK +0.6%, SEK +0.5%).  EMG currencies are also largely firmer led by ZAR (+0.9%) on the back of gold’s strength and PLN (+0.6%) which was simply reversing some of its recent weakness vs. the euro.  On the downside, the only notable decliner is TRY (-1.4%), which tumbled after the central bank cut its base rate by 100 basis points to 18% in a surprise move.  In fact, TRY has now reached a record low vs. the dollar and shows no signs of rebounding as long as President Erdogan continues to pressure the central bank to keep rates low amid spiraling inflation.  (This could be a harbinger of the US going forward if we aren’t careful!)

It is Flash PMI day and the European and UK data showed weaker than expected output readings though higher than expected price readings.  We shall see what happens in the US at 9:45. Prior to that we see Initial Claims (exp 320K) and Continuing Claims (2.6M) and we also see Leading Indicators at 10:00 (0.7%).  The BOE left policy on hold, as expected, but did raise their forecast for peak inflation this year above 4%.  However, they are also in the transitory camp, so clearly not overly concerned on the matter.

There are no Fed speakers today although we hear from six of them tomorrow as they continue to try to finetune their message.  The dollar pushed up to its recent highs in the immediate aftermath of the FOMC meeting, but as risk was embraced, it fell back off.  If the market is convinced that the Fed really will taper, and if they actually do, I expect it to support the dollar, at least in the near term.  However, my sense is that slowing economic data will halt any initial progress they make which could well see the dollar decline as long positions are unwound.  For today, though, a modest drift higher from current levels seems reasonable.

Good luck and stay safe
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Avoiding a Crash

The Chinese have taken a stand
Regarding the firm, Evergrande
They’ve added more cash
Avoiding a crash
And now feel they’ve got things in hand

So, now all eyes turn to the Fed
And tapering timing, instead
The question at hand
Is can they withstand
Slow growth while still moving ahead?

Fear was palpable on Monday as China Evergrande missed an interest payment and concerns grew that a major disruption in Chinese debt markets, with the ability to spread elsewhere, was around the corner.  Yesterday, however, investors collectively decided that the world was not, in fact, going to end, and dip buyers got to work supporting equity markets.  The buyers’ faith has been rewarded as last night, the PBOC added net CNY70 billion to the markets to help tide over financing issues.  In addition, an oddly worded statement was released that Evergrande had addressed the interest payment due tomorrow via private negotiations with bondholders.  (Critically, that doesn’t mean they paid, just that the bondholders aren’t going to sue for repayment, hence avoiding a bankruptcy filing.)  As is always the case in a situation of this nature, nothing has actually changed at Evergrande so they are still bankrupt with a massive amount of debt that they will never repay in full, but no government, whether communist or democratic, ever wants to actually deal with the problem and liquidate.  This is the enduring lesson of Lehman Brothers.

Which means…it’s Fed day!  As we all know, this afternoon at 2:00 the FOMC will release the statement with their latest views and 30 minutes later, Chairman Powell will face the press.  At this time, the topic of most interest to everyone is the timing of the Fed’s reduction in asset purchases, aka tapering.  When we last left this story (prior to the Fed’s quiet period a week and a half ago, pretty much every Fed regional president (Kashkari excluded) and a few minor governors had indicated that tapering was appropriate soon.  On the other hand, the power center, Powell, Brainerd and Williams, had said no such thing, but had admitted that the conversation had begun.

You may recall that at the August FOMC meeting, the Fed indicated that the goal of “substantial further progress” had not yet been met with regard to the maximum employment mandate, although they begrudgingly admitted that the inflation side of the coin had been achieved.  (As an aside, while there has never been an answer to the question of how long an averaging period the Fed would consider with respect to their revamped average inflation target, simple arithmetic shows that if one averages the core PCE data from May 2020 through July 2021, the result is 2.0%.  If the forecast for the August core number, to be released on October 1, is correct at 3.6%, that means that one can head back to March 2020 and still show an average of 2.0%.  And remember, core PCE is not about to collapse back down to 2.0% or lower anytime soon, so this exercise will continue to expand the averaging period.)

Current expectations are that the initial tapering will start in either November or December of this year, and certainly by January 2022.  Clearly, based on the inflation mandate, we are already behind schedule, but the problem the Fed has is that the recent growth data has been far less impressive.  The August NFP data was quite disappointing at 235K, a 500K miss to estimates.  Not only that, while the July data was strong, the June data was also a major miss, which begs the question, was July the aberration or August?  Ask yourself this, will Chairman Powell, who is up for reappointment shortly, tighten policy into an economy where employment growth is slowing?  There is every possibility that tapering is put on hold for a few more months in order to be sure that monetary stimulus withdrawal is not premature.  The fact that a decision like that will only stoke the inflationary fires further will be addressed by an even more strident statement that inflation is transitory, dammit!  My point is, it is not a slam dunk that they announce tapering today.

For a perfect example as to why this is the case, look no further than the ECB, where today we heard another ECB member, the Estonian central bank chief, explain that when the PEPP runs out in March, it would be appropriate to expand the older APP program to pick up the slack.  In other words, they will technically keep their word and let the PEPP expire, but they will not stop QE.  The Fed, ECB and BOJ have all realized that their respective economies are addicted to QE and that withdrawal symptoms will be remarkably painful, so none of them are inclined to go through that process.  Can-kicking remains these central banks’ strongest talent.

OK, to markets ahead of the Fed.  Asia was mixed as the Nikkei (-0.7%) remains under pressure, clearly unimpressed by the BOJ’s ongoing efforts which were reiterated last night after their meeting.  However, Chinese equities (Hang Seng +0.5%, Shanghai +0.4%), not surprisingly, fared better after the liquidity injection.  In Europe, it is all green as further hints that the ECB will let the PEPP lapse in name only has investors confident that monetary support is a permanent situation.  So, the DAX (+0.55%), CAC (+1.1%) and FTSE 100 (+1.2%) are all poppin’.  US futures have also gotten the message and are firmer by about 0.5% this morning.

Bond markets are ever so slightly softer with yields edging up a bit.  Treasuries have been the worst performer although yields are only higher by 1.4bps.  In Europe, Bunds are unchanged while OATs and Gilts have risen 0.5bps each.

Commodity prices, on the other hand, have performed quite well this morning with oil (WTI +1.5%) leading energy higher and base metals (Cu +2.4%, Al +1.6%, Sn +3.6%) all much firmer although gold (0.0%) is not taking part in the fun.  Ags are also firmer this morning as the commodity space is finding buyers everywhere.

The dollar is somewhat softer this morning with NOK (+0.5%) leading the G10 and the rest of the commodity bloc also strong (CAD +0.3%, AUD +0.25%, NZXD +0.25%).  The one true laggard is JPY (-0.3%) which is suffering from the lack of a need for a haven along with general malaise after the BOJ.  In the EMG space, HUF (-0.75%) is the outlier, falling after the central bank raised rates a less than expected 15 basis points after three consecutive 30 basis point hikes, and hinted that despite inflation’s rise, less hikes would be coming in the future.  Away from that, though, there is a mix of gainers and loser with the commodity bloc strong (CLP +0.45%, ZAR +0.4%, RUB +0.4%) while commodity importers are suffering (INR -0.35%, PHP -0.25%, PLN -0.2%).

Ahead of the Fed we see Existing Home Sales (exp 5.89M), but really, look for a quiet market until 2:00 and the FOMC statement.  My view is they will be less hawkish than the market seems to expect, and I think that will be a negative for the dollar, but at this point, all we can do is wait.

Good luck and stay safe
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Far From Benign

There once was a market decline
That seemed, at the time, to consign
Investors with shares
To turn into bears
An outcome quite far from benign

But that was a long time ago
As by afternoon all the flow
Was buying the dip
Thus, proving this blip
Was not a bull market deathblow

I wonder if stock prices declining for 18 hours now counts as a correction.  What had appeared to be the beginnings of a more protracted fall in stocks turned into nothing more than a modest blip in the ongoing bull market.  Some teeth were gnashed, and some positions lightened, but by 3:15pm, it was all over with a 1.3% rebound from that time to the close.  Granted, the S&P 500 did decline 1.7% on the day, but given the substantial buying impulse seen at the end of the day, as well as the change in tone of the market narrative, it certainly feels this morning like the worst is behind us.  While China Evergrande continues to be bankrupt, the new story is that despite its large size, it is not large enough to be a real catalyst for market destruction and, anyway, the PBOC would never let things get to a point where its bankruptcy would lead to contagion elsewhere in the Chinese markets/economy.

As to the last point, be careful with your assumptions.  While this is not meant to be a prediction, consider that President Xi Jinping has spent the last year cracking down on successful firms in China as they have amassed both wealth and power, something that an autocrat of Xi’s nature cannot abide.  So, a fair question to ask is, would Xi let the Chinese economy crash in order to consolidate his power even further?  While I don’t believe he would purposely do that, I would not rule out him allowing things to unfold in a manner he sees as beneficial to his ultimate plans, thus financial distress in China could well be in our future.  And if you are Xi Jinping, the idea that Western markets would react badly to an Evergrande collapse would only be a positive.  My point is, I don’t think you can rule out other motives in this situation.

At any rate, this literally seems like ancient history at this time, with markets all in the green and the market narrative of ‘buy the dip’ proving itself once again to be the proper course of action.  Pavlov himself could not have conditioned retail investors any better than the Fed and other central banks have done over the past decade.

So, with Evergrande in the rearview mirror, the market gets to (re)turn its focus to the FOMC meeting, which begins this morning and whose outcome will be announced at 2pm tomorrow.  That means we are back to talking about tapering.  Will they, or won’t they?  And if they do, when will they start?

The market consensus is clearly that tapering is coming with about two-thirds of market economists forecasting the first reduction in asset purchases will occur in November.  While there are some differing views on how they will taper, the consensus appears to be a reduction of $10 billion of Treasuries and $5 billion of mortgage-backed securities each month until they are done.  So, eight months of reductions takes us to next June if we start in November.  Of course, this assumes that there are no interruptions, and that the Fed leadership remains intact.

First, remember, Chairman Powell’s term is up in February, and while he remains the favorite to be reappointed, it seems the most progressive wing of the Democratic party wants to see someone else, with Lael Brainerd, a current Fed governor and past Treasury Undersecretary, seen as the leading alternative.  Ms Brainerd has consistently been even more dovish than Powell, and if she were to be confirmed for the Chair, it would be easy to believe she halted any tapering at that point.  After all, if one believes in MMT, (which by all accounts Ms Brainerd embraces), why would the Fed ever stop buying Treasuries?  Again, this is not predictive, just something to keep in mind.

Second, the tapering narrative is based on the idea that economic growth coming out of the Covid recession is self-sustaining and no longer needs central bank support.  But what if the recovery is more anemic than currently forecast.  The one consistency we have seen over the course of the past months is that forecasts for economic growth in Q3 and Q4 have declined dramatically.  For instance, the Atlanta Fed’s GDPNow forecast model is pointing to 3.65% currently, down from 5.3% at the beginning of the month and 7.6% just two months ago.  Shortages of certain things still abound and prices on staples like beef, pork, and poultry, continue to rise rapidly.  In short, the situation in the economy is anything but clear.

In this case, the question really becomes, will the Fed turn its attention to inflation, or will it remain focused only on unemployment?  If the inflation heat reaches too high a temperature, then it would be easy to believe tapering will occur far more rapidly.  However, if growth remains the focus, then any reason to delay tapering will be sought.  I remain in the camp that while they may initiate tapering, the Fed will be buying bonds long after June 2022.  We shall see.

A quick turn to markets shows that all is right with the world!  Stocks are almost universally higher as Asia (Hang Seng +0.5%, Shanghai +0.2%) led the beginning of the rebound although Japan (Nikkei -2.1%) was still coming to grips with yesterday’s narrative coming out of their holiday.  Europe is strongly higher this morning (DAX +1.45%, CAC +1.4%, FTSE 100 +1.15%) as fear has rapidly dissipated.  And after the worst US equity session in months, futures this morning are higher by about 0.8% across the board.

It should be no surprise that bonds are for sale this morning with yields mostly higher.   Treasury yields, which fell 6bps yesterday, have bounced slightly, up 1.7bps this morning.  European sovereigns, which saw a lesser rally yesterday have barely sold off with nothing rebounding even a full basis point.  One noteworthy outlier is Greece, whose bonds are sharply higher with 10-year yields declining 4.6bps, after Greek central bank comments that the ECB would never stop buying Greek paper.

Commodity prices are generally firmer with oil (WTI +1.2%) leading although gold (+0.2%), copper (+0.95%) and aluminum (+1.0%) are all embracing the risk rebound.

And finally, the dollar, which had rallied so sharply yesterday morning, has given back all of those gains.  NOK (+0.8%) leads the G10 charge higher with CAD (+0.5%) next in line as oil’s rebound supports both currencies.  The rest of the bloc has seen less exuberance, generally between 0.1% and 0.25%, although JPY (-0.1%) has slipped as its haven status is no longer a benefit.

EMG currencies have seen a little less dramatic movement with the leading gainer CZK (+0.3%) followed by RUB (+0.25%) with the latter benefitting from oil while the former continues to find support based on views its central bank remains hawkish enough to raise rates.  Otherwise, the gainers have been quite modest, 0.2% or less with two currencies falling on the day, ZAR (-0.2%) and PLN (-0.25%).  In both cases, it appears the concerns lie with central bank policy prospects.  However, given the modest size of the decline, it is hardly a key issue.

On the data front, this morning brings Housing Starts (exp 1550K) and Building Permits (1600K), although with the FOMC meeting in the background, neither is likely to move the needle.  And that’s really it for the day as there are no speakers.  As long as we don’t see a bombshell from Evergrande, which seems unlikely in our time zone, today feels like a quiet session with potential modest further dollar weakness.  All eyes will continue to be on tomorrow’s FOMC announcement, and, more importantly, Chairman Powell’s comments at the press conference.  Until then, slow going is likely.

Good luck and stay safe
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