Lest Things Implode

The central banks all through the West
Are trying to figure how best
To, policy, tighten
But not scare or frighten
Investors and so they are stressed

Meanwhile from Beijing data showed
That Chinese growth actually slowed
With prospects now dimmed
The central bank trimmed
Two interest rates, lest things implode

There is a new contest amongst the punditry to see who can call for the most shocking rate policy by the Fed this year.  With the FOMC in their quiet period, they cannot respond to comments by the likes of JPM Chair Jamie Dimon (the Fed could raise rates 7 times this year!) or hedge fund manager and noted short seller Bill Ackman (the Fed should raise rates by 50 basis points in March to shock the market), and so those comments get to filter through the market discussion and creep into the narrative.  A quick look at Fed funds futures shows that the market is now pricing in not only a 25bp rate hike, but a probability of slightly more at the March meeting.

Now, don’t get me wrong, I think the Fed is hugely behind the curve, as evidenced by the fact they are still purchasing assets despite raging inflation, and think an immediate end to asset purchases would be appropriate policy, as well as raising rates in 0.5% increments or more until they start to make a dent in the depth of negative real yields, but I also know that is not going to happen.  Time and again they have effectively explained to us all that while inflation is certainly not a good thing, the worst possible outcome would be a decline in the stock market.  Their deference to investors rather than to Main Street has become a glaring issue, and one that does not reflect well on their reputation.  And yet, Chairman Powell has never given us a reason to believe that he will simply focus on inflation, which is currently by far the biggest problem in the economy.

However, with the market having already priced in a 0.25% rate hike for March, it is entirely realistic they will raise rates at that meeting.  The key question, though, is will they be able to continue to tighten policy when equity markets start to respond more negatively?  For the past 35 years (since Black Monday in 1987) the answer has been a resounding NO.  Why does anybody think this time is different?

Interestingly, at the same time virtually every Western central bank is trying to figure out the best way to fight the rapidly rising inflation seen throughout the world, the Middle Kingdom has their own, unique, issues, namely disappointing economic growth and expanding omicron growth leading up to the Winter Olympics.  Of course, the last thing that President Xi can allow is any inkling that things in China are not running smoothly, and so after the release of weaker than expected IP, Fixed Asset, Retail Sales and GDP data for Q4, the PBOC cut both its Medium-Term Lending and 7-day Reverse Repo rates by 0.10% last night.  In addition to the weaker data came the news that yet another property developer, Logan Group, may have made guarantees that do not appear on their balance sheet to the tune of $812 million.  I have lost count of the number of property developers in China that are now under growing pressure ever since the initial stories about China Evergrande.  But that is the point, the entire property sector is under huge pressure of imploding and property development has been somewhere between 25%-30% of the Chinese GDP growth.  This does not bode well for Chinese GDP growth going forward, which does not bode well for global growth.  PS, one last thing to mention here is the Chinese birth rate fell to its lowest level since 1950!  Only 10.62 million babies were born in 2021, despite significant efforts by the government to encourage family growth.  As demographics is destiny, unless the Chinese change their immigration policies, the nation is going to find itself in some very difficult straits as the population there ages rapidly and the working population shrinks.  Just sayin’.

Ok, with that out of the way, a look around today’s holiday markets shows that risk is on!  Aside from the Hang Seng (-0.7%) overnight, which is where so many property firms are listed, every other major market is in the green.  The Nikkei (+0.75%) and Shanghai (+0.6%) were both solid performers as that PBOC rate cut was seen as encouraging.  In Europe, the DAX (+0.4%), CAC (+0.6%) and FTSE 100 (+0.6%) are all firmer as are the peripheral markets.  Even US futures (+0.1% across the board) are firmer although there is no trading here today due to the MLK holiday.

Bond markets, on the other hand, are under pressure everywhere as Treasury futures are down 13 ticks or about 3 basis points higher, while European sovereigns (Bunds +1.7bps, OATs +2.0bps, Gilts +2.8bps) are all seeing higher yields as well.  In fact, 10-year Bunds are approaching 0.0% for the first time since May 2019.  Asia was no different with only China (-0.8bps) seeing a yield decline and sharp rises in Australia (+6.7bps) and South Korea (+9.7bps).

In the commodity markets, WTI (0.0%) is flat although Brent (-0.3%) is edging down from its multi-year highs.  NatGas (-0.6%) is also edging lower and European gas prices are falling even more significantly as a combination of LNG cargoes and warmer weather eases some pressure on that market.  Gold (+0.2%) is firmer, despite what appears to be a risk-on day, although copper (-0.7%) is under a bit of pressure.  In other words, the noise is overwhelming the signal here.

As to the dollar this morning, mixed is the best description as there are gainers and losers in both G10 and EMG blocs.  Interestingly, despite oil’s lackluster trading, both NOK (+0.3%) and CAD (+0.2%) are the leading gainers in the G10 while JPY (-0.25%) is following its risk history, selling off as equities gain.  In the emerging markets, RUB (-0.55%) is the worst performer as there seems to be growing concern over the imposition of tighter sanctions in the event Russia does invade the Ukraine.  KRW (-0.45%) is next in line after North Korea launched yet two more ballistic missiles, raising tension on the peninsula.  On the plus side, THB (+0.4%) has been continuing its recent gains as the nation opens up more completely from Covid lockdowns.

It is a relatively light data week with Housing the main focus, and with the Fed in their quiet period, we won’t be getting help there either.

Tuesday Empire Manufacturing 25.0
Wednesday Housing Starts 1650K
Building Permits 1700K
Thursday Initial Claims 220K
Continuing Claims 1521K
Philly Fed 19.8
Existing Home Sales 6.41M
Friday Leading Indicators 0.8%

Source: Bloomberg

In truth, it is shaping up to be a quiet week.  Next week brings the central bank onslaught with the Fed, BOJ and BOC, but until then, we will need to take our cues from equities and geopolitical tensions to see if anything occurs that may inspire the jettisoning of risk assets in a hurry.  My gut tells me we will not be seeing anything of that nature, and so a range bound week for the dollar seems in store.

Good luck and stay safe
Adf

Buying Will Stop

It seems nearly every day now
Some Fed members make the same vow
First buying will stop
Next Fed funds will pop
Then asset run-off we’ll allow

Thus far markets have been subdued
Though some players now have construed
That buying the dip
Has lost all its zip
While selling all rallies is shrewd

Another day, another series of Fed speakers explaining that inflation is the primary focus, that when QE stops in March it may (read will) be appropriate to raise the Fed Funds rate by 0.25% and that the Fed has powerful tools to prevent inflation from getting out of hand.  While it is encouraging that they have finally figured out inflation is a problem, the fact that they still don’t understand it is a problem of their own making is somewhat disconcerting.  However, moving in the right direction is clearly a positive.

So, after Brainerd, Waller, Barkin and Evans all basically said the same thing, here is what we know.  It seems a virtual certainty that the Fed Funds rate will be raised at the March meeting with a very high likelihood of at least two more hikes as the year progresses.  Mr Waller even suggested more than four total this year, although that is clearly a minority view, right now, on the FOMC.  The problem is that 25 basis point increments every 12 weeks is not going to make much of a dent in inflation running at 7.0%.  And, even if inflation falls back down to 4.0%, it will still take more than three years for the Fed to even reach a point where real yields are back to 0.0%.   Not only that, when Waller was asked about 0.50% increments, he dismissed the idea as being destabilizing for markets.  (Yet again we can read between the lines and recognize that preventing an equity market decline remains the Fed’s primary focus regardless of recent comments on inflation.)

But back to the real yield story.  It is important to understand that negative real yields are not a bug in their plans, they are the feature.  Negative real yields are the only way for the US (and every overly indebted nation) to reduce the value of their debt without a technical default.  The Fed knows this playbook from their actions in the wake of WWII, where they capped yields at 2.50% and inflation ran at 10.0%.  A few years later, the debt/GDP ratio had fallen from 125% to 35% and the country’s finances were back in order.  That process worked then because the US economy dominated the global economy and essentially everything was manufactured here.  Given the dramatic changes that have taken place in the ensuing 80 years, it is not clear that the citizenry in the US will be quite as patient this time, but that is almost certainly the Fed’s plan.

If we assume that real yields are set to remain negative for a long time into the future, what are the likely impacts going to be?  First and foremost, real assets like commodities and real estate should perform well and maintain their value if not appreciate.  Bonds, on the other hand, will have a tougher time, although there are many things which may help support them, not least of which would be a reversal of policy by central banks.  Equities are going to find themselves segregated into companies that have businesses and are profitable and those that have benefitted from the ongoing monetary largesse of the central banks and may find that funding their businesses will get more difficult.  In other words, credit is going to matter going forward in this environment.  Finally, the dollar’s behavior will be contingent on just how other nations approach the real yield question.  For those countries that follow sound money policies, and seek to end financial repression, their currencies should benefit.  However, all signs are pointing, at this time, to the fact the US will not be considering sound money policies as they are short-term politically unpalatable, and the dollar will underperform going forward.  I apologize for the dour message on a Friday, but the constant Fed blather becomes difficult to tune out after a while.

Ok, here’s what we have seen overnight.  Yesterday’s tech rout in the US took equity markets lower across the board and that was followed in Asia as well (Nikkei -1.3%, Hang Seng -0.2%, Shanghai -1.0%).  Europe, too, is in the red with fairly solid declines in the DAX (-0.6%) and CAC (-0.6%) although the FTSE 100 (-0.1%) is outperforming after November GDP data showed surprisingly strong growth in the UK across both manufacturing and services. Meanwhile, US futures are hovering either side of unchanged although NASDAQ futures have recently turned down a bit more aggressively.

An interesting feature of today’s price action is that not only are stocks being sold, but so are bonds, and everywhere.  Treasury yields are higher by 3.0bps, although that is simply unwinding yesterday’s rally where yields fell a similar amount.  European sovereigns are also selling off with yields higher across the board (Bunds +2.4bps, OATs +2.4bps, Gilts +2.8bps).  While the positive news from the UK seems a rationale for the Gilt market, German GDP actually fell in Q4 bringing their Y/Y number down to 2.7% and one would have thought that might support Bunds.

Where, you may ask, are investors hiding if they are selling both stocks and bonds?  Commodities are looking better this morning with oil (+0.7%) continuing its recent rally although NatGas (-2.6%) remains beholden to the winter weather.  A warmer day here in the Northeast is undermining the price.  Precious metals (Au +0.1%, Ag +0.2%) are both on the right side of unchanged and most industrial metals are doing well (Cu -0.7%, Zn +1.9%, Sn +2.3%).  Agricultural prices are also beholden to the weather so are seeing a mixed bag this morning.

Finally, the dollar is mixed this morning, with an equal set of gainers and losers in both the G10 and EMG blocs.  JPY (+0.3%) is the leader in the clubhouse as the very obvious risk-off sentiment is encouraging repatriation of funds while AUD (-0.3%) is the laggard, seemingly on the back of the hawkish Fed comments (or perhaps on the fact that Novak Djokovic will not be playing in the Australian Open after all!)  In the emerging markets RUB (-0.6%) is the worst performer on the back of fears of further sanctions as the Ukraine situation continues to escalate, while INR (-0.35%) has also suffered overnight, this more on the talk of Fed hawkishness.  However, after those two, decliners have moved very little, certainly not enough to make a case about anything in particular.  On the plus side, CLP (+0.5%) and ZAR (+0.4%) are the leaders.  The peso is following yesterday’s strength with more as traders anticipate more hawkishness from the central bank while the rand is trading on the back of some key technical levels having been breached and pointing to yet more strength short-term.

Data this morning brings Retail Sales (exp -0.1%, +0.1% ex autos) as well as IP (0.2%), Capacity Utilization (77.0%) and Michigan Sentiment (70.0).  Yesterday’s PPI data did nothing to dispel the idea that inflation is well entrenched in the US economy regardless of what Fed members say in testimony or commentary.

Using the dollar index (DXY) as a proxy, the dollar has fallen 1.5% since this time last week.  Heading into this year, dollar bullishness was rampant as expectations for much tighter Fed policy were seen as likely to push the dollar higher.  However, the early price action is beginning to dispel that notion.  I have a feeling that we are going to see investors sell dollar rallies at the same time they sell equity rallies.  This is a huge sentiment change from the previous “buy the dip” mentality that had been prevalent since Ben Bernanke first introduced QE all those years ago.  Caveat emptor is the new watchword, for both stocks and the dollar.

Good luck, good weekend and stay safe
Adf

No Delay

Investors have not yet digested
The truth of what Jay has suggested
There’ll be no delay
QT’s on the way
(Unless the Dow Jones is molested)

Given the change in tone from the Fed and a number of other central banks, where suddenly hawkishness is in vogue, the fact that risky assets (read stocks) have only given back a small proportion of their year-long gains is actually quite remarkable.  The implication is that equity investors are completely comfortable with the transition to positive real interest rates and that valuations at current nosebleed levels are appropriate.  The problem with this thesis is that one of the key arguments made by equity bulls during the past two years has been that negative real interest rates are a crucial support to the market, and as long as they remain in place, then stocks should only go higher.

But consider how high the Fed will have to raise interest rates to get back to real ZIRP, let alone positive real rates.  If CPI remains at its current level of 6.8% (the December data is to be released on Wednesday and is expected to print at 7.0%), that implies twenty-seven 0.25% rate hikes going forward!  That’s more than four years of rate rises assuming they act at every meeting.  Ask yourself how the equity market will perform during a four-year rate hiking cycle.  My take is there would be at least a few hiccups along the way, and some probably pretty large.  Consider, too, that looking at the Fed funds futures curve, the implied Fed funds rate in January 2026 is a shade under 2.0%.  In other words, despite the fact that we saw some pretty sharp movement across the interest rate markets last week, with 10-year yields rising 25 basis points and 2-year yields rising 13 basis points, those moves would just be the beginning if there was truly belief that the Fed was going to address inflation.

Rather, the evidence at this stage indicates that the market does not believe the Fed’s tough talk, at least not that they will do “whatever it takes” to address rising inflation.  Instead, market pricing indicates that the Fed will try to show they mean business but have no appetite to allow the equity market to decline any substantial amount.  If (when) stocks do start to fall, the current belief is the Fed will come to the rescue and halt any tightening in its tracks.  As I have written previously, Powell and his committee are caught in a trap of their own design, and will need to make a decision to either allow inflation to keep running hot to try to prevent an equity meltdown, or take a real stand on inflation and let the (blue) chips fall where they may.  The similarities between Jay Powell and Paul Volcker, the last Fed chair willing to take the latter stand, stop at the fact neither man had an economics PhD.  But Jay Powell is no Paul Volcker, and it seems incredibly unlikely that he will have the fortitude to continue the inflation fight in the face of sharply declining asset markets.

What does this mean for markets going forward?  As we remain in the early stages (after all, the Fed is still executing QE purchases, albeit fewer than they had been doing previously) tough talk and modest policy changes are likely to continue for now.  Equity markets are likely to continue their performance from the year’s first week and continue to slide, and I would expect that bond markets will remain under pressure as well.  And with the Fed leading the way vis-à-vis the ECB and BOJ, I expect the dollar should continue to perform fairly well against those currencies.

However, there will come a point when investors begin to grow wary of the short- and medium-term outlooks for risk assets amid a rising rate environment.  This will be highlighted by the fact that inflation will remain well above the interest rate levels, and in order to contain the psychology of inflation, the Fed will need to continue its tough talk.  Already, when looking at the S&P 500, despite being just 3% below its all-time highs, more that 50% of its components are trading below their 50-day moving averages (i.e. are in a down-trend) which tells you just how crucial the FAANG stocks are.  And none of those mega cap stocks will benefit from higher interest rates.  In the end, there is significant room for equity (and all risk asset) declines if the Fed toes the tightening line.

Looking at markets this morning shows that no new decisions have been taken as both equity and bond markets are little changed since Friday.  Perhaps investors are awaiting Wednesday’s CPI data to determine the likely path going forward.  Or perhaps they are awaiting the comments from both Powell and Brainerd, both of whom will be facing the Senate this week for confirmation hearings for their new terms.  However, we do continue to hear hawkish comments with Richmond Fed President Barkin explaining that a March rate hike would suit him, and ex-Fed member Bill Dudley explaining that there is MUCH more work to be done raising rates.

So, after Friday’s late sell-off in the US, equities in Asia rebounded a bit (Hang Seng +1.1%, Shanghai +0.4%, Nikkei closed) although European bourses are all modestly in the red (DAX -0.3%, CAC -0.4%, FTSE 100 -0.1%). US futures are also turning red with NASDAQ futures (-0.35%) leading the way down.

Meanwhile, bond markets are mixed this morning with Treasury yields edging higher by just 0.4bps as I type, albeit remaining at its highest levels since before the pandemic, while we are seeing modest yield declines in Europe (Bunds -1.0bps, OATS -1.5bps, Gilts -0.3bps).  The biggest mover though are Italian BTPs (-5.3bps) as they retrace some of their past two-week underperformance.

On the commodity front, oil (-0.2%) has edged back down a few cents although remains much closer to recent highs than lows, while NatGas (+4.4%) has jumped on the back of much colder weather forecasts in the US Northeast and Midwest areas.  Gold (+0.3%) continues to trade either side of $1800/oz, although copper (-0.2%) is under a bit of pressure this morning.

As to the dollar, it is mixed today with SEK (-0.4%), CHF (-0.35%) and EUR (-0.3%) all under pressure while JPY (+0.25%) is showing its haven bona fides.  This definitely feels like a risk move as there was virtually no data or commentary out overnight.  In the EMG space, RUB (+0.9%) is the leading gainer as traders continue to look for further tightening by the central bank despite the fact that real rates there are actually back to positive already.  INR (+0.35%) and IDR (+0.35%) also gained with the rupee benefitting from equity market inflows while the rupiah responded to word that the government would soon lift the coal export ban.  On the downside, the CE4 are in the worst shape, but those are merely following the euro’s decline.

There is a decent amount of data coming up this week as follows:

Tuesday NFIB Small Biz Optimism 98.5
Wednesday CPI 0.4% (7.0% Y/Y)
-ex food & energy 0.5% (5.4% Y/Y)
Fed’s Beige Book
Thursday Initial Claims 200K
Continuing Claims 1760K
PPI 0.4% (9.8% Y/Y)
-ex food & energy 0.5% (8.0% Y/Y)
Friday Retail Sales -0.1%
-ex autos 0.2%
IP 0.2%
Capacity Utilization 77.0%
Michigan Sentiment 70.0

Source: Bloomberg

In addition to the data, we hear from seven Fed speakers and have the nomination hearings for Powell (Tuesday) and Brainerd (Thursday), so plenty of opportunity for more hawk-talk.

For now, I continue to like the dollar for as long as the Fed maintains the hawkish vibe.  However, I also expect that if risk assets start to really underperform, that talk will soften in a hurry.

Good luck and stay safe
Adf

Walking the Walk

Two central banks managed to shock
The market by walking the walk
The Old Lady jacked
By fifteen, in fact
Banxico then doubled the talk

So, now that it’s all said and done
C bankers, a new tale have spun
The virus no longer
Is such a fearmonger
Inflation’s now job number one

Talk, as we all know, is cheap, but from the two largest central banks, that’s mostly what we got.  While Chairman Powell got a positive market response from his erstwhile hawkish comments initially, yesterday investors started to rethink the benefits of tighter monetary policy and decided equity markets might not be the best place to hold their assets.  This is especially true of those invested in the mega-cap tech companies as those are the ones that most closely approximate an extremely long-duration bond.  So, the NASDAQ’s -2.5% performance has been followed by weakness around the globe and NASDAQ futures pointing down -0.9% this morning.  As many have said (present company included) the idea that the Fed will be aggressively tightening monetary policy in the face of a sharp sell-off in the stock market is pure fantasy.  The only question is exactly how far stocks need to fall before they blink.  My money is on somewhere between 10% and 20%.

Meanwhile, Madame Lagarde continues to pitch her view that inflation remains transitory and that while it is higher than the target right now, by next year, it will be back below target and the ECB’s concerns will focus on deflation again.  So, while the PEPP will indeed be wound down, it will not disappear as it is always available for a reappearance should they deem it necessary.  And in the meantime, they will increase the APP by €40 billion/month while still accepting Greek junk paper as part of the mix.  Even though inflation is running at 4.9% (2.6% core) as confirmed this morning, they espouse no concern that it is a problem.  Perhaps the most confusing part of this tale is that the EURUSD exchange rate rallied on the back of a more hawkish Fed / more dovish ECB combination.  One has to believe that is a pure sell the news result and the euro will slowly return to recent lows and make new ones to boot.

One final word about the major central banks as the BOJ concluded its meeting last night and…left policy unchanged as universally expected.  There is no indication they are going to do anything different for a long time to come.

However, when you step away from the Big 3 central banks, there was far more action in the mix, some of it quite surprising.  First, the BOE did raise the base rate by 15 basis points to 0.25% and indicated that it will be rising all throughout next year, with expectations that by September it will be 1.00%.  The MPC’s evaluation that omicron would not derail the economy and price pressures, especially from the labor market, were reaching dangerous levels led to the move and the surprise helped the pound rally as much as 0.7% at one point.  Earlier yesterday, the Norges Bank raised rates 25bps, up to 0.50%, and essentially promised another 25bp rise by March.  Then, in the afternoon, Banco de Mexico stepped in and raised their overnight rate by 0.50%, twice the expected hike and the largest move since they began this tightening cycle back in June.  It seems they are concerned about “the magnitude and diversity” of price pressures and do not want to allow inflation expectations to get unanchored, as central bankers are wont to say.

Summing up central bank week, the adjustment has been significant from the last round of meetings with inflation clearly now the main focus for every one of them, perhaps except for Turkey, where they cut the one-week repo rate by 100 basis points to 14.0% and continue to watch the TRY (-7.0%) collapse.  It is almost as if President Erdogan is trying to recreate the Weimar hyperinflation of the 1920’s without the war reparations.

Will they be able to maintain this inflation fighting stance if global equity markets decline?  That, of course, is the big question, and one which history does not show favorably.  At least not the current crop of central bankers.  Barring the resurrection of Paul Volcker, I think we know the path this will take.

This poet is seeking his muse
To help him define next year’s views
Thus, til New Year’s passed
Do not be aghast
My note, you’ll not have, to peruse

Ok, for my final note of the year, let’s recap what has happened overnight.  As mentioned above, risk is under pressure after a poor performance by equity markets in the US.  So, the Nikkei (-1.8%), Hang Seng (-1.2%) and Shanghai (-1.2%) all fell pretty sharply overnight.  This morning, Europe has also been generally weak, but not quite as badly off as Asia with the DAX (-0.65%) and CAC (-0.7%) both lower although the FTSE 100 (+0.3%) is bucking the trend after stronger than expected Retail Sales data (+1.4%).  Meanwhile, Germany has been dealing with soaring inflation (PPI 19.2%, a new historic high) and weakening growth expectations as the IFO (92.6) fell to its lowest level since January and is trending sharply lower.  US futures are also pointing lower at this hour.

Bond markets, meanwhile, are generally firmer although Treasury yields are unchanged at this time.  Europe, though, has seen declining yields across the board led by French OATs (-2.6bps) and Bunds (-1.8bps) with the peripherals also doing well.  Gilts are bucking this trend as well, with yields unchanged this morning.

In the commodity space, oil (-1.75%) is leading the energy sector lower along with NatGas (-1.9%), but metals markets are going the other way.  Gold (+0.5%, and back above $1800/oz) and silver (+0.7%) feel more like inflation hedges this morning, and we are seeing strength in the industrial space with copper (+0.45%), aluminum (+2.1%) and tin (+1.8%) all rallying.  

Lastly, looking at the dollar, on this broad risk-off day, it is generally stronger vs. its G10 counterparts with only the yen (+0.2%) showing its haven status.  Otherwise, NZD (-0.5%) and AUD (-0.4%) are leading the way lower with the entire commodity bloc under pressure.  As to the single currency, it is currently slightly softer (-0.1%) but I believe it has much further to run by year end.  

In the EMG bloc, excluding TRY’s collapse, the biggest mover has actually been ZAR (+0.6%) after it reported that the hospitalization rate during the omicron outbreak has collapsed to just 1.7% of cases being admitted.  This speaks to the variant’s less pernicious symptoms despite its rapid spread.  Other than that, on the plus side KRW (+0.25%) benefitted from central bank comments that they would continue to support the economy but raise rates if necessary.  On the downside, CLP (-0.4%) is opening poorly as traders brace for this weekend’s runoff presidential election between a hard left and hard right candidate with no middle ground to be found.  However, beyond those moves, there has been much less activity.

There is no economic data today and only one Fed speaker, Governor Waller at 1:00pm.  So, the FX market will once again be seeking its catalysts from other markets or the tape.  At this point, if risk continues to be shed, I expect the dollar to continue to recoup its recent losses and eventually make new highs.

As I mention above, this will be the last daily note for 2021 but the FX Poet will return with his forecasts on January 3rd, 2022, and the daily will follow afterwards.  To everyone who continues to read, thank you for your support and I hope everyone has a happy and healthy holiday season.

Good luck, good weekend and stay safe
Adf

Dire Straits

In Europe, the UK, and States
The central banks face dire straits
Inflation’s ascending
But omicron’s trending
So, what should they do about rates?

First Jay will most certainly say
More tapering is on the way
But Andrew is stuck
With Covid amok
While Christine, a choice, will delay

It is central bank week and all eyes are on the decisions and statements to be made by the Fed on Wednesday and the BOE and ECB on Thursday.  In fact, the BOJ will be meeting Friday, but by that time, given the fact that markets are likely to be exhausted from whatever occurs earlier in the week and the assumption nothing there will change, that news seems unlikely to matter much.

By this time, the market narrative (as opposed to the Fed’s preferred narrative) has evolved to the Fed must taper QE even more rapidly with doubling that rate seen as the bare minimum.  You may recall that in November, the Fed announced it would be reducing its QE purchases by $15 billion / month until such time as QE ended.  At that point, they would then consider the idea about raising interest rates assuming inflation remained a concern.  Of course, since then, no matter how you measure inflation, (CPI, core PCE, Trimmed Mean, Sticky) it has risen to levels not seen since the early 1980’s.  This has resulted in a near hysterical call by the punditry for much faster tapering and nearly immediate interest rate hikes.  The longer the Fed delays the process, the fact that rising inflation forces real yields lower means that monetary conditions are easing during a period of extraordinary fiscal policy led demand.  This simply exacerbates the inflation situation feeding this self-reinforcing loop.  Quite frankly, I believe the punditry is correct on this issue, but also expect that the Fed will do less than has become widely believed is necessary because inaction is their default setting.

The dollar, which is largely firmer across the board this morning, continues to benefit from the anticipated hawkishness that this new narrative has evoked.  Arguably, that sets up the opportunity for a sell-off in the greenback if Powell doesn’t deliver the goods, and realistically, even if he does on a ‘sell the news’ outcome.

Turning to the Old Lady of Threadneedle Street, Governor Andrew Bailey has already drawn the ire of financial markets (and some members of Parliament) with his comments from October that many took as a ‘promise’ to raise the base rate then in an effort to address rising inflation in the UK.  But he didn’t do so, and blamed market participants for hearing what he said as such a promise.  That led to investors and traders assuming the rate hike would be coming this week, with more to follow, and that the base rate, currently at 0.10%, would be raised to 1.25% by the end of 2022.  However, omicron has thrown a wrench into the works as the Johnson government is now considering Plan B, or C or D (I lose count) as their newest lockdown strictures to prevent the spread of the latest variant.  Arguably, raising interest rates into a period where the economy is shutting down would be categorized as a policy mistake, and one easily avoided.  Thus, the BOE finds itself in a difficult spot, wait to find out more about omicron despite inflation’s rapid and persistent rise, or address inflation at the risk of tightening into a slowing economy.

The pound, despite expectations which had been focused on the BOE leading the interest rate cycle amongst the big four central banks, has traded back down to its lowest level in a year, although realistically to its average over the past five years.  The trend, though, is clearly lower and any reasonable hawkishness by the Fed is likely to see Sterling test, and break below, 1.30, in my view.  At this point, I feel like the pound is completely beholden to Powell, not Bailey.

Finally, the ECB also announces their policy decisions on Thursday, just 45 minutes after the BOE.  Here the discussion has been around what happens when the PEPP, which is due to expire in March 2022, ends and what type of additional support will they be pumping into the economy.  It has already become clear that the original QE program, the APP, will be expanded in some form, but one of the things about that was the requirement that the ECB stick to the capital key with respect to its purchases, and the inability of that program to purchase non-IG debt.  The problem there is that Greece remains junk credit, but also the Greek government bond market remains entirely dependent on the ECB’s purchases to continue to function.  At the same time, Germany, where inflation is running the hottest (Wholesale Prices rose 16.6% in November, the highest level ever in the series back to June 1968) is where the largest proportion of bonds is purchased, easing local financial conditions even further thus exacerbating the inflation story there.  In many ways, it is understandable as to why there is less clarity on the ECB’s potential actions.  As many problems as the Fed has created for themselves, the ECB probably has more, and Madame Lagarde is not a central banker by trade, but rather a politician.  As such, she is far more likely to push for a politically comfortable solution than an economically sound one.

The euro had been trending steadily lower until Thanksgiving when we saw a bounce and it has been consolidating ever since.  However, my take is the ECB is likely to be more dovish, rather than less, and in the wake of a Fed that is clearly tightening policy and will be seen to have to tighten further going forward, the euro is likely to feel more pressure to decline going forward.  Look for a test of 1.10 sometime early in Q1.

OK, now that we’ve set the stage for the week ahead, let’s quickly tour the overnight activity.  After yet another rally in the NY afternoon, Asia was mostly higher (Nikkei +0.7%, Hang Seng -0.2%, Shanghai +0.4%) with Europe showing a similar type of performance (DAX +0.9%, CAC +0.15%, FTSE 100 -0.1%).  US futures are all pointing a bit higher, but only about 0.2%.  Net, risk appetite seems to be modest today ahead of the meetings this week.

Interestingly, despite decent equity market performance, and despite no end in sight for inflation pressures, bond markets have generally rallied today with yields edging lower.  Treasury yields have slipped by 1.4bps, while Bunds (-1.0bps), OATs (-1.5bps) and Gilts (-1.7bps) all show similar yield declines.  This seems a little odd given the inflation narrative remains strong, but perhaps is a response to concerns over a policy mistake, or three, amongst the central banks.

Commodity prices are mixed this morning with oil (-0.7%) under pressure while NatGas (+1.5%) is making gains based on colder weather.  (PS, European NatGas is up 9.3% this morning to $38.33/mmBTU, compared to US NatGas at $3.98/mmBTU).  That is NOT a typo, almost 10x the price.  It seems that colder weather and the ongoing Russia/Ukraine/Belarus issues are having a big impact.  Metals prices are generally firmer with precious (Au +0.4%, Ag +0.4%) looking solid while industrial (Cu +0.3%, Al +1.2%) also perform well although some of the lesser metals like Ni (-0.6%) and Sn (-0.2%) are underperforming.

As to the dollar, it is universally stronger vs. the G10 with NOK (-0.6%) and AUD (-0.5%) the laggards although CAD (-0.3%) is also under the gun.  It seems oil is an issue as well as the Chinese economy with respect to the Aussie.  EMG currencies are broadly softer, but other than TRY (-2.0%) which continues to trade to new historic lows amid policy blunders, the movement has not been excessive.  MYR (-0.4%) is the next worst performer, consolidating recent gains as traders await presumed hawkish news from the Fed, with most other currencies showing similar types of losses on the same story.  The exceptions to this rule are ZAR (+0.5%) which rallied on the strength of the metals complex and IDR (+0.2%) which benefitted based on a reduced borrowing plan for the government.

On the data front, ahead of the Fed we see PPI and Retail Sales plus a bit more stuff later in the week.

Tuesday NFIB Small Biz Optimism 98.4
PPI 0.5% (9.2% Y/Y)
-ex food & energy 0.4% (7.2% Y/Y)
Wednesday Empire Manufacturing 25.0
Retail Sales 0.8%
-ex autos 0.9%
Business Inventories 1.1%
FOMC Meeting
Thursday Initial Claims 195K
Continuing Claims 1938K
Housing Starts 1566K
Building Permits 1660K
Philly Fed 29.6
IP 0.7%
Capacity Utilization 76.8%

Source: Bloomberg

The demand story certainly seems robust based on Retail Sales, and that has to continue to influence the Fed.  I find the inventories data interesting as firms evolve from just-in-time to just-in-case models, another inflationary process.  But in the end, this week is all about the Fed (and BOE and ECB) so until we know more from there, look for choppy markets with no real direction.

Good luck and stay safe
Adf

Damnified

The market has turned its attention
To Brainerd’s potential ascension
As Chair of the Fed
Thus, bond bulls imbed
The view QE gets an extension

This adds to the growing divide
Twixt nations who’ve identified
Inflation as bad
From those who are mad
Their laxness have been damnified

The dollar is under some pressure this morning as bonds rally (yields decline) and commodity prices pick up further.  If equity markets were higher this would be a classic risk-on session, alas, that picture is mixed, and anyway, whatever movement there is has been modest at best.  (It’s almost as if equity bulls are getting tired at all-time highs with record valuations.)

What, then, you may ask, is driving today’s price action?  I give you Lael Brainerd PhD, current Fed governor, former Under Secretary of International Affairs at the US Treasury, and the woman most likely to be our next Federal Reserve Chair.  The news broke that President Biden interviewed her for the role and there is a growing belief that in the current political zeitgeist, a Democratic woman favored by the progressive wing of the party will be much more palatable than a Republican man with a mixed track record on issues like FOMC membership trading improprieties.  It doesn’t hurt that she has been an unrequited dove since her appointment by President Obama in 2014, nor that she has been vocal on the need for more stringent regulatory control over the big banks.

As markets are discounting instruments, ostensibly looking forward a number of months to where things will be rather than where they currently sit, there is a growing belief that a Chairwoman Brainerd will be loath to continue tapering asset purchases and far more comfortable allowing inflation to run even hotter in her desire to achieve an even lower unemployment rate.  Hence, the idea that fed funds rate hikes will be coming sooner has been pushed back further.  In the wake of last week’s very surprising BOE meeting, where the widely anticipate rate hike was delayed, and the Fed’s own extremely dovish tapering message, the idea that a change at the Fed will lean even more dovish than now is music to bond bulls’ ears.  And so, as we survey the largest economies, the US seems to be turning more dovish, the Eurozone continues to burnish its dovish bona fides and the BOJ…well the BOJ is unlikely to ever tighten policy again.

However, as we look elsewhere in the world, the story is very different.  Central banks all over, from smaller G10 nations to large EMG group members have clearly articulated that inflation is a major concern with no clear end in sight and that tighter monetary policy is in order.  In the G10, Canada appears on the cusp of tightening, Norway has done so already and promised another hike next month.  New Zealand has ended QE and raised rates, Australia has given up on YCC and Sweden is hinting at a rate rise coming soon.  The noteworthy link is these are all small, relatively open economies with trade a key part of the mix and rising prices are very evident.

But do not forget the EMG space where we have seen far more dramatic moves already and are almost certain to see more of the same going forward.  The Czech Republic hiked rates 125bps last week, far more than expected, while Russia has already raised rates 2.50% in the past 9 months with no signs of slowing down.  Meanwhile, Polish central bankers are previewing more rapid rate hikes despite a larger than expected 75 basis point move last week.  In LATAM, Brazil has already raised rates 5.25% and is in no mood to stop with inflation running above 10% there.  Mexico, too, is up 0.75% from its lows while Chile (+2.25%), Colombia (+0.75%) and Peru (+1.75%) have all reacted strongly to rising inflation.

The point is this dichotomy between the G3 and the rest of the world seems unlikely to continue forever.  There seem to be two likely scenarios to close this interest rate gap, neither of them to be hoped for; either the G3 will finally blink, recognize inflation is real and raise rates far more rapidly than currently expected, or the transitory story will be correct as the economic imbalances will drive a massive crash with economic growth slowing dramatically into a severe recession and no reason to raise interest rates.  In the first case, financial assets will almost certainly suffer greatly while commodities should perform well.  In the second case, everything will suffer greatly with cash regaining its title as king.

Like I said, neither is a pleasant outcome, but neither is about to happen yet either.  So, looking at today’s activity, the growing assumption of a more dovish Fed (remember that vice-chairs Clarida and Quarles will be out within months as well) has led to lower yields and a somewhat softer dollar along with ongoing higher commodity prices.

Equities, however, remain mixed overall, albeit starting to edge higher in the session.  In Asia, the picture was mixed with the Nikkei (-0.75%) falling on the back of yen strength, while the Hang Seng (+0.2%) and Shanghai (+0.2%) both managed to edge higher.  Europe, which had been mixed to lower earlier in the session has started to turn green with the DAX (+0.2%), CAC (+0.3%) and FTSE 100 (+0.1%) all in positive territory. US futures are generally little changed ahead of this morning’s PPI data, (exp 8.6%, 6.8% ex food & energy) but really with the market focusing on tomorrow’s CPI data.

As mentioned, bonds are having a good day, with Treasuries (-3.1bps) falling back to Friday’s low yields, while European sovereigns (Bunds -3.5bps, OATs -3.7bps, Gilts -1.3bps) all rally as well.  In Europe, the curves are flattening pretty aggressively, hardly a vote of confidence in future activity.

Oil prices (+0.45%) are once again firmer although NatGas (-1.6%) has slipped as warm weather in the mid-Atlantic and Midwest states reduces near term heating demand.  Precious metals, which have been rallying nicely of late are little changed on the day but industrial metals (Cu +0.5%, Al +0.1%, Sn +0.3%) are all a bit firmer.  Agricultural products continue to rise as food inflation worldwide continues to grow.

Finally, the dollar, which had been broadly softer earlier in the session on the dovish discussion, has rebounded slightly, although is hardly rocking.  In the G10, the largest moves have been 0.25% in either direction (AUD -0.25%, JPY +0.25%) however, there have been limited stories to drive perceptions.  Given the yen’s recent bout of significant weakness, this appears to be a corrective move rather than a new direction.  As to Aussie, it too seems more technical than fundamental in nature.

Emerging markets, however, have seen more movement led by THB (+0.8%) and KRW (+0.5%) on the news that both economies are reopening amid a decline in Covid infections and the allowance of more inbound tourist traffic.  RUB (+0.45%) seems to be benefitting from oil’s rise as well.  On the downside, ZAR (-0.6%) fell after a report that foreign holdings of South African sovereign debt fell to its lowest level in 10 years.

On the data front, aside from the PPI, we have already received the NFIB Small Business Optimism number at a disappointing 98.2 (exp 99.5) indicating that the growth impulse in the US is still under pressure.  In addition, there are 4 more Fed speakers today after yesterday’s warnings from Vice-chair Clarida that inflation may be a problem going forward.

For now, the dollar seems to be under modest pressure as it consolidates the latest leg of a slow move higher.  If the Fed tapering is going to diminish, the dollar bulls are going to have a harder road to hoe going forward.  As such, much will depend on who is our next Fed chair.

Good luck and stay safe
Adf

Their Latest Excuse

While prices worldwide keep on rising
Most central banks are still devising
Their latest excuse
For why money, loose,
Is still the least unappetizing

On Wednesday Chair Powell explained
That QE would slowly be drained
Then Thursday the Bank
Of England helped sank
Gilt yields, leaving traders bloodstained

Now Friday’s arrived and we’re all
Concerned that a Payrolls curveball
Could quickly defuse
The new dovish views
With hawks back for their curtain call

If you sell stuff in the UK, or hold assets there, I sure hope you’ve hedged your currency exposure.  In what can only be described as shocking, the Bank of England left policy on hold yesterday after numerous hints from members, including several explicitly from Governor Andrew Bailey, that something needed to be done about rising inflation. The combination of rising inflation prints, rising inflation forecasts and comments from BOE members had the market highly convinced that a 0.15% base rate hike was coming yesterday, with the idea it would then allow the central bank to hike further in 25 basis point increments with futures pointing to the base rate at 1.00% come next December.  But it was not to be.  Instead, in a 7-2 vote, the BOE left policy rates unchanged and will continue its current QE program which has £20 billion left to buy to reach their target.

The result was a massive repricing of markets as interest rates tumbled across the entire curve and the pound tumbled along side them.  In what is perhaps the most brazen lie audacious statement from a major central banker lately, Bailey explained in a Bloomberg TV interview that it was “not our job to steer markets.”  Seriously?  That is all every central banker ever tries to do.  If financial stability is one of the goals enumerated for central banks, the BOE failed dismally yesterday.  Tallying up the impact shows that 10-year Gilt yields fell 13 basis points (and another 4.1 this morning), OIS markets saw the 1-year interest rate decline 20 basis points and the pound fell 1.4% yesterday and a further 0.5% this morning.  It was ugly.

Perhaps the lesson to learn here is that as central banks around the world try to adjust monetary policy going forward, there are going to be a lot more bumps along the way, with market expectations being left unfulfilled and severe market reactions accordingly.  Forward guidance, which has become a critical tool for central banks over the past decade plus is no longer going to be as effective.  When Ben Bernanke highlighted the idea in 2009, it was thought to be a great addition to the central bank toolkit, the ability to adjust markets without adjusting policy.  And while that may have been true when monetary policy was being eased for years, it turns out that forward guidance is a bit more difficult to handle in the other direction.  Market volatility, across all markets, is likely to increase over the next couple of years as the coordinated central bank activities we have become used to seeing disappear.  Consider that while the Fed, ECB, BOJ and BOE have all pushed back on raising rates soon, the Norgesbank, BOC, RBNZ, RBA and a host of emerging market central banks are starting the process or already well along the way.

Turning to this morning’s data, if you recall, the last two NFP numbers were quite disappointing, with both coming in well below expectations.  The only thing we know about the labor market is that we don’t really know what is going on there anymore.  Clearly, based simply on the JOLTS data we know there are more than 10 million job openings in the country.  (That is also made obvious whenever you leave your home and see all the help wanted signs in store windows.)  But despite clearly rising wages, it has thus far not been enough to entice many people back into the labor force.  So, the Unemployment Rate remains far higher than it was pre-pandemic, but there are plenty of jobs available.  In this situation I feel for the Fed, as there is no clarity available with conflicting data rampant.  At any rate, here are the forecasts heading into the release:

Nonfarm Payrolls 450K
Private Payrolls 420K
Manuacturing Payrolls 30K
Unemployment Rate 4.7%
Average Hourly Earnings 0.4% (4.9% Y/Y)
Average Weekly Hours 34.8
Participation Rate 61.7%

Source: Bloomberg

One interesting thing is that excluding the pandemic stimulus checks, the current Y/Y Earnings data is the highest since the series began in 2006.  And worse still, it is lagging CPI by at least a half-point.  My sense is that we are likely to see another weaker than expected number as the kinks in the labor market have not yet been worked out.

Ok, a quick look at markets shows that Asia had a rough go of it last night (Nikkei -0.6%, Hang Seng -1.4%, Shanghai -1.0%) as continued concerns over the Chinese property market weigh on the economy there while Japan looks more like position adjustment ahead of the weekend.  Europe, on the other hand, is doing much better (DAX +0.15%, CAC +0.6%, FTSE 100 +0.55%) despite much weaker than expected IP data from both Germany (-1.1%) and France (-1.3%) in September.  Too, Eurozone Retail Sales (-0.3%) badly missed expectations in September, but revisions helped ameliorate some of those losses.  Regardless, I would argue that the weak data has encouraged investors and traders to believe that all the talk of tightening to address inflation is ebbing.  Meanwhile, US futures, which had spent the bulk of the evening essentially unchanged are now higher by about 0.25%.

Bond yields are generally lower again this morning with most European sovereigns seeing declines of around 1 basis point except for Gilts, pushing 4bps.  Treasuries, which had seen softer yields earlier in the session have now turned around and edged lower (higher yields) but are still less than a basis point different from yesterday’s close.

Commodity prices also had a wild session yesterday with oil initially rallying $2/bbl before abruptly reversing and falling $5/bbl to close back below $80 for the first time in a month.  Given that backdrop, this morning’s 0.6% rise seems less interesting and it is still below $80.  NatGas (-0.5%) has slipped this morning, while the rest of the commodity complex is showing no trends whatsoever, with both gainers and losers.  Like every other market, traders are trying to come to grips with the new central bank situation.

The one consistency has been the dollar, which rallied yesterday and is continuing today.  In the G10, the pound (-0.5%) is the worst performer but we are seeing weakness in AUD (-0.4%), CHF (-0.4%) and NOK (-0.35%) as well with the entire bloc under pressure.  NOK is clearly still being impacted by yesterday’s oil moves while the others seem to be feeling the heat from suddenly more dovish thoughts regarding policy.  In the EMG space, PHP (+0.55%) is the outlier, rallying on comments from the central bank that it will continue to support the economy and news that the Covid infection rate has been falling.  Otherwise, the bulk of the bloc is in the red led by ZAR (-0.45%), PLN (-0.4%) and MXN (-0.35%).  Of these, the most noteworthy is PLN, where the central bank, which had just been touting its hawkish bona fides, has completely reversed and indicated that further rate hikes may not be necessary.  This seems odd given inflation is running at 6.8%, and forecast to top 8.0% next year, while the base rate was just raised to 1.25%.  It feels to me like PLN could fall further.

So, for now, we all await the payroll data and then get to reevaluate our views and expectations of Fed actions.  Nothing has changed my view that inflation will continue higher and nothing has changed my view that growth is going to slow.  So, while the Fed may begin to taper, I still believe they will stop before the end.  However, for now, the Fed is the most hawkish dove out there, so the dollar can continue to rally.

Good luck, good weekend and stay safe
Adf

It’s Still Transitory

Said Jay, I’m not worried ‘bout wages
Creating inflation in stages
I’ll stick to my story
It’s still transitory
And will be for many more ages

So now it’s the Old Lady’s turn
To help explain if her concern
‘Bout rising inflation
Will be the causation
Of rate hikes and trader heartburn

Like a child having a temper tantrum, the Fed continues to hold its breath and stamp its feet and tell us, “[i]nflation is elevated, largely reflecting factors that are expected to be transitory. Supply and demand imbalances related to the pandemic and the reopening of the economy have contributed to a sizable price increase in some sectors.” [my emphasis.]  In other words, it’s not the fault of their policies that inflation is elevated, it’s the darn pandemic and supply chain issues.  (This is remarkably similar to how the German Reichsbank president, Rudy Havenstein, behaved as that bank printed trillions of marks fanning the flames of the Weimar hyperinflation.  At every bank meeting the discussion centered on rising prices and not once did it occur to them that they were at fault by continuing to print money.)

Nonetheless, Chairman Powell must be extremely pleased this morning as he was able to announce the tapering of QE purchases, beginning this month, and equity and bond markets responded by rallying.  There was, however, another quieter announcement which may well have helped the cause, this one by the Treasury.  Given the rally in asset prices, collection of tax receipts by the government has grown dramatically and so the Treasury General Account (the government’s ‘checking’ account at the Fed) is now amply funded with over $210 billion available to spend.  This has allowed the Treasury to reduce their quarterly refunding amounts by…$15 billion, the exact amount by which the Fed is reducing its QE purchases.  Hmmmm.

So, to recap the Fed story, the tapering has begun, inflation is still transitory, although they continue to bastardize the meaning of that word, and they remain focused on the employment situation which, if things go well, could achieve maximum employment sometime next year.  Rate hikes will not be considered until they finish tapering QE to zero, and they will taper at the pace they deem correct based on conditions, so the $15 billion/month is subject to change.  One more thing; when asked at the press conference about inflation rising faster than anticipated, Powell responded, “We think we can be patient.  If a response is called for, we will not hesitate.”  Them’s pretty big words for a guy who can look at the economy’s behavior over the past twelve months and decide that inflation remains only a potential problem.

Enough about Jay, he’s not going to change, and in my view, he only has two meetings left anyway.  Consider this; President Biden needs to get the progressives onboard to have any chance of passing any part of the current spending bills and in order for them to compromise on that subject, they will want something in return.  They also hate Powell, as repeatedly vocalized by Senator Warren, so it is easy to foresee the President sacrificing Powell for the sake of his spending bill.  Especially given the results of the Virginia elections, which moved heavily against the Democrats, the administration will want to get this done before the mid-term elections next year.  I think Powell is toast.

On to the rest of the central bank world where this morning the BOE will announce their latest decision.  The market continues to be about 50/50 on a rate hike today, but have fully priced one in by December, so either today or next month.  Interestingly, the UK Gilt market is rallying this morning ahead of the announcement, with yields lower by 3.1 basis points.  What makes that so interesting is that the futures market is pricing in 100 basis points of rate hikes by the BOE within the next 12 months, which would take the base rate up to 1.0%.  Right now, 10-year Gilt yields are 1.03%.  If the futures market is right, then either Gilts are going to sell off sharply as the yield curve maintains its current shape or the market is beginning to price in much slower growth in the UK.  My money is on the latter as the UK has proven itself to be willing to fight inflation far more strenuously than the Fed in the past.  If slowing growth is a consequence, they will accept that more readily I believe.

Still on the central bank trail, it is worth highlighting that Poland’s central bank raised rates by 0.75% yesterday in a huge market surprise as they respond to quickly rising inflation.  Concerns are that CPI will reach 8.0% this year, so despite the rate hike, there is still much work to do as the current base rate there, after the hike, is 1.25%.  This morning the Norgesbank left rates on hold but essentially promised to raise them by 25bps next month to 0.50%. While they are the first G10 country to have raised interest rates, even at 0.50%, their deposit rate remains far, far below CPI of 4.1%.

So, to recap, central banks everywhere are finally starting to move in response to rapidly rising inflation.  While some countries are moving faster than others, the big picture is rates are set to go higher…for now.  However, when economic growth begins to slow more dramatically, and it is already started doing so, it remains to be seen how aggressive any central bank will be, especially the Fed.

Ok, let’s look at today’s markets.  As I said earlier, equities are rocking.  After yesterday’s US performance, where all 3 major indices reached new all-time highs, we saw strength in Asia (Nikkei +0.9%, Hang Seng +0.8%, Shanghai +0.8%) and Europe (DAX +0.5%, CAC +0.5%, FTSE 100 +0.2%).  US futures, on the other hand, are mixed with NASDAQ (+0.5%) firmer while the other two indices are little changed.

Bond prices have rallied everywhere in the world, which given the idea of tighter policy seems incongruent.  However, it has become abundantly clear that bond prices no longer reflect market expectations of inflation, but rather market expectations of QE.  At any rate, Treasuries (-3.5bps) are leading the way but Gilts (-3.1bps), Bunds (-1.7bps) and OATs (-1.8bps) are all seeing demand this morning.

After yesterday’s confusion, commodity prices are tending higher this morning with oil (+1.7%) leading the way, but gains, too, in NatGas (+0.75%), gold (+0.5%) and copper (+0.6%).  Agricultural products are mixed, as are the rest of the industrial metals, but generally, this space has seen strength today.

As to the dollar, it is king today, firmer vs. virtually every other currency in both the G10 and EMG blocs.  The euro (-0.6%) is the laggard in the G10 as the market is clearly voting the ECB will be even more dovish than the Fed going forward.  But the pound (-0.4%) is soft ahead of the BOE and surprisingly, NOK (-0.4%) is soft despite both rising oil prices and a relatively hawkish Norgesbank.  The best performer is the yen, which is essentially unchanged today.

In the EMG space, PLN (-1.0%) and HUF (-1.0%) are the laggards as both countries grapple with much faster inflation and lagging monetary policy.  But CZK (-0.7%) and TRY (-0.65%) are also under relative pressure as their monetary policies, too, are lagging the inflation situation.  Throughout Asia, most currencies slid as well, just not as much as we are seeing in EEMEA.

On the data front, Initial Claims (exp 275K) headlines this morning along with Continuing Claims (2150K), Nonfarm Productivity (-3.1%), Unit Labor Costs (7.0%) and the Trade Balance (-$80.2B).  It is hard to look at the productivity and ULC data and not be concerned about the future economic situation here.  Rapidly rising labor costs and shrinking productivity is not a pretty mix.  As to the Fed, mercifully there are no additional speakers today, so we need look only at data and market response.

Clearly market euphoria remains high at this time, and so further equity gains seem likely.  Alas, the underlying structure of things does not feel that stable to me.  I expect that we are getting much closer to a more substantial risk-off period which will result in a much stronger dollar (and yen), and likely weaker asset prices.  For hedgers, be careful.

Good luck and stay safe
Adf

A Touch of Despair

The Beige Book detected the fact
That bottom lines all have been whacked
As wages explode
While growth, somewhat, slowed
Inflation, it seems, ain’t abstract

Meanwhile we heard from a vice-Chair
Whose words had a touch of despair
It seems he now thinks
There just might be links
Twixt QE and price everywhere

Chairman Powell’s comments due tomorrow are taking on much greater importance than just a few days ago as the Fed narrative is seemingly in the middle of a change.  While many have been willing to dismiss the fact that the regional Fed presidents have been more hawkish lately, leading the charge for the beginning of tapering, the Fed governors had been far more sanguine on the subject, at least until very recently.  Tuesday, we heard from Governor Waller about his concerns that inflation could be more persistent, especially if one looked at the headline measures as he dismissed the other measures as efforts at manipulation.  Yesterday it was vice-Chair Quarles’ turn to put the market on notice that inflation’s persistence has begun to become troublesome and while he still felt price pressures would abate next year, his level of confidence in that forecast was clearly declining.  Both of them hinted at the possible need for rate hikes sooner than previously expected.

Yesterday, too, the release of the Fed’s Beige Book presented a clear picture of two issues: wages were rising rapidly, and growth was slowing.  The problem stems from the fact that despite wage increases of 20% or more, companies are still having a problem staffing up to desired levels and that has led to reduced output.  It has also led to business after business explaining that they would be raising prices to offset increased costs for not just wages, but raw materials and shipping.  In your Economics 101 textbook (likely Samuelson’s) this was the very definition of a wage-price spiral.

It is this recent hawkish turn by several Fed governors that brings even greater attention to Chairman Powell’s comments tomorrow.  The market is already assuming that tapering will begin next month, but the question remains, will the Fed be able to continue along that line if economic activity continues to slide?  I raise this issue because after Tuesday’s weaker than expected housing data, the Atlanta Fed’s GDPNow indicator has fallen to 0.533% for Q3.  And that’s an annual rate, down from Q2’s 6.8% GDP growth.  It appears the Fed may have a difficult decision to make in the near future; fight rapidly rising inflation or fight rapidly slowing growth. As I’ve written before, stagflation is a b*tch.

Adding to the economic problems is the continued slowing of growth in China where ongoing power shortages combined with a resurgence of Covid related shutdowns and the implosion of China Evergrande have resulted in the slowest, non-Covid, growth in decades.  At the same time, the PBOC continues to drain liquidity from the economy in an effort to reduce leverage which has the effect of further slowing activity there.  Given China has been the global growth engine for at least the past decade, a slowdown there means we are going to see slower activity everywhere else.  Alas, for the central banking community, it is not clear that will help price pressures abate, not as long as energy and raw material prices continue to rise.

Summing it all up shows that growth worldwide is falling from Q2’s peak while price pressures are flowing from commodities to shipping and now wages.  All this is occurring with interest rates broadly at their lowest levels in history. (I know some countries have raised rates a bit, but the reality is there is far less room to ease policy than tighten overall.)  Given this backdrop, it remains amazing to me that equity markets worldwide have been able to continue to perform well.  And yet, they continue to do so broadly, albeit not last night.  However, I believe that interest rate markets are beginning to recognize that the future may not be so rosy as we are seeing yields continue to climb and inflation breakevens rise to levels not seen in nearly a decade.  Remember, there is no perpetual motion machine and no free lunch.  Central banks have spent the entire post GFC period continually supporting markets while allowing significant imbalances to develop across all segments of the economy and, ironically, markets.  I have often said the Fed’s biggest problem will arrive when they announce a policy change and the market ignores the announcement.  I fear that time is growing much nearer.

With those cheery thoughts to support us, let’s take a look at the overnight session.  It seems that risk is having a bit of a struggle today with most of Asia (Nikkei -1.9%, Hang Seng -0.5%, Shanghai +0.2%) under pressure and Europe (DAX -0.1%, CAC -0.4%, FTSE 100 -0.6%), too, having difficulty this morning.  US futures are also pointing lower, -0.3% or so across the major ones, which implies pressure at the opening at the very least.  China continues to be a drag on the global markets as other Chinese real estate companies are starting to fall and the word is Evergrande’s sales have fallen 97%.  I guess buying from a bankrupt company is not that attractive a proposition.

In a bit of a surprise, European sovereign bond yields are rising this morning (Bunds +1.6bps, OATs +1.2bps, Gilts +3.7bps) as ordinarily one would expect a rush into safe havens when risk is on the run.  However, as the EU begins another summit, it is likely to simply highlight the ongoing problems across the continent, notably in energy, and that seems to be sapping confidence from investors.  Treasury yields are very marginally softer on the day, so far, but with more and more Fed members talking up inflation worries, I expect they are likely to continue to rise for a while yet.

Commodity markets are under pressure today as well with oil (WTI -0.8%) and NatGas (-1.7%) leading the way, but weakness, too, in copper (-2.9%), aluminum (-0.3%) and all the main agriculturals (soy -0.7%, wheat -0.7%, corn -0.5%).  By contrast, gold’s unchanged price is looking good!

As to the dollar, it is broadly, though not universally, stronger this morning.  In the G10, AUD (-0.3%) and NZD (-0.3%) lead the way down with the rest of the commodity bloc also suffering a bit.  On the plus side, JPY (+0.25%) is the only gainer, which given equity price action seems pretty standard.  In the emerging markets, TRY (-2.4%) is the outlier after the central bank cut interest rates by 2.0%, double the expected outcome, to 16.0%, despite inflation running at 19.6% in September.  You may recall that President Erdogan fired several central bankers last week as they were clearly not willing to do his bidding.  There is nothing promising about the lira these days.  Aside from that, the rest of the space is softer led by ZAR (-0.7%) on weaker commodity prices, and PLN (-0.4%) as investors’ concerns grow that the EU is going to try to punish Poland for its recent court ruling that said EU law does not reign supreme in Poland.  Other movers have been less significant but are spread across all three geographies.

On the data front, this morning brings the weekly Initial (exp 297K) and Continuing (2548K) Claims numbers as well as Philly Fed (25.0), Leading Indicators (+0.4%) and Existing Home Sales (6.09M).  Of this group, I expect the Philly number will give the most information, but in truth, I believe traders and investors are more interested in hearing from Chris Waller again as well as NY Fed president Williams this morning to try to get any more information about the evolving Fed story.

Broadly speaking, I believe the US interest rate story continues to underpin the dollar and I see nothing to change that view.  The dollar has been trending higher since summer and while the last week has seen marginal dollar softness, I believe it is merely a good time to take advantage and buy dollars for receivables hedgers.

Good luck and stay safe
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A Fad that is Passing

Said central banks, stop your harassing
Inflation’s a fad that is passing
By next year we see
(Or by ‘Twenty-three)
More bonds you will all be amassing

But lately some central bank hawks
Explained that the recent price shocks
Could well last much longer
With wage growth much stronger
And that might not be good for stocks

As we walk in on this Columbus Day holiday, where US banks and the Federal Reserve are closed, although equity markets remain open, the most notable price movement has been in oil where WTI (+2.8%) has rallied to its highest price since October 2014 and now sits well above the $80/bbl level.  Fortunately, we’ve been constantly reassured that this is a temporary transitory phenomenon by numerous central bankers around the world, most frequently by Chairman Powell and ECB President Lagarde.  The claim continues to be that the only reason prices keep rising is as a result of constricted supply chains amid a massive recovery (due to their actions) from the Covid pandemic economy-wide shutdowns.  Soon enough, they also exhort, these supply chain snafus will have been corrected and then shortages of stuff will be a distant memory as we revert to the steady growth and low inflation economies we have all come to know and love.  It’s such a nice, neat story and I’m confident that they both tell themselves constantly that it is true.

Alas, reality has a nasty way of intruding upon a good storyline and recent energy price action is pretty clearly pointing to a different story than the one being peddled by Powell and Lagarde.  In fact, some of their own colleagues, as well as brethren from other key central banks like the BOE, are singing a different tune, one much more in line with reality.  For instance, last night, Klaas Knot, the Dutch Central bank president and ECB member warned investors not to underestimate inflation risks, “This risky behavior [excessive leverage] is only sustainable at low inflation and interest rates.  From the perspective of healthy risk management, it is also important to take other scenarios into consideration.”  I wonder what other scenarios he is considering.  Refreshingly, he followed that comment with this, “There is more in the inflation process we don’t understand than we do understand,” as humble a comment as one can ever expect from a central banker!

However, given Knot’s constant hawkish rhetoric, markets did not really react to his comments, as they were not terribly new.  Of more interest were comments from two separate BOE members, Governor Andrew Bailey and Michael Saunders, the most hawkish member of the MPC.  In both cases, they commented that the market was quite right to begin pricing in higher interest rates as inflation was becoming more problematic and could be “very damaging” if policymakers don’t act.  Traders did not need much prompting beyond this to reprice interest rate futures such that a first hike of 15 basis points (to 0.25%) is now expected by December, while by the end of 2022, the market is pricing a base rate of 0.75%, so two more hikes after that.  Given that UK CPI is forecast to hit 4.0% in Q4 this year, that still seems awfully far behind the curve, but then compared to the US, where inflation is already well above 4%, even on the PCE measure, and Fed Funds remained pegged at 0.00%-0.25%, that counts as tight policy.  When the comments were first published, the pound did jump as much as 0.45%, however, that has already largely faded and as I type, the pound is only 0.1% higher on the day.

Perhaps these are the first real signs that the central bank community is recognizing inflation may not be as transitory as their models (and political needs) had indicated was likely (and necessary) respectively.  Instead, its persistence is becoming more evident, even to them, and calls for tighter monetary policy to address inflation are likely to grow.  Of course, given the extraordinary levels of leverage in the global monetary system, higher rates are going to be very difficult to achieve without an ensuing dramatic decline in asset prices.  This is the corner into which the Fed (and the ECB) have painted themselves.  (As I’ve said before, if I were Chairman Powell, I would be happy to step down allowing my successor to deal with the mess that is surely coming.)  Even if the Fed does begin to taper QE purchases, they will remain behind the curve for a very long time, and those vaunted ‘tools’, which they keep describing as available, will likely not be used to full effect.  Not only is inflation going to continue to rise, but central banks are going to continue to remain behind the curve for a long time to come.  Be prepared.

Ok, with that in mind, let’s look at markets overnight.  Equities in Asia had a pretty good session, with the Nikkei (+1.6%) and the Hang Seng (+2.0%) both performing well, although Shanghai was unchanged on the day.  Europe (DAX -0.5%, CAC -0.4%), on the other hand, is a little less optimistic.  The outlier here is the UK (FTSE 100 +0.15%) where it seems investors are happy to hear of a central bank willing to address incipient inflation.  US futures are all pointing lower, however, led by the NASDAQ (-0.7%) but -0.4% losses elsewhere.

The Treasury bond market is closed in the US today, but in Europe, the trend is clear, higher yields across the board, which is exactly what we saw in Asia as well.  So, Bunds (+3.5bps), OATs (+3.0bps) and Gilts (+5.0bps) are all selling off sharply with similar movement seen across the continent.  Asia, too saw sharp declines in bond prices with Australia (+8.0bps) leading the way but even China (+6.0bps) falling sharply despite ordinary efforts to prevent volatility in that market.

In the commodity space, while oil is leading the way, pretty much everything except gold is higher with NatGas (+3.8%), copper (+1.4%) aluminum (+2.3%) and the agricultural products all firmer on the day.  Remember this, the longer food and energy prices continue to climb, the more likely those price rises bleed into “core” inflation and drive that higher as well.

Turning to the dollar, the biggest loser today is JPY (-0.6%) as the widening yield differential in favor of the dollar has reached a point where Japanese investors have started to move money more actively into USD investments on an unhedged basis.  At this point, there doesn’t seem to be much reason for JPY to rally, so a test of 115 seems to be far more likely in the near term.  After that, we shall see.  On the plus side, AUD (+0.5%) has been the biggest beneficiary of the commodity rally while surprisingly, neither NOK nor CAD, both unchanged on the day, have seen a boost from the much higher oil prices.

In the EMG bloc, INR (-0.5%) and PHP (-0.4%) are the laggards of note with RUB (+0.3%) the only notable gainer.  Oil is obviously supporting the ruble while the rupee and peso both suffer on the same story, as both India and the Philippines are major oil importers.

On the data front, nothing is released today due to the holiday, but we get some important things this week:

Tuesday NFIB Small Biz Optimism 99.5
JOLTS Job Openings 10.934M
Wednesday CPI 0.3% (5.3% Y/Y)
-ex food & energy 0.2% (4.1% Y/Y)
FOMC Minutes
Thursday Initial Claims 320K
Continuing Claims 2686K
PPI 0.6% (8.7% Y/Y)
-ex food & energy 0.5% (7.1% Y/Y)
Friday Empire Manufacturing 25.0
Retail Sales -0.2%
-ex autos 0.5%
Business Inventories 0.6%
Michigan Sentiment 73.5

Source: Bloomberg

Aside from critical CPI and Retail Sales data, we hear from ten different Fed speakers across more than a dozen events this week, including Governor Brainerd on Wednesday, someone we should be listening to very closely given the rising probability she is named the new Chair.

Right now, the dollar is consolidating its recent gains, but showing no signs of giving any of them back.  I expect that we will see another leg higher in the near future as there is no evidence that either inflation or US yields are going to decline soon.  And right now, I think those are the drivers.  At some point, inflation may become detrimental to the dollar, but for now, buy dollars on dips.

Good luck and stay safe
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