Real Savoir Faire

There once was an aging Fed Chair

With poise and some real savoir faire

He claimed the foundation

Of rising inflation

Were objects that, right now, were rare

But soon when supply chains are mended

And joblessness falls as intended

Inflation will sink

To levels we think

Are fine, and the world will be splendid

Remember when the FOMC Statement and following press conference were seen as hawkish?  That was sooo last week!  There was talk of rate hikes in only TWO YEARS!  There was talk about talk about tapering the purchase of assets as monetary policy started to ‘normalize’.  (Not for nothing but given we have had the same monetary policy for effectively the past 13 years, ZIRP and QE might be considered normal now, not positive real rates and a stable balance sheet.)  Well, apparently the market reaction was not seen as appropriate by Chairman Jay and his cadre of central bankers, so we have heard a definitive retreat on those concepts in the ensuing six days.  

Just since Monday, we have heard from six different FOMC members and every one of them has essentially said, “just kidding!”  Yesterday, Chairman Powell testified to a House Subcommittee on Covid and was forced to explain, yet again, that policy changes were still a long way down the road and that inflation remains transitory.  It was not, however, just Powell delivering that message.  It was also Cleveland’s Loretta Mester, SF’s Mary Daly and NY’s John Williams amongst others.  Current policy settings are appropriate, inflation is transitory and there is still a long way to go before that elusive substantial further progress toward the Fed’s dual mandates will have been achieved.

History has shown that the Fed’s effective reaction function, at least since Alan Greenspan was Chair, is defined by an equity market decline of a certain amount.  This is especially true if the decline happens quickly whereupon they will jump in and ease policy.  It appears that the amount of market angst necessary to get the Fed to change their tune regarding infinite liquidity and monetary support continues to shrink.  It used to take a decline on the order of 15%-20% to get the Fed nervous.  This time, the S&P 500 fell less than 2% before virtually the entire committee was on the tape walking back their tough talk.  And yet, they would have you believe that when inflation is roaring higher for the rest of the year, they have the intestinal fortitude to fight it effectively by raising interest rates or reducing QE.  As actions speak louder than words, my money is on the Fed being completely unable to address rising inflation.  Be prepared.

This topic continues to be the primary narrative in markets around the world, with many other countries now grappling with the transitory inflation story as well.  Nothing else really matters, and rightly so.  If inflation is building a head of steam and will be rising around the world, central banks are going to be forced to respond.  Some will respond more forcefully and more quickly than others, and it is those currencies which are likely to outperform going forward.  Investors today are generally unfamiliar with investing in an inflationary environment.  The 1970’s were the last time we really saw inflation of substance and even I was still in college (and I am almost certainly much older than you) when that was the situation, with many, if not most, of the current investment community not yet even born.

A quick look at the chart of the Dollar Index (DXY) from that time shows that from the autumn of 1971, right after President Nixon closed the gold window and ended Breton Woods, through the end of 1979, right after Paul Volcker was named Fed Chair and had just started his inflation fight, the dollar declined about 28% (roughly 4% per annum).  Of course, once Volcker got going and US interest rates were raised dramatically to kill off inflation, the dollar rose more than 75% in the following four years.

The point is that while we may disparage the Fed’s actions as being wrong-headed, their policies matter immensely.  Jay Powell may wind up with his reputation in tatters akin to Arthur Burns and G. William Miller, the Fed Chairs who oversaw the sharp rises in inflation in the 1970’s preceding Mr Volcker.  It seems unlikely this outcome is his goal, however, his insistence on toeing the political line rather than hewing to sound money policies bodes ill for the future.

Anyway, while US equity markets have essentially retraced all their post FOMC losses, the rest of the world has seen a more mixed outcome.  In Asia last night, the Nikkei (0.0%) was essentially flat although there were gains in the Hang Seng (+1.8%) and Shanghai (+0.25%).  Europe, on the other hand, is under some pressure this morning with both the DAX (-0.5%) and CAC (-0.4%) feeling some pain based on softer than expected, though still strong, Flash PMI data.  The UK, however, is seeing a much better performance (FTSE 100 +0.35%) as not only was the PMI data stronger than expected, but there apparently is a breakthrough on the lingering Brexit issues of treating goods in Northern Ireland.  Meanwhile, US futures are essentially unchanged this morning, perhaps waiting for some more encouragement from today’s roster of Fed speakers.

Bond markets, after a very choppy few days, have calmed down greatly with Treasuries (+1.2bps) softening a bit while European sovereigns (Bunds -1.4bps, OATs -1.4bps) are seeing some demand.  UK Gilts are little changed as the market there awaits tomorrow’s BOE meeting, where some believe there is a chance for a more hawkish tilt.

Commodity prices are definitely firmer this morning led by oil (+0.7%) but also seeing strength in precious metals (Au +0.25%, Ag +0.7%), base metals (Cu +0.7%, Fe +1.4%, Sn +0.2%) and agricultural products (Soybeans +0.5%, Wheat +1.2%, Corn +0.4%).  Clearly the commodity markets see inflation in the future.

Finally, the dollar is mixed this morning but, in truth, the relatively small movements indicate a lack of interest.  Commodity currencies like NOK (+0.1%), AUD (+0.2%) and NZD (+0.2%) are the leading G10 gainers while JPY (-0.35%) continues to come under pressure, arguably suffering from the fact that Japan imports virtually all its commodities.

In the EMG space, the picture is also mixed with HUF (+0.7%) the leading gainer after the central bank raised its benchmark rate to 0.9% yesterday a 0.3% increase that was expected.  But the idea that they are joining the several other EMG central banks in tightening mode (Brazil, Russia, Ukraine) has investors buying up the forint.  Away from that, ZAR (+0.4%) is clearly benefitting from higher commodity prices as are RUB (+0.2%) and MXN (+0.1%) although the latter two are quite modest.  On the downside, KRW (-0.5%) saw the sharpest declines as a combination of equity outflows as well as a sharp rise in Covid infections was seen quite negatively.  But in truth, most APAC currencies were under some pressure overnight, albeit not to the extent seen in Seoul.

Today’s data brings the Flash PMI (exp 61.5 Mfg, 70.0 Services) as well as New Home Sales (865K).  But more importantly, we have three more Fed speakers set to reiterate the message that policy is not going to change for a while yet, so no need for investors to panic in any market.  The dollar responded logically to the idea that the Fed was going to tighten policy, but now that they have gone out of their way to walk that idea back, I expect the dollar is more likely to drift lower for now.  Perhaps when it becomes clearer that the Fed is actually going to move, we could see some strength again.  But that is likely still a few weeks or months away.  Trade the range for now.

Good luck and stay safe


Somewhat Dismayed

The ECB’s somewhat dismayed
That risk appetite, as conveyed
By stocks is excessive
And has made a mess of
Their plans.  Now they’re really afraid

It is interesting that two of the most memorable battle cries in financial markets were coined by men of the driest character and background.  We all remember the beginning of the Eurozone debt crisis, not ten years ago, when the so-called doom loop created by banks in a given country owning excessive amounts of their own government’s debt and when that debt became suspect (Portugal, Italy, Greece, Spain) the banks in those nations went to the wall.  The ECB was forced to step in to save the day, and did so, but things did not calm down until Super Mario Draghi, then ECB President (and now Italian PM) uttered his famous, off-the-cuff, remark of the ECB doing “whatever it takes” to save the euro.

Less of us were involved in the markets in December 1996 when then Fed Chair Alan Greenspan uttered the other famous market expression, “irrational exuberance” while speaking about the inflating of the tech bubble (which inflated for another 3 ½ years) and questioning if prices at that time had run too far ahead of sensible valuations.

In hindsight, both of the problems about which these catch phrases were created were the result of policy failures on the part of governments (debt crisis) or the central bank itself (tech bubble), but in neither case was the speaker able to take an objective view, thus calling out forces beyond their control as the cause of the problem.

Since then, both phrases have become part of the financial lexicon as shorthand for a situation that exists and the willingness of central bankers to address a problem.  This leads us to this morning’s release by the ECB of their Financial Stability Review where a subsection was titled “Financial markets exhibited remarkable exuberance as US yields rose. (author’s emphasis)”  Arguably, the title pales in comparison to ‘irrational exuberance’, but more importantly, it highlights, once again, the inability of a central bank to recognize that the folly of their own policies is what is driving the problems in markets and economies.

Ostensibly they are concerned that a mere 10% decline in US equity markets could result in “…a significant tightening of euro-area financial conditions, similar to around a third of the tightening witnessed after the coronavirus shock in March 2020.”  Wow!  A 10% decline?  If one were looking for a prime example of a fragile economy, clearly the Eurozone is exhibit A.  Once again, what we see is a central bank that is unwilling, or unable, to recognize that the fallout from its own policies is the underlying problem while seeking an alternative scapegoat explanation in order to present themselves in the best possible light.  After all, if the US markets decline, its not the ECB’s fault!

Inadvertently, perhaps, but clearly, the ECB has outlined one truth; given the synchronicity of central bank policies around the world, all economies are more tightly linked together and will rise and fall together.  Although there are those who claim particular markets have better prospects than others, the reality has become that correlations between equity markets around the world are very high, with the only real question how equities correlate to bonds.  It is this last issue where we have seen significant changes lately.  For quite a long time, the correlation between the S&P 500 and the 10-year US Treasury was positive, meaning that both bond and stock prices rallied and fell together.  However, since about February 2021, that relationship has turned around and is now solidly negative, with bond prices rising and stock prices falling.  It is this latter relationship that is the classic risk-on / risk-off meme, something that had gone missing for years.  Apparently, it is coming back, and that terrifies the ECB.

The timing of the report’s release could not have been better as this morning is a very clear risk-off session.  Yesterday afternoon, US equity markets sold off pretty sharply in the last half-hour of the session.  That sell-off has persisted throughout Asia (Nikkei -1.3%, Shanghai -0.5%, Hong Kong was closed) and Europe (DAX -1.3%, CAC -1.1%, FTSE 100 -1.1%).  US futures are also in the red (Dow -0.6%, SPX -0.8%, Nasdaq -1.2%), so the concerns are global in nature.

A bit more interestingly is the bond market’s behavior, where it appears that owning sovereign paper from any nation is unpopular today.  Treasury yields have backed up 2 basis points and we are seeing higher yields throughout Europe as well (Bunds +1.3bps, OATs +0.5bps, Gilts +2.1bps).  Apparently, the bond market concerns stem from the UK’s inflation report which showed that while CPI rose, as expected to 1.5%, RPI (Retail Price Index) rose much more than expected to 2.9% Y/Y.  While both are designed to be measures of average price increases over time, the RPI considers housing prices and mortgages.  Not surprisingly, given the explosion in housing prices, RPI is much higher and rising faster.  It also may represent a more accurate representation of people’s cost of living.  (Here’s a thought experiment: what would US RPI be right now given CPI just jumped to 4.2%?)  At any rate, it appears investors are shunning both stocks and bonds this morning.

Are they buying commodities?  Not on your life!  Prices in this sector are down across the board led by WTI (-1.8%) but seeing Gold (-0.6%) and Silver (-2.0%) suffering along with base metals (Cu -2.4%, Al -0.9%, Zn -0.85%) and foodstuffs (Soy -0.8%, Wheat -1.7%, Corn -0.3%).  Oh yeah, bitcoin, which many believe is a hedge of some sort, is lower by 16% in the past 24 hours and more than one-third in the past week.

So, what are investors buying?  Pretty much the only thing higher today is the dollar which has rallied vs. every currency we track.  In the G10, NZD (-0.9%) is the laggard followed by NOK (-0.8%) and AUD (-0.7%) with the strong theme there being weakness in the commodity sector.  But the European currencies are all under pressure as well, with EUR (-0.2%) and GBP (-0.3%) suffering.  Even JPY (-0.4%) is not holding up its end of the risk-off bargain, declining vs. a robust dollar.

Emerging markets are seeing similar activity with every currency flat to down led by TRY (-0.6%), ZAR (-0.45%) and MXN (-0.4%), all suffering from commodity weakness.  CE4 currencies are also under pressure, following the euro down while APAC currencies had less angst overnight, sliding on the order of 0.2%.

On the data front, today only brings the FOMC Minutes from the April meeting, which will be scrutinized to see how much discussion on tapering took place, if any, but let’s face it, other than Robert Kaplan of Dallas, it seems pretty clear from everybody else that has spoken, that it is not a current topic of conversation.  As it happens, we will hear from 3 more Fed speakers (Bullard, Quarles and Bostsic) as well, but all of them have been on message since the meeting so don’t look for any changes.

Certainly, based on today’s price action, the idea that 10-year yields are driving the dollar remains alive and well.  If yields continue to back up, the dollar will remain bid, and after all, given its recent decline, it has room to move as a simple correction.  I continue to look at 1.2350 as the critical level in the euro, and by extension the dollar writ large.  A break above there opens the chance for a much more substantial dollar decline.  But that does not appear to be on the cards for today.

Good luck and stay safe

Money’s Still Free

There once was a time, long ago
When traders all just had to know
If payrolls were strong
So they could go long
If not, they would sell with the flow

But these days, with ZIRP and QE
Attention’s not on NFP
Instead it’s the pace
Of central bank grace
And making sure money’s still free

One of the biggest changes in the market environment since the onset of the global pandemic has been the change in what markets find important.  This is not the first time market focus has changed, nor will it be the last, but a change has definitely occurred.  Consider, for a moment, why the market focuses so intently on certain data points.  Essentially, traders and investors are looking for the information that best describes the policy focus of the time, and therefore, changes in that information are sufficient to change opinions, at least in the short term, about markets.  And remember, that policy focus can come from one of two places, either the Fed or the Administration.

A step back in time shows that in the early 1980’s, when Paul Volcker was Fed Chair, the number that mattered the most was the M2 money supply which was reported on Thursday afternoons.  In fact, the market impact grew so large that they had to change the release time from 3:50 pm to 4:10 pm, after the stock market closed, to reduce market volatility. Trading desks would have betting pools on the number and there were a group of economists, Fed watchers, whose entire job was to observe Fed monetary activity in the markets and make estimates of this number.  At the time, the Fed would not explicitly publish their target Fed Funds rate, they would add and remove liquidity from the money markets in order to achieve it.  And, in fact, you never heard comments from FOMC members which is why Fed Chairs are now compelled to testify to Congress twice a year.

But as time passed and the economy recovered from the recession of 1980-81, the Reagan Administration became highly focused on the US Trade Balance, (especially the deficit with Japan) which became THE number right up through the early 90’s.  Once again, betting pools were common on trading desks and futures markets would move sharply in the wake of the 8:30am release.

At some point there, while Alan Greenspan was still Fed Chair, but there was a new administration, the market turned its attention away from trade and started to focus on domestic indicators, with payrolls claiming the mantle of the best indicator of economic activity.  This suited the Fed, given its mandate included employment, and it suited the Clinton Administration, given they were keen to show how well the economy was doing in order to distract the populace from various scandals.

With the change in Fed Chair from Greenspan to Ben Bernanke, the Fed suddenly became a very different source of market information.  No longer did economists need to read tea leaves, but instead the Fed told us explicitly what they were doing and where rates were set.  Thus, during the GFC, Bernanke was on the tape constantly trying to guide markets to his preferred place.  And that place was full employment, so payrolls still mattered a great deal.  Of course, the market still cared about other things, like the level of interest rates, but still, NFP was seen as the single best indicator available.  Remember, during Bernanke’s leadership, the Fed initiated the QE that began the expansion of its balance sheet and changed the way the Fed worked, seemingly forever.  No longer would the Fed adjust the reserve balances in the system, instead, they would simply post an interest rate and if supply or demand didn’t suffice to achieve that rate, they would step into the markets and smooth things out.

Payrolls were still the focus through Chair Yellen’s term, especially since her background is as a labor economist, so the employment half of the mandate was far more important to her than the inflation half, and so, if anything, NFP took on greater importance.

Jay Powell’s turn at the Fed started amid a period where the economy was getting significant fiscal support and interest rates were trying to be normalized.  In fact, the Unemployment Rate had fallen to its lowest level in more than 50 years and seemed quite stable there, so Powell seemed to have an easy job, just don’t screw things up.  Alas, his efforts to continue normalizing interest rates (aka tightening policy) resulted in a sharp equity market correction in December 2018.  The President was none too pleased with that outcome, as the Trump administration was highly focused on the stock market as a barometer of its performance.  Thus, once again, the Fed stepped in to stabilize markets, and turned from tightening policy to easing in the Powell Pivot.  And perhaps that is the real message here, the most important data point to both the Fed and every administration is not payrolls or unemployment or inflation.  It is the S&P500.

But Covid’s shock to the market was unlike anything seen in a century, at least, and arguably, given the interconnectivity of the global economy compared to the last pandemic in 1918-20, ever.  So, the first NFP data points were shocking, but the market quickly grew accustomed to numbers that would have been unthinkable just months prior.  Instead, the numbers that mattered were the infection count, and the mortality rate.  And arguably, those are still the numbers that matter, along with the vaccination rate and the stimulus size.  All of these have been the market’s primary focus since March last year, and until the idea of the government lockdown fades, are likely to continue to be the keys for market behavior.

Which brings us back to this morning, when the payroll report is to be published.  Does it really have that much impact any longer?  Or has its usefulness as an indicator faded?  Well, it seems apparent that market participants are far more intent on hearing from Fed speakers and trying to discern when monetary accommodation is going to be reduced (never) than on the jobs number.  In fact, given virtually every major central bank has explained that rates will remain at current levels for the next 3 to 4 years, at least, the only thing the data can tell us is if that will last longer than currently expected.

Ok, ahead of payrolls we have seen a general embrasure of risk, with equity markets strong, following yesterday’s US rally.  The Nikkei (+1.5%) and Hang Seng (+0.6%) both performed well although shanghai (-0.2%) slipped slightly.  In Europe, the CAC (+1.1%) leads the way followed by the DAX (+0.3%) after weak Factory order numbers (-1.9%) and the FTSE 100 (+0.1%).  US futures are currently trading higher by about 0.5% to round things out.

Bond markets are behaving as you would expect in a risk on session, with 10-year Treasuries printing at a new high yield for the move, 1.16%, up 2.1bps.  In Europe, the bond selling is greater with Bunds (+2.5bps) and Gilts (+5.3bps) getting tossed in favor of stocks.  Commodities are still in vogue, with oil (+1.0%) and gold (+0.4%) firm alongside all the base metals and agriculturals.

Finally, the dollar, is acting a bit more like expected, softening a bit while risk is being acquired.  The dollar’s recent rally alongside the equity rally seemed unusual compared to recent history, but today, things look more normal.  S,o NOK (+0.4%) and CAD (+0.3%) lead the G10 charge while JPY (-0.15%) is today’s laggard.  Clearly these stories are commodities and risk preference.  In the EMG space, APAC currencies were under a bit of pressure overnight, led by KRW (-0.4%) and MYR (-0.25%), but this morning we are seeing strength in TRY (+1.0%), RUB (+0.8%) and MXN (+0.4%) to lead the way.  The CE4 are also performing relatively well alongside modest strength in the euro (+0.2%).

Now the data:

Nonfarm Payrolls 105K
Private Payrolls 163K
Manufacturing Payrolls 30K
Unemployment Rate 6.7%
Average Hourly Earnings 0.3% (5.0% Y/Y)
Average Weekly Hours 34.7
Participation Rate 61.5%
Trade Balance -$65.7B

Source: Bloomberg

Which brings us back to the question, does it really matter?  And the answer is, not to the stock market, and therefore not really to the Fed.  However, a strong number here could well hit the bond market pretty hard as well as support the dollar more fully.  We shall see.  FWIW, I don’t believe the dollar’s correction is over, and another 1%-2% is entirely viable in the short-run.

Good luck, good weekend and stay safe