Tag Archives: #inflation

Outmoded

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In Germany prices exploded
While confidence there has eroded
Now all eyes will turn
Back home where we’ll learn
On Tuesday if QE’s outmoded

The most disturbing aspect of the inflation argument (you know, is it transitory or not) is the fact that those in the transitory camp are willing to completely ignore the damage inflation does to household budgets.  Their attitude was recently articulated by the chief European economist at TS Lombard, Dario Perkins, thusly, “There is nothing inherently dangerous about inflation settling in, say, a 3-5% range instead of the 1-2% that’s been normal for the past decade.”  He continued, “the bigger risk is that hitherto dovish central bankers lose their nerve and raise interest rates until it causes a recession, like they’ve done in the past.”

Let’s consider that for a moment.  The simple math shows that at a 2% inflation rate, the price of something rises about 22% over the course of a decade.  So, that Toyota Camry that cost $25,000 in 2011 would cost $30,475 today.  However, at a 5% inflation rate over that time, it would cost $40,725, a 63% increase.  That’s a pretty big difference.  Add in the fact that wage gains have certainly not been averaging 5% per year and it is easy to see how inflation can be extremely damaging to anybody, let alone to the average wage earner.  The point is, while to an economist, inflation appears to be an abstract concept that is simply a number input into their models, to the rest of us, it is the cost of living.  And there is nothing that indicates the cost of living will stop rising sharply anytime soon.

This was reinforced overnight when Germany released its wholesale price index, which rose 12.3% in the past twelve months.  That is the highest rate of increase since 1974 in the wake of the OPEC oil embargo.  Now fortunately, the ECB is on the case.  Isabel Schnabel, the ECB’s head of markets explained, “The prospect of persistently excessive inflation, as feared by some, remains highly unlikely.  But should inflation sustainably reach our target of 2% unexpectedly soon, we will act equally quickly and resolutely.”  You know, they have tools!

On the subject of Wholesale, or Producer, Prices, while Germany’s were the highest print we’ve seen from a major economy, recall last week that Chinese PPI printed at 9.5%, in the US it was 8.3% and even in Japan, a nation that has not seen inflation in two decades, PPI rose 5.6% last month.  It appears that the cost of making “stuff” is rising pretty rapidly.  And even if the pace of these increases does slow down, the probability of prices declining is essentially nil.  Remember, the current central bank mantra is deflation is the worst possible outcome and they will do all they can to prevent it.  All I can say is, I sure hope everyone’s wages can keep pace with inflation, because otherwise, we are all at a permanent disadvantage compared to where things had been just a year or two ago.

Well, I guess there is one beneficiary of higher inflation…governments issuing debt.  As long as inflation grows faster than the size of their debt, a government’s real obligations decline.  And you wonder why the Fed insists inflation is transitory.  Oh yeah, for all of you who think that higher inflation will lead to higher interest rates, I wouldn’t count on that outcome either.  Whether or not the Fed actually tapers, they have exactly zero incentive to raise rates anytime soon.  And as to bonds, they have shown before (post WWII) that they are willing to cap yields at a rate well below inflation if it suits their needs.  And I assure you, it suits their needs right now.

So, what will all this do to the currency markets?  As always, FX is a relative game so what matters is the degree of change from one currency to the next.  The medium-term bearish case for the dollar is that inflation in the US will run hotter than in Europe, Japan or elsewhere, while the Fed caps yields in some manner.  The resultant expansion of negative real yields will have a significant negative impact on the dollar.  This argument will fail if one of two things occurs; either other central banks shoot for even greater negative yields, or, more likely, the Fed allows the back end of the curve to rise thus moderating the impact of negative real yields.  In either case, the dollar should benefit.  In fact, this is why the taper discussion is of such importance to the FX market, tapering implies higher yields in the back end of the US yield curve and therefore an opportunity for a stronger dollar.  Remember, though, there are many moving pieces, so even if the Fed does taper, that is not necessarily going to support the dollar all that much.

Ok, let’s look at this morning’s markets, where risk is largely being acquired, although there is no obvious reason why that is the case.  Equity markets in Asia were mixed with both gainers (Nikkei +0.2%, Shanghai +0.3%) and Losers (Hang Seng (-1.5%) as the ongoing Chinese crackdown on internet companies received new news.  It seems that the Chinese government is going to split up Ant Financial such that its lending business is a separate company under stricter government control.  Ali Baba, which is listed in HK, not Shanghai, fell sharply, as did other tech companies in China, hence the dichotomy between the Hang Seng and Shanghai indices.  But excluding Chinese tech, stocks were in demand.  The same is true in Europe where the screen is entirely green (DAX +1.1%, CAC +0.8%, FTSE 100 +0.8%) as it seems there is little concern about a passthrough of inflation, but great hope that reopening economies will perform well.  US futures are also looking robust this morning, with all three major indices higher by at least 0.5% as I type.

Funnily enough, despite the risk appetite in equities, bond prices are rallying as well, with 10-year Treasury yields lower by 1.7bps, and European sovereigns also seeing modest yield declines of between 0.5 and 1.0 bps. Apparently, as concerns grow over the possibility of a technical US default due to a debt ceiling issue, the safety trade is to buy Treasuries.  At least that is the explanation being offered today.

On the commodity front, oil (WTI +0.8%) is leading the way higher although we are seeing gains in many of the industrial metals as well, notably aluminum (+1.6%), which seems to be feeling some supply shortages.  Copper (-0.45%), surprisingly, is softer on the day, but the rest of that space is firmer.  I mentioned Uranium last week, and as an FYI, it is higher by 5% this morning as more and more people begin to understand the combination of a structural shortage of the metal and the increasing likelihood that any carbonless future will require nuclear power to be far more prevalent.

Finally, the dollar is broadly, although not universally, stronger this morning.  In the G10, only NOK (+0.2%) and CAD (+0.1%) have managed to hold their own this morning on the strength of oil’s rally.  Meanwhile, CHF (-0.7%) is under the most pressure as havens lose their luster, although the rest of the bloc has only seen declines of between -0.1% and -0.3%.  In the EMG bloc, THB (-0.75%) and KRW (-0.6%) lead the way lower as both nations saw equity market outflows on weakness in Asian tech stocks.  But generally, almost all currencies here are softer by between -0.2% and -0.4%.  the exceptions are TRY (+0.3%) and RUB (+0.25%) with the latter supported by oil while the former is benefitting from hope that the central bank will maintain tight policy to fight inflation.

On the data front, we have both CPI and Retail Sales leading a busy week:

Today Monthly Budget Statement -$175B
Tuesday NFIB Small Biz Optimism 99.0
CPI 0.4% (5.3% Y/Y)
-ex food & energy 0.3% (4.2% Y/Y)
Wednesday Empire Manufacturing 18.0
IP 0.4%
Capacity Utilization 76.4%
Thursday Initial Claims 320K
Continuing Claims 2740K
Retail Sales -0.8%
-ex auto -0.1%
Philly Fed 19.0
Friday Michigan Sentiment 72.0

Source: Bloomberg

With no recent stimulus checks, Retail Sales are forecast to suffer greatly.  Meanwhile, the CPI readings are forecast to be a tick lower than last month, but still above 5.0% for the third consecutive month.  Certainly, my personal experience is that prices continue to rise quite rapidly, and I would not be surprised to see a higher print.  Mercifully, the Fed is in its quiet period ahead of next week’s FOMC meeting, so we no longer need to hear about when anybody thinks tapering should occur.  The next information will be the real deal from Chairman Powell.

The tapering argument seems to be the driver right now, with a growing belief the Fed will reduce its QE purchases and US rates will rise, at least in the back end.  That seems to be the genesis of the dollar’s support.  As long as that attitude exists, the dollar should do well.  But if the data this week points to further slowing in the US economy, I would expect the taper story to fade along with the dollar.

Good luck and stay safe
Adf

They Cannot Wait

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While Jay and the FOMC
Are certain it’s transitory
Inflation elsewhere
Has forced some to pare
Their policy stance by degree

Thus none of us ought be amazed
That yesterday Banxico raised
Its overnight rate
As they cannot wait
Til prices (and people) get crazed

Last week the central bank of Brazil raised its overnight rate by 1.0%, taking it back to 5.25%, and promised to continue raising rates until they get inflation back under control.  This seems pretty reasonable since the latest inflation reading there was 8.99%.  Currently, the market is pricing in a 1.25% rate hike next month.  Yesterday afternoon, Mexico’s central bank raised the overnight rate by 25 basis points for the second consecutive meeting, taking it up to 4.50%.  Given that the latest reading on inflation there is 5.81%, it seems they, too, have further to raise rates in order to tame rising prices.

In fact, this is a scenario we are witnessing around the world in emerging markets, where inflation has been rising quite rapidly and the monetary authorities, recognizing that they don’t have infinite capacity to borrow in either their local currency or in dollars, find themselves in a very uncomfortable position.  Either attack inflation now by raising rates and earning the wrath of their government, or let it rip and watch the country descend into more dire straits, akin to Argentina, Turkey, or worst of all, Venezuela.

But that the Fed would respond to inflation in the same manner.  Instead, we continue to get high inflation readings (yesterday’s PPI jumped to 7.8%, 6.2% ex food & energy) and a steady stream of pablum about the transitory nature of inflation in the US.  While only time will actually tell if higher inflation is truly here to stay, there certainly seems to be a lot of evidence that is the case.  One cannot open a newspaper (or perhaps scroll a newsfeed) without immediately seeing a story about how fast food restaurants, or food manufacturers or…fill in the blank, are raising prices because of a combination of higher input and shipping costs.  Perhaps, what is more surprising is that these companies have gained confidence that higher prices will not scare off their customers, meaning these price rises will stick.

On the wage front, this morning’s story of how newly minted college graduates taking (getting?) a job at Evercore Securities will now be paid a starting salary of $120,000 per year seems a pretty good indication that wages are rising.  Given the JOLTS data showing there are over 10 million open positions in the country, it is not surprising that ‘finding qualified people to hire’ remains the top problem of small businesses according to the NFIB survey.  The implication is wages are going to continue to rise and prices alongside them.

Speaking of shipping costs, we continue to see record rises in shipping rates as well as huge delays in timing.  China closed one-quarter of its Ningbo port, the third largest in China, because of concerns over the spread of the delta variant of Covid.  While US ports have not yet closed because of this, the backlog of ships waiting to unload continues to run near record high levels, and now delays from China will result in even bigger logistical and supply chain problems.  All in all, it remains difficult for this author to see a future, at least a near future, where prices do anything but go much higher.

Into that environment we continue to see the key Fed leadership remain sanguine over the prospects of inflation, maintaining the narrative that any price rises are transitory.  Apparently, this has come to mean prices will stop going up so rapidly but are unlikely to come back down.  While there is a growing chorus of FOMC members, mostly regional presidents, that believe it is coming time to taper QE purchases, until we hear that from Powell or Williams or Brainerd, I think it remains a 50:50 proposition at best.    But even if they do start to taper, given their history of responding to asset valuations, any stock market decline, which would seem likely given the current valuations are entirely built on the ‘lower forever’ interest rate scenario, would almost certainly see them stop quickly.  Painting a picture where real yields do anything but fall deeper into negative territory continues to be a difficult thing.  And that, ultimately, is going to be a negative for the dollar.

But when is ultimately?  It is still a little ways off.  Until then, it appears that the market is set up for the dollar to strengthen somewhat further.  The dollar’s relationship with 10-year yields, which had been strong in Q1 and broke in Q2, seems to be back on track.  All the taper talk has bond traders looking for a further backup in yields, and correspondingly, a further rise in the dollar.  While today it is drifting lower vs. most of its counterparts, this can easily be explained by the fact that it is a summer Friday and traders are paring positions going into the weekend.  But the medium-term view needs to be that higher US yields will support the dollar.

As to the rest of the markets, Asian equity markets continue to struggle as the spread of the delta variant accelerates and more countries in the region consider more drastic responses.  Last night saw losses in all the major markets (Nikkei -0.15%, Hang Seng -0.5%, Shanghai -0.25%) and as long as these nations have difficulty managing the resurgence of infections, investors seem to believe that the growth story will be negatively impacted.  Europe, on the other hand, is all green this morning (DAX +0.4%, CAC +0.35%, FTSE 100 +0.35%) as there is a greater belief that Covid issues are under better control.  Vaccination rates have risen quite rapidly and so while infection rates may be rising, hospitalizations are not, just like in the US.  Many analysts continue to believe European equity markets, writ large, are undervalued vs. their US counterparts, and while there is tapering talk here, there is absolutely no indication whatsoever that the ECB is going to do anything but continue to print money.

Treasury yields have drifted lower by 1.3bps this morning, which helps explain the dollar’s modest decline, but they remain right at 1.35% and show no signs of retracing last week’s sharp move higher.  European sovereigns, on the other hand, are a bit softer this morning, classic risk-on behavior, with Bunds (+0.9bps) and OATs (+1.4bps) slipping into the weekend.  Gilts are essentially unchanged, as it happens.

The commodity market is showing no clear directional bias of late, with both oil (-0.35%) and gold (+0.4%) having retraced a portion of major price declines over the past two weeks, but neither showing signs of either a break higher or the next leg down.  Rather, they are both a bit choppy right now.

Finally, the dollar is mostly softer against its G10 counterparts, with NOK (+0.3%) the leader and the euro pushing up 0.25%.  Frankly, both of these appear to be trading moves, as both had shown weakness all week, so positions are likely being pared into the weekend.

In the emerging market space, KRW (-0.65%) continues to be the bloc’s biggest laggard, falling for the fifth consecutive day as the combination of the record level of Covid infections, and concerns over the semiconductor space in the KOSPI have seen sellers come out of the woodwork for both stocks and the currency.  Away from the won, weakness was evident throughout the APAC currencies, albeit to a much lesser extent, as the Covid spread story is regionwide.  On the plus side, both CE4 and LATAM currencies are performing well, with MXN (+0.4%) the leader on the back of Banxico’s rate hike, and RUB (+0.4%) seeing position unwinding after a particularly weak trading period this week.

Data this morning brings Michigan Sentiment (exp 81.2) as well as some further secondary price indices, Import and Export prices, which have been running well above 10% each.  The point is there is inflationary pressure everywhere.

It is not surprising that after a week where the dollar was broadly stronger, it softens on Friday, but nothing has changed the short-term view that modestly higher US yields will lead to further dollar strength.  Keep an eye on the 1.1704 level in EURUSD, which I believe can be a catalyst for a much larger move higher in the dollar if it breaks.

Good luck, good weekend and stay safe
Adf

Nowhere Near

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Charles Evans, on Tuesday, explained
Inflation can well be contained
In fact, his concern
Is prices could turn
Back lower ere targets are gained

“I’m going to be very regretful if we sort of claim victory on averaging 2% and then we find ourselves in 2023 with about a 1.8% inflation rate, sustainable, going forward. That would be a challenge for our long-run framework,” he [Evans] said. “We ought to be willing to average inflation above 2%—frankly, well above 2%. [author’s emphasis]”

One cannot overstate the hubris associated with the above quote from Chicago Fed President Charles Evans.  The fact that he legitimately believes the Fed’s powers are such that they can fine-tune a $24 trillion economy to the point that measured estimates of particular features of that economy are able to be managed to a decimal place of an annualized percentage outcome is extraordinary.  It is the perfect illustration of the fact that the Fed is completely out of touch with the economy in which you and I live and completely ensconced in a model driven framework where data represents reality.  But it is exactly this hubris that has resulted in the policy decisions that have brought the world negative interest rates and a defense of debt monetization.  As long as central bankers, notably the Fed, continue to believe that their models are the economy, rather than a simplified representation of the economy, they are likely to continue to make decisions with significant unintended consequences from which we all will suffer.

This morning the market awaits
The latest inflation updates
What’s patently clear
Is they’re nowhere near
An outcome to end the debates

Speaking of inflation, this morning brings the latest CPI data with expectations running as follows: Headline (0.5%, 5.3% Y/Y) and ex food & energy (0.4%, 4.3% Y/Y).  Both of those forecasts are slightly lower than the prints seen in July, and if realized, you can be sure that we will hear a chorus of FOMC members highlighting the transitory nature of inflation.  Of course, if the outcomes are higher than forecast, something we have seen in each of the past twelve reports, we will also hear a chorus of FOMC members explaining that this remains a temporary phenomenon and that inflation is transitory.  [Perhaps when Ralph Waldo Emerson wrote in 1841, “a foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines,” he was anticipating the Fed.]  However, financial markets may not be quite as sanguine over the results, especially if they continue their year-long streak of outperforming the median estimate.

Markets, of late, have been starting to discern between those products that will benefit from altered policy and those products that will suffer.  Nowhere is this clearer than in the US equity markets where we have seen the NASDAQ underperform its brethren indices.  Recall, given the NASDAQ’s strong bias toward high growth (and low profit) companies that benefit greatly from extremely low interest rates, the index behaves very much like a very long-duration bond.  So, in a scenario where inflation is rising and market expectations are for tapering of asset purchases to begin soon(ish), it should be no surprise that the NASDAQ falls alongside the price of bonds.  At the same time, if the implication is that rising inflation is being caused by rebounding growth, rather than supply-chain blockages, there is an opportunity for more mundane, value-type companies to outperform.  Hence, the differing performance of the DOW vs. the NASDAQ.
Of course, the place where inflation is likely to have the most direct effect is the bond market, where long-term yields are theoretically supposed to reflect inflation expectations.  And while we have certainly seen yields rise over the past week, there is no way they currently reflect those expectations.  They cannot do so as long the Fed continues to buy all the new issuance, and then some, thus artificially driving up prices and driving down yields.  Ask yourself this, does it make sense that US 10-year yields are at 1.36% if inflation is at 5.4%?  Of course, the answer to that is a resounding ‘No!’  Yet, that is the current situation.  To observe the bond market and believe it is not artificially inflated (everywhere in the world, mind you) is akin to believing that the moon is made of green cheese.  It just ain’t so!

At any rate, ahead of this morning’s CPI release, investors have generally been biding their time as they wait to determine if they need to adjust their world view.  Equity markets are generally a bit firmer as Asia mostly eked out some gains (Nikkei +0.6%, Hang Seng +0.2%, Shanghai 0.0%) with Europe following suit (DAX 0.0%, CAC +0.3%, FTSE 100 +0.5%).  US futures are split with the NASDAQ (-0.2%) slipping following yesterday’s losses, while the other two main indices are essentially unchanged.  All in all, it appears that there is some hope that CPI prints on the low side to allow the Fed narrative to continue apace, and therefore to allow rates to remain lower for longer.

Bond markets, though, are starting to get a bit antsy these days with Treasury yields edging higher again (+1.7bps) with similar type gains seen throughout Europe (Gilts +1.4bps, OATs +1.8bps, Bunds +0.8bps).  At this point, 10-year Treasury yields have risen 0.25% in the space of a week, which is a very substantial move, especially when considering that the base at the beginning was just 1.12%.  One has to believe the Fed is watching extremely closely as they do not want to see the market run too far ahead of their mooted tapering and create Taper tantrum #2 inadvertently.  It is here where a higher than forecast CPI print could have quite an impact and which may force the Fed to reconsider the idea of tapering.  After all, they cannot afford for 10-year yields to rise to 2.0% while they are still purchasing $120 billion per month of paper.

Commodity prices are mixed today with oil (-1.1%) feeling the pressure of higher yields while gold (+0.5%) seems to be ignoring that same pressure.  Of course, gold was just subject to a significant sell-off, so this could easily be a simple trading bounce.  As it happens, both agricultural and base metal prices are showing a mixture of gainers and losers and no real underlying theme.

Finally, the dollar is definitely stronger again this morning.  While the movement vs. its G10 brethren has not been large, it is unanimous, with all currencies in the red today.  A particular shout-out goes to the euro, which is trading just pips from the key support level of 1.1704.  Watch that carefully as a break there is likely to open up much lower levels.  In the emerging markets, KRW (-0.6%) has been the laggard, followed by TRY (-0.5%) and HUF (-0.4%).  The won has been suffering from a combination of rising covid cases, with a record high 2200 reported yesterday, which has been encouraging the liquidation by foreign investors of Korean equities.  Meanwhile, TRY is under pressure as traders are concerned the President Erdogan will once again interfere in the central bank’s business and prevent them from raising rates at tomorrow’s meeting.  Finally, the forint seems to be suffering for the sins of its neighbors as concerns over German growth, a key market, and Polish politics, a close neighbor, have encouraged selling.

And that’s really it for today.  All eyes will be on the CPI at 8:30. More than just watching the tape, I always pay attention to @inflation_guy on Twitter as he does an excellent job breaking down the drivers of the number and offering insight into how things may evolve.  I highly recommend following him.

As to the dollar, the slow grind higher continues and as long as US rates are rising, I think so will the dollar.  If we break the 1.1704 level in the euro, look for a bit of an acceleration.  But don’t be surprised if we reject the move given it is the first test of the support level since it was established back in March.

Good luck and stay safe
Adf

Resolute

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The narrative is resolute
That though prices did overshoot
They’re certain to fall
And that, above all,
The Fed’s in control, absolute

However, concern is now growing
That growth round the world’s started slowing
Though Friday’s report
On jobs was the sort
To help the bull market keep going

Clearly, my concerns over a weak payroll report were misplaced as Friday’s data was strong on every front, although perhaps too strong on some.  Nonfarm payrolls grew a robust 943K with net revisions higher of 119K for the past two months.  The Unemployment Rate crashed to 5.4%, down one-half percent, and Average Hourly Earnings rose 4.0% Y/Y.  It is the last of these that may generate some concern, at least from the perspective of the transitory inflation story.

While it is unambiguously good news for the working population that their wages are rising, something that has been absent for the past two decades, as with Newton’s first law (every action has an equal and opposite reaction) the direct result of rising wages tends to be rising prices.  So, while getting paid more is good, if the things one buys cost more, the net impact may not be as positive.  And in fact, consider that while the 4.0% annual rise is the highest (excluding the distortions immediately following the  Covid-19 lockdowns) in the series since at least the turn of the century, when compared to the most recent CPI data (you remember, 5.4%) we find that the average employee continues to fall behind on a real basis.

When discussing inflation, notice that the Fed harps on things like used car prices or hotel prices as the key drivers of the recent rise in the data.  They also tend to explain that commodity prices play a role, and that is something they cannot control.  But when was the last time Chairman Powell talked about rapidly rising wages or housing prices as an underlying cause of inflation?  In fact, when asked about whether the Fed should begin tapering mortgage-backed securities purchases sooner because of rapidly rising house prices, he claimed the Fed’s purchases have no impact on house prices, but rather it was things like the temporary jump in lumber prices that were the problem.  Oh yeah, and see, lumber prices have fallen back down so there is nothing to worry about.

Of course, wages are not part of CPI directly.  Rising wages are reflected in the rising prices of everything as companies both large and small find it necessary to raise prices to maintain their profitability.  Certainly, there are some companies that have more pricing power than others and so are quicker to raise prices, but in the end, rising wages result in one of two things, higher prices or lower margins, and oftentimes both.  In the broad scheme of things, neither of these outcomes is particularly positive for generating real economic growth, which is arguably the goal of all monetary policies.

Consider, to the extent rising wages force companies to raise the price of their product or service, the result is an upward bias in inflation that is independent of the price of oil or lumber or copper.  In fact, one of the key features of the past 40 years of disinflation has been the fact that labor’s share of the economic pie has fallen substantially compared to that of capital.  This has been the result of the globalization of the workforce as the addition of more than 1 billion new workers from developing nations was sufficient to keep downward pressure on wages.

Arguably, this has also been one of the key reasons corporate profit margins have risen and stock prices along with them.  Now consider what would happen if that very long-term trend was in the process of reversing.  There is a likelihood of rising prices of goods and services, otherwise known as inflation.  There is also a likelihood of a revaluation of equity prices if margins start to decline. And nothing helps margins decline like rising labor costs.

Consider, also, this is the sticky type of inflation, exactly the opposite of all the transitory claims.  This is the widely (and rightly) feared wage-price spiral.  I am not saying this is the current situation, at least not yet, but that things are falling into place that could easily result in this outcome.

Now put yourself in Chairman Powell’s shoes.  Prices have begun rising more rapidly as companies respond to rising wage pressures.  The employment situation has been improving more rapidly so there is less concern over the attainment of that part of your mandate.  But…the amount of leverage in the system is astronomical with government debt running at record high levels (Federal government at 127%) and all debt, including household and corporate at 400% of GDP.  Do you believe that the economy can withstand higher interest rates of any substance?  After all, in order to tackle inflation, real rates need to be positive.  What do you think would happen if the Fed raised rates to 6%?  And this is my point as to why the Fed has painted themselves into the proverbial corner.  They cannot possibly respond to inflation with their “tools” because the negative ramifications would be far too large to withstand.  It is also why I don’t’ believe the Fed will make any substantive policy changes despite all the tapering talk.  They simply can’t afford to.

Ok, on to the markets.  One of the notable things overnight was the flash crash in the price of gold, which tumbled $73 as the session began on a huge sell order in the futures market, although has since regained $54 and is currently down 1.1% from Friday’s close.  The other things was the release of Chinese CPI (1.0%) and PPI (9.0%), both of which printed a few ticks higher than expected.  Obviously, there is not nearly as much pass-through domestically from producer to consumer prices in China, but that tends to be a result of the fact that consumption is a much smaller share of the Chinese economy.  However, higher prices on the production side, despite the government’s efforts to stop commodity speculation and hoarding, does not bode well for the transitory story.  And while discussing EMG inflation readings, early this morning we saw Brazil (1.45% M/M) and Mexico (5.86% Y/Y) both print higher than forecast results.  Certainly, it is no surprise that both central banks are in tightening mode.

A quick peak at equity markets showed Asia performed reasonably well (Nikkei +0.3%, Hang Seng +0.4%, Shanghai +1.0%) although Europe has been struggling a bit (DAX -0.2%, CAC -0.1%, FTSE 100 -0.4%).  US futures, meanwhile, are either side of unchanged with very modest moves.

Treasury yields have given back 2 basis points from Friday’s post-NFP surge of 7.5bps, although there are many who continue to believe the short-term down trend has been ended.  European sovereigns are also rallying a bit, with Bunds (-1.3bps), OATs (-1.3bps) and Gilts (-3.5bps) leading a screen that has seen every European bond rally today.

Commodity prices are perhaps the most interesting as oil prices have fallen quite sharply (-4.0%) with WTI back to $65.50/bbl, its lowest level since late May.  This appears to be a recognition of the growth of the Delta variant and how more and more nations are responding with another wave of lockdowns and restrictions on movement, thus less travel and overall economic activity.  As such, it should be no surprise that copper (-1.5%) is lower or that the metals space as a whole is under pressure.

Interestingly, the dollar is not showing a clear trend at all today, with gainers and losers about evenly mixed and no particularly large moves.  In the G10, NOK (-0.3%) is the laggard, clearly impacted by oil’s decline, but away from that, the mix is basically +/- 0.1%, in other words, no real change.  In the emerging markets, ZAR (+0.3%) is the leader, although this appears more to be a response to its sharp weakness last week than to any specific news.  And that is the only EMG currency that moved more than 0.2%, again, demonstrating very little in the way of new information.

Data this week brings CPI amongst a bunch of lesser numbers:

Today JOLTS Jobs Openings 9.27M
Tuesday NFIB Small Biz Optimism 102.0
Nonfarm Productivity 3.2%
Unit Labor Costs 0.9%
Wednesday CPI 0.5% (5.3% Y/Y)
-ex food & energy 0.4% (4.3% Y/Y)
Thursday Initial Claims 375K
Continuing Claims 2.88M
PPI 0.6% (7.1% Y/Y)
-ex food & energy 0.5% (5.6% Y/Y)
Friday Michigan Sentiment 81.2

Source: Bloomberg

At this point, the response to the CPI data will be either of the following; a high number will be ignored (transitory remember), and a low number will be proof they are correct.  So, while we may all be suffering, the narrative will have no such problems!

There are a handful of Fed speakers this week as well, with the two most hawkish voices (Mester and George) on the calendar.  Right now, the narrative has evolved to tapering is part of the conversation and Jackson Hole will give us more clarity.  The market is pricing the first rate hike by December 2022 based on the recent commentary.  We shall see.  Until then, I don’t anticipate a great deal as many desks will be thinly staffed due to summer vacations.  Just be careful if you have a large amount to execute.

Good luck and stay safe
Adf

Some Water to Tread

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The quickening pace of the spread
Of delta means looking ahead
The prospects for both
Inflation and growth
Seem likely, some water, to tread

The upshot is central bank staff
Will trot out some chart or some graph
Highlighting that rates
In all nation states
Should once more be cut, least in half

The talk of the markets is the pace of the spread of the delta variant of Covid and how the latest wave of lockdowns and other measures has reduced growth forecasts for the second half of the year.  This is especially true throughout Asia as nations that had seemingly weathered the initial wave of Covid with aplomb find themselves woefully unprepared for the current situation.  A combination of less widespread vaccinations and less effective health infrastructure has resulted in the fast spreading virus wreaking havoc.  China, for instance, finds itself in this position as half of its 32 provinces are reporting cases and officials there have closed major tourist destinations because of the spread.  This is a far cry from their earlier claims of having controlled the virus better than anyone else.  But the same situation exists throughout Europe and the Americas as the delta variant runs its course.

The clearest market response to this situation has been from bond markets where yields continue to fall around the world on the weaker prospects for growth.  The amount of negative yielding debt worldwide has risen back to $16.7 trillion, up from $12.9 trillion at the end of June, although still below the $18.3 trillion reached in December of last year.  However, the trajectory of this move, which is approaching vertical, offers the possibility that we could easily take out those old highs in the next week or two.

The problem is that rapidly declining bond yields do not accord easily with higher inflation or inflation expectations.  Yet higher inflation continues to be present and inflation expectations continue to rise.  This is the great conundrum in markets right now.  How can markets be anticipating slower growth while inflation measures continue to rise?  Shouldn’t slower growth lead to lower inflation?

In ordinary economic environments, there has certainly been a strong relationship between growth and inflation, but I challenge anyone to describe this economic situation as ordinary.  Rather, as a result of collective government responses to the pandemic, with whole swaths of various economies around the world being closed, along with massive fiscal and monetary stimulus being added to those same economies, a series of supply shocks have been created.  Thus, when the artificially stoked demand (from the stimulus) meets the constrained supply (from the lockdowns) the natural response is for prices to rise in order to achieve a new equilibrium.  The point is that the supply constraints continue to drive much of the pricing behavior, and therefore the inflation story, while the central banks can only really affect the demand side of the equation.  After all, while they may be able to print lots of money, they cannot print chickens, toilet paper or semiconductors, all things that have seen supply reduced.

A large part of the central banks’ transitory inflation theme stems from the fact that their models tell them that supply will be replenished and therefore prices will ease.  Alas, there has been little indication that the real world is paying attention to central bank models, as we continue to see shipping delays, manufacturing delays and higher raw materials prices as the supply infrastructure remains under significant strain.

Perhaps the most telling feature regarding the current views on inflation, even more than the rise in economic statistics, is the growth in the number of stories in the mainstream media regarding why different ordinary products and services have become more expensive.  Just this morning, the WSJ explained why both vacations and patio furniture are more expensive, and a quick Google trends search shows the term “more expensive” is being searched at near peak levels virtually daily.  The central bank community has put themselves in a significant bind, and while some nations are beginning to respond, the big 3, Fed, ECB and BOJ, show absolutely no signs of changing their behavior in the near term.  As such, the outlook is for more printed money, the same or few available goods and higher prices across the board.

Turning to markets, all that money continues to be a positive for equity investors as a great deal of that liquidity keeps finding its way into equity markets.  While Japan (Nikkei -0.2%) lagged last night, the rest of Asia rebounded with both the Hang Seng and Shanghai indices rising 0.9%.  Europe, too, continues to perform well with the DAX (+0.8%), CAC (+0.4%) and FTSE 100 (+0.4%) all in the green after PMI Services indices were released.  While all of those data points were strong, they all missed expectations and were slightly softer than last month.  In other words, the trajectory continues to be lower, although the absolute readings remain strong.  Perhaps despite what Timbuk 3 explained, you won’t need shades for the future after all.

As to the bond market, we continue to see demand as yields are lower almost everywhere.  Treasury yields have fallen 1 basis point, with European sovereigns even stronger (Bunds -1.7bps, OATs -2.0bps, Gilts -1.3bps).  In fact, the only bond market to sell off overnight was in New Zealand (+5bps) as comments from the central bank indicated they are likely to raise rates next week, and as many as 3 times by the end of the year as inflation continues to rise while the unemployment rate fell to a surprisingly low 4.0%.

Commodity prices continue to lack direction, although the negativity on the economy has impacted oil prices which are down 1.1% this morning.  However, gold (+0.4%) is looking up, as are agricultural prices with the big three products all higher by between 0.3%-0.6%.  Base metals, though, are under pressure (Cu -0.4%, Sn -0.3%) which given the evolving economic sentiment makes some sense.

Finally, the dollar is ever so slightly softer this morning with only NZD (+0.7%) showing real movement and dragging AUD (+0.3%) along with it.  Otherwise, the rest of the G10 is +/- 0.1% from yesterday’s closing levels.  The EMG picture is a bit more mixed with gainers and losers on the order of 0.4%, although even that is only a few currencies.  The leader today is KRW (+0.4%) which responded to increased expectations that the BOK would be raising interest rates soon, perhaps later this month, with some analysts even floating the idea for a 50bp hike.  We have seen a similar gain in HUF (0.4%) as the market continues to digest hawkish commentary from the central bank there, but after those two, gainers have been far less impressive.  On the downside, TRY (-0.4%) is the laggard du jour as the market grows increasingly concerned that the central bank will not be able to keep up with rising inflation there.  Elsewhere, THB (-0.35%) fell on weakening growth prospects and the rest of the space was less interesting.

Two notable data points are to be released today with ADP Employment (exp 683K) early and then the ISM Services (60.5) index released at 10:00. The ADP number will be seen by many as a harbinger of Friday’s NFP, so could well have a big impact if it surprises in either direction.

Interestingly, the dollar continues to hold its own lately despite declining yields as it appears investors are buying dollars to buy Treasuries.  After all, as more and more debt turns into negative yields, Treasuries look that much more attractive.  At least until the Fed admits that inflation is going to be more persistent than previously discussed.

Good luck and stay safe
Adf

Thrilled…Chilled

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The ECB just must be thrilled
Inflation they’ve tried hard to build
Is finally growing
Though Germany’s showing
The growth impulse there has been chilled

The news from the Continent this morning would seem to be pretty good.  GDP, which rose 2.0% Q/Q in Q2 was substantially higher than the forecast 1.5%.  The growth leadership came from Spain (2.8%) and Italy (2.7%) although France (0.9%) was somewhat lackluster and Germany (1.5%) was extremely disappointing, coming in well below expectations.  At the same time, Eurozone CPI rose to 2.2% in July, above both the expected 2.0% print, and the ECB’s target rate.  Given everything we have heard from Madame Lagarde and virtually every ECB speaker over the past months, this must be quite exciting as it is a demonstration of success of their policies.  It seems that buying an additional €3.3 trillion in assets was finally sufficient to drive inflation higher.  (Well, arguably, what that did was drive up the price of virtually every commodity while government lockdowns were able to reduce productive capacity sufficiently to create massive bottlenecks in supply chains forcing prices higher.)  Nonetheless, the ECB gets to take a victory lap as they have achieved their target.

As an aside, you may recall yesterday’s data that showed German CPI rose a shockingly high 3.8%, a level at which the good people of that nation are very likely horrified.  While the Eurozone, as a whole, continues to recover pretty well, there must be a little concern that Germany is facing a period of stagflation, with subpar growth and higher prices.  Of course, this is the worst possible outcome for policymakers as the remedy for the two aspects require opposite policies and thus a choice must be made that will almost certainly result in greater pain for the economy initially.  Forty years ago, Fed Chair Paul Volcker was able to withstand the political heat when making this decision, but I fear there is not a central banker in the seat who could do so today.

Perhaps the most disappointing aspect of all this is that European equity markets are all in the red, with not a single one responding positively to the data.  Ironically, Spain’s IBEX (-1.0%) is the laggard, despite Spain’s top of the list growth.  Then comes the DAX (-0.8%) and the CAC (-0.25%).  For good measure, the FTSE 100 (-0.9%) is following suit although its GDP data won’t be published for two more weeks.  Arguably, despite this positive news, the ongoing spread of the delta variant seems to be undermining both confidence and actual activity at some level.

Of course, European markets tend to take their cues from what happens in Asia before they open, and last night was another risk-off session there with the Nikkei (-1.8%), Hang Seng (-1.35%) and Shanghai (-0.4%) all sliding.  There are two stories here, one Japanese and one Chinese.  From Japan, the issue is clearly the resurgence of Covid as the recently imposed emergency lockdown has been extended further amid a spike in daily cases to near 10K, higher than the peaks seen in both January and May of this year.  The rapid spread of the disease has policymakers there quite flustered and investors are beginning to show their concern.

China, on the other hand, assures us that they have no Covid problems, rather markets there are suffering over policy decisions.  One observation that might be made is that the government is enhancing regulations on very specific segments of the economy in order to achieve their stated goals from the most recent 5-year plan.  So, education is very clearly seen as critical, far too important for capitalism to have any influence, and I would expect that this industry sector will ultimately privatize and turn into the suggested non-profit organizations.  On the tech side, China is all about hardware type tech, and will do all they can to support companies in that space.  However, companies like Didi, AliBaba and Tencent don’t produce anything worthwhile, they simply consume resources to provide retail services, none of which lead toward Xi Jinping’s ultimate goals.  As such, they are likely to find increasing restrictions on what they do in order to reduce their influence on the economy.

And as I hinted at the other day, there appears to be growing concern that the real estate bubble that exists in China has been a key feature of their demographic problems.  Couples are less likely to have children if they cannot afford to buy a house, and the damage from China’s one-child policy will take generations to repair, although that is a key focus of the government.  As such, do not be surprised if real estate firms come under pressure with respect to things like restrictions on margins and pricing as the government tries to deflate that bubble.  This opens the possibility that yet another sector of the Chinese equity market is going to come under further pressure.  To the extent that Asian markets set the tone for the global day, that does not bode well for the near future.

Interestingly, despite a lackluster performance by the European and Asian equity markets (and US futures, which are all lower this morning), the bond markets are not exactly on fire.  While it is true that Treasury yields have slipped 2.5bps, European sovereigns are either side of unchanged today, with nothing moving more than 0.3bps in either direction.  I would have expected a bit better performance given the equity risk-off signal.

Commodity markets are generally a bit softer with oil (-0.2%) slipping a bit although it has recovered almost all of its losses from two weeks ago and sits at $73.50/bbl.  Gold, after a huge rally yesterday is unchanged this morning, while base metals are mixed (Cu -0.2%, Al +1.4%, Sn +0.15%).  Finally, ags are all softer this morning as weather conditions in key growing areas have improved lately.

Lastly, the dollar can best be described as mixed, with NOK (-0.4%) and AUD (-0.35%) the laggards amid softer oil and  commodity prices while EUR (+0.1%) and CHF (+0.1%) have both edged higher on what I would contend is the ongoing decline in real US interest rates.

Emerging market currencies have performed far better generally with TRY (+0.6%) and PHP (+0.6%) the leaders although both EEMEA and other APAC currencies have performed well.  The lira responded to the Turkish central bank raising its inflation forecast thus implying rates would remain higher there for the foreseeable future.  Meanwhile, the peso seemed to benefit from the idea that the renewed covid lockdown would reduce its balance of payments issues by reducing its trade deficit.  On the other side of the ledger was KRW (-0.3%) which continues to suffer from the uncertainty over Chinese business activity.

On the data front today, we get the Fed’s key inflation reading; Core PCE (exp 3.7%) as well as Personal Income (-0.3%), Personal Spending (0.7%), Chicago PMI (64.1) and Michigan Sentiment (80.8).  Clearly all eyes will be on the PCE number, where a higher print will likely encourage more taper talk.  However, if it is below expectations, look for a very positive market response.  We also hear from two Fed speakers, Bullard and Brainerd, the former who has turned far more hawkish and has been calling for a taper, while Ms Brainerd is not nearly ready for such action.  And in the end, Brainerd matters more than Bullard for now.

I expect the market will take its cues from the PCE data, with a higher print likely to undermine the dollar while a softer print could well see a bit of a rebound from the past several sessions’ weakness.

Good luck, good weekend and stay safe
Adf

Tougher for Jay

Posted on by

The Fed once again will convey
Inflation just ain’t here to stay
But every release
That shows an increase
Makes life that much tougher for Jay

Meanwhile, Chinese comments last night
Explained everything was alright
They further suggested
That more be invested
To underscore risk appetite

As we await the FOMC meeting’s conclusion this afternoon, markets have generally remained calm, even those in China.  Apparently, 20% is the limit as to how far any government will allow equity markets to decline. After three raucous sessions in China and Hong Kong, as investors fled from those companies under attack review by the Chinese government for their alleged regulatory transgressions, the Chinese press was out in force explaining that there were no long term problems and that both the economy and stock markets were just fine and quite safe.  “Recent declines are unsustainable” claimed the Securities Daily, a state-owned financial paper.  We shall see if that is the case, especially since there is no indication that the government has finished its regulatory crackdown across different industries.

However, the carnage of the past several sessions was not evident last night as the Hang Seng (+1.5%) rebounded nicely while Shanghai (-0.6%) managed to close 1.5% above the lows seen early in the session.  It hardly seems coincidental that the Chinese reacted to the declines after a 20% fall as that seems to be the number that defines concern.  Recall, in Q4 2018, Chairman Powell, who had been adamant there were no issues and was blissfully allowing the Fed’s balance sheet to slowly shrink while simultaneously raising interest rates made a quick 180˚ turn on Boxing Day when the S&P’s decline had reached 20%.  It seems that no central banker or government is willing to allow a bear market on their watch, even those that need never face the voters.

While forecasting the future is extremely difficult, it seems likely that if President Xi turns his sights on another industry, (Real Estate anyone?) then we could easily see another wave lower across these markets.  While instability is not desired, when push comes to shove, Xi’s ideology trumps all other concerns, and if he believes it is being threatened by the growth and power of an industry, you can be certain that industry will be targeted.  Caveat investor!

As to the Fed, the universal expectation is there will be no policy changes, so interest rates will remain the same and the asset purchase program will continue at its monthly pace of $120 billion.  The real questions center around tapering (will they mention it in the statement and how will Powell address it in the press conference) and the nature of inflation.  While clearly the latter will be described as transitory, will there be some acknowledgement that it is running hotter than they ever expected?

At Powell’s Congressional testimony several weeks ago, he was clear that “substantial further progress” toward their goals of maximum employment and average inflation stably at 2.0%, had not yet been made.  Has that progress been made in the interim?  I think not.  This implies, to me at least, that there is no policy change in the offing for a long time to come.  While there are many analysts who are looking for a more hawkish turn from the Fed in response to the clearly rising price pressures, the hallmark of this (and every previous) committee is that they will stick to their narrative regardless of the situation on the ground.  I expect they will ignore the much higher than expected inflation prints and that when asked at the press conference, Powell will strongly maintain inflation is transitory and will be falling soon.  Monday, I explained my concern that CPI is likely to moderate for a short period of time before heading sharply higher again, and that Powell and the Fed will take that moderation as victory.  Nothing has changed that view, nor the view that the Fed will fall far behind the curve when it comes to fighting inflation.  But that is the future.  For now, the Fed is very likely to remain calm and stick to their story.

OK, with that out of the way, we can peruse the markets, which, as I mentioned above, have been vey quiet awaiting the FOMC.  The other key Asian market, the Nikkei (-1.4%) fell overnight after having rallied during the Chinese fireworks, as the spread of the delta variant of Covid-19 and ongoing lockdowns in Japan have started to concern investors.

Europe, on the other hand, is all green on the screen led by the CAC (+0.75%) with both the DAX (+0.2%) and FTSE 100 (+0.2%) up similar but lesser amounts.  You’re hard pressed to point to the data as a driver as the little we saw showed German Import prices rise 12.9%, the highest level since September 1981, while French Consumer Confidence fell a tick to 101.  Hardly the stuff of bullish sentiment.  US futures, currently, sit essentially unchanged as traders and investors await Powell’s pronouncements.

The bond market is mixed this morning, with Treasury yields edging higher by 1 basis point while most of Europe is seeing a very modest decline in yields, less than 1bp.  Essentially, this is the price action of positions being adjusted ahead of key data.

Commodity prices show oil rising (+0.5%) but very little movement anywhere else in the space with both metals and agricultural prices either side of unchanged on the day.

Lastly, the dollar is ever so slightly stronger vs. most G10 counterparts, with AUD (-0.25%) and NZD (-0.2%) the laggards as concern grows over the economic impact of the ongoing spread of the delta variant.  CAD (+0.25%) is the one gainer of note, seemingly following oil’s lead.  EMG currencies have had a more mixed session with KRW (-0.4%) the worst performer on the back of rising Covid cases and ongoing concerns over what is happening in China.  The only other laggard of note is HUF (-0.3%) which is still suffering from its ongoing political fight with the EU and the result that EU Covid aid has been indefinitely delayed.  On the plus side, RUB (+0.35%) is following oil while CNY (+0.2%) seems to be benefitting from the calm imposed on markets last night.  Otherwise, movement in this space has been minimal.

All eyes are on the FOMC at 2:00 this afternoon, with only very minor data releases before then.  My read is that the market is looking for a slightly hawkish tilt to the Fed as a response to the rapidly rising inflation.  However, I disagree, and feel the risk is a more dovish than expected outcome. The fact that US economic data continues to mildly disappoint will weigh on any decision.  If I am correct, I think the dollar will have the opportunity to sink a bit further, but only a bit.

Good luck and stay safe
Adf

Time to Flee

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No longer will President Xi
Allow billionaires to run free
His edict last night
Proved his grip is tight
And showed traders t’was time to flee

The biggest story overnight was the continued crackdown by Chinese authorities on any private industry that has developed a measure of power in the Chinese economy.  While the tale of Didi Chuxing, the Chinese Uber, was seen as a warning, apparently, the government is becoming more impatient over the pace of adherence to the new view.  Briefly, Didi went public and then several days later the Chinese government forced them to remove their app from public availability and crushed their business under the pretext of data security.  Didi shares fell sharply.  Last night the government explained that private education companies, which were teaching the CCP curriculum, were to cease being profit-making companies “hijacked by capitalism”, and essentially will be forced to delist.  It can be no surprise that the prices of these shares fell dramatically, in one case by 98/%, as investors flee as quickly as possible.  This resulted in sharp declines across all indices there with the Hang Seng (-4.1%) and Shanghai (-2.35%) and led to a general risk-off tone.

Apparently, President Xi is no longer willing to accept that anybody else in China can have some measure of power or influence beyond his control.  Other changes involve the payment networks Alipay and Wechat, which are on the verge of being subsumed by China’s upcoming CBDC, the e-yuan.  Exclusive rights for things like music licenses are being removed and essentially, it appears that capitalism with Chinese characteristics is morphing into a full-blown state-owned economy.  We cannot be too surprised by this; after all, Xi Jinping has been ruling with an increasingly tighter grip on all segments of the economy and he is a clear adherent to strict communism.  Remember, the definition of communism is that all property is publicly (read government) owned.  We have not seen the last of this process so be careful going forward.

The ECB told us that they
Would no longer stand in the way
Of prices that rise
Until they surmise
That growth has made major headway

Now later this week from the Fed
Some pundits think, shortly ahead,
They’ll slow down their buying
Of bonds, as they’re trying,
To counter, inflation, widespread

Inflation (whether CPI or PCE), is a price series that demonstrates characteristics similar to every other price series like stocks or bonds or currencies.  There are trend movements, there are overshoots in both directions that tend to correct and there are periods of consolidation.  One of the best definitions of a trend is a series that makes either higher lows and higher highs, or conversely, lower highs and lower lows.  In other words, something that is trending higher will typically trade to a new high level and then after a period, pull back somewhat, a normal correction, before moving on to further new highs.  When the uptrend is in force, each high is higher than the last, and, more importantly, each low is higher than the last.  I make this point because I am concerned that when looking at the backgrounds of all the FOMC members, not one of them has any trading history.

This is important because, my sense on the inflation story is that it is quite realistic that we see a slowdown in price growth in the next several months, where 5.4% headline CPI falls to 4.8% and 4.5% and so forth, as this price series goes through a correction just like the stock, bond and currency markets.  Of course, if this is what we see, it is almost guaranteed that Chairman Powell, and his band of merry men (and women) will be all over the tape crowing over the transitory nature of inflation.

Alas, my concern is that given what I believe is a strong uptrend in inflation, this retracement in CPI (and PCE) will stop at a higher level than the previous lows and set itself up for another, more powerful move higher.  In the meantime, the Fed will have waved away any concerns over inflation as they continue to pump unlimited liquidity into the system to run the economy as hot as possible.  After all, in their collective mind, they will have proven inflation is transitory.  However, the next leg higher in CPI and PCE is liable to be far more severe, occurring far more quickly than the Fed expects, and lead to a more permanent unanchoring of inflation expectations.

It will also put the Fed in an even tighter bind than they currently find themselves.  This is because if CPI prints 6%, or 7% or more, the market is far less likely to accept their jawboning as a reason to maintain low yields and high stock prices.  Rather, they will be forced to decide between addressing inflation, which means raising interest rates sharply and significantly impacting, in a very negative way, the real economy, as well as asset markets; or they will have to come up with some other way to measure inflation such that it is not rising at such a ferocious clip but is still seen as credible.  One of their dilemmas is that, politically, inflation is already becoming a problem for the Biden administration, and that is at 5%.  Be prepared for the Misery Index (a Ronald Reagan invention that was the sum of CPI and the Unemployment Rate) to become a popular meme from all of President Biden’s opponents going forward.

Oh yeah, if you think that letting inflation run hot like that is going to goose equity market returns, especially when starting from such incredibly steep valuations, you would be wrong.  History shows that when inflation rises above 5%, equity markets do not provide any type of real hedge.  Let me be clear that this is not going to play out by autumn 2021, but could very well be the case come summer or autumn 2022, a particularly difficult time for the incumbent party in Washington as mid-term elections will be upcoming and the party in power tends to get the blame for economic problems.

What about the dollar you may ask?  In this scenario, the dollar is very likely to suffer greatly, so keep that in mind as you look ahead to your hedging needs for next year and beyond.

In the meantime, the Chinese inspired sell-off has led to some risk concerns, but not (yet) a widespread sell-off.  For instance, the Nikkei (+1.0%) managed to rally in the face of the Chinese equity market declines although, outside Japan, the screens are basically all red in Asia.  European bourses are somewhat lower (DAX -0.4%, CAC -0.25%, FTSE 100 -0.25%) as they respond to the general negative tone in risk as well as a much weaker than expected German IFO reading of 101.2, well down from last month’s reading.  However, these levels are well off the session lows, as are US futures, which are down on the order of -0.25%, although were much lower earlier.

Bond markets are a little more mixed as Treasury yields fall 3.2bps (taking real yields to historic lows of -1.12%) but European sovereigns are more mixed with Bunds unchanged and OATs (+0.8bps) and Gilts (-0.8bps) not giving us any direction.

Commodity prices are mostly lower led by oil (-0.8%), although gold (+0.3%) is showing some positive haven characteristics.  Clearly, declining real yields are also supporting the precious metals.  Foodstuffs are softer (about which everyone except farmers are happy) and base metals are mixed with copper (+1.35%) leading the way higher although both Al (-0.4%) and Sn (-0.3%) are under pressure.

Finally, the dollar is not exhibiting its ordinary risk-off attitude this morning, as it is broadly softer vs. its G10 counterparts with only AUD (-0.1%) down on the day, arguably given concerns of changes with the Chinese economy.  But the rest of the bloc is marginally higher as I type led by SEK (+0.35%) and GBP (+0.3%), both of which are seeming to respond to reopening economies.

In the EMG space, however, there are many more decliners than gainers, led by RUB (-0.45%) on the back of oil’s weakness, but also KRW (-0.4%) which is feeling the pinch of the change in tone from China.  This story is going to be the second biggest driver, after the Fed, for a while, I think.

Of course, this week brings the FOMC meeting, but also Q2 GDP and Core PCE, so there is much to look forward to here.

Today New Home Sales 800K
Tuesday Durable Goods 2.0%
-ex Transport 0.8%
Case Shiller Home Prices 16.2%
Consumer Confidence 124.0
Wednesday FOMC Rate Decision 0.00% – 0.25%
IOER 0.15%
Thursday Q2GDP 8.5%
Initial Claims 380K
Continuing Claims 3192K
Friday Personal Income -0.4%
Personal Spending 0.7%
Core PCE 0.6% (3.7% Y/Y)
Chicago PMI 63.3
Michigan Sentiment 80.8

Source: Bloomberg

Obviously, the Fed is the big story as the data that comes before will not be seen as critical.  The GDP print will be quite interesting, but it is widely accepted that this is the peak and we will be slowing down from here.  However, Friday’s Core PCE number will really be scrutinized as another high print will make Powell’s task that much harder with respect to convincing people that inflation is transitory, especially if their favorite indicator keeps running higher.  Ultimately, I expect we will see a short-term retracement on the rate of inflation before the next leg up and that is the one about which we should all be concerned.

As to today’s market, if equity markets manage to shake off their concerns over Chinese activities, the dollar seems likely to continue with today’s soft tone.  If not, though, look for a rebound.

Good luck and stay safe
Adf

Far From Benign

Posted on by

Was yesterday’s market decline
A flash or a longer-term sign
Of things gone astray
That might well give way
To outcomes quite far from benign

Is this the end?  Have we seen the top in the equity markets?  That seems to be the question being asked this morning as both traders and investors try to determine if the first risk-off session in a number of months is the beginning of a trend, or merely a symptom of some short-term position excesses.  While Asian markets (Nikkei -1.0%, Hang Seng -0.85%, Shanghai -0.1%) continued along the theme of greater problems to come, Europe is not quite as worried, at least not in the equity space.  Interestingly, despite the rebound in Europe (DAX +0.1%, CAC +0.4%, FTSE 100 +0.3%) European sovereign debt has continued its rally with yields there lower by a pretty consistent 3 basis points across the board.

Meanwhile, after a tremendous rally in the Treasury market yesterday, where 10-year yields fell 10 basis points and the 2yr-10-yr spread flattened to below 100bps, buyers are still at large with the 10-year declining a further 1.2bps as I write.

It seems the narrative that is beginning to take hold is that the economic rebound from the Covid recession has reached its peak and that going forward, growth will quickly revert to trend.  This newer narrative has been reinforced by the spread of the delta variant of Covid throughout Asia and Europe (and the US, although lockdowns don’t seem to be on the agenda here) and the renewed closures being imposed around the world.  For instance, half of Australia has been put back under lockdown, as has New Zealand and growing parts of Southeast Asia including Singapore and Indonesia.  Europe, too, is feeling the pressure with rising caseloads n the UK, Spain and France resulting in calls for further restrictions.   The upshot of this is that earnings will struggle to rise as much as previously expected and that inflation pressures will quickly abate, and the concept of transitory inflation may be proven correct.

Chair Powell and friends are quite sure
Inflation, we won’t long endure
But pundits abound
Who’ll gladly expound
On why it’s the problem du jour

This brings us back to the big question hanging over markets, is inflation transitory or persistent?  Certainly, the recent trend in the data might argue for persistence as we continue to see higher prints than both the previous period as well as than forecasted.  As long as that is the case, it will be more and more difficult for the central banks to declare victory.  While commodity futures markets are well off their highs, a broad index of basic materials prices, things where there are no futures markets, is at all-time highs and rising.  Wages continue to rise as well, as the disconnect between the number of unemployed people and the number of job openings is forcing business to increase pay to get workers to come on board.  All of these things point to continued higher prices going forward, as do surveys of both consumers and businesses who virtually all agree higher prices are in our future.

However, the evidence from the bond market, the market that is historically seen as the most attuned to inflationary pressures, would argue that the inflation scare has passed.  With yields tumbling, US 10-year yields are more than 60 basis points off their late March highs, and the yield curve flattening.  All indications are that bond investors are sanguine over the inflation threat and are actually more worried about deflation.

The argument on this side remains that temporary bottlenecks have resulted in price pressures during the reopening of economies from the Covid lockdowns.  Economists’ models point to those very price pressures as the impetus for increased supply and, thus, lower prices in the future.  The problem is that the timeline for increasing supply is very different across different products.  Perhaps the most widely known shortage is semiconductors which has led to reductions in the production of cars, washing machines and consumer electronics.  But it takes at least 2 years to build a semiconductor factory, so it is quite possible the shortage will not be alleviated anytime soon.  Similarly, with mined raw materials, it takes multiple years to open up new mines, so shortages in copper or tin may not be alleviated for a number of years yet.  Of course, if growth is slowing, demand for these items will diminish and price pressures are likely to fade as well.

Let’s consider a few things about which we are certain.  First, securities prices do not travel in a straight line, and in fact, there are many short-term reversals involved in long-term trends.  Thus, if inflation is indeed persistent, the recent bond rally may well be the result of short-term factors and position reductions.  Recall, higher yields were the consensus Wall Street forecast three months ago, with expectations for the 10-year to be yielding between 2.0% and 2.5% in December.  Large fund managers were on board with that idea and built large positions, which take time to unwind.  It is entirely possible we are seeing the last throes of those position adjustments right now.

Another thing about which we are (pretty) certain is that during the Fed’s quiet period, we will not hear from any Fed speakers.  This means that in the event the market really does continue yesterday’s declines and starts to accelerate, the Fed will be hamstrung in their ability to try to jawbone things back to a smoother path.  Would Powell break the quiet period if markets fell 5% or 8% in a day?  My sense is he might, but that is exactly the type of thing that markets like to test.

Finally, let’s not forget that markets are hugely imperfect forecasters of the future.  After all, it was only 3 months ago when markets were forecasting much greater inflation while anticipating no change in Fed policy until 2024.  So, just because the current market view points to a potential slowing of economic growth and reduced inflation pressures, the economy behaves independently of the markets, and may well show us that the views from March were, in fact, correct.

Having already touched on equity and bond markets, a quick look at the FX markets shows that the dollar continues to power ahead vs. its G10 counterparts with NOK (-0.7%) and NZD (-0.65%) the laggards this morning.  NOK continues to suffer from oil’s remarkable 7.5% decline yesterday, while New Zealand is suffering on renewed lockdown fervor, and this after the RBNZ just last week explained they were about to tighten policy!  But we are seeing weakness in the pound (-0.45%) and AUD (-0.35%) both of which seem to be Covid shutdown related, while JPY (0.0%) is the only currency holding up in the bloc today despite further negative news regarding the Olympics and athletes contracting Covid as well as sponsors pulling out.

Emerging markets have been more varied with losers in Asia (SGD -0.35%, KRW -0.25%) on the back of Covid lockdowns, while gainers have included TRY (+0.4%), INR (+0.35%) and RUB (+0.3%).  The ruble seems to be reacting to the end of oil’s decline, unlike NOK, while INR saw equity market inflows driving the currency higher.  TRY, which is on holiday today, is benefitting from a higher inflation reading than expected and expectations of further policy tightening by the central bank there.

On the data front today we see Housing Starts (exp 1590K) and Building Permits (1696K).  We all know the housing market remains hot, so these data points are unlikely to move markets.  Rather, watch carefully for a continuation of yesterday’s risk off session and a stronger dollar.  I have a feeling that this morning’s price action is more pause than trend.

Good luck and stay safe
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How They Debase

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The world’s central banks, as a whole
Have signaled they need to control
Not only the pace
Of how they debase
Their cash, but of digging for coal

Thus, now the Big 3 have explained
The policies they have ordained
Will fund, efforts, green
But not what is seen
Endorsing ‘brown’ growth unrestrained

Last night’s BOJ meeting resulted in exactly zero monetary policy surprises but did serve to confirm that the central banking community has decided to take on a task well outside their traditional purview; climate change.  While they left policy unchanged, as universally expected, they announced that they would be introducing a new funding measure targeting both green and sustainability-linked loans and bonds.  In other words, as well as purchasing JGB’s, equities and ETF’s, they are going to expand their portfolio into ESG bonds.  The interesting thing is that the universe of ESG bonds in Japan is not that large, so the BOJ is going to wind up buying non-JPY denominated assets.  In other words, they are going to be selling a bunch of newly printed yen and converting it into other currencies to achieve their new goals.  This sounds suspiciously like FX intervention, but dressed in more politically correct clothing.  The impact, however, is likely to be a bias for a somewhat weaker yen over time.  For those of you with yen assets, keep that in mind.

Meanwhile, we have already heard from both the Fed and ECB that they, too, are going to increase their focus on climate.  Here, too, one might question whether this is an appropriate use of central bank resources.  After all, it’s not as though the economy in either place is humming along with solid growth, low inflation and excellent future prospects based on strong productivity.  But hey, combatting climate change is far trendier than the boring aspects of monetary policy, like trying to address rapidly rising inflation without tightening policy and risking a crash in equity markets.

In the end, the only thing this shift in policy focus will achieve is longer-lasting inflation.  The effort to develop new and cleaner energy by starving current energy production of capital will result in higher prices for the stuff we actually use.  Over a long enough time horizon, this strategy can make sense; alas we live our lives in the here and now and need energy every day to do so.  Germany is the perfect example of what can happen when politics overrides economics. Electricity prices in Germany average $0.383 (€0.324) per kWh.  In the US, that number is $0.104 per kWh.  Ever since the Fukushima earthquake led to Germany scrapping their nuclear fleet of power reactors, the price of electricity there has more than tripled.  I fear this is in our future if monetary policymakers turn their attention away from their primary role.

Of course, higher inflation is in our future even if they don’t do this, and there is no evidence yet, at least from the Fed or ECB, that they are about to change the current monetary policy stance that is exacerbating that inflation.  However, almost daily we are seeing markets respond to data and comments from other countries that are far more concerned with the inflationary outlook.  Last week the RBNZ ended QE abruptly and indicated they may start raising rates soon.  Last night, CPI there jumped to 3.3%, the highest level since 2011 and above their target band.  It should be no surprise that NZD (+0.45%) rose after the print as did local yields as expectations for a rate hike accelerated.  In fact, I believe this is what the immediate future will look like; smaller countries with rising inflation will tighten monetary policy and their currencies will appreciate accordingly.

Turning to today’s markets, risk was under pressure overnight after a generally weak US session.  Led by the Nikkei (-1.0%), most of Asia was softer, but not all (Hang Seng 0.0%, Shanghai -0.7%, Australia +0.2%).  Europe, which had been higher on the opening has since drifted down and is now mixed with the DAX (0.0%) unchanged while the CAC (-0.5%) lags the rest of the continent and the FTSE 100 (+0.2%) has managed to hold its early gains.  US futures have also held onto small gains with all three indices up about 0.2%.

Bond markets are somewhat mixed as Treasuries (+2.5bps) sell off after yesterdays rally where yields fell 5bps.  However, European sovereigns are all in demand this morning with yield declines ranging from 1.0 to 1.8 basis points.  Commodity markets show crude slightly higher (+0.15%), gold under pressure (-0.7%) and base metals mixed (Cu -0.3%, Al +0.3%, Sn +0.7%).

In the FX markets, aside from kiwi, NOK (+0.25%) has rallied on oil’s rebound from its lows earlier this week, but the rest of the G10 is softer.  It should be no surprise JPY (-0.35%) is the worst performer, while the other currencies are simply drifting slightly lower, down in the 0.1% – 0.2% range.  In the EMG bloc, ZAR (+1.5%) is the big winner as it regains some of the ground it lost earlier in the week on the back of the rioting there.  The government has sent in the army to key hot spots to quell the unrest and so far, it seems to be working thus international investors are returning.  Otherwise, we see gains in RUB (+0.3%) and MXN (+0.3%), both of which benefit from oil and tighter monetary policy from their respective central banks.  On the downside, TWD (-0.4%) has been the worst performer in the bloc as dividend repatriation from foreign equity holders pressured the currency.  This is not a long-term issue.   Away from that, some of the CE4 are drifting lower alongside the euro but there has not been much other news of note.

On the data front this morning we see Retail Sales (exp -0.3%, +0.4% ex autos) as well as Michigan Sentiment (86.5).  After two days of Powell testimony, where he continued to maintain there would be no policy tightening and that inflation is transitory, today we hear from NY’s Williams, one of the key members of the FOMC, and someone who has remains steadfastly dovish.

The dollar’s recent strength seems to have reached its limit so I expect that we could see a bit of a pullback if for no other reason than traders who got long during the week will want to square up ahead of the weekend.

Good luck, good weekend and stay safe
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