Inflation is clearly passé As traders and markets display Remarkable trust The Fed will adjust The path of rate hikes come what may The upshot is there’s a new meme A landing so soft it would seem No jobs will be lost And there is no cost Alas I fear it’s just a dream I’m not sure if you saw the announcement yesterday, but everything is beautiful! Inflation is a thing of the past, the economy continues to tick over quite nicely with employment remaining robust and the idea of recession is just a figment of the permabears’ imagination. At least that’s what it seems like based on market movements of late. Yes, PPI printed lower than forecast, which after the somewhat softer CPI and the known base effects, was not hugely surprising. Perhaps a bit more surprising was that the Claims data, both on an Initial and Continuing basis, printed lower than expected. The implication here is that the labor market remains quite robust with those folks who have been laid off able to find new employment quite rapidly. While there is still plenty of data pointing to a manufacturing recession (ISM, IP, Factory Orders), the Services situation remains far better with increased activity and rising wages still apparent. So, perhaps the optimists have it nailed, and believe Chairman Powell has managed to create a soft landing, where inflation comes back to target without having to cause a recession. However, it feels like it is still a little early to take that victory lap. After all, the inflation data was literally one data point driven largely by base effects and regardless of your view, one data point does not a trend make. Certainly, the equity market is all-in on the soft-landing scenario. The Treasury market, at least since the CPI print on Wednesday has rallied dramatically (another 10bps yesterday) and is now 29bps lower over the past week. In fact, the 2yr Treasury has rallied even further, with yields there falling by 35bps over the same period. To say that the market has adjusted its views on the Fed’s future activities would be an understatement. There is still a 91% probability priced into a 25bp rate hike this month, but there are no more hikes after that priced at this stage and the first cut is seen in either March or May next year, at least according to the Fed funds futures market. And what of the dollar? While it is bouncing a little today, that is clearly modest position adjustment amid profit-taking as it is sharply lower on the week against all its G10 counterparts and almost all its EMG brethren. There is, of course, one fly in the ointment, oil prices, and commodities in general. One of the key features of markets over time is that they tend to be self-correcting. The saying, the solution to high prices is high prices is trying to explain the idea that high prices result in additional supply coming to market (to take advantage of those high prices) which results in prices falling back to earlier, lower levels. The same process occurs with low prices as well, where low prices inspire increased demand and reduced supply thus driving prices higher again. Well, oil is exhibit A for this process. Since oil continues to be priced and traded largely in dollars, when the dollar is strong, non-dollar countries (basically everybody else) finds that oil is expensive and so demand wanes a bit resulting in softening oil prices. However, when the dollar declines, as we have seen in the past week, that opens the door for oil, and most commodities which are priced in dollars, to rally sharply. Of course, if you are the Fed and continue to try to dampen price pressures, the last thing you want is a weak dollar and high commodity prices as both lead directly to rising inflation. In fact, one reason that US inflation did not reach the levels seen in Europe and the UK is that the dollar remained quite strong throughout this period thus reducing inflationary pressures. But right now, that dynamic is reversing with the dollar under pressure and commodity prices rising. That bodes ill for continued declines in CPI and PPI which is certainly not part of the new narrative. (As an aside, it is this very feature that drives the de-dollarization narrative as you can easily understand why China, who is the largest importer of oil in the world, would like to see the dollar dethroned so they can pay for their imports with their own currency (printed as necessary) rather than have to earn dollars elsewhere to pay for their oil and other commodity imports.) At any rate, I feel it is very important for everyone to remember that it is never the case when all signals point in the same direction. It is only the case that the market responds to a group of signals that reinforce their underlying view, happily ignoring the rest. As another saying accurately makes clear, nothing matters until it matters. Ok, as we head into the weekend with a week’s worth of euphoria behind us, what is today shaping up to be? Well, equity markets are muddling about with most ever so slightly higher but some sliding after the previous two days’ strong rallies. US futures are also lackluster at this hour (8:00) barely higher as traders prepare for another summer weekend. Bond markets, too, are quiet after a raucous week, with yields little changed on the day in the US and throughout Europe and in Japan. One cannot be surprised by the market response to the CPI data and now that this new narrative of rainbows, unicorns and lollipops is making its way around to every corner of the market, there is no reason to think that much will change in the near term. Arguably, even if inflation is beaten and is heading back to 2%, a big IF, there is precious little reason for 10-year yields to fall very far as they would currently be offering a 1.75% real yield, a very normal situation throughout history. Although, there would certainly be cause to believe the 2yr is set to see yields decline further and the yield curve normalize. But again, I believe it is very early to take that as gospel. Commodity markets are following the same pattern here, consolidation after a week of strong rallies in all the major commodities so the question is, will those rallies continue next week? Or have we reached the end. This story is true of the dollar as well, which is intimately linked to the commodity story. Will today’s Michigan Sentiment (exp 65.5) change any views? I doubt it although if the reading is quite strong, and given the growing bullish zeitgeist, it could certainly pump risk assets further. However, a soft reading seems unlikely to derail the current risk attitude at this point. With the Fed commentary under wraps until the FOMC meeting, today is likely to be entirely equity focused. To that end, the big banks have been reporting Q2 earnings this morning and so far, they have all beaten (dramatically reduced) forecasts. I expect that is all that is needed for risk to retain its luster, so do not be surprised to see the dollar continue its recent slide and stocks and commodities finish higher on the day. Good luck and good weekend adf
Tag Archives: #inflation
Double Secret Inflation
In Sintra, each central bank head From Europe, Japan and the Fed Explained all was well Amongst their cartel So, ideas of changing were dead However, in Asia it seems The PBOC’s latest schemes To strengthen the yuan Have failed to catch on Look, now, for a change in regimes
The panel in Sintra that mattered had the three key central bank heads on the dais, Powell, Lagarde and Ueda, and each one held true to their recent word. Both Powell and Lagarde insisted that inflation remains too high and that the surprising resilience in both the US and European (?) economies means that they would both be continuing their policy tightening going forward. Powell hinted at a July hike and Lagarde promised one a few weeks ago. At the same time, Ueda-san explained that while headline inflation was higher than their target, given the lack of wage growth, the BOJ’s ‘double-secret’ core inflation reading was still below 2% and so there would be no policy changes anytime soon. He did explain that if this key reading moved sustainably above 2%, it would be appropriate to tighten monetary policy, but quite frankly, my take (and I’m not alone) is that all three of these central bank heads are very happy with the current situation.
Why, you may ask, are they happy? Well, politically, inflation remains the biggest headache for both Powell and Lagarde, and quite frankly most of the rest of the world, while in Japan, recent rises in inflation have not raised the same political ire. At the same time, as long as the BOJ continues YCC and QE with negative rates, the flood of liquidity into the market there helps offset the liquidity withdrawn by the Fed and ECB. The result of this policy mix is a very gradual reduction in total global liquidity along with an ongoing demand for US and European sovereign issuance. It should be no surprise that Japan is now the largest holder of US Treasuries outside the Fed. As well, the policy dichotomy has resulted in a continued depreciation of the yen which supports the mercantilist aspects of the Japanese economy. And finally, higher inflation in Japan helps erode the real value of the 250% of GDP worth of JGBs outstanding, allowing eventual repayment of that debt to proceed more smoothly. Talk about a win, win, win! Until we see a material change in the macroeconomic statistics in one of these three areas, it would be a huge surprise if policies changed.
The upshot of this analysis is that it seems unlikely that we are going to see any substantive movement in yields, either up or down, given the relative offsets in policy, and that the yen is likely to continue to erode in value. Last autumn, the yen fell very sharply, breaching 150 for a short time and generating serous angst at the BOJ and MOF. We saw intervention and the idea was there was a line in the sand at that level. However, my take is that as long as the move remains gradual, and it has been gradual as the yen has steadily, but slowly depreciated for the past 5 months, about 2%/month, we are likely to see more verbal intervention, but not so much in the way of actual activity. In the end, unless policies change, actual intervention simply serves to moderate the move.
Speaking of failed intervention, we can turn to China which has a similar problem to Japan, weakening growth and low inflation. As I have written before, a weak renminbi is the best outlet valve they have, and the market has been doing the job. However, here the movement has been a bit faster than the PBOC would like thus resulting in more overt and covert intervention. On the overt side, we continue to see the PBOC try to fix the onshore currency strong (dollar lower) than the market would indicate as they try to get the message across that they don’t want the currency to collapse. On the covert side, there has been an increase in the number of stories regarding Chinese banks, like China Construction Bank and Bank of China, actively selling USDCNH, the offshore renminbi in an effort to slow the currency’s depreciation. But the story that is circulating is that all throughout Africa and Asia, nations that were encouraged to accept CNY for sales of commodities are now quite unhappy with the CNY’s weakness and are quickly selling as much as they can in order to preserve their reserve’s value. My sense is this process will continue as the dichotomy between a stronger than expected US economy and a weaker than expected Chinese one continues to push the renminbi lower. PS, for everyone who was concerned about the dollar losing its reserve currency status to the renminbi or some theoretical BRICS backed currency, this should help remind you of why any change to the dollar’s global status is very far in the future.
And those are today’s stories. Yesterday’s mixed US risk picture has been followed overnight with Chinese shares, both Mainland and Hong Kong, suffering but the Nikkei eking out a gain. In Europe, the FTSE 100 is under pressure, but we are seeing strength on the continent despite what I would consider slightly worse than expected data prints in German State CPIs as well as Eurozone Confidence measures. However, the one place where inflation slowed sharply was Spain, where headline fell to 1.9%! While that was a touch higher than forecast, it is the first reading of any country in the Eurozone below the 2% level since early 2021. Alas, what is not getting much press is the fact that core CPI there fell far less than expected to 5.9% and remains well above targets. The ECB has a long way to go.
Bonds are under pressure across the board today, with yields higher by about 3bps-4bps in Treasuries and across Europe. This seems to be a response to the idea that a) neither the Fed nor ECB is going to stop raising rates and b) inflation is not falling as quickly as hoped. JGB yields, though, remain well below the YCC cap at 0.38% so there is no pressure on Ueda-san to change his tune.
Oil prices are creeping higher this morning but remain below $70/bbl and in truth have not done very much lately. The big picture of structural supply deficits vs. concerns over shorter term demand deficits due to the coming recession continue to play out as choppy markets but no direction. Copper has fallen sharply this morning and is down more than 5% in the past week. Its recent rally appears to have been a short squeeze more than a fundamental view. Gold, meanwhile, continues to consolidate just above $1900/oz.
Finally, the dollar is mixed on the day, with both gainers and losers across the EMG space although it is broadly lower vs the G10. AUD (+0.5%) is the leading major currency after better-than-expected Retail Sales data was released overnight but the rest of the bloc, while higher, is just barely so. In the EMG, PLN (+0.75%) is the best performer, but that is very clearly a position rebalancing after a week of structural weakness. On the downside, KRW (-0.75%) is the worst performer after weaker Chinese data impacted the view of Korea’s future. Otherwise, most currencies are relatively unchanged on the day.
We get some important data today starting with Initial Claims (exp 265K) and Continuing Claims (1765K) as well as Q1 GDP (1.4%). Frankly, since this is the third look at GDP, I expect that the Claims data, which has been trending higher lately, is the most critical piece. If we see another strong print, be prepared for the recession narrative to come back with a vengeance, but if it is soft, then there will be nothing stopping the Fed going forward.
Powell made some comments this morning in Madrid, but they were about bank stability not economic policy, and we hear from Bostic this afternoon. But frankly, I see little reason for a change in sentiment anywhere on the Fed given the data continues to show surprising economic strength. As such, I still like the dollar medium term.
Good luck
Adf
No Longer Clear
Inflation remains Far higher than desired Will Ueda-san blink?
Which one of these is not like the other?
|
Central Bank |
Policy Interest Rate |
Core CPI |
|
Federal Reserve |
5.25% |
5.3% |
|
ECB |
4.00% |
5.3% |
|
BOE |
5.00% |
7.1% |
|
Bank of Canada |
4.75% |
4.2% |
|
RBA |
4.10% |
6.8% (headline) |
|
BOJ |
-0.10% |
3.2% |
Source: Bloomberg
Japanese inflation readings were released overnight, and they showed no signs of declining. In fact, they were actually a tick higher than the median forecasts. However, there has been zero indication that the BOJ is set to respond to the highest inflation in decades. As everything economic is political, by its very nature, the reality seems to be that there is not yet any political price for PM Kishida to pay for rising inflation. Recall, as inflation started to pick up sharply in the wake of the pandemic reopenings, the universal central bank response was, inflation is transitory and it will subside soon. Politically, at that time, governments were keen to keep interest rates near (or below) zero as part of their belief that it would foster economic activity and recession was the big concern.
However, once it became so clear that even central banks understood this bout of inflation was not a transitory phenomenon, policy prescriptions changed rapidly leading to the very rapid rise in interest rates we have seen since early 2022. Politically, inflation was the lead story in every media outlet with governments around the world and their central banks being blamed, so they had to respond. (Whether their response has been effective is an entirely different story). Except in one place, Japan. As is abundantly clear from the table I constructed above, the BOJ has yet to alter their monetary policy stance despite core CPI remaining at extremely elevated levels far above the BOJ’s 2% target. In fact, prior to the recent spike, you have to go back to 1981 to see Japanese core CPI this high.
Apparently, though, inflation is not making headlines in Japan as it has been throughout the rest of the G7 and so the BOJ is perfectly happy to continue on their path of infinite QE and YCC. Remarkably, 10-year JGB yields fell further last night, now around 0.35%, as there is seemingly very little concern that a policy change is in the offing there. Certainly, there has been no indication from any BOJ commentary nor from Kishida’s government. As such, it can be no surprise that the yen continues to fall, declining 1% this week and more than 3% over the past month.
Interestingly, there has definitely been an uptick in the buzz from market talking heads about the need for the BOJ to abandon YCC and that a change is imminent. I have seen a number of analyses that foretell of the inevitable change and how the yen is likely to rise dramatically when it happens. FWIW, which may not be that much, I agree that when the BOJ does change policy, we are likely to see the yen rally sharply. The problem is, I see no indication that is going to happen anytime soon. Show me the headlines in the Asahi Shimbun or the Nikkei Shimbum (major Japanese newspapers) that are focused on inflation and I will change my view. But until it is a political problem, the BOJ is serving its current function of supplying the world’s liquidity with a correspondingly weaker yen as a result.
The messaging’s no longer clear Regarding the rest of the year While some at the Fed See more hikes ahead Some others feel ending is near
Once again yesterday we heard mixed messages from Fed speakers with some (Barkin) talking about evaluating their actions so far and waiting for more proof that further tightening was needed while others (Bowman, Waller) seeming pretty clear that more hikes are in the offing. Powell’s Senate testimony was largely the same as the House testimony on Wednesday with more of the questions focused on bank capital rather than monetary policy. Of course, the big question remains, are they done or not? Fed funds futures are still pricing a 72% chance of a hike in July and a terminal rate of 5.33%, so one more hike from current levels. But the arguments on both sides remain active. It appears to me that as long as the employment situation remains robust, they will continue to hike until inflation falls closer to their target. Yesterday’s Initial Claims data printed just a touch higher, 264K, and the trend certainly seems to be moving higher, but is not nearly at levels consistent with recession. The NFP report in two weeks will be critical but until then, we are likely to be whipsawed by commentary.
As to the overnight session, risk is very definitely on its heels this morning with equity markets in the red around the world, with all of Asia falling by -1.5% or more although European bourses have not suffered quite as much, -0.3% to -0.8%. US futures are also under pressure, down about -0.5% at this hour (8:00).
Bond markets, on the other hand, are performing their role as safe haven, with yields sharply lower this morning. Treasury yields, which had risen yesterday have given all that back and then some, down 6bps, while in Europe, sovereigns are down 12-13bps virtually across the board. The latter seems to be a response to the Flash PMI data which was released showing slowing activity across the continent, especially in France where both Manufacturing and Services fell below 50 and where German Manufacturing PMI tumbled to 41.0. If the Eurozone economy is truly performing so poorly, it is hard to believe that the ECB will continue on its current path much longer. One other rate story is the short-term GBP rates which are now pricing a terminal rate by the BOE at 6.13%, pricing another 5 rate hikes into the curve by the middle of next year.
However, on this risk off day, it is the dollar that is truly king of the world, rallying vs every one of its counterparts in both the G10 and EMG. NOK (-2.2%) is the G10 laggard on the back of general risk aversion as well as the fact that oil prices are tumbling again, down a further -1.25% this morning on the recession fears. But the weakness is pervasive with AUD (-1.0%) weak and the euro (-0.7%) giving up chunks of its recent gains in short order. Interestingly, the yen (-0.1%) is the best performer in the G10. The picture in the emerging markets is similar, with substantial losses across the board led by TRY (-1.3%) and ZAR (-1.1%). Of course, Turkey’s lira is destined to continue collapsing given the dysfunctional monetary policy there, but ZAR is feeling the pressure of declining metals prices, especially gold, which is down again this morning and now pressing $1900/oz. Meanwhile, China’s renminbi continues to slide, trading to new lows for this move with the dollar marching inexorably higher.
On the data front, today brings Flash PMI data (exp 48.5 Manufacturing, 54.0 Services, 53.5 Composite) and that’s it. Two more Fed speakers, Bullard and Mester, are due to speak and both have been leading hawks so we know what to expect. So, looking at the rest of the session, I suspect that the dollar will maintain most of its gains, but do not be surprised to see a little sell off as we head into the weekend and positions are reduced.
Good luck and good weekend
Adf
4% is the New 2%
The Kingdom that’s sort of United Reported inflation’s ignited And simply won’t fall Regardless of all The rate hikes that they’ve expedited But of more importance today Is hearing what Jay has to say He’ll speak to the House Whose members will grouse Though their views will not hold much sway
Starting with the first big data point, CPI in the UK was higher than expected yet again, printing at 8.7%, unchanged from April’s reading and above the 8.4% consensus expectation. Core CPI actually rose further, to 7.1%, a new high reading for the current bout of inflation and an indication that thus far, the BOE has not been very effective in fighting inflation. The market response was mostly in line with what one would expect as the equity market sold off alongside Gilts as yields climbed further. In fact, 2yr Gilt yields are now above 5.0% for the first time since 2008 and the UK yield curve is also steeply inverted, albeit not as steeply as the US curve. As well, the OIS market is now pricing a one-third probability of a 50bp rate hike by the BOE when they meet tomorrow. But weirdly, the pound is under pressure this morning. It is the worst performing G10 currency (-0.4%) and unlike most recent market reactions, where higher interest rates lead to currency strength, it has a throwback feel to your old International Finance textbooks where higher inflation leads to currency weakness.
Arguably, the biggest problem that Governor Bailey has right now is that it doesn’t seem to matter what the BOE does, prices are continuing to rise. My sense is that interest rate hikes may not be the right medicine for the UK’s current ailments (which could well be true in the US) as the genesis of this inflation is not excessive economic growth driving demand but rather fiscal policy profligacy driving demand. If it is the latter, then higher interest rates may only exacerbate the inflation situation as the increased cost of debt service simply adds to the growing budget deficit which increases the amount of money available for people to spend. Consider, if one owns 2yr Gilts yielding 5%, the amount of income available to that person/entity is far greater than when 2yr Gilts were yielding 1% two years ago and so there is more money to spend. Just like in the US, the employment situation in the UK remains tight and wages are rising along with interest rates. In other words, there is a lot more money floating around chasing goods, a pretty surefire recipe for increasing inflation. Alas, this idea doesn’t fit well within the Keynesian dogma so I fear things will take a long time to recover in the UK.
Turning to the US, this morning we will hear from Chairman Powell for the first time since the FOMC meeting a week ago as he testifies before the House Financial Services Committee. While it is always difficult to anticipate what types of questions people like Representative Maxine Waters (who thankfully no longer chairs this committee) will ask, I expect that there will be a lot of discussion regarding whether the Fed should continue tightening policy in the face of recent softer, albeit still high, inflation readings, and what is being done about issues like bank safety and oversight. I am also quite confident that there will be questions/demands for the Fed to do something about climate change although Chairman Powell has already made clear it is not in their mandate.
However, ex ante, trying to assess what Powell is likely to say, I would estimate he will continue with the current Fed mantra of inflation remains far too high and that they are going to bring the rate of inflation back to their 2% target. He is also likely to admit that doing so will cause pain via rising unemployment, something no Congressman/woman is going to want to hear. But just like in the UK as explained above, it is entirely possible that the Fed’s reading of the current situation may not be accurate. The playbook, as written by Paul Volcker, explains that the way to squash inflation is to raise interest rates high enough to cause a recession, kill demand and watch price increases end. And that worked well in 1980-1982 as the US was dealing with both rising commodity prices as well as a demographic boom as Baby Boomers were entering the workforce along with women and there was a significant uptick in activity and productivity.
The problem for Powell, who came of age during that period, is that is not very descriptive of today’s economy. Instead, we have just come through a massive fiscal policy spend on the back of the pandemic response (similar to the end of a war) but the demographics are far less impactful as population is growing far more slowly and the working population is growing even slower. Higher interest rates have increased the income for retirees and allowed them to increase demand as they spend that newfound money. I’m not saying that cutting rates is the right path, just that raising them a lot more may not be very effective either. Fiscal discipline would be a far more effective tool to fight inflation in the current environment I believe. Alas, that is something that simply no longer exists. As such, I fear that we are going to see inflation remain much higher than we had become used to for a much longer time. I expect 4% is the new 2%.
At any rate, ahead of the Powell comments, which begin at 10:00am, this is what we’ve seen overnight. Japanese equities continue to rock, rising again and now up nearly 29% YTD in yen terms. The Nikkei has reached its highest level since December 1989, although has not yet passed the peak set in September of that year. However, Chinese equities are on a completely different trajectory right now, with both the Hang Seng and mainland indices down on the year. It seems investors are not enamored of President Xi’s economic leadership right now. As to Europe, it is mostly softer, albeit not by much and US futures are similarly down slightly ahead of the opening.
Bond yields are edging higher outside of the UK with Treasuries back up 3bps and most of the continent up around 1bp. Looking at Treasury activity lately, it has been choppy but not trending either higher or lower and sits in the middle of the 3.50% – 4.0% range that has defined trading since September.
Oil prices are little changed this morning and are also hanging about in a range lately as the market tries to determine the supply/demand function. Is China growing enough to increase demand substantially? How much oil is Iran getting into the market? These are the questions that have no clear answers so visibility into trends is limited. Meanwhile, gold got clobbered yesterday on dollar strength and the base metals had a similar response.
Finally, the dollar remains stronger rather than weaker overall, rallying yesterday against most of its counterparts and holding the bulk of those gains. Today’s outlier is KRW (-0.9%) which suffered after the release of its export data showed a 12.5% decline of exports to China. In truth, this bodes ill for both currencies, the won and the renminbi, which saw the offshore version trade through 7.20 last night for the first time in this move. As I have written before, this has further to go.
There is no data today so basically, all eyes will be on the tape at 10:00 to hear what Powell has to say and how he responds to the questions. For now, the market is losing conviction that another rate hike is coming, although there is no indication from Fed speakers that they have changed their view. Next week, we will see the PCE data, and I suspect much will depend on how that prints before any new views can be expressed. In the meantime, the dollar is caught between a sense of risk-off and a sense the Fed may be done. Choppy is the name of the game.
Good luck
Adf
Possibly Burst
It turns out inflation’s not dead
At least in the UK, instead
With prices there surging
The market is purging
All thoughts rate cuts might be ahead
However, elsewhere, there’s concern
That soon there will be a downturn
Thus, stocks have reversed
And possibly burst
The bubble for which most folks yearn
Interestingly, inflation discussions are really beginning to diverge around the world. What had been a global phenomenon, with prices rising everywhere on the back of pandemic lockdown induced shortages combined with massive fiscal stimulus pumping up demand, is starting to shake out a bit more idiosyncratically. While in the US we have seen a clear reduction in the trend of prices over the past year, albeit still far above the Fed’s comfort level, elsewhere, this is not necessarily the case. Today’s example is the UK, where CPI printed at 8.7%, far above the median forecast of 8.2%, although mercifully lower than last month’s 10.1%. However, core CPI, which excludes energy, food, alcohol and tobacco in the UK, rose to 6.8%, a new high level for this bout of inflation and the highest in the UK since 1992.
One cannot be surprised that the market responded with Gilt yields jumping more than 6bps while the rest of global bond markets have seen yields decline in the face of a broad risk-off sentiment. More impressively, the OIS market has immediately priced in more than 30bps of additional rate hikes before the end of the year this morning. While UK stocks are lower, so are equity markets everywhere around the world and perhaps most surprisingly, the pound has only fallen -0.2%. I suspect that is due to the tension of higher interest rates supporting the currency while worries over the future of policy and the economy are undermining it. That said, year-to-date, the pound is still the best performing G10 currency vs. the dollar, with gains on the order of 2.5%. If pressed, I would expect that the pound is likely to range trade going forward as the market continues to reprice Fed expectations higher (removing those forecast rate cuts) while the UK side remains stagnant for now.
Turning our attention to the economy writ large, there is a growing sense that the widely expected recession is coming soon to a screen near you. Data continues to show weakening trends with, for instance, today’s German IFO Expectations falling to 88.6, far below forecasts, on the back of weakening manufacturing trends in Germany. As well, yesterday’s US data had its lowlights with the flash manufacturing PMI falling to 48.5, while the Richmond Fed Manufacturing Index fell to -15, both well below expectations. Layer on the background debt ceiling concerns, where the most recent word is that talks have stalled right now, and there is plenty of reason to turn pessimistic on things. Arguably, these were keys to yesterday’s equity market declines in the US and we have continued to see red on the screens in every market in Asia and Europe.
One of the biggest market concerns is China, where talk of slowing growth is continuing as this month’s production and investment data, released last week, was generally softer than expected with property continuing to drag things down, but fixed assets in general softening further. There continue to be expectations that the PBOC is going to be easing monetary policy further and the renminbi’s recent slide shows no signs of stopping. This view is also evident in commodity markets, specifically metals markets where copper (-1.5% today, -4.1% in the past week) and aluminum (-0.6%, -3.7%) are under increased pressure as concerns over slowing Chinese growth are impacting demand for these key industrial metals.
There is, however, one place where this is not so evident, oil prices (+1.5%) as the market continues to respond to prospective production cuts by OPEC+ in the coming months. The thing about oil is that its demand elasticity is nearly vertical. Certainly, at the margins there can be more or less demand based on the economic conditions extant, but there is a baseline of demand that is simply not going to disappear. It is important to remember that despite all the efforts at reduction in the use of fossil fuels, global oil demand hit a record last year. It is also key to remember that for the past decade, investment in the production of new oil and gas reserves has been severely lacking. The implication is that while oil prices have fallen well below the highs seen in the immediate wake of the Russian invasion of Ukraine, nothing has changed the long-term supply demand equation which greatly favors demand over supply, i.e. oil prices are likely to rise consistently, if not steadily, over the coming decades.
Summing it all up, today appears to have investors and traders thinking the worst, not the best of things going forward.
A quick look at overnight markets shows that equity market declines have largely been greater than -1.0% with the biggest markets, DAX, CAC, FTSE 100, pushing -2.0%. There has been no place to hide here, and from a technical perspective, yesterday’s price action looks like an outside bearish reversal, which simply means that the closing level has market technicians selling for right now. We have seen a significant equity rally in the face of a lot of negative news, so perhaps that run is now over.
Global bond yields are consolidating recent gains, with small declines today not nearly enough to offset what had been 30bp-40bp increases in the past two weeks. In this market, clearly the debt ceiling talks are the primary story with macroeconomics a distant second for now. There is just one week before the X-date, at least the latest one, and I suspect that we will hear of an agreement early next week helping to reduce at least some of the pressure on risk attitudes.
Lastly, the dollar is largely stronger this morning with an outlier in NZD (-1.85%) which fell sharply after the RBNZ essentially promised that last night’s 25bp rate hike, to 5.50%, is the last one coming, a big change from market expectations of a 50% probability of a 50bp hike last night. Essentially, they explained that property market pressures and slowing consumer activity convinced them rates are appropriate to fight inflation. Kiwi dragged Aussie (-0.5%) lower as well, but the rest of the bloc has seen far less damage with the yen (+0.15%) actually managing a small gain. But make no mistake, over the past week and month, the dollar has regained its footing, at least against the G10.
In the emerging market bloc, the picture is more mixed with both winners and losers overnight with HUF (+0.8%) the leader, bouncing after the central bank cut its Deposit rate by 1 full percentage point yesterday, as expected and the forint fell sharply. Meanwhile, MXN (+0.6%) is also showing signs of life after having fallen every day in the past week as the market now assumes Banxico has finished its rate hikes. On the downside, MYR (-0.45%) and KRW (-0.4%) are both feeling the pressure of the weaker Chinese growth story given its importance to their own economies.
On the data front, the FOMC Minutes are released this afternoon and have a chance to be quite interesting given what appears to be the beginning of a split of opinions regarding the appropriate next steps. As well, we hear from Governor Waller around lunch time, and ahead of the Minutes. Waller certainly leans toward the hawkish end of the spectrum, so keep that in mind.
Adding it all up and the combination of declining risk appetite and a growing belief that the Fed is not going to pivot anytime soon implies that the dollar should maintain its footing for now.
Good luck
Adf
Every Reason
While prices in Europe are leaping
According to Christine’s bookkeeping
She’s got “every reason”
To keep on appeasin’
The ECB doves who are sleeping
So, rather than look to the Fed
She’s focused on China instead
Where they just cut rates
As growth there stagnates
And Covid continues to spread
One has to wonder exactly what Christine Lagarde is looking at when she makes comments like she did this morning. Specifically, she said the following in a radio interview in France, [emphasis added] “We have every reason to not react as quickly and as abruptly as we could imagine the Fed might, but we have started to respond and we, of course, stand ready to respond with monetary policy if figures, data, facts, require it.” Remember, the ECB has a single mandate, achieving price stability which they define as 2% inflation over the medium term. With this in mind, let me recount this morning’s data, which clearly has Madame Lagarde nonplussed: German Dec PPI +5.0% M/M and +24.2% Y/Y, the highest figures ever in the history of German record keeping back to 1949. Eurozone Dec CPI +0.4% M/M and 5.0% Y/Y, also the highest since the creation of the Eurozone. I realize I am a simple FX salesman, but to my uneducated eye, those indications of inflation seem somewhat above 2.0%. Perhaps mathematics in France is different than here in the US, but I would challenge Madame Lagarde to explain a bit more carefully why, despite all evidence to the contrary, she thinks the ECB is acting in accordance with their mandate. I suspect there are about 83 million people in Germany who may be wondering the same thing.
Certainly, traders do not believe her or her colleagues when they say, as Pablo Hernandez de Cos did “an increase in interest rates is not expected in 2022.” De Cos is the head of the Spanish central bank and a Governing Council member and clearly not a hawk. Yet, the OIS market in Europe is pricing in 0.20% of rate hikes by the end of 2022 (the ECB has been moving in 10 basis point increments), so two rate hikes. I also realize that there appear to be many econometric models around that are forecasting a return to much lower inflation within the next twelve months, certainly those are the models the central banks themselves are using. It seems that the real question is at what point will the central banks, specifically the Fed and ECB, recognize that their models may not be a very accurate representation of reality? And I fear the answer is, never!
Perhaps Madame Lagarde was channeling Yi Gang, the PBOC’s Governor, although the situation on the ground in China is clearly different than that in Europe. For instance, after cutting two important interest rates last Friday, the PBOC cut two different interest rates last night, the 1-year loan prime rate by 0.10% down to 3.70%, and the 5-year rate was cut by 5 basis points to 4.60%. China continues to struggle with their zero covid policy. They continue to fall behind the curve there as the omicron variant is so incredibly transmissible. But what is clear is that China is growing increasingly concerned over the pace of growth in the economy and so the PBOC has begun to act even more aggressively. While 5 and 10 basis point moves may not seem like a lot, given how infrequently the PBOC has been willing to cut interest rates, they are an important signal to market participants that support is at hand. This was made clear by the equity markets last night where the Hang Seng, home to so many property companies, exploded higher by 3.4% although Shanghai’s market was quite subdued, actually slipping 0.1%.
In the end, it is clear that global synchronicity is not an appropriate way to think about the current macroeconomic situation. Given the dramatically different ways that different nations approached the Covid pandemic, it should be no surprise that there are huge differences in rates of growth and inflation around the world. The hedging implications of this outcome are that it will require more specific analysis of each country in which there is an exposure to determine the best way to mitigate risks there.
With that in mind, let us take a look at markets this morning. Despite Shanghai’s lackluster performance, the rest of Asia was actually quite solid with the Nikkei (+1.1%) rounding out the top markets. Europe, on the other hand, has been less positive with the DAX (+0.1%) edging higher while both the CAC (-0.1%) and FTSE 100 (-0.1%) are slipping a bit. I guess more promises of ongoing policy ease were not enough to overcome the soaring inflation story on the continent. US futures are all pointing higher at this hour, with NASDAQ (+0.9%) leading the way although that index has fallen by 10% from its highs, so has more room to catch up.
Looking at the bond market, I can’t help but wonder if we have seen peak hawkishness earlier this week, at least for the Fed. After the long weekend, we saw the 10-year Treasury yield trade up to 1.88%, but since then it has slipped back with today’s price action seeing yields fall an additional 2.7 basis points and placing us 4bps off those highs. Now, this could simply be a short-term correction, but with the Fed announcement next week, it really does feel like the market has gotten way ahead of itself. At this point, the only way next week’s FOMC could be seen as hawkish would be if they actually raised rates, something to which I ascribe a zero probability. One other thing to recall is that recent surveys continue to show a large contingent of fund managers believe that inflation is transitory which implies that they are likely to take advantage of the current rise in yields and prevent things from running away.
On the commodity front, oil (-0.4%) has stopped running higher, although this pause seems much more like a consolidation than a change in views. NatGas (-1.5%) is also a bit softer today in both the US and Europe as seasonal or higher temperatures continue to reduce marginal demand. Turning to metals markets, gold (-0.2%) is slightly softer this morning, but overall, despite rising interest rates, has held up quite well lately and remains well above the $1800/oz level. Interestingly, silver (0.0% today +4.6% this week) seems to be having a much better time of things and technically looks to have broken out higher. Arguably, this information blends well with the thought that bond yields may have peaked, but we shall see.
As to the dollar, it is mixed this morning with both gainers and losers in both the G10 and EMG spaces. The funny thing is, other than RUB (-0.6%) which is leading the way lower today on the back of threats of more substantial sanctions in the event Russia does invade the Ukraine, the rest of the story is much harder to pin down. For instance, from a news perspective Bank Indonesia met last night and left rates on hold, as expected, but indicated that it would begin normalizing monetary policy in March, returning its RRR to its pre-covid levels, but the rupiah only rose 0.2%. In fact, today’s leading gainer is ZAR (+0.75%), but given the dearth of either data or news, the best bet here seems to be a response to precious metals strength. One other thing to remember is that despite easing by the PBOC, the renminbi continues to edge higher. Frankly, I see no reason for it to weaken anytime soon, especially with my view the dollar will be suffering going forward.
On the data front, Initial Claims (exp 225K), Continuing Claims (1563K), Philly Fed (19.0) and Existing Home Sales (6.43M) are on the calendar. Remember, Empire Manufacturing was a huge bust earlier this week, so watch the Philly Fed number for any indication of weakness and slowing growth here at home. In fact, it is that scenario that will allow the Fed to remain on the dovish side, although I fear it will not slow down the inflation train.
If there are any inklings that the Fed is not going to be as hawkish as had seemed to be believed just a few days ago, I expect that the dollar will come under further pressure. In fact, in order to change that view we will need to see a very hawkish outcome from next Wednesday’s FOMC, something I do not anticipate. Payables hedgers, I fear the dollar may be near its peak, so don’t miss out.
Good luck and stay safe
Adf
Confidence Wilts
As central banks worldwide prepare
To raise rates investors don’t dare
Buy bonds, bunds or gilts
While confidence wilts
Defining Jay Powell’s nightmare
The upshot is negative rates
Are no longer apt for long dates
But we’re still a ways
From NIRP’s end of days
While Christine and friends have debates
Whatever else you thought mattered to markets (e.g. Russia/Ukraine, oil prices, omicron) you were wrong. Right now, there is a single issue that has every pundit’s tongue wagging; the speed at which the Fed tightens policy. Don’t get me wrong, oil’s impressive ongoing rally feeds into that discussion, but is clearly not the driver. So too, omicron’s impact as it spreads rapidly, but seems clearly to be far less dangerous to the vast majority of people who contract the disease. As to Russia and the widespread concerns that it will invade the Ukraine shortly, that would certainly have a short-term market impact, with risk appetite likely reduced, but it won’t have the staying power of the Fed tightening discussion.
So, coming full circle, let’s get back to the Fed. The last official news we had was that tapering of asset purchases was due to end in March with the Fed funds rate beginning to rise sometime after that. Based on the dot plot, expectations at the Eccles Building were for three 0.25% rate increases this year (Jun, Sep and Dec). Finally, regarding the balance sheet, expectations were that process would begin at a modest level before the end of 2022 and its impact would be minimal, you remember, as exciting as watching paint dry. However, while the cat’s away (Fed quiet period) the mice will play (punditry usurp the narrative).
As of this morning, the best I can figure is that current market expectations are something along the following lines: QE will still end in March but the first of at least four 0.25% rate hikes will occur at the March FOMC meeting as well. In fact, at this point, the futures market is pricing in a 12.5% probability that the Fed will raise rates by 0.50% in March! In addition, regarding the balance sheet, you may recall that in 2017, the last time the Fed tried to reduce the size of the balance sheet, they started at $10 billion/month and slowly expanded that to $50 billion/month right up until the stock market tanked and they reversed course. This time, the punditry has interpreted Powell’s comments that the runoff will be happening more quickly than in 2017 as a starting point of between $40 billion and $50 billion per month and rising quickly to $100 billion/month as they strive to reach their target size, whatever that may be.
The arguments for this type of action are the economy is much stronger now than it was in 2017 and, more importantly, inflation is MUCH higher than it was in 2017, as well as the fact that the balance sheet is more than twice the size, so bigger steps are needed. Now, don’t get me wrong, I am a strong proponent of the Fed disentangling itself as much as possible from the markets and economy, however, I can’t help but wonder if the Fed moves according to the evolving Street narrative, just how big an impact that will have on asset markets. Consider that since the S&P 500 traded to its most recent high on January 4th, just 2 weeks ago, it has fallen 5.0%. The NASDAQ 100 has fallen 10.5% from its pre-Thanksgiving high and 8.5% from its level on January 4th. Ask yourself if you believe that Jay Powell will sit by and watch as a much deeper correction unfolds in equity markets. I cannot help but feel that the narrative has run well ahead of reality, and that next week’s FOMC meeting is going to be significantly more dovish than currently considered. We have seen quite substantial market movement in the past several weeks, and if there is one thing that we know for sure it is that central banks abhor sharp, quick movement in markets, whether higher (irrational exuberance anyone?) or lower (Powell pivot, “whatever it takes”.)
The argument for higher interest rates is clear with inflation around the world (ex Japan) soaring, but central bankers are unlikely, in my view, to tighten as rapidly as the market now seems to believe. They simply cannot stand the pain and more importantly, fear the onset of a recession for which they will be blamed. For now, though, this is the only story that matters, so we have another week of speculation until the FOMC reveals their latest moves.
Ok, so yesterday was a massive risk-off day, with equities getting clobbered while bonds sold off sharply on fears of central bank actions. In fact, the only things that performed well were oil, which rose 2.7% (and another 1.5% this morning) and the dollar, which rallied against virtually all its G10 and EMG counterparts. Overnight saw the Nikkei (-2.8%) follow in the footsteps of the US markets although the Hang Seng (+0.1%) and Shanghai (-0.3%) were far more sanguine. Interestingly, European bourses are mostly green today (DAX +0.25%, CAC +0.55%, FTSE 100 +0.25%) despite further data showing inflation is showing no sign of abating either on the continent (German CPI 5.7%) or in the UK (CPI 5.4%, RPI 7.5%). As to US futures, +0.2% describes them well at this hour.
Bond markets remain under severe pressure with yields higher everywhere except China and South Korea. Treasuries (+1.4bps) continue their breakout and seem likely to trade to 2.0% sooner rather than later. Bunds (+2.6bps and yielding +0.003%) have traded back to a positive yield for the first time since May 2019. Of course, with inflation running at 5.7%, that seems small consolation. OATs (+2.4bps) and the rest of the continental bonds are showing similar yield rises while Gilts (+5.2bps) are leading the way lower in price as investors respond to the higher than already high expectations for inflation this morning. Remember, the BOE is tipped to raise the base rate as well next week, but the global impact will be far less than whatever the Fed does.
Oil prices continue to soar as the supply/demand situation continues to indicate insufficient supply for growing demand. This morning, the IEA released an update showing they expect demand to grow by an additional 200K barrels/day in 2022 while OPEC+ members have been unable to meet their pumping quotas and are actually short by over 700K barrels/day. I don’t believe it is a question of IF oil is going to trade back over $100/bbl, it is a question of HOW SOON. Remember, with NatGas (-0.5% today) still incredibly expensive in Europe, utilities there are now substituting oil for gas as they try to generate electricity, adding more demand to the oil market. And remember, none of this pricing includes the potential ramifications if Russia does invade the Ukraine and the pipelines that run through Ukraine get shut down.
Finally, the dollar is retracing some of yesterday’s substantial rally, falling against all its G10 brethren (NOK +0.45%, AUD +0.4%, CAD +0.3%) led by the commodity currencies, and falling against most of its EMG counterparts with RUB (+1.4%) and ZAR (+1.05%) leading the way. The former is clearly benefitting from oil’s sharp rally, but also from rising interest rates there. Meanwhile, a higher than expected CPI print in South Africa, (5.9%) has analysts calling for more rate hikes there this year and next with as much as 250bps expected now.
On the data front, yesterday saw a horrific Empire Manufacturing outcome (-0.7 vs. exp 25.0), clearly not a positive sign for the economic outlook. This morning brings only Housing Starts (exp 1650K) and Building Permits (1703K), neither of which seem likely to move the needle.
With the Fed silent, the narrative continues to run amok (an interesting visual) but that is what is driving markets right now. This is beginning to feel like an over reaction to the news we have seen, so I would be wary of expecting a continuation of yesterday’s risk-off sentiment. While we will almost certainly see some more volatility before the FOMC announcements next week, it seems to me that we are likely to remain within recent trading ranges in the dollar rather than break out for now.
Good luck and stay safe
Adf
Buying Will Stop
It seems nearly every day now
Some Fed members make the same vow
First buying will stop
Next Fed funds will pop
Then asset run-off we’ll allow
Thus far markets have been subdued
Though some players now have construed
That buying the dip
Has lost all its zip
While selling all rallies is shrewd
Another day, another series of Fed speakers explaining that inflation is the primary focus, that when QE stops in March it may (read will) be appropriate to raise the Fed Funds rate by 0.25% and that the Fed has powerful tools to prevent inflation from getting out of hand. While it is encouraging that they have finally figured out inflation is a problem, the fact that they still don’t understand it is a problem of their own making is somewhat disconcerting. However, moving in the right direction is clearly a positive.
So, after Brainerd, Waller, Barkin and Evans all basically said the same thing, here is what we know. It seems a virtual certainty that the Fed Funds rate will be raised at the March meeting with a very high likelihood of at least two more hikes as the year progresses. Mr Waller even suggested more than four total this year, although that is clearly a minority view, right now, on the FOMC. The problem is that 25 basis point increments every 12 weeks is not going to make much of a dent in inflation running at 7.0%. And, even if inflation falls back down to 4.0%, it will still take more than three years for the Fed to even reach a point where real yields are back to 0.0%. Not only that, when Waller was asked about 0.50% increments, he dismissed the idea as being destabilizing for markets. (Yet again we can read between the lines and recognize that preventing an equity market decline remains the Fed’s primary focus regardless of recent comments on inflation.)
But back to the real yield story. It is important to understand that negative real yields are not a bug in their plans, they are the feature. Negative real yields are the only way for the US (and every overly indebted nation) to reduce the value of their debt without a technical default. The Fed knows this playbook from their actions in the wake of WWII, where they capped yields at 2.50% and inflation ran at 10.0%. A few years later, the debt/GDP ratio had fallen from 125% to 35% and the country’s finances were back in order. That process worked then because the US economy dominated the global economy and essentially everything was manufactured here. Given the dramatic changes that have taken place in the ensuing 80 years, it is not clear that the citizenry in the US will be quite as patient this time, but that is almost certainly the Fed’s plan.
If we assume that real yields are set to remain negative for a long time into the future, what are the likely impacts going to be? First and foremost, real assets like commodities and real estate should perform well and maintain their value if not appreciate. Bonds, on the other hand, will have a tougher time, although there are many things which may help support them, not least of which would be a reversal of policy by central banks. Equities are going to find themselves segregated into companies that have businesses and are profitable and those that have benefitted from the ongoing monetary largesse of the central banks and may find that funding their businesses will get more difficult. In other words, credit is going to matter going forward in this environment. Finally, the dollar’s behavior will be contingent on just how other nations approach the real yield question. For those countries that follow sound money policies, and seek to end financial repression, their currencies should benefit. However, all signs are pointing, at this time, to the fact the US will not be considering sound money policies as they are short-term politically unpalatable, and the dollar will underperform going forward. I apologize for the dour message on a Friday, but the constant Fed blather becomes difficult to tune out after a while.
Ok, here’s what we have seen overnight. Yesterday’s tech rout in the US took equity markets lower across the board and that was followed in Asia as well (Nikkei -1.3%, Hang Seng -0.2%, Shanghai -1.0%). Europe, too, is in the red with fairly solid declines in the DAX (-0.6%) and CAC (-0.6%) although the FTSE 100 (-0.1%) is outperforming after November GDP data showed surprisingly strong growth in the UK across both manufacturing and services. Meanwhile, US futures are hovering either side of unchanged although NASDAQ futures have recently turned down a bit more aggressively.
An interesting feature of today’s price action is that not only are stocks being sold, but so are bonds, and everywhere. Treasury yields are higher by 3.0bps, although that is simply unwinding yesterday’s rally where yields fell a similar amount. European sovereigns are also selling off with yields higher across the board (Bunds +2.4bps, OATs +2.4bps, Gilts +2.8bps). While the positive news from the UK seems a rationale for the Gilt market, German GDP actually fell in Q4 bringing their Y/Y number down to 2.7% and one would have thought that might support Bunds.
Where, you may ask, are investors hiding if they are selling both stocks and bonds? Commodities are looking better this morning with oil (+0.7%) continuing its recent rally although NatGas (-2.6%) remains beholden to the winter weather. A warmer day here in the Northeast is undermining the price. Precious metals (Au +0.1%, Ag +0.2%) are both on the right side of unchanged and most industrial metals are doing well (Cu -0.7%, Zn +1.9%, Sn +2.3%). Agricultural prices are also beholden to the weather so are seeing a mixed bag this morning.
Finally, the dollar is mixed this morning, with an equal set of gainers and losers in both the G10 and EMG blocs. JPY (+0.3%) is the leader in the clubhouse as the very obvious risk-off sentiment is encouraging repatriation of funds while AUD (-0.3%) is the laggard, seemingly on the back of the hawkish Fed comments (or perhaps on the fact that Novak Djokovic will not be playing in the Australian Open after all!) In the emerging markets RUB (-0.6%) is the worst performer on the back of fears of further sanctions as the Ukraine situation continues to escalate, while INR (-0.35%) has also suffered overnight, this more on the talk of Fed hawkishness. However, after those two, decliners have moved very little, certainly not enough to make a case about anything in particular. On the plus side, CLP (+0.5%) and ZAR (+0.4%) are the leaders. The peso is following yesterday’s strength with more as traders anticipate more hawkishness from the central bank while the rand is trading on the back of some key technical levels having been breached and pointing to yet more strength short-term.
Data this morning brings Retail Sales (exp -0.1%, +0.1% ex autos) as well as IP (0.2%), Capacity Utilization (77.0%) and Michigan Sentiment (70.0). Yesterday’s PPI data did nothing to dispel the idea that inflation is well entrenched in the US economy regardless of what Fed members say in testimony or commentary.
Using the dollar index (DXY) as a proxy, the dollar has fallen 1.5% since this time last week. Heading into this year, dollar bullishness was rampant as expectations for much tighter Fed policy were seen as likely to push the dollar higher. However, the early price action is beginning to dispel that notion. I have a feeling that we are going to see investors sell dollar rallies at the same time they sell equity rallies. This is a huge sentiment change from the previous “buy the dip” mentality that had been prevalent since Ben Bernanke first introduced QE all those years ago. Caveat emptor is the new watchword, for both stocks and the dollar.
Good luck, good weekend and stay safe
Adf
Out of Place
The holiday season has passed
And this year the reigning forecast
Is for higher rates
Right here in the States
Thus, dollars will soon be amassed
But frequently, as is the case
Consensus is, here, out of place
Though some nations will
Raise rates, like Brazil
The Fed soon will turn about-face
Reading the many forecasts that are published this time of year, the consensus certainly appears to be that the Fed is going to continue to tighten policy and the only question is how soon they will begin raising interest rates; March, May or June? The Fed narrative has evolved from there is no inflation, to inflation is transitory to inflation is persistent and we will address it with our tools. But will they? Since Paul Volcker retired as Fed Chair (1979-1987) we have had a steady run of people in that seat who like to talk tough, but when there is any hiccup in the market, are instantly prepared to add more liquidity to the system. Starting with the Maestro himself, in the wake of the October 1987 stock market crash, to Bennie the Beard, the diminutive Ms Yellen and on up to today’s Chair Powell, history has shown that there is always a reason NOT to tighten policy because the consequences of doing so are worse than those of letting things run hotter. Ultimately, I see no reason for this time to be any different than the past 35 years and expect that as interest rates begin to climb here, and equity markets reprice assumptions, the Fed will not be able to withstand the pain.
But for now, the higher US interest rate story remains front and center. This was made clear yesterday when 10-year yields rallied 12 basis points in a thin session, trading back to levels last seen in November. Perhaps not surprisingly, the dollar reversed its late year losses as well, rallying vs. almost all its counterparts with the yen (-0.7%) by far the worst performer in the G10. It seems that the Japanese investor community has decided that a 155 basis point spread in the10-year, in an environment where expectations for a stronger dollar are rampant is a sufficient reason to sell yen and buy dollars.
And the truth is that given inflation is a global phenomenon these days, there are only a handful of nations where expectations don’t include higher interest rates. For instance, Japan, though they have stopped QE are not even contemplating higher interest rates. The ECB has indicated QE will be reduced to some extent (they claim cut in half, but I will believe that when I see it) but is certainly not considering higher interest rates. Turkey is kind of a special case as President Erdogan continues to try his unorthodox inflation fighting methodology, but if the currency reprises the late 2021 collapse, which is entirely realistic, if not probable, that is subject to change.
However, there is one more nation of note that is almost certainly going to be working against the grain of higher interest rates this year, China. President Xi has a growing list of economic problems that will result in further policy ease regardless of any inflationary consequences at this time. The fundamental flaw is the Chinese property market, which has obviously been under severe pressure since the problems at China Evergrande came to light. This is fundamental because it represents more than 30% of the Chinese economy and has been THE key reason that Chinese GDP has been growing as rapidly as it has over the past two decades. With Evergrande and several (many?) other property developers going to the wall, the property sector is going to have a much slower growth trajectory, if it is positive at all, and that is going to drag on the entire economy. After all, if they are not going to build ghost cities (Evergrande’s specialty), they don’t need as much concrete, steel, copper, etc., and the whole support framework that has been created for the industry will slow down as well. The upshot is that the PBOC seems highly likely to continue to ease policy in various ways including RRR cuts, as well as reductions in interest rates.
On the surface, one would expect that to work against CNY strength and fit smoothly with the stronger dollar thesis. However, the competing view is that President Xi is more focused on the long-term viability of the renminbi as a stable store of value and strong currency, and I expect that imperative will dominate this year and in the future. Thus, while your textbooks would explain the renminbi should fall, I beg to differ this year. We shall see as things evolve.
Ok, starting the year, there is clearly a solid risk appetite. Yesterday saw strong gains in the US equity market which was followed by the Nikkei (+1.8%) last night, although Shanghai (-0.2%) and the Hang Seng (0.0%) failed to follow suit. Europe (DAX +0.7%, CAC +1.4%, FTSE 100 +1.4%) are all bullish this morning as are US futures (+0.35% across the board). Record Covid infections are clearly not seen as a problem anymore.
After yesterday’s dramatic sell-off in Treasuries, this morning yields there have consolidated and are essentially unchanged. In Europe, though, there has been a mixed picture with Gilts (+8.3bps) following the US lead, while the continent (Bunds -1.5bps, OATs -2.5bps) are clearly more comfortable that interest rates have no reason to rise sharply there anytime soon.
In the commodity markets, oil (+0.3%) is continuing its run higher from last year and, quite frankly, shows no sign of stopping. This is a simple supply demand imbalance with not nearly enough supply for ongoing demand. NatGas (+1.8%) continues to trade well as cold weather in the NorthEast and much of Europe and a lack of Russian deliveries to the continent continue to demonstrate the supply demand imbalance there as well. Gold (+0.25%) has bounced after getting roasted yesterday, although it spent the last weeks of the year grinding higher, so we remain around $1800/oz. Industrial metals, though, are mixed with copper (-0.8%) under some pressure while aluminum (+1.4%) and zinc (+2.4%) are both having good days.
As to the dollar, aside from the yen’s sharp decline, the rest of the G10 is +/- 0.15% or less, not enough to consider for a story rather than position adjustments at the beginning of the year. In the EMG space, though, the dollar has had a bit more positivity with ZAR (-0.9%) and RUB (-0.8%) the worst performers (I need to ignore TRY given the insanity ongoing there). In both cases, rapidly rising inflation continues to outpace the central bank efforts to rein it in and the currency is weakening accordingly. In fact, that is largely what we are seeing throughout this bloc, with central banks throughout lagging the rise in prices. In the EMG space, this trend has room to run.
On the data front, we get a decent amount of stuff this week, culminating in the payroll report:
| Today | ISM Manufacturing | 60.0 |
| ISM Prices Paid | 79.3 | |
| JOLTS Job Openings | 11,100K | |
| Wednesday | ADP Employment | 420K |
| FOMC Minutes | ||
| Thursday | Initial Claims | 195K |
| Continuing Claims | 1682K | |
| Trade Balance | -$81.0B | |
| Factory Orders | 1.5% | |
| -ex transport | 1.1% | |
| ISM Services | 67.0 | |
| Friday | Nonfarm Payrolls | 424K |
| Private Payrolls | 384K | |
| Manufacturing Payrolls | 35K | |
| Unemployment Rate | 4.1% | |
| Average Hourly Earnings | 0.4% (4.2% Y/Y) | |
| Average Weekly Hours | 34.8 | |
| Participation Rate | 61.9% |
Source: Bloomberg
In addition to the data, we start to hear from FOMC members again with Kashkari, Bullard, Daly and Bostic all on the calendar this week. My impression is that investors and traders will be looking for hints as to the timing of rates liftoff. But we are a long way from that happening yet.
For now, though, the narrative is clear, and a firmer dollar seems the most likely outcome in the near term.
Good luck and stay safe
Adf
Walking the Walk
Two central banks managed to shock The market by walking the walk The Old Lady jacked By fifteen, in fact Banxico then doubled the talk So, now that it’s all said and done C bankers, a new tale have spun The virus no longer Is such a fearmonger Inflation’s now job number one Talk, as we all know, is cheap, but from the two largest central banks, that’s mostly what we got. While Chairman Powell got a positive market response from his erstwhile hawkish comments initially, yesterday investors started to rethink the benefits of tighter monetary policy and decided equity markets might not be the best place to hold their assets. This is especially true of those invested in the mega-cap tech companies as those are the ones that most closely approximate an extremely long-duration bond. So, the NASDAQ’s -2.5% performance has been followed by weakness around the globe and NASDAQ futures pointing down -0.9% this morning. As many have said (present company included) the idea that the Fed will be aggressively tightening monetary policy in the face of a sharp sell-off in the stock market is pure fantasy. The only question is exactly how far stocks need to fall before they blink. My money is on somewhere between 10% and 20%. Meanwhile, Madame Lagarde continues to pitch her view that inflation remains transitory and that while it is higher than the target right now, by next year, it will be back below target and the ECB’s concerns will focus on deflation again. So, while the PEPP will indeed be wound down, it will not disappear as it is always available for a reappearance should they deem it necessary. And in the meantime, they will increase the APP by €40 billion/month while still accepting Greek junk paper as part of the mix. Even though inflation is running at 4.9% (2.6% core) as confirmed this morning, they espouse no concern that it is a problem. Perhaps the most confusing part of this tale is that the EURUSD exchange rate rallied on the back of a more hawkish Fed / more dovish ECB combination. One has to believe that is a pure sell the news result and the euro will slowly return to recent lows and make new ones to boot. One final word about the major central banks as the BOJ concluded its meeting last night and…left policy unchanged as universally expected. There is no indication they are going to do anything different for a long time to come. However, when you step away from the Big 3 central banks, there was far more action in the mix, some of it quite surprising. First, the BOE did raise the base rate by 15 basis points to 0.25% and indicated that it will be rising all throughout next year, with expectations that by September it will be 1.00%. The MPC’s evaluation that omicron would not derail the economy and price pressures, especially from the labor market, were reaching dangerous levels led to the move and the surprise helped the pound rally as much as 0.7% at one point. Earlier yesterday, the Norges Bank raised rates 25bps, up to 0.50%, and essentially promised another 25bp rise by March. Then, in the afternoon, Banco de Mexico stepped in and raised their overnight rate by 0.50%, twice the expected hike and the largest move since they began this tightening cycle back in June. It seems they are concerned about “the magnitude and diversity” of price pressures and do not want to allow inflation expectations to get unanchored, as central bankers are wont to say. Summing up central bank week, the adjustment has been significant from the last round of meetings with inflation clearly now the main focus for every one of them, perhaps except for Turkey, where they cut the one-week repo rate by 100 basis points to 14.0% and continue to watch the TRY (-7.0%) collapse. It is almost as if President Erdogan is trying to recreate the Weimar hyperinflation of the 1920’s without the war reparations. Will they be able to maintain this inflation fighting stance if global equity markets decline? That, of course, is the big question, and one which history does not show favorably. At least not the current crop of central bankers. Barring the resurrection of Paul Volcker, I think we know the path this will take. This poet is seeking his muse To help him define next year’s views Thus, til New Year’s passed Do not be aghast My note, you’ll not have, to peruse Ok, for my final note of the year, let’s recap what has happened overnight. As mentioned above, risk is under pressure after a poor performance by equity markets in the US. So, the Nikkei (-1.8%), Hang Seng (-1.2%) and Shanghai (-1.2%) all fell pretty sharply overnight. This morning, Europe has also been generally weak, but not quite as badly off as Asia with the DAX (-0.65%) and CAC (-0.7%) both lower although the FTSE 100 (+0.3%) is bucking the trend after stronger than expected Retail Sales data (+1.4%). Meanwhile, Germany has been dealing with soaring inflation (PPI 19.2%, a new historic high) and weakening growth expectations as the IFO (92.6) fell to its lowest level since January and is trending sharply lower. US futures are also pointing lower at this hour. Bond markets, meanwhile, are generally firmer although Treasury yields are unchanged at this time. Europe, though, has seen declining yields across the board led by French OATs (-2.6bps) and Bunds (-1.8bps) with the peripherals also doing well. Gilts are bucking this trend as well, with yields unchanged this morning. In the commodity space, oil (-1.75%) is leading the energy sector lower along with NatGas (-1.9%), but metals markets are going the other way. Gold (+0.5%, and back above $1800/oz) and silver (+0.7%) feel more like inflation hedges this morning, and we are seeing strength in the industrial space with copper (+0.45%), aluminum (+2.1%) and tin (+1.8%) all rallying. Lastly, looking at the dollar, on this broad risk-off day, it is generally stronger vs. its G10 counterparts with only the yen (+0.2%) showing its haven status. Otherwise, NZD (-0.5%) and AUD (-0.4%) are leading the way lower with the entire commodity bloc under pressure. As to the single currency, it is currently slightly softer (-0.1%) but I believe it has much further to run by year end. In the EMG bloc, excluding TRY’s collapse, the biggest mover has actually been ZAR (+0.6%) after it reported that the hospitalization rate during the omicron outbreak has collapsed to just 1.7% of cases being admitted. This speaks to the variant’s less pernicious symptoms despite its rapid spread. Other than that, on the plus side KRW (+0.25%) benefitted from central bank comments that they would continue to support the economy but raise rates if necessary. On the downside, CLP (-0.4%) is opening poorly as traders brace for this weekend’s runoff presidential election between a hard left and hard right candidate with no middle ground to be found. However, beyond those moves, there has been much less activity. There is no economic data today and only one Fed speaker, Governor Waller at 1:00pm. So, the FX market will once again be seeking its catalysts from other markets or the tape. At this point, if risk continues to be shed, I expect the dollar to continue to recoup its recent losses and eventually make new highs. As I mention above, this will be the last daily note for 2021 but the FX Poet will return with his forecasts on January 3rd, 2022, and the daily will follow afterwards. To everyone who continues to read, thank you for your support and I hope everyone has a happy and healthy holiday season. Good luck, good weekend and stay safe Adf
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