Tag Archives: #inflation

The Bottom’s Not In

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Attention this morning’s returned
To Treasuries, where we have learned
The bottom’s not in
As yields underpin
The dollar that once had been spurned

Plus ça change, plus ça même chose.

During the past several weeks, there have been a number of stories that seemed designed to shift our attention away from what has been the major market driver in 2021…the Treasury market.  But despite the Ever Given running aground, despite the forced liquidation of Archegos Capital Management and despite Covid’s resurgence throughout Europe and additional mooted lockdowns there, the clear driver of market activity remains US Treasury yields, specifically in the back end of the curve.  As I type this morning, the 10-year has risen 5.7bps on the session with the yield now 1.765%, its highest level since January 22, 2020.  This movement has dragged up yields across the US yield curve, with 5-year yields fast approaching 1.0% while even 2-year yields, which remain anchored by the Fed’s promises to keep the Fed Funds rate at its current level through at least 2023, has edged up by 1.4 basis points.

And this movement is not isolated to the United States, as sovereign yields across the board are higher today with European markets looking at gains of between 5.5bps and 7.5 bps, while overnight saw Australian yields climb 9.2 basis points.  But it is clearly the Treasury market in the lead.  The current story seems to revolve around the ongoing outperformance of the US economy vis-à-vis those of Europe and much of Asia, the success of the US vaccine program and the promise of yet another fiscal stimulus bill coming from the Biden administration.  That trifecta dwarfs all other nations’ activities and so has seen ongoing flows into US equity markets as well as into the dollar.  And the thing is, for now, it is hard to see what can derail this story in the short-term.  In fact, with the latest payroll data due to be released Friday and expected to show a substantial gain in the number of jobs, while more and more states reduce Covid inspired economic restrictions, things seem like they will only get better.

And perhaps things will only get better.  Perhaps we have passed the worst of the pandemic.  Perhaps all Covid inspired restrictions will be relaxed and people will head back out on vacations and to movies and theme parks. Perhaps shopping malls will regain their allure as people look for anyplace to go that is not inside their own home.  In this case, as the service sector reopens along with the jobs attendant to that process, the Fed would likely be able to justify a very gradual reduction in some of their stimulus.  And this could all happen.  But, so could we wake up tomorrow to learn that pigs really can fly.

Instead, while there is no doubt that the US remains the driving force in the economy right now, as it leads other nations out of the pandemic, the imbalances that have developed due to the policies implemented during the pandemic will take a very long time to unwind.  In addition, they pose a very real threat to the stability of markets and economies.  For instance, how will nations around the world address the issue of the massive rise in their debt/GDP ratios.  While servicing costs right now are tenable given the historically low level of interest rates, investors may well start demanding higher yields to compensate for the growing riskiness of those portfolios.  After all, we have seen many nations default on their debt in the past, with Greece and Argentina just the two latest on the list.

But rising yields will force governments to choose between honoring their debt promises, or paying for their activities, a choice no elected politician ever wants to make.  It is not unreasonable to assume that this choice will be forced on countries by the markets (and in fact, is starting to be forced as we watch yield curves steepen) with two potential outcomes; either the central bank caps yields to insure that debt service remains viable, or the debt is restructured by the central bank who will monetize it.  Either situation will almost certainly result in rising inflation, not of the asset kind, but will also result in a situation where those tools that central banks claim they have to fight inflation will not be available.  After all, if they are capping yields, they cannot very well raise rates to fight inflation.

It is this endgame that has some very thoughtful people concerned, as when this situation has arisen in the past, and after all, there is nothing new under the sun, the result has been a combination of much more significant inflation and debt defaults.  Now, in the US, the idea of a debt default seems quite impossible.  However, the idea of higher inflation, especially given the Fed’s stated desire to see inflation rise, is much easier to accept.  And after all, given the newly stated desire to achieve an average inflation rate, with a desire to see higher than 2.0% inflation readings for some indeterminate amount of time, how will the Fed know when they’ve seen enough?  The point is, the Fed, and every central bank, still has a very difficult task ahead of them to maintain stability while supporting the economy.  And there is no guarantee that their actions will work.

With that joyous thought in mind, a quick look at other markets beyond bonds shows that equities remain supported with widespread gains overnight (Nikkei +0.15%, Hang Seng +0.8%, Shanghai +0.6%), while European bourses are all green as well (DAX +0.6%, CAC +0.55%, FTSE 100 +0.25%).  US futures, however, are starting to fade, led by the NASDAQ (-0.8%) although SPX futures (-0.2%) have turned lower as well.  Remember, the NASDAQ, with its predominantly growth-oriented companies, is similar to a long-term bond, as higher yields reduce the current discounted value of its future growth.

Commodity markets are under pressure this morning as well with oil (-1.5%) falling back a bit further, and both base and precious metals all under the gun.  This commodity story is synchronous with the combination of rising yields and…a rising dollar.  And the dollar continues to rise, against all early year supposition.

Versus the G10, it is higher against all comers, with JPY (-0.5%) leading the way lower and breaking above 110 for the first time in a year.  However, this move looks far more sustainable than the price action seen in the immediate wake of the initial Covid panic.  Quite frankly, in the short-term, there is no reason to think USDJPY cannot rise to 115.00.  But the weakness is universal with SEK (-0.4%) and NOK (-0.3%) also continuing lower.  While the latter is undermined by the oil decline, the Swedish krona remains the highest beta G10 currency, and is simply leading the euro (-0.25%) on its downward path.

EMG currencies are not in any better shape with TRY (-2.2%) by far the worst performer as more bets get piled on that the new central bank governor will be cutting interest rates soon at the behest of President Erdogan.  INR (-1.2%) is the next worst performer, suffering as state-run banks were seen actively buying dollars in the market ahead of their fiscal year-end, cleaning up their balance sheets.  But pretty much the entire bloc is lower by between 0.2% and 0.4% on the simple fact that the dollar is growing in demand as US yields lead the way higher.

On the data front, two minor releases today, Case Shiller Home Prices (exp 11.2%) and Consumer Confidence (96.9) are unlikely to have much impact as the market looks forward to the employment situation starting with tomorrow’s ADP Employment report and then Friday’s NFP data.

Adding it all up comes to the idea that the current trends, higher yields and a higher dollar, remain firmly entrenched and I see no reason for them to change in the near future.

Good luck and stay safe
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Hubris

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Said Janet, the risk remains “small”
Inflation could come to the ball
But if that’s the case
The tools are in place
To stop it with one conference call

hu∙bris
/ (h)yoobrəs/
noun: excessive pride or self-confidence

“Is there a risk of inflation?  I think there’s a small risk and I think it’s manageable.”  So said Treasury Secretary Janet Yellen Sunday morning on the talk show circuit.  “I don’t think it’s a significant risk, and if it materializes, we’ll certainly monitor for it, but we have the tools to address it.”  (Left unasked, and unanswered, do they have the gumption to use those tools if necessary?)

Let me take you back to a time when the world was a simpler place; the economy was booming, house prices were rising, and making money was as easy as buying a home with 100% borrowed money (while lying on your mortgage application to get approved), holding it for a few months and flipping it for a profit. This was before the GFC, before QE, before ZIRP and NIRP and PEPP and every acronym we have grown accustomed to hearing.  In fact, this was before Bitcoin.

In May 2007, Federal Reserve Chairman Ben Bernanke, responding to a reporter’s question regarding the first inklings of a problem in the sector told us,  “Given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the sub-prime sector on the broader housing market will likely be limited.”  Ten months later, as these troubles had not yet disappeared, and in fact appeared to be growing, Bennie the Beard uttered his most infamous words, “At this juncture, however, the impact on the broader economy and financial markets of the problems in the sub-prime market seems likely to be contained.”

Notice anything similar about these situations?  A brewing crisis in the economy was analyzed and seen as insignificant relative to the Fed’s goals and, more importantly, inimical to the Fed’s desired outcomes.  As such, it is easily dismissed by those in charge.  Granted, Janet is no longer Fed chair, but we have heard exactly the same story from Chairman Jay and can look forward to hearing it again on Wednesday.

Of course, Bernanke could not have been more wrong in his assessment of the sub-prime situation, which was allowed to fester until such time as it broke financial markets causing a massive upheaval, tremendous capital losses and economic damage and ultimately resulted in a series of policies that have served to undermine the essence of capital markets; creative destruction.  While hindsight is always 20/20, it does not detract from the reality that, as the proverb goes, an ounce of prevention is worth a pound of cure.

But right now, the message is clear, there is no need to be concerned over transient inflation readings that are likely to appear in the next few months.  Besides, the Fed is targeting average inflation over time, so a few months of above target inflation are actually welcome.  And rising bond yields are a good thing as they demonstrate confidence in the economy.  Maybe Janet and Jay are right, and everything is just ducky, but based on the Fed’s track record, a lot of ‘smart’ money is betting they are not.  Personally, especially based on my observations of what things cost when I buy them, I’m with the smart money, not the Fed.  But for now, inflation has been dismissed as a concern and the combination of fiscal and monetary stimulus are moving full speed ahead.

Will this ultimately result in a substantial correction in risk appetite?  If Yellen’s and Powell’s view on inflation is wrong, and it does return with more staying power than currently anticipated, it will require a major decision; whether to address inflation at the expense of slowing economic growth, or letting the economy and prices run hotter for longer with the likelihood of much longer term damage.  At this stage, it seems pretty clear they will opt for the latter, which is the greatest argument for a weakening dollar, but perhaps not so much vs. other fiat currencies, instead vs. all commodities.  As to general risk appetite, I suspect it would be significantly harmed by high inflation.

However, inflation remains a future concern, not one for today, and so markets remain enamored of the current themes; namely expectations for a significant economic rebound on the back of fiscal stimulus leading to higher equity prices, higher commodity prices and higher bond yields.  That still feels like an unlikely trio of outcomes, but so be it.

This morning, we are seeing risk acquisition with only Shanghai (-1.0%) falling of all major indices overnight as Tencent continues to come under pressure after the government crackdown on its financial services business.  But the Nikkei (+0.2%) and Hang Seng (+0.3%) both managed modest gains and we have seen similar rises throughout Europe (DAX +0.2%, CAC +0.3%, FTSE 100 +0.3%) despite the fact that the ruling CDU party in Germany got clobbered in weekend elections in two states.  US futures are also pointing higher by similar amounts across the board.

Bond markets, interestingly, have actually rallied very modestly with Treasury yields lower by 1.2 basis points, and similar yield declines in both Bunds and OATs.  That said, remember that the 10-year did see yields climb 8 basis points on Friday amid a broad-based bond sell-off around the world.  In other words, this feels more like consolidation than a trend change.

Commodity markets have also generally edged higher, with oil (+0.35%), gold (+0.1%) and Aluminum (+1.0%) showing that the reflation trade is still in play.

Given the modesty of movement across markets, it seems only right that the dollar is mixed this morning, with a variety of gainers and laggards, although only a few with significant movement.  In the G10 this morning, SEK (-0.7%) is the worst performer as CPI was released at a lower than expected 1.5% Y/Y vs 1.8% expected.  This has renewed speculation that the Riksbank may be forced to cut rates back below zero again, something they clearly do not want to do.  But beyond this, price action has been +/- 0.2% basically, which is indicative of no real news.

In EMG currencies, it is also a mixed picture with ZAR (+0.7%) the biggest gainer on what appear to be carry trade inflows, with TRY (+0.6%) next in line as traders anticipate a rate hike by the central bank later this week.  Most of LATAM is not yet open after this weekend’s change in the clocks, but the MXN (+0.3%) is a bit firmer as I type.  On the downside, there is a group led by KRW (-0.3%) and HUF (-0.25%), showing both the breadth and depth (or lack thereof) of movement.  In other words, movement of this nature is generally not a sign of new news.

On the data front, all eyes are on the FOMC meeting on Wednesday, but we do get a few other releases this week as follows:

Today Empire Manufacturing 14.5
Tuesday Retail Sales -0.5%
-ex autos 0.1%
IP 0.4%
Capacity Utilization 75.5%
Wednesday Housing Starts 1555K
Building Permits 1750K
FOMC Decision 0.00% – 0.25%
Thursday Initial Claims 700K
Continuing Claims 4.07M
Philly Fed 24.0
Leading Indicators 0.3%

Source: Bloomberg

While Retail Sales will garner some interest, the reality is that the market is almost entirely focused on the FOMC and how it will respond to, or whether it will even mention, the situation in the bond market.  Certainly, a strong Retail Sales report could encourage an even more significant selloff in bonds, which, while seemingly embraced by the Fed, cannot be seen as good news for the Treasury.  After all, they are the ones who have to pay all that interest. (Arguably, we are the ones who pay it, but that is an entirely different conversation.)

As to the dollar, while it has wandered aimlessly for the past few sessions, I get the sneaking suspicion that it is headed for another test of its recent highs as I believe bond yields remain the key market driver, and that move is not nearly over.

Good luck and stay safe
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No Paradox

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In Europe, the ECB hawks
Explained in their most recent talks
The rising of late
In THE 10-year rate
Was normal and no paradox

At home, hawks are also reduced
To cheering the 10-year yield’s boost
Since Powell’s a dove
And rules from above
The hawks can’t shake him from his roost

In a world where every central bank is adding massive amounts of liquidity, how can you determine which central bankers are hawks and which are doves?  Since no one is allowed to make the case that short-term rates should be raised to try to slow down rising inflation, the next best thing for the hawks to do is to cheer on the rise in longer term yields.  And that continues to be the number one story in markets around the world, rising bond yields.  Yesterday saw Treasury yields rise 9 basis points as investors continue to see US data point to rising inflationary pressures.  The ISM Services Price Index rose to its highest level since 2008, just like we saw in the Manufacturing Index on Monday.  Even official inflation measures continue to print a bit higher than forecast, a sign that underlying price pressures are quite widespread.

In the past, this type of economic data would encourage the hawkish contingent of every central bank to argue for raising the short-term rate.  But hawkish views appear to have been written by Dr Seuss, as they have been removed from the canon of financial discussion.  Which leaves the back end of the curve the only place where they can express their views.  And so, we now hear from Klaas Knot, Dutch central bank president that rising government bond yields are a “positive story”, while Jens Weidmann, Bundesbank president explained that these moves are not “a particularly worrisome development.”  We have heard the same thing from Fed speakers as well, although not universally, as the doves, notably Lael Brainerd, hint at Fed action to prevent an unruly market.  My take is an unruly market is one that goes in the opposite direction to their desires.

But despite the central bank commentary, it is becoming ever clearer that inflationary pressures are rising around the world.  We have spent the past 40 years in an environment of constantly decreasing inflation as a combination of globalization and technological advancement have reduced the cost of so many things.  And while technology continues to march forward, globalization is under severe attack, even from its previous political cheerleaders.  This is evident in the current US administration, where strengthening and localizing supply chains is a goal, something that will clearly increase costs.  Add to that increased shipping costs alongside capacity shortages and rising energy costs, and you have the makings of a higher price regime.  (An anecdote on rising price pressures: a friend of mine who lives in Paris told me the prices of the following foods; fresh salmon €60/kg, 1 grapefruit €2.25 and 1 avocado €2.65.  I checked my supermarket app and found the following prices here in New Jersey; fresh salmon $9.99/lb, 1 grapefruit $1.00 and 1 avocado $2.50.  Prices are high and rising everywhere!)

The final piece of this puzzle is broad economic activity, which the data continues to show has seen a real burst in the US, although there is still concern over the employment situation.  Every survey has shown the US economy growing rapidly in Q1 with the Atlanta Fed’s GDPNow forecast currently at 10%.  Adding it all up leads to the following understanding; it is not only the Fed that is willing to run the economy hot, but every G10 central bank, which means that monetary support will continue to flow for years to come.  Combining that activity with the massive fiscal support and the still significant supply bottlenecks that were a result of the government shutdowns in response to Covid brings about a scenario where there is a ton of money in the system and not enough goods to satisfy the demand.  If central banks don’t tap the breaks, rising prices and price expectations will lead to rising yields, and ultimately to declining equities.  The only asset class that will continue to perform is commodities, because owning “stuff” will be a better trade than owning paper assets.  And that’s enough of those cheery thoughts.

On to today’s markets, where, alas, risk is being jettisoned around the world.  After yesterday’s tech led selloff in the US, Asian equity markets really got hammered (Nikkei -2.1%, Hang Seng -2.1%, Shanghai -2.1%) and European markets are also under the gun (DAX -0.45%, CAC -0.3%, FTSE 100 -1.0%).  US futures?  All red at this hour, down about 0.3%, although that is off the lows seen earlier this morning.

Bond yields, meanwhile, despite my discussion of how they are rising, have actually slipped back a bit this morning in classic risk-off price action.  So, Treasuries (-1.9bps), Bunds (-2.6bps), OATs (-2.1bps) and Gilts (-4.1bps) are all rallying.  But this is not a trend change, it is merely indicative of the fact that now that yields have backed up substantially, the concept of government bonds as an effective risk mitigant is coming back in vogue.  After all, when 10-yr Treasuries yield 0.7%, it hardly offers protection to a portfolio, but at more than double that rate, it is starting to help a little in times of stress.

Commodity prices are mixed this morning with oil taking back early session losses to sit unchanged as I type, but base metals in the midst of a modest correction after a remarkable rally for the past several months.  This morning copper (-4.1%) and Nickel (-8.2%) are leading the way lower, but with the ongoing economic activity and absence of new capacity, these are almost certainly temporary moves.  Gold, which has been under significant pressure lately seems to have found a floor, perhaps only temporarily, at $1700, but given the dollar’s ongoing strength, it cannot be surprising gold remains under pressure.

As to the dollar, I would say it is very modestly stronger today, although what had earlier been virtually universal has now ebbed back a bit.  In the G10, CHF (-0.4%) and JPY (-0.3%) are the worst performers, which given the risk attitude is actually quite surprising.  I think the Swiss story is actually a Polish one, where Poland has refused to support local banks who took out CHF loans and have been suffering from currency strength far outstripping the interest rate benefits.  It seems, concern is growing that these loans may be restructured and ultimately impact the Swiss banks and Swiss economy.  Meanwhile, the yen’s weakness stems from a poor response to a 30-year bond sale last night, where yields rose 3.5 bps amid a very weak bid-to-cover ratio for the sale.  Perhaps even the Japanese are getting tired of zero rates!  But away from those two currencies, the rest of the bloc is +/- 0.2% or less, indicating nothing of real interest is going on.

EMG currencies are also mixed with Asian currencies suffering amid the broad risk off environment overnight and CE4 currencies lower on the back of euro weakness.  On the plus side, BRL (+0.7%) and MXN (+0.6%) are the leading gainers, which appears to be an ongoing reaction to aggressive central bank of Brazil intervention to try to prevent further weakness there.  In this space too, the broad risk appetite will continue to remain key.

On the data front we see a bunch of stuff starting with Initial Claims (exp 750K) and Continuing Claims (4.3M), but we also see Nonfarm Productivity (-4.7%), Unit Labor Costs (6.6%) and Factory Orders (2.1%) this morning.  Perhaps of more importance we hear from Chairman Powell today, right at noon, and all eyes and ears will be focused on how he describes recent market activity as well as to see if he hints at any type of Fed response.  Many pundits, this one included, believe there is a cap to how high the Fed will allow yields to rise, the question is, what is that cap.  I have heard several compelling arguments that 2.0% is where things start to become uncomfortable for the Fed, but ultimately, I believe that it will depend on the data.  If the data starts to show that the economy is under pressure before 2.0% is reached, the Fed will step in at that time and stop the madness.  Until then, as we have heard from central bankers worldwide, higher yields in the back end are a good thing, so they will continue to be with us for the foreseeable future.  And yes, that means that until US inflation data starts to print higher, and real yields start to decline, the dollar is very likely to retain its bid.

Good luck and stay safe
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More Terrified

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The narrative starting to form
Is bond market vol’s the new norm
But Jay and Christine
Explain they’re serene
Regarding this new firestorm

However, the impact worldwide
Is some nations must set aside
Their plans for more spending
As yields are ascending
And FinMins grow more terrified

Confusion is the new watchword as investors are torn between the old normal of central bank omnipotence and the emerging new normal of unfettered chaos.  Now, perhaps unfettered chaos overstates the new normal, but price action, especially in the Treasury and other major government bond markets, has been significantly more volatile than what we had become used to since the first months of the Covid crisis passed last year.  And remember, prior to Covid’s appearance on the world stage, it was widely ‘known’ that the Fed and its central bank brethren had committed to insuring yields would remain low to support the economy.  Of course, there was the odd hiccup (the taper tantrum of 2013, the repo crisis of 2018) but generally speaking, the bond market was not a very exciting place to be.  Yields were relatively low on a long-term historical basis and tended to grind slowly lower as debt deflation central bank action guided inflation to a low and stable rate.

But lately, that story seems to be changing.  Perhaps it is the ~$10 trillion of pandemic support that has been (or will soon be) added to the global economy, with the US at $5 trillion, including the upcoming $1.9 trillion bill working its way through Congress, the leading proponent.  Or perhaps it is the fact that the novel coronavirus was novel in how it impacted economies, with not only a significant demand shock, but also a significant supply shock.  This is important because supply shocks are what tend to drive inflation with the OPEC oil embargos of 1973 and 1979 as exhibits A and B.

And this matters a lot.  Last week’s bond market price action was quite disruptive, and the terrible results of the US 7-year Treasury auction got tongues wagging even more about how yields could really explode higher.  Now, so far this year we have heard from numerous Fed speakers that higher yields were a good sign as they foretold a strong economic recovery.  However, we all know that the US government cannot really afford for yields to head that much higher as the ensuing rise in debt service costs would become quite problematic.  But when Chairman Powell spoke last week, he changed nothing regarding his view that the Fed was committed to the current level of support for a substantially longer time.

Yesterday, however, we heard the first inkling that the Fed may not be so happy about recent bond market volatility as Governor Brainerd explained that the sharp moves “caught her eye”, and that movement like that was not appropriate.  This is more in sync with what we have consistently heard from ECB members regarding the sharp rise in yields there.  At this point, I count at least five ECB speakers trying to talk down yields by explaining they have plenty of flexibility in their current toolkit (they can buy more bonds more quickly) if they deem it necessary.

But this is where it gets confusing.  Apparently, at least according to a top story in Bloomberg this morning which explains that ECB policymakers see no need for drastic action to address the rapidly rising yields of European government bonds, everything is fine.  But if everything is fine, why the onslaught of commentary from so many senior ECB members?  After all, the last thing the ECB wants is for higher yields to drive the euro higher, which would have the triple negative impact of containing any inflationary impulses, hurting export industries and ultimately slowing growth.  To me, the outlier is this morning’s story rather than the commentary we have been hearing.  Now, last week, because of a large maturity of French debt, the ECB’s PEPP actually net reduced purchases, an odd response to concerns over rising yields.  Watch carefully for this week’s action when it is released next Monday, but my sense is that number will have risen quite a bit.

And yet, this morning, bond yields throughout Europe and the US are strongly higher with Treasuries (+5.3bps) leading the way, but Gilts (+3.6bps), OATs (+2.7bps) and Bunds (+2.4bps) all starting to show a near-term bottom in yields.  The one absolute is that bond volatility continues to be much higher than it has been in the past, and I assure you, that is not the outcome that any central bank wants to see.

And there are knock-on effects to this price action as well, where less liquid emerging and other markets are finding fewer buyers for their paper.  Recent auctions in Australia, Thailand, Indonesia, New Zealand, Italy and Germany all saw much lower than normal bid-to-cover ratios with higher yields and less debt sold.  Make no mistake, this is the key issue going forward.  If bond investors are unwilling to finance the ongoing spending sprees by governments at ultra-low yields, that is going to have significant ramifications for economies, and markets, everywhere.  This is especially so if higher Treasury yields help the dollar higher which will have a twofold effect on emerging market economies and really slow things down.  We are not out of the woods yet with respect to the impact of Covid and the responses by governments.

However, while these are medium term issues, the story today is of pure risk acquisition.  After yesterday’s poor performance by US equity markets, Asia turned things around (Nikkei +0.5%, Hang Seng +2.7%, Shanghai +1.9%) and Europe has followed along (DAX +0.9%, CAC +0.6%, FTSE 100 +0.8%).  US futures are right there with Europe, with all three indices higher by ~0.6%.

As mentioned above, yields everywhere are higher, as are oil prices (+1.5%).  However, metals prices are soft on both the precious and base sides, and agricultural prices are mixed, at best.

And lastly, the dollar, which had been softer all morning, is starting to find it footing and rebound.  CHF (-0.3%) and JPY (-0.25%) are the leading decliners, but the entire G10 bloc is lower except for CAD (+0.1%), which has arguably benefitted from oil’s rally as well as higher yields in its government bond market.  In what cannot be a great surprise, comments from the ECB’s Pablo Hernandez de Cos (Spanish central bank president) expressed the view that they must avoid a premature rise in nominal interest rates, i.e. they will not allow yields to rise unopposed.  And it was these comments that undermined the euro, and the bulk of the G10 currencies.

On the EMG front, overnight saw some strength in Asian currencies led by INR (+0.9%) and IDR (+0.55%) as both were recipients of foreign inflows to take advantage of the higher yield structure available there.  On the downside, BRL (-0.7%) and MXN (-0.5%) are the laggards as concerns grow over both governments’ ongoing response to the economic disruption caused by Covid.  We have seen the Central Bank of Brazil intervening in markets consistently for the past week or so, but that has not prevented the real from declining 5% during that time.  I fear it has further to fall.

On the data front, ADP Employment (exp 205K) leads the day and ISM Services (58.7) comes a bit later.  Then, this afternoon we see the Fed’s Beige Book.  We also hear from three more Fed speakers, but it would be shocking to hear any message other than they will keep the pedal to the metal for now.

Given all the focus on the Treasury market these days, it can be no surprise that the correlation between 10-year yields and the euro has turned negative (higher yields leads to lower euro price) and I see no reason for that to change.  The story about the ECB being unconcerned with yields seems highly unlikely.  Rather, I believe they have demonstrated they are extremely concerned with European government bond yields and will do all they can to prevent them from moving much higher.  While things will be volatile, I have a sense the dollar is going to continue to outperform expectations of its decline for a while longer.

Good luck and stay safe
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Suspicions

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Fed staffers relayed their suspicions
That ease in financial conditions
Could lead to distress
Which could make a mess
For Powell and all politicians

But Jay heard the story and said
The risks when we’re looking ahead
Are growth is too slow
Inflation too low
So, money still pours from the Fed

Yesterday’s Fed Minutes left us with a bit of a conundrum as there appears to be a difference of opinion regarding the current state of the economy and financial markets between the Fed staffers and their bosses.  The bosses, of course, are the 19 members of the FOMC, 7 governors including the Chair and vice-Chair and the 12 regional Fed presidents.  The staffers are the several thousand PhD economists who work for that group and develop and run econometric models designed, ostensibly, to help better understand the economy and predict its future path.  On the one hand, based on the Fed’s prowess, or lack thereof, in forecasting the economy’s future path, it is understandable how the bosses might ignore their staffers.  When looking at past Fed forecasts, they are notoriously poor at determining how the economy is progressing, seemingly because the models upon which they rely do not represent the US economy very well.  On the other hand, the willful blindness exhibited by the bosses with respect to the current financial conditions is disqualifying, in itself, of trusting their views.  As I said, quite the conundrum.

This was made a little clearer yesterday when the FOMC Minutes showed that the staff had indicated the following:

The staff provided an update on its assessments of the stability of the financial system and, on balance, characterized the financial vulnerabilities of the U.S. financial system as notable. The staff assessed asset valuation pressures as elevated. In particular, corporate bond spreads had declined to pre-pandemic levels, which were at the lower ends of their historical distributions. In addition, measures of the equity risk premium declined further, returning to pre-pandemic levels. Prices for industrial and multifamily properties continued to grow through 2020 at about the same pace as in the past several years, while prices of office buildings and retail establishments started to fall. The staff assessed vulnerabilities associated with household and business borrowing as notable, reflecting increased leverage and decreased incomes and revenues in 2020. Small businesses were hit particularly hard. [author’s emphasis].

And yet, after hearing the staff reports, neither the FOMC statement nor Chairman Powell at the ensuing press conference referred to elevated asset values or financial system vulnerabilities.  Rather, those, and most other concerns, were described as moderate, while explaining that downside outcomes to inflation still dominated their thinking.  In the intervening 3 weeks, we have seen Treasury yields rise 30 basis points in the 10-year and inflation breakevens rise 22 basis points.  In other words, it is beginning to appear as though the Fed and the market are watching two different movies.  The risk to this scenario is that the Fed can fall dangerously behind the curve with respect to keeping the economy on their preferred path, and may be forced to dramatically shift policy (read raise rates) if (when) it becomes clear rising inflation is not a temporary phenomenon.  Now, while it is likely to take the Fed quite a while to recognize this discrepancy, I assure you, when it occurs and the Fed feels forced to act, the market response will be dramatic.  But for now, that is just not on the cards.  If anything, as we continue to hear from various Fed speakers, there is no indication they are going to consider tighter policy for several years to come.

In the meantime, there is no reason to suspect that market participants will change their short-term behavior, so ongoing manias will continue.  Just be careful with your personal accounts.  Remember, when things turn, return OF capital is far more important than return ON capital!

Now to today’s session.  Once again, the traditional risk memes are a bit confused this morning.  Equity markets have not had a good session with Asia mostly lower (Nikkei -0.2%, Hang Seng -1.6%, although Shanghai reopened with a gain, +0.5%).  European markets are also under pressure (DAX -0.1%, CAC -0.4%, FTSE 100 -0.9%) despite the fact that today marks the beginning of the disbursement of EU-wide support funded by EU-wide bond issuance.  You may remember last July when, to great fanfare, the EU agreed a €750 billion joint debt issuance, to be backed by all members.  Well, we are now seven months later, and they are finally starting to disburse the funds.  And do not seek respite in US futures markets as they are all lower by between 0.25% (DOW) and 0.8% (NASDAQ).

What is interesting is that despite the equity market weakness, bond markets are falling as well.  It appears that growing concerns over rising inflation are outweighing the risk aversion theme.  Thus, 10-year Treasury yields are higher by 1.9bps this morning and we are seeing even larger rises in some European markets (Gilts +4.1bps, OATs +2.6bps, Bunds +1.8bps).  So, I ask you, which market is telling us the true risk story today?

Perhaps if we look to commodities we will get a hint.  Alas, the information here is muddled at best.  Oil prices continue to rise, up another 0.3% this morning, as up to 4 million barrels of daily production in Texas and the Midwest have been shut in because of the winter storms.  That is 36% of US production, and clearly making an impact. Meanwhile, base metals have been mixed with Aluminum higher and Copper lower.  Precious metals?  Mixed as well with gold (+0.4%) rebounding from a couple of really bad sessions while silver (-0.75%) continues to slide.

Thus far, making a claim as to the risk sense of markets is essentially impossible.  So, now we turn to the dollar.  If tradition is a guide, the dollar’s broad weakness, lower vs. all G10 counterparts and many EMG ones as well, would indicate a risk on session.  But if investors are moving into risky assets, why are stocks under uniform pressure? Perhaps they are all moving their money into Bitcoin (+0.2% today, +11.2% in the past week).

But back to the fiat world where we see GBP (+0.6%) as the leading G10 gainer which appears to be a result of traders expecting the UK to recover much faster than Europe given the relative success of their Covid vaccination program.  But even the worst performers, CAD and JPY are higher by 0.15% this morning.  NOK (+0.4%) seems to be benefitting from the ongoing oil rally, and the rest of the bloc may be beginning to see the resumption of the dollar short trade.

EMG currencies are a bit more mixed, with most APAC currencies softening overnight, but LATAM and CE4 currencies benefitting from the dollar’s overall softness.  CLP (+0.5%) leads the way on the strength of rising copper prices, with ZAR (+0.45%) following closely behind.

Yesterday’s US data was surprisingly good, with Retail Sales exploding higher by 5.3% on a monthly basis (I guess the most recent stimulus checks were spent!) and PPI jumping by a full percent, to a still low 1.7%, which may well foreshadow the future of CPI.  We also saw strong IP and Capacity Utilization data.  This morning brings Initial Claims (exp 770K), Continuing Claims (4.425M), Housing Starts (1660K), Building Permits (1680K) and Philly Fed (20.0) all at 8:30. We also have two more Fed speakers, the hyper dovish Lael Brainerd and a more middle of the road dove Rafael Bostic.

Wrapping it all up shows a weak dollar, weak bond prices and weak stock prices.  It feels like at least one of these needs to adjust its trajectory for the day to make any sense, but as of now, I am not willing to bet which.  As far as the FX market goes, we appear to be rangebound for now, although any eventual break still feels like it will be for a lower dollar.

Good luck and stay safe
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Pending A-pocalypse

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Inflation’s on everyone’s lips
As traders now need come to grips
With data still soft
But forecasts that oft
Point to pending a-pocalypse

Is inflation really coming soon?  Or perhaps the question should be, is measured inflation really coming soon?  I’m confident most of us have seen the rise in prices for things that we purchase on a regular basis, be it food, clothing, cable subscriptions or hard goods.  And of course, asset price inflation has been rampant for years, but apparently that doesn’t count at all.  However, the focus on this statistic has increased dramatically during the past several months which is a huge change from, not only the immediate post-pandemic economy, but in reality, the past thirty years of economic activity.  In fact, ever since Paul Volcker, as Fed Chair, slew the inflationary dragon that lived in the 1970’s, we have seen a secular move lower in measured consumer prices alongside a secular move lower in nominal interest rates.

But the pandemic has forced a lot of very smart people (present company excluded) to reconsider this trend, with many concluding that higher prices, even the measured kind, are in our future.  And this is not a discussion of a short-term blip higher due to pent up demand, but rather the long-term trend higher that will need to be addressed aggressively by the Fed lest it gets out of hand.

The argument for inflation centers on the difference between the post GFC financial response and the post Covid shock financial response.  Back in 2009, the Fed cut rates to zero and inaugurated their first balance sheet expansion of note with QE1.  Several more bouts of QE along with years of near zero rates had virtually no impact on CPI or PCE as the transmission mechanism, commercial banks, were not playing their part as expected.  Remember, QE simply replaces Treasuries with bank reserves on a commercial bank balance sheet.  It is up to the commercial bank to lend out that money in order for QE to support the economy.  But commercial banks were not finding the risk adjusted returns they needed, especially compared to the riskless returns they were receiving from the Fed from its IOER program.  So, the banking sector sold the Fed their bonds and held reserves where they got paid interest, while enabling them to have a riskless asset on their books.  In other words, only a limited amount of QE wound up in the public’s pocket.  The upshot was that spending power did not increase (remember, wages stagnated) and so pricing pressures did not materialize, hence no measured inflation.

But this time around, fiscal policy has been massive, with the CARES act of nearly $2 trillion including direct payments to the public as well as forgivable small business loans via the PPP program.  So, banks didn’t need to lend the money to get things moving, the government solved that part of the equation. Much of that money wound up directly in the economy (although certainly some found its way into RobinHood accounts and Bitcoin), thus amping up demand.  At the same time, the lockdowns around the world resulted in broken supply chains, meaning many goods were in short supply.  This resulted in the classic, more money chasing fewer goods situation, which leads to higher prices.  This helps explain the trajectory of inflation since the initial Covid impact, where prices collapsed at first, but have now been rising back sharply.  While they have not yet reached pre-Covid levels, it certainly appears that will be the case soon.

Which leads us back to the question of, what will prevail?  Will the rebound continue, or will the long-term trend reassert itself?  This matters for two reasons.  First, we will all be impacted by rising inflation in some manner if it really takes off.  But from a markets perspective, if US inflation is rising rapidly, it will put the Fed in a bind with respect to their promise to keep rates at zero until the end of 2023.  If the market starts to believe the Fed is going to raise rates sooner to fight inflation, that will likely have a very deleterious effect on equity and bond prices, but a very positive effect on the dollar.  The combination of risk-off and higher returns will make the dollar quite attractive to many, certainly enough to reverse the recent downtrend.

Lately, we are seeing the beginnings of this discussion, which is why the yield curve has steepened, why stock markets have stalled and why the dollar has stopped sliding.  Fedspeak this week has been cacophonous, but more importantly has shown there is a pretty large group of FOMC members who see the need for tapering policy, starting with reducing QE, but eventually moving toward higher rates.  Yesterday, uber-dove Governor Lael Brainerd pushed back on that story, but really, all eyes will be on Chairman Powell this afternoon when he speaks.  To date, he has not indicated a concern with inflation nor any idea he would like to taper purchases, so any change in that stance is likely to lead to a significant market response.  Pay attention at 12:30!

With that as backdrop, a quick tour of the markets shows that risk appetite is moderately positive this morning.  While the Nikkei (+0.85%) and Hang Seng (+0.9%) both did well, Shanghai suffered (-0.9%) despite data showing record export performance by China last year.  Europe is far less exciting with small gains (DAX +0.2%, CAC +0.1% and FTSE 100 +0.7%) following Germany’s release of 2020 GDP data showing a full-year decline of “just” -5.0%, slightly less bad than expected.  US futures are mixed at this hour, but the moves are all small and offer no real news.

Bond markets show Treasury yields higher by 2bps, while European bonds have all seen yields slip between 1.0 and 1.7bps, at least the havens there.  Italian BTP’s are selling off hard, with yields rising 5.7bps, and the rest of the PIGS have also been under pressure.  Oil prices are little changed this morning, still holding onto their gains since November.  Gold prices are slightly softer and appear to be biding their time until the next big piece of news hits.

Finally, the dollar is somewhat mixed this morning, with the G10 basically split between gainers and losers, although the gains have been a bit larger (AUD +0.4%, SEK +0.3%) than the losses (CHF -0.2%, JPY -0.1%).  But this looks like position adjustments and potential order flow rather than a narrative driven move.  EMG currencies are also split, but there are clearly more gainers than losers here, with the commodity bloc doing best (ZAR +0.85%, RUB +0.65%, BRL +0.6%) and losses more random led by KRW (-0.25%) and CZK (-0.2%).  If pressed, one needs look past oil and gold to see agricultural commodities and base metals still performing well and supporting those currencies.  KRW, on the other hand is a bit more confusing given the growth in China, it’s main exporting destination.  Again, position adjustments are quite viable given the won’s more than 11% gain since May.

This morning’s data slate includes only Initial Claims (exp 789K) and Continuing Claims (5.0M), which if far from expectations could wiggle markets, but seem unlikely to do so as everyone awaits Powell’s speech.  Until then, I expect that the dollar will continue to remain supported, but if Powell reiterates a very dovish stance, we could easily see the dollar head much lower.  Of course, if he gives credence to the taper view, look for some real market fireworks, with both bonds and stocks selling off and the dollar jumping sharply.

Good luck and stay safe
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Each of them Dreads

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The word from three central bank heads
Was something that each of them dreads
Is failing to let
Inflation beset
Their nations, thus tightening spreads

Instead, each one promised that they
Won’t tighten till some future day
When ‘flation is soaring
And folks are imploring
They stop prices running away

As we come to the end of the week, on a Friday the 13th no less, investors continue to be encouraged by the central bank community.  Yesterday, at an ECB sponsored forum, the heads of the three major central banks, Fed Chairman Jerome Powell, ECB President Christine Lagarde and BOE Governor Andrew Bailey, all explained that their greatest fear was that the second wave of Covid would force extended shutdowns across their economies and more permanent scarring as unemployment rose and the skills of those who couldn’t find a job diminished.  The upshot was that all three essentially committed to displaying patience with regard to tightening policy at such time in the future as inflation starts to return.  In other words, measured inflation will need to be really jumping before any of these three, and by extension most other central bankers, will consider a change in the current policy stance.

Forgetting for a moment, the fact that this means support for asset prices will remain a permanent feature, let us consider the pros and cons of this policy stance.  On the one hand, especially given the central banking community’s woeful forecasting record, waiting for confirmation of a condition before responding means they are far less likely to inadvertently stifle a recovery.  On the other hand, this means central banks are promising to become completely reactive, waiting for the whites of inflation’s eyes, as it were, and therefore will be sacrificing their ability to manage expectations.  In essence, it almost seems like they are dismantling one of the major tools in their toolkits, forward guidance.  Or perhaps, they are not dismantling it, but rather they are changing its nature.

Currently, forward guidance consists of their comments/promises of policy maintenance for an uncertain, but extended period of time.  For instance, the Fed’s forecasts indicate interest rates will remain at current levels through 2023.  (Remember Powell’s comment, “we’re not even thinking about thinking about raising rates.”)  But what if inflation were to start to rise significantly before then?  Does the current guidance preclude them from raising rates sooner?  That is unclear, and I would hope not, but broken promises by central banks are also not good policy.  However, if the new forward guidance is metric based, for instance, we won’t adjust policy until inflation is firmly above 2.0% for a period of time, then all they can do is sit back and watch the data, waiting for the economy to reach those milestones, before acting.  The problem for them here is that inflation has a way of getting out of hand and could require quite severe policy medicine to tame it.  Remember what it took for Paul Volcker as Fed Chair back in the early 1980’s.

My observation is that, as with the initiation of forward guidance, this is a policy that is much easier to start than to unwind, and either it will become a permanent feature of monetary policy (a distinct possibility) or the unfortunate soul who is Fed Chair when it needs to be altered will be roasted alive.  In the meantime, what we know is that central banks around the world are extremely unlikely to tighten policy for many years to come.  We have heard that from the BOJ, the RBA, and the RBNZ as well as the big three.  All told, one could make the case that interest rates have found their new, permanent level.

And with that in mind, let us tour market activity this Friday morning.  Equities in Asia followed from Wall Street’s disappointing performance yesterday and all sold off.  The Nikkei (-0.5%) fell for only the second time in the past two weeks.  Meanwhile, after President Trump signed an executive order preventing US investors from supporting companies owned or controlled by the PLA (China’s armed forces), equities in HK (Hang Seng -0.1%) and Shanghai (-0.9%) both fell as well.  The story in Europe is less clear, with some modest strength (DAX +0.2%), CAC (+0.3%) but also some weakness (FTSE -0.5%).  I would blame the latter on further disruption in the UK government (resignation of a high ranking minister, Dominic cummings) and a fading hope on a Brexit deal, but then the pound is higher, so that doesn’t seem right either.

Bond markets, which all rallied sharply yesterday, are continuing that price action, albeit at a more modest pace, with all European markets showing yield declines of between one and two basis points, although Treasuries are essentially unchanged right now.  Of course, Treasuries had the biggest rally yesterday.

Oil is softer (WTI – 1.0%) and gold is a touch firmer (+0.2%) although the latter seems clearly to have found significant support a bit lower than here.  As to the dollar, on the whole it is softer, but not terribly so.  For instance, GBP (+0.3%) is the leading gainer, with AUD (+0.2%) next on the list, but those are hardly impressive moves.  While the bulk of this bloc are firmer, SEK (-0.4%) has fallen on what appears to be a combination of position adjustments and bets on the future direction of the NOKSEK cross.  As to the EMG bloc, there are more gainers than losers, but MXN (+0.3%) is the biggest positive mover, which seems to be a hangover from Banxico’s surprise decision yesterday afternoon, to leave the overnight rate at 4.25% while the market was anticipating a 25-basis point reduction.  On the downside, CLP (-0.95%) is the worst performer, as investors appear concerned that there will be further financial policy adjustments that hinder the long-term opportunity in the country.

On the data front, overnight we saw Eurozone Q3 GDP released at 12.6% Q/Q (-4.4% Y/Y), a tick worse than expectations but it is hard to imply that had an impact of any sort on the markets.  In the US, yesterday saw a modestly better outcome in Initial Claims, and CPI was actually 0.1% softer than expected (helping the bond rally). This morning brings PPI (exp 0.4%, 1.2% Y/Y), about which nobody cares given we have seen CPI already, and then Michigan Sentiment (82.0) at 10:00.  We have two Fed speakers on the docket, Williams early, and then James Bullard.  But given the unanimity of the last vote, and the fact that we just heard from Chairman Powell, it would be a huge surprise to hear something new from either of them.

So, as we head into the weekend, with the dollar having been strong all week, a little further softness would not be a big surprise.  However, there is no reason to believe that there will be a significant move in either direction before we log off for the weekend.

Good luck, good weekend and stay safe
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The New Weasel Word

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The bulk of the FOMC
Explained their preferred policy
More government spending,
Perhaps never ending,
Is what almost all want to see

Meanwhile, ‘cross the pond, what we heard
Is ‘bove 2% is preferred
They’ll soon change their stance
To give growth a chance
Inflation’s the new weasel word

Another day, another central bank explanation that higher inflation is just what the doctor ordered to improve the economy.  This time, Banque de France’s Governor, Francois Villeroy de Galhau, explained that the current formulation used by the ECB, “below, but close to, 2%”, is misunderstood.  Rather than 2% being a ceiling, what they have meant all along is that it is a symmetrical target.  Uh huh!  I’ve been around long enough to remember that back in 1988, when the ECB was first being considered, Germany was adamant that they would not accept a central bank that would allow inflation, and so forced the ECB to look just like the Bundesbank.  That meant closely monitoring price pressures and preventing them from ever getting out of hand.  Hence, the ECB remit, was absolutely designed as a ceiling, with the Germans reluctant to even allow 2% inflation.  Of course, for most of the rest of Europe, inflation was the saving grace for their economies.  Higher inflation begat weaker currencies which allowed France, Italy, Spain, et.al. to continue to compete with a German economy that became ever more efficient.

But twenty-some years into the experiment of the single currency, and despite the fact that the German economy remains the largest and most important in the Eurozone, the inflationistas of Southern Europe are gaining the upper hand.  These comments by Villeroy are just the latest sign that the ECB is going to abandon its price stability rules, although you can be sure that they will never say that.  Of course, the problem the ECB has is similar to that of Japan and the US, goosing measured inflation has been beyond their capabilities for the past decade (more than two decades for the BOJ), so simply changing their target hardly seems like it will be sufficient to do the job.  My fear, and that of all of Germany, is that one day they will be successful in achieving this new goal and will not be able to stop inflation at their preferred level, but instead will see it rise much higher.  But that is not today’s problem.  Just be aware that we are likely to begin hearing many other ECB members start discussing how inflation running hot for a while is a good thing.  Arguably, the only exceptions to this will be the Bundesbank and Dutch central bank.

And once again, I will remind you all that there is literally no chance that the ECB will sit back and watch, rather than act, if the Fed actually succeeds in raising inflation and weakening the dollar.

Speaking of the Fed, this week has seen a significant amount of Fedspeak already, with Chairman Powell on the stand in Congress for the past three days.  What he, and virtually every other Fed speaker explained, was that more fiscal stimulus was required if the government wanted to help boost growth.  The Fed has done all they can, and to listen to Powell, they have been extremely effective, but the next step was Congress’s to take.  The exception to this thought process came from St Louis Fed President Bullard, who explained that based on his forecasts, the worst is behind us and no further fiscal stimulus is needed.  What makes this so surprising is that he has been one of the most dovish of all Fed members, while this is a distinctly hawkish sentiment.  But he is the outlier and will not affect the ultimate outcome at this stage.

Powell was on the stand next to Treasury Secretary Mnuchin, who made the comment with the biggest impact on markets.  He mentioned that he and House Speaker Pelosi were back to negotiating on a new stimulus package, which the equity market took as a sign a deal would be reached quickly.  We shall see.  Clearly, there is a great deal of angst in Congress right now, so the ability to agree on anything across the aisle is highly questionable.

With that in mind, a look at markets shows what had been a mixed opening is turning into a more negative session.  Overnight saw Asian equity markets with minimal gains and losses (Nikkei +0.5%, Hang Seng -0.3%, Shanghai -0.2%), but Europe, which had been behaving in a similar manner early in the session has turned sharply lower.  At this time, the DAX (-1.95%) and CAC (-2.0%) are leading the way lower, with the FTSE 100 (-0.8%) having a relatively better day.  At the same time, US futures turned from flat to lower, with all three indices now pointing to -0.6% losses at the open.

It is difficult to point to a specific comment or piece of news driving this new sentiment, but it appears that the bond market is in the same camp as stocks.  Treasury yields, while they remain in a narrow range, have slipped 1bp, to 0.65%, and we are seeing Bunds (-2bps) and Gilts (-3bps) also garner demand as havens are in play.  Apparently, central bank desire for inflation is not seen as a serious situation quite yet.

Commodity prices have turned around as well, with oil falling 2% from morning highs, and gold dropping 1%.  In other words, this is a uniform risk reduction, although I would suspect that gold prices should lag the decline elsewhere.

As to the dollar, it is starting to pick up a more substantial bid with EUR (-0.3%) and GBP (-0.35%) sliding from earlier levels.  NOK (-1.15%) remains the worst performer in the G10, which given the decline in oil prices and evolving risk sentiment should be no surprise.  But at this point in the day, the entire bloc is weaker vs. the buck.  EMG currencies, too, have completely reversed some modest early morning strength, and, once again, ZAR (-1.2%) and MXN (-1.0%) lead the way lower.  One must be impressed with the increased volatility in those currencies, as they start to approach levels seen in the initial stages of the Covid crisis.  For anyone who thought that the dollar had lost its haven status, recent price action should put paid to that notion.

On the data front, today brings Durable Goods (exp 1.4%, 1.0% ex Transport) and we hear from two more Fed speakers, Williams and Esther George.  While Williams is almost certain to repeat Powell’s current mantra of more fiscal support, Ms George is one of the more hawkish Fed members and could well sound more like James Bullard than Jay Powell.  We shall see.

This has been a risk-off week, with equity markets down across the board and the dollar higher vs. every major currency in the world.  It seems highly unlikely that the Durable Goods number will change that broader sentiment, and so the ongoing equity market correction, as well as USD rebound seems likely to continue into the weekend.  Remember, short USD positions are still the rule, so there is plenty of ammunition for a further short covering.

Good luck, good weekend and stay safe
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Prices Keep Falling

Posted on by

Suga-san’s ascent
Has not altered the landscape
Prices keep falling

The distance between stated economic goals and actual economic outcomes remains wide as the economic impact of the many pandemic inspired government ordered lockdowns continues to be felt around the world.  The latest example comes from Japan, where August’s CPI readings fell, as expected, to 0.2% Y/Y at the headline level while the ex-fresh food measure (the one the BOJ prefers) fell to -0.4%.  Although pundits in the US have become fond of ridiculing the Fed’s efforts at raising inflation to 2.0%, especially given their inability to do so since defining that level as stable prices in 2012, to see real ineptitude, one must turn east and look at the BOJ’s track record on inflation.  In the land of the rising sun, the favored measure of CPI ex-fresh food has averaged 0.5% for the last 35 years!  The point is the Fed is not the first, nor only, central bank to fail in its mission to generate inflation via monetary policy.

(As an aside, it is an entirely different argument to discuss the merits of seeking to drive inflation higher to begin with, as there is a strong case to be made that limited inflation is a necessary condition for economic success at the national level.)  But 2.0% inflation has become the global central banking mantra. And though the favored inflation measure across nations often differs, the one key similarity is that every G10 nation, as well as many in the emerging markets, has been unable to achieve their goal.  The few exceptions are those nations like Venezuela, Argentina and Turkey that have the opposite problem, soaring inflation and no ability to control that.

But back to Japan, where decades of futility on the inflation front have put paid to the idea that printing money is all that is needed to generate rising prices.  The missing ingredient for all central banks is that they need to pump money into places that result in lending and spending, not simply asset purchases, or those excess funds will simply sit on bank balance sheets with no impact.

Remember, GDP growth, in the long run, comes from a combination of population growth and productivity growth.  Japan has the misfortune, in this case, of being one of the few nations on earth where the population is actually shrinking.  It is also the oldest nation, meaning the average and median age is higher there than any other country on earth (except Monaco which really doesn’t matter in this context).  The point here is that as people age, they tend to consume less stuff, spending less money and therefore driving less growth in the economy.  It is these two factors that will prevent Japan from achieving a much higher rate of inflation until such time as the country’s demographics change.  A new Prime Minister will not solve this problem, regardless of what policies he supports and implements.

Keeping this in mind, the idea that Japan is far more likely to cope with ongoing deflation rather than rising inflation, if we turn our attention to how that impacts the Japanese yen, we quickly realize that the currency is likely to appreciate over time.  Dusting off your Finance 101 textbooks, you will see that inflation has the side effect of weakening a nation’s currency, which quickly feeds into driving further inflation.  Adding to this impact is if the nation runs a current account deficit, which is generally the case when inflation is high and rising.  Harking back to Argentina and Venezuela, this is exactly the behavior we see in those economies.  The flip side of that, though, is that deflation should lead to a nation’s currency appreciating.  This is especially so when that nation runs a current account surplus.  And of course, you cannot find a nation that fits that bill better than Japan (well maybe Switzerland).  The upshot of this is, further JPY appreciation seems to be an extremely likely outcome.  Therefore, as long as prices cease to rise in Japan, there will be upward pressure on the currency.  We have seen this for years, and there is no reason for it to stop now.

Of course, as I always remind everyone, FX is a relative game, so it matters a great deal what is happening in both nations on a relative basis.  And in this case, when comparing the US, where prices are rising and the current account has been in deficit for the past two decades, and Japan, where prices are falling and the current account has been in surplus for the past four decades, the outcome seems clear.  However, the market is already aware of that situation and so the current level of USDJPY reflects that information.  However, as we look ahead, either negative surprises in Japanese prices or positive surprises in the US are going to be important drivers in the FX market.  This is likely to be seen in interest rate spreads, which have narrowed significantly since March when the Fed cut rates aggressively but have stabilized lately.  If the Fed is, in fact, going to put forth the easiest monetary policy around, then a further narrowing of this spread is quite possible, if not likely, and further JPY appreciation will ultimately be the result.  This is what we have seen broadly since the middle of 2015, a steady trend lower in USDJPY, and there is no reason to believe that is going to change.

Whew!  That turned out to be more involved than I expected at the start.  So let me quickly survey the situation today.  Risk is under modest pressure generally, although there were several equity markets that put in a good performance overnight.  After a weak US session, Asia saw modest gains in most places (Nikkei +0.2%, Hang Seng +0.5%) although Shanghai (+2.1%) was quite strong.  European markets are far less convinced of the positives with the DAX (+0.4%) and CAC (-0.1%) not showing much movement, and some of the fringe markets (Spain -1.3%) having a bit more difficulty.  US futures are mixed, although the top performer is the NASDAQ (+0.4%).

Bond markets continue to trade in a tight range, as central bank purchases offset ongoing issuance by governments, and we are going to need some new news or policies to change this story.  Something like an increase in the ECB’s PEPP program, or the BOE increasing its purchases will be necessary to change this, as the Fed is already purchasing a huge amount of paper each month.

And finally, the rest of the FX market shows that the dollar is broadly, but not universally under pressure.  G10 activity shows that NZD (+0.4%) is the leader, although JPY (+0.3%) is having another good day, while NOK (-0.25%) is the laggard.  But as can be seen by the modest movements, and given the fact it is Friday, this is likely position adjustments rather than data driven.

In the EMG space, KRW (+1.2%) was the biggest gainer overnight, which was hard to explain based on outside influences.  The KOSPI rose 0.25%, hardly a huge rally, and interest rates were unchanged.  The best estimate here is that ongoing strength in China is seen as a distinct positive for the won, as South Korea remains highly dependent on the mainland for economic activity.  Beyond the won, though, while there were more gainers than losers, the size of movement was not that significant.

On the data front, speaking of the current account, we see the Q2 reading this morning (exp -$160.0B), as well as Leading Indicators (1.3%) and Michigan Sentiment (75.0).  We also hear from three Fed speakers (Bullard, Bostic and Kashkari) but having just heard from Powell on Wednesday, it seems unlikely they will give us any new information. Rather, today appears to be a consolidation day, with marginal movements as weak positions get unwound into the weekend.

Good luck, good weekend and stay safe
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Nations Regress

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When two weeks ago I last wrote
The narrative was to promote
A dollar decline
Which did intertwine
With hatred for Trump ere the vote

But since then the dollar’s rebounded
While experts galore are confounded
Poor Europe’s a mess
While nations regress
On Covid, where hope had been founded

I told you so?  Before my mandatory leave began, the market narrative was that the dollar was not merely falling, but “collapsing” as everything about the US was deemed negative.  The background story continued to be about US politics and how global investors were steadily exiting the US, ostensibly because of the current administration.  Adding to that was Chairman Powell’s speech at the virtual Jackson Hole symposium outlining average inflation targeting, which implied that the Fed was not going to respond to incipient inflation by raising rates until measured inflation was significantly higher and remained there sufficiently long to offset the past decade’s period of undershooting inflation.  In other words, if (when) inflation rises, US interest rates will remain pegged to the floor, thus offering no support for the dollar.  While there were a few voices in the wilderness arguing the point, this outcome seemed assured.

And the dollar did decline with the euro finally breeching the 1.20 level, ever so briefly, back on September 1st.  But as I argued before leaving, there was no way the ECB was going to sit by idly and watch the euro continue to rally without a policy response.  ECB Chief economist Philip Lane was the first to start verbal intervention, which was sufficient to take the wind out of the euro’s sails right after it touched 1.20.  Since then, the ECB meeting last week was noteworthy for not discussing the euro at all, with market participants, once again, quickly accepting that the ECB would allow the single currency to rally further.  But this weekend saw the second volley of verbal intervention, this time by Madame Lagarde, VP Guindos, Ollie Rehn and Mr Lane, yet again.  Expect this pattern to be repeated regularly, every euro rally will be met with more verbal intervention.

Of course, over time, verbal intervention will not be enough to do the job, which implies that at some point in the future, we will see a more intensive effort by the ECB to help pump up inflation.  In order of appearance look for a significant increase in QE via the PEPP program, stronger forward guidance regarding the timing of any incipient rate hikes (never!), a further cut to interest rates and finally, actual intervention.  In the end, there is absolutely no way that the ECB is going to allow the euro to rally very much further than it already has.  After all, CPI in the Eurozone is sitting at -0.2% (core +0.4%), so far below target that they must do more.  And a stronger euro is not going to help the cause.

Speaking of inflation, I think it is worth mentioning the US situation, where for the second straight month, CPI data was much higher than expected.  While many analysts are convinced that the Fed’s rampant asset purchases and expansion of the money supply are unlikely to drive inflation going forward, I beg to differ.  The lesson we learned from the GFC and the Fed’s first gargantuan expansion of money supply and their balance sheet was that if all that money sits in excess reserves on commercial bank balance sheets, velocity of money declines and inflation is absent.  This time, however, the new funds are not simply sitting on the banks’ collective balance sheets but are rather being spent by the recipients of Federal government largesse.  This is driving velocity higher, and with it, inflation.  Now, whatever one may think of Chairman Powell and his Fed brethren, they are not stupid.  The Jackson Hole speech, I believe, served two purposes.  First, it was to help investors understand the Fed’s reaction function going forward, i.e. higher inflation does not mean higher interest rates.  But second, and something that has seen a lot less press, is that the Fed has just moved the goalposts ahead of what they see as a rising tide of inflation.  Now, if (when) inflation runs hot over the next 12-24 months, the Fed will have already explained that they do not need to respond as the average inflation rate has not yet achieved 2.0%.  It is this outcome that will eventually undermine the dollar’s value, higher inflation with no monetary response, but we are still many months away from that outcome.

Turning to today’s activity, after two weeks of broad dollar strength, as well as some equity market pyrotechnics, we are seeing a bit of a dollar sell-off today.  It would be hard to characterize the markets as risk-on given the fact that European bourses are essentially flat on the day (DAX -0.1%, CAC +0.1%) while Asian equity markets showed only modest strength at best (Nikkei, Hang Seng and Shanghai all +0.6%).  Yes, US futures are pointing higher by 1.0%, but that seems more to do with the two large M&A deals announced than anything else.

In the meantime, bond markets have shown no indication of risk being on, with 10-year Treasury yields essentially unchanged since Friday at 0.67%, and effectively unchanged since I last wrote on August 28!  The same is largely true across European government bond markets, with, if anything, a bias for risk-off as most of those have seen yields slide one to two basis points.

And finally, the dollar’s specifics show GBP (+0.6%) to be the top G10 performer, which given its recent performance, down more than 4% since I last wrote, seems to be a bit of a breather rather than anything positive per se.  In the UK, today sees the beginning of the Parliamentary debate regarding PM Johnson’s proposed rewrite of aspects of Brexit legislation, which many think, if passed, will insure a hard Brexit.  As to the rest of the bloc, gains are mostly in the 0.25% range, with the most common theme the uptick in economists’ collective forecasts for economic prospects compared with last month.

Interestingly, in the EMG bloc, movement is less pronounced, with MXN (+0.4%) the biggest gainer, while RUB (-0.4%) is the laggard.  Clearly, as both are oil related, oil is not the driver.  However, when EMG currencies move less than 0.5%, it is hard to get too excited overall.

On the data front this week, the big story is, of course, the FOMC meeting on Wednesday, but we have a bunch of things to absorb.

Tuesday Empire Manufacturing 6.0
IP 1.0%
Capacity Utilization 71.4%
Wednesday Retail Sales 1.0%
-ex autos 1.0%
Business Inventories 0.2%
FOMC Rate Decision 0.00%-0.25%
Thursday Initial Claims 850K
Continuing Claims 13.0M
Housing Starts 1480K
Building Permits 1520K
Friday Leading Indicators 1.3%
Michigan Sentiment 75.0

Source: Bloomberg

What we have seen lately is the lagging indicators showing that the bounce after the reopening of the economy was stronger than expected, but there is growing concern that it may not be sustainable.  At the same time, the only thing interesting about the FOMC meeting will be the new forecasts as well as the dot plot.  After all, Jay just told us what they are going to do for the foreseeable future (nothing) two weeks ago.

Good luck and stay safe
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