Severely Distraught

At Jackson Hole, Powell explained
Inflation goals have been attained
But joblessness still
Is high, so they will
Go slow ere their bond buying’s waned

The market heard slow and they thought
The stock market had to be bought
So, prices keep rising
And it’s not surprising
The hawks are severely distraught

In my absence, clearly the biggest story has been Chairman Powell’s Jackson Hole speech, where he promised at some point that the Fed would begin to taper their bond purchases, but that it was still a bit too early to do so.  He admitted that inflation had achieved their target but was still quite concerned over the employment portion of the Fed’s mandate, hence the ongoing delay in the tapering.  And perhaps he was prescient as after Jackson Hole the NFP number was a massively disappointing miss, just 235K vs 733K median forecast.  And to be clear, that number was well below the lowest forecast of 70 estimates.  The point is, the evolution of the economy is clearly not adhering to the views expressed by many, if not most, FOMC members.  We have begun to see significant reductions in GDP growth forecasts for the second half of the year, with major investment banks all cutting their forecasts and the Atlanta Fed’s GDPNow number falling to a remarkably precise 3.661% for Q3.

With this as a backdrop, it can be no surprise that the dollar has fallen dramatically during the past two weeks.  For instance, in the G10, NOK (+4.2%) and NZD (+4.2%) both led the way higher as commodity prices rebounded, oil especially, and the US interest rates fell.  In fact, the only currency to underperform the dollar since my last note has been the Japanese yen (-0.15%), which is essentially unchanged.  The story is the same in the EMG space with virtually every currency rising led by ZAR (+6.9%) and BRL (+4.1%).  In fact, only Argentina’s peso (-0.65%) managed to decline over the previous two weeks.  The point is, the belief in a stronger dollar, based on the idea of the Fed tapering QE and then eventually raising interest rates, has come a cropper.  The question is, where do we go from here?

With Jay in the mirror, rearview
It’s Christine’s time, now, to come through
On Thursday we’ll hear
If she’s set to steer
The ECB toward Waterloo

As the market walks in after the Labor Day holiday in the US, we are seeing the beginnings of a correction of the past two week’s price action, at least in the FX markets.  Surveying the overnight data shows a minor dichotomy in Germany, where IP (+1.0%) rose a bit more than expected although the ZEW Surveys were both softer than expected.  Meanwhile, Eurozone GDP grew at a slightly better than previously reported 2.2% quarterly rate in Q2, although that does not include the most recent wave of delta variant imposed lockdowns.  In other words, we are no longer observing either uniform strength or weakness in the data, with different parts of each national economy being impacted very differently by Covid-19.  One other thing to note here is the decline in support for the ruling CDU party in Germany where elections will be held in less than two weeks.  It seems that despite 16 years of relative prosperity there, under the leadership of Chancellor Angela Merkel, the populace is looking for a change.  This matters to the FX markets as a change in German economic policy priorities is going to have a major impact on the Eurozone, and by extension the euro.  Of course, at this point, it is too early to tell just what that impact may be.

Of more immediate interest to the market will be Thursday’s ECB meeting, where, while policy settings will not be altered, all eyes and ears will be on Madame Lagarde to understand if the ECB, too, is now beginning to consider a tapering of its QE purchases.  Last week, CPI data from the Eurozone printed at 3.0%, its highest level since September 2008, and well above the ECB’s 2.0% target (albeit not quite as far above as in the US).  This has some of the punditry starting to expect that the ECB, too, is ready to begin to taper QE.  However, the Eurozone growth impulse remains significantly slower than that in the US, and with the area unemployment rate still running at an uncomfortably high 7.6%, (much higher in the PIGS), it remains difficult to see why they would be so keen to begin removing accommodation.  Given the ECB storyline, similar to the Fed, is that inflation is transitory, there is no reason to believe the ECB is getting set to move soon.  Rather, I expect that although the PEPP may well end next March on schedule, it will simply be replaced with either an extension or expansion of the original APP, and likely both.  The reality is that the bulk of the Eurozone would see a collapse in growth without the ongoing support of the ECB.

Turning away from that happy news, a quick survey of markets shows that equities in Asia have continued their recent strong performance (Nikkei +0.9%, Hang Seng +0.7%, Shanghai +1.5%), all of which have rallied sharply in the past two weeks.  Europe, however, has not embraced today’s data, or is nervous about potential ECB action, as markets there are a bit softer (DAX -0.3%, CAC -0.1%, FTSE 100 -0.4%).  US futures markets are essentially unchanged at this hour, continuing their recent very slow grind higher.

Of more interest today is the bond market, where Treasury yields have rallied 4.1 basis points and we are seeing higher yields throughout Europe as well (Bunds +3.9bps, OATs +4.3bps, Gilts +3.2bps).  During my break, yields have managed to rally 10bps (including today) which really tells you that the market is still completely in thrall to the transitory story.  Either that, or the Fed continues to absorb any excess paper around.  However, higher yields seem to be helping the dollar more than other currencies despite similar size movements.

While the movement has not been significant, especially compared to the dollar weakness seen during the past two weeks, we are seeing strength in the dollar vs G10 currencies (AUD -0.5%, CAD -0.4%); EMG currencies (ZAR -0.6%, TRY -0.6%); and commodities (WTI -0.6%, Au -0.7%, Cu -1.1%).  Looking at today’s price action, it appears that US rate movement has been the dominant driver.

On the data front, it is a remarkably quiet week with just a handful of numbers:

Wednesday JOLTs Job Openings 10.0M
Fed’s Beige Book
Thursday Initial Claims 335K
Continuing Claims 2744K
PPI 0.6% (8.2% Y/Y)
-ex food & energy 0.5% (6.6% Y/Y)

Source: Bloomberg

We also hear from six Fed speakers, with NY President Williams the most important voice.  But thus far, the Fed’s messaging has been quite effective as they continue to assuage fixed income investors with the transitory tale and thus interest rates remain near their longer-term lows.  While at some point I expect this narrative to lose its hold on the investment community, it does not appear to be an imminent threat.

While I was out, the market flipped its views from concern over tapering leading to higher interest rates, to when tapering comes, it will be “like watching paint dry”*.  FX investors and traders determined there was no cause for a much stronger dollar, and so the buck gave back previous gains and now sits back in the middle of its trading range.  As such, we need to search for the next potential catalyst to change big picture views.  While my money is on the collapse of the transitory narrative, and ensuing dollar weakness, you can be certain the Fed will fight hard to keep that story going.  In other words, I expect that the trading range will remain intact for the foreseeable future.  Trade accordingly.

Good luck and stay safe
Adf

*June 15, 2017 comments from then Fed Chair Janet Yellen regarding the normalization of Fed policy and the balance sheet, where she described the process as similar to watching paint dry.  It turns out, that policy process was a bit more exciting, especially in Q4 2018 when equity markets fell 20% and Chair Powell was forced to abandon that policy.

To Taper’s Ordained

The Minutes on Wednesday explained
That QE would still be sustained
But ere this year ends
Some felt that the trends
Implied that, to taper’s, ordained

But ask yourself this, my good friends
What happens if tapering sends
The stock market down
Will they turn around
And restart QE as amends?

Remember all the times the Fed tried to tell the world that their current policy stance, notably the massive amount of QE purchases, were not the driving force in the equity market?  Stock market bulls played along with this as well, explaining that historically high valuation measures were all appropriate given the huge corporate profit margins, and had nothing to do with the Fed’s suppression of interest rates along the entire yield curve.  The bulls would point to 30-year interest rates below 2.00% and explain that when you discounted future cash flows at such low levels, it was only natural that stock valuations were high.  The fact that it was the Fed that was simultaneously buying up all the net Treasury issuance, and then some, thus driving rates artificially lower, as well as promising to do so for the foreseeable future was seen as a minor detail.

Perhaps that detail was not as minor as the bulls would have you believe!  Yesterday, the FOMC Minutes were released and the part that garnered all the attention was the discussion on the current asset purchase framework and how it might change in the future.

“Most participants judged that the Committee’s standard of “substantial further progress” toward the maximum-employment goal had not yet been met. At the same time, most participants remarked that this standard had been achieved with respect to the price- stability goal. (my emphasis) A few participants noted, however, that the transitory nature of this year’s rise in inflation, as well as the recent declines in longer-term yields and in market-based measures of inflation compensation, cast doubt on the degree of progress that had been made toward the price-stability goal since December.”

So, it seems they are in sync on the fact that the employment situation has room to run, and they don’t want to act too early because of that.  But what I find more interesting is that they can use the term ‘price stability’ when discussing inflation running in the 4.0%-5.0% range.  As well, it is apparent that many of the committee members are drinking their own Kool-Aid on the transitory story.

“Looking ahead, most participants noted that, provided that the economy were to evolve broadly as they anticipated, they judged that it could be appropriate to start reducing the pace of asset purchases this year because they saw the Committee’s “substantial further progress” criterion as satisfied with respect to the price-stability goal and as close to being satisfied with respect to the maximum employment goal. Various participants commented that economic and financial conditions would likely warrant a reduction in coming months. Several others indicated, however, that a reduction in the pace of asset purchases was more likely to become appropriate early next year because they saw prevailing conditions in the labor market as not being close to meeting the Committee’s “substantial further progress” standard or because of uncertainty about the degree of progress toward the price-stability goal.” (my emphasis)

But this was the money line, the clear talk that most of the committee expected tapering to begin before the end of the year.  While we have not yet heard any of the three key leaders (Powell, Williams and Brainerd) say they were ready to taper, it seems that most of the rest of the committee is on board.  Jackson Hole suddenly became much more interesting, because if Powell discusses tapering as likely to occur soon, it will be a done deal.  But if he doesn’t explain that tapering is coming soon, it is possible that we see four dissents, at the next meeting.  And how about this for a thought, what if those three are the only votes to stand pat, and the other six voting members want to start the taper?  That would truly be unprecedented and, I think, have major negative market ramifications.  I don’t expect that to occur, but after everything that has occurred over the past 18 months, I wouldn’t rule out anything anymore.

At any rate, the tapering talk remains topic number one in every market, and one cannot be surprised that the market’s reaction has been a clear risk-off response.  Equity markets around the world are lower, substantially so in Europe; bond markets are rallying as risk is jettisoned; commodity prices are falling, and the dollar is king!

So, let’s take a tour and see where things are.  Starting in Asia, we saw equities decline throughout the region with the Nikkei (-1.1%), Hang Seng (-2.1%) and Shanghai (-0.6%) all under pressure.  But the real pressure was felt in Korea (KOSPI -1.9%) and Taiwan (TAIEX -2.7%).  In fact, the only markets in the region to hold their own were in New Zealand.  Turning to Europe, it is a uniform decline with the DAX (-1.6%), CAC (-2.5%), and FTSE 100 (-2.0%) all falling sharply, with the lesser known indices also completely in the red.  I guess the prospect of less Fed largesse is not seen as a positive after all.  Meanwhile, ahead of this morning’s opening, US equity futures are all sharply lower, on the order of 0.75%.

Turning to the bond market, the prospect of less Fed buying is having an interesting outcome, bonds are rallying.  Of course, this is because Treasuries remain the ultimate financial safe-haven trade and as investors flee risky assets, bonds are the natural response.  So, 10-year Treasury yields have fallen 3.5bps, and we are seeing yields decline in the European market as well, at least those countries that are deemed solvent.  So, Bunds (-1.4bps), OATs (-1.1bps) and Gilts (-3.4bps) are all seeing demand.  Yields for the PIGS, however, are unchanged to higher on the day.

Commodity prices are uniformly lower, except for gold, which is essentially unchanged on the day.  Oil (-3.7%) leads the way down, but we are seeing weakness in base metals (Cu -3.3%) as well as the Agricultural space (Wheat -1.5%, Soybeans -1.2%).

Finally, the dollar is on top of the world this morning, as investors are buying dollars to buy bonds, or so it seems.  In classic risk-off fashion, only the yen (+0.1%) has managed to hold its own vs. the dollar as the rest of the G10 bloc is weaker led by NOK (-0.95%) and AUD (-0.95%).  NZD (-0.7%) and CAD (-0.7%) are also suffering greatly given the commodity weakness story.  But do not ignore the euro (-0.15%) which while it hasn’t moved very far, has managed to finally trade below the key 1.1704 support level, and is set, in my view, to head much lower.

In the EMG space, ZAR (-1.3%) is the leading decliner, falling alongside the commodity complex.  KRW (-0.7%) has given back all of yesterday’s gains as equity outflows continue to dominate the market there, but we are seeing weakness across the board with most currencies falling between 0.3%-0.6% purely on the dollar’s overall strength.

On the data front, this morning brings the weekly Initial Claims (exp 364K) and Continuing Claims (2.8M) as well as Philly Fed (23.1) and Leading Indicators (+0.7%).  There’s no scheduled Fedspeak, but what else can they say after yesterday’s Minutes anyway?  If you recall, Monday’s Empire Mfg was quite weak, so I would not be surprised to see Philly follow suit.  In fact, I think the biggest problem the Fed is going to have is that the data is rolling over and looking like a slowing economy, despite high inflation.  If they keep seeing economic weakness, are they really going to taper into a weakening economy?  They may start, but I doubt they get two months in before they stop, especially if equities continue to revalue (fall).  As to the dollar, for now, I like its prospects and suspect that we are going to trade to levels not seen since June of last year.

Good luck and stay safe
Adf