A Beginning, a Middle and End

“A beginning, a middle and end”
Is how Powell outlined the trend
Of current inflation
Which has caused frustration
For central banks who overspend

As Ralph Waldo Emerson so notably observed, “A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines.”  I am reminded of this each time I read that (little statesman) Jay Powell or (the divine) Madame Lagarde explain that inflation is largely transitory.  Little-minded they certainly appear to be, no?  Every day the evidence grows that inflation is trending higher yet despite this information, they remain consistent in their belief (or at least in their comments) that all of this price appreciation will quickly pass.  Yesterday, at an ECB held virtual symposium, Powell expressed frustration that supply chain bottlenecks have not been resolved as quickly as the Fed’s models indicate they should be.  Or perhaps the frustration stems from the fact that they have been completely wrong about inflation and it is starting to have a serious impact on their idealized world.  Whatever the case, each time they try to gloss over the implications of inflation, they lose just a touch more credibility (to the extent they have any remaining) in the markets’ collective eyes.  While the Fed’s track record for forecasting has always been awful, the current situation appears to be one of either intransigence in the face of new evidence, or more likely, a recognition that a change in their narrative has the potential to lead to much worse outcomes.

Fortunately, they continue to explain that if inflation were to get out of hand, they have the tools to address the issue and they are not afraid to use them!  However, history indicates that is not the case.  Consider that those ‘tools’ consist of the ability to raise interest rates and tighten monetary policy.  We all recall that just 3 years ago, as the Fed was attempting to normalize its balance sheet, allowing purchased assets to mature without being replaced, as well as slowly move interest rates higher, the equity market tumbled 20% in Q4 2018.  This led to the Powell pivot, where he decided that a declining stock market was a negative for his personal balance sheet the economy and instead, the FOMC cut rates in January to mitigate the damage already done.  The situation today appears far more dangerous with market leverage and valuations at historic highs.  Tightening policy in this market condition is likely to result in at least a 20% revaluation of equities, something the Fed can clearly not countenance.  Hence, it is far easier to ignore inflation than to respond to it.  Meanwhile, Paul Volcker spins in his grave!

In the meantime, Eurozone inflation readings released thus far this morning have shown virtually every one at the highest levels since before the GFC, at the very least, if not the highest readings in three decades.  For instance, French CPI printed at 2.7%, its highest print since June 2008.  Italian CPI, at 3.0%, is merely its highest since 2012, but in fairness, prior to the euro’s creation, Italian CPI regularly ran at much higher levels resulting in a continuing depreciation of the lire. Shortly we will see German inflation, with some of its States already reporting levels above 4.2%, their highest prints since the mid 1990’s, which is also the current forecast for the nation as a whole.  The point is, there is absolutely no evidence that inflation is peaking, and while Powell and Lagarde twiddle their thumbs, things are going to get worse before they get better.

So, what does this mean for markets?  Well, we have already seen yield curves steepen in the US and throughout Europe as there is a strong belief that despite rising inflation, neither the Fed nor ECB is going to respond.  Yes, the Fed said they would think about tapering come November, but if anything, that is likely to simply steepen the curve further as the price-insensitive buyer of last resort reduces its purchases.  The real question is, at what point will the Fed decide that yields are too high and adjust policy to rein them in?  SMBC’s house forecast is for 1.80% by the end of the year, which is in line with much of the Street.  The conundrum, however, is that Street forecasts are for continued higher prices in equities as well, and it seems to me that the two scenarios are unlikely to be achieved simultaneously.  If rates do continue higher, while I think the short-term impact will be USD positive, I fear the equity market may not be quite as sanguine.

Overnight, markets continue to wrestle with the conflicting ideas of rising inflation and central bank sanguinity on its transitory nature.  While we have seen a sharp rise in yields over the past week, last night was a consolidating session with bond market movement quite limited.  Treasury yields have edged higher by 1.2bps, but at 1.53% remain a few ticks below the peak seen Monday.  We have seen similar, modest, price action on the continent (Bunds +0.5bps, OATs +0.4bps) although Gilts (+2.4bps) have responded to better-than-expected GDP results for Q2, which showed year on year growth of 23.6%.  Not surprisingly, this has helped the pound as well, which is firmer this morning by 0.1%.

Equity markets have also had mixed reviews with Asia (Nikkei -0.3%, Hang Seng -0.4%, Shanghai +0.9%) not giving consistent direction and Europe following suit (DAX -0.2%, CAC 0.0%, FTSE 100 +0.2%).  US futures are higher by about 0.5% at this hour as traders await this morning’s data releases.

While oil prices have slipped a bit this morning (WTI -0.8%) the same cannot be said for NatGas (+2.7%) as the energy situation remains fraught in Europe and the UK (and Asia).  The rest of the commodity space is generally under pressure as well with copper (-1.7%) and aluminum (-0.4%) both falling while the precious sector is essentially unchanged on the day.

The dollar, while mixed in the overnight session, saw significant strength yesterday which has seen the euro fall below 1.1600 for the first time since July 2020, and looking for all the world like it has further to run.  Unless yields in the US stop rising, my take is we could well see 1.12 before long.  But in the past two days we have seen some sharp declines; NOK (-1.5%), NZD (-1.3%) and EUR (-0.9%) have all suffered.  Even the yen (-0.45%) is declining here despite some evidence of risk mitigation.  In fact, it has weakened to its lowest point since the beginning of the Covid situation in February 2020, and here, too, looks as though it as room to run.  115 anyone?

EMG currencies have shown similar price behavior, falling sharply yesterday with a more mixed overnight session.  But the breadth of the decline is indicative of a dollar story, not any idiosyncratic issues in particular countries.  While those clearly exist, they are not driving the market right now.

This morning’s data calendar brings the weekly Initial (exp 330K) and Continuing (2790K) Claims data as well as the third look at Q2 GDP (6.6%).  Then at 9:45 we see Chicago PMI (65.0).  While the GDP data contains inflation information, it is not widely followed or used in models.  However, it is interesting to note that the Core PCE calculation there is at 6.1%, which happens to be the highest print since Q3 1983!  Perhaps this is why it is ignored.

We also hear from six Fed speakers in addition to Powell and Yellen sitting down in front of the House Financial Services Committee.  Of course, Powell has made clear his views on the transitory nature of inflation and I’m confident no question from a Congressman will get him to admit anything different.  Rather, I expect a staunch defense of the two disgraced Fed regional presidents who resigned after their insider trading was made known, and both he and Yellen to beseech Congress to raise the debt ceiling and not allow the government to shut down.  In other words, nothing new will occur.

The dollar has pretty clearly broken out of its recent range and I expect that this move has some legs.  I would be buying dollars on dips when the opportunity arises.  For payables hedgers, pick your spots and lock in comfortable rates.  The trend is now your friend.

Good luck and stay safe
Adf

Reason to Fear

In Europe, the price of Nat Gas
Has risen to new highs, alas
As winter comes near
There’s reason to fear
A rebound will not come to pass

As well the impact on inflation
Is likely to add to frustration
Of Madame Lagarde
As she tries so hard
To hide the debt monetization

Some days are simply less interesting than others, and thus far, today falls into the fairly dull category.  There has been limited new news in financial markets overall.  While the ongoing concerns over the imminent failure of China Evergrande continue to weigh on Asian stocks (Nikkei -0.6%, Hang Seng -1.5%, Shanghai -1.3%), the story that is beginning to see some light in Europe is focused on the extraordinary rise in Natural Gas prices.  As a point of reference, in the US, Nat Gas closed yesterday at $5.34/MMBtu, itself a significant rise in price over the past six months, nearly doubling in that time.  Europeans, however, would give their eye teeth for such a low price as the price in the Netherlands for TTF (a contract standard) is $22.61/MMBtu!  This price has risen nearly fourfold during the past six months and now stands more thar four times as costly as in the US.  Whatever concerns you may have had about your personal energy costs rising in the US, they are dwarfed by the situation in Europe.

This matters for a number of reasons beyond the economic (for instance, how will people in Europe afford to heat their homes in the fast approaching winter and continue to feed their families as well?)  but our focus here is on markets and economics.  Thus, consider the following:  Europe remains a manufacturing and exporting powerhouse and is reliant on stable supply and pricing of natural gas to power their factories.  Obviously, recent price action has been anything but stable, and given the European dependence on Russian gas supplies, there is a geopolitical element overhanging the market as well.  LNG can be a substitute, but Asian buyers have been paying up to purchase most of those cargoes, so Europe is finding itself with reduced supply and correspondingly rising prices.

The first big industrial impact came yesterday when a major manufacturer of fertilizer shut down two UK plants because the cost of Nat Gas had risen too far to allow them to be competitive.  Consider the chain of events here: first, closure of the plant means reduced overall output, as well as furloughed, if not fired, workers. Second, reduction in the supply of fertilizer means that the price for farmers will almost certainly rise higher, thus forcing farmers to either raise their prices or reduce production (or go out of business).  Higher food prices, which have already risen dramatically, will result in reduced non-food consumption and strain family budgets as it feeds into inflation.  Net, slower growth and higher prices are the exact wrong combination for any economy and one to be avoided at all costs.  Alas, this is very likely the type of future that awaits many, if not most, European countries, the dreaded stagflation.  The ECB has its work cut out to combat this issue effectively while the Eurozone economy sits on more than €11.3 trillion in debt.  I don’t envy Madame Lagarde’s current position.

Beyond the macroeconomic issues, what are the potential market impacts?  Here things, as always, are less clear, but thus far, we have seen one impact, and that is a declining euro (-0.4%).  In fact, all European currencies are falling today as it becomes clearer that economic activity across the pond is going to be further impaired by this situation.  It has been sufficient to offset perceived benefits of European economies reopening in the wake of the spread of the delta variant of Covid.  However, the upshot of this currency weakness has been equity market strength.  It seems that any concerns of the ECB considering tighter policy have been pushed even further into the future thus encouraging investors to continue to add risk to their portfolios.  Hence, this morning, in the wake of the ongoing rise in Nat Gas prices, we see European equities all in the green (DAX +0.5%, CAC +1.0%, FTSE 100 +0.45%).  Under the guise of TINA, weaker growth leads to continued low rates and higher stock prices.  What could possibly go wrong?

US markets are biding their time at this hour, with futures essentially unchanged and really, so are bond markets.  Of the major sovereigns, only Gilts (+1.8bps) have moved more than a fraction of a basis point this morning.  While risk may be on, it is not aggressively so.  Either that, or European banks are back to buying more and more of their national bonds tightening the doom loop that ultimately led to the Eurozone crisis in 2012.

Commodities?  Well, as it happens, after a multi-day rally, oil prices are consolidating with WTI (-0.25%) basically holding the bulk of the $10 in gains it has made in the past month.  Nat Gas, too, is consolidating this morning, down $0.16/MMBtu, although that represents 3% (Natty is very, very volatile!)  With the dollar rocking, we are also seeing weakness across the metals’ markets, both precious (gold -0.75%) and industrial (Cu -2.0%, Al -0.6%, Pb -1.6%).  In fact, the only commodity that is performing well today is Uranium, which is higher by a further 8.1%.

Finally, the dollar is king today, rising against 9 of its G10 counterparts with CHF (-0.5%) the laggard and only NZD (+0.1%) able to show any strength today.  The Kiwi story has been a much better than expected GDP print (2.8% vs 1.1% expected) leading to growing expectations of a 0.50% rate hike next month.  Meanwhile, the rest of the bloc is suffering from the aforementioned cracks in the rebound theory as well as broad-based dollar strength.  This strength has been universal in EMG markets, with every currency sliding against the greenback.  Thus far, the worst performer has been PLN (-0.6%) followed by THB (-0.5%) and HUF (-0.5%).  Beyond that, most currencies are down in the 0.2% range.  Interestingly, for both PLN and HUF, the market discussion is about raising interest rates with Hungary looking at 50bps while Poland has called for a “gentle” rise, assumed to be 0.25%.  As to THB, it seems the market has been reacting to a rise in the number of Covid cases which is perpetuating the Asian risk-off theme.

We have a full slate of data today at 8:30 with Initial (exp 323K) and Continuing (2740K) Claims; Philly Fed (19.0) and the biggest of the day, Retail Sales (-0.7%, 0.0% ex autos).  Tuesday’s Empire Manufacturing data was MUCH stronger than expected, so there will be some hope for Philly to beat.  But the Retail Sales data is the key.  Remember, this number started to slide once the stimulus checks stopped, and last month we saw a much worse than expected -1.1% outcome.  Given the uncertainty over the near-term trajectory of the economy, this will be seen as an important number.

Well, the dollar managed to strengthen despite lacking support from yields, certainly a blow to the dollar bears out there.  The thing is, against the G10, I continue to see the dollar in a range (1.17/1.19) and will need to see a break of either side to change views.  If forced to opine, I would say the medium-term trend for the dollar is gradually higher, but would need to see the euro below 1.17, or the DXY above 93.50 before getting too excited.

I will be out of the office tomorrow so no poetry until Monday.

Good luck, good weekend and stay safe
Adf

Recalibrate

Christine said she’d recalibrate
The PEPP, but she clearly did state
No taper’s occurring
Because we’re still spurring
Inflation to reach our mandate

I felt it was important for all of us to be reminded of what tapering means, hence this definition from the Merriam-Webster dictionary:

taper   verb

1               : to become progressively smaller toward one end
2               : to diminish gradually (emphasis added)

But perhaps there is a better source to explain Madame Lagarde’s dissembling comments yesterday; Lewis Carrol.

“I don’t know what you mean by ‘glory,’ ” Alice said.
Humpty Dumpty smiled contemptuously. “Of course, you don’t—till I tell you. I meant ‘there’s a nice knock-down argument for you!'”
“But ‘glory’ doesn’t mean ‘a nice knock-down argument’,” Alice objected.
“When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean—neither more nor less.”
“The question is,” said Alice, “whether you can make words mean so many different things.”
“The question is,” said Humpty Dumpty, “which is to be master—that’s all.”

Apparently, Madame Lagarde was channeling Humpty Dumpty in her press conference yesterday when she said that while the ECB would be gradually reducing the rate of purchases in the PEPP program in the coming quarter, it was definitely not tapering.  One of the problems this author has with centralbankspeak is that my education taught me based on the plain meaning of the words used.  Hence, claiming that a reduced rate of purchases is not tapering is simply dishonest.  However, central bankers everywhere, led by the Fed and ECB, have come to rely on redefining terms in order to placate both of their masters, markets and governments, who frequently require opposing policies to achieve their goals.

Remember, too, what happened to Humpty Dumpty, a lesson I daresay has been lost on Powell, Lagarde and their comrades-in-arms:

Humpty Dumpty sat on a wall
Humpty Dumpty had a great fall
All the King’s horses and all the King’s men
Couldn’t put Humpty together again.

As economist Herbert Stein explained in 1986, “if something cannot go on forever, it will stop.”  Central bank balance sheets cannot grow indefinitely, at least not without other repercussions.  The most likely relief valve will be the currency, but do not be surprised if there is significant damage to all financial assets at the time investors and markets cease to accept centralbankspeak as a valid guide to the future.

Ever since the GFC, central banks around the world have been aggressively adding liquidity to economies at a far faster pace than those economies create goods and services.  For the first decade of this process, that liquidity mostly found its way into financial markets resulting in the longest bull market in history.  But lately, that liquidity has begun to seep into the real economy on the back of a massive uptick in fiscal stimulus.  The result, you may have noticed, is that financial markets have stopped rising at their previous rate, but the price of stuff you buy every day/week, has started to rise much more rapidly. It is this fact that was the genesis of the ‘transitory’ inflation story, as central banks, notably the Fed, recognize they cannot afford to be blamed for rising consumer inflation, but also cannot afford to fight inflation in the traditional manner of raising interest rates as they are terrified adjusting their current policy will result in a massive market decline.  Hence, I fear the Humpty Dumpty metaphor will wind up being very accurate.  However, he hasn’t fallen yet.

And so, Madame Lagarde did exactly what she set out to do; she was able to explain the ECB would be slowing their PEPP purchases without the market responding in a knee-jerk sell-off.  She placated the hawks on the ECB Council, and watched as Italian BTPs outperformed German bunds thus reducing pressure on the biggest potential problem in Europe.  In the end, kudos are due, at least for now.  I sure hope it lasts, but fear there is much turmoil in our future.

In the meantime, the overall market response to Lagarde has been…buy risk!  Equity markets everywhere are in the green with Asia (Nikkei +1.25%, Hang Seng +1.9%, Shanghai +0.3%) charging ahead and Europe (DAX +0.3%, CAC +0.3%, FTSE 100 +0.3%) following, albeit at a bit slower rate.  US futures, after two lackluster sessions in NY, are pointing higher by 0.4% to start the day.

Of course, with risk appetites whetted, there is no need to hold havens like bonds and so prices there have fallen everywhere with corresponding rises in yields.  Treasuries (+2.9bps) are leading the way but we are seeing Europe (Bunds +1.8bps, OATs +1.9bps, Gilts +1.1bps) all under some pressure as well.  As long as risk is in the ascendancy, I expect that bond yields will continue to edge higher.

Commodity prices are also firmer this morning led by oil (+1.7%) and the entire energy complex.  But metals, too, are up, at least industrial metals with copper (+1.9%), aluminum (+1.6%) and tin (+1.2%) all much stronger and with the latter two pushing to multi-year highs.  While gold is flat on the day, and has been doing very little lately, broadly speaking, the commodity complex continues to perform well.

Finally, the dollar, not surprisingly, is under significant pressure this morning, down versus most of its G10 counterparts, notably the commodity bloc.  NZD (+0.6%), NOK (+0.45%) and AUD and CAD (+0.4%) are all looking strong today bolstered by broad dollar weakness and strong commodity price action.  On the flip side, JPY (-0.2%) is the only real decliner as haven assets are sold, although CHF is also modestly softer.  In the emerging markets, the screen is entirely green led by ZAR (+0.75%), CZK (+0.5%) and IDR (+0.35%).  Rand is clearly in thrall to commodity prices while the koruna is rallying on the back of a much higher than expected CPI print of 4.1%, which has traders looking for a central bank rate increase at the next meeting at the end of the month.  As to the rupiah, it seems this is entirely a result of the risk-on attitude in markets this morning.

On the data front, early this morning the UK released its monthly GDP print at a worse than expected 0.1%, blamed now on the increase of the delta variant.  German CPI was confirmed at 3.9% in August, and Italian IP managed to rise 0.8% in July, a bit better than expected.  Here at home we will see PPI (exp 8.2%, 6.6% ex food & energy) which will continue to challenge the transitory narrative but will not have nearly the impact of next Tuesday’s CPI release.  As well, we hear from the Cleveland Fed’s Loretta Mester this morning, but she has already explained she is ready to taper QE purchases, so unless that story changes, I don’t foresee any impact.

While the dollar is softer this morning, there is no indication it is going to decline substantially at any point in the near future.  Rather, we remain in the middle of the 1.17/1.20 trading range that has capped movement since June.  I see no reason for anything to change here and expect the week to finish in a quiet manner.

Good luck, good weekend and stay safe
Adf

Anything But Preordained

Some pundits think Madame Lagarde
Is ready, the PEPP, to retard
But others believe
She’ll never achieve
Her goals sans her bank’s credit card

Meanwhile data last night explained
That factory prices had gained
The idea inflation
Is due for cessation
Is anything but preordained

Two noteworthy stories this morning are the ECB meeting, where shortly we will learn if the much-mooted reduction in PEPP purchases is, in fact, on the way and Chinese inflation data.  Similar to the Fed, despite a more lackluster economic performance across the Eurozone as a whole, the hawkish contingent of the ECB (Germany, Austria, Finland and the Netherlands) have been extremely vocal in their calls for tapering PEPP bond purchases.  While the Germans have been the most vocal, and are also seeing the highest inflation readings, this entire bloc has a history of fiscal prudence and the ongoing ECB asset purchase programs, which essentially fund fiscal policy in the PIGS, remains a significant concern.  However, the majority of nations in the Eurozone appear quite comfortable with the ongoing purchase programs.  At times like this, one cannot think along the lines of the economic logic of tapering; instead one must consider the political logic.  Remember, Lagarde is a politician, not a true central banker steeped in policy and economics.  To the extent that enough of her constituents believe the current purchase rate of €80 billion to €85 billion per month is appropriate, that is the rate she will maintain.

Markets are generally, I believe, looking for a modest reduction in PEPP purchases, so if the ECB does not adjust purchases lower, I would expect European sovereign bonds (currently slightly firmer with yields lower by about 1 basis point) to rally and the euro (+0.15% this morning) to decline.  European bourses, currently all lower by between 0.25% and 0.75%, are also likely to perform well on the news.

On a different note, China reported its inflation data last night and while CPI there remains muted (0.8% Y/Y), PPI (9.5% Y/Y) is absolutely soaring.  This is the highest reading since August 2008, right before the GFC began, and is the product of rising commodity prices as well as increases in shipping costs and shortages of labor.  The reason this matters so much to the rest of the world is that China continues to be the source of a significant portion of “stuff” consumed by most nations.  Whether that is tee-shirts or iPhones, rising prices at the Chinese factory gate imply further price pressures elsewhere in the world, notably here in the US.  Several studies have shown a strong relationship between Chinese PPI and US CPI, and the logic behind the relationship seems impeccable.  Perhaps a key question is whether or not Chinese PPI increases are also transitory, as that would offer some hope for the Fed.  Alas, history has shown that the moderation of Chinese PPI is measured in years, not months.

Before we turn to today’s markets, I believe it is worthwhile to mention the latest Fedspeak.  Yesterday we heard from NY Fed president John Williams who stayed on message, explaining that substantial further progress had been made on the Fed’s inflation goal, but not yet on the employment goal.  He followed that up by telling us that if things go according to his forecasts, tapering could well begin before the end of the year.  The theme of tapering before the end of 2021, assuming the economy grows according to plan, has been reiterated by numerous Fed speakers at this point, with both Kaplan and Bostic adding to Williams’ comments yesterday.  But what happens if growth does not achieve those lofty goals?  After all, the Atlanta Fed’s own GDPNow data is now forecasting 1.943% growth in Q3.  That seems quite a bit lower than FOMC forecasts.  And yesterday’s JOLTS data showed nearly 11 million job openings are extant, as the supply of willing workers continues to shrink.  A cynic might believe that the current Fedspeak regarding the potential for tapering shortly, assuming data adheres to forecasts, is just a ruse as there is limited expectation, within the Fed, that the data will perform.  This will allow the Fed to maintain their easy money with a strong rationale while sounding more responsible.  But that would be too cynical by half. Do remember, however, Fed forecasts are notoriously inaccurate.

OK, markets overnight are continuing down a very modest risk-off path.  Equities in Asia were generally lower (Nikkei -0.6%, Hang Seng -2.3%) with Shanghai (+0.5%) a major exception.  Ongoing crackdowns on on-line gaming continue to undermine the value of some of China’s biggest (HK listed) companies, while the debt problems at China Evergrande continue to explode.  (China Evergrande is the second largest real estate company in China with a massive debt load of >$350 billion and has been dramatically impacted by China’s attempts to deflate its real estate bubble.  It has been downgraded multiple times and its stock price has now fallen well below its IPO price.  There are grave concerns about its ability to remain an ongoing company, but given the size of its debt load, a failure would have a major impact on the Chinese banking sector as well as, potentially, markets worldwide.  Think Lehman Brothers.)  Alongside the previously mentioned weakness in Europe, US futures are all currently lower by about 0.25%.

Treasury prices are continuing their modest rally, with yields falling another 1.2bps as risk appetite generally wanes.  Given the FOMC meeting is still two weeks away, investors remain comfortable that Treasuries are still a better buy than other securities.  Interestingly, the debt ceiling question does not seem to have reached the market’s collective consciousness yet, although it does offer the opportunity for some serious concern.  However, history shows that despite all the huffing and puffing, Congress will never allow a default, so this is probably the correct behavior.

Commodity prices are rebounding with oil (+0.8%), gold (+0.45%) and copper (+1.3%) leading the way.  The rest of the industrial space is generally firmer although foodstuffs are all softer this morning in anticipation of upcoming crop reports (“sell Mortimer!”)

As to the dollar, it is on its heels this morning, down versus all its G10 counterparts led by NOK (+0.35%) and GBP (+0.3%).  Clearly the former is benefitting from oil’s rise while the pound seems to be benefitting from BOE comments indicating a greater concern with inflation and the fact the Old Lady may need to address that sooner than previously anticipated.  In the EMG bloc, there are far more winners than losers, but the gains have been muted.  For instance, PHP (+0.4%) has been the biggest winner, followed by ZAR (+0.3%) and RUB (+0.25%).  While the latter two are clear beneficiaries of firmer oil and commodity prices, PHP seems to have gained on the back of a potential reversal of Covid lockdown policy by the government, with less restrictions coming.  On the downside, only KRW (-0.25%) was really under pressure as the Asian risk-off environment continues to see local equity market sales and outflows by international investors.

On the data front, this morning brings only Initial (exp 335K) and Continuing (2.73M) Claims.  However, we do hear from four more Fed speakers, with only Chicago’s Evans having yet to say tapering could be a 2021 event.  In truth, at this point, given how consistent the message has been, I feel like data is more likely to drive markets than comments.  Given today’s calendar is so light, I expect we will see another day of modest movement.  The one caveat is if the ECB surprises in some manner, with a greater risk of a more dovish stance than the market assumes.

Good luck and stay safe
Adf

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.

Jay’s Watershed

The PMI data released
This morning show prices increased
As bottlenecks build
With orders unfilled
Inflation has shown it’s a beast

The question is, how will the Fed
Respond as they’re looking ahead
Will prices be tamed
Or else be inflamed
This may well be Jay’s watershed

Yesterday’s ECB meeting pretty much went according to plan.  There is exactly zero expectation that Lagarde and her crew will be tightening policy at any point in the remote future.  In fact, while she tried to be diplomatic over a description of when they would consider tightening policy; when they see inflation achieving their 2.0% target at the “midpoint” of their forecast horizon of two to three years, this morning Banque de France Governor Villeroy was quite explicit in saying the ECB’s projections must show inflation stable at 2.0% in 12-18 months.  In truth, it is rare for a central banker to give an explicit timeframe on anything, so this is a bit unusual.  But, in the end, the ECB essentially promised that they are not going to consider tightening policy anytime soon.  They will deal with the asset purchase programs at the next meeting, but there is no indication they are going to reduce the pace of purchases, whatever name they call the program.

One cannot be surprised that the euro fell in the wake of the ECB meeting as the market received confirmation of their previous bias that the Fed will be tightening policy before the ECB.  But will they?

Before we speak of the Fed let’s take a quick look at this morning’s PMI data out of Europe.  The most notable feature of the releases, for Germany France and the Eurozone as a whole was the rapid increase in prices.  Remember, this is a diffusion index, where the outcome is the difference between the number of companies saying they are doing something (in this case raising prices) and the number saying they are not.  In Europe, the input price index was 89, while the selling price index rose to 71.  Both of these are record high levels and both indicate that price pressures are very real in Europe despite much less robust growth than in the US.  And remember, the ECB has promised not to tighten until they see stable inflation in their forecasts 18 months ahead.  (I wonder what they will do if they see sharply rising inflation in that time frame?)

While the latest CPI reading from the Eurozone was relatively modest at 2.0%, it strikes me that price pressures of the type described by the PMI data will change those numbers pretty quickly.  Will the ECB respond if growth is still lagging?  My money is on, no, they will let prices fly, but who knows, maybe Madame Lagarde is closer in temperament to Paul Volcker than Arthur Burns.

Which brings us back to the Fed and their meeting next week.  The market discussion continues to be on the timing of any tapering of asset purchases as well as the details of how they will taper (stop buying MBS first or everything in proportion).  But I wonder if the market is missing the boat on this question.  It seems to me the question is not when will they taper but will they taper at all?  While we have not heard from any FOMC member for a week, this week’s data continues to paint a picture of an economy that has topped out and is beginning to roll over.  The most concerning number was yesterday’s Initial Claims at a much higher than expected 419K.  Not only does that break the recent downtrend, but it came in the week of the monthly survey which means there is some likelihood that the July NFP report will be quite disappointing.  Given the Fed’s hyper focus on employment, that will certainly not encourage tapering.  The other disappointing data release was the Chicago Fed National Activity Index, a number that does not get a huge amount of play, but one that is a pretty good descriptor of overall activity.  It fell sharply, to 0.09, well below both expectations and last month’s reading, again indicating slowing growth momentum.

This morning we will see the flash PMI data for the US (exp 62.0 Mfg, 64.5 Services) but of more interest will be the price components here.  Something tells me they will be in the 80’s or 90’s as prices continue to rise everywhere.  While I believe the Fed should be tapering, and raising rates too, I continue to expect them to do nothing of the sort.  History has shown that when put in these circumstances, the Fed, and most major central banks, respond far too slowly to prevent inflation getting out of hand and then ultimately are required to become very aggressive, à la Paul Volcker from 1979-82, to turn things around.  But that is a long way off in the future.

But for now, we wait for Wednesday’s FOMC statement and the following press conference.  Until then, the narrative remains the Fed is going to begin tapering sometime in 2022 and raising rates in 2023.  With that narrative, the dollar is going to remain well-bid.

Ok, on a summer Friday, it should be no surprise that markets are not very exciting.  We did see some weakness in Asia (Hang Seng -1.45%, Shanghai -0.7%, Nikkei still closed) but Europe feels good about the ECB’s promise of easy money forever with indices there all nicely higher (DAX +1.0%, CAC /-1.0%, FTSE 100 +0.8%).  US futures are higher by about 0.5% at this hour, adding to yesterday’s modest gains.

Bond markets are behaving as one would expect in a risk-on session, with yields edging higher.  Treasuries are seeing a gain of 1.3bps while Europe has seen a bit more selling pressure with yields higher by about 2bps across the board.

Commodity price are broadly higher this morning with oil (+0.1%) consolidating its recent rebound but base metals (Cu +0.4%, Al +0.7% and Sn +1.1%) all performing well.  All that manufacturing activity is driving those metals higher.  Precious metals, meanwhile, are under pressure (Au -0.5%. Ag -1.1%).

Finally, the dollar is doing well this morning despite the positive risk attitude.  In the G10, JPY (-0.3%) is the laggard as Covid infections spread, notably in the Olympic village, and concerns over the situation grow.  But both GBP (-0.25%) and CHF (-0.25%) are also under pressure, largely for the same reasons as Covid infections continue to mount.  The only gainer of note is NZD (+0.2%) which is the beneficiary of short covering going into the weekend.

In the emerging markets, ZAR (-0.55%) is the worst performer, falling as concerns grow that the SARB will remain too dovish as inflation rises there.  Recall, they just saw a higher than expected CPI print, but there is no indication that policy tightening is on the way.  HUF (-0.5%) is the other noteworthy laggard as the ongoing philosophical differences between President Orban and the EU have resulted in delays for Hungary to receive further Covid related aid that is clearly needed in the country.  The forint remains weak despite a much more hawkish tone from the central bank as well.

Other than the PMI data, there is nothing else to be released and we remain in the Fed’s quiet period, so no comments either.  Right now, the market is accumulating dollars on the basis of the idea the Fed will begin tapering soon.  If equities continue to rally, this goldilocks narrative could well help the dollar into the weekend.

Good luck, good weekend and stay safe
Adf

Christine Lagarde’s Goal

This morning, Christine Lagarde’s goal
Is focused on how to cajole
The market to see
That her ECB
Has total command and control

Ahead of the ECB statement and the subsequent press conference this morning, markets are mostly biding their time.  Monday’s risk-off session is but a hazy memory and everyone is completely back on board for the reflation trade despite rising numbers of Covid cases as well as newly imposed lockdowns by governments throughout the world.  While that may seem incongruous, apparently, the belief is that any such lockdowns will be for a much shorter period this time than we saw last year, and so the impact on economic activity will be much smaller.

With a benign backdrop, it is worthwhile, I believe, to consider what we are likely to see and hear from the ECB and how it may impact markets.  We already know that they have changed their inflation target from, “close to, but below 2.0%” to ‘2.0%’.  In addition, we have been told that there is a willingness to accept a period of time where inflation runs above their target as the ECB seeks to fine-tune both the message and the outcome.  Of course, when you think about what CPI measures, it is designed to measure the average rate of price increases for the population as a whole, the idea of fine-tuning something of this nature is ridiculous.  Add to that the extreme difficulty in measuring the data (after all, what exactly makes up the consumer basket? and how does it change over time?  and isn’t it different for literally every person?) and the fact that central banks are concerned if inflation prints at 1.7% or 2.0% is ludicrous.  As my friend @inflation_guy (you should follow him on Twitter) always explains, you cannot reject the null hypothesis that 1.7% and 2.0% are essentially the same thing in this context.  In other words, there is no difference between 2.0% inflation, where central bankers apparently feel comfortable, and 1.7% inflation, where central bankers bemoan the impending deflationary crisis.

As well, the ECB is going to explain their new asset purchase process.  Currently, there are two programs, the Public Sector Purchase Program (PSPP) which is the original QE program and had rules about adhering to the capital key and not purchasing more than 33% of the outstanding debt of any nation in order to prevent monetizing that debt.  Covid brought a second program, the Pandemic Emergency Purchase Program (PEPP), which had no such restrictions regarding what was eligible and how much of any particular nation’s bonds could be acquired but was limited in size and time.  Granted they both expanded the size of the program twice and extended its maturity, but at least they tried to make believe it was temporary.  The recent framework review is likely to allow PEPP to expire in March 2022, as currently planned, but at the same time expand the PSPP and its pace of purchases so that there will be no difference at all to the market.  In other words, though they will attempt to describe their policies as ‘new’, nothing is likely to change at all.

Finally, they apparently will be altering their forward guidance to promise interest rates will remain unchanged at current levels until inflation is forecast to reach or slightly surpass 2% and remain there for some time within the central bank’s projection period of two to three years.  Given the decades long lack of inflationary impulse in the Eurozone due to anemic underlying economic growth and ongoing high unemployment, this essentially means that the ECB will never raise rates again.  The ongoing financial repression being practiced by central banks shows no sign of abating and the ECB’s big framework adjustment will do nothing to change that outcome.

Will any of this matter?  That is debatable.  First, the market is already fully aware of all these mooted changes, so any price impact has arguably already been seen.  And second, have they really changed anything?  I would argue the answer to that is no.  While the descriptions of policies may have changed, the actions forthcoming will remain identical.  Interest rates will not move, and they will continue to purchase the same number of bonds that they are buying now.  As such, despite a lot of tongue wagging, I expect that the impact on the euro will be exactly zero.  Instead, the single currency will remain focused on the Fed’s (remember the FOMC meets next week), interest rate policy and the overall risk appetite in the market.

Turning to markets ahead of the ECB announcement we see that risk remains in vogue with strong gains in Asia (Hang Seng +1.85, Shanghai +0.35%, Nikkei closed) and Europe (DAX +0.9%, CAC +0.8%) although the FTSE 100 is barely changed on the day.  US futures are all green and higher by about 0.2% at this hour.

Bond markets have calmed down after a few very choppy days with Treasury yields backing up 1bp and now back to 1.30%, nearly 18 basis points above the low print seen Monday.  European sovereigns are mixed with Gilts seeing yields edge up by 0.8bps, while OATs have seen yields slide 0.8bps and Bunds are unchanged on the day.  Of course, with the ECB imminent, traders are waiting to see if there is any surprise forthcoming so are being cautious.

Oil prices continue their sharp rebound from Monday’s virtual collapse, rising another 0.6% and now firmly back above $70/bbl.  It turns out that Monday was a great opportunity to buy oil on the cheap!  Precious metals continue to disappoint with gold (-0.4%) slipping back below $1800/oz, although really just chopping around in a range.  Copper is firmer by 0.8% this morning but the rest of the non-ferrous group is slightly softer.

As to the dollar, it is under pressure virtually across the board this morning as there is certainly no fear visible in markets.  In the G10, NOK (+0.9%) is the leader on the back of oil’s rebound with the rest of the bloc seeing broad-based, but shallow, gains.  In the emerging markets, HUF (+0.55%) is the leader after recent comments from a central banker that they will be raising rates until their inflation goal is met.  (So old school!)  Meanwhile, overnight saw strength in APAC currencies (PHP +0.45%, IDR +0.4%, KRW +0.35%) as positive risk sentiment saw foreign inflows into the entire region’s stock markets.

We do get some data this morning starting with Initial (exp 350K) and Continuing (3.1M) Claims at 8:30 as well as Leading Indicators (0.8%) and Existing Home Sales (5.90M).  Fed speakers remain incommunicado due to the quiet period so as long as the ECB meets expectations the dollar should continue to follow its risk theme, which today is risk-on => dollar lower.

Good luck and stay safe
Adf

T’won’t be a Disaster

The Minutes explained that the Fed

Continues, when looking ahead

To brush off inflation

And seek job creation

Though prices keep rising instead

Meanwhile, there’s a new policy





That came from Lagarde’s ECB

T’won’t be a disaster

If prices rise faster

So, nothing will stop more QE

There is no little irony in the fact that the one-two punch of the Fed and ECB reconfirming that ‘lower for longer’ remains the driving force behind central bank policy has resulted in a pretty solid risk-off session this morning.  After all, I thought ‘lower for longer’ was the driver of ongoing risk appetite.

However, that is the case, as yesterday the FOMC Minutes essentially confirmed that while there are two camps in the committee, the one that matters (Powell, Clarida, Williams and Brainerd) remain extremely dovish.  Inflation concerns are non-existent as the transitory story remains their default option, and although several members expressed they thought rates may need to rise sooner than their previous expectations, a larger group remains convinced that current policy is appropriate and necessary for them to achieve their goals of average 2% inflation and maximum employment.  Remember, they have yet to achieve the undefined ‘substantial further progress’ on the jobs front.  Funnily enough, it seems that despite 10 years of undershooting their inflation target, there are several members who believe that the past 3 months of overshooting has evened things out!  Ultimately, my take on the Minutes was that the market’s initial reaction to the meeting 3 weeks ago was misguided.  There is no hawkish tilt and QE remains the norm.  In fact, if you consider how recent data releases have pretty consistently disappointed vs. expectations, a case can be made that we have seen peak GDP growth and that we are rapidly heading back toward the recent trend levels or lower.  In that event, increased QE is more likely than tapering.

As to the ECB, the long-awaited results of their policy review will be released this morning and Madame Lagarde will regale us with her explanations of why they are adjusting policies.  It appears the first thing is a change in their inflation target to 2.0% from ‘below, but close to, 2.0%’.  In addition, they are to make clear that an overshoot of their target is not necessarily seen as a problem if it remains a short-term phenomenon.  Given that last month’s 2.0% reading was the first time they have achieved that milestone in nearly 3 years, there is certainly no indication that the ECB will be backing off their QE programs either.  As of June, the ECB balance sheet, at €7.9 trillion, has risen to 67.7% of Eurozone GDP.  This is far higher than the Fed’s 37.0% although well behind the BOJ’s 131.6% level.  Perhaps the ECB has the BOJ’s ratio in mind as a target!

Adding up the new policy information results in a situation where…nothing has changed.  Easy money remains the default option and, if anything, we are merely likely to hear that as central banks begin to try to tackle issues far outside their purview and capabilities (climate change and diversity to name but two) there is no end in sight for the current policy mix. [This is not to say that those issues are unimportant, just that central banks do not have the tools to address them.]

But here we are this morning, after the two major central bank players have reiterated their stance that no policy changes are imminent, or if anything, that current ultra-easy monetary policy is here to stay, and risk is getting tossed aside aggressively.

For instance, equity markets around the world have been under significant pressure.  Last night saw the Nikkei (-0.9%), Hang Seng (-2.9%) and Shanghai (-0.8%) all fall pretty substantially.  While the Japanese story appears linked to the latest government lockdowns imposed, the other two markets seem to be suffering from some of the recent actions by the PBOC and CCP, where they are cracking down on international equity listings as well as the ongoing crackdown on freedom in HK.  European bourses are uniformly awful this morning with the DAX (-1.7%) actually the best performer as we see the CAC (-2.25%) and FTSE 100 (-1.9%) sinking even further.  Even worse off are Italy (-2.7%) and Spain (-2.6%) as investors have weighed the new information and seemingly decided that all is not right with the world.  As there has been no new data to drive markets, this morning appears to be a negative vote on the Fed and ECB.  Just to be clear, US futures are down uniformly by 1.4% at this hour, so the risk-off attitude is global.

Turning to the bond market, it should be no surprise that with risk being jettisoned, bonds are in high demand.  Treasury yields have fallen 6.5bps this morning, taking the move since Friday to 21bps with the 10-year now yielding 1.25%, its lowest level since February.  Is this really a vote for transitory inflation?  Or is this a vote for assets with some perceived safety? My money is on the latter.  European sovereigns are also rallying with Bunds (-4.1bps), OATs (-2.7bps) and Gilts (-4.8bps) all putting in strong performances.  The laggards here this morning are the PIGS, where yields are barely changed.

In the commodity space, yesterday saw a massive reversal in oil prices, with the early morning 2% rally completely undone and WTI finishing lower by 1.7% on the day (3.6% from the peak).  This morning, we are lower by a further 0.4% as commodity traders are feeling the risk-off feelings as well.  Base metals, too, are weak (Cu -1.75%, Al -0.3%, Sn -0.4%) but gold (+0.7%) is looking quite good as real yields tumble.

As to the dollar, in the G10 space, commodity currencies are falling sharply (NZD -0.75%, AUD -0.7%, CAD -0.6%, NOK -0.6%) while havens are rallying (CHF +0.9%, JPY +0.8%).  The euro (+0.45%) is firmer as well, which given the remarkable slide in USD yields seems long overdue.

Emerging market currencies are seeing similar behavior with the commodity bloc (MXN -0.75%, RUB -0.5%) sliding along with a number of APAC currencies (THB -0.65%, KRW -0.6%, MYR -0.5%).  It seems that Covid is making a serious resurgence in Asia and that has been reflected in these currencies.  On the plus side, the CE4 are all firmer this morning as they simply track the euro’s performance on the day.

On the data front, our last numbers for the week come from Initial (exp 350K) and Continuing (3.35M) Claims at 8:30 this morning.  Arguably, these numbers should be amongst the most important given the Fed’s focus on the job situation.  However, given the broad risk off sentiment so far, I expect sentiment will dominate any data.  There are no further Fed speakers scheduled this week, which means that the FX markets are likely to take their cues from equities and bonds.  Perhaps the correlation between yields and the dollar will start to reassert itself, which means if the bond market rally continues, the dollar has further to decline, at least against more haven type currencies.  But if risk continues to be anathema to investors, I expect the EMG bloc to suffer more than the dollar.

Good luck and stay safe

Adf

Poor Madame Lagarde

As prices worldwide start to rise

And central banks, rates, normalize

Poor Madame Lagarde

May soon find it hard

To ably, her goals, realize

Let me start by saying that I will be out of the office starting tomorrow, returning July 6th.

Despite the fact that the markets in the US are showing only limited signs that the Fed is actually considering tightening, the punditry continues to believe that tapering asset purchases is next up on the Fed’s agenda.  In fact, the discussion is becoming granular with respect to which assets they should consider addressing.  The two current theses are; reduce purchases of both Treasuries and Mortgages at a similar rate, or just reduce Mortgage purchases given the bubble the Fed has blown in the housing market.  And there are FOMC members on both sides of that argument although it cannot be surprising that the more dovish members continue to insist that buying $40 billion / month of Mortgage-backed securities is having absolutely no impact on the housing market.  But the point is that the analyst community is fully on board with the idea the Fed is going to be reducing its asset purchases soon.

I highlight this because when combined with the fact that so many other countries are more definitively moving past unlimited policy ease, with some already tightening, it becomes interesting to consider which nations are not considering any policy changes.  And this is where the ECB comes into view.

As of now, the ECB (and BOJ) insist that there are no plans to change their policy mix anytime soon.  And yet, they seem to have the opposite problem of the Fed, the market is pricing in rate increases there, currently a 0.10% hike by the end of Q3, and bond yields have been rising steadily with German bund yields almost back up to 0.00%.  (As an aside, it continues to be remarkable to me that one can make the statement, back up to 0.00%!)  Given the slower trajectory of growth thus far in Europe, especially with respect to inflation readings, Madame Lagarde and her cadre of central bankers certainly have their work cut out for them to maintain the policy stance they desire and believe is necessary to support the economy there.  Will the ECB be forced to ease further in some manner, like extending PEPP in order to achieve their aims?

In contrast, despite the fact that the Fed is talking about talking about tapering, and the dot plot indicated a majority of FOMC members believe they will be raising rates by the end of 2023, the bond market remains sanguine over the prospect of either higher inflation or higher interest rates.  Go figure.  

So, who do we believe when surveying the current situation?  On the one hand, it is always tough to argue with the market.  Whether or not we understand the actual drivers, the collective intelligence of investors tends to be exceptionally accurate at recognizing trends and future outcomes.  On the other hand, the phrase, ‘don’t fight the Fed’ has been around for a long time because it has proven to be an effective input into any investment thesis.  The problem is, when those two indicators are at odds with each other, choosing the likely outcome is extraordinarily difficult, more so than normal.

One way to think about it is that both can be right if you consider they may have differing timelines.  For instance, the market tends to discount actions in the 9 month to 1year timeframe while the Fed may well be considering more immediate actions.  However, in this case, I feel like the Fed is looking at a similar timeline as the market.  Ultimately, as I’ve mentioned before, it appears the Fed remains completely reactive to market movement.  Thus, right now, regardless of their rhetoric, my take is if the market demands easier policy, they will make it known via a sell-off in equities that will result in the Fed stepping in with support.  If, on the other hand, the market is comfortable with the current situation, a continued benign rise in equities is on the cards.  As the Fed has put themselves in the position of reactivity, my money is on the market this time, not the Fed.  We shall see.

As I was quite delayed this morning, a very quick recap of the overnight session shows that risk was under pressure in Asia but that Europe has responded very well to much stronger than expected confidence indicators for manufacturing and consumers across the continent.  So while all three main Asian indices fell about 1.0%, Europe has seen gains of at least 0.6% with the DAX up 1.2%.

As it happens this morning, Treasury prices have edged a bit lower with the 10-year yield rising 2bps, but that was after a nice rally yesterday, so we continue to trade right around 1.50%.  Big picture here is nothing has changed.  European sovereigns are softer as risk appetite improves on the continent, with 2.0bp rises in the major markets.

While oil prices (+0.5%) are a bit firmer, the metals complex is under pressure this morning with gold and silver both down sharply (-1.4%) and base metals also falling (Cu -1.0%, Al -0.7%).

The metals’ movement is more in sync with the dollar, which has rallied against all its G10 peers and most EMG currencies.  AUD (-0.7%) and NZD (-0.7%) are the laggards here with NOK (-0.6%) next in line.  Obviously, oil is not the driver, although Aussie and Kiwi would suffer from metal price declines.  However, it appears that Covid continues to haunt many countries and the market seems to be responding to perceptions that growth will be slowing rather than continuing its recent uptrend.  

In EMG, RUB (-0.8%), PLN (0.65%) and ZAR (-0.6%) are amongst the worst performers with ruble and rand clearly impacted by metals prices while the zloty seems to be suffering from a more classical interpretation of inflation’s impact on a currency, as higher inflation expectations are leading to a weaker currency.

On the data front, Case Shiller House Prices rose 14.88%, higher than expected and continuing the trend that has been in place for more than a year.  Later we get Consumer Confidence exp (119.0) although it seems unlikely with payrolls coming on Friday, that the market will pay much attention.

Only Thomas Barkin from Richmond speaks on behalf of the Fed today, but there is no reason to believe that it will change any views.  The narrative is still the same.

The dollar is feeling quite strong this morning and seems likely to maintain those gains as the day proceeds.  If the market truly believes the Fed is going to taper, we should see the evidence in the bond market with higher yields.  But for now, the dollar’s strength feels more like short-covering than a change in the long-term view of ultimate dollar weakness.  However, this can persist for a while (just like inflation 😊)

Good luck, and have a great holiday weekend.  I will be back on the 6th.

Adf

Yields Are Repressed

You have to be mighty impressed
The bond market’s not even stressed
Although CPI
Has reached a new high
One wonders if yields are repressed

Clearly, there is only one story of import these days, and that is whether or not inflation is transitory.  Chairman Powell and his minions have spent the last several months harping on this idea, and although there was a time when several FOMC members seemed to get nervous and wanted to discuss tapering QE, it seems highly likely that next week’s FOMC meeting will focus on the fact that “substantial progress” has not yet been made toward the Fed’s goals of maximum employment and 2% average inflation.  Well, at least on the goal of maximum employment.  It seems pretty clear that they have made some progress on the inflation front.

While the headline Y/Y print of 5.0% was clearly impressive, and the highest since August 2008, personally, I am more impressed with the core M/M print of 0.7% as that is not impacted by what happened during the pandemic.  And the fact that this followed last month’s 0.9% print could indicate that inflation is becoming a bit less transitory.  But the Fed has done a wonderful job of selling its story.  One has to believe that Chairman Powell could not have wanted a better outcome than yesterday’s market price action with the S&P 500 making new highs while the bond market rallied sharply with the 10-year yield falling 6 basis points to 1.43%.

For a moment, let us try to unpack this price action.  On the one hand, it is easy to understand the equity rally as the decline in nominal yields alongside the rising recorded inflation has led to a dramatic fall in real yields.  One view, which many utilize, is that real 10-year yields are simply the 10-year yield less the current headline CPI rate.  Of course, right now, that comes to -3.57%, a level only seen a handful of times in the past, all of which occurred during significant inflationary periods in the 1970’s and early 1980’s.  Negative real yields are a boon for stocks, but historically are awful for the dollar and yet the dollar actually rallied slightly yesterday.  It seems to me that a more consistent outcome would require the dollar to decline sharply from here.  After all, even using Bund yields, currently -0.284%, and Eurozone CPI (2.0%), one sees real yields in the Eurozone far higher (-2.284%) than here in the US.  Something seems amiss.

Something else to consider is bond positioning.  There continues to be a great deal of discussion pointing to the bond market rally as a massive short squeeze.  Last week’s CFTC data was hardly indicative of that type of movement, although we will learn more this afternoon.  However, there is another place where both hedge funds and retail investors play, the ETF market, and when it comes to bond speculation, TLT is the product of choice.  Interestingly, more than 37% of the shares outstanding have been shorted in this ETF, a pretty good indication that there were a lot of bets for a higher yield.  But the word is that a significant portion of these shorts were closed out yesterday, on the order of $7 billion in short covering in total, which would certainly explain the sharp rally in the bond market.  This begs the question, is the price action technical in nature rather than a reflection of the views that inflation is truly transitory?  The problem with this question is we will not be able to answer it with any certainty for at least another three to four months.  But for now, the Fed has the upper hand.  In fact, there doesn’t seem to be any reason for them to adjust policy next week at all.  Why taper if the current policy mix is working?

Speaking of policy mixes that seem to be working, I would be remiss if I didn’t mention that the ECB meeting yesterday resulted in exactly…nothing.  Policy was left unchanged, Madame Lagarde promised to continue to buy assets at a faster pace than the first quarter, and then she spent an hour in her press conference saying virtually nothing.  It may have been her finest performance in the role.

The bond market seems to have made up its mind that the Fed is correct although there remain many pundits who disagree.  I expect that we will be continuing this discussion all summer long and with every high CPI print, you can look for the punditry to pump up the volume of their critiques of the Fed. However, we need only see one dip in the data for the Fed to claim victory and move on from the inflation discussion.  Next month’s CPI report will truly be important as the base effects will have disappeared.  Last year, the June M/M CPI was 0.5%.  If inflation is truly with us, we need to see M/M in June 2021 to be at least that high, if not a repeat of the 0.6%-0.8% numbers we have been seeing lately.  Between now and then we will see a number of price indicators including the Fed’s favorite core PCE.  For the past several months, every price indicator has been high and surprising on the high side.  The next months’ worth of data will be very important to both the Fed and the markets.  Enjoy the ride.

With two of the three key near-term catalysts now out of the way, all eyes will turn to next Wednesday’s FOMC meeting.  But that leaves us 4 sessions to trade in the interim.  Right now, with the fed narrative of transitory inflation dominating, it is easy to expect continued risk-on market performance.  Interestingly, that was not actually the case in Asia as the Nikkei (0.0%) was flat and Shanghai (-0.5%) fell although the Hang Seng (+0.35%) managed to close higher on the day.  Europe, however, got the memo and is green across the board (DAX +0.4%, CAC +0.7%, FTSE 100 +0.5%).  US futures, too, are picking up buyers as they all trade 0.25% or so higher at this hour.  

Meanwhile, in the bond market, Treasury yields have backed up 1.3bps, which looks far more technical than fundamental.  After all, they have fallen 18 bps in the past week, a rebound is no surprise.  However, European sovereign markets were closed before the bond party really started yesterday afternoon and they are in catch up mode today.  Bunds (-2.0bps) and OATS (-2.1bps) are performing well, but nothing like Gilts (-4.6bps), nor like the PIGS, all of which are seeing yield declines of at least 4bps.

Commodity prices are generally higher led by oil (WTI +0.5%) with the industrial metals all performing well (Cu +1.9%, Fe +1.0%, Sn +0.6%) although despite the dramatic decline in yields, gold (-0.5%) continues to underperform.  That feels like it is going to change soon.

Finally, in FX markets, the dollar is king of the G10, rising against all of its counterparts here with NZD (-0.4%) and SEK (-0.4%) leading the way down.  While the kiwi price action appears to be technical after having seen a decent rally lately, Sweden’s krona continues to suffer from its lower CPI print yesterday, once again delaying any idea that they may need to tighten policy in the near term.  The rest of the bloc is softer, but the movement has been far less impressive.

What makes that price action interesting is the fact that EMG currencies have actually had a much better performance with IDR (+0.4%), KRW (+0.4%) and TRY (+0.4%) all showing modest strength.  In Turkey, FinMin comments regarding the divergence between CPI and PPI were taken somewhat hawkishly.  In Seoul, a BOK governor mentioned the idea that one or two rate hikes should not be seen as tightening given the current record low level of interest rates (currently 0.50%).  However, it seems the market would see 50bps of tightening as tightening.  And lastly, the rupiah continues to benefit from foreign buying of bonds with inflows rising for a third consecutive week.

Data this morning brings Michigan Sentiment (exp 84.4) and careful attention will be paid to the inflation expectation readings, with the 1yr expected at 4.7%.  Remember, the Fed relies on those well-anchored inflation expectations, so if they are rising here, that might cause a little indigestion in Washington.

At this stage, just as we are seeing the bond market rally ostensibly on short covering, my sense is the dollar is behaving in the same way.  The data and rates would indicate the dollar should fall, but it continues to grind higher right now.  In the end, “the fundamentals things apply, as time goes by”1, and right now, they all point to a weaker dollar.  

Good luck, good weekend and stay safe
Adf

1.	Apologies to Wilson Dooley