The quickening pace of the spread
Of delta means looking ahead
The prospects for both
Inflation and growth
Seem likely, some water, to tread
The upshot is central bank staff
Will trot out some chart or some graph
Highlighting that rates
In all nation states
Should once more be cut, least in half
The talk of the markets is the pace of the spread of the delta variant of Covid and how the latest wave of lockdowns and other measures has reduced growth forecasts for the second half of the year. This is especially true throughout Asia as nations that had seemingly weathered the initial wave of Covid with aplomb find themselves woefully unprepared for the current situation. A combination of less widespread vaccinations and less effective health infrastructure has resulted in the fast spreading virus wreaking havoc. China, for instance, finds itself in this position as half of its 32 provinces are reporting cases and officials there have closed major tourist destinations because of the spread. This is a far cry from their earlier claims of having controlled the virus better than anyone else. But the same situation exists throughout Europe and the Americas as the delta variant runs its course.
The clearest market response to this situation has been from bond markets where yields continue to fall around the world on the weaker prospects for growth. The amount of negative yielding debt worldwide has risen back to $16.7 trillion, up from $12.9 trillion at the end of June, although still below the $18.3 trillion reached in December of last year. However, the trajectory of this move, which is approaching vertical, offers the possibility that we could easily take out those old highs in the next week or two.
The problem is that rapidly declining bond yields do not accord easily with higher inflation or inflation expectations. Yet higher inflation continues to be present and inflation expectations continue to rise. This is the great conundrum in markets right now. How can markets be anticipating slower growth while inflation measures continue to rise? Shouldn’t slower growth lead to lower inflation?
In ordinary economic environments, there has certainly been a strong relationship between growth and inflation, but I challenge anyone to describe this economic situation as ordinary. Rather, as a result of collective government responses to the pandemic, with whole swaths of various economies around the world being closed, along with massive fiscal and monetary stimulus being added to those same economies, a series of supply shocks have been created. Thus, when the artificially stoked demand (from the stimulus) meets the constrained supply (from the lockdowns) the natural response is for prices to rise in order to achieve a new equilibrium. The point is that the supply constraints continue to drive much of the pricing behavior, and therefore the inflation story, while the central banks can only really affect the demand side of the equation. After all, while they may be able to print lots of money, they cannot print chickens, toilet paper or semiconductors, all things that have seen supply reduced.
A large part of the central banks’ transitory inflation theme stems from the fact that their models tell them that supply will be replenished and therefore prices will ease. Alas, there has been little indication that the real world is paying attention to central bank models, as we continue to see shipping delays, manufacturing delays and higher raw materials prices as the supply infrastructure remains under significant strain.
Perhaps the most telling feature regarding the current views on inflation, even more than the rise in economic statistics, is the growth in the number of stories in the mainstream media regarding why different ordinary products and services have become more expensive. Just this morning, the WSJ explained why both vacations and patio furniture are more expensive, and a quick Google trends search shows the term “more expensive” is being searched at near peak levels virtually daily. The central bank community has put themselves in a significant bind, and while some nations are beginning to respond, the big 3, Fed, ECB and BOJ, show absolutely no signs of changing their behavior in the near term. As such, the outlook is for more printed money, the same or few available goods and higher prices across the board.
Turning to markets, all that money continues to be a positive for equity investors as a great deal of that liquidity keeps finding its way into equity markets. While Japan (Nikkei -0.2%) lagged last night, the rest of Asia rebounded with both the Hang Seng and Shanghai indices rising 0.9%. Europe, too, continues to perform well with the DAX (+0.8%), CAC (+0.4%) and FTSE 100 (+0.4%) all in the green after PMI Services indices were released. While all of those data points were strong, they all missed expectations and were slightly softer than last month. In other words, the trajectory continues to be lower, although the absolute readings remain strong. Perhaps despite what Timbuk 3 explained, you won’t need shades for the future after all.
As to the bond market, we continue to see demand as yields are lower almost everywhere. Treasury yields have fallen 1 basis point, with European sovereigns even stronger (Bunds -1.7bps, OATs -2.0bps, Gilts -1.3bps). In fact, the only bond market to sell off overnight was in New Zealand (+5bps) as comments from the central bank indicated they are likely to raise rates next week, and as many as 3 times by the end of the year as inflation continues to rise while the unemployment rate fell to a surprisingly low 4.0%.
Commodity prices continue to lack direction, although the negativity on the economy has impacted oil prices which are down 1.1% this morning. However, gold (+0.4%) is looking up, as are agricultural prices with the big three products all higher by between 0.3%-0.6%. Base metals, though, are under pressure (Cu -0.4%, Sn -0.3%) which given the evolving economic sentiment makes some sense.
Finally, the dollar is ever so slightly softer this morning with only NZD (+0.7%) showing real movement and dragging AUD (+0.3%) along with it. Otherwise, the rest of the G10 is +/- 0.1% from yesterday’s closing levels. The EMG picture is a bit more mixed with gainers and losers on the order of 0.4%, although even that is only a few currencies. The leader today is KRW (+0.4%) which responded to increased expectations that the BOK would be raising interest rates soon, perhaps later this month, with some analysts even floating the idea for a 50bp hike. We have seen a similar gain in HUF (0.4%) as the market continues to digest hawkish commentary from the central bank there, but after those two, gainers have been far less impressive. On the downside, TRY (-0.4%) is the laggard du jour as the market grows increasingly concerned that the central bank will not be able to keep up with rising inflation there. Elsewhere, THB (-0.35%) fell on weakening growth prospects and the rest of the space was less interesting.
Two notable data points are to be released today with ADP Employment (exp 683K) early and then the ISM Services (60.5) index released at 10:00. The ADP number will be seen by many as a harbinger of Friday’s NFP, so could well have a big impact if it surprises in either direction.
Interestingly, the dollar continues to hold its own lately despite declining yields as it appears investors are buying dollars to buy Treasuries. After all, as more and more debt turns into negative yields, Treasuries look that much more attractive. At least until the Fed admits that inflation is going to be more persistent than previously discussed.
Good luck and stay safe