Before Omicron

There once was a narrative told
Explaining the Fed still controlled
The market’s reaction
Preventing contraction
Thus, making sure stocks ne’er got sold

But that was before Omicron
Evolved and put more pressure on
The future success
Of Fed’ral largesse
With no real conclusion foregone

So, later this morning we’ll hear,
When Janet and Jay both appear,
In front of the Senate
If they’ve still the tenet
That all will be well by next year

Perhaps all is not right with the world.  At least that would be a conclusion easily drawn based on market activity this morning.  Once again, risk is being shed rapidly and across the board.  Not only that, but the market is completely rethinking the idea of tighter monetary policy by the Fed with the growing conclusion that it is just not going to happen, at least not on the timeline that had been assumed a few short days ago.

It seems that the Omicron variant of Covid is proving to be a bigger deal in investor’s eyes than had been originally assumed.  When this variant was first identified by South African scientists, the initial belief was it was more virulent but not as acute as the Delta variant.  So, while it was spreading quite rapidly, those who were infected displayed milder symptoms than previous variants.  (If you think about the biology of this, that makes perfect sense.  After all, every organism’s biologic goal is to continue to reproduce as much as possible.  If a virus is so severe that its host dies, then it cannot reproduce very effectively.  Thus, a more virulent, less severe strain is far more likely to remain in the world than a less virulent, more deadly strain, which by killing its hosts will die off as well.)

In the meantime, financial markets have been trying to determine just what type of impact this new strain is going to have on economies and whether it will induce another series of lockdowns slowing economic activity, or if it will be handled in a different manner.  And so far, there is no clear conclusion as evidenced by the fact that we saw a massive sell-off in risk assets Friday, a major rebound yesterday and another sell-off this morning.  If pressed, I would expect lockdowns to come back into vogue as despite questions over their overall efficacy, their imposition allows government officials to highlight they are ‘doing something’ to prevent the spread.  Additional bad news came from the CEO of Moderna, one of the vaccine manufacturers, when he indicated that the nature of this variant would likely evade the vaccines’ defense.

So, story number one today is Omicron and how this new Covid variant is going to impact the global economy.  Ironically, central bankers around the world must be secretly thrilled by this situation as the focus there takes the spotlight off their problem, rapidly rising inflation.

For instance, after yesterday’s higher than expected CPI prints in Spain and Germany, one cannot be surprised that the Eurozone’s CPI printed this morning at 4.9%, the highest level since the Eurozone was born in 1997, and far higher than any of the 40 economist forecasts published.  Madame Lagarde wasted no time explaining that this was all temporary and that by the middle of next year inflation would be back to its pre-pandemic levels, but it seems fewer and fewer people are willing to believe that story.  Do not mistake the run to the relative safety of sovereign bonds as a vote of confidence in the central bank community.  Rather that is simply seen as a less risky place to park funds than the equity market, which by virtually every measure, remains significantly overvalued.

This leads to the third major story of the day, the upcoming testimony by Chairman Powell and Treasury Secretary Yellen in front of the Senate Banking Committee.  The pre-released opening comments focus on Omicron and how it can be a risk for both growth and inflation thus once again trying to divert attention from Fed policies as a problem by blaming exogenous events beyond their control.  Of course, this story will resolve itself starting at 10:00, so we will all listen in then.

Ok, with all that as prelude, a quick tour of markets shows just how much risk is in disfavor this morning.  Overnight in Asia we saw broad weakness (Nikkei -1.6%, Hang Seng -1.6%) although once again Shanghai was flat.  Europe is completely in the red (DAX -1.45%, CAC -1.25%, FTSE 100 -1.0%) and US futures are also pointing lower (DOW -1.2%, SPX -1.0%, NASDAQ -0.5%).

Meanwhile, bond markets are ripping higher with Treasuries (-5.1bps) leading the way as yields fall back to levels last seen in early September.  In Europe, Bunds (-2.1bps), OATs (-2.2bps) and Gilts (-4.0bps) are all seeing demand pick up with the rest of the Continent all looking at lower yields despite rising inflation.  Fear is clearly a powerful motivator.  Even in Asia we saw JGB’s (-1.9bps) rally as did Australian and New Zealand paper.

Commodity markets are having quite a day with some really mixed outcomes.  Oil (-2.5%) is back in the red after yesterday’s early morning rebound faded during the day, and although oil did close higher, it was well of the early highs.  NatGas (-5.0%) is falling sharply, which at this time of year is typically weather related.  On the other hand, gold (+0.5%) is bouncing from yesterday and industrial metals (Cu +1.4%, Al +1.6%, Sn +2.7%) are in clear demand.  It seems odd that on a risk-off day, these metals would rally, but there you have it.

Finally, the dollar can only be described as mixed this morning, with commodity currencies under pressure (NOK -0.4%, CAD -0.25%) while financial currencies (EUR +0.5%, CHF +0.5%, JPY +0
4%) are benefitting on receding expectations for a tighter Fed.  PS, I’m sure the risk off scenario is not hurting the yen or Swiss franc either.

Emerging market currencies are demonstrating a broader based strength with TRY (-1.6%) really the only major loser as further turmoil engulfs the central bank there and expectations for lower interest rates and higher inflation drive locals to get rid of as much lira as possible.  Otherwise, PLN (+0.8%) is leading the way higher as expectations for the central bank to raise rates grow with talk now the rate hike will be greater than 50 basis points.  But MYR (+0.8%) and CZK (+0.75%) are also showing strength with the ringgit simply rebounding after a 10-day down move as bargain hunters stepped in, while the koruna has benefitted from hawkish comments from the central bank governor.  It appears that most EMG central banks are taking the inflation situation quite seriously and I would look for further rate hikes throughout the space.

Aside from the Powell/Yellen testimony, this morning brings Case Shiller House Prices (exp 19.3%), Chicago PMI (67.0) and Consumer Confidence (111.0).  As well, two other Fed speakers, Williams and Clarida, will be on the tape, but it is hard to believe they will get much notice with Powell front and center.

The dollar appears to be back following the interest rate story, which means that if expectations of Fed tightening dissipate, the dollar will likely fade as well, at least versus the financial currencies.  Commodities have a life of their own and will continue to dominate those currencies beholden to them.  The tension between potential slower growth and rising inflation has not been solved, and while my view is the Fed will allow inflation to burn still hotter, keep in mind that if they do act to tighten policy, the dollar should find immediate support.

Good luck and stay safe
Adf

Sang the Blues

The President’s finally decided
That Lael and Jay have now divided
The tasks at the Fed
And both of them said
Inflation just won’t be abided

The bond market took in the news
And quickly adjusted its views
Thus, interest rates rose
While gold felt the throes
Of pain as goldbugs sang the blues

By now, we all know that Chairman Powell has been reappointed to his current role as Fed Chair and Governor Brainerd has been elevated to Vice-Chair.  The underlying belief seems to be that the Biden administration was not prepared for what would likely have been a much more difficult confirmation fight to get Brainerd as Chair and decided to husband whatever political capital they still have left to fight for their spending legislation.  Arguably, the most interesting part of the process was that both Powell and Brainerd, in their remarks, indicated that fighting inflation was a key priority.  As Powell said, “We will use our tools both to support the economy and strong labor market, and to prevent higher inflation from becoming entrenched.”  Now that is a wonderful sentiment, and of course, directly in line with the Fed’s Congressional mandate to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.”  Alas for them both, the tools necessary for the different pieces of the mandate tend to be opposite in their nature.

However, the market response was clear as to its broad belief that tighter Fed policy is on the horizon.  Between those comments and what we heard last week from Governor Waller, vice-Chair Clarida and St Louis Fed President Bullard, it seems clear that the meeting in December is going to be all about the timing of the tapering.  While the progressive wing of the Democratic party remains steadfast in their belief in the power of MMT to deliver prosperity for all, it appears that the reality on the ground, namely that inflation is exploding higher, has become too big a problem to ignore for President Biden.

Here’s the thing.  The traditional tool for fighting rising inflation is to raise interest rates above the rate of inflation to create positive real yields.  Now, depending on how you define inflation; CPI, PCE, the core version of either, or the trimmed mean version of either, given where all of those measures currently stand, the minimum amount of rate increases is going to be 300 basis points, with a chance that it could be 400 or more.  Now, ask yourself how an economy that is leveraged to the hilt (total debt/GDP > 895%) will respond to interest rates rising by 300 or 400 basis points.  How about the stock market, with its current Shiller CAPE (cyclically adjusted P/E) above 39 compared to a median of 15.86 over the past 150 years?  How do you think that will respond to the interest rate curve rising by 300 or 400 basis points?  The picture is not pretty.

It remains to be seen just how much pain the Fed and the Administration can stand if the Fed actually does start to tighten policy more aggressively in the face of rapidly rising inflation.  Consider that in Q4 2018, the last time the Fed was trying to ‘normalize’ policy by allowing the balance sheet to run down slowly while also raising interest rates, stocks fell 20% and the result was the ‘Powell Pivot’ on Boxing Day that year, where the Chairman explained that tightening policy wasn’t actually that critical at the time and would end immediately.  At that time the same measure of debt/GDP was ‘merely’ 763% and the CAPE was 29.  We have much further to fall today, and I expect that when/if that starts to happen, the Fed will not blithely continue tightening policy to fight inflation.  Remember the idea that the Fed has painted themselves into a corner?  Well, this is the corner in which they have painted themselves.  They need to raise rates to fight inflation but doing so is likely to provoke a severely negative market, and potentially economic, reaction.

Now, while we are all waiting for that shoe to drop, let’s take a look at how markets responded to the news.  The first thing to note is the bond market, where 10-year yields rose 9 bps yesterday and that trend has continued this morning with yields higher by another 2.3bps.  With the 10-year currently yielding 1.65%, all eyes are on the 1.75% level, the peak seen in March, and the level many see as a critical technical level, a break of which could open up much higher yields.  It should not be surprising that we have seen higher yields elsewhere as well, with European sovereigns (Bunds +5.9bps, OATs +5.7bps, Gilts +4.8bps) responding to three factors this morning; the US market movement, better than expected preliminary PMI data across the continent and hawkish comments from both Isabel Schnabel and Klaas Knot, two ECB members. You may recall last week when I described some Schnabel comments as apparently dovish, and a potential capitulation of the remaining hawks on the ECB.  Apparently, I was mistaken.  Today she was much clearer about the risks of inflation being to the upside and that they must be considered.  If the hawks are in flight, bonds have further to decline.

In the equity markets, yesterday’s news initially brought a rally in the US, but by the end of the day, as bond yields rose, the NASDAQ, which is effectively a very long duration asset, fell 1.25%, although the rest of the US market fared far better.  The overnight session saw a more modest reaction with the Nikkei (+0.1%) and Shanghai (+0.2%) edging higher although the Hang Seng (-1.2%) suffered on weaker consumer and pharma stocks.  Europe has rebounded from its worst levels but is still lower (DAX -0.7%, CAC -0.25%, FTSE 100 0.0%) despite (because of?) the PMI data.  I guess hawkish monetary policy trumps good economic data, a harbinger of what may be on the horizon.  At this hour, US futures are little changed, so perhaps there is good news in store.

News that the Biden administration is releasing 30 million barrels of oil from the SPR along with releases by India and South Korea has weighed on oil prices (WTI -1.5%) although NatGas (+4.8%) is not following along for the ride.  Gold (-0.5%) got clobbered yesterday and is down 2.7% from Friday’s closing levels.  Clearly, inflation fighting by the Fed is not seen as a positive.  As to the rest of the metals complex, it is generally higher as expectations grow that demand around the world is going to pick back up.

Finally, in the FX market, the truly notable mover today is TRY (-11.2%!) which appears to be starting to suffer from a true run in the wake of President Erdogan’s praise of the recent interest rate cut and claiming that Turkey is fighting an “economic war of independence.”  It seems he’s losing right now.  Relative to that movement, nothing else seems substantial although MXN (-0.8%) is feeling pressure from declining oil prices while other EMG currencies slid on the broad strong dollar theme.  In the G10, NZD (-0.5%) is the weakest performer as long positions were cut ahead of the RBNZ meeting next week, but the bulk of the bloc is modestly lower as US interest rates continue to power ahead.

On the data front, we see the preliminary PMI data (exp 59.1 Mfg, 59.0 Services) and that’s really it.  Yesterday’s Existing Home Sales were better than expected, but really, today’s markets will continue to be driven by interest rates and views on how the Fed is going to behave going forward.  Taking Powell at his word means that tighter policy is coming which should help the dollar amid a broader risk-off sentiment.  Plan accordingly.

Good luck and stay safe
Adf

Prices Keep Rising

In Europe, though prices keep rising
The central bank is emphasizing
No rate hikes are near
In this or next year
So, traders, their views, are revising

Meanwhile in the States the reverse
Is true with inflation much worse
Now traders believe
The Fed’s on the eve
Of trying to tighten their purse

It cannot be surprising that inflation remains topic number one in the markets as its existence is driving virtually every narrative.  For instance, the choice for next Fed Chair is seen as having a direct impact on inflation based on the relative dovishness of Lael Brainerd vs. Jay Powell.  Too, as oil prices have risen so sharply over the past year, driving up the price of gas at the pump and inflation in general, the Biden Administration is now exhorting all nations to release oil from their strategic reserves in order to damp down those price pressures.  And what about wages, you may ask?  As per the WSJ this morning, here is the latest on the just agreed wage deal at Deere & Co, whose workers had been on strike for the past 5 weeks,

“Deere workers returning to assembly plants and warehouses will get an immediate 10% raise, and each worker will receive an $8,500 bonus. Additional 5% pay raises will be provided in 2023 and 2025, and lump-sum bonuses amounting to 3% of workers’ annual pay will be awarded in the three other years.
The deal approved Wednesday also will increase the base pay level for Deere’s continuous-improvement program by about 4%, giving workers more weekly pay from the program if their productivity meets the company’s goals. About two-thirds of UAW-represented Deere workers receive production-based compensation on top of their regular wages, according to the company.”

Apparently, the cost of the settlement is on the order of $3.5 billion, a very substantial portion of their forecast 2021 earnings estimates of $5.8 billion.  It strikes that either Deere is going to be raising prices (likely) to offset that margin compression, or its earnings numbers are going to diminish (also likely) thus putting pressure on its stock over time.  Recall, Chairman Powell has been adamant, and we have heard from numerous other Fed speakers as well, that wage inflation is not imminent and thus recent price rises are likely to be temporary.  This appears to be one more data point that makes the Fed story less plausible.

In Europe, however, there is a full-court press by ECB members to convince the investment and trading communities that they are not going to raise rates anytime soon as inflation there, too, is still transitory.  While it should be no surprise that Mario Centeno, the Portuguese central bank head and ECB member is all-in for never raising rates again, it is a huge surprise that Germany’s Isabel Schnabel is talking about the need to avoid premature tightening as deflation risks still haunt the Eurozone.  Her comments come despite CPI in Germany running at 4.5%, the highest since the reunification in the early 90’s and causing significant domestic strife.  If one was looking for a sign that the ECB doves have coopted the hawks to their side, there is no better indication than this!  As such, traders, who had been pricing for a 10bp rise in the deposit rate by the end of 2022 have pushed that view back nearly 12 months.

In sum, the battle between the central bank narratives and reality continues apace with the central banks, remarkably, holding their own in the face of growing evidence to dispute their claims.  And it is this battle that will continue to drive markets and help maintain volatility as each data point or comment has the ability to alter things at the margin.

So, as we look at markets this morning, remember the backdrop remains, Inflation, friend or foe?

Ok, how has risk appetite been affected by the latest news?  Well, US equities all moved lower yesterday and that carried over into Asia with the Nikkei (-0.3%), Hang Seng (-1.3%) and Shanghai (-0.5%) all in the red.  Part of that is because the Chinese property sector continues to weigh on sentiment there with the latest news that several large property companies, including Evergrande, are set to unload stakes in other companies to raise cash.  While these sales will be at great losses, the imperative for the cash is obvious.  Not surprisingly, selling large stakes of publicly held companies tends to weigh on their stock price and thus the market as a whole.

In Europe, the picture is more mixed (DAX +0.1%, CAC +0.2%, FTSE 100 -0.2%) with the UK seeming to suffer from growing concerns the Johnson government may invoke Article 16 from the Brexit deal which would suspend part of the Northern Ireland solution and could quickly evoke retaliation by the EU.  As to US futures, given it appears to be illegal for two consecutive down days in the equity markets, it should not be surprising that futures are pointing higher by between 0.2% and 0.5% at this hour.

Bond market price action is a very clear result of the central bank narrative as European sovereigns have all seen rallies (lower yields) while Treasuries remain under pressure as investors anticipate higher rates in the States.  This morning the 10-year Treasury yield is higher by 1 basis point while in Europe (Bunds -0.9bps, OATs -1.3bps, Gilts -2.7bps) the entire continent has seen demand pick up and yields decline.  Clearly, if the ECB remains full-bore on QE, it will support these prices for a long time.

Turning to the commodity markets, pretty much the entire space is softer today led by oil (-0.5%), gold (-0.2%) and copper (-0.7%).  But there is weakness across the rest of the industrial and precious metal space as well.  In fact, the only gainers on the day are NatGas (+1.8%) which looks very much like a rebound from its recent sharp sell-off, and the agricultural space, where the big 3 products are all firmer by a bit.

Turning to the FX markets, the dollar is under a bit of pressure this morning, which mostly seems like a pull-back from its recent strength.  Technically, it does seem overbought.  In the G10, NZD (+0.7%) is far and away the leading gainer after the RBNZ published their inflation expectations survey at the highest level in a decade and traders began to price in another 25 basis point rate hike at their meeting next week.  However, after that, the rest of the bloc has seen much more modest strength except for NOK (-0.1%) which is suffering from oil’s recent travails, and JPY (-0.1%) which may be reacting to news that the Kishida government is discussing yet more fiscal stimulus, this time to the tune of ¥78.9 trillion.

Emerging market currencies have a more mixed tone with the outlier continuing to be TRY (-2.1%) as the central bank remained true to form and cut its base rate to 15.0% despite runaway inflation.  Next worst is CLP (-0.7%) which has fallen as the finance ministry has stopped its regular dollar sales to maintain cash balances, but pulling support from the currency, and then we see both MXN (-0.55%) and ZAR (-0.5%) suffering on the back of commodity weakness.  On the plus side, HUF (+0.7%) is the big winner after the central bank raised rates by a more than expected 0.70% in their efforts to fight inflation.

On the data front this morning comes weekly Initial (exp 260K) and Continuing (2120K) Claims as well as the Philly Fed (24.0) and Leading Indicators (0.8%).  The Fed speaker onslaught slows a bit today with only four speakers, although despite yesterday’s plethora of speakers, it doesn’t appear we learned anything new.

For now, the broad narrative remains the Fed is going to be the first large central bank to tighten and that is driving the dollar higher.  While today we seem to be pausing for a bit, this story does not yet appear to have run its course.  Hence, I reiterate for payables hedgers, pick your levels and take advantage of the dollar’s strength for now.  orders are an excellent way to manage this risk.

Good luck and stay safe
Adf

Hawks Now Despair

The imminent news of the day
Is President Joe will convey
His choice for Fed chair
As hawks now despair
Lael Brainerd will soon lead the way

Her bona fides highlight her views
More policy ease she would choose
Inflation? No worry
But she’s in a hurry
For banks to put under the screws

The word from Washington is that President Biden will be announcing his selection for Fed chair imminently.  The very fact that the news was released using that phraseology implies to some (this author included) that we will have a new Fed Chair going forward, Lael Brainerd.  It is widely known that the President interviewed both Brainerd and Powell last week and ostensibly, Ms Brainerd accorded herself quite well.  It is also widely known that the progressive wing of the Democratic Party, which continues to gain sway over policy decisions, hates Chairman Powell and believes that not only would a Chairwoman Brainerd maintain policies to pay for their wish list, but that she would also be much tougher on the banking industry on a regulatory basis.

Of course, the key question is, can Brainerd win approval from a split Senate?  However, it is not clear that Powell could win approval either.  In Brainerd’s case, the vote would almost certainly be a straight party-line vote with Vice-president Harris casting the tiebreaker if necessary, although, it is quite possible that one or two of the very centrist Republican senators vote yea for her.  Powell, on the other hand, has enemies on both sides of the aisle, as there is a contingent of Republicans who believe he is to blame for the current inflation, while we also know there is a contingent of Democrats, led by Senator Warren, who despise him.  In other words, it doesn’t appear either is a slam dunk despite the fact both are currently on the Fed board and have been approved in the past.

Given we already know how markets have responded to the Powell Chairmanship, let us consider how a Chair Brainerd might be viewed.  Whether it is true or not, the current narrative is that Ms Brainerd would be more dovish than Powell, far less likely to complete the current tapering initiative and potentially seek reasons to further expand the Fed’s balance sheet.  If that were to be the case, one would have to be bullish financial assets with both stocks and bonds benefitting from that policy mix.  In addition, given the current inflationary impulse, and the likelihood that a Chair Brainerd continues to believe in the transitory theory, commodity prices are likely to continue their climb higher.  As to the dollar, based on this thesis, the dollar’s recent rise would likely come to an end, as the ongoing decline in real rates would undermine its value proposition.  You may wonder why bond prices would perform well despite rising inflation and the answer is simple, the ongoing QE purchases would support them, and a change in view regarding the timing of any tightening would likely see the short end of the curve rally, driving rates there much lower as well.

Of course, this is speculation regarding speculation of a particular outcome.  However, based on the market’s previous responses to these types of policy stimuli, I would contend they are reasonable.  Regardless, this all depends on any announcement.

One thing to note is that the case for a dollar decline is relatively strong in the event the market perception changes regarding further Fed policy tightness.  The dollar has been benefitting from the perception that the Fed is leading the way among the major central banks, with respect to removing policy ease.  If that perception were to change, so will the trajectory of the greenback.

Turning to the markets this morning, after a lackluster day in the US yesterday, where the major indices barely moved, we saw a mixed performance in Asia (Nikkei +0.1%, Hang Seng +1.3%, Shanghai -0.3%) as China continues to feel downward pressure from the real estate sector there.  Europe, on the other hand, is having a better day (DAX +0.5%, CAC +0.4%, FTSE 100 +0.2%) despite growing concerns over NatGas supplies due to some delays in NordStream 2 approvals.  It seems that a combination of ongoing dovish comments from Madame Lagarde and a new analysis by Capital Economics indicating interest rates in Europe will not rise before 2025, have inspired more risk-taking.  Meanwhile, US futures, which had been lower earlier in the session, have now edged back to essentially unchanged on the day.

In the bond market, yesterday saw some very aggressive selling with Treasury yields rising 5 basis points and pretty much dragging the entire space with them.  This morning, however, things have reversed with Treasury yields (-1.9bps) down along with Bunds (-1.9bps), OATS (-2.0bps) and Gilts (-2.0bps).  As long as there is belief in the QE process, bonds will retain a bid.  As an aside, there was an interesting article yesterday from MNI reporting on the fact that Italy and the other PIGS are seeking a permanent change in EU lending rules to insure that they get more money with less strings, as has been occurring during the Covid inspired emergency.  This has all the signs of a new policy that will be enacted, permanently increasing the amount of support that Southern Europe receives from the EU, and likely, over time to build tensions.  I would look for PIGS spreads vs. Bunds to narrow on this conversation, but it will not help the euro.

As to commodities, this morning most are in the green led by oil (+0.4%) which is continuing yesterday’s late day rally although prices are still much lower on the week.  NatGas (+2.8%) is clearly rising in concert with the European story on Nordstream 2 while gold (+0.6%) and silver (+0.85%) continue to confound by rising sharply alongside the dollar.  Ags are a little softer as are base metals (Al -1.6%, Zn -0.9%), so the message from this market is just not clear.

Turning to the dollar, it is broadly stronger this morning with SEK (-0.3%) and CHF (-0.3%) the laggards in the G10 although GBP (+0.25%) and NOK (+0.2%) are both firmer.  Going backwards, NOK is clearly being supported by oil prices while the pound is benefitting from modestly positive employment news amid a spate of releases there.  As to the losers, there is really no news in either currency which implies the general dollar bullish framework continues to be the key driver.  In the emerging markets, TRY (-1.4%) is today’s worst performer as investors fear further rate cuts despite rapidly rising inflation.  Interestingly, RUB (-0.5%) is also under pressure despite oil’s rebound as concerns over rising inflation in Russia are also impacting investment decisions.  CLP (-0.5%) is the other laggard here as a combination of broad dollar strength and concerns over inflation seem to be undermining the peso.

On the data front, we see Retail Sales (exp 1.5%, 1.0% ex autos) as well as IP (0.9%) and Capacity Utilization (75.9%) this morning.  We get the Fed train rolling with five speakers this morning ranging from the most hawkish (George) to the most dovish (Daly).  However, I believe all eyes will be on the Chairmanship story, not comments from underlings.

The dollar broadly continues to rally with the euro having traded to its lowest level since July 2020 and there is nothing that indicates this trend is going to change soon.  While there are good reasons to expect the dollar to eventually decline, right now, higher is the direction of travel so keep that in mind for your hedging.  However, for those with a longer-term view, looking into 2023 and 2024, current levels may well look attractive if payables are the exposure.

Good luck and stay safe
Adf

Shocked

The surge in inflation has shocked
Officials who’ve tried to concoct
A tale that high prices
Don’t mean there’s a crisis
But lately those views have been mocked

Just yesterday, CPI showed
Inflation’s begun to explode
Will Powell respond?
Or is he too fond
Of QE, his bonds to unload?

I am old enough to remember when rising used car prices and their impact on inflation were considered an aberration, and thus transitory.  Back in the summer of…’21, better known as the good old days, when CPI prints of 5.4% were allegedly being distorted by the temporary impact of the semiconductor shortage which significantly reduced new car production and drove demand into used vehicles.  However, we were assured at the time that this was an anomaly driven by the vagaries of Covid-19 inspired lockdowns and that it would all soon pass.  In fact, back in the day, the Fed was still concerned about deflation.

Well Jay, how about now?  Once again, I will posit that were I the current Fed Chair, I wouldn’t accept renomination even if offered as I would not want to be at the helm of the Fed when inflation achieves 1970’s levels while growth slows.  And, as inflation has become topic number one across the country, so much so that President Biden stated, “Reversing inflation is a top priority,” the Fed is set to be in the crosshairs of every pundit and politician for the next several years.  One can’t help but consider that both vice-chairs, Clarida and Quarles, leaving ASAP is analogous to rats fleeing a sinking ship.  The Fed, my friends, has a lot of problems ahead of them and it remains unclear if they have the gumption to utilize the tools available to stop the growing momentum of rising inflation.

And that is pretty much the entire market story these days; inflation – how high will it go and how will central banks respond.  Every day there is some other comment from some other central banker that helps us evaluate which nations are serious about addressing the problem and which are simply paying lip service as they allow, if not encourage, rising inflation in order to devalue the real value of their massive debts.

As such, we get comments from folks such as Austria’s central bank chief, and ECB Governing Council member, Robert Holzmann, who explained that all ECB asset purchases could end by next September.  While that is a wonderful sentiment, at least for those who believe inflation is a serious problem, I find it very difficult to believe that the rest of the ECB, where there reside a large cote of doves, are in agreement.  In fact, the last we heard from Madame Lagarde was her dismissal of the idea that the ECB might raise rates anytime soon, admonishing traders that their pricing for rate hikes in the futures markets was incorrect.

The takeaway from all this is the following; listen to what central bank heads say, as a guide to their actions.  While not always on target (see BOE Governor Andrew Bailey last week), generally speaking if the central bank chief has no urgency in their concern over an issue like inflation, the central bank will not act.  Given the pace of inflation’s recent rises, essentially every central bank around the world is behind the curve, and while some EMG banks are trying hard to catch up, there is no movement of note in the G10.  Look for inflation to continue to rise to levels not seen since the 1960’s and 1970’s.

So, how are markets digesting this news?  Not terribly well.  At least they didn’t yesterday, when equity markets fell around the world along with bond markets while gold and the dollar both soared.  However, this morning we have seen a respite from the past several sessions with equity markets rebounding in Asia (Nikkei +0.6%, Hang Seng +1.0%, Shanghai +1.1%) and Europe (DAX +0.1%, CAC +0.1%, FTSE 100 +0.4%) albeit with Europe lagging a bit.  US futures are also firmer led by the NASDAQ (+0.7%) but with decent gains in the other indices.  Of course, the NASDAQ has been the market hit hardest by the sharp rally in bond yields, so on a day where the Treasury market is closed thus yields are unchanged, that makes a little sense.

Speaking of bonds, yesterday saw some serious volatility with 10-year Treasuries eventually settling with yields higher by 11bps.  Part of that was due to the 30-year Treasury auction which wound up with a more than 5 basis point tail and saw 30-year yields climb 14bps on the day.  But not to worry, 5-year yields also spiked by 13bps, so it was a universal wipe-out.  This morning, in Europe, early bond losses (yield rises) have retreated and the big 3 markets, Bunds, OATs and Gilts, are little changed at this hour.  But the rest of Europe is not so lucky, especially with the PIGS still under pressure.  I guess the thought that the ECB could stop buying bonds at any time in the future is not a welcome reminder for investors there.

Commodity prices, too, were whipsawed yesterday, with oil winding up the day lower by more than 4% from its morning highs.  This morning, that trend continues with WTI (-0.9%) continuing lower on a combination of weakening growth expectations and rising interest rates.  NatGas has rebounded slightly (+2.5%) but is now hovering around $5/mmBTU, which is more than $1 lower than we saw during October.  It seems that some of those fears have abated.  Gold, however, continues to rally, up another 0.4% today and about 4% in the past week.  Perhaps it has not entirely lost its inflationary magic.

And finally, the dollar continues to perform very well after a remarkable performance yesterday.  For instance, yesterday saw the greenback rally vs every currency, both G10 and EMG, with many seeing declines in excess of 1%.  ZAR (-2.6%) led the EMG rout while NOK (-1.65%) was the leader in the G10 clubhouse.  But don’t discount the euro having taken out every level of technical support around and falling 1%.  This morning that trend largely continues, with CAD (-0.55%) the worst performer on the back of oil’s continued weakness, but pretty much all of the G10 under the gun.  In the emerging markets, however, there are some notable rebounds with ZAR (+1.5%) and BRL (+1.0%) both rebounding from yesterday’s movements.  The South African story has to do with the budget, which forecast a reduction in borrowing and maintaining a debt/GDP ratio below 80%, clearly both positive stories in this day and age.  The real, on the other hand, seems to be benefitting from views that the central bank is going to tighten further as inflation printed at a higher than expected 10.67% yesterday, and the BCB has been one of the most aggressive when it comes to responding to inflation.

With the Veteran’s Day holiday today (thank you all for your service), banks and the Fed are closed, but markets will remain open until 12:00 and then liquidity will clearly suffer even more greatly.  There is no data nor speakers due, so I expect the FX market to follow equities for clues about risk.  In the end, the dollar is on a roll right now, and I don’t see a reason for that to stop in the near term.  Later on?  Perhaps a very different story.

Good luck and stay safe
Adf

Damnified

The market has turned its attention
To Brainerd’s potential ascension
As Chair of the Fed
Thus, bond bulls imbed
The view QE gets an extension

This adds to the growing divide
Twixt nations who’ve identified
Inflation as bad
From those who are mad
Their laxness have been damnified

The dollar is under some pressure this morning as bonds rally (yields decline) and commodity prices pick up further.  If equity markets were higher this would be a classic risk-on session, alas, that picture is mixed, and anyway, whatever movement there is has been modest at best.  (It’s almost as if equity bulls are getting tired at all-time highs with record valuations.)

What, then, you may ask, is driving today’s price action?  I give you Lael Brainerd PhD, current Fed governor, former Under Secretary of International Affairs at the US Treasury, and the woman most likely to be our next Federal Reserve Chair.  The news broke that President Biden interviewed her for the role and there is a growing belief that in the current political zeitgeist, a Democratic woman favored by the progressive wing of the party will be much more palatable than a Republican man with a mixed track record on issues like FOMC membership trading improprieties.  It doesn’t hurt that she has been an unrequited dove since her appointment by President Obama in 2014, nor that she has been vocal on the need for more stringent regulatory control over the big banks.

As markets are discounting instruments, ostensibly looking forward a number of months to where things will be rather than where they currently sit, there is a growing belief that a Chairwoman Brainerd will be loath to continue tapering asset purchases and far more comfortable allowing inflation to run even hotter in her desire to achieve an even lower unemployment rate.  Hence, the idea that fed funds rate hikes will be coming sooner has been pushed back further.  In the wake of last week’s very surprising BOE meeting, where the widely anticipate rate hike was delayed, and the Fed’s own extremely dovish tapering message, the idea that a change at the Fed will lean even more dovish than now is music to bond bulls’ ears.  And so, as we survey the largest economies, the US seems to be turning more dovish, the Eurozone continues to burnish its dovish bona fides and the BOJ…well the BOJ is unlikely to ever tighten policy again.

However, as we look elsewhere in the world, the story is very different.  Central banks all over, from smaller G10 nations to large EMG group members have clearly articulated that inflation is a major concern with no clear end in sight and that tighter monetary policy is in order.  In the G10, Canada appears on the cusp of tightening, Norway has done so already and promised another hike next month.  New Zealand has ended QE and raised rates, Australia has given up on YCC and Sweden is hinting at a rate rise coming soon.  The noteworthy link is these are all small, relatively open economies with trade a key part of the mix and rising prices are very evident.

But do not forget the EMG space where we have seen far more dramatic moves already and are almost certain to see more of the same going forward.  The Czech Republic hiked rates 125bps last week, far more than expected, while Russia has already raised rates 2.50% in the past 9 months with no signs of slowing down.  Meanwhile, Polish central bankers are previewing more rapid rate hikes despite a larger than expected 75 basis point move last week.  In LATAM, Brazil has already raised rates 5.25% and is in no mood to stop with inflation running above 10% there.  Mexico, too, is up 0.75% from its lows while Chile (+2.25%), Colombia (+0.75%) and Peru (+1.75%) have all reacted strongly to rising inflation.

The point is this dichotomy between the G3 and the rest of the world seems unlikely to continue forever.  There seem to be two likely scenarios to close this interest rate gap, neither of them to be hoped for; either the G3 will finally blink, recognize inflation is real and raise rates far more rapidly than currently expected, or the transitory story will be correct as the economic imbalances will drive a massive crash with economic growth slowing dramatically into a severe recession and no reason to raise interest rates.  In the first case, financial assets will almost certainly suffer greatly while commodities should perform well.  In the second case, everything will suffer greatly with cash regaining its title as king.

Like I said, neither is a pleasant outcome, but neither is about to happen yet either.  So, looking at today’s activity, the growing assumption of a more dovish Fed (remember that vice-chairs Clarida and Quarles will be out within months as well) has led to lower yields and a somewhat softer dollar along with ongoing higher commodity prices.

Equities, however, remain mixed overall, albeit starting to edge higher in the session.  In Asia, the picture was mixed with the Nikkei (-0.75%) falling on the back of yen strength, while the Hang Seng (+0.2%) and Shanghai (+0.2%) both managed to edge higher.  Europe, which had been mixed to lower earlier in the session has started to turn green with the DAX (+0.2%), CAC (+0.3%) and FTSE 100 (+0.1%) all in positive territory. US futures are generally little changed ahead of this morning’s PPI data, (exp 8.6%, 6.8% ex food & energy) but really with the market focusing on tomorrow’s CPI data.

As mentioned, bonds are having a good day, with Treasuries (-3.1bps) falling back to Friday’s low yields, while European sovereigns (Bunds -3.5bps, OATs -3.7bps, Gilts -1.3bps) all rally as well.  In Europe, the curves are flattening pretty aggressively, hardly a vote of confidence in future activity.

Oil prices (+0.45%) are once again firmer although NatGas (-1.6%) has slipped as warm weather in the mid-Atlantic and Midwest states reduces near term heating demand.  Precious metals, which have been rallying nicely of late are little changed on the day but industrial metals (Cu +0.5%, Al +0.1%, Sn +0.3%) are all a bit firmer.  Agricultural products continue to rise as food inflation worldwide continues to grow.

Finally, the dollar, which had been broadly softer earlier in the session on the dovish discussion, has rebounded slightly, although is hardly rocking.  In the G10, the largest moves have been 0.25% in either direction (AUD -0.25%, JPY +0.25%) however, there have been limited stories to drive perceptions.  Given the yen’s recent bout of significant weakness, this appears to be a corrective move rather than a new direction.  As to Aussie, it too seems more technical than fundamental in nature.

Emerging markets, however, have seen more movement led by THB (+0.8%) and KRW (+0.5%) on the news that both economies are reopening amid a decline in Covid infections and the allowance of more inbound tourist traffic.  RUB (+0.45%) seems to be benefitting from oil’s rise as well.  On the downside, ZAR (-0.6%) fell after a report that foreign holdings of South African sovereign debt fell to its lowest level in 10 years.

On the data front, aside from the PPI, we have already received the NFIB Small Business Optimism number at a disappointing 98.2 (exp 99.5) indicating that the growth impulse in the US is still under pressure.  In addition, there are 4 more Fed speakers today after yesterday’s warnings from Vice-chair Clarida that inflation may be a problem going forward.

For now, the dollar seems to be under modest pressure as it consolidates the latest leg of a slow move higher.  If the Fed tapering is going to diminish, the dollar bulls are going to have a harder road to hoe going forward.  As such, much will depend on who is our next Fed chair.

Good luck and stay safe
Adf

Growing Disdain

There is now a silver haired queen
Whose role since she came on the scene
Has been to explain,
With growing disdain,
Inflation is still unforeseen
 
Her minions, as well, all campaign
To make sure the message is plain
Though prices are rising
They won’t be revising
Their plans, or so said Philip Lane
 
There is a growing disconnect between the ECB and the rest of the world’s central banks.  While the transitory narrative has been increasingly taken out back and shot, the ECB will not let that story die.  Just today, ECB Chief Economist Philip Lane defended the ECB stance, explaining, “If we look at the situation over the medium term, the inflation rate is still too low, below our 2% target.  This period of inflation is very unusual and temporary, and not a sign of a chronic situation.  The situation we are in now is very different from the 1970’s and 1980’s.”  [author’s emphasis]  In other words, in case Madame Lagarde’s comments from last week that the ECB is “very unlikely” to raise rates next year, were not clear, the ECB is telling us that their mind is made up and there will be no policy tightening in the foreseeable future.
 
In fairness, raising interest rates will not convince Russia to pump more natural gas through the pipelines to help mitigate the dramatic rise in prices there.  Nor will it help build new semiconductor fabs to alleviate that shortage.  However, what it might do is reduce demand for many things thus easing supply constraints and perhaps encouraging prices to fall.  After all, that is exactly what tighter monetary policy is supposed to do.  The problem with that logic, though, is that there isn’t a central banker on the continent that is willing to risk slowing down growth in order to address rapidly rising prices.  The politics of that move would likely bring more rioters into the streets.  Once again, central banks’ vaunted independence is shown to be a sham.  They are completely political and beholden to the government in charge at any given time.
 
And so, we are left with a situation where prices continue to rise throughout the world while the two largest economic areas, the US and Eurozone, maintain the easiest monetary policy in history.  Yes, I know the Fed said it would begin to reduce its QE purchases, but even if they do reduce purchases by $15 billion / month, they are still going to expand their balance sheet by a further $420 billion and interest rates are still at zero.  There remains virtually zero chance that inflation is going to fade as long as the current incentive structure remains in place. 
 
Speaking of the Fed, Friday’s NFP data was substantially better than expected with job growth rising 531K and revisions higher for the previous two months of an additional 235K.  The Unemployment Rate fell to 4.6% and wages continue to climb smartly, +4.9% Y/Y.  (Of course, on a real basis, that is still negative given the current 5.4% CPI with expectations that on Wednesday, the latest release will jump to 5.9%.)  However, Chairman Powell has indicated that the Fed believes there is still a great deal of slack in the labor market, based on the Participation Rate remaining well below pre-pandemic levels, and so raising rates prematurely would be a mistake.  Summing it all up, there is no reason to believe that either US or ECB monetary policy is going to be changing anytime soon, regardless of the data.
 
The question at hand, then, is what will this mean for markets in general and the dollar in particular?  As long as new, excess liquidity continues to flood the markets, there is little reason to believe that the ongoing bull market in equities, commodities, real estate, and bonds is going to end.  While history has shown that rising inflation will eventually hurt both bonds and stocks, we are not yet at that point, and quite frankly don’t appear to be approaching it that rapidly.  Though there remains a small cadre of old-timers (present company included) who have a difficult time accepting current valuations as normal and who have actually lived through inflationary times, the bulk of the market participants do not carry that baggage and so are unencumbered by negative thoughts of that nature.  But, as an example of how inflation can degrade equity markets, from Q4 1968 through Q1 1980, the S&P 500 fell 1% in nominal terms while inflation averaged 7.1% per year with a high print of 14.8%.  The point is that the last time we had an inflation situation of the current magnitude, holding equities did not solve the problem.  As George Santayana famously told us back in 1905, “Those who cannot remember the past are condemned to repeat it.”
 
With this in mind, let us take a look at markets and the week ahead.  Aside from the ECB comments this morning, arguably the most impactful news from the weekend was the story that Elon Musk is planning to sell $20 billion worth of stock in order to pay his upcoming tax bill.  Not surprisingly Tesla’s stock is lower by nearly 6% on the news and it seems to have put a damper on all equity activity.  After all, if Tesla isn’t going higher, certainly nothing else can have value!
 
Looking at equity markets, Asia (Nikkei -0.35%, Hang Seng -0.4%, Shanghai +0.2%) were mixed but leaning weaker.  That is an apt description of Europe as well (DAX -0.2%, CAC +0.2%, FTSE 100 -0.1%) although overall, the movement has not been that significant.  US futures, meanwhile, are little changed although NASDAQ futures are slightly lower while the other two major indices are edging higher.
 
Bonds, on the other hand, are all under pressure with Treasuries (+2.8bps) leading the way although this was after a major rally on Friday that saw the 10-year yield fall 7bps and a total of 15bps since the FOMC last Wednesday.  But European sovereigns, too, are all lower with yields rising (Bunds +2.0bps, OATs +2.1bps, Gilts +2.9bps).  Perhaps bond investors are beginning to register their concern over the inflation story.
 
On that front, commodity prices are rebounding off the lows seen last week led by energy with oil (+1.25% and back over $82/bbl) and NatGas (+1.1%) both having good days.  The rest of the space, though, is more mixed with copper (+0.2%) and tin (+0.4%) both firmer this morning, while aluminum (-0.2%) and iron ore (-3.25%) are both suffering.  Precious metals are little changed although Friday saw a sharp rally in the barbarous relic.  And yes, the cryptocurrency space is rocking today as well.
 
As to the dollar, it has had a mixed performance this morning with both gainers and losers across the G10 and EMG spaces.  In the G10, NZD (+0.6%) is the clear leader as the government is talking of ending the draconian lockdown measures by the end of the month.  In fact, we saw similar behavior in the EMG currencies as THB (+0.8%) and IDR (+0.5%) rallied on similar news.  On the flip side, BRL (-0.8%) continues to decline despite the central bank being one of the most aggressive in its rate hike path having raised the SELIC rate from 2% in March to 7.75% last month with expectations growing for yet another hike in December.  Of course, inflation is running at 10.25% there, so real yields remain firmly negative.
 
On the data front, this is inflation week with both the PPI and CPI on the docket.
 

Tuesday

NFIB Small Biz Optimism

99.5

 

PPI

0.6% (8.6% Y/Y)

 

-ex food & energy

0.5 (6.8% Y/Y)

Wednesday

Initial Claims

263K

 

Continuing Claims

2050K

 

CPI

0.6% (5.9% Y/Y)

 

-ex food & energy

0.4% (4.3% Y/Y)

Friday

JOLTS Job Openings

10.4M

 

Michigan Sentiment

72.5

Source: Bloomberg
 
Of course, the Fed doesn’t care about CPI as its models work better with core PCE, which also happens to be designed to be permanently lower.  The rest of us, however, know better and recognize the pain.  We have a number of Fed speakers on the calendar this week as well, with Chairman Powell headlining 9 planned appearances.  My sense is that there will be a strenuous effort to press the storyline that inflation may take a little longer to fall back, but don’t worry, it will fall again.
 
If pressed, I would say the dollar is far more likely to continue to grind higher, but that any movement will be slow.  While Treasury yields are not supportive right now, the reality is that amid major currency bonds, Treasuries continue to offer the best combination of yield and liquidity so remain in demand.  I think that along with the need for other economies to buy dollars to buy energy will maintain the bid in the buck.
 
Good luck and stay safe
Adf
 

It’s Still Transitory

Said Jay, I’m not worried ‘bout wages
Creating inflation in stages
I’ll stick to my story
It’s still transitory
And will be for many more ages

So now it’s the Old Lady’s turn
To help explain if her concern
‘Bout rising inflation
Will be the causation
Of rate hikes and trader heartburn

Like a child having a temper tantrum, the Fed continues to hold its breath and stamp its feet and tell us, “[i]nflation is elevated, largely reflecting factors that are expected to be transitory. Supply and demand imbalances related to the pandemic and the reopening of the economy have contributed to a sizable price increase in some sectors.” [my emphasis.]  In other words, it’s not the fault of their policies that inflation is elevated, it’s the darn pandemic and supply chain issues.  (This is remarkably similar to how the German Reichsbank president, Rudy Havenstein, behaved as that bank printed trillions of marks fanning the flames of the Weimar hyperinflation.  At every bank meeting the discussion centered on rising prices and not once did it occur to them that they were at fault by continuing to print money.)

Nonetheless, Chairman Powell must be extremely pleased this morning as he was able to announce the tapering of QE purchases, beginning this month, and equity and bond markets responded by rallying.  There was, however, another quieter announcement which may well have helped the cause, this one by the Treasury.  Given the rally in asset prices, collection of tax receipts by the government has grown dramatically and so the Treasury General Account (the government’s ‘checking’ account at the Fed) is now amply funded with over $210 billion available to spend.  This has allowed the Treasury to reduce their quarterly refunding amounts by…$15 billion, the exact amount by which the Fed is reducing its QE purchases.  Hmmmm.

So, to recap the Fed story, the tapering has begun, inflation is still transitory, although they continue to bastardize the meaning of that word, and they remain focused on the employment situation which, if things go well, could achieve maximum employment sometime next year.  Rate hikes will not be considered until they finish tapering QE to zero, and they will taper at the pace they deem correct based on conditions, so the $15 billion/month is subject to change.  One more thing; when asked at the press conference about inflation rising faster than anticipated, Powell responded, “We think we can be patient.  If a response is called for, we will not hesitate.”  Them’s pretty big words for a guy who can look at the economy’s behavior over the past twelve months and decide that inflation remains only a potential problem.

Enough about Jay, he’s not going to change, and in my view, he only has two meetings left anyway.  Consider this; President Biden needs to get the progressives onboard to have any chance of passing any part of the current spending bills and in order for them to compromise on that subject, they will want something in return.  They also hate Powell, as repeatedly vocalized by Senator Warren, so it is easy to foresee the President sacrificing Powell for the sake of his spending bill.  Especially given the results of the Virginia elections, which moved heavily against the Democrats, the administration will want to get this done before the mid-term elections next year.  I think Powell is toast.

On to the rest of the central bank world where this morning the BOE will announce their latest decision.  The market continues to be about 50/50 on a rate hike today, but have fully priced one in by December, so either today or next month.  Interestingly, the UK Gilt market is rallying this morning ahead of the announcement, with yields lower by 3.1 basis points.  What makes that so interesting is that the futures market is pricing in 100 basis points of rate hikes by the BOE within the next 12 months, which would take the base rate up to 1.0%.  Right now, 10-year Gilt yields are 1.03%.  If the futures market is right, then either Gilts are going to sell off sharply as the yield curve maintains its current shape or the market is beginning to price in much slower growth in the UK.  My money is on the latter as the UK has proven itself to be willing to fight inflation far more strenuously than the Fed in the past.  If slowing growth is a consequence, they will accept that more readily I believe.

Still on the central bank trail, it is worth highlighting that Poland’s central bank raised rates by 0.75% yesterday in a huge market surprise as they respond to quickly rising inflation.  Concerns are that CPI will reach 8.0% this year, so despite the rate hike, there is still much work to do as the current base rate there, after the hike, is 1.25%.  This morning the Norgesbank left rates on hold but essentially promised to raise them by 25bps next month to 0.50%. While they are the first G10 country to have raised interest rates, even at 0.50%, their deposit rate remains far, far below CPI of 4.1%.

So, to recap, central banks everywhere are finally starting to move in response to rapidly rising inflation.  While some countries are moving faster than others, the big picture is rates are set to go higher…for now.  However, when economic growth begins to slow more dramatically, and it is already started doing so, it remains to be seen how aggressive any central bank will be, especially the Fed.

Ok, let’s look at today’s markets.  As I said earlier, equities are rocking.  After yesterday’s US performance, where all 3 major indices reached new all-time highs, we saw strength in Asia (Nikkei +0.9%, Hang Seng +0.8%, Shanghai +0.8%) and Europe (DAX +0.5%, CAC +0.5%, FTSE 100 +0.2%).  US futures, on the other hand, are mixed with NASDAQ (+0.5%) firmer while the other two indices are little changed.

Bond prices have rallied everywhere in the world, which given the idea of tighter policy seems incongruent.  However, it has become abundantly clear that bond prices no longer reflect market expectations of inflation, but rather market expectations of QE.  At any rate, Treasuries (-3.5bps) are leading the way but Gilts (-3.1bps), Bunds (-1.7bps) and OATs (-1.8bps) are all seeing demand this morning.

After yesterday’s confusion, commodity prices are tending higher this morning with oil (+1.7%) leading the way, but gains, too, in NatGas (+0.75%), gold (+0.5%) and copper (+0.6%).  Agricultural products are mixed, as are the rest of the industrial metals, but generally, this space has seen strength today.

As to the dollar, it is king today, firmer vs. virtually every other currency in both the G10 and EMG blocs.  The euro (-0.6%) is the laggard in the G10 as the market is clearly voting the ECB will be even more dovish than the Fed going forward.  But the pound (-0.4%) is soft ahead of the BOE and surprisingly, NOK (-0.4%) is soft despite both rising oil prices and a relatively hawkish Norgesbank.  The best performer is the yen, which is essentially unchanged today.

In the EMG space, PLN (-1.0%) and HUF (-1.0%) are the laggards as both countries grapple with much faster inflation and lagging monetary policy.  But CZK (-0.7%) and TRY (-0.65%) are also under relative pressure as their monetary policies, too, are lagging the inflation situation.  Throughout Asia, most currencies slid as well, just not as much as we are seeing in EEMEA.

On the data front, Initial Claims (exp 275K) headlines this morning along with Continuing Claims (2150K), Nonfarm Productivity (-3.1%), Unit Labor Costs (7.0%) and the Trade Balance (-$80.2B).  It is hard to look at the productivity and ULC data and not be concerned about the future economic situation here.  Rapidly rising labor costs and shrinking productivity is not a pretty mix.  As to the Fed, mercifully there are no additional speakers today, so we need look only at data and market response.

Clearly market euphoria remains high at this time, and so further equity gains seem likely.  Alas, the underlying structure of things does not feel that stable to me.  I expect that we are getting much closer to a more substantial risk-off period which will result in a much stronger dollar (and yen), and likely weaker asset prices.  For hedgers, be careful.

Good luck and stay safe
Adf

Feathered and Tarred

The talk of the town is that Jay
Will outline the taper today
Inflation’s been mulish
And he has been foolish
-ly saying t’would soon go away

This outcome means Madame Lagarde
Remains as the final blowhard
Who claims that inflation
Is our ‘magination
Which might get her feathered and tarred

It’s Fed day today and the market discussion continues apace as to just what Chairman Powell and his FOMC acolytes are going to do this afternoon.  The overwhelming majority view amongst the economics set is the Fed will outline its plans to taper QE purchases starting immediately.  Expectations are for a reduction in purchases by $10 billion/month of Treasuries and $5 billion/month of Mortgage Backed Securities.  Many analysts also believe the statement will leave wiggle room for the FOMC to adjust the pace as necessary depending on the unfolding economic conditions.  Powell has been taking great pains in trying to separate the timing of reducing QE with the timing of raising interest rates, and I expect that will continue to be part of the discussion.  Of course, the market is currently pricing in two 25bp rate hikes in 2022, essentially saying the Fed will finish the taper next June and hike rates immediately.  This is clearly not Powell’s desired path, but the wisdom of crowds may just have it right.  We shall see.

In addition to that part of the announcement, we are going to hear the Fed’s view on how inflation will evolve going forward, although at this point, I think even they have realized they cannot use the word transitory in their communications.  Talk about devaluing the meaning of a word!  What remains remarkable to me is the unwavering belief, at least the expressed unwavering belief, that while inflation may print high for a little while longer, it is due to settle back down to the 2% level going forward.  I continue to ask myself, why is that the central bank view?  And not just in the US, but in almost every developed nation.  For instance, just moments ago Madame Lagarde was quoted as saying, “Medium-term inflation outlook remains subdued,” and “conditions for rate hike unlikely to be met next year.”

To date, there has certainly been no indication that global supply chains are working more smoothly than they were during the summer, and every indication things will get worse before they get better.  The number of ships anchored off major ports continues to grow, the number of truck drivers continues to shrink and demand, courtesy of literally countless trillions of dollars of fiscal stimulus shows no sign of abating.  Add to that the current environmental zeitgeist, which demonizes fossil fuels and seeks to prevent any investment in their production thus reducing supply into accelerating demand and it is easy to make the case that prices are likely to rise going forward, not fall.

There is a saying in economics that, ‘the cure for high prices is high prices.’  The idea is that higher prices will encourage increased supply thus driving prices back down.  And historically, this has been true, especially in commodity markets.  However, the unspoken adjunct to that saying is that policies do not exist to prevent increased supply and that the incentive of higher revenues is sufficient to encourage that new supply to be created.  Alas, the world in which we find ourselves today is rife with policies that may have political support but are not economically sound.  The current US energy policy mix preventing oil drilling in ANWR and offshore, as well as the cancellation of the Keystone Pipeline served only to reduce the potential supply of oil with no replacement strategy.  If policy prevents new production, then no price is high enough to solve that problem, and therefore the ceiling on prices is much higher.

I focus on energy because it is a built-in component of everything that is produced and consumed, and while the Fed may ignore its price movement, manufacturers and service providers do not and will raise prices to cover those increased costs.  The upshot here is that instead of high prices encouraging new supply, it appears increasingly likely that prices will have to rise high enough to destroy new, and existing, demand before markets can once again return to a semblance of balance.  Given the fact that fiscal largesse has been extraordinary and household savings has exploded to unprecedented heights during the pandemic and remains well above pre-pandemic levels, it seems that demand is not going to diminish anytime soon.  I fear that rising prices is a new feature of our lives, across all segments, and something we must learn to address going forward.  While there is no reason to believe we are heading to a Weimar-style hyperinflation, do not be surprised if the “new normal” CPI is 3.5%-4.5% going forward.  At the current time, there is simply nothing to indicate this problem will be addressed by the Fed although we are likely to see smaller, open economy central banks raise interest rates far more aggressively.  As that process plays out, the dollar will almost certainly weaken, but we are still months away from that situation.

So, ahead of the FOMC statement and Powell presser this afternoon, here’s what’s been happening in markets.  Despite record high closes in the US markets yesterday, Asia (Nikkei -0.4%, Hang Seng -0.3%, Shanghai -0.2%) did not follow through at all.  Europe, too, sees no joy although only the FTSE 100 (-0.2%) has even moved on the day with other major markets essentially unchanged.  US futures are also little changed at this time with everyone waiting for Jay.

Bond markets, on the other hand are continuing their recent rally with Treasury yields lower by 1.4bps and Europe (Bunds -1.5bps, OATs -2.0bps, Gilts -0.3bps) all rallying as well.  Peripheral markets are doing even better as it seems the European view is turning toward the idea that the ECB will be outlining their new QE program in December with no capital key involved.

Commodity prices continue to give mixed signals with oil (WTI -2.4%) falling sharply, ostensibly on comments from President Biden admonishing OPEC+ to pump more oil.  Will that really get them to do so?  NatGas (-0.7%) is also a bit softer, but the metals complex is actually firmer with copper (+1.05%, aluminum +1.45%, and tin +1.8%) all showing strong gains.  This as opposed to precious metals which are essentially unchanged on the day.

As to the dollar, it is hard to describe today.  While versus the G10, it is generally weaker (CHF +0.4%, NZD +0.4%, SEK +0.3%) it has performed far better against EMG currencies (TRY -0.8%, RUB -0.7%, KRW -0.6%) although PLN (+0.4%) is having a good day.  Unpacking all this the Swiss story seems to be premised on the idea that the market is testing the SNB to see if they can force more intervention while the kiwi story is a response to stronger jobs data overnight.  Sweden seems to be benefitting from the emerging view of tighter policy from the Riksbank as they reduce QE.  On the EMG side, Turkey’s inflation rate continues to be breathtakingly high (CPI 19.89%, PPI 46.31%!) and yet there is no indication the central bank will respond by tightening policy as that is against the view of President Erdogan.  Oil’s decline is obviously driving the ruble lower, surprisingly not NOK, and KRW saw an increase in foreign equity sales and outflows thus weakening the won.

Ahead of the FOMC we see ADP Employment (exp 400K), ISM Services (62.0) and Factory Orders (0.1%), but while ADP will enter the conversation tomorrow, once we are past the Fed, I expect the morning session to be extremely quiet ahead of 2:00pm.  From there, all bets are off, although my take is the level of hawkishness on the FOMC is edging higher.  Perhaps there is some dollar strength to be seen post-Powell.

Good luck and stay safe
Adf

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