A New T#heme

The news yesterday from the Fed
Was Vice-Chair Clarida has fled
While later today
Chair Jay seeks to sway
The Senate to keep him Fed head

But in the meantime, it would seem
The narrative has a new theme
It seems pretty clear
Four rate hikes this year
Have gone from the fringe to mainstream

As we walk in this morning, there seems to be a lot of movement with respect to market expectations regarding the Fed’s actions going forward and exactly how those actions are going to impact the various markets.  Today’s headline event is Chairman Powell’s renomination testimony in the Senate as everyone is waiting to see just how much effort Senator Elizabeth Warren puts into trying to derail the process.  It is widely known that the Senator does not care for Mr Powell going so far as to calling him “dangerous” in his recent semi-annual testimony to the Senate.  Yesterday, she also wrote a letter demanding to see all the personal trading records of all Fed officers which probably was part of the impetus for vice-Chair, Richard Clarida, to step down early from his post.  So, on the one hand, we will be treated(?) to the scene of some Senators trying to play gotcha with the Fed Chair today with the ever-present possibility that some comment is made with a real market impact.

On the other hand, the tightening train has not merely pulled away from the station but is starting to gather serious speed.  Earlier this morning, Atlanta Fed President Bostic commented that he sees 3 rate hikes this year and that the Fed “will act to ensure inflation doesn’t run away from us.”  Futures markets are now pricing in a more than 60% probability of a fourth rate hike in 2022 with an increasing number of Fed speakers explaining a rate hike in March would be appropriate.  We are also hearing the 4-hike scenario from an increasing number of pundits with Goldman Sachs economists publishing that view yesterday while JPMorgan Chairman Jamie Dimon explained that “four rate hikes of 0.25% each would not have an enormous effect on the economy.”  And that is likely correct, a Fed Funds rate of 1.0% doesn’t seem that onerous for businesses.  Of course, what impact would four interest rate hikes have on financial asset prices, especially if they were joined with a reduction in the size of the Fed’s balance sheet?  And it is this latter question that seems likely to be the key as we continue to hear from more and more Fed speakers that the idea of allowing the balance sheet to ‘run-off’ is appropriate.

For those of you with shorter memories, the last time the Fed tried to reduce the size of its balance sheet, from 2017-2018, they were also raising interest rates, albeit far more slowly.  Of course, CPI had peaked below 3.0% in that cycle, GDP was running at 2.4% and wages were growing at 2.5% while the balance sheet was less than half its current size.  The point is conditions were clearly very different.  However, not only did the equity market’s 20% decline inspire the Powell Pivot on Boxing Day 2018, but nine months later, the repo market blew up forcing the Fed to take dramatic action to ensure that sufficient liquidity was made available to the banking system.  I assure you, neither of those outcomes were part of the carefully described plans the Fed had made to ‘normalize’ monetary policy.

Will this time be different?  While starting conditions certainly are different, the one thing of which we can be sure is that the complexities of the international money markets remain opaque even to the central banks charged with their oversight.  While there is no way to anticipate exactly what will happen to derail the current plans, one can almost be certain that things will not work out the way they are currently planned.  Personally, I remain convinced that markets will have a very difficult time handling any reductions in the excess liquidity that has been the dominant feature of the post Covid-19 global financial markets, and that despite a lot of tough talk now, the Fed, at least, will be walking back that hawkishness before too long.

And perhaps, markets are beginning to agree with me.  After all, hawkish monetary policy is rarely the backdrop for a risk-on attitude.  Yet that is a pretty fair description of today’s price action.  Equities are rebounding along with commodities; bonds are benign, and the dollar is softening.

While yesterday saw US equity markets in the red most of the day, the NASDAQ staged a furious late day rally to close flat although market breadth was awful (1205 gainers vs. 2201 losers).  And while Asia was still under pressure (Nikkei -0.9%, Hang Seng 0.05, Shanghai -0.7%), Europe has taken heart from something as we are seeing solid gains across the board there (DAX +1.15%, CAC +1.35%, FTSE 100 +0.7%) despite a complete lack of news.  US futures, too, have turned green with all three main indices up about 0.3% at this hour.

The Treasury rout is on hold with yields essentially unchanged this morning and the 10-year right at the key level of 1.75%.  In Europe, Bunds (-0.9bps) and Gilts (-2.3bps) are both trading well while the rest of the sovereign market is virtually unchanged.  Again, there has been essentially no news of note.

Oil prices are rallying (WTI +1.4%) while NatGas (-0.9%) has consolidated some of yesterday’s gains despite the fact it is 14 degrees here in NJ this morning.  Gold (+0.3%) and silver (+0.6%) are both firmer, as are industrial metals (Cu +0.6%, Al +0.1%, Zn +2.4%) and the ags are strong as well.

Finally, the dollar is under modest pressure with NOK (+0.4%) leading the G10 revival on the strength of oil’s rally, while CAD (+0.3%) follows closely behind.  JPY (-0.25%) is the only laggard here, again pointing to the risk characteristics in today’s price action.  EMG markets have seen similar price action with THB (+0.6%) the leading gainer followed by HUF (+0.4%) and KRW (+0.35%), all benefitting from the pause in the US yield rally and generally better risk appetite.

Today’s only data point has been released, NFIB Small Business Optimism (98.9, slightly better than 98.7 expected) and has had virtually no impact on the market.  This brings us back to the Fed as today’s most likely catalyst, as not only will we hear from Chair Powell starting at 10:00, but also from two of the most hawkish regional bank presidents, Mester and George between 9:00 and 9:30.

With risk in vogue for the session, I expect the dollar will have difficulty gaining any ground, but nothing has changed my short-term view that the Fed’s hawkishness is going to be the key driver of a stronger dollar…right up until they reverse course!

Good luck and stay safe
Adf

Costs are Aflame

The central banks of the G10
Are starting to realize the ‘when’
Of interest rate rises
To forestall a crisis
Is sooner than they thought back then

Inflation breakevens keep rising
While companies are proselytizing
That they’re not to blame
As costs are aflame
Thus CB’s, their plans, are revising

It is difficult to scan a news source these days without seeing a story of how some company or another is raising their prices by X% due to increased shipping/raw material costs/labor costs.  And the reporter doesn’t really have to look that hard for the typical anecdotes that accompany this type of story since the situation has become increasingly prevalent.  Just this morning I read about Unilever, WD-40 and P&G all explaining that prices have not only already risen but would be rising further in the months ahead.  Obviously, this does not bode well for the transitory narrative, which is in its death throes.  That being said, it is still not the universal opinion of all Fed members.  For instance, yesterday NY Fed president John Williams exclaimed that long-term inflation expectations have risen to levels “consistent with the 2% goal.”  Now, I’m not sure what long-term expectations he is looking at, but yesterday, the 5-year/5-year inflation rate in the US Treasury market closed at 2.915%, its highest level since the series began in 2002.  The 19-year history of this measure shows an average of 1.85%, which seems more in line with Williams’ comments.  But one must be willfully blind to look at the chart of this series and claim inflation expectations remain sedate.

The risk for the central banks that maintain inflation is not a growing issue is loss of whatever credibility they have remaining.  And the upshot is, markets are not listening to them anymore and have begun to price in more aggressive rate hikes around the world.  In the US, the first rate hike is priced for next July, right about the time the Fed previously expected to finish tapering.  And there is a second hike priced in before the end of 2022.  In the UK, the first hike is priced for this December with three more expected by next September.  Even in the Eurozone, a full hike is priced in by the end of next year, something that not a single ECB banker has expressed, and in fact, several have categorically denied.

At the same time, longer term yields are rising as well, with 10-year Treasuries up to 1.68% even after having fallen 2.1 bps in the overnight session.  German bunds, while still negative (-0.09%) are at their highest level since May 2019, which was the last time their yield was at 0.0%.  And we are seeing similar price action across Gilts, OATs and Australian GBs.  (The latter despite the fact that the RBA remains adamant that they will not be raising interest rates until 2024.  Methinks they will have some crow to eat on that subject.)

The problem for central banks, and their respective governments, is that given the extraordinary amount of debt outstanding, higher yields can quickly become a problem.  So, ask yourself how can a central bank prevent rising yields without raising front end rates or expanding their balance sheets further?  You will not like this answer but here is a taste of what could be coming our way; regulatory changes that force institutions to buy government bonds.  Consider the ease with which central banks could require commercial banks to expand the ratio of government bonds in their asset portfolio, or insurance companies or pension funds or all three.  Financial repression can take form in many ways, and this would likely be the first step.  After all, for the average person, this is a relatively esoteric process and would not likely be widely understood hence would not cause an uproar.  Of course, all those insurance company and pension fund portfolios that needed to replace stock holdings with bonds would result in some pretty big selling pressure in the equity market, which would get a little more press.  But central banks wouldn’t get the blame as they are one step removed from the process.  In their eyes, this would be a win-win.

The implication is not that this is imminent, just that it is a possible pathway in the future, and one that seems more and more likely as inflation drives yields higher.  However, for now, the market is still of the belief that central banks will be forced to raise rates and are pricing accordingly.  Given the widespread nature of this belief set, the relative impact on currencies remains muted.  However, if US rates continue to lead the way higher, I think the dollar will continue to see the most support.

Ok, a quick look at today shows that despite the gathering inflation clouds, risk is in vogue with equities generally higher and bonds generally softer.  Last night saw modest gains in the Nikkei (+0.35%) and Hang Seng (+0.4%) although Shanghai (-0.35%) continues to feel the pain of the property situation in China. (As an aside, Evergrande made a surprise partial payment on the USD bond coupon that had been overdue and was about to trigger a default. So, it lives to default another day.)  Europe, too, is having a generally positive session with the CAC (+1.1%) leading the way higher but strong gains in the DAX (+0.7%) and FTSE 100 (+0.55%).  Here, the data released was the preliminary PMI data, which was best described as mixed compared to forecasts, but broadly softer compared to last month, and continues to trend lower.  The outlier here was the UK, which had stronger PMI data, but much weaker than expected Retail Sales data, so perhaps offsetting news.  As to US futures markets, the are either side of unchanged at this hour after this week’s rally.

Bond markets throughout the continent are seeing selling pressure with yields rising (Bunds +1.7bps, OATs +1.6bps) but Gilts (-0.8bps) have a bid along with Treasuries (-2.1bps).  The trend, though remains for higher yields as investors respond to rising inflationary forecasts.  Central banks have their work cut out for them if they want to maintain control of these markets.

In the commodity markets, oil (+0.4%) and NatGas (+0.8%) are back in the green as are copper (+0.75%) and gold (+0.55%).  In fact, pretty much the entire complex including industrial metals and agricultural products are all firmer this morning.

Finally, the dollar is softer across the board in the G10, with AUD (+0.45%) the leading gainer on the back of the commodity picture, followed by SEK (+0.35%) and NOK (+0.35%) which are similarly well situated.  The pound (+0.05%) is the laggard as the Retail Sales data seems to have undermined some bullish views.  In the emerging markets, there are two outliers, one in each direction.  The only loser of the day is TRY (-1.0%) which continues to suffer from yesterday’s surprising 200bps rate cut.  Meanwhile, RUB (+1.4%) has been the leading gainer after the Bank of Russia surprised the market with a 75bp rate hike, much larger than the 25bp-50bp that had been forecast.  Adding that to the price of oil has been an unalloyed positive.  Away from those two, however, gains are modest with ZAR (+0.35%) the next best performer following commodity prices higher.

Preliminary PMI data is the only thing on the docket data wise this morning, but Chairman Powell speaks at 11:00 as the final speaker before the quiet period begins.  Given the differences we heard from Williams and Waller, it will be very interesting to see if Powell is more concerned about inflation or employment.

As such, I expect a muted morning ahead of Powell’s comments and then the opportunity for some activity if he substantially changes the narrative.  My sense is that any change would be hawkish and therefore a dollar positive.

Good luck, good weekend and stay safe
Adf

PS, I will be out of the office next week so no poetry again until November 1st.

Protests Are Growing

In China the growth impulse waned
As policy makers have strained
To maintain control
While reaching the goal
Of growth that Xi has preordained

In other news protests are growing
By pundits that markets are showing
Too much in the way
Of rate hikes today
Since wags think inflation is slowing

Risk is getting battered this morning, but interestingly, so are many havens.  It seems that the combination of slowing growth and higher inflation is not all that positive for assets in general, at least not financial ones.  Who would have thunk it?

Our story starts in China where Q3 GDP was released at a slower than expected 4.9% down from 7.9% in Q2 and 18.3% in Q1.  If nothing else, the trend seems to be clear.  And, while Retail Sales there rose a more than expected 4.4%, IP (3.1%) and Fixed asset Investment (7.3%), the true drivers of the Chinese economy, both slumped sharply from last quarter and were well below estimates.  In other words, the Chinese economy is not growing as quickly as the punditry, and arguably, the market had expected.  This is made clear by the ongoing lackluster performance in Chinese equity markets which are also being accosted by President Xi’s ongoing transformation of the Chinese economy to one more of his liking.  (In this vein, the latest is the attack on the press such that all media must now be state-owned.  Clearly there is no 1st Amendment there.)  Of course, if the press is state-controlled, it is much easier for the government to prevent inconvenient stories about things like Evergrande from becoming widespread inside the country.  That being said, we know the Evergrande situation is under control because the PBOC told us so!

Ultimately, this matters to markets because China has been a significant growth engine for the global economy and if it is slowing more rapidly than expected, it doesn’t bode well for the rest of the world.  Apparently ongoing energy shortages in China continue to wreak havoc on manufacturing companies and hence supply chains around the world.  But don’t worry, factory gate inflation there is only running at 10.7%, so there seems little chance of inflationary pressures seeping into the rest of the world.  In the end, risk appetite is unlikely to increase substantially if the narrative turns to one of slower growth ahead, unable to support earnings expectations.

With this in mind, it is understandable why equity markets are under pressure this morning which has been true in almost every major market; Nikkei (-0.15%), Shanghai (-0.1%), DAX (-0.5%), CAC (-0.8%), FTSE 100 (-0.2%). US futures (-0.3%), with only the Hang Seng (+0.3%) bucking the trend.  Funnily enough, though, bond markets are also under universal pressure (Treasuries +4.4bps, Bunds +4.4bps, OATs +4.7bps, Gilts +6.7bps, Australia GBs +9.0bps, China +5.3bps, and the pièce de résistance, New Zealand +15.5bps) as it seems investors are beginning to fret more seriously over inflation and ensuing policy action by central bankers.

Yesterday, BOE Governor Andrew Bailey explained that the BOE will “have to act” to curb inflationary forces.  That is a pretty clear statement of intent and one based on the reality that inflation is well above their target and trending higher.  Interest rate markets quickly priced in rate hikes in the UK with the first expected next month and a second by February.  In fact, by next September, the market is now pricing in 4 rate hikes, expecting the base rate to be 1.00% vs. the current rate of 0.10%.  In New Zealand, meanwhile, CPI printed at 4.9% last night, well above the expected 4.2% and the market quickly adjusted its views on interest rates there as well, with a 0.375% increase now price for the late November meeting and expectations that in one year’s time, the OCR (overnight cash rate) will be up at 1.95% compared to today’s 0.50%.

Naturally, this price action doesn’t suit the central bank narrative and so there has been a concerted push back on the higher inflation story from many sectors.  My personal favorite is from the pundits who are focusing on the Fed staff economists with the claim that they are far more accurate than the Street and their current forecast of 2022 inflation of 1.7% should be the baseline.  But we have heard from others with vested interests in the low inflation narrative like Blackrock (who gets paid by the Fed to manage the purchases of assets) as well as a number of European central bankers (Villeroy and Vizco) who maintain that it is critical the ECB keep policy flexibility when PEPP ends.  This appears to be code for ignore the inflation and keep buying bonds.

The point of today’s story is that the carefully controlled narrative that has been fostered by the central banking community is under increasing pressure, if not falling apart completely.  Markets are pricing in rate hikes despite protests by central bankers, as they see rising inflation trends as becoming much more persistent than those central bankers would like you to believe.  At this point, no matter what inflation statistic you consider (CPI, PCE, trimmed-mean CPI, median CPI, sticky CPI) all are running well above the Fed’s 2.0% target and all are trending higher.  The same situation obtains in almost every major nation as the combination of 18 months of excessive money-printing and significant fiscal spending seems to have done the trick with respect to reviving both inflation and inflation expectations.  If I were the Fed, I’d be taking a victory lap as they have been fighting deflation for a decade.  Clearly, they have won!

So, if stocks and bonds are both falling, what is rising?  I’m sure you won’t be surprised that oil (+1.6%) is leading the way higher as demand continues to rise while supply doesn’t.  OPEC+ has refused to increase production any further and the US production situation remains under pressure from Biden administration policies.  While NatGas in the US is softer (-1.8%), in Europe, it is much firmer again (+16.2%) as Russia continues to restrict supply.  Precious metals remain unloved (Au -0.2%, Ag -0.2%) but industrial metals are firm (Cu +0.9%, Al +0.45%, Sn +1.2%) along with the agriculturals.

Finally, the dollar is definitely in demand rising against 9 of its G10 brethren (only NOK has managed to hold its own on the back of oil’s rally) but with the rest of the bunch falling between 0.1% and 0.5% on general dollar strength. After all, if neither NZD (-0.1%) nor GBP (-0.15%) can rally after interest rate markets have jumped like they have, what chance to other currencies have today?

EMG currencies are also under pressure this morning led by ZAR (-1.0%) and followed by MXN (-0.6%) with both falling despite rising oil and commodity prices.  Both seem to be suffering from a general malaise regarding EMG currencies as concerns grow that rising inflationary pressures are going to slow growth domestically, thus pressuring their central banks to maintain easier policy than necessary to fight rising inflation.  Stagflation is a b*tch.

Turning to the data front, this week sees much less of interest with housing being the focus:

Today IP 0.2%
Capacity Utilization 76.5%
Tuesday Housing Starts 1615K
Building Permits 16680K
Wednesday Fed Beige Book
Thursday Initial Claims 300K
Continuing Claims 2550K
Philly Fed 25.0
Leading Indicators 0.4%
Existing Home Sales 6.08M

Source: Bloomberg

On the Fed front, 10 more speakers are on the docket across a dozen different venues including Chairman Powell on Friday morning.  At this point, with inflation rising more rapidly than expected everywhere in the world and the market pricing in rate hikes far more aggressively than central banks deem appropriate, the case can be made that the central banks have lost control of the narrative.  I expect this week’s onslaught of commentary to try very hard to regain the upper hand.  However, as I have long maintained, at some point the Fed will speak and act and the market will not care.  We could well be approaching that point.  In that event, the only thing that seems certain is that volatility will rise.

As to the dollar today, I think we need to see some confirmation that this modest corrective decline is over, but for now, the medium-term trend remains for a higher dollar.  I see nothing to change that view yet.

Good luck and stay safe
Adf