As energy prices decline
Inflation, at least the headline,
Continues to shrink
As central banks think
Their actions have been quite benign
The problem is that at its core
Inflation is far from a floor
So, Christine and Jay
Ain’t ready to say
They’re done and won’t hike anymore
European inflation readings continue to fall alongside the ongoing decline in energy prices. Headline numbers in France, Italy and Germany, as well as Spain and most of the Eurozone, have fallen sharply in the past month and seem likely to continue to do so. Core inflation readings, however, for those countries that measure such things, and for the Eurozone as a whole, are demonstrating the same stickiness that we have seen here in the US. Ultimately, the problem is that an inflationary mindset has begun to take hold in many people’s view. While there is a great deal of complaining about rising prices, people continue to pay them, and the hangover of fiscal stimulus that was seen everywhere and continues to be pumped into economies around the world has allowed companies to raise prices while maintaining sales.
There continues to be a strong disagreement within the analyst community regarding the future of inflation as there are many who have watched the trajectory of energy price declines and anticipate a return to 0%-2% inflation by the end of the year. At the same time, there is another camp, in which the Fxpoet falls, that expects inflation to remain sticky in the 4% range for the foreseeable future. Arguably, until such time as the massive amount of liquidity that was injected into the economy in response to Covid (and the GFC) is removed, I fear prices will err on the side of rising faster than we had become used to for so long.
Taking this one step further, the central bank playbook on inflation, as written by Paul Volcker in the 1980’s, was to tighten monetary policy enough to cause a severe recession and break demand. We all know that Chairman Powell has read that book and is following it as best he can these days. And, he has most of his team on board with that view. Just this morning, Cleveland Fed President, and known hawk, Loretta Mester explained to the FT, “I don’t really see a compelling reason to pause – meaning wait until you get more evidence to decide what to do. I would see more of a compelling case for bringing rates up…and then holding for a while until you get less uncertain about where the economy is going.” These are not the words of someone who is concerned that rising interest rates are going to derail the US economy. It is sentiment like this that has the Fed funds futures market pricing in a 64% probability of a rate hike in two weeks’ time. It is also sentiment like this that is supporting the dollar, which has traded to its highest level in more than two months and is crushing the large, vocal contingent of dollar short positions around.
But, heading back to the recession argument, the data that we continue to receive shows no clear signs in either direction, rather it shows lots of conflict. Yesterday I mentioned the decline in GDI, a seeming harbinger of weaker growth. Meanwhile, yesterday’s data releases perfectly encapsulated the issue, with Consumer Confidence printing at a higher than expected 102.3, while the Dallas Fed Manufacturing Index fell to a wretched -29.1, far worse than expected and a level only reached during recessions in the past. And there’s more to this story as last night China’s PMI data was all released at worse than expected levels (Manufacturing 48.8, Non-manufacturing 54.5, Composite 52.9) with all 3 readings slowing compared to April and an indication that the Chinese reopening story seems well and truly dead.
This poses a sticky problem for President Xi as the clearly slowing Chinese economy seems likely to require further stimulus, whether fiscal, monetary, or both, with the ‘smart money ‘betting on monetary easing. However, the renminbi (-0.4%) fell again last night and has been sliding pretty steadily since January. Now, firmly above 7.10, it is fast approaching levels that the PBOC has previously indicated are inappropriate. The question is, what will they do? Easing monetary policy opens the door to rising prices, a potentially severe problem in China, while standing pat will likely result in further economic decline, not exactly what Xi is seeking. My money is on easier policy and if necessary, price controls, something at which the Chinese government excels.
One cannot be surprised that with news like this, risk is taking a breather today, despite the ongoing euphoria over NVDA and AI. Yesterday’s mixed performance in the US led to substantial weakness overnight in Asia, with all main indices falling by at least -1.0%. Meanwhile, Europe this morning is also largely in the red, albeit only to the tune of -0.5%, and at this hour (8:00) US futures are pointing lower by -0.3% across the board.
At the same time, the combination of falling inflation rates in Europe and the fact that a debt ceiling deal appears to be coming together has yields continuing to slide with Treasuries (-4.4bps) actually underperforming European sovereign yields which are all lower by between 7bps and 8bps. The other thing to note here is that the yield curve inversion in the US, currently back to -78bps, is showing no signs of righting itself soon. It has been nearly one year since the curve inverted, and recession alarms have been ringing everywhere, although one has not yet been sighted. I expect continued volatility in this market as the debt ceiling bill will allow for a significant uptick in issuance right away and the question is, who will buy all this debt?
Oil prices (-2.8%) continue to point to slowing economic activity and that is confirmed by weakness in the base metals as well. While the Fed sees no signs of a recession, it seems pretty clear that some markets disagree. Do not be surprised to see another production cut by OPEC+ as the summer progresses.
Finally, the dollar is king again, rising against virtually all its G10 and EMG counterparts, with the G10, sans JPY, all falling between -0.4% and -0.6%. This is a broadscale risk-off move and one which is likely to continue as long as we see the combination of tough talk from the Fed and slowing economic data.
Speaking of economic data, today brings Chicago PMI (exp 47.2), JOLTS Job Openings (9.4M) and the Fed’s Beige Book this afternoon. It is pretty clear that manufacturing activity remains in the doldrums here but pay close attention to the JOLTS data as the Fed is watching it closely for clues as to labor market tightness. A weak number there is likely to have a bigger market impact than anything else today.
Net, I see no reason to dispute the dollar’s strength at the current time. Talk to me when the Fed changes its tune, and we can see a dollar reversal. Until then, higher for longer is both the interest rate and USD mantra.