A Small Crisis Grows

Investors are starting to feel
That China has lost its appeal
So, capital flees
From all stocks, Chinese
As Xi brings exploiters to heel

While, thus far the impact’s been small
On markets elsewhere, please recall
That history shows
A small crisis grows
Quite quickly with each margin call

Giving credit where it is due, the Chinese have successfully distracted almost every market participant from tomorrow’s FOMC meeting.  The ongoing rout in Chinese equity markets (Shanghai -2.5%, Hang Seng -4.2%) has been fueled by the government’s hardline stance against several different industries that had become investor favorites.  If you think of the progression of events, it began with private financial firms (remember the Ant IPO that was squashed when Jack Ma was disappeared for a while?) and has continued as the evolution of the DC/EP (China’s digital yuan or CBDC) has forced the two big private payment firms, Alipay and WeChat Pay to fall into line and restrict their offerings going forward.

We have also seen the government address concerns over other tech companies and their capitalist intentions and actions, which has taken the form of questions over data security in Didi Global, the ride hailing app, and Meituan, the food service company.  After all, both of these companies are clarion calls for people to be independent, choosing their work schedule and effort, as opposed to toiling for a proper, state-owned firm.  Naturally, this is anathema to President Xi as he continues to remold the nation into his preferred view.

The latest attack has been on the private education industry, which while nominally teaching the approved curriculum, were clearly seen as an impediment to government control, and more importantly, the appropriate spread of communism.  Remember, the CCP rules the roost in China and President Xi is General Secretary of the Chinese Communist Party.  It was certainly dichotomous that an area of such immense social importance, that preached communism, would be offered by capitalist firms.

The takeaway here, though, is not that things are getting tougher for investors in China, but that history has shown that most financial crises start small and gather momentum.  While many of you may not remember the Asia crisis of 1997, it started as an issue solely confined to Thailand and the Thai baht.  Questions over the country’s ability to repay its creditors, especially as its USD reserves had shrunk and the dollar’s rally was becoming a major problem locally.  But Thailand is not a very large country from an economic perspective, and so it was initially thought this would amount to very little.  Within a month or two of the initial concerns, however, the entire region was in turmoil as it turned out virtually none of the countries there had sufficient USD reserves, and all had borrowed heavily in dollars and were having difficulty repaying those loans.  There was a huge swoon in markets, which ultimately led to Russia defaulting on its debt while Long Term Capital, a famed hedge fund of the time, wound up on the brink and was only saved by the Fed forcing the entire Wall Street community to put up money to save it.  (Ironically, Bear Stearns is the one bank that wouldn’t participate in that rescue and we know what happened to them 10 years later!)

Speaking of the GFC, this too, was seen as a minor problem at the start.  As the housing bubble inflated, the working assumption was that the entire national housing market could never fall all at once, so all of those mortgage-backed derivatives were created and sold as low risk, high return investments throughout the world.  When the first concerns were raised, none other than Fed Chair Bernanke explained that “…the troubles in the subprime sector on the broader housing market will likely be limited.”  We know how that worked out and of course, the problems quickly became global in nature and forced the first invocation of a new emergency program known as QE.

One last example of the ability of seemingly distant events to impact the entire global financial structure comes from China in 2015.  That summer, just 6 years ago, the PBOC surprised markets with a mini-devaluation of the yuan, about 2%, as a relief valve for an equity market that had started to come under pressure several months previously.  But once the PBOC acted, risk appetite disappeared and we saw a severe contraction in global equity markets, a huge bond rally and strength in the dollar as the haven of choice.

The point is that while you may consider the fact that the Chinese government is cracking down on companies that it considers to be ideologically impure, and that it will have nothing to do with your investments in the FANGMAN group of stocks, there is every chance that this action serves as the catalyst for, at the very least, a short-term price adjustment in equity indices around the world. After all, China’s growth has been a key pillar of the global growth scenario.  If that is slipping, there are likely to be problems everywhere.  Be warned and wary.

OK, on to today’s activity where the Chinese rout continues to be ignored by Japan (Nikkei +0.5%), but continues to pressure European indices lower (DAX -0.4%, CAC -0.3%, FTSE 100 -0.4%) as well as US futures, all of which are down around -0.2% at this hour.

Bond markets are a bit more uniform this morning, led by Treasury yields (-2.9bps) although European sovereigns have not rallied as much, with most seeing yield declines of roughly 1 basis point.  (As an aside, yesterday’s price action, which saw US equity markets ultimately rebound, saw Treasuries give up their early gains and close with slightly higher yields on the day.)

In the commodity space, oil is essentially unchanged on the day, as is gold, with neither moving even 0.1%.  Copper is the biggest mover, falling 1.0%, although there is lesser weakness in other base metals.  Agricultural products are mixed with both Soybean and Corn higher by 1.0% while Wheat has slipped 0.4%.

As to the dollar, on this broadly risk-off day, it is broadly higher.  In the G10 bloc, the commodity currencies are the worst performers (NZD -0.7%, NOK -0.5%, AUD -0.4%) while the rest of the bloc has seen less pressure.  Naturally, JPY (+0.25%) is bucking the dollar trend in this type of session.  In the emerging markets, ZAR (-0.7%) is the laggard as traders digest the post-riot relief act from the government and give it two thumbs down.  The next biggest loser is CNY (-0.35%), although at this point, I’ve already described the reasons capital is leaving the country.  Otherwise, most of these currencies are lower, but the movement has been on the order of -0.1% to -0.2%, so not very dramatic.  There is one outlier on the plus side, KRW (+0.4%) which seems to have been on the back of exporters selling dollars after yesterday’s won decline to its lowest level in almost a year.  However, if CNY continues to weaken, I believe KRW will ultimately follow it.

On the data front this morning we see Durable Goods (exp 2.2%, 0.8% ex transport) as well as Case Shiller House Prices (16.33%) and Consumer Confidence (123.8).  The real information overload starts tomorrow with the FOMC and on through the rest of the week with Q2 GDP and Core PCE.

The dollar is back in risk mode.  If equities continue to suffer, look for the dollar to remain bid.  If they rebound, the dollar is likely to soften by the end of the day.

Good luck and stay safe
Adf

Time to Flee

No longer will President Xi
Allow billionaires to run free
His edict last night
Proved his grip is tight
And showed traders t’was time to flee

The biggest story overnight was the continued crackdown by Chinese authorities on any private industry that has developed a measure of power in the Chinese economy.  While the tale of Didi Chuxing, the Chinese Uber, was seen as a warning, apparently, the government is becoming more impatient over the pace of adherence to the new view.  Briefly, Didi went public and then several days later the Chinese government forced them to remove their app from public availability and crushed their business under the pretext of data security.  Didi shares fell sharply.  Last night the government explained that private education companies, which were teaching the CCP curriculum, were to cease being profit-making companies “hijacked by capitalism”, and essentially will be forced to delist.  It can be no surprise that the prices of these shares fell dramatically, in one case by 98/%, as investors flee as quickly as possible.  This resulted in sharp declines across all indices there with the Hang Seng (-4.1%) and Shanghai (-2.35%) and led to a general risk-off tone.

Apparently, President Xi is no longer willing to accept that anybody else in China can have some measure of power or influence beyond his control.  Other changes involve the payment networks Alipay and Wechat, which are on the verge of being subsumed by China’s upcoming CBDC, the e-yuan.  Exclusive rights for things like music licenses are being removed and essentially, it appears that capitalism with Chinese characteristics is morphing into a full-blown state-owned economy.  We cannot be too surprised by this; after all, Xi Jinping has been ruling with an increasingly tighter grip on all segments of the economy and he is a clear adherent to strict communism.  Remember, the definition of communism is that all property is publicly (read government) owned.  We have not seen the last of this process so be careful going forward.

The ECB told us that they
Would no longer stand in the way
Of prices that rise
Until they surmise
That growth has made major headway

Now later this week from the Fed
Some pundits think, shortly ahead,
They’ll slow down their buying
Of bonds, as they’re trying,
To counter, inflation, widespread

Inflation (whether CPI or PCE), is a price series that demonstrates characteristics similar to every other price series like stocks or bonds or currencies.  There are trend movements, there are overshoots in both directions that tend to correct and there are periods of consolidation.  One of the best definitions of a trend is a series that makes either higher lows and higher highs, or conversely, lower highs and lower lows.  In other words, something that is trending higher will typically trade to a new high level and then after a period, pull back somewhat, a normal correction, before moving on to further new highs.  When the uptrend is in force, each high is higher than the last, and, more importantly, each low is higher than the last.  I make this point because I am concerned that when looking at the backgrounds of all the FOMC members, not one of them has any trading history.

This is important because, my sense on the inflation story is that it is quite realistic that we see a slowdown in price growth in the next several months, where 5.4% headline CPI falls to 4.8% and 4.5% and so forth, as this price series goes through a correction just like the stock, bond and currency markets.  Of course, if this is what we see, it is almost guaranteed that Chairman Powell, and his band of merry men (and women) will be all over the tape crowing over the transitory nature of inflation.

Alas, my concern is that given what I believe is a strong uptrend in inflation, this retracement in CPI (and PCE) will stop at a higher level than the previous lows and set itself up for another, more powerful move higher.  In the meantime, the Fed will have waved away any concerns over inflation as they continue to pump unlimited liquidity into the system to run the economy as hot as possible.  After all, in their collective mind, they will have proven inflation is transitory.  However, the next leg higher in CPI and PCE is liable to be far more severe, occurring far more quickly than the Fed expects, and lead to a more permanent unanchoring of inflation expectations.

It will also put the Fed in an even tighter bind than they currently find themselves.  This is because if CPI prints 6%, or 7% or more, the market is far less likely to accept their jawboning as a reason to maintain low yields and high stock prices.  Rather, they will be forced to decide between addressing inflation, which means raising interest rates sharply and significantly impacting, in a very negative way, the real economy, as well as asset markets; or they will have to come up with some other way to measure inflation such that it is not rising at such a ferocious clip but is still seen as credible.  One of their dilemmas is that, politically, inflation is already becoming a problem for the Biden administration, and that is at 5%.  Be prepared for the Misery Index (a Ronald Reagan invention that was the sum of CPI and the Unemployment Rate) to become a popular meme from all of President Biden’s opponents going forward.

Oh yeah, if you think that letting inflation run hot like that is going to goose equity market returns, especially when starting from such incredibly steep valuations, you would be wrong.  History shows that when inflation rises above 5%, equity markets do not provide any type of real hedge.  Let me be clear that this is not going to play out by autumn 2021, but could very well be the case come summer or autumn 2022, a particularly difficult time for the incumbent party in Washington as mid-term elections will be upcoming and the party in power tends to get the blame for economic problems.

What about the dollar you may ask?  In this scenario, the dollar is very likely to suffer greatly, so keep that in mind as you look ahead to your hedging needs for next year and beyond.

In the meantime, the Chinese inspired sell-off has led to some risk concerns, but not (yet) a widespread sell-off.  For instance, the Nikkei (+1.0%) managed to rally in the face of the Chinese equity market declines although, outside Japan, the screens are basically all red in Asia.  European bourses are somewhat lower (DAX -0.4%, CAC -0.25%, FTSE 100 -0.25%) as they respond to the general negative tone in risk as well as a much weaker than expected German IFO reading of 101.2, well down from last month’s reading.  However, these levels are well off the session lows, as are US futures, which are down on the order of -0.25%, although were much lower earlier.

Bond markets are a little more mixed as Treasury yields fall 3.2bps (taking real yields to historic lows of -1.12%) but European sovereigns are more mixed with Bunds unchanged and OATs (+0.8bps) and Gilts (-0.8bps) not giving us any direction.

Commodity prices are mostly lower led by oil (-0.8%), although gold (+0.3%) is showing some positive haven characteristics.  Clearly, declining real yields are also supporting the precious metals.  Foodstuffs are softer (about which everyone except farmers are happy) and base metals are mixed with copper (+1.35%) leading the way higher although both Al (-0.4%) and Sn (-0.3%) are under pressure.

Finally, the dollar is not exhibiting its ordinary risk-off attitude this morning, as it is broadly softer vs. its G10 counterparts with only AUD (-0.1%) down on the day, arguably given concerns of changes with the Chinese economy.  But the rest of the bloc is marginally higher as I type led by SEK (+0.35%) and GBP (+0.3%), both of which are seeming to respond to reopening economies.

In the EMG space, however, there are many more decliners than gainers, led by RUB (-0.45%) on the back of oil’s weakness, but also KRW (-0.4%) which is feeling the pinch of the change in tone from China.  This story is going to be the second biggest driver, after the Fed, for a while, I think.

Of course, this week brings the FOMC meeting, but also Q2 GDP and Core PCE, so there is much to look forward to here.

Today New Home Sales 800K
Tuesday Durable Goods 2.0%
-ex Transport 0.8%
Case Shiller Home Prices 16.2%
Consumer Confidence 124.0
Wednesday FOMC Rate Decision 0.00% – 0.25%
IOER 0.15%
Thursday Q2GDP 8.5%
Initial Claims 380K
Continuing Claims 3192K
Friday Personal Income -0.4%
Personal Spending 0.7%
Core PCE 0.6% (3.7% Y/Y)
Chicago PMI 63.3
Michigan Sentiment 80.8

Source: Bloomberg

Obviously, the Fed is the big story as the data that comes before will not be seen as critical.  The GDP print will be quite interesting, but it is widely accepted that this is the peak and we will be slowing down from here.  However, Friday’s Core PCE number will really be scrutinized as another high print will make Powell’s task that much harder with respect to convincing people that inflation is transitory, especially if their favorite indicator keeps running higher.  Ultimately, I expect we will see a short-term retracement on the rate of inflation before the next leg up and that is the one about which we should all be concerned.

As to today’s market, if equity markets manage to shake off their concerns over Chinese activities, the dollar seems likely to continue with today’s soft tone.  If not, though, look for a rebound.

Good luck and stay safe
Adf

Far From Benign

Was yesterday’s market decline
A flash or a longer-term sign
Of things gone astray
That might well give way
To outcomes quite far from benign

Is this the end?  Have we seen the top in the equity markets?  That seems to be the question being asked this morning as both traders and investors try to determine if the first risk-off session in a number of months is the beginning of a trend, or merely a symptom of some short-term position excesses.  While Asian markets (Nikkei -1.0%, Hang Seng -0.85%, Shanghai -0.1%) continued along the theme of greater problems to come, Europe is not quite as worried, at least not in the equity space.  Interestingly, despite the rebound in Europe (DAX +0.1%, CAC +0.4%, FTSE 100 +0.3%) European sovereign debt has continued its rally with yields there lower by a pretty consistent 3 basis points across the board.

Meanwhile, after a tremendous rally in the Treasury market yesterday, where 10-year yields fell 10 basis points and the 2yr-10-yr spread flattened to below 100bps, buyers are still at large with the 10-year declining a further 1.2bps as I write.

It seems the narrative that is beginning to take hold is that the economic rebound from the Covid recession has reached its peak and that going forward, growth will quickly revert to trend.  This newer narrative has been reinforced by the spread of the delta variant of Covid throughout Asia and Europe (and the US, although lockdowns don’t seem to be on the agenda here) and the renewed closures being imposed around the world.  For instance, half of Australia has been put back under lockdown, as has New Zealand and growing parts of Southeast Asia including Singapore and Indonesia.  Europe, too, is feeling the pressure with rising caseloads n the UK, Spain and France resulting in calls for further restrictions.   The upshot of this is that earnings will struggle to rise as much as previously expected and that inflation pressures will quickly abate, and the concept of transitory inflation may be proven correct.

Chair Powell and friends are quite sure
Inflation, we won’t long endure
But pundits abound
Who’ll gladly expound
On why it’s the problem du jour

This brings us back to the big question hanging over markets, is inflation transitory or persistent?  Certainly, the recent trend in the data might argue for persistence as we continue to see higher prints than both the previous period as well as than forecasted.  As long as that is the case, it will be more and more difficult for the central banks to declare victory.  While commodity futures markets are well off their highs, a broad index of basic materials prices, things where there are no futures markets, is at all-time highs and rising.  Wages continue to rise as well, as the disconnect between the number of unemployed people and the number of job openings is forcing business to increase pay to get workers to come on board.  All of these things point to continued higher prices going forward, as do surveys of both consumers and businesses who virtually all agree higher prices are in our future.

However, the evidence from the bond market, the market that is historically seen as the most attuned to inflationary pressures, would argue that the inflation scare has passed.  With yields tumbling, US 10-year yields are more than 60 basis points off their late March highs, and the yield curve flattening.  All indications are that bond investors are sanguine over the inflation threat and are actually more worried about deflation.

The argument on this side remains that temporary bottlenecks have resulted in price pressures during the reopening of economies from the Covid lockdowns.  Economists’ models point to those very price pressures as the impetus for increased supply and, thus, lower prices in the future.  The problem is that the timeline for increasing supply is very different across different products.  Perhaps the most widely known shortage is semiconductors which has led to reductions in the production of cars, washing machines and consumer electronics.  But it takes at least 2 years to build a semiconductor factory, so it is quite possible the shortage will not be alleviated anytime soon.  Similarly, with mined raw materials, it takes multiple years to open up new mines, so shortages in copper or tin may not be alleviated for a number of years yet.  Of course, if growth is slowing, demand for these items will diminish and price pressures are likely to fade as well.

Let’s consider a few things about which we are certain.  First, securities prices do not travel in a straight line, and in fact, there are many short-term reversals involved in long-term trends.  Thus, if inflation is indeed persistent, the recent bond rally may well be the result of short-term factors and position reductions.  Recall, higher yields were the consensus Wall Street forecast three months ago, with expectations for the 10-year to be yielding between 2.0% and 2.5% in December.  Large fund managers were on board with that idea and built large positions, which take time to unwind.  It is entirely possible we are seeing the last throes of those position adjustments right now.

Another thing about which we are (pretty) certain is that during the Fed’s quiet period, we will not hear from any Fed speakers.  This means that in the event the market really does continue yesterday’s declines and starts to accelerate, the Fed will be hamstrung in their ability to try to jawbone things back to a smoother path.  Would Powell break the quiet period if markets fell 5% or 8% in a day?  My sense is he might, but that is exactly the type of thing that markets like to test.

Finally, let’s not forget that markets are hugely imperfect forecasters of the future.  After all, it was only 3 months ago when markets were forecasting much greater inflation while anticipating no change in Fed policy until 2024.  So, just because the current market view points to a potential slowing of economic growth and reduced inflation pressures, the economy behaves independently of the markets, and may well show us that the views from March were, in fact, correct.

Having already touched on equity and bond markets, a quick look at the FX markets shows that the dollar continues to power ahead vs. its G10 counterparts with NOK (-0.7%) and NZD (-0.65%) the laggards this morning.  NOK continues to suffer from oil’s remarkable 7.5% decline yesterday, while New Zealand is suffering on renewed lockdown fervor, and this after the RBNZ just last week explained they were about to tighten policy!  But we are seeing weakness in the pound (-0.45%) and AUD (-0.35%) both of which seem to be Covid shutdown related, while JPY (0.0%) is the only currency holding up in the bloc today despite further negative news regarding the Olympics and athletes contracting Covid as well as sponsors pulling out.

Emerging markets have been more varied with losers in Asia (SGD -0.35%, KRW -0.25%) on the back of Covid lockdowns, while gainers have included TRY (+0.4%), INR (+0.35%) and RUB (+0.3%).  The ruble seems to be reacting to the end of oil’s decline, unlike NOK, while INR saw equity market inflows driving the currency higher.  TRY, which is on holiday today, is benefitting from a higher inflation reading than expected and expectations of further policy tightening by the central bank there.

On the data front today we see Housing Starts (exp 1590K) and Building Permits (1696K).  We all know the housing market remains hot, so these data points are unlikely to move markets.  Rather, watch carefully for a continuation of yesterday’s risk off session and a stronger dollar.  I have a feeling that this morning’s price action is more pause than trend.

Good luck and stay safe
Adf

Bears’ Great Delight

As Covid renews its broad spread
Investors have started to shed
Their risk appetite,
To bears’ great delight,
And snap up more havens instead

Risk is off this morning on a global basis.  Equity markets worldwide have fallen, many quite sharply, while haven assets, like bonds, the yen and the dollar, are performing quite well.  It seems that the ongoing increase in Covid infections, not only throughout emerging markets, but in many developed ones as well, has investors rethinking the strength of the economic recovery.

The latest mutation of Covid, referred to as the delta variant, is apparently significantly more virulent than the original.  This has led to a quickening of the pace of infections around the world.  Governments are responding in exactly the manner we have come to expect, imposing lockdowns and curfews and restricting mobility.  Depending on the nation, this has taken various forms, but in the end, it is clearly an impediment to near-term growth.  Recent examples of government edicts include France, where they are now imposing fines on anyone who goes to a restaurant without a vaccine ‘passport’ as well as on the restaurants that allow those people in.  Japan has had calls to cancel the Olympics, as not only will there be no spectators, but an increasing number of athletes are testing positive for the virus and being ruled out of competition.

A quick look at hugely imperfect data from Worldometer shows that 8 of the 10 nations with the most reported new cases yesterday are emerging markets, led by Indonesia and India.  But perhaps of more interest is that the largest number of new cases reported was from the UK.  Today is ‘Freedom Day’ in the UK, where the lockdowns have ended, and people were to be able to resume their pre-Covid lives.  However, one has to wonder if the number of infections continues to rise at this pace, how long it will be before further restrictions are imposed.  Clearly, market participants are concerned as evidenced by the >2.0% decline in the FTSE 100 as well as the 0.45% decline in the pound.

While this story is not the only driver of markets, it is clearly having the most impact.  It has dwarfed the impact of the OPEC+ agreement to raise output thus easing supply concerns for the time being.  Oil (WTI – 2.75%) is reacting as would be expected given the large amount of marginal supply that will be entering the market, but arguably, lower oil prices should be a positive for risk appetite.  As I indicated, today is a Covid day.  The other strong theme is in agricultural products where prices are rising in all the major grains (Soybeans +0.6%, Wheat +1.4%, Corn +1.7%) as the weather is having a detrimental impact on projected crop sizes.  The ongoing drought and extreme heat in the Western US have served to reduce estimates of plantings and heavy rains have impacted crops toward the middle of the country.

With all that ‘good’ news in mind, it cannot be surprising that risk assets have suffered substantially, and havens are in demand.  For instance, Asian equity markets were almost universally in the red (Nikkei -1.25%, Hang Seng -1.85%, Shanghai 0.0%), while European markets are performing far worse (DAX -2.0%, CAC -2.0%, FTSE MIB (Italy) -2.9%).  US futures are all pointing lower with the Dow (-1.0%) leading the way but the others down sharply as well.

Bonds, on the other hand, are swimming in it this morning, with demand strong almost everywhere.  Treasuries are leading the way, with yields down 4.7bps to 1.244%, their lowest level since February, and despite all the inflation indications around, sure look like they are headed lower.  But we are seeing demand throughout Europe as well with Bunds (-2.4bps, OATs -2.0bps and Gilts -3.6bps) all well bid.  The laggards here are the PIGS, which are essentially unchanged at this hour, but had actually seen higher yields earlier in the session.  After all, who would consider Greek bonds, where debt/GDP is 179% amid a failing economy, as a haven asset.

We’ve already discussed commodities except for the metals markets which are all lower.  Gold (-0.35%) is not performing its haven function, and the base metals (Cu -1.7%, Al -0.1%, sn -0.7%) are all responding to slowing growth concerns.

Ahh, but to find a market where something is higher, one need only look at the dollar, which is firmer against every currency except the yen, the other great haven.  CAD (-1.2%) is the laggard today, falling on the back of the sharp decline in oil and metals prices.  NOK (-0.9%) is next in line, for obvious reasons, and then AUD (-0.7%, and NZD (-0.7%) as commodity weakness drags them lower.  The euro (-0.25%) is performing relatively well despite the uptick in reported infections, as market participants start to look ahead to the ECB meeting on Thursday and wonder if anything of note will appear beyond what has already been said about their new framework.  In addition, consider that weakness in commodities actually helps the Eurozone, a large net importer.

In the EMG space, it is entirely red, with RUB (-0.75%) leading the way lower, but weakness in all regions.  TRY (-0.7%), KRW (-0.7%), CZK (-0.55%) and MXN (-0.5%) are all suffering on the same story, weaker growth, increased Covid infections and a run to safety and away from high yielding EMG currencies.

Data this week is quite sparse, with housing the main theme

Tuesday Housing Starts 1590K
Building Permits 1700K
Thursday Initial Claims 350K
Continuing Claims 3.05M
Leading Indicators 0.8%
Existing Home Sales 5.90M
Friday Flash PMI Mfg 62.0
Flash PMI Services 64.5

Source: Bloomberg

The Fed is now in their quiet period, so no speakers until the meeting on the 28th.  Thursday, we hear from the ECB, where no policy changes are expected, although further discussion of PEPP and the original QE, APP, are anticipated.  So, until Thursday, it appears that the FX markets will be beholden to both exogenous risks, like more Covid stories, and risk sentiment.  If the equity market remains under pressure, you can expect the dollar to maintain its bid tone.  If something happens to turn equities around (and right now, that is hard to see) then the dollar will likely retreat in a hurry.

Good luck and stay safe
Adf

How They Debase

The world’s central banks, as a whole
Have signaled they need to control
Not only the pace
Of how they debase
Their cash, but of digging for coal

Thus, now the Big 3 have explained
The policies they have ordained
Will fund, efforts, green
But not what is seen
Endorsing ‘brown’ growth unrestrained

Last night’s BOJ meeting resulted in exactly zero monetary policy surprises but did serve to confirm that the central banking community has decided to take on a task well outside their traditional purview; climate change.  While they left policy unchanged, as universally expected, they announced that they would be introducing a new funding measure targeting both green and sustainability-linked loans and bonds.  In other words, as well as purchasing JGB’s, equities and ETF’s, they are going to expand their portfolio into ESG bonds.  The interesting thing is that the universe of ESG bonds in Japan is not that large, so the BOJ is going to wind up buying non-JPY denominated assets.  In other words, they are going to be selling a bunch of newly printed yen and converting it into other currencies to achieve their new goals.  This sounds suspiciously like FX intervention, but dressed in more politically correct clothing.  The impact, however, is likely to be a bias for a somewhat weaker yen over time.  For those of you with yen assets, keep that in mind.

Meanwhile, we have already heard from both the Fed and ECB that they, too, are going to increase their focus on climate.  Here, too, one might question whether this is an appropriate use of central bank resources.  After all, it’s not as though the economy in either place is humming along with solid growth, low inflation and excellent future prospects based on strong productivity.  But hey, combatting climate change is far trendier than the boring aspects of monetary policy, like trying to address rapidly rising inflation without tightening policy and risking a crash in equity markets.

In the end, the only thing this shift in policy focus will achieve is longer-lasting inflation.  The effort to develop new and cleaner energy by starving current energy production of capital will result in higher prices for the stuff we actually use.  Over a long enough time horizon, this strategy can make sense; alas we live our lives in the here and now and need energy every day to do so.  Germany is the perfect example of what can happen when politics overrides economics. Electricity prices in Germany average $0.383 (€0.324) per kWh.  In the US, that number is $0.104 per kWh.  Ever since the Fukushima earthquake led to Germany scrapping their nuclear fleet of power reactors, the price of electricity there has more than tripled.  I fear this is in our future if monetary policymakers turn their attention away from their primary role.

Of course, higher inflation is in our future even if they don’t do this, and there is no evidence yet, at least from the Fed or ECB, that they are about to change the current monetary policy stance that is exacerbating that inflation.  However, almost daily we are seeing markets respond to data and comments from other countries that are far more concerned with the inflationary outlook.  Last week the RBNZ ended QE abruptly and indicated they may start raising rates soon.  Last night, CPI there jumped to 3.3%, the highest level since 2011 and above their target band.  It should be no surprise that NZD (+0.45%) rose after the print as did local yields as expectations for a rate hike accelerated.  In fact, I believe this is what the immediate future will look like; smaller countries with rising inflation will tighten monetary policy and their currencies will appreciate accordingly.

Turning to today’s markets, risk was under pressure overnight after a generally weak US session.  Led by the Nikkei (-1.0%), most of Asia was softer, but not all (Hang Seng 0.0%, Shanghai -0.7%, Australia +0.2%).  Europe, which had been higher on the opening has since drifted down and is now mixed with the DAX (0.0%) unchanged while the CAC (-0.5%) lags the rest of the continent and the FTSE 100 (+0.2%) has managed to hold its early gains.  US futures have also held onto small gains with all three indices up about 0.2%.

Bond markets are somewhat mixed as Treasuries (+2.5bps) sell off after yesterdays rally where yields fell 5bps.  However, European sovereigns are all in demand this morning with yield declines ranging from 1.0 to 1.8 basis points.  Commodity markets show crude slightly higher (+0.15%), gold under pressure (-0.7%) and base metals mixed (Cu -0.3%, Al +0.3%, Sn +0.7%).

In the FX markets, aside from kiwi, NOK (+0.25%) has rallied on oil’s rebound from its lows earlier this week, but the rest of the G10 is softer.  It should be no surprise JPY (-0.35%) is the worst performer, while the other currencies are simply drifting slightly lower, down in the 0.1% – 0.2% range.  In the EMG bloc, ZAR (+1.5%) is the big winner as it regains some of the ground it lost earlier in the week on the back of the rioting there.  The government has sent in the army to key hot spots to quell the unrest and so far, it seems to be working thus international investors are returning.  Otherwise, we see gains in RUB (+0.3%) and MXN (+0.3%), both of which benefit from oil and tighter monetary policy from their respective central banks.  On the downside, TWD (-0.4%) has been the worst performer in the bloc as dividend repatriation from foreign equity holders pressured the currency.  This is not a long-term issue.   Away from that, some of the CE4 are drifting lower alongside the euro but there has not been much other news of note.

On the data front this morning we see Retail Sales (exp -0.3%, +0.4% ex autos) as well as Michigan Sentiment (86.5).  After two days of Powell testimony, where he continued to maintain there would be no policy tightening and that inflation is transitory, today we hear from NY’s Williams, one of the key members of the FOMC, and someone who has remains steadfastly dovish.

The dollar’s recent strength seems to have reached its limit so I expect that we could see a bit of a pullback if for no other reason than traders who got long during the week will want to square up ahead of the weekend.

Good luck, good weekend and stay safe
Adf

Progress, Substantial

To everyone who thought the Fed
Was ready to taper, Jay said
‘Til progress, substantial,
Is made, no financial
Adjustments are reckoned ahead

If, prior to yesterday, you were worried that the Fed was getting prepared to taper its asset purchases, stop worrying.  It doesn’t matter what Dallas Fed President Kaplan, or even SF Fed President Daly says about the timing of tapering.  The only ones who matter are Powell, Clarida, Williams and Brainerd, and as the Chairman made clear once again yesterday, they ain’t going to taper anytime soon.

In testimony to the House Financial Services Committee Chairman Jay sent a clear message; nothing is changing until the Fed (read the above-mentioned four) sees “substantial further progress” on their twin goals of maximum employment and an average inflation rate of 2.0%.  Obviously, they have moved a lot closer on the inflation front, with many pundits (present company included) saying that they have clearly exceeded their goal and need to address that issue.  But for as much vitriol as is reserved for our previous president, both the Fed and Congress are clearly all-in on the idea that the 3.5% Unemployment Rate achieved during his term just before the pandemic emerged, which was the lowest in 50 years, is actually the appropriate level of NAIRU.

NAIRU stands for the Non-Accelerating Inflation Rate of Unemployment and is the economic acronym for the unemployment rate deemed to be the lowest possible without causing increased wage pressures leading to rising inflation.  For the longest time, this rate was thought to be somewhere in the 4.5%-5.5% area, but in the decade following the GFC, as policymakers pushed to run the economy as hot as possible, the lack of measured consumerinflation, despite record low unemployment, forced economists to rethink their models.  Arguably, it is this change in view that has led to the fascination with MMT and the willingness of the current Fed to continue QE despite the evident froth in the asset markets.  Of course, now those asset markets are not just paper ones like stocks and bonds, but also housing and commodities.

But that is the situation today, despite what appears to be very clear evidence that inflationary pressures are not just high, but longer lasting as well, the Fed has their story and they are sticking to it.  They made this clear to everyone last year with the new policy framework that specifically explains they will remain behind the curve on inflation because they will not adjust policy until they see real data, not surveys, that demonstrate growth is overheating.  Yet, given the Fed’s history, where they have often tightened policy in anticipation of higher inflation and thereby reduced growth, or even caused recessions, the market has learned to expect that type of response.  While I personally believe prudent policy would be to tighten at this time, I take Mr Powell at his word, they are not going to change anytime soon.  I assure you that of the dots in the last dot plot, Jay Powell’s was not one of the ones expecting interest rates to be 0.50% by the end of 2023.

One of the things that makes this so interesting is the difference of this policy with that of an increasing number of other central banks, where recognition of rising inflation is forcing them to rethink their commitment to ZIRP.  Earlier this week, the RBNZ abruptly ended QE and explained rates may rise before the summer is over.  Yesterday, the Bank of Canada reduced its QE purchases by another C$1 billion/week, furthering the progress they started in June, and Governor Macklem made clear that if inflation did persist, they would react appropriately.  Last night it was the Bank of Korea’s turn to explain that economic activity was picking up quickly and inflationary pressures alongside that which would make them consider raising the base rate at their next meeting.  Finally, all eyes are turning toward the BOE as this morning’s employment report showed that the recovery is still picking up pace and that wage growth, at a 7.3% Q/Q rise, is really starting to take off.  Market talk is now focused on whether the Old Lady will be the next to start to tighten.

In truth, the only three central banks that have made clear they are not ready to do so are the big 3, the Fed, ECB and BOJ.  The BOJ meets tonight with no changes to policy expected as they seem to be focused on what they can do to address climate change (my sense is they can have the same success on climate change as they have had on raising inflation, i.e. none).  Next week the ECB will unveil their new framework which seems likely to include the successor to the PEPP as well as their already telegraphed new symmetrical inflation target of 2.0%.  And then the Fed meets the following week, at which point they will work very hard to play down inflation in the statement but will not alter policy regardless.

As you consider the policy changes afoot, as well as the trajectory of inflation, and combine that with your finance 101 models that show inflation undermines the value of a currency in the FX markets, it would lead you to believe that the dollar has real downside opportunity vs. many currencies, just not the euro or the yen.  But markets are fickle, so don’t put all your eggs in that basket.

Turning to today’s activities, while Chinese equity markets performed well (Hang Seng +0.75%, Shanghai +1.0%) after Chinese GDP data was released at 7.9% for Q2, just a tick lower than forecast, and the rest of the data, Retail Sales and Fixed Asset Investment all beat expectations, the rest of the world has been much less exuberant.  For instance, the Nikkei (-1.15%) stumbled along with Australian and New Zealand indices, although the rest of SE Asia actually followed China higher.  Europe has been under pressure from the start this morning led by the DAX (-0.9
%) although the CAC (-0.75%) and FTSE 100 (-0.7%) are nothing to write home about.  US futures are also under pressure (Dow -0.5%, SPX -0.3%) although the NASDAQ continues to power ahead (+0.2%).

In this broadly risk-off session, it is no surprise that bond markets are rallying.  Treasuries, after seeing yields decline 7bps after Powell’s testimony, are down another 2bps this morning.  Similarly, we are seeing strength in Bunds (-1.4bps) and OATs (-1.1bps) although Gilts (+1.4bps) seem to be concerned about potential BOE policy changes.

On the commodity front, oil fell sharply after the Powell testimony and has continued its downward move, falling 1.8% this morning.  Gold, which had been higher earlier in the session is now down 0.15%, although copper (+0.6%) remains in positive territory.  At this point, risk has come under pressure across markets although there is no obvious catalyst.

It should not be surprising that as risk is jettisoned, the dollar is rebounding.  From what had been a mixed session earlier in the day, the dollar is now firmer against 9 of the G10 with NOK (-0.5%) the laggard although the entire commodity bloc is suffering.  The only gainer is the pound (+0.1%) which seems to be on the back of the idea the BOE may begin to tighten sooner than previously expected.

EMG currencies that are currently trading are all falling, led by ZAR (-0.7%), PLN (-0.5%) and HUF (-0.5%).  The rand is very obviously suffering alongside the commodity story, while HUF and PLN are under pressure as a story about both nations losing access to some EU funds because of their stance on issues of judicial and immigration policies is seen as a negative for their fiscal balances.  Overnight we did see strength in KRW (+0.6%) and TWD (+0.4%) with the former benefitting from the BOK’s comments on tightening policy while the latter saw substantial equity market inflows driving the currency higher.

Data today includes Initial (exp 350K) and Continuing (3.3M) Claims as well as Empire Mfg (18.0), Philly Fed (28.0), IP (0.6%) and Capacity Utilization (75.6%).  Yesterday’s PPI was also much higher than forecast, but that can be no surprise given the CPI data on Tuesday.  In addition, Chairman Powell testifies before the Senate Banking Panel today, with the same prepared testimony but a whole new set of questions.  (I did reach out to my Senator, Menendez, to ask why Chairman Powell thinks forcing prices higher is helping his constituents, but I’m guessing it won’t make the cut!)

And that’s the day.  Right now, with risk under pressure, the dollar has a firm tone.  But the background of numerous other central banks starting to tighten as they recognize rising inflation and the Fed ignoring it all does not bode well for the dollar in the medium term.

Good luck and stay safe
Adf

QE’s Paradigm

Said Daly, this “pop” was expected
But basically, we have projected
This only will last
A few months, then pass
Thus, higher rates we have rejected

Said Bullard, it may well be time
To alter QE’s paradigm
By end of this year
It ought to be clear
That tapering is not a crime

And finally, today Chairman Jay
Is like to have something to say
‘Bout why rising prices
Do not mean a crisis
Is brewing and soon on the way

The one thing about writing this note on a daily basis is that you really get to see the topic du jour.  In fact, arguably, that is the purpose of the note.  When Brexit happened in 2016, it was likely the topic of 75% of my output.  Covid dominated last year for at least 3 months, where virtually every discussion referenced its impact.  And now we are onto the next topic which just will not go away.  In fact, if anything it is growing in importance.  Of course, I mean inflation.

By now you are all aware that June’s CPI reading was 5.4% on a headline basis and 4.5% ex food & energy with both readings substantially higher than forecasted by the punditry.  The monthly gains in both series was 0.9%.  Now my rudimentary math skills tell me that if I annualized 0.9%, I would wind up with an inflation rate of 11.4%.  I don’t know about you, but to me that number represents some real problems.  Of course, despite the reality on the ground, the FOMC cannot possibly admit that their policies are driving the economy into a ditch, so they continue to spin a tale of transitory price gains that are entirely due to short-term impacts on supply chains and gains relative to last year’s extremely depressed prices on the back of Covid inspired lockdowns.  And while, last year’s Covid-inspired lockdowns did have a major negative impact on prices, the idea that supply chain disruptions are short-term are more an article of faith, based on economic textbook theories, than a description of reality.

In addition, the other key leg of the Fed thinking is that inflation expectations remain ‘well-anchored.’  Alas, I fear that anchor may have come loose and is starting to drift with the current of inflation prints to a higher level.  This was made evident in the NY Fed’s survey of inflation expectations released on Monday showing that people expected inflation to be 4.8% in one year’s time.  The Fed also likes to point to inflation breakevens in the market (the difference between nominal Treasury yields and their TIPS counterparts) and how those have fallen.  It is true, they are lower than we saw at the peak in mid-May (2.56%), but in the past week, they have risen 15 basis points, to 2.37%, and appear to be headed yet higher.

And this is not merely a US phenomenon.  For instance, just this morning CPI in the UK printed at 2.5%, rising a more than expected 0.4% from last month, and we have seen this occur around the world, as both developed countries (e.g. Germany, Canada and Spain) and developing nations (e.g. Brazil, India and Mexico) have all been suffering from prices rising faster than expected.  Now, there are some nations that are addressing the issue with monetary policy by tightening (Brazil, Mexico and Hungary being the latest).  But there are others that continue to whistle pass this particular graveyard and remain adamant there is no problem (US, UK Europe).

Chairman Powell testifies to the House today (my apologies for mistakenly explaining it would be yesterday) and it has the opportunity to be quite interesting.  While there will not doubt be a certain amount of fawning by some members of the committee, at least a few members have a more conservative bent and may ask uncomfortable questions.  I keep waiting to hear someone ask, ‘Chairman Powell, can you please explain why you believe my constituents are better off when paying higher prices for the items they regularly purchase?  After all, isn’t that what Fed policy to raise inflation is all about?’  Alas, I don’t expect anyone to be so bold.

In the end, based on a lot of history, Powell will never directly answer a question on inflation other than to say that it is transitory and that the current monetary policy settings are appropriate.  If pressed further, he will explain the Fed “has the tools” necessary to combat inflation, but it is not yet time to use them.  While it is possible he has a Freudian slip and reveals his true thinking, he has become pretty polished in these affairs and the audience is generally not sharp enough to throw him off his game.

To sum it all up, inflation is screaming higher rising rapidly and the Fed remains sanguine and unlikely to adjust their policies in the near future.  While Daly and Bullard, two doves who spoke yesterday, indicated that tapering QE would likely be appropriate at some point, there was no evident hurry in their views.  Consumer prices are going higher from here, count on it.

There are some nations, however, that are willing to address inflation.  We already see several raising rates and last night, the RBNZ explained they would be ending QE by next week.  This was quite a surprise to the market and so we saw 10-year yields in New Zealand jump 7.3 basis points while NZD (+1.0%) has been the best performing currency in the world as expectations are now that the RBNZ will begin raising rates by the end of the summer.  But that the Fed had this type of common sense.

Ok, enough ranting on inflation.  Let’s see how this string of higher CPI prints has been impacting markets.  On the equity front, it has not been a happy period.  Yesterday saw US markets sell off, albeit only in the 0.3%-0.4% range. But Asia was far worse (Nikkei -0.4%, Hang Seng -0.6%, Shanghai -1.1%) and Europe is entirely in the red as well (DAX -0.2%, CAC -0.25%, FTSE 100 -0.6%) with the UK leading the way lower after that CPI print.  US futures, though, have had enough of the selling and are very modestly higher at this time.  Perhaps they think Powell will save the day.

Did I mention the 30-year bond auction was a disaster yesterday?  Apparently, with inflation running at 5.4%, locking in a yield of 1.975% for 30-years does not seem very attractive to investors.  Hence, the abrupt move to 2.05% after the auction announcement, with a long tail.  While yields are a touch lower this morning (10-year -2.0bps, 30-year -2.6bps) that has more to do with the jettisoning of equity risk than a desire to earn large negative real returns.  In Europe, it should be no surprise that Gilt yields are higher, +3.6bps, after the CPI print, but the continent is largely unchanged on the day.

Oil prices have backed off a bit, falling 0.8% this morning, but WTI remains just below $75/bbl and the trend is still firmly higher.  Gold is perking up a bit as declining real yields always helps the barbarous relic and is higher by 0.5% with silver +0.8%.  Base metals, however, are in a different place with Cu (-0.75%) and Al (-0.5%) leading the way lower.  Foodstuffs are generally higher, which of course explains the ongoing unrest in a growing list of developing countries.

As to the dollar, it is broadly weaker vs. its G10 counterparts, with kiwi far and away the leader while the rest of the bloc is firmer by between 0.1%-0.3%.  That feels much more like a dollar consolidation than any other stories beyond NZD and GBP’s inflation print.  In the EMG bloc, the picture is more mixed with PHP (-0.6%) the laggard as capital continues to flow out of the country amid foreign reserve levels sinking.  The rest of the APAC bloc was also soft, but much of that came yesterday in NY’s session with little adjustment from those levels.  On the plus side, MXN (+0.3%) is the leading gainer and the CE4 are all higher by about 0.2%, but this remains dollar consolidation after a run higher.

Somewhat anticlimactically we are going to see PPI this morning (exp 6.7%, 5.1% ex food & energy), but given the CPI has already been released, it will have to be really special to have an impact.  The Fed’s Beige Book is released at 2:00 but the highlight will be the Chairman at noon.  Frankly, until then, I don’t expect very much at all, but the market will be hanging on every word he speaks.

Broadly, the dollar remains well bid.  Yesterday saw the market anticipate the Fed being forced to tighten sooner than previously expected.  Powell has the opportunity to squelch that view or encourage it.  While I believe he will lean toward the former, that is the key market risk right now.  If I were a hedger, I would think about getting things done this morning, not this afternoon.

Good luck and stay safe
Adf

Capitalism is Spurned

When looking through history’s pages

It seems there are only two stages

At times capital

Has markets in thrall

At others, it’s all about wages

Four decades past Maggie and Ron

Convinced us, for things to move on

T’was capital needed

For growth unimpeded

But seemingly those days are gone

Instead, now the cycle has turned

As two generations have learned

That labor should take

The bulk of the cake

While capitalism is spurned

The upshot is that now inflation

Will percolate throughout the nation

While central banks claim

That prices are tame

Your costs will increase sans cessation

With markets fairly quiet this morning I thought it would be an interesting idea to step back to a more macro view of the current financial and economic framework as I strongly believe it is important to understand the very big picture in order to understand short term market activities.

A number of prominent historians and economists contend that both history and the economy are cyclical in nature although long-term trends underlie the process.  One might envision a sine wave overlaying an upward sloping line as a description.  Now the period and amplitude of the sine wave are open to question, but I would offer that a full cycle occurs in the timeframe of 80-100 years.  As per Neil Howe’s excellent book, The Fourth Turning, this encompasses four generations over which time each generation’s response to their upbringing and the events that occurred during those formative years result in fairly similar outcomes every fourth generation.

Ultimately, I believe it is valid to consider the cyclical nature in terms of the importance of the two key inputs to economic activity; capital and labor.  It is the combination of these two inputs that creates all the economic wealth that exists.  However, depending on the government regulatory situation and the societal zeitgeist, one will always dominate the other.

If we look back 100 years to the Roaring Twenties, it was clear capital had the upper hand as the administrations of Warren Harding and Calvin Coolidge maintained a very laissez faire attitude to the economy and watched as large companies grew to dominate the economy.  Of course, the Great Depression ended that theme and resulted in FDR’s New Deal and ultimately the ensuing 40 years of government intervention in the economy alongside labor’s growing power.  Forty years on from the Depression saw the height of government interventionism with the ‘guns and butter’ strategy of LBJ, the Vietnam War, the Great Society and also, the seeds of the next change, the Summer of Love.  At that point, the economic effects of the government’s heavy hand were starting to have a negative impact, restricting growth and driving inflation higher.

Like day follows night, this led to a change in the zeitgeist and a change in the relationship between capital and labor.  The Reagan/Thatcher revolution arose at a time when people saw only the negatives of government and led to a reduction of government control and activity (on a relative basis), as well as the beginnings of the financialization of the economy.  Arguably, that peaked in the dot com bubble in 2001, or perhaps in the GFC in 2008, but certainly, ever since the latter, we have seen a significant adjustment in the relationship of the government and the governed.

My contention is that we are entering into a new period of labor’s ascendancy versus capital and increased government involvement in every facet of life.  While this has manifest itself in numerous ways, from the perspective of markets, what this means is that the heavy hand of central banks is going to weigh even more greatly on events than it has until now. The myth of the independent central bank is no longer even discussed.  Rather, central banks and finance ministries are now working hand in hand as partners in trying to manage their respective economies.  And ultimately, what that means is that QE has become a permanent part of the financial landscape as debt monetization is required in order to fund every new government initiative.  If this thesis is correct, the idea that the Fed may begin to taper its QE purchases starting next year seems highly unlikely.  Instead, as I have written before, it seems more likely they will increase those purchases as the latest ‘sugar high’ of fiscal stimulus wanes and the economy once again slows down.

Interestingly, the most salient comments made today appear to back up this thesis.  Madame Lagarde was interviewed on Bloomberg TV this morning and explained that a new policy shift would be forthcoming in the near future from the ECB.  Recognizing that the PEPP was due to expire come March and recognizing that the Eurozone economy was not growing anywhere near its desired rate, the ECB is already preparing for the PEPP’s successor.  In other words, QE will not end at its originally appointed time.  In addition, she explained that they would be adjusting their forward guidance as the previous model clearly did not achieve their goals.  (Might I suggest, QE Forever?  It’s catchy and sums things up perfectly!)

So, to recap; the broad cycles of history are turning through an inflection point and we are very likely to see capital’s importance diminish relative to labor going forward.  This means that profit margins will shrink amid higher wages and greater regulatory burdens.  Equity returns will suffer accordingly, especially on a real basis as price pressures will continue to rise.  However, debt monetization will prevent yields from rising, so negative real yields are also likely here to stay for a while.  As to currencies, their value will depend on the relative speed with which different countries adapt to the new realities, so it is not yet clear how things will turn out.  It is also largely why currencies have range-traded for so long, the outcome is not yet clear.

With that to consider as a background, I would offer that market activity remains fairly unexciting.  For now, the ongoing themes remain in place, so, central bank liquidity continues to be broadly supportive of asset markets and arguably will continue to be so for the time being.

Turning to today’s session shows that Asian equity markets followed Friday’s US lead by rallying nicely (Nikkei +2.2%, Hang Seng and Shanghai +0.6%) as markets continue to respond to the PBOC’s modest policy ease announced last week regarding the RRR reduction.  Europe, though, is a bit less bubbly this morning (DAX -0.1%, CAC -0.3%, FTSE 100 -0.6%).  Finally, US futures are mixed with the NASDAQ continuing its run higher (+0.2%) but the other two markets less happy with modest declines.

Bond markets, after selling off Friday in what was clearly a short-term profit taking act, have rallied back a bit this morning with yields declining in Treasuries (-1.5bps), Bunds (-1.5bps), OATs (-2.0bps) and Gilts (-2.0bps).

Commodity prices are under pressure, with oil (-1.4%) leading the way lower, but weakness across both precious (Au -0.45%) and base (Cu –1.4%) metals and most ags.  In other words, the morning is shaping up as a risk-off session.

This is true in the FX market as well with the dollar broadly firmer in both the G10 and EMG blocs.  Commodity currencies are the biggest laggards (NOK -0.6%, CAD -0.45%, AUD -0.4%) but the dollar is higher universally in the G10.  As to the EMG bloc, ZAR (-1.8%) is by far the worst performer as a combination of increased Covid spread and local violence after the imprisonment of former president Jacob Zuma has seen capital flee the nation.  However, here too, the bulk of the bloc is softer with the commodity currencies (MXN -0.5%, RUB -0.45%) next worse off.

While there is no data today, this week does bring some important news, including the latest CPI reading tomorrow:

Tuesday NFIB Small Biz Optimism 99.5
CPI 0.5% (4.9% Y/Y)
-ex food & energy 0.4% (4.0% Y/Y)
Wednesday PPI 0.5% (6.7% Y/Y)
-ex food & energy 0.5% (5.0% Y/Y)
Fed’s Beige Book
Thursday Initial Claims 350K
Continuing Claims 3.5M
Philly Fed 28.0
Empire Manufacturing 18.0
IP 0.6%
Capacity Utilization 75.6%
Friday Retail Sales -0.4%
-ex autos 0.4%
Michigan Sentiment 86.5

Source: Bloomberg

On the Fed front, the highlight will be Chairman Powell testifying before the House on Tuesday and the Senate on Wednesday, with only a few other speakers slated for the week.

At this point, the market question is; will the dollar rally that has been quite impressive for the past weeks, albeit halted on Friday, continue, or have we seen the top?  Given the breakdown in the treasury yield – dollar relationship, my gut tells me the dollar has a bit further to go.

Good luck and stay safe

Adf

T’won’t be a Disaster

The Minutes explained that the Fed

Continues, when looking ahead

To brush off inflation

And seek job creation

Though prices keep rising instead

Meanwhile, there’s a new policy





That came from Lagarde’s ECB

T’won’t be a disaster

If prices rise faster

So, nothing will stop more QE

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe

Adf

Quite Unforeseen

When OPEC, a group of fifteen

Producers, all gathered in Wien

Nobody assumed

The meeting was doomed

To failure, t’was quite unforeseen

Alas, for the group overall

The UAE prince had the gall

To strongly demand

Their quota expand

The Saudis, though, wouldn’t play ball

The big story this morning revolves around the failure to agree, by OPEC+, on new production quotas going forward.  While expansion of output was on the agenda as each member was keen to take advantage of the rising price of crude and its products, it seems the UAE demanded a much larger share of the increase than the Saudis wanted to give.  Ordinarily, this type of horse trading takes place in the background as OPEC likes to show its unity, but for some reason, this particular situation burst into plain sight.  Undoubtedly there are many underlying issues between Saudi Arabia and the UAE, but right now, this is the one that matters.  The result has been that oil continues to rise sharply, up another 1.75% this morning taking the gains this year to nearly 60%.  As is frequently the case in a bullish commodity market, the price curve is in steep backwardation, with the front month contracts being significantly more expensive than the outer months.  This is an indication of a lack of short-term supply, something borne out by the continued drawdown of reserves in storage.

What makes this situation so interesting is the fact that the dollar has not fallen sharply while the price of oil has risen.  Historically, rising commodity prices go hand in hand with a weaker dollar, at least versus its counterpart currencies, but that is not really the case this time.  Thus, for those nations that import oil, their local costs have increased more than proportionally as the lack of dollar weakness means it costs much more local currency to procure each barrel.  For instance, since the start of 2021, the Japanese yen has weakened 6.8% and the Swiss franc has fallen 4.1% while oil’s price has soared.  Neither of these nations produces a drop of oil, so their energy costs have climbed substantially.  In the emerging markets, TRY (-14.1%), ARS (-12.2%), PEN (-8.0%) and THB (-7.0%) are the worst performers this year, none of whom have a significant oil industry and all of whom rely on imports for the bulk of their usage.  A weaker currency and higher oil prices are very damaging to those economies.

The question at hand is whether or not this internecine spat will end soon, with some sort of compromise, or if the UAE will stand its ground under increasing pressure.  One thing to consider is that the US shale producers are not likely to come to the market’s rescue in the near term, if ever, as it appears that even at these prices, the capital flowing into the sector to increase production has not expanded, and if anything, given the green initiatives and demands to stop funding fossil fuel production, is likely to decrease.  We may be approaching a scenario where the US, which continues to pump about 11 million barrels/day, will find itself in very good stead relative to many other developed nations that import a higher percentage of their energy needs.  Arguably, this will help the dollar, which means that for some countries, things are only going to get tougher.

As an aside, there is another commodity that has been performing pretty well despite the dollar’s strength, gold.  Here, too, history has shown that a rising dollar price of gold is highly correlated with a weaker dollar on the foreign exchange markets.  But that is not the current situation, as after a very short-term drop in the wake of the FOMC meeting’s alleged hawkishness, gold has rebounded while the dollar has retained virtually all of its gains from the same meeting.  My sense is that there are larger underlying changes in market perception, one of which is that inflation expectations are becoming embedded.

Of course, that is not evident in the bond market, where Treasury yields remain in their downtrend that began in early May in the wake of the massively disappointing NFP report that month.  Since then, yields have fallen more than 20 basis points and show no sign of slowing down.  Oddly, if the market was pricing in a tapering by the Fed, I would have anticipated bond yields to rise somewhat, so this is simply another conundrum in the market right now.  

Turning to the overnight session, one might argue we are looking at a very modest risk-off session.  Equity markets have been desultory with Asia (Nikkei +0.15%, Hang Seng -0.25%, Shanghai -0.1%) not showing much activity while European bourses (DAX -0.4%, CAC -0.3%, FTSE 100 -0.15%) are a bit softer.  Arguably, the European markets have responded to much weaker than expected German data with Factory Orders falling -3.7% ad the ZEW Expectations Survey falling to 63.3, well below the expected 75.2 reading.  Questions about whether or not the global economy has peaked are starting to be asked as stimulus measures fade away.  By the way, US futures are essentially unchanged at this hour.

While today’s Treasury movement has been nil, we are seeing yields decline across Europe with Bunds (-1.5bps), OATs (1.9bps) and Gilts (-1.1bps) all seeing a bit of demand on the back of waning risk appetite.  Remember, too, that the inflation impulse in Europe remains far less substantial than that in the US.

Aside from oil (+1.75%) and gold (+0.8%), the rest of the commodity bloc is also pretty firm this morning with Copper (+1.5%) and Iron ore (+1.6%) leading the base metals higher.

Finally, in the FX market, the best way to describe things would be mixed.  The RBA met last night and was more hawkish than anticipated.  They not only indicated they were going to reduce the amount of QE purchases when the current program comes up for renewal, but they appear to be ending YCC as well, explaining that they would not be supporting the November 2024 bonds when they become the 3-year maturity.  Not surprisingly, we saw AUD (+0.6%) rally, which dragged NZD (+0.8%) up even more as traders speculate the RBNZ is going to raise rates as well.  Away from that, though, the bulk of the G10 bloc was softer led by NOK (-0.55%), which given oil’s continued rise makes little sense.  At this point, I will chalk it up to trading technicals as I see no strong rationale.  As to the rest of the bloc, modest declines are the name of the game.

Emerging markets have also seen similar mixed price action with ZAR (+0.25%) the leading gainer on the back of gold’s strength while HUF (-0.65%) is the laggard as the market awaits comments from the central bank regarding its green policy ideas.  The next weakest currency in this bloc is PHP (-0.5%) as the central bank confirmed it would not be reducing stimulus until it had further confidence the economy there would be picking up.

On the data front, there are only a few releases due although we do see the FOMC Minutes tomorrow.

TodayISM Services63.5
WednesdayJOLTs Job Applications9313K
 FOMC Minutes 
ThursdayInitial Claims350K
 Continuing Claims3325K

Source: Bloomberg

Aside from this limited information, we hear from just one Fed speaker tomorrow.  Perhaps the market will have the opportunity to make up its own mind about where things are going to go.

At this point, the Fed narrative remains that inflation is transitory and that they will continue to support the economy going forward.  However, there is a group of FOMC members who clearly believe that it is time to cut back on QE.  That will be the major discussion for the next several months, to taper or not, and if so, how quickly it will occur.  My view continues to be that the core of the Fed is not nearly prepared to taper QE purchases as they know that the ongoing expansion of Federal debt will require the Fed to remain an active part of the market lest things get more concerning for bond traders.

As to the dollar, it remains in its trading range having reached the top of that range last week.  I would not be surprised to see a bit of dollar weakness overall, if for no other reason than the dollar is likely to slip back toward the middle of its range.

Good luck and stay safe

Adf