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.

Stop It

There are several central banks which
Are starting to look at a switch
From policy ease
To tight, if you please
As QE they now want to ditch

The Old Lady and RBA
Are two that seem ready to say
Inflation’s too high
And so we must try
To stop it ere it runs away

The dollar is under pressure this morning as investors and traders start to look elsewhere in the world for the next example of policy tightening.  The story of tapering in the US is, quite frankly, getting long in the tooth as it has been a topic of discussion for the past six months and every inflation reading points to the fact that, despite their protestations, FOMC members realize they need to do something.  But in essence, that is already a given in the market, so short of Chairman Powell explaining in his Friday appearance that the FOMC is likely to end QE entirely next month, this is no longer market moving activity.  The dollar has already benefitted from the relatively higher yields that are extant in the Treasury market, and expectations for a further run up are limited.

However, the same is not true elsewhere in the world as central bank plans are only recently crystalizing alongside the universally higher inflation prints.  So, the BOE, which has been more vocal than most, seems to be working hard to prepare markets for a rate hike and the market has taken the ball and run with it.  Thus, UK yields in the short end of the curve have moved rapidly higher with 3-year gilt yields higher by 53 basis points in the past 6 weeks and 15 bps in the past three sessions.  On Sunday we heard from BOE Governor Bailey that they will “have to act” soon to address rapidly rising inflation, and traders continue to push UK yields higher and take the pound along with it.  This morning, pound Sterling is higher by 0.75% and amongst the leading FX gainers on this ongoing activity.

Perhaps more interesting is the market reaction to the RBA Minutes last night, where discussion regarding rising real estate prices and the need to do something about them has encouraged the investment community to push yields much higher, challenging the RBA’s YCC in the 3-year AGB.  In fact, despite the RBA explicitly reiterating that conditions for raising rates “will not be met before 2024”, yields continue to rise sharply as fears that inflation will outpace current RBA expectations grow widespread.  Given this price action, one cannot be surprised that the Aussie dollar (+0.85%) has also risen quite sharply this morning.

The thing is, there are a number of conundrums here as well.  For instance, the euro is performing well this morning, up 0.4%, and there has been absolutely zero indication that the ECB is considering tighter monetary policy.  It is widely known that the PEPP will expire in March, but it is also very clear that the previous QE program, the APP, is going to be expanded and extended in some manner to make up for the PEPP.  The only question here is exactly what form it will take.  Similarly, there is no indication that the BOJ is even considering the end of QE or NIRP or YCC, yet the yen has managed to gain 0.3% this morning as well.

In fact, today’s price action is looking much more like broad-based dollar weakness abetted by some other idiosyncratic features rather than other stories driving the market.  This becomes clearer when viewing the commodity markets where virtually every commodity price is higher this morning led by oil (+1.25%), gold (+0.75%), copper (+1.15%) and aluminum (+1.6%).  Today is very much a classic risk-on type session with the dollar under pressure and other assets performing well in sync.

For instance, equity markets are in the green everywhere (Nikkei +0.65%, Hang Seng +1.5%, Shanghai +0.7%, DAX +0.2%, FTSE 100 +0.1%) with US futures also pointing higher by roughly 0.4% across the board.  At the same time, bond yields are creeping higher (Bunds +1.8bps, OATs +2.1bps, Gilts +1.8bps) as investors jettison their haven assets in order to jump on the risk bandwagon.  Treasury yields, though, are unchanged on the day although still trending higher from the levels seen late last week.

Adding it up; rising equity prices, rising commodity prices, falling bond prices, and a weaker dollar (with EMG currencies also firmer across the board) results in a clear risk-on framework.  This will warm the cockles of every central bankers’ heart as they will all see it as a vote of confidence in the job they are doing.  Whether that is an accurate representation is another question entirely, but you can’t fight the tape.  Risk is clearly in vogue today.

It is, however, worth asking if this positive attitude is misplaced.  After all, the recent data has hardly been the stuff of dreams.  Yesterday’s US releases were uniformly awful (IP -1.3%, Capacity Utilization 75.2%) with both significantly worse than forecast.  The upshot is that the Atlanta Fed GDPNow number fell to 1.165%, another step lower and an indication that despite (because of?) high inflation, growth is slowing more rapidly.  Meanwhile, Eurozone Construction Output fell -1.3% in August, continuing the down trend that began in March of this year.

I recognize it is earnings season and the initial releases for Q2 have been quite positive.  But I ask, is slowing growth and rising inflation really a recipe for continued earnings growth?  History tells us the answer is no, and I see no reason to believe this time is different.  Today’s price action seems anomalous to the big picture ideas, so be cognizant of that fact.  While markets can remain irrational longer than we can remain solvent, that does not mean it is sensible to go ‘all-in’ on risk because there is one very positive market day.  Tread carefully.

This morning’s US data brings Housing Starts (exp 1613K) and Building Permits (1680K) and that is all.  Though these are unlikely to get the market excited, we also hear from four Fed speakers, Daly, Barkin, Bostic and Waller, where efforts at recapturing the narrative will be primary.  It is growing increasingly clear that the Fed is annoyed that the persistent inflation narrative is gaining traction as it may force their hand in tightening policy before they would like.  Just remember, as important as the Fed is (and every central bank in their own economy), the market is much bigger.  And if the market determines that the Fed is no longer leading the way, or will soon need to change tack, it will force the issue.  On this you can depend.

While today everything is coming up roses, the lesson is that the Fed’s control over markets is beginning to wane.  Eventually that will be quite a negative for the dollar, but for now, despite today’s decline, I think the trend remains for a higher dollar.

Good luck and stay safe
Adf

Something Awry

It’s not clear why there’s a concern
Inflation could cause a downturn
Cause stocks keep on rising
Though Jay’s emphasizing
The Fed, QE’s, set to adjourn

But still there is something awry
In how traders, every dip, buy
With growth clearly slowing
Though wages are growing
The value of stocks seems too high

One has to be remarkably impressed with the price action of risk assets these days and their ability to completely ignore growing signs that long-delayed problems are fast approaching.  The first of these problems is clearly inflation, something that has been ignored for decades by investors as long-term factors like globalization and demographics, as well as technological innovation, have served to suppress any significant inflationary impulse throughout the developed world.  Certainly, there were some EMG nations (Argentina, Venezuela, Zimbabwe) that managed to buck that trend and impose policies so horrendous as to negate the long-term benefits of stable prices, but generally speaking, inflation has not been a problem.

Then, Covid came along and the policy response was truly draconian dramatic, essentially shutting down much of the global economy for a number of months.  In hindsight, it cannot be surprising that the disruption to finely tuned supply chains that was imposed has been difficult to repair.  After all, it took years to achieve the true just-in-time nature of manufacturing and distribution across almost every industry.  While there are currently herculean efforts to get things back to the way they were, I suspect we will never again return to the previous situation.  A combination of policy decisions and population adaptations has altered the underlying framework thus there is no going back.

Consider the current energy situation (crisis?) as an example.  What is very clear now is that the price of energy is rising rapidly with both oil (+69% YTD, 0.85% today) and NatGas (+127% YTD, 1.0% today) continuing to climb with no end in sight.  Arguably, there have been a number of deliberate policy choices as well as some investing fashions which have dramatically reduced the investment in the production of these two key energy sources thus not merely reducing current supply but prospects for future supply as well.  Pressure from environmentalists to prevent this investment has done wonders for driving up prices, alas the mooted renewable replacements have yet to demonstrate their long-term effectiveness as uninterrupted power sources.  And this situation is manifest not only in the West, but in China as well, where they are currently suffering from major power shortages amid rapidly rising prices for LNG and coal as well as oil.  This morning’s WSJ has a lead article on how the rising price of NatGas is going to drive up winter heating bills substantially and the negative consequences for lower- and middle-income folks.

And yet…risk appetite remains robust.  You can tell because regardless of the news, equity prices consistently rise.  I grant it is not actually every day, but the trend remains quite clearly higher.  In traditional analysis, it would be difficult to rationalize this price movement as while the current situation may be working fine for companies, the fact is there are numerous issues that are coming, notably rising wages and a shrinking labor force, that are going to pressure margins, and arguably profits, going forward.  Clearly, however, that tradition is dead.  In its stead is the investor view that as long as the Fed keeps supplying liquidity to the markets economy, it will prevent any significant price dislocation.  Trickle Down theory remains alive and well on Wall Street.  This is evident today, where equity markets worldwide are higher, and has been evident in the fact that the recent Evergrande induced scare that resulted in a 5% correction was the first correction of that magnitude in more than a year.  The current investment zeitgeist remains; stocks only go up so buy more.  While I recognize I sound curmudgeonly on this topic, remember, reality is a b*tch and it will win out in the end.  Until then, though, it is unclear what type of catalyst is needed to change views, so risk assets are likely to remain in favor regardless of everything else.

And of course, today is a perfect example where equity markets are all green (Nikkei +1.8%, Hang Seng +1.5%, Shanghai +0.4%) in Asia and Europe (DAX +0.3%, CAC +0.4%, FTSE 100 +0.3%) as well.  Don’t worry, US futures are all pointing higher by 0.25%-0.35% at this hour, so all our 401K’s still look good.

Meanwhile, bonds are not required in a risk-on scenario so it should be no surprise that yields are rallying today with Treasuries (+3.3bps) leading the way but higher yields throughout Europe as well (Bunds +2.0bps, OATs +2.3bps, Gilts +3.7bps).  These price movements have been seen throughout the rest of the continent and in Asia last night with yields rising universally.

Commodity prices are broadly firmer, although with risk appetite robust, precious metals (Au -0.85, Ag -1.2%) are unwanted.  We discussed oil prices and we are seeing strength in the industrial metals (Cu +2.4%, Al +2.4%) as well as the Ags (corn +1.2%, wheat +1.4%, soybeans +0.7%).  In other words, risky assets are the place to be.

You should not be surprised that the dollar (and yen) are suffering on this movement given haven assets serve no purpose today!  In the G10 space, GBP (+0.6%) is leading the way higher followed by NOK (+0.55%) and then everything else is just modestly higher except JPY (-0.6%).  The sterling story seems to revolve around continued belief in BOE rate hikes coming early next year while NOK is simply following oil for now.

Of more interest, I believe, is the yen, which admittedly has been falling quite rapidly, down nearly 5% in the past three weeks, and quite frankly, shows no signs of stopping.  At this point, it doesn’t seem so much like Japanese investment outflows as it does like a speculative move that has discerned there is limited real demand for the currency.  Amazingly, last night, the new FinMin, Shunichi Suzuki, felt compelled to explain that, “stability in currencies is very important.” He further indicated that there was concern a weaker yen could cause prices to rise, especially energy prices.  Now, call me crazy but, BOJ policy for the past decade explicitly and the past three decades with less verve, has been to drive inflation higher.  Abenomics was all about achieving 2.0% inflation, something that had not been seen since before the Japanese bubble collapsed in 1989.  Now, suddenly, with inflation running at 0.2%, they are starting to get concerned that higher energy prices are going to be a problem?  Are they going to raise rates?  Are they going to intervene?  Absolutely not in either case.  Sometimes you have to wonder what animates policy maker comments.

As to EMG currencies, ZAR (+0.6%) and KRW (+0.4%) are the leaders this morning with the former benefitting from higher metals prices while the latter is responding to comments from the BOK governor that a rate hike could be coming at the November meeting.  On the downside here, TRY (-0.4%) continues to suffer from Erdogan’s capriciousness with respect to his central bankers, while THB (-0.3%) appears to be consolidating after a strong rally over the past week.

We have a bunch more data this morning led by Retail Sales (exp -0.2%, +0.5% ex autos) as well as Empire Manufacturing (25.0) and Michigan Sentiment (73.1).  There are two more Fed speakers, Bullard and Williams, but it seems unlikely that either will change the current narrative of a taper coming soon.

The reality is you can’t fight the tape.  As long as risk appetite remains buoyant, the dollar and yen are likely to remain on their back foot.  For the dollar, I see no long-term danger as I believe it will consolidate further before making its next move higher.  the yen, on the other hand, could be a bit more concerning.  If fear has gone missing, and with yields rising elsewhere in the world, a much weaker yen remains a real possibility.

Good luck, good weekend and stay safe
Adf

Risks They Have Wrought

It’s not clear why anyone thought
The ECB ever would not
Continue to buy
More bonds as they try
To safeguard ‘gainst risks they have wrought

So, when PEPP, next March, does expire
A new plan we’ll get to admire
As Christine will ne’er
Be set to foreswear
Her drive to push bond prices higher

If ever anyone was talking their own book, it was Greek central bank president Yannis Stournaras this morning on the subject of the ECB’s potential actions post-PEPP.  “Asset purchases aim at favorable financing conditions, at smooth transition of monetary policy to prevent any kind of fragmentation in jurisdictions in the euro area.  I’m sure that the Governing Council will continue to aim at this.” [author’s emphasis] These comments were in response to a report that the ECB is considering instituting a new asset purchase program when the emergency PEPP expires in March.  This is certainly no surprise as I posited this exact outcome a month ago (Severely Distraught – Sep 7) and the idea has gained credence since then.

One of the features of the ECB’s APP (original QE program from 2015) is that they are required to purchase bonds based on the so-called capital key in order to give the illusion they are not monetizing national debt.  This means that they must buy them in proportion to the relative size of each economy.  Another feature is that the bonds they purchase must be investment grade (IG).  This rules out Greek debt which currently is rated BB-, 3 notches below IG.  The PEPP, however, given the dire emergency created by governments shutting down their economies when Covid-19 first appeared, did away with those inconveniences and was empowered to buy anything deemed necessary.  Not surprisingly, purchases of bonds from the PIGS was far above their relative economic weight which has served to narrow credit spreads across the entire continent.  If the PEPP simply expires and is not replaced, it is unambiguous that PIGS’ debt would fall sharply in price with yields rising correspondingly, and those nations would find themselves in far worse fiscal shape.  In fairness, the ECB can hardly allow that to happen to just a few nations so they will continue their PEPP purchases in some manner or other.  And I assure you they will continue to purchase Greek debt regardless of its credit rating.

It is useful to compare this future to that of the Fed, where Chairman Powell has indicated that as long as the payroll number this Friday is not a complete disaster (currently expected 500K), a reduction in the pace of QE is appropriate. On the surface, it would be quite reasonable to expect the euro to decline further given what is likely to be a divergence in relative yields.  Yesterday’s ADP Employment report (568K) was better than expected and certainly seems to be of sufficient strength to support the Chairman’s view of continued strength in the labor market.  Thus, if the Fed does begin to taper while the ECB discusses its next version of QE, I would look for the euro’s recent decline to continue.

Of course, the big question is, will the Fed continue to taper if the economic situation in the US starts to show much less impetus?  For instance, the Atlanta Fed’s GDPNow forecast is estimating Q3 GDP growth at 1.333%, MUCH weaker than it had been in the past and a MUCH sharper slowdown than the Fed’s own forecasts.  While the number may well be higher than that, it does speak to a run of weaker than expected economic data in the US.  Inflation, meanwhile, shows no signs of abating soon.  The Fed looks set to find themselves in a very uncomfortable position with the following choices: tighten into slowing growth or let inflation run much hotter than targeted for much longer than anticipated.  (If I were Powell, given the trainwreck that is approaching, I don’t think I would accept the offer of reappointment should it be made!)

In sum, while the decision process in Europe is much easier with slower growth and lower inflation, extending monetary largesse still seems appropriate, in the States, some tough decisions will need to be made.  The problem is that there is not a single person in any Federal position who appears capable of making (and owning) a tough decision.  In fact, it is this lack of demonstrated decision-making prowess that leads to the idea that stagflation is the most likely outcome going forward.

But it is still a few weeks/months before these decisions will need to be made and, in the meantime, Buy Stonks!  Well, at least, that seems to be the investor mindset as fleeting fears over contagion from China Evergrande’s slow motion bankruptcy and comments from Vladimir Putin that Russia would, of course, supply the necessary NatGas for Europe, have been sufficient to remind the equity crowd that a 5% decline from an all-time high price level is an amazing opportunity to buy more stocks.  Hence, yesterday morning’s fears have abated and all is once again right with the world.

(As an aside, it strikes me that relying on a key geopolitical adversary to supply the life’s blood of your economy is a very risky strategy.  But Putin would never use this as leverage for something else, would he?  I fear it could be a very long cold winter in Europe.)

OK, with that in mind, let’s look at markets this morning.  Equity markets are green everywhere ranging from the Nikkei (+0.5%) to the Hang Seng (+3.1%) with all of Europe in between (DAX +1.2%, CAC +1.35%, FTSE 100 +1.0%) while China remains closed.  US futures are also firmer, currently pointing to a 0.75% rise on the open.

Bond markets are in pretty good shape as well.  Yesterday, after substantial early session weakness, they rebounded, and this morning are continuing on that trend.  While Treasuries are only lower by 0.2bps, in Europe we are seeing much better buying (Bunds -1.7bps, OATs -2.1bps, Gilts -1.2bps) with PIGS bonds (Italy -5.1bps, Greece -3.0bps) showing even more strength.

Commodity prices are consolidating after what has been a significant run higher with oil (-1.6%) and NatGas (-2.0%) both off highs seen yesterday morning.  Gold is unchanged on the day while copper (+1.1%) has bounced along with other base metals.  Ags, too, are a bit firmer this morning.

This positive risk attitude has seen the dollar cede some of its recent gains with AUD (+0.35%) leading the way in the G10 on the back of stronger commodity prices, followed by SEK (+0.3%) and NZD (+0.3%) both benefitting from better risk appetite as well.  Only NOK (-0.1%) is under pressure on the back of the oil price decline.  EMG currencies are universally stronger led by ZAR (+0.7%), PHP (+0.6%) and RUB (+0.5%).  ZAR is clearly benefitting from the commodity rally while PHP was higher on some positive growth comments from the central bank there.  The ruble seems to be benefitting from the view that a higher than expected CPI print there will force the central bank to raise rates more than previously anticipated.

On the data front, today brings only Initial (exp 348K) and Continuing (2762K) Claims.  Given tomorrow is payroll day, these are unlikely to move the market.  We also hear from Cleveland Fed president Mester, one of the more hawkish voices, discussing inflation, but my sense is all eyes are on tomorrow’s NFP to make sure that the taper is coming.  As such, today is likely to continue to see risk appetite with higher stock prices and a soft dollar.  But large moves seem unlikely.

Good luck and stay safe
Adf

Raring to Spend

Japan’s new PM
Fumio Kishida is
Raring to spend yen

The LDP elected Fumio Kishida as its new president, thereby assuring him of the job of Japan’s 65th Prime Minister.  Relacing Yoshihide Suga, Kishida-san has a tall task ahead of him in leading the nation back to a growth trajectory.  In addition, he must face the voters by November as well as rally his supporters in an upper house election next year.  Apparently, his plan is…spend more money!  He has promised to spend tens of trillions of yen (hundreds of billions of dollars equivalent) in order to help resuscitate the Japanese economy and bolster the middle class.

As refreshing as it is to have a new administration, it seems as though the policy playbook continues to consist of a single page…spend more yen.  Perhaps something will change in Japan, but it seems unlikely.  Rather, the nation will continue to struggle with the same macroeconomic issues that have plagued it for the past decades; excess debt driving slower growth amid an aging population.  The yen (+0.1%) has stabilized this morning but appears to be trending pretty sharply lower.  While support (USD resistance) is strong at 111.65-85, should we breech that level, a move toward 115.00 appears quite reasonable as well as likely.

As energy prices rise higher
Most governments seek a supplier
Of power that will
Completely fulfil
The orders that they all desire

In other news, it is becoming abundantly clear that the combination of energy policies that have been enacted recently are not having the desired outcome, assuming that outcome is to develop clean energy in abundance.  This is made evident by the dramatically rising prices of things like natural gas in Europe (+400% since 1Mar21) and the US (+130% YTD) and coal (+160% YTD).  Of course, the latter is rarely considered ‘clean’ but it is reliable.  And that is the crux of the matter.  Reliability of both wind and solar power has been called into question lately and reliance on baseload power sources like coal, which Europe, China, and India have in abundance, and NatGas, which they don’t, is driving policy decisions.

For instance, China is mulling energy price hikes for industry in an effort to reduce demand.  And if that doesn’t work, they will raise prices for residential users.  Go figure, a communist nation using price signals to adjust behavior!  At any rate, the immediate impact is likely to be downgraded growth prospects for China’s economy as rising energy prices will lead to rising export prices, lower exports, and lower growth.  We have already seen Chinese equity markets under pressure recently as the energy situation worsens.  Shanghai (-1.8%, -5.5% in past two weeks) is leading the way lower amid growing concern that Evergrande is not the biggest problem impacting China.  At some point, I expect the renminbi is going to suffer a bit more than its recent price action has shown.  Slowing growth and continued monetary expansion are going to add a great deal of pressure to the currency as it may be the only outlet available for the economy.  I fear it could be a “long cold lonely winter” in China this year.

Of course, it’s not just China where energy prices are rising, they are higher everywhere.  I’m sure you see it when you refill your gas tank, or when you pay your electric bill.  And this is a problem for economic growth as higher energy costs feed into product and service pricing directly, as well as reduce the amount of disposable income available for spending by the population.  Higher prices and slower growth (i.e. stagflation) are a very real risk, and by some measures have already arrived.

Beyond the direct discomfort we all will feel from its impacts, the policy questions are critical.  Consider, last time stagflation was upon us, then Fed Chairman Paul Volcker raised interest rates sharply in order to attack the inflation issue driving the US economy into a severe double-dip recession.  Oh yeah, the S&P 500 fell nearly 30% over the two-year period.  But ask yourself if, given the current zeitgeist as well as the current makeup of the Fed, there is any possibility that Chairman Powell (or his successor) will attack inflation in the same way.  It seems highly unlikely that would be the case.  Rather, it is a virtual certainty that the focus will be on the ‘stag’ part of the term and more money printing and spending will be recommended.  After all, given the increasing acceptance of the MMT mindset, that’s all that needs to be done.  Remember, policies matter, and if policies are designed to achieve short-term goals at the expense of longer-term needs, the ultimate outcome tends to be poor.  As in China, the currency is likely to be the relief valve for the economy which is what informs my view of longer-term USD weakness.  However, for now, the dollar is following 10-year Treasury yields, which seem to be trending higher, albeit not today when they have fallen 4.2 basis points.

Summing it all up, rising energy prices are starting to have deleterious effects on all parts of the global economy and the financial market implications are only going to grow.  In addition, the policy actions going forward are critical, and the chance of a policy error seem to grow daily.  The idea of short-term pain for long-term gain is obsolete in the year 2021.  Be prepared for more problems in the future.

Ok, a quick run around markets shows that after yesterday’s sharp US equity sell-off, Japan (Nikkei -2.1%) followed suit as did Shanghai although the Hang Seng managed to rally 0.7%.  Europe, on the other hand has decided that central banks will come to the rescue, as we are seeing a nice rebound from yesterday’s price action (DAX +1.1%, CAC +1.2%, FTSE 100 +1.0%).  US futures, too, are higher led by the NASDAQ (+1.0%) as declining yields are helping out.

But are yields really declining?  The fact that the bond market has bounced slightly after a dramatic 1-week decline is hardly a sign of a rebound.  Rather, it is normal trading activity.  While the trend remains for higher yields, today, all of Europe has seen yields slide on the order of 2 basis points alongside the Treasury yield declines.  This feels very much like a lull in the action, not a top/bottom in the market.

Commodity prices are behaving in a similar manner as oil (-0.8%) and NatGas (-1.2%) are leading the way lower, consolidating what has been an impressive rally.  Metals prices are mixed with gold (+0.6%) rebounding but base metals (Cu -0.4%, Al -0.2%, Sn -0.6%) all sliding.  Agricultural prices are mixed as the overall session seems to be one of position adjustments after a big move.

As to the dollar, it is mixed, albeit slightly firmer if anything.  In the G10, NOK (-0.35%) is falling alongside oil prices with NZD (-0.3%) the next worst performer on weakening commodity prices.  JPY (+0.1%) and CHF (+0.1%) are both modestly firmer, but here, too, things seem more position oriented than trend worthy.  EMG currencies are mixed with an equal number of gainers and losers, but the notable thing is that the biggest movers have only seen price adjustments of 0.3% or less.  In other words, there are precious few stories here to think about.

There is no data of note this morning, but we do hear from a lot of central bankers, notably Chairman Powell alongside Lagarde, Kuroda and Bailey (BOE) at an ECB forum.  We also hear from Harker, Daly and Bostic, but the narrative remains tapering is coming in November, and none of these three will be able to change that narrative.

In truth, I would have expected the dollar to soften today given the bond market, so the fact it remains reasonably well bid is a sign that there is further strength in this move.  The euro is pushing to critical technical support at 1.1650, a break of which is likely to see a much sharper decline.  Hedgers, keep that in mind.

Good luck and stay safe
Adf

Far From Surreal

The Fed explained that they all feel
A taper is far from surreal
The goal for inflation
Has reached satiation
While job growth ought soon seal the deal

Heading into the FOMC meeting, the consensus was growing around the idea that the Fed would begin tapering later this year, and the consensus feels gratified this morning.  Chairman Powell explained that, if things go as anticipated, tapering “could come as soon as the next meeting.”  That meeting is slated for November 2nd and 3rd, and so the market has now built this into their models and pricing.  In fact, they were pretty clear that the inflation part of the mandate has already been fulfilled, and they were just waiting on the jobs numbers.

An interesting aspect of the jobs situation, though, is how they have subtly adjusted their goals.  Back in December, when they first laid out their test of “substantial further progress”, the employment situation showed that some 10 million jobs had been lost due to Covid-19.  Since then, the economy has created 4.7 million jobs, less than half the losses.  Certainly, back then, the idea that recovering half the lost jobs would have been considered “substantial further progress” seems unlikely.  Expectations were rampant that once vaccinations were widely implemented at least 80% of those jobs would return.  Yet here we are with the Fed explaining that recovering only half of the lost jobs is now defined as substantial.  I don’t know about you, but that seems a pretty weak definition of substantial.

Now, given Powell’s hyper focus on maximum employment, one might ask why a 50% recovery of lost jobs is sufficient to move the needle on policy.  Of course, the only answer is that despite the Fed’s insistence that recent inflation readings are transitory and caused by supply chain bottlenecks and reopening of the economy, the reality is they have begun to realize that prices are rising a lot faster than they thought likely.  In addition, they must recognize that both housing price and rent inflation haven’t even been a significant part of the CPI/PCE readings to date and will only drive things higher.  in other words, they are clearly beginning to figure out that they are falling much further behind the curve than they had anticipated.

Turning to the other key release from the FOMC, the dot plot, it now appears that an internal consensus is growing that the first rate hike will occur in Q4 2022 with three more hikes in 2023 and an additional three or four in 2024.  The thing about this rate trajectory is that it still only takes Fed Funds to 2.00% after three more years.  That is not nearly enough to impact the inflationary impulse, which even they acknowledge will still be above their 2.0% target in 2024.  In essence, the dot plot is explaining that real interest rates in the US are going to be negative for a very long time.  Just how negative, though, remains the $64 trillion question.  Given inflation’s trajectory and the current school of thought regarding monetary policy (that lower rates leads to higher growth), I fear that the gap between Fed Funds and inflation is likely to be much larger than the 0.2% they anticipate in 2024.  While this will continue to support asset prices, and especially commodity prices, the impact on the dollar will depend on how other central banks respond to growing inflation in their respective economies.

Said China to its Evergrande
Defaulting on bonds is now banned
So, sell your assets
And pay dollar debts
Take seriously this command

CHINA TELLS EVERGRANDE TO AVOID NEAR-TERM DEFAULT ON BONDS

This headline flashed across the screens a short time ago and I could not resist a few words on the subject.  It speaks to the arrogance of the Xi administration that they believe commanding Evergrande not to default is sufficient to prevent Evergrande from defaulting.  One cannot help but recall the story of King Canute as he commanded the incoming tide to halt, except Canute was using that effort as an example of the limits of power, while Xi is clearly expecting Evergrande to obey him.  With Evergrande debt trading around 25₵ on the dollar, and the PBOC continuing in their efforts to wring leverage out of the system, it is a virtual guaranty that Evergrande is going under.  I wouldn’t want to be Hui Yan Ka, its Chairman, when he fails to follow a direct order.  Recall what happened to the Chairman of China Huarong when that company failed.

Ok, how are markets behaving in the wake of the FOMC meeting?  Pretty darn well!  Powell successfully explained that at some point they would begin slowing their infusion of liquidity without crashing markets.  No tantrum this time.  So, US equities rallied after the FOMC meeting with all three indices closing higher by about 1%.  Overnight in Asia we saw the Hang Seng (+1.2%) and Shanghai (+0.4%) both rally (Japan was closed for Autumnal Equinox Day), and we have seen strength throughout Europe this morning as well.  Gains on the continent (DAX and CAC +0.8%) are more impressive than in the UK (FTSE 100 +0.2%), although every market is higher on the day.  US futures are all currently about 0.5% higher, although that is a bit off the earlier session highs.  Overall, risk remains in vogue and we still have not had a 5% decline in the S&P in more than 200 trading days.

With risk in the fore, it is no surprise that bond yields are higher, but the reality is that they continue to trade in a pretty tight range.  Hence, Treasury yields are higher by 2.4bps this morning, but just back to 1.324%.  Essentially, we have been in a 1.20%-1.40%% trading range since July 4th and show no sign of that changing.  In Europe, yields have also edged higher, with Bunds (+1.6bps) showing the biggest move while both OATs (+0.9bps) and Gilts (+0.6bps) have moved less aggressively.

Commodity prices are mixed this morning with oil lower (-0.7%) along with copper (-0.25%) although the rest of the base metal complex (Al +0.6%, Sn +0.55%) are firmer along with gold (+0.3%).  Not surprisingly given the lack of consistency, agricultural prices are also mixed this morning.

The dollar, however, is clearly under pressure this morning with only JPY failing to gain, while the commodity bloc performs well (CAD +0.8%, NOK +0.6%, SEK +0.5%).  EMG currencies are also largely firmer led by ZAR (+0.9%) on the back of gold’s strength and PLN (+0.6%) which was simply reversing some of its recent weakness vs. the euro.  On the downside, the only notable decliner is TRY (-1.4%), which tumbled after the central bank cut its base rate by 100 basis points to 18% in a surprise move.  In fact, TRY has now reached a record low vs. the dollar and shows no signs of rebounding as long as President Erdogan continues to pressure the central bank to keep rates low amid spiraling inflation.  (This could be a harbinger of the US going forward if we aren’t careful!)

It is Flash PMI day and the European and UK data showed weaker than expected output readings though higher than expected price readings.  We shall see what happens in the US at 9:45. Prior to that we see Initial Claims (exp 320K) and Continuing Claims (2.6M) and we also see Leading Indicators at 10:00 (0.7%).  The BOE left policy on hold, as expected, but did raise their forecast for peak inflation this year above 4%.  However, they are also in the transitory camp, so clearly not overly concerned on the matter.

There are no Fed speakers today although we hear from six of them tomorrow as they continue to try to finetune their message.  The dollar pushed up to its recent highs in the immediate aftermath of the FOMC meeting, but as risk was embraced, it fell back off.  If the market is convinced that the Fed really will taper, and if they actually do, I expect it to support the dollar, at least in the near term.  However, my sense is that slowing economic data will halt any initial progress they make which could well see the dollar decline as long positions are unwound.  For today, though, a modest drift higher from current levels seems reasonable.

Good luck and stay safe
Adf

Avoiding a Crash

The Chinese have taken a stand
Regarding the firm, Evergrande
They’ve added more cash
Avoiding a crash
And now feel they’ve got things in hand

So, now all eyes turn to the Fed
And tapering timing, instead
The question at hand
Is can they withstand
Slow growth while still moving ahead?

Fear was palpable on Monday as China Evergrande missed an interest payment and concerns grew that a major disruption in Chinese debt markets, with the ability to spread elsewhere, was around the corner.  Yesterday, however, investors collectively decided that the world was not, in fact, going to end, and dip buyers got to work supporting equity markets.  The buyers’ faith has been rewarded as last night, the PBOC added net CNY70 billion to the markets to help tide over financing issues.  In addition, an oddly worded statement was released that Evergrande had addressed the interest payment due tomorrow via private negotiations with bondholders.  (Critically, that doesn’t mean they paid, just that the bondholders aren’t going to sue for repayment, hence avoiding a bankruptcy filing.)  As is always the case in a situation of this nature, nothing has actually changed at Evergrande so they are still bankrupt with a massive amount of debt that they will never repay in full, but no government, whether communist or democratic, ever wants to actually deal with the problem and liquidate.  This is the enduring lesson of Lehman Brothers.

Which means…it’s Fed day!  As we all know, this afternoon at 2:00 the FOMC will release the statement with their latest views and 30 minutes later, Chairman Powell will face the press.  At this time, the topic of most interest to everyone is the timing of the Fed’s reduction in asset purchases, aka tapering.  When we last left this story (prior to the Fed’s quiet period a week and a half ago, pretty much every Fed regional president (Kashkari excluded) and a few minor governors had indicated that tapering was appropriate soon.  On the other hand, the power center, Powell, Brainerd and Williams, had said no such thing, but had admitted that the conversation had begun.

You may recall that at the August FOMC meeting, the Fed indicated that the goal of “substantial further progress” had not yet been met with regard to the maximum employment mandate, although they begrudgingly admitted that the inflation side of the coin had been achieved.  (As an aside, while there has never been an answer to the question of how long an averaging period the Fed would consider with respect to their revamped average inflation target, simple arithmetic shows that if one averages the core PCE data from May 2020 through July 2021, the result is 2.0%.  If the forecast for the August core number, to be released on October 1, is correct at 3.6%, that means that one can head back to March 2020 and still show an average of 2.0%.  And remember, core PCE is not about to collapse back down to 2.0% or lower anytime soon, so this exercise will continue to expand the averaging period.)

Current expectations are that the initial tapering will start in either November or December of this year, and certainly by January 2022.  Clearly, based on the inflation mandate, we are already behind schedule, but the problem the Fed has is that the recent growth data has been far less impressive.  The August NFP data was quite disappointing at 235K, a 500K miss to estimates.  Not only that, while the July data was strong, the June data was also a major miss, which begs the question, was July the aberration or August?  Ask yourself this, will Chairman Powell, who is up for reappointment shortly, tighten policy into an economy where employment growth is slowing?  There is every possibility that tapering is put on hold for a few more months in order to be sure that monetary stimulus withdrawal is not premature.  The fact that a decision like that will only stoke the inflationary fires further will be addressed by an even more strident statement that inflation is transitory, dammit!  My point is, it is not a slam dunk that they announce tapering today.

For a perfect example as to why this is the case, look no further than the ECB, where today we heard another ECB member, the Estonian central bank chief, explain that when the PEPP runs out in March, it would be appropriate to expand the older APP program to pick up the slack.  In other words, they will technically keep their word and let the PEPP expire, but they will not stop QE.  The Fed, ECB and BOJ have all realized that their respective economies are addicted to QE and that withdrawal symptoms will be remarkably painful, so none of them are inclined to go through that process.  Can-kicking remains these central banks’ strongest talent.

OK, to markets ahead of the Fed.  Asia was mixed as the Nikkei (-0.7%) remains under pressure, clearly unimpressed by the BOJ’s ongoing efforts which were reiterated last night after their meeting.  However, Chinese equities (Hang Seng +0.5%, Shanghai +0.4%), not surprisingly, fared better after the liquidity injection.  In Europe, it is all green as further hints that the ECB will let the PEPP lapse in name only has investors confident that monetary support is a permanent situation.  So, the DAX (+0.55%), CAC (+1.1%) and FTSE 100 (+1.2%) are all poppin’.  US futures have also gotten the message and are firmer by about 0.5% this morning.

Bond markets are ever so slightly softer with yields edging up a bit.  Treasuries have been the worst performer although yields are only higher by 1.4bps.  In Europe, Bunds are unchanged while OATs and Gilts have risen 0.5bps each.

Commodity prices, on the other hand, have performed quite well this morning with oil (WTI +1.5%) leading energy higher and base metals (Cu +2.4%, Al +1.6%, Sn +3.6%) all much firmer although gold (0.0%) is not taking part in the fun.  Ags are also firmer this morning as the commodity space is finding buyers everywhere.

The dollar is somewhat softer this morning with NOK (+0.5%) leading the G10 and the rest of the commodity bloc also strong (CAD +0.3%, AUD +0.25%, NZXD +0.25%).  The one true laggard is JPY (-0.3%) which is suffering from the lack of a need for a haven along with general malaise after the BOJ.  In the EMG space, HUF (-0.75%) is the outlier, falling after the central bank raised rates a less than expected 15 basis points after three consecutive 30 basis point hikes, and hinted that despite inflation’s rise, less hikes would be coming in the future.  Away from that, though, there is a mix of gainers and loser with the commodity bloc strong (CLP +0.45%, ZAR +0.4%, RUB +0.4%) while commodity importers are suffering (INR -0.35%, PHP -0.25%, PLN -0.2%).

Ahead of the Fed we see Existing Home Sales (exp 5.89M), but really, look for a quiet market until 2:00 and the FOMC statement.  My view is they will be less hawkish than the market seems to expect, and I think that will be a negative for the dollar, but at this point, all we can do is wait.

Good luck and stay safe
Adf

Far From Benign

There once was a market decline
That seemed, at the time, to consign
Investors with shares
To turn into bears
An outcome quite far from benign

But that was a long time ago
As by afternoon all the flow
Was buying the dip
Thus, proving this blip
Was not a bull market deathblow

I wonder if stock prices declining for 18 hours now counts as a correction.  What had appeared to be the beginnings of a more protracted fall in stocks turned into nothing more than a modest blip in the ongoing bull market.  Some teeth were gnashed, and some positions lightened, but by 3:15pm, it was all over with a 1.3% rebound from that time to the close.  Granted, the S&P 500 did decline 1.7% on the day, but given the substantial buying impulse seen at the end of the day, as well as the change in tone of the market narrative, it certainly feels this morning like the worst is behind us.  While China Evergrande continues to be bankrupt, the new story is that despite its large size, it is not large enough to be a real catalyst for market destruction and, anyway, the PBOC would never let things get to a point where its bankruptcy would lead to contagion elsewhere in the Chinese markets/economy.

As to the last point, be careful with your assumptions.  While this is not meant to be a prediction, consider that President Xi Jinping has spent the last year cracking down on successful firms in China as they have amassed both wealth and power, something that an autocrat of Xi’s nature cannot abide.  So, a fair question to ask is, would Xi let the Chinese economy crash in order to consolidate his power even further?  While I don’t believe he would purposely do that, I would not rule out him allowing things to unfold in a manner he sees as beneficial to his ultimate plans, thus financial distress in China could well be in our future.  And if you are Xi Jinping, the idea that Western markets would react badly to an Evergrande collapse would only be a positive.  My point is, I don’t think you can rule out other motives in this situation.

At any rate, this literally seems like ancient history at this time, with markets all in the green and the market narrative of ‘buy the dip’ proving itself once again to be the proper course of action.  Pavlov himself could not have conditioned retail investors any better than the Fed and other central banks have done over the past decade.

So, with Evergrande in the rearview mirror, the market gets to (re)turn its focus to the FOMC meeting, which begins this morning and whose outcome will be announced at 2pm tomorrow.  That means we are back to talking about tapering.  Will they, or won’t they?  And if they do, when will they start?

The market consensus is clearly that tapering is coming with about two-thirds of market economists forecasting the first reduction in asset purchases will occur in November.  While there are some differing views on how they will taper, the consensus appears to be a reduction of $10 billion of Treasuries and $5 billion of mortgage-backed securities each month until they are done.  So, eight months of reductions takes us to next June if we start in November.  Of course, this assumes that there are no interruptions, and that the Fed leadership remains intact.

First, remember, Chairman Powell’s term is up in February, and while he remains the favorite to be reappointed, it seems the most progressive wing of the Democratic party wants to see someone else, with Lael Brainerd, a current Fed governor and past Treasury Undersecretary, seen as the leading alternative.  Ms Brainerd has consistently been even more dovish than Powell, and if she were to be confirmed for the Chair, it would be easy to believe she halted any tapering at that point.  After all, if one believes in MMT, (which by all accounts Ms Brainerd embraces), why would the Fed ever stop buying Treasuries?  Again, this is not predictive, just something to keep in mind.

Second, the tapering narrative is based on the idea that economic growth coming out of the Covid recession is self-sustaining and no longer needs central bank support.  But what if the recovery is more anemic than currently forecast.  The one consistency we have seen over the course of the past months is that forecasts for economic growth in Q3 and Q4 have declined dramatically.  For instance, the Atlanta Fed’s GDPNow forecast model is pointing to 3.65% currently, down from 5.3% at the beginning of the month and 7.6% just two months ago.  Shortages of certain things still abound and prices on staples like beef, pork, and poultry, continue to rise rapidly.  In short, the situation in the economy is anything but clear.

In this case, the question really becomes, will the Fed turn its attention to inflation, or will it remain focused only on unemployment?  If the inflation heat reaches too high a temperature, then it would be easy to believe tapering will occur far more rapidly.  However, if growth remains the focus, then any reason to delay tapering will be sought.  I remain in the camp that while they may initiate tapering, the Fed will be buying bonds long after June 2022.  We shall see.

A quick turn to markets shows that all is right with the world!  Stocks are almost universally higher as Asia (Hang Seng +0.5%, Shanghai +0.2%) led the beginning of the rebound although Japan (Nikkei -2.1%) was still coming to grips with yesterday’s narrative coming out of their holiday.  Europe is strongly higher this morning (DAX +1.45%, CAC +1.4%, FTSE 100 +1.15%) as fear has rapidly dissipated.  And after the worst US equity session in months, futures this morning are higher by about 0.8% across the board.

It should be no surprise that bonds are for sale this morning with yields mostly higher.   Treasury yields, which fell 6bps yesterday, have bounced slightly, up 1.7bps this morning.  European sovereigns, which saw a lesser rally yesterday have barely sold off with nothing rebounding even a full basis point.  One noteworthy outlier is Greece, whose bonds are sharply higher with 10-year yields declining 4.6bps, after Greek central bank comments that the ECB would never stop buying Greek paper.

Commodity prices are generally firmer with oil (WTI +1.2%) leading although gold (+0.2%), copper (+0.95%) and aluminum (+1.0%) are all embracing the risk rebound.

And finally, the dollar, which had rallied so sharply yesterday morning, has given back all of those gains.  NOK (+0.8%) leads the G10 charge higher with CAD (+0.5%) next in line as oil’s rebound supports both currencies.  The rest of the bloc has seen less exuberance, generally between 0.1% and 0.25%, although JPY (-0.1%) has slipped as its haven status is no longer a benefit.

EMG currencies have seen a little less dramatic movement with the leading gainer CZK (+0.3%) followed by RUB (+0.25%) with the latter benefitting from oil while the former continues to find support based on views its central bank remains hawkish enough to raise rates.  Otherwise, the gainers have been quite modest, 0.2% or less with two currencies falling on the day, ZAR (-0.2%) and PLN (-0.25%).  In both cases, it appears the concerns lie with central bank policy prospects.  However, given the modest size of the decline, it is hardly a key issue.

On the data front, this morning brings Housing Starts (exp 1550K) and Building Permits (1600K), although with the FOMC meeting in the background, neither is likely to move the needle.  And that’s really it for the day as there are no speakers.  As long as we don’t see a bombshell from Evergrande, which seems unlikely in our time zone, today feels like a quiet session with potential modest further dollar weakness.  All eyes will continue to be on tomorrow’s FOMC announcement, and, more importantly, Chairman Powell’s comments at the press conference.  Until then, slow going is likely.

Good luck and stay safe
Adf

Outmoded

In Germany prices exploded
While confidence there has eroded
Now all eyes will turn
Back home where we’ll learn
On Tuesday if QE’s outmoded

The most disturbing aspect of the inflation argument (you know, is it transitory or not) is the fact that those in the transitory camp are willing to completely ignore the damage inflation does to household budgets.  Their attitude was recently articulated by the chief European economist at TS Lombard, Dario Perkins, thusly, “There is nothing inherently dangerous about inflation settling in, say, a 3-5% range instead of the 1-2% that’s been normal for the past decade.”  He continued, “the bigger risk is that hitherto dovish central bankers lose their nerve and raise interest rates until it causes a recession, like they’ve done in the past.”

Let’s consider that for a moment.  The simple math shows that at a 2% inflation rate, the price of something rises about 22% over the course of a decade.  So, that Toyota Camry that cost $25,000 in 2011 would cost $30,475 today.  However, at a 5% inflation rate over that time, it would cost $40,725, a 63% increase.  That’s a pretty big difference.  Add in the fact that wage gains have certainly not been averaging 5% per year and it is easy to see how inflation can be extremely damaging to anybody, let alone to the average wage earner.  The point is, while to an economist, inflation appears to be an abstract concept that is simply a number input into their models, to the rest of us, it is the cost of living.  And there is nothing that indicates the cost of living will stop rising sharply anytime soon.

This was reinforced overnight when Germany released its wholesale price index, which rose 12.3% in the past twelve months.  That is the highest rate of increase since 1974 in the wake of the OPEC oil embargo.  Now fortunately, the ECB is on the case.  Isabel Schnabel, the ECB’s head of markets explained, “The prospect of persistently excessive inflation, as feared by some, remains highly unlikely.  But should inflation sustainably reach our target of 2% unexpectedly soon, we will act equally quickly and resolutely.”  You know, they have tools!

On the subject of Wholesale, or Producer, Prices, while Germany’s were the highest print we’ve seen from a major economy, recall last week that Chinese PPI printed at 9.5%, in the US it was 8.3% and even in Japan, a nation that has not seen inflation in two decades, PPI rose 5.6% last month.  It appears that the cost of making “stuff” is rising pretty rapidly.  And even if the pace of these increases does slow down, the probability of prices declining is essentially nil.  Remember, the current central bank mantra is deflation is the worst possible outcome and they will do all they can to prevent it.  All I can say is, I sure hope everyone’s wages can keep pace with inflation, because otherwise, we are all at a permanent disadvantage compared to where things had been just a year or two ago.

Well, I guess there is one beneficiary of higher inflation…governments issuing debt.  As long as inflation grows faster than the size of their debt, a government’s real obligations decline.  And you wonder why the Fed insists inflation is transitory.  Oh yeah, for all of you who think that higher inflation will lead to higher interest rates, I wouldn’t count on that outcome either.  Whether or not the Fed actually tapers, they have exactly zero incentive to raise rates anytime soon.  And as to bonds, they have shown before (post WWII) that they are willing to cap yields at a rate well below inflation if it suits their needs.  And I assure you, it suits their needs right now.

So, what will all this do to the currency markets?  As always, FX is a relative game so what matters is the degree of change from one currency to the next.  The medium-term bearish case for the dollar is that inflation in the US will run hotter than in Europe, Japan or elsewhere, while the Fed caps yields in some manner.  The resultant expansion of negative real yields will have a significant negative impact on the dollar.  This argument will fail if one of two things occurs; either other central banks shoot for even greater negative yields, or, more likely, the Fed allows the back end of the curve to rise thus moderating the impact of negative real yields.  In either case, the dollar should benefit.  In fact, this is why the taper discussion is of such importance to the FX market, tapering implies higher yields in the back end of the US yield curve and therefore an opportunity for a stronger dollar.  Remember, though, there are many moving pieces, so even if the Fed does taper, that is not necessarily going to support the dollar all that much.

Ok, let’s look at this morning’s markets, where risk is largely being acquired, although there is no obvious reason why that is the case.  Equity markets in Asia were mixed with both gainers (Nikkei +0.2%, Shanghai +0.3%) and Losers (Hang Seng (-1.5%) as the ongoing Chinese crackdown on internet companies received new news.  It seems that the Chinese government is going to split up Ant Financial such that its lending business is a separate company under stricter government control.  Ali Baba, which is listed in HK, not Shanghai, fell sharply, as did other tech companies in China, hence the dichotomy between the Hang Seng and Shanghai indices.  But excluding Chinese tech, stocks were in demand.  The same is true in Europe where the screen is entirely green (DAX +1.1%, CAC +0.8%, FTSE 100 +0.8%) as it seems there is little concern about a passthrough of inflation, but great hope that reopening economies will perform well.  US futures are also looking robust this morning, with all three major indices higher by at least 0.5% as I type.

Funnily enough, despite the risk appetite in equities, bond prices are rallying as well, with 10-year Treasury yields lower by 1.7bps, and European sovereigns also seeing modest yield declines of between 0.5 and 1.0 bps. Apparently, as concerns grow over the possibility of a technical US default due to a debt ceiling issue, the safety trade is to buy Treasuries.  At least that is the explanation being offered today.

On the commodity front, oil (WTI +0.8%) is leading the way higher although we are seeing gains in many of the industrial metals as well, notably aluminum (+1.6%), which seems to be feeling some supply shortages.  Copper (-0.45%), surprisingly, is softer on the day, but the rest of that space is firmer.  I mentioned Uranium last week, and as an FYI, it is higher by 5% this morning as more and more people begin to understand the combination of a structural shortage of the metal and the increasing likelihood that any carbonless future will require nuclear power to be far more prevalent.

Finally, the dollar is broadly, although not universally, stronger this morning.  In the G10, only NOK (+0.2%) and CAD (+0.1%) have managed to hold their own this morning on the strength of oil’s rally.  Meanwhile, CHF (-0.7%) is under the most pressure as havens lose their luster, although the rest of the bloc has only seen declines of between -0.1% and -0.3%.  In the EMG bloc, THB (-0.75%) and KRW (-0.6%) lead the way lower as both nations saw equity market outflows on weakness in Asian tech stocks.  But generally, almost all currencies here are softer by between -0.2% and -0.4%.  the exceptions are TRY (+0.3%) and RUB (+0.25%) with the latter supported by oil while the former is benefitting from hope that the central bank will maintain tight policy to fight inflation.

On the data front, we have both CPI and Retail Sales leading a busy week:

Today Monthly Budget Statement -$175B
Tuesday NFIB Small Biz Optimism 99.0
CPI 0.4% (5.3% Y/Y)
-ex food & energy 0.3% (4.2% Y/Y)
Wednesday Empire Manufacturing 18.0
IP 0.4%
Capacity Utilization 76.4%
Thursday Initial Claims 320K
Continuing Claims 2740K
Retail Sales -0.8%
-ex auto -0.1%
Philly Fed 19.0
Friday Michigan Sentiment 72.0

Source: Bloomberg

With no recent stimulus checks, Retail Sales are forecast to suffer greatly.  Meanwhile, the CPI readings are forecast to be a tick lower than last month, but still above 5.0% for the third consecutive month.  Certainly, my personal experience is that prices continue to rise quite rapidly, and I would not be surprised to see a higher print.  Mercifully, the Fed is in its quiet period ahead of next week’s FOMC meeting, so we no longer need to hear about when anybody thinks tapering should occur.  The next information will be the real deal from Chairman Powell.

The tapering argument seems to be the driver right now, with a growing belief the Fed will reduce its QE purchases and US rates will rise, at least in the back end.  That seems to be the genesis of the dollar’s support.  As long as that attitude exists, the dollar should do well.  But if the data this week points to further slowing in the US economy, I would expect the taper story to fade along with the dollar.

Good luck and stay safe
Adf

Recalibrate

Christine said she’d recalibrate
The PEPP, but she clearly did state
No taper’s occurring
Because we’re still spurring
Inflation to reach our mandate

I felt it was important for all of us to be reminded of what tapering means, hence this definition from the Merriam-Webster dictionary:

taper   verb

1               : to become progressively smaller toward one end
2               : to diminish gradually (emphasis added)

But perhaps there is a better source to explain Madame Lagarde’s dissembling comments yesterday; Lewis Carrol.

“I don’t know what you mean by ‘glory,’ ” Alice said.
Humpty Dumpty smiled contemptuously. “Of course, you don’t—till I tell you. I meant ‘there’s a nice knock-down argument for you!'”
“But ‘glory’ doesn’t mean ‘a nice knock-down argument’,” Alice objected.
“When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean—neither more nor less.”
“The question is,” said Alice, “whether you can make words mean so many different things.”
“The question is,” said Humpty Dumpty, “which is to be master—that’s all.”

Apparently, Madame Lagarde was channeling Humpty Dumpty in her press conference yesterday when she said that while the ECB would be gradually reducing the rate of purchases in the PEPP program in the coming quarter, it was definitely not tapering.  One of the problems this author has with centralbankspeak is that my education taught me based on the plain meaning of the words used.  Hence, claiming that a reduced rate of purchases is not tapering is simply dishonest.  However, central bankers everywhere, led by the Fed and ECB, have come to rely on redefining terms in order to placate both of their masters, markets and governments, who frequently require opposing policies to achieve their goals.

Remember, too, what happened to Humpty Dumpty, a lesson I daresay has been lost on Powell, Lagarde and their comrades-in-arms:

Humpty Dumpty sat on a wall
Humpty Dumpty had a great fall
All the King’s horses and all the King’s men
Couldn’t put Humpty together again.

As economist Herbert Stein explained in 1986, “if something cannot go on forever, it will stop.”  Central bank balance sheets cannot grow indefinitely, at least not without other repercussions.  The most likely relief valve will be the currency, but do not be surprised if there is significant damage to all financial assets at the time investors and markets cease to accept centralbankspeak as a valid guide to the future.

Ever since the GFC, central banks around the world have been aggressively adding liquidity to economies at a far faster pace than those economies create goods and services.  For the first decade of this process, that liquidity mostly found its way into financial markets resulting in the longest bull market in history.  But lately, that liquidity has begun to seep into the real economy on the back of a massive uptick in fiscal stimulus.  The result, you may have noticed, is that financial markets have stopped rising at their previous rate, but the price of stuff you buy every day/week, has started to rise much more rapidly. It is this fact that was the genesis of the ‘transitory’ inflation story, as central banks, notably the Fed, recognize they cannot afford to be blamed for rising consumer inflation, but also cannot afford to fight inflation in the traditional manner of raising interest rates as they are terrified adjusting their current policy will result in a massive market decline.  Hence, I fear the Humpty Dumpty metaphor will wind up being very accurate.  However, he hasn’t fallen yet.

And so, Madame Lagarde did exactly what she set out to do; she was able to explain the ECB would be slowing their PEPP purchases without the market responding in a knee-jerk sell-off.  She placated the hawks on the ECB Council, and watched as Italian BTPs outperformed German bunds thus reducing pressure on the biggest potential problem in Europe.  In the end, kudos are due, at least for now.  I sure hope it lasts, but fear there is much turmoil in our future.

In the meantime, the overall market response to Lagarde has been…buy risk!  Equity markets everywhere are in the green with Asia (Nikkei +1.25%, Hang Seng +1.9%, Shanghai +0.3%) charging ahead and Europe (DAX +0.3%, CAC +0.3%, FTSE 100 +0.3%) following, albeit at a bit slower rate.  US futures, after two lackluster sessions in NY, are pointing higher by 0.4% to start the day.

Of course, with risk appetites whetted, there is no need to hold havens like bonds and so prices there have fallen everywhere with corresponding rises in yields.  Treasuries (+2.9bps) are leading the way but we are seeing Europe (Bunds +1.8bps, OATs +1.9bps, Gilts +1.1bps) all under some pressure as well.  As long as risk is in the ascendancy, I expect that bond yields will continue to edge higher.

Commodity prices are also firmer this morning led by oil (+1.7%) and the entire energy complex.  But metals, too, are up, at least industrial metals with copper (+1.9%), aluminum (+1.6%) and tin (+1.2%) all much stronger and with the latter two pushing to multi-year highs.  While gold is flat on the day, and has been doing very little lately, broadly speaking, the commodity complex continues to perform well.

Finally, the dollar, not surprisingly, is under significant pressure this morning, down versus most of its G10 counterparts, notably the commodity bloc.  NZD (+0.6%), NOK (+0.45%) and AUD and CAD (+0.4%) are all looking strong today bolstered by broad dollar weakness and strong commodity price action.  On the flip side, JPY (-0.2%) is the only real decliner as haven assets are sold, although CHF is also modestly softer.  In the emerging markets, the screen is entirely green led by ZAR (+0.75%), CZK (+0.5%) and IDR (+0.35%).  Rand is clearly in thrall to commodity prices while the koruna is rallying on the back of a much higher than expected CPI print of 4.1%, which has traders looking for a central bank rate increase at the next meeting at the end of the month.  As to the rupiah, it seems this is entirely a result of the risk-on attitude in markets this morning.

On the data front, early this morning the UK released its monthly GDP print at a worse than expected 0.1%, blamed now on the increase of the delta variant.  German CPI was confirmed at 3.9% in August, and Italian IP managed to rise 0.8% in July, a bit better than expected.  Here at home we will see PPI (exp 8.2%, 6.6% ex food & energy) which will continue to challenge the transitory narrative but will not have nearly the impact of next Tuesday’s CPI release.  As well, we hear from the Cleveland Fed’s Loretta Mester this morning, but she has already explained she is ready to taper QE purchases, so unless that story changes, I don’t foresee any impact.

While the dollar is softer this morning, there is no indication it is going to decline substantially at any point in the near future.  Rather, we remain in the middle of the 1.17/1.20 trading range that has capped movement since June.  I see no reason for anything to change here and expect the week to finish in a quiet manner.

Good luck, good weekend and stay safe
Adf