They Cannot Wait

While Jay and the FOMC
Are certain it’s transitory
Inflation elsewhere
Has forced some to pare
Their policy stance by degree

Thus none of us ought be amazed
That yesterday Banxico raised
Its overnight rate
As they cannot wait
Til prices (and people) get crazed

Last week the central bank of Brazil raised its overnight rate by 1.0%, taking it back to 5.25%, and promised to continue raising rates until they get inflation back under control.  This seems pretty reasonable since the latest inflation reading there was 8.99%.  Currently, the market is pricing in a 1.25% rate hike next month.  Yesterday afternoon, Mexico’s central bank raised the overnight rate by 25 basis points for the second consecutive meeting, taking it up to 4.50%.  Given that the latest reading on inflation there is 5.81%, it seems they, too, have further to raise rates in order to tame rising prices.

In fact, this is a scenario we are witnessing around the world in emerging markets, where inflation has been rising quite rapidly and the monetary authorities, recognizing that they don’t have infinite capacity to borrow in either their local currency or in dollars, find themselves in a very uncomfortable position.  Either attack inflation now by raising rates and earning the wrath of their government, or let it rip and watch the country descend into more dire straits, akin to Argentina, Turkey, or worst of all, Venezuela.

But that the Fed would respond to inflation in the same manner.  Instead, we continue to get high inflation readings (yesterday’s PPI jumped to 7.8%, 6.2% ex food & energy) and a steady stream of pablum about the transitory nature of inflation in the US.  While only time will actually tell if higher inflation is truly here to stay, there certainly seems to be a lot of evidence that is the case.  One cannot open a newspaper (or perhaps scroll a newsfeed) without immediately seeing a story about how fast food restaurants, or food manufacturers or…fill in the blank, are raising prices because of a combination of higher input and shipping costs.  Perhaps, what is more surprising is that these companies have gained confidence that higher prices will not scare off their customers, meaning these price rises will stick.

On the wage front, this morning’s story of how newly minted college graduates taking (getting?) a job at Evercore Securities will now be paid a starting salary of $120,000 per year seems a pretty good indication that wages are rising.  Given the JOLTS data showing there are over 10 million open positions in the country, it is not surprising that ‘finding qualified people to hire’ remains the top problem of small businesses according to the NFIB survey.  The implication is wages are going to continue to rise and prices alongside them.

Speaking of shipping costs, we continue to see record rises in shipping rates as well as huge delays in timing.  China closed one-quarter of its Ningbo port, the third largest in China, because of concerns over the spread of the delta variant of Covid.  While US ports have not yet closed because of this, the backlog of ships waiting to unload continues to run near record high levels, and now delays from China will result in even bigger logistical and supply chain problems.  All in all, it remains difficult for this author to see a future, at least a near future, where prices do anything but go much higher.

Into that environment we continue to see the key Fed leadership remain sanguine over the prospects of inflation, maintaining the narrative that any price rises are transitory.  Apparently, this has come to mean prices will stop going up so rapidly but are unlikely to come back down.  While there is a growing chorus of FOMC members, mostly regional presidents, that believe it is coming time to taper QE purchases, until we hear that from Powell or Williams or Brainerd, I think it remains a 50:50 proposition at best.    But even if they do start to taper, given their history of responding to asset valuations, any stock market decline, which would seem likely given the current valuations are entirely built on the ‘lower forever’ interest rate scenario, would almost certainly see them stop quickly.  Painting a picture where real yields do anything but fall deeper into negative territory continues to be a difficult thing.  And that, ultimately, is going to be a negative for the dollar.

But when is ultimately?  It is still a little ways off.  Until then, it appears that the market is set up for the dollar to strengthen somewhat further.  The dollar’s relationship with 10-year yields, which had been strong in Q1 and broke in Q2, seems to be back on track.  All the taper talk has bond traders looking for a further backup in yields, and correspondingly, a further rise in the dollar.  While today it is drifting lower vs. most of its counterparts, this can easily be explained by the fact that it is a summer Friday and traders are paring positions going into the weekend.  But the medium-term view needs to be that higher US yields will support the dollar.

As to the rest of the markets, Asian equity markets continue to struggle as the spread of the delta variant accelerates and more countries in the region consider more drastic responses.  Last night saw losses in all the major markets (Nikkei -0.15%, Hang Seng -0.5%, Shanghai -0.25%) and as long as these nations have difficulty managing the resurgence of infections, investors seem to believe that the growth story will be negatively impacted.  Europe, on the other hand, is all green this morning (DAX +0.4%, CAC +0.35%, FTSE 100 +0.35%) as there is a greater belief that Covid issues are under better control.  Vaccination rates have risen quite rapidly and so while infection rates may be rising, hospitalizations are not, just like in the US.  Many analysts continue to believe European equity markets, writ large, are undervalued vs. their US counterparts, and while there is tapering talk here, there is absolutely no indication whatsoever that the ECB is going to do anything but continue to print money.

Treasury yields have drifted lower by 1.3bps this morning, which helps explain the dollar’s modest decline, but they remain right at 1.35% and show no signs of retracing last week’s sharp move higher.  European sovereigns, on the other hand, are a bit softer this morning, classic risk-on behavior, with Bunds (+0.9bps) and OATs (+1.4bps) slipping into the weekend.  Gilts are essentially unchanged, as it happens.

The commodity market is showing no clear directional bias of late, with both oil (-0.35%) and gold (+0.4%) having retraced a portion of major price declines over the past two weeks, but neither showing signs of either a break higher or the next leg down.  Rather, they are both a bit choppy right now.

Finally, the dollar is mostly softer against its G10 counterparts, with NOK (+0.3%) the leader and the euro pushing up 0.25%.  Frankly, both of these appear to be trading moves, as both had shown weakness all week, so positions are likely being pared into the weekend.

In the emerging market space, KRW (-0.65%) continues to be the bloc’s biggest laggard, falling for the fifth consecutive day as the combination of the record level of Covid infections, and concerns over the semiconductor space in the KOSPI have seen sellers come out of the woodwork for both stocks and the currency.  Away from the won, weakness was evident throughout the APAC currencies, albeit to a much lesser extent, as the Covid spread story is regionwide.  On the plus side, both CE4 and LATAM currencies are performing well, with MXN (+0.4%) the leader on the back of Banxico’s rate hike, and RUB (+0.4%) seeing position unwinding after a particularly weak trading period this week.

Data this morning brings Michigan Sentiment (exp 81.2) as well as some further secondary price indices, Import and Export prices, which have been running well above 10% each.  The point is there is inflationary pressure everywhere.

It is not surprising that after a week where the dollar was broadly stronger, it softens on Friday, but nothing has changed the short-term view that modestly higher US yields will lead to further dollar strength.  Keep an eye on the 1.1704 level in EURUSD, which I believe can be a catalyst for a much larger move higher in the dollar if it breaks.

Good luck, good weekend and stay safe
Adf

Nothing Will Thwart

Inflation continues to be
The problem the Fed will not see
The latest report
Shows nothing will thwart
Their views that it’s transitory

Perspective is a funny thing; it has the ability to allow different people to see the same events in very different ways.  For example, yesterday’s CPI report, which printed at 5.4% headline and 4.3% ex food & energy, was fodder for both those with an inflationary bias and those who are in the transitory camp.  As predicted here yesterday morning, any number that was not higher than the June report would be touted as proof inflation is transitory.  And so it has been.  The highlighted facts are the month on month reading was ‘only’ 0.5%, much lower than the previous three months’ readings of 0.9%.  Of course, that is true, but it ignores the fact that a monthly rate of 0.5% annualizes to 6.16%, still dramatically higher than the target.  As well, there was much ink spilled on the fact that used car prices, which had admittedly been rising remarkably quickly due to the unusual circumstances of the semiconductor shortage impeding new car production, fell back to a more normal pace of growth.  The problem with that story is despite one of the ostensible key reasons inflation had been misleadingly higher, used car prices, ceasing to be an issue, inflation still printed at 5.4%!  Clearly there are other things at work here.

Another aspect of perspective comes in the form of the averaging concept, which is the Fed’s latest ruse in rationalizing higher inflation.  For instance, those in the transitory camp, which seems to include the entire FOMC, but also much of the punditry, remain hostile to the idea of inflation settling in at a rate of 1.8%, slightly below the Fed’s target, but are entirely sanguine about that same statistic running at 2.8% for a while to help make up for lost time.  It is this distorted lens that seems to drive the description of inflation as ‘too-low’.  From up here in the cheap seats, inflation cannot be too low.  The idea that we are all better off with prices rising is wrong on its face.

And the idea that wage increases drive inflation also needs to be reconsidered.  After all, if that were the case, we would all be rooting for inflation as that means our wages would be rising quickly.  However, as we know simply by living our lives, and as has been demonstrated by the data, wage increases are broadly lagging inflation.  In fact, yesterday, as part of the Bureau of Labor Statistics data dump, Real Average Hourly and Weekly Earnings showed Y/Y declines of -1.2% and -0.7% in July.  It is no secret that inflation destroys the real value of your earnings, and yet the Fed continues to target a higher level of inflation than had been seen during the past decade and remains comfortable that the current sharply higher numbers are inconsequential in the long run.

However, in the end, whether we agree or disagree with the Fed’s current policy stance and its impacts, the reality is we are not going to have any say in the matter.  All we can do is strive to understand their reaction functions and manage our risks accordingly.  Ultimately, I continue to see the biggest risk as a significantly higher rate of inflation in the US, which will eventually drive nominal yields somewhat higher and real yields still lower than current levels.  That cannot be good for the dollar but will likely help the prices of ‘stuff’.  In the end, be long anything on the periodic table, as that will maintain its value.

The summer doldrums continue as market movement remains fairly limited across equities, bonds, commodities and currencies.  This is not to say there aren’t individual things that move or are trending, just that the broader picture is one of a decided lack of activity.

Last night, for instance, Asian equity markets (Nikkei -0.2%, Hang Seng -0.5%, Shanghai -0.2%) were all lower, but only just.  European markets are more mixed, with both gainers (DAX +0.4%, CAC +0.2%) and losers (FTSE 100 -0.1%) but as can be seen, the movements are not terribly exciting.  This morning saw the release of a plethora of UK data led by Q/Q GDP (+4.8%) and then many of its details showing Consumption by both the government and the population at large grew dramatically, while businesses slowed down somewhat, with IP and Construction both lagging estimates.  I guess investors were generally unimpressed as both the stock market and the pound (-0.1%) have edged somewhat lower after the reports.  Finally, US futures are either side of unchanged again, with the NASDAQ continuing to lag in the wake of the recent rise in US 10-year yields.

Speaking of yields, after the very sharp rise seen in the previous five sessions, yesterday’s Treasury price action was far less exciting and this morning we see the 10-year yield higher by just 1.0 basis point after a decline of similar magnitude Wednesday.  European sovereigns show Bunds (+0.8bps) and OATs (+0.7bps) modestly softer while Gilts (+2.5bps) seem to believe that the UK data was actually better than other market impressions.

Commodity prices are mixed this morning as oil (-0.2%) has given up early gains, along with gold (-0.1%) and the agricultural space.  Copper, however, is bucking the trend and higher by 0.8%.

Lastly, the dollar can only be characterized as mixed this morning, with some weakness in AUD and NZD (-0.25% each) and some strength in NOK (+0.2%) and otherwise a lot of nothing in between.  It is hard to make a case that there is much market moving news in any of these currencies as the UK was the only country with significant new information.

Emerging market currencies are also split, with KRW (-0.4%) continuing to lag the rest of the space as concern grows over the semiconductor manufacturing sector leading to continued equity market outflows and currency sales.  I would imagine that the recent rantings by Kim Jong-Un’s little sister about increased nuclear activity cannot be helping the situation there, but it is not getting headline press in financial discussions.  Otherwise, PLN (-0.3%) is the next weakest currency in the bloc today which seems to be a reaction to some legislation passed that would ostensibly restrict media and speech in the country.  On the plus side, TRY (+1.0%) is today’s champion as traders and investors respond to the central bank’s moderately more hawkish than expected statement after leaving interest rates unchanged (at 19.0%!) as widely expected.  Otherwise, there is nothing noteworthy in the space.

Data today brings the weekly Initial Claims (exp 375K) and Continuing Claims (2.9M) data as well as PPI (7.2%, 5.6% ex food & energy).  However, with CPI already having been released, this data seems relatively insignificant.  There are no scheduled Fed speakers as most FOMC members seem to be going on vacation ahead of the Jackson Hole conference in two weeks’ time.

For now, the dollar seems to be tracking yields pretty well, so if we see movement in the bond market, look for the dollar to follow.  Otherwise, we are likely to remain rangebound for the time being.

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

A Popular View

It seems that a popular view

Explains that the Fed will pursue

A slowdown in buying

More bonds as they’re trying 

To bid, fondly, QE adieu





At least that’s what pundits all thought

The Powell press conference had wrought

They talked about talking

But are not yet walking

The path to where policy’s taut

It appears virtually unanimous that the punditry believes the FOMC is going to be tightening policy (i.e. tapering) in the ‘near future’.  Of course, the near future is just as imprecise as transitory, the Fed’s favorite word.  Neither of these words convey any specificity, which makes them very powerful in the narrative game, but perhaps not so powerful when directly addressed.  My take on transitory is as follows: initial expectations were it meant 2 or 3 quarters of price pressures which would then dissipate as supply chains were quickly reconnected.  However, it has since morphed into as much as 2 to 3 years given the reality that certain shortages, notably semiconductors, may take much longer to abate as the timeline to build out new capacity is typically 2 to 3 years.  I guess it all depends on your frame of reference as to what transitory means.  For instance, to a tortoise, 2 to 3 year is clearly but a blip in their lives, but to a fruit fly, it is beyond an eternity.  Sadly, the market’s attention span is much closer to that of a fruit fly’s than a tortoise’s so 2 to 3 years feels a lot more permanent than not.  This is especially so since there is no way to know if other, more persistent inflationary issues may arise in the interim.

As to the ‘near future’, that seems to mean somewhere between the middle of 2022 and the middle of 2024.  Here too, the timeline is extremely flexible to accommodate whatever story is trying to be sold told.  When puffing up the strength of the economic recovery, expectations tend toward the earliest estimates.  In fact, we continue to hear from several FOMC members that tapering will soon be appropriate.  However, if we look at who is making those comments (Bullard, Kaplan, Rosengren and Bostic), we find that only Raphael Bostic from Atlanta currently has a vote.  At the same time, those who are least interested in the idea of tapering include the leadership (Powell, Clarida and Williams) as well as the other governors (Bowman, Brainard, Quarles and Waller), and they have permanent votes.  In other words, my take on the FOMC meeting is it was far less hawkish than much of the punditry has described.  And there is one group, which really matters, that is apparently in agreement with me; the bond market!  Treasury prices after an initial sell-off (yield rally) have reversed that move and are essentially unchanged with a flatter yield curve.  It strikes me that if the Fed were to taper, yields would start to rise in the long end as the removal of that support would have a significant negative price impact.

So, if I were to piece together the narrative now it appears to be the following: inflation is still transitory if it remains well above target for the next 2 years and the bond market is convinced that is the case (ostensibly a survey showed that 70% of fixed income managers believe the transitory story).  Meanwhile, despite the transitory nature of inflation, the Fed is going to tighten its monetary policy sometime next year and potentially even raise the Fed Funds rate in 2023.  Personally, that seems somewhat contradictory to me, but apparently cognitive dissonance is a prerequisite to becoming an FOMC member these days.

At any rate, given the lack of actual policy changes by the Fed, all we have is the narrative.  This week we will have four more Fed speakers to continue to reiterate that narrative, that despite the transitory nature of inflation we are going to tighten policy in the future.  Of course, that begs the question, Why?  Why tighten policy if there is no inflation?  Cognitive dissonance indeed.

In the meantime, as markets continue to try to figure out what exactly is happening, we wind up with paralysis by analysis and relatively limited movement.  For instance, equity markets in Asia were all essentially unchanged overnight, with not one of them moving even 0.1%.  Europe, on the other hand is having a tougher go this morning with red across the screen (DAX -0.1%, CAC -0.5% and FTSE 100 -0.5%) with a real outlier as Spain’s IBEX (-1.5%).  There has been no data released but there is growing concern that the Delta variant of Covid is going to cause another lockdown in Europe before they finished reopening the first time.  This is based on the fact that we have seen lockdowns reimposed in Australia, Japan, Singapore and Israel after all those nations seemed to be moving forward.  As to US futures, they are either side of unchanged at this hour awaiting some clarity on anything.

It can be no surprise that bond markets are rallying slightly with Treasuries (-1.7bps) leading the way but small yield declines in Europe as well (Bunds -0.8bps, OATs -1.1bps, Gilts -1.8bps).  With equity markets under pressure, this is a natural reaction.  And if you consider the reasoning, worries over another Covid wave, then slower growth would be expected.

Funnily enough, Covid is having a currency impact today as well.  In the G10, the new Health Minister, Sajid Javid, has said he wants to see the country return to normal “as soon and as quickly as possible.”  Despite the equity market concerns, the FX market saw that as bullish and the pound (+0.2%) is the leading gainer in the G10 this morning.  But as the morning has progressed and risk sentiment has become less positive, the dollar is starting to asset itself against most of the rest of the bloc with NZD (-0.35%) and NOK (-0.3%) the laggards.  Both of these are under pressure from declining commodity prices as oil (-0.1%) is sagging a bit.

In the EMG bloc, ZAR (-0.8%) is in the worst condition this morning as the Delta Covid variant has increased its spread and the government is behind the curve in treating the issue.  But we saw weakness overnight in THB (-0.6%), and this morning the CE4 are all under the gun as well.  And the story seems to be the same everywhere, tighter Covid restrictions are undermining currencies while positivity is helping them.

It is a big data week as it culminates in the payroll report on Friday:

TuesdayCase Shiller Home Prices14.85%
 Consumer Confidence119.0
WednesdayADP Employment550K
 Chicago PMI70.0
ThursdayInitial Claims389K
 Continuing Claims3335K
 ISM Manufacturing61.0
 ISM Prices Paid86.0
FridayNonfarm Payrolls700K
 Private Payrolls600K
 Manufacturing Payrolls25K
 Unemployment Rate5.7%
 Average Hourly Earnings0.3% (3.6% y/Y)
 Average Weekly Hours34.9
 Participation Rate61.7%
 Trade Balance-$71.3B
 Factory Orders1.5%

Source: Bloomberg

Obviously, all eyes will be on the payroll data as the Fed has made it clear that employment is their key focus for now.  There was an interesting story in the WSJ this morning highlighting how the states that have ended the Federal Unemployment Insurance bonus have seen an immediate pickup in employment with jobs suddenly being filled.  That bodes well for the future, but it also means we will have this issue for another quarter if all the states that maintain the bonuses continue to do so.

As mentioned above, several Fed speakers will be out selling the narrative that inflation is transitory, but tapering may be coming anyway.  (A cynic might think they are not being totally honest in what they are saying, but only a cynic.)

A quick top down look at the FX market leads me to believe that individual national stories are currently the real drivers.  So those nations that are raising interest rates to fight inflation (Mexico, Brazil, Hungary, Russia) are likely to see their currencies hold up.  Those nations that are having serious relapses in Covid infections (South Africa, much of Europe) are likely to see their currencies come under pressure.  Where the two meet (South Korea), it seems to depend on the day as to which way the currency goes.  With that in mind, though, I would bet the monetary policy story will have more permanence will be the ultimate driver.

Today, the dollar seems to be in fine fettle as risk is on the back foot given the increasing Covid concerns over the Delta variant.  But do not be surprised if tomorrow is different.

Good luck and stay safe

Adf

Bears Have Retreated

At first, no one thought it could be

That Powell would lessen QE

But less than a week

Was needed to wreak

Destruction ‘pon his new decree

The bond market bears have retreated

With steepeners now all deleted

While stocks are unsure

If this is the cure

And just how this news should be greeted

Last week’s FOMC meeting continues to be the main topic of market discussion as many assumptions have been questioned, especially those of the inflationist camp.  The change in the dot plot was clearly unforeseen and has been the talk of the market ever since.  Arguably, there are two key questions that have arisen in the wake of the meeting; 1) what happened to the Fed’s insistence that they would not adjust policy preemptively based on forecasts? and 2) is maximum employment no longer deemed to be an Unemployment Rate near 3.5%?

What has been made very clear, however, is that the market still believes the Fed can address inflation, or at the very least, that the market buys the Fed’s transitory inflation narrative.  Regarding the latter, it relies almost entirely on the idea that supply-side bottlenecks will be quickly addressed, thus forcing prices lower and reducing the inflationary threat.  My question is, why do so many assume that restarting production can be accomplished so quickly?  In many cases, businesses have closed, thus no longer manufacturing products.  In others, businesses are running shorter or fewer shifts due to the inability to hire/retain staff to operate.  Glibly, many say that those businesses can simply raise wages to attract staff.  And while that may be true, you can be sure that will result in rising prices as well.  So, if supply returns at a higher price point, is that not still inflationary? 

Under the theory that a picture is worth a thousand words, I have created a decision matrix that outlines my sense of how things may play out over the coming months.  Having observed the Fed and its reaction function to market situations for quite a long time, I remain convinced that despite all the rhetoric regarding maximum employment or inflation expectations, the single most important data point for the Fed is the S&P 500.  History has shown that when it declines sharply, between 10%-20%, they will step in, ease policy in some manner and seek to assuage the investment community regardless of trivialities like inflation, GDP growth or unemployment.  Thus far, nothing the Fed has done has changed that opinion.

Remember, these are my personal views and I assigned rough probabilities along with estimates of what could happen under the defined scenarios.  Ultimately, the question that keeps haunting me is; if inflation is transitory, why would they need to taper policy easing?  After all, the underlying assumption is that the current policy remains economically supportive without negative inflationary consequences, so why change?  I believe the answer to this question belies the entire Fed narrative.  But that’s just me.  The highlighted area is the expected outcome in one year’s time based on Friday’s closing markets (BCOM = Bloomberg Commodity Index).  Interestingly, the math worked out where I saw weaker stocks, higher yields, a weaker dollar and higher commodities.  In truth, if inflation is in our future, that does not seem to be wrong.

As to markets this morning, while Asian equity markets were largely under pressure (Nikkei -3.3%, Hang Seng -1.1%, Shanghai +0.1%), still reeling from the Fed’s allegedly hawkish stance, Europe is modestly firmer (DAX +0.7%, CAC +0.3%, FTSE 100 +0.2%).  Perhaps hawks only fly East.  US futures are also higher this morning, by roughly 0.5%, as the early concerns over tighter policy have clearly been allayed, by what though, I’m not sure.

Of course, all the real action has been in the bond market, where yields worldwide have fallen sharply since the FOMC meeting.  Not only have yields fallen, but curves have flattened dramatically as well with movement on both ends of the curve, shorter dated yields have risen under the new assumption that the Fed will be raising rates, while the bank end has rallied sharply with yields declining as investors ostensibly believe that inflation is, in fact, transitory.  While the overnight session has seen minimal movement (Treasuries 0.0bps, Bunds =0.4bps, Gilts -0.3bps), the movement since Wednesday has been impressive.  The $64 billion question is, will this new movement continue into a deeper trend, or reverse as new data is released.

Commodity prices have not yet abandoned the inflation story, at least some of them haven’t.  Oil (+0.2%) continues to perform well as demand continues apace and supply remains in the crosshairs of every ESG focused investor.  Precious metals have rallied on the back of declining yields, both real and nominal, but base metals have slipped as there is a growing belief that they were massively overbought on an inflation scare that has now been defused.  Funnily enough, I always had the commodity/inflation relationship the other way around, with higher commodity prices driving inflation.

Finally, the dollar this morning is weaker from Friday’s levels, but still generally stronger from its levels post FOMC.  The crosscurrents here are strong.  On the one hand, transitory inflation means less reason for a depreciating currency while on the other, lower rates that come with less inflation make the dollar less attractive.  At the same time, if risk is going to be back in vogue, the dollar will lose support as well. 

On the data front, there is a fair amount of data this week, although nothing of note today.

TuesdayExisting Home Sales5.71M
WednesdayFlash PMI Manufacturing61.5
 Flash PMIM Services70.0
 New Home Sales871K
ThursdayInitial Claims380K
 Continuing Claims3481K
 Durable Goods2.9%
 -ex transport0.7%
 Q1 GDP6.4%
FridayPersonal Income-2.7%
 Personal Spending0.4%
 Core PCE0.5% (3.9% Y/Y)
 Michigan Sentiment86.5

Source: Bloomberg

As well as all of this, we heard from ten different Fed speakers, including Chairman Powell testifying to Congress tomorrow afternoon.  It would seem there will be a significant effort to fine tune their message in the wake of last week’s meeting and the market volatility.

The dollar’s strength had been predicated on the idea that US yields were increasing and if that is no longer the case, my sense is that the dollar is likely to retrace its recent steps higher.  For those who with currency payables, keep that in mind.

Good luck and stay safe

Adf

Likely Too Soon

The narrative now seems to be
That tapering’s what we will see
The meeting in June
Is likely too soon
By autumn, though, Jay may agree

tran∙si∙to∙ry
adjective
not permanent.
“transitory periods of medieval greatness”

per∙sist∙ent
adjective
continuing to exist or endure over a prolonged period.
“persistent rain will affect many areas”

Forgive my pedanticism this morning but I couldn’t help but notice the following comment from former NY Fed President William Dudley.  “The recent spike in US inflation is likely transitory for now – but it could become more persistent in the coming years as more people return to work.”  Now, I don’t know about you, but I would describe the words ‘transitory’ and ‘persistent’ as antonyms.  And, of course, we all know that the Fed has assured us that recent rises in inflation are transitory.  In fact, they assure us multiple times each day.  And yet, here is a former FOMC member, from one of the most important seats, NY Fed president, explaining that this transitory phenomenon could well be persistent.  If you ever wondered why the term ‘Fedspeak’ was coined, it was because ‘doublespeak’ was already taken by George Orwell in his classic ‘1984’.  Apparently, one does not regain one’s intellectual honesty when leaving a government institution where mendacity is the coin of the realm.

However, let us now turn to today’s main story; tapering.  The discussion on tapering of QE continues apace and the market is settling on a narrative that the Fed will reduce the amount of its monthly purchases by the end of the year.  Certainly, there are a minority of Fed governors who want to get the conversation going in earnest, with St Louis’ James Bullard the latest.  And this idea fits smoothly with the concept that the US economy is expanding rapidly with price pressures, even if transitory, building just as rapidly.  Just yesterday, Elon Musk compared the shortage in microprocessors needed to build Teslas to the shortage of toilet paper at the beginning of the pandemic last year.  (As an aside, one, more permanent, result of that TP shortage is that prices in my local Shop-Rite are significantly higher today than pre-pandemic, at least 40% higher, even though the shortage was transitory no longer persists.)  

The point is that the combination of shortages of specific items, bottlenecks in shipping and dramatically increasing demand fed by massive government stimulus programs are all feeding into higher prices, i.e. inflation.  Even the most committed central bank doves around the world have noticed this situation, and while most are unwilling to alter policy yet, the discussion is clearly beginning.  Last night, the RBA omitted their promise “to undertake further bond purchases to assist with progress goals,” despite maintaining their YCC target of 0.10% for 3-year AGB’s.  As well, yesterday Fed Governor Lael Brainerd, arguably the most dovish FOMC member, explained, “while the level of inflation in my near-term outlook has moved somewhat higher, my expectation for the contour of inflation moving back towards its underlying trend in the period beyond the reopening remains broadly unchanged.”  Apparently, Lael attended the Alan Greenspan school of Fedspeak.

Add it all up and you get a market that is convinced that tapering is visible on the horizon and will begin before Christmas 2021.  While I don’t doubt it is appropriate, as I believe inflation is not actually transitory, I am also skeptical that the Fed is ready to alter its policy until it sees data showing the employment situation has reached its newly formed goals.  I fear that, as usual, the Fed will be late to the tightening party and the outcome will be a far more dramatic policy reversal and much bigger market impact (read stock market decline) than desired.

How, you may ask, has this impacted markets today?  The big winner has been the dollar, which is firmer against virtually all its counterparts this morning.  For instance, NZD (-0.5%) is the laggard in the G10 space after RBNZ comments explaining the balance sheet will remain large for a long time.  In other words, while they may stop buying new securities, they will replace maturing debt and so maintain a significant presence in their bond market.  Meanwhile, CHF (-0.5%) is under pressure after SNB Vice-president Zurbruegg explained that the bank’s expansive monetary policy, consisting of NIRP and FX intervention is still necessary.  The rest of the bloc is also softer, but not quite to that extent with AUD (-0.35%) under pressure from commodity price pullbacks and JPY (-0.35%) suffering after odd comments by a BOJ member that they would respond to any untoward JPY strength in the event the Fed does begin to taper.

Emerging market currencies have also been under pressure all evening led by TRY (-0.9%) and KRW (-0.65%).  The latter’s movement was a clear response to the PBOC setting its fixing rate for a weaker CNY than the market had anticipated, thus opening the way for a weaker KRW.  Given the fact that South Korea both competes aggressively in some markets with Chinese manufacturers, and has China as its largest market, the intricacies of the KRW/CNY relationship are many and complex.  But in a broad dollar on scenario, it is not too surprising to see both currencies weaken, and given KRW’s recent strong performance, it had much further to fall.  But currency weakness in this bloc is across EEMEA, APAC and LATAM, which tells us it is much more about the dollar than about any particular idiosyncratic stories.

In the rest of the markets, equities were mixed in Asia (Nikkei +0.45%, Hang Seng -0.6%, Shanghai -0.75%) while Europe is green, but only just (DAX +0.15%, CAC +0.3%, FTSE 100 +0.1%).  US futures are either side of unchanged at this hour as the market tries to digest the tapering story.  Remember, much of the valuation premium that exists in the US is predicated on lower forever interest rates.  If they start to climb, that could easily spell trouble.

Speaking of interest rates, they have edged lower in the session with 10-year Treasury yields down 0.3bps while in Europe, yields have fallen a bit faster (bunds -1.4bps, OATs -1.5bps, gilts -1.2bps).  Certainly, there is no keen inflationary scare in this market as of yet.

Interestingly, oil prices continue to rise, despite the stronger dollar, with WTI (+1.0%) trading to new highs for the move.  But the rest of the commodity space finds itself under pressure this morning as the dollar’s strength takes its toll.  Precious metals are softer (Au -0.25%, Ag -0.5%) as are base metals (Cu -0.8%, Al -0.5%) although the ags are holding up.  But if dollar strength is persistent, I expect that commodity prices will remain on the back foot.

On the data front, today brings only the Fed’s Beige Book this afternoon, as the ADP employment number is delayed due to the Memorial Day holiday Monday.  As well, we hear from four Fed speakers, including three, Harker, Kaplan and Bostic, who have been in the tapering camp for several weeks now.  However, until we start to see the Treasury market sell off more aggressively, I think tapering will be a nice talking point, but not yet deemed a foregone conclusion.  As such, that link between Treasury yields and the dollar remains solid, with the dollar likely to respond well to further discussions of tapering and higher yields.  We shall see if that is what comes to pass regardless of the current narrative.

Good luck and stay safe
Adf




To ZIRP They’ll Adhere

The sides of the battle are set
Will shortfalls, inflation, beget
Or is it the call
That prices will fall
Because of those trillions in debt

In circles, official, it’s clear
That no one believes past this year
Inflation will heighten
And so, they won’t tighten
But rather, to ZIRP they’ll adhere

It appears that the market is arriving at an inflection point of some type as the question of inflation continues to dominate most macroeconomic discussions.  For those in the deflation camp, rising prices are not nearly enough to declare that inflation is either upon us or coming soon, while inflationistas are quite comfortable highlighting the steady drumbeat of rising prices across both commodities and finished products as evidence of the new paradigm.  Both sides of this discussion recognize that the CPI data released last week was juiced by the base effects of the economic impact of last year’s government lockdowns and the ensuing price declines we saw in March, April and May of last year.  Which means that the entire argument is based on dueling forecasts of the future beyond that.  In other words, until we see the CPI print covering June but released in the middle of July, we will only have speculation as to the future impact.

What is transitory?  Ultimately, that becomes the biggest question in markets as the Fed has been harping on that word for months now.  According to Merriam-Webster, it describes something of brief duration or temporary.  Which begs the question, what is brief?  Is 3 months brief?  6 months?  Longer?  Arguably, brief depends on the context involved.  For instance, 3 months is an eternity when considering a spot FX trading position, while it is but a blink of an eye when considering a pension fund’s time horizon for investments.

There continue to be strong arguments in favor of both sides of the argument.  On the deflationist side the main points are; debt, demographics, technology and globalization, all of which have been instrumental in essentially killing inflation over the past 40 years.  No one can argue with the fact that the massive amount of debt outstanding will lead to an increasing utilization of resources to service that debt and prevent spending elsewhere driving up prices.  As nations around the world age, the strong belief is that individuals consume less (except perhaps healthcare) and thus reduce demand for everyday items.  Technology essentially exists to reinvent old processes in a more efficient form, thus reducing the cost of providing them, while globalization has been the underlying cause for the excess supply of labor, capping wages and any wage/price spiral.  In addition, they argue that inflation is not a one-off price rise, but a constant series of rising prices that feeds through to every item over time.

Inflationists see the world in a different manner post-Covid, as they highlight the breakdown of globalization with regulations preventing international travel and efforts to reduce the length of supply chains.  In addition, they point to the extraordinary growth in the money supply, with the added fact that unlike in the wake of the GFC, this time there is significant fiscal spending which is pushing that money beyond the confines of financial markets and manifesting itself as rising prices.  We continue to see company after company announce price hikes of 7%-15% for everyday staples which is exactly they type of situation that gets people talking about inflation.  Inflationists highlight the fact that there are shortages of commodity products worldwide and that because of the dramatic shutdowns last year from Covid, capex in mining and energy exploration was decimated thus delaying any opportunity for supply to catch up to current demand, which, by the way, is growing rapidly amidst the fiscal support.  As they are wont to say, the Fed can’t print copper or corn.  The point is, if there are basic product shortages for more than a year and prices continue to rise, is that still transitory?

Right now, there is no clear answer, which is what makes the discussion both entertaining and crucial to the future direction of financial markets.  By now, you are all aware I remain in the inflationist camp and have been for a while.  I cannot ignore the rising prices I see every time I go into a store.  But the deflationists make excellent points.  This argument discussion will rage for at least another two months and the July CPI release.  Until then, the one thing that seems clear is that market volatility is likely to remain significant.

As to markets today, while Asia had a mixed equity session (Nikkei -0.9%, Hang Seng +0.6%, Shanghai +0.8%), Europe has come under pressure as the morning has progressed.  At this time, we are seeing all red numbers led by the FTSE 100 (-0.7%), with the CAC (-0.4%) and DAX (-0.3%) both slipping as well.  US futures, which had been essentially unchanged all night are starting to slip as well, with all three major indices currently lower by 0.3%.

Interestingly, bond yields are edging higher this morning, at least edging describes Treasury yields (+0.2bps) while in Europe, sovereign markets are selling off pretty aggressively.  Bunds (+2.2bps), OATs (+3.1bps) and Gilts (+2.1bps) are all lower, while Italian BTPs (+5.5bps) continue to see their spread vs. bunds widen rapidly, up more than 20bps in the past 3 months.

Commodity prices are having a more complicated session with oil essentially unchanged, gold (+0.3%) and silver (+0.75%) both firmer along with base metals (Cu +0.5%, Al +0.9%, Sn +0.6%) while agricultural products are more mixed (Soybeans +0.4%, Wheat -0.8%, Corn +0.75%).

Finally, the dollar is mixed with gainers and losers across both G10 and EMG blocs.  Even though commodity prices are holding up reasonably well, the commodity bloc in the G10 is weak this morning, led by NZD (-0.7%), NOK (-0.6%) and AUD (-0.3%).  Much of this movement seems to be on the back of positioning rather than fundamental news.  On the plus side, JPY (+0.2%), and EUR (+0.2%) are the leading gainers, but it is hard to get excited about such small movements.

EMG currencies have seen a bit more variance with APAC currencies under pressure (IDR -0.6%, KRW -0.5%, SGD (-0.3%) as concerns grow over another wave of Covid inspired lockdowns slowing recovery efforts in the economies throughout the region.  CNY is little changed after overnight data showed Retail Sales (17.7%) much weaker than the expected 25.0% gain although the other key data points, Fixed Asset Investment (19.9%) and IP (9.8%) were both pretty much in line.  On the positive side we see TRY (+1.0%) on the back of easing Covid restrictions alongside a healthy C/A surplus in April, and HUF (+0.7%) after a central banker intimated that they could be raising interest rates to fight inflation as soon as next month.

Not a ton of data this week, but here is what we see:

Today Empire Manufacturing 23.9
Tuesday Housing Starts 1705K
Building Permits 1770K
Wednesday FOMC Minutes
Thursday Initial Claims 455K
Continuing Claims 3.64M
Philly Fed 41.9
Friday Existing Home Sales 6.08M

Source: Bloomberg

The Fed speaking calendar is a bit less full this week with only four different speakers although they will speak seven times in total.  Vice-Chair Clarida is the most important voice, but we already know that he is going to simply defend the current policy regardless of data.

With all that in mind, it appears that the dollar remains beholden to the Treasury market, so today’s limited movement, so far, in the 10-year has seen mixed and limited movement in the buck.  This goes back to the opening discussion; if you think inflation is coming, and expect Treasury yields to continue to rise, look for the dollar to follow along.  If you are in the deflationist camp, it’s the opposite.  But remember, at a point in time, inflation will undermine the dollar’s value.  Just not right away.

Good luck and stay safe
Adf