In London on Threadneedle Street
The Old Lady’s not been discrete
Some hikes are impending
With rates soon ascending
Before they shrink their balance sheet
The BOE has made it quite clear that they are itching to raise interest rates pretty soon in order to address rising inflation. Today’s employment data, which saw the Unemployment Rate fall to 4.5% while employment grew by 235K on a 3M/3M basis, has helped to cement the idea that the economy is continuing to rebound sharply and price pressures are likely to continue to grow. With CPI at 3.2%, already well above the 2.0% target, and tipped to rise much further by the end of the year given the rapid rise in energy and commodity prices, the BOE has come to believe they need to do something to prevent inflation from getting out of control. Unlike the Fed, the BOE has also indicated they are quite comfortable raising interest rates before shrinking their balance sheet back to pre-pandemic levels.
The risk they face, which has become the talk of the market today, is that by raising rates so soon, especially before the Fed acts, they will simultaneously destroy the nascent growth impulse while failing to address the cause of the inflation. And in truth, that could well happen. Alas, that is a result of trying to address a stagflationary environment with the limited tools available to a central bank. For the time being, the biggest decision a central bank has is to determine which affliction is a bigger problem, rising prices or slowing economic activity. Since this seems to be the situation in almost every developed nation, we are going to witness a lot of variations on this theme going forward.
The interesting thing about the pound is that its behavior amid pending rate hikes, as well as the market narrative about the pound, seems to be quite negative. For some reason, there has been a connection made between an early rate hike in the UK and a falling pound. This is opposite what we have seen in most other countries, where those rate hikes have been supportive of the currency as would normally be expected. But there is now talk that the UK is going to make a policy error by tightening ahead of the Fed. This argument seems specious, however, as economic growth has rarely been a short-term driver of exchange rates, while interest rate changes are critical. The idea that suddenly traders and investors are critiquing the long-term ramifications of the BOE is preposterous. Instead, I would offer that any pound weakness, although an early decline after the data release has already been reversed, is far more likely due to the dollar’s continuing broad strength. So, as I type, the pound is essentially unchanged on the day.
Of course, this begs the question, is the Fed going to start to tighten policy with their potential tapering decision next month. My answer is leaning towards no. The reasoning here is that we will have already seen the first estimate of Q3 GDP by the time the Fed meets, and the early indications are that GDP growth has really declined sharply with the Atlanta Fed’s GDPNow forecast declining to 1.306% after the payroll data on Friday. Tightening policy into a clearly slowing economy seems highly improbable for this Fed regardless of the inflation situation. It seems far more likely that a weak GDP print will result in the Fed walking back their tapering language by describing the slowing growth as an impediment from achieving that vaunted “substantial further progress” on their employment goals and thus tapering is not yet appropriate. Remember, after nearly a decade of worrying about deflation, not inflation, concern over rising prices is not their normal response. Despite talk of the tools they have available to fight inflation, there is no indication the Fed has the gumption to use them if the result would be a recession, or more frighteningly for them, a stock market decline.
Thus, the question that remains is, how will the market respond to a Fed that decides not to taper with inflation still rising? Much of the current discussion regarding the Treasury market is around the idea that tapering is the driver of the steeper yield curve, although there is a strong case to be made it is simply consistently higher inflation readings doing the work. For our purposes in the FX markets, it’s not clear the underlying driver matters that much. The key is where do rates and yields go from here. If they continue to rise, I expect the dollar has further room to rise as well.
Ok, with markets back to full strength today, a look around sees a pretty negative risk sentiment. Equities in Asia (Nikkei -0.95%, Hang Seng -1.4%, Shanghai -1.25%) were all under pressure with the latter two dealing with yet another property company that is defaulting on a USD bond. The China story appears to be getting a bit less comfortable as we watch what seems to be a slow motion implosion of the real estate bubble there. As to Europe, its all red there as well (DAX -0.4%, CAC -0.5%, FTSE 100 -0.4%) as London is suffering despite the strong data and Germany seems to be feeling the weight of stagflation after PPI (+13.2% Y/Y in Sept) rose to its highest level since 1974 while the ZEW Surveys all fell even further than expected. At this hour, US futures are either side of unchanged.
On this risk off day, bond markets are seeing a bit of a bid, but in truth, it is not that impressive, especially given how far they have fallen recently. So, Treasury yields (-1.6bps) have edged just below 1.60% for now while European sovereigns (Bunds -0.6bps, OATs -0.8bps, Gilts -1.4bps) have also seen very modest demand.
Oil prices (+0.4%) continue to lead the way higher for most commodities, although today’s movement has been less consistent. The trend, however, remains firmly upward in this space. So, while NatGas (-1.6%) is lower on the session, we are seeing gains in gold (+0.5%) and aluminum (+0.7%) although copper (-0.25%) is consolidating today. Many less visible commodity prices are rising though, things like lumber (+5.5%) and cotton (+2.3%) which are all part of the same trend.
Finally, the FX markets have seen a very slight amount of dollar weakness net, although there are quite a number of currencies that have fallen vs. the greenback as well. In the G10, NOK (+0.7%) is the leader on oil price rises while AUD (+0.4%) and NZD (+0.4%) are following on the broader commodity price trend. Interestingly, JPY (0.0%) is not seeing any bid despite a declining risk appetite. This seems to be a situation where the spread between Treasuries and JGB’s has widened sufficiently to interest Japanese investors who are selling yen/buying dollars to buy bonds. As long as Treasury yields continue to rise, look for USDJPY to follow. After all, it has risen 1.7% in the past week alone.
In the emerging markets, THB (+1.3%) has been the big winner after the government eased restrictions for travelers entering the country thus opening the way for more tourism, a key part of the economy there. ZAR (+0.85%) and MXN (+0.5%) are the next best performers on the strength of the commodity story. On the downside, many APAC currencies (TWD (-0.35%, KRW -0.3%, INR -0.2%) saw declines on a combination of continued concerns over the potential implications of the Chinese real estate issue as well as rising commodity prices as all these nations are commodity importers.
Data-wise, NFIB Small Business Optimism was just released at a slightly weaker than expected 99.1, hardly a harbinger of strong future growth, while the JOLTS Jobs report (exp 10.954M) is due at 10:00 this morning. There are three Fed speakers on the slate with vice-Chair Clarida at the World Bank/IMF meetings and Bostic and Barkin also due. It will be interesting to see the evolution of the narrative as it becomes clearer that GDP growth is slowing rapidly. But given that has not yet happened, I expect more taper talk for now.
There is no reason to think that the dollar’s recent strength has reached its peak. If anything, my take is we are consolidating before the next leg higher so hedge accordingly.
Good luck and stay safe