Tantrum “lite” won’t help US Dollar
US financial markets have had to contend with three “hawkish surprises” so far this month and on each occasion price action has been broadly the same. Initially the Dollar rallied, the S&P 500 sold off and US Treasury yields rose but these (modest) moves were very quickly reversed.
Volatility and directionality have thus remained limited, although the Dollar NEER has slowly weakened to within touching distance of a 3-year low – in line with our bearish Dollar outlook (see Dollar and the three bears, 19th April 2021).
Price action suggests that markets are still seemingly not convinced, rightly in our view, that US inflation will remain materially above target medium-term and that the Federal Reserve will have to tighten monetary policy any time soon.
The question is whether US financial markets will follow the same pattern following today’s release (at 13.30 London time) of US PCE-inflation data for April.
The consensus forecast is that core PCE-inflation – the Federal Reserve’s preferred measure of inflation – rose from 1.8% yoy in March to 2.9% yoy, a 29-year high and well above the Federal Reserve’s medium-term target of 2%.
Our view is that the scope for core PCE-inflation to surprise materially to the upside in April is limited, with the risk to the Dollar based on recent precedent biased to the downside in coming sessions.
Medium-term we think the case for US CPI-inflation to remain well above the Fed’s target is far from water tight. Moreover, the Fed has form when it comes to keeping monetary policy very loose despite decent US GDP growth and an improving domestic labour market.
Our core scenario at present is that the Federal Reserve will only start tapering its monthly asset purchases in 2022 and only start hiking its policy rate in 2023. We therefore remain bearish the US Dollar – a theme we will develop in future FIRMS reports.
Tantrum “lite”: Financial markets comfortably navigate “hawkish surprises”
Financial markets have comfortably navigated three “hawkish surprises” in the past month. As taper-tantrums go this one has barely registered.
i) On 4th May Treasury Secretary and former Federal Reserve Chairperson Janet Yellen said that the Federal Reserve may have to hike its policy rate to stop the US economy from overheating.
ii) On 12th May data showed that US CPI-inflation, in year-on-year terms, had risen by far more than expected in April. Headline CPI-inflation rose to 4.2% from 2.6% in March (consensus forecast was 3.6%) while core CPI-inflation rose to 3.0% from 1.6% in March (consensus forecast was 2.3%) – see Figure 5.
iii) On 19th May the Federal Reserve published the minutes of its 27-28 April policy meeting. The minutes stated that “A number of participants suggested that if the economy continued to make rapid progress toward the Committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.” Effectively some FOMC members thought that if certain conditions were met it would be appropriate at some point to discuss a plan to “taper” the Federal Reserve’s QE program.
US Treasury yields initially spiked higher intra-day on 4th May and closed higher on 12th and 19th May (see Figure 1). Moreover after each of these events the S&P 500 closed lower and the US Dollar Nominal Effective Exchange Rate (NEER) stronger according to our estimates (see Figure 1).
However, US Treasury yields closed slightly lower on 4th May and more notably closed lower on both 5th May and 20th May and following all three events the S&P 500 rebounded and the Dollar weakened (see Figure 1). The bottom line is that financial markets quickly reversed the initial moves. So volatility in US asset prices rose has remained very modest (see Figure 2) and in level terms they have moved very little since early May (see Figure 3).
- US Treasury yields, including the benchmark 10-year yield, have remained in a reasonably narrow range in place since early March. The 2s-10s yield spread (147bp), which is largely driven by markets’ inflation expectations, is currently broadly in the middle of a narrow 8-week range of 139-153bp (see Figure 4). Markets are still only pricing in about 12-13bp of Federal rate hikes by end-2022 or put differently a 50% probability of a 25bp hike.
- The S&P 500 has treaded water, with the index yesterday closing only 0.9% higher than on 4th
- The Dollar NEER weakened a further 1.2% from 3rd May to a 3-year low on 18th May, in line with our forecast of further Dollar depreciation (see Dollar and the three bears, 19th April 2021). However, the Dollar has since traded sideways, according to our calculations (see Figure 4). Similarly the narrower DXY Index has oscillated within a range only 0.8% since 17th May although it remains within touching distance of a 38-month low.
Markets not yet buying into inflation scare stories and imminent Fed tightening
Admittedly, taken individually none of these events – particularly Treasury Secretary Yellen’s comments and the Federal Reserve’s policy meeting minutes – were earth-shattering. Yellen, after all, was in generic terms stating the obvious and very quickly backtracked, clarifying that she was not forecasting US rates to rise or that they should rise – a subtle but important distinction from her original comment. Moreover, the Federal Reserve’s hawkish turn was at most incremental, with its minutes containing at least five caveats:
i. “A number of participants”. That is not the same as a majority let alone all of the FOMC members.
ii. “if the economy continued to make rapid progress toward the Committee’s goals” (our emphasis). That is a pretty important and yet ill-defined conditionality.
iii. “it might be appropriate”. Again the Federal Reserve did not commit to much.
iv. “At some point in upcoming meetings. The Federal Reserve clearly gave itself plenty of room for manoeuvre with regards the timeline for a more clear-cut hawkish turn.
v. “to begin discussing a plan”. If putting in action a plan is the first derivative, to begin discussing a plan is its third derivative.
However, even in cumulative terms these three events, including the magnitude of the jump in CPI-inflation in April blindsiding analysts, have failed to really move the needle. This price action suggests to us that:
1. While analysts correctly in our view forecast that year-on-year measures of US inflation will continue to rise in coming months, markets, also rightly in our view, are still seemingly holding onto the idea that this inflation spike may be transitory and that inflation will not remain materially above the Fed’s target over the medium-term. As John Authers (Bloomberg) notes, the Federal Reserve’s favoured 5-year, 5-year breakeven rate, which effectively measures expected inflation from 2026 to 2031, spiked at 2.4% earlier this month but has fallen back to around 2.2%, the kind of inflation level that the Federal Reserve would arguably be comfortable with and tolerate.
2. Markets, again rightly in our view, have not yet bought into the notion that the Federal Reserve is “behind the curve” and about to announce a tightening of US monetary policy, specifically an explicit, time-specific plan to reduce monthly purchases of US Treasuries and Mortgage Backed Securities currently running at respectively $80bn and $40bn; and
3. There is still appetite to be short Dollars, with markets prone to selling Dollar rallies.
Markets face another hurdle today: Release of US PCE-inflation data for April
The US Bureau of Economic Analysis is due to release today at 13.30 London time personal income, personal spending and importantly Personal Consumption Expenditure (PCE) inflation data for April. Markets will undoubtedly focus on the release of core PCE-inflation data, the Federal Reserve’s preferred measure of consumer price inflation.
The consensus forecast is that it rose from 1.8% yoy in March to 2.9% yoy in April – a 29-year high and well above the Federal Reserve’s medium-term target of 2% (see Figure 5). Analysts’ forecasts have seemingly taken into account the fact that core CPI-inflation in April rose much faster than expected and we would therefore argue that the risk of core PCE-inflation surprising materially to the upside is modest.
If core PCE-inflation is broadly in line with the consensus forecast, the Dollar may not do very much in our opinion. If it comes in slightly above consensus price action in the past three weeks suggests that US yields and the Dollar may initially rise but those gains could quickly be reversed with the Dollar continuing to trade sideways with a bias to the downside at these levels. If core PCE-inflation undershoots analysts’ forecast, we are of the view that the Dollar could weaken more materially.
Federal Reserve has in recent years been a cautious, slow moving machine
Assuming that core PCE-inflation rose to 2.9% yoy in April, the Federal Reserve’s “core” policy rate – its nominal policy rate deflated by core PCE-inflation (ex-post) – will have fallen to a multi-decade low of about 2.9%. However, it will have still averaged -1.4% over 12 months despite US GDP growth having averaged only 1.1% qoq between Q2 2020 and Q1 2021 (see Figure 6) and despite residual weakness in the labour market. The number of unemployed and those not in the labour force but wanting a job totalled 16.46 million in April 2021, or 5.7 million more than in December 2019, and averaged over 20 million over 12 months (see Figure 7).
By comparison the Federal Reserve’s “real core” policy rate also averaged -1.4% between 2012 and 2015 despite annualised GDP growth averaging a decent 2.2% qoq and the number of unemployed and those not in the labour force but wanting a job averaging 16.8 million according to our calculations (see Figures 6 & 7). In simple terms the gap between the red and blue lines in Figures 6 & 7 is not particularly large by historical standards. The Federal Reserve could therefore argue (as it has done implicitly) that interest rate policy has not been excessively loose in the past year or so and therefore can justifiably remain stimulative for the foreseeable future.
After all the Federal Reserve only started to reduce its monthly bond purchases from $85bn in December 2013 (and took 10 months to reduce them to zero) and only delivered its first 25bp policy rate hike in December 2015. The Federal Reserve then took another 12 months to deliver its second 25bp policy rate hike in December 2016 and another 10 months (October 2917) to start shrinking its balance sheet when it was clear that US GDP growth was well anchored and picking up (it averaged 2.7% qoq in 2017-2018).
Case for US inflation remaining well above Fed forecast far from water-tight
Beyond today’s data release, we see a number of reasons why the year-on-year rate of US inflation, including core PCE-inflation, will moderate in 2022 and ultimately not remain materially above the Federal Reserve’s target as we already argued in US markets playing along to Fed tune…for now (14th May 2021).
1. For starters, base effects (i.e. high inflation in 2021) will be more favourable.
2. The long-commodity play may start running into serious valuation issues, with speculative positions being unwound. The price of copper (spot contract) and steel rebars (1-month contract) has already fallen about 6.5% since 10th May and 12th May respectively, due in part to the Chinese government threatening to lean against speculative trading in key commodities. The Bloomberg commodity price index has fallen 1%, which may not seem like much. However, if global commodity prices continue to tread water, the implication is that its year-on-rate of increase will start to moderate in April 2022 which would in turn, albeit with a lag, contribute to lower year-on-year CPI-inflation in our view.
3. Stocks of raw materials and commodities are likely to be least partially replenished over the next 12 months.
4. Higher consumer prices will attract new suppliers to come on line.
5. Finally, and perhaps most importantly, much of the famed “pent-up demand” will have been spent by end-2021 because most developed and some EM economies will have re-opened for business by then. Therefore, the marginal impact of consumption on consumer prices (demand-pull inflation) will be weaker in 2022 in our view, even without taking into account the possibility that tax rates will rise in a number of developed economies, including the United States and United Kingdom
With this in mind our core scenario at present is that the Federal Reserve will only start tapering its monthly asset purchases in 2022 and only start hiking its policy rate in 2023. We therefore remain bearish the US Dollar – a theme we will develop in future FIRMS reports.