“Well it's the same room but everything’s different"
- Crowded House, Weather With You
Throughout May, it was not just the weather in the UK that was overcast and confusing...
Something wasn’t quite right. As we moved into the meteorological summer, the cold and rain persisted. In many respects this was synonymous to my views in financial markets. At the start of the month, expectations of global growth, led by the US were dominant, equity and risk sentiment were positive (following a very strong Q1 earnings season). The USD remained on the back foot, as flows continued to favour EUR and CNY, exacerbated at the margin by rising core yields in the eurozone, on hopes of policy normalisation ahead of the Fed – a view we firmly disagree with.
However, two consecutive economic releases from the US changed the dynamic and the dominant economic narrative. Firstly the US employment report for April wildly disappointed expectations (266k vs. in excess of 1m job gains) and, due to the fact that the Fed had explicitly linked the first stages of policy normalisation (tapering QE purchases) to ‘substantial further progress’ towards the twin policy goals, this data – in this instance the key metric being the newly asymmetric full employment goal – pushed back taper expectations. The narrative evolved that, at the average monthly pace of job gains over the quarter (roughly 500k), it would take until Q3 2022 to reach full employment (let alone beyond, as monetary policy aims to do its part in addressing social inequalities). This was a significantly dovish iteration from the prior market thinking on policy normalisation.
Then came the inflation – so to speak.
US headline CPI printed 4.2% for April, significantly above expectations and target. For a brief period, this drove higher inflation expectations and breakevens that saw a re-steepening of the US yield curve and inflation firmly installed as the dominant macro discussion point. Two camps quickly appeared: those who thought this was the start of a new era of prolonged inflation pressure driven by the rapid expansion of the global money supply and unprecedented pandemic stimulus and; those who believe that the current drivers of inflation are transient supply and demand mismatches as a function of global demand switching back on faster than its supply counterpart!
While there have been some pullbacks in commodity prices over recent weeks, this debate is still very active. We remain on the ‘transient’ side of the debate.
To add to this complicated backdrop there have been a number of further distortions to key market barometers. Firstly, there continues to be a substantial cash balance at the Treasury which appears to be absorbing the current pace of debt issuance without impacting the US yield curve. This has likely eased a lot of the supply pressure on Treasuries and helped to flatten the curve. At the same time, the cash glut at the front end of the curve also continues (as stimulus cash floods into consumer and State and Local Government accounts faster than it can be spent, or lent by recipient banks) driving 3m yields close to 0.0%. All of this has put pressure on the USD.
Secondly, it has seemed clear for a while now that there was a dominant ‘flow’ in the market. A consistent seller of USD, and particularly notable selling strength following any positive data release. This week’s statement from the Russian Central Bank that it plans to run down the USD holdings in its Sovereign Wealth Fund to zero - replacing them with EUR and CNY, fits the ‘flow’ criteria that was notable over recent months in EURUSD and USDCNY.
So what now?
From my perspective, markets have become too confident in the narrative that the Fed are on hold for longer due to a looser than expected labour market (fuelled by a cyclical if not structural supply/demand imbalance), firstly because my view is that the US labour market dynamic is stronger than the last payroll release suggests, and secondly because if there is a more permanent factor driving the supply / demand mismatch in the US labour market, then by definition this alters estimates of the tightness of the labour market and the equilibrium or full employment level in respect of wage inflation pressure - which should impact the Fed reaction function.
In short, my view of the Fed reaction function is that it is not as far removed from the market perception of it at the start of May. And that any delay to the start of policy normalisation will be countered by a faster or more sustained pace of tightening once they get under way - the ‘hockey stick’! Furthermore, my view is that the risks are now more skewed to the topside for US yields (despite the continued cash balance distortion) and for the USD, as a stronger than expected (expectations are now quite low) incoming labour market data likely fosters a tighter Fed reaction function; therefore it is likely that the boost to nominal yields is driven by real yields. This is important for the USD – especially vs. EM.
I guess you could say that the market continues to view the USD “like a lounge-room lizard”, whereas I expect it now has the chance to “sing like a bird released”!
Sources
https://www.bls.gov/news.release/pdf/empsit.pdf
https://www.bloomberg.com/news/articles/2021-06-03/williams-says-now-is-not-the-time-for-fed-to-adjust-bond-buying
https://www.businessinsider.com/treasury-secretary-janet-yellen-us-full-employment-next-year-forecast-2021-3?r=US&IR=T
https://www.cnbc.com/2021/05/12/consumer-price-index-april-2021.html
https://www.bloomberg.com/news/articles/2021-06-03/russia-cuts-dollar-from-119-billion-wealth-fund-amid-sanctions
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