Market commentary: Markets focussed on May CPI; Fed being given the benefit of the doubt

From

Stephen Miller

1. Markets focussed on May CPI. Fed being given the benefit of the doubt but there is doubt!

All eyes tonight on the May CPI report. The market expectation is for a ‘headline’ rise of 0.4% mom or 4.7% yoy and for the ‘core’ arise also of 0.4% mom or 3.4% yoy. Such an increase in the ‘core’ measure would be the highest for almost 30 years.

While the inflation debate has been a key focus for markets in 2021, it seems that markets are by and large accepting of the Fed narrative that the recent acceleration of inflation is  “transitory”. Bond yields have retreated from their highs (indeed, overnight bond yields closed at their lowest level since early March) and equity markets appear to have consolidated at or near record highs.

There is an argument that a disappointing April jobs report followed by a May report, released on Friday, which was solid without being spectacular, means that capacity pressures are not a clear and present danger. But the detail of those reports suggest that supply-side issues are more prominent than any deficiency of demand for labour. That notion is lent support by a much greater than expected increase in average earnings, indicating that wage inflation may be taking root in the US.

However, while the efforts by various Fed speakers appeared to have assuaged market concerns, doubt remains.

On occasions, unless addressed, “transitory” inflation can take on an air of permanence. In the words of former Australian Prime Minister Keating “the inflation genie gets out of the bottle” and once that occurs, it is a difficult process getting the genie back inside the bottle. That is precisely what happened with the oil price shocks of the 70s when policy generally “accommodated” the increase in oil prices. Not that the current circumstance is entirely redolent of what took place back then.

Both Obama era Treasury Secretary Larry Summers and former Pimco Head and Allianz adviser Mohamed El-Erian and BlackRock CEO, Larry Fink, have expressed concerns regarding inflation as well as some of the latent financial stability dangers that are inherent in the historically high – some say “excessive” – levels of monetary accommodation.

They cite inflationary pressures as mounting from the boost in demand created by the $US2 trillion-plus in savings that Americans have accumulated during the pandemic; from historically high levels of monetary accommodation including large-scale Federal Reserve debt purchases, along with Fed forecasts of essentially zero interest rates into 2024; from roughly $US3 trillion in fiscal stimulus passed by Congress; and from soaring stock and real estate prices.

Further they say that a variety of factors suggests that inflation may yet accelerate – including further price pressures as demand growth outstrips supply growth; rising materials costs and diminished inventories; higher home prices that have so far not been reflected at all in official price indexes; and the impact of inflation expectations on purchasing behaviour.

The Biden agenda, including higher minimum wages, strengthened unions, increased employee benefits and strengthened regulation all push up business costs and prices.

Also in the frame is the Fed’s move toward ‘outcomes-based’ framework for monetary policy which some claim locks the Fed into a process whereby it acts only if inflation persistently surprises on the upside. By that stage the inflation genie might well be (persistently) out of the bottle.

The move to an ‘outcomes-based’ framework for monetary policy at a time of intensifying inflation pressures and growing financial market imbalances increases the probability of a policy mistake, with the Fed getting behind the curve on the withdrawal of the current stimulus. Such a mistake may mean that later in the piece the Fed has to jam down hard on the monetary brakes, leading to sharp upward movements in bond yields and a significant correction in equity markets. Such a scenario looms as a major challenge for investors in the future, including how multi-asset investors react to a potential reversal of long-held assumptions regarding asset return correlation.

Should inflation be more persistent than the Fed appears to believe, and which markets appear to have accepted, albeit guardedly, then the sorts of accidents conjectured by Summers, El-Erian, Fink and others might result in a period of upheaval for markets. 

The Fed may be a little bit more advanced than the “not thinking about thinking” about monetary tightening that Chairman Powell characterised as the Fed’s stance last year –  but only just a bit. What that means is that after a period where monthly inflation reports have largely been sidelined as a market focus, that they once again assume primacy they once enjoyed as the statistical report that matters.

Certainly, all eyes are on tonight’s May CPI report!

2. ECB meeting also a key focus on Thursday

The other key focus for markets is tonight’s ECB meeting. That meeting is a major quarterly forecast review with the Governing Council to review the current state and outlook for the Eurozone’s economy and presumably to assess whether any recalibration of policy settings should flow from that review. While official commentary will almost certainly reflect the better tone of recent economic reports and an attendant improving outlook as the dislocation wrought by the pandemic recedes, it is doubtful that that will be enough for the ECB to indicate a retreat from the current historically high levels of monetary accommodation, let alone to set out a ‘tapering’ roadmap. 

In all likelihood, The ECB will indicate a continuance of the current rate of bond purchases from the elevated June quarter pace decided by the Council at their March meeting. The renewed strength of the EUR after the slight depreciation during the March quarter, together with lingering uncertainties associated with the pandemic are likely to keep the ECB on its current course. 

3. Bank of Canada maintains current level of stimulus ahead of a likely taper in July/No template for the RBA

As was widely anticipated, the Bank of Canada left the policy rate unchanged and maintained its current pace of bond purchases in what can be described as a “placeholder” ahead of an expected reduction in bond purchases when it meets again on July 14.  It also retains a projection on an increase in the policy rate sometime in the second half of 2022.

The central bank was among the first[1] from advanced economies to shift to a less expansionary policy[2] in April, when it accelerated the timetable for a possible interest-rate increase and pared back its bond purchases. That shift has also been seen in both the Norges Bank and the RBNZ, and contrasts with a relatively more cautious tone from the RBA who continue to assert that a policy rate increase is “unlikely to be until 2024 at the earliest.” Something it is likely to retain when it announces adjustments to its 3 year bond target and / or QE at its meeting on July 6th. 

The Bank of Canada (and RBNZ and Norges Bank approaches) is also in contrast to the tone adopted by the major central banks such as the Fed and the ECB.

The relative caution from the RBA is motivated by the absence of any “lived experience” of wage and / or price inflation. 

The inflationary pressures in the US are clear but are less visible in Australia. 

While base effects will see June quarter annual ‘headline’ inflation likely get close to 4%, the RBA’s preferred trimmed mean measure is forecast to be around 1.5%, still well south of the RBA’s 2-3% target. Indeed, the RBA forecasts only have inflation reaching the bottom of the 2-3% inflation target band in June 2023, and even then, wages are forecast to be running at a paltry 2 ¼ %.

As part of the quest to generate tight labour markets and attendant wage and price inflation, the RBA remains motivated to avoid an unwelcome upward movement in the AUD. Any move up in the AUD could well frustrate the task of getting unemployment down and wage growth and inflation up. It seems clear that the RBA has achieved its stated objective in pursuing yield curve control and QE of “keeping the AUD lower than it otherwise would have been”. In my view, it won’t wish to unwind those achievements by “prematurely” foreshadowing a significant retreat from the currently historically high levels of monetary accommodation.

The RBA also appears largely unconcerned by market expectations of inflation rebounding. Like the Fed, that may reflect a belief that any near-term inflation will be essentially transitory. It may also reflect that current market-based expectations of inflation are toward the bottom end of the RBA’s 2-3% target range.

The July Board meeting is “live” with the RBA Board having to consider whether the current historically high levels of monetary accommodation will continue in its current form. 

The Board will make a decision on whether the 3-year bond target will roll to the November 2024 bond from the current April 2024. That meeting will also consider future bond purchases following the completion of the second $100 billion of purchases under the government bond purchase program in September.

The Board is unlikely to roll to the November 2024 bond. 

Given the RBA’s  unequivocal commitment to full employment and given that despite progress on the unemployment front, it is still some way north of the 4 per cent or even “3 point something” previously cited by the Governor as getting close to capacity, the RBA would appear to be likely to implement only marginal adjustments to its QE program. Changes to QE appear likely to be implemented “flexibly” and with caution, perhaps by signalling a likely weekly run-rate of purchases say between $2.5b – $4b a week. 

Such measures are at this stage rather small in the scheme of things given the prevailing expectation of the RBA Board that a policy rate increase is “unlikely to be until 2024 at the earliest.”

For the time being it remains the case that while the economy’s performance has certainly exceeded expectations, recent price and wage growth remains at levels that are still uncomfortably low for the RBA and its inflation objective and, as mentioned, the unemployment rate, again while having bettered expectations, is still some way from a level consistent with full capacity. 

While ever that remains, and while ever the Fed remains in no hurry to adjust its settings, and while ever there is no “lived experience” of adequate wage and price inflation, we should expect the maintenance of the historically high accommodatory tack from the RBA.

By Stephen Miller, Investment strategist

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[1] https://www.bloomberg.com/news/articles/2021-04-22/inflation-forces-the-bank-of-canada-s-hand-ahead-of-fed-and-ecb
[2] https://www.bloomberg.com/news/articles/2021-04-21/bank-of-canada-pares-bond-purchases-sees-rate-hikes-earlier

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