Markets pushing September aside to favor a December Fed rate hike

Outlook:

This week is simply enormous for top-tier data and events. Garnering much attention is PM Abe’s visit to the US, where the WSJ thinks the trans-Pacific trading and military deal is of less importance than what Abe says about Japan’s behavior during WW II.

Separately, the AUD can be expected to be squirrelly all week ahead of Chinese manufacturing PMI on Friday. The CAD may be squirrelly on oil.

Aside from the first quarter GDP and Fed on Wednesday, we also get other markers of US growth—the Chicago PMI on Thursday and manufacturing ISM on Friday. Our picture of the US economy could change entirely over this week. Was the Q1 dip a seasonal aberration? When can we no longer blame weather and the Pacific port strike?

The other big thing is flash eurozone inflation on Thursday, probably a nice little gain from red (-0.1% in March) to zero. Core inflation probably gained from 0.6% to 0.7%, too, even if German retail sales falter.

The Fed is probably not the most important event this week although it may seem like it. There is no press conference after the meeting, just the Statement. Expectations are leaning toward no hints about the timing of the First Rate Hike unless the Fed decides to put June back on the table. The probability of that is pretty low, maybe 15%. The probability of the Fed ruling out June, however, is ze-ro—the Fed wants to keep “flexibililty.” September is being pushed aside to favor December now, on the grounds that the strong dollar is impeding the recovery.

But the Fed must be noticing that inflation expectations are rising. Bloomberg notes “In January, when Treasury yields indicated the likelihood the U.S. would face a bout of deflation within a year, Fed offi-cials lifted their assessment of the economy, played down low inflation and said cheaper energy would help boost consumer buying power in its policy statement. A shift in the Fed’s stance occurred in March, when policy makers cut their forecast for how much they expected the key rate would rise this year. Fed Chair Janet Yellen also made the case for a cautious approach to rates in a March 27 speech. By that time, U.S. consumer prices were in the midst of falling for a third month as a raft of disappointing re-ports on economic growth and consumer spending showed that lower gasoline prices did little to boost demand.”

Everyone warned against raising rates too soon only to have to lower them again later. To be sure, “inflation has fallen short of the Fed’s 2 percent goal for 34 straight months. One reason is the dollar, which has appreciated 18 percent against 10 global currencies since the end of June… A stronger green-back helps keep inflation in check by holding down import prices and curbing demand for U.S. exports.” For this reason, many forecasters (including Morgan Stanley) see December as the likely date.

But not everyone agrees. Core consumer prices in March were up 1.8% y/y and while we weren’t watch-ing, energy prices are up over the last two months after a 6-year low in Jan.

Reuters notes the 10-year breakeven rate between the nominal 10-year T-note and the TIPS, is up from 1.53% in Jan to 1.9%. A JP Morgan bond guy says “that drift higher should continue as long as oil pric-es remain firm, lifting the breakeven rate back towards the longer-term average back above 2 percent.” Brent futures are up 45% from January and WTI is up 40%. If oil continues to make this kind of gain, next year’s inflation will look much, much bigger.

Deutsche Bank estimates a 50% rise in energy costs leads to a 0.9% gain in US inflation a year later. UBS says a $15 rise in oil would raise U.S. inflation by 0.6% over the coming year, $25 would equate to 1% and $35 would add 1.4%. “Their equivalent estimates for the euro zone are: a $15 rise adds 0.5 per-centage point to headline inflation, $25 equates to 0.8 percentage point and $35 equals 1.1 percentage point.”

This is not to say the ECB or the Fed will change their policy stances right away, and in the case of the Fed, not this week. But gains in energy prices inevitably leads to gains in inflation, not matter how hard economists try to strip out unmanageable factors. Last Thursday, WTI hit the highest high ($58.41) since Dec 22. We can’t expect the Fed to forecast oil prices any better than the oil guys can forecast it—which is not at all—but the era of deflation or low-flation might be ending. The question is whether the bond guys see it this way. Until we get the 10-year well over 2% and clearly not going to retreat back under 2%, we’d have to say the inflation scenario is not yet upon us. The bond buys may be wrong, but they are running the show.

While we may expect the euro to bounce up some more this week to test the previous high around 1.0900 or maybe more, the FX market remains stubbornly short. And a vast, enormous short it is. Mar-ket News reports the last CFTC Commitments of Traders report shows speculators had a net euro short position of 214,645 contracts as of April 21, compared to 212,347 contracts the week before. This is not quite as big as the record, 226,560 contracts from the March 31 report. Anything over 100,000 contracts is perceived as “extended,” or oversold in technical parlance. Traders have to clear out stale shorts they are holding in order to get short again. Chances are good this is exactly what is going to happen, but not today and probably not this week. First the Fed must speak and with any luck will men-tion both oil and the dollar as inflation factors. We need to get the word “inflation” back in the public discussion for any real progress in currencies.