Outlook: The financial press is chock-full of Fed analysis, some of it really quite stupid. The FT has a coherent explanation, even if we do not agree with its core premise, that the Fed statement indicates it will not tolerate higher inflation. “The Fed’s moves mark a major setback for investors who this year have rushed to buy securities that might benefit from faster inflation, betting that the combination of exceptionally easy monetary and fiscal policy and a global economy emerging from its Covid-19 lockdown would cause prices to spike. The unexpected central bank pivot has raised doubts about how much inflationary pressure the Fed is really willing to tolerate.”
We say this is the wrong attitude because Mr. Powell very clearly stated that the Fed will indeed tolerate higher inflation in order to make up for extra-low inflation over the previous few years in order to get an average of 2%. What is it about the concept of “average” that people don’t get? The problem is likely that the Fed doesn’t name a number, just as it doesn’t quantify “substantial progress” in jobs.
The long bond nose-dived, implying confidence the Fed will control inflation. “The yield on 30-year US Treasuries plunged to its lowest level since February, and was at 2.07 percent on Friday, down from 2.21 percent ahead of the Fed meeting.” The hardest hit are commodities, so that “Natural resources suffered the biggest hit, with Bloomberg’s commodity price index tumbling 3.6 percent on Thursday, its biggest one-day drop in more than a year, with WTI oil falling 1.5 percent.
“So-called US value stocks — often cheaper, out-of-favor companies that are more sensitive to the pace of economic growth — fell another 1.3 percent on Thursday to extend the initial drop they suffered on Wednesday, the day of the Fed’s announcement. MSCI’s index of global value stocks had already fallen 1.2 percent on Thursday.” This implies managing inflation expectations has a ruling influence on overgrowth, something else we don’t see.
Note that the 10-year breakeven is a tad lower at 2.27% as of yesterday, from 2.54% at the high on May 17. This is nowhere close to justifying the overreaction in some measures, including the giant drop in commodities.
We are taking off our economist hat and putting on our technical analysis hat. First, overreaction to the Fed’s new stance can easily be seen by prices breaking the “normal” range. This can be seen in the form of the standard error channel, the Bollinger band, and the ATR (average true range) channel. Breakouts must be respected but remember that more breakouts are false than real and more temporary than lasting; we tend to think this one is the real deal and will be lasting, but others will have doubts and express them loudly. And it’s not just currencies that executed breakouts. We already had breakouts in oil and other commodities, most prominently lumber, which is now retreating as it should, having gotten severely overbought.
Even when a breakout is real, meaning it has a decent Cause and marks a true change of direction, it tends to stop and reverse after a few periods as speculators take profit (and some have second thoughts). The reversal is usually short-lived when the breakout has caused, usually arriving after about 5 days. Then we are all dancing on ice to see if the new move resumes. At a guess, it will resume this time, based on actual US growth with signs of robustness and resilience, jobs reports notwithstanding.
In other words, copper and lumber and even oil are retreating because they had been overbought in the first place and the Fed is just an excuse to burst the bubble. But the price rises have an authentic Cause—recovery from Covid in the big economies. Oil can still go to $100, as we wrote yesterday.
The Fed did not change policy this week. As Powell was careful to note, the dot-plots are personal (and anonymous) opinions, not a forecast or a policy statement. The overreaction to a shift in stance is excessive and should correct. The Fed did nothing more than open the door a crack.
Bloomberg has a relevant comment: “The spread between 5- and 30-year Treasury yields tumbled by most since February in the two trading sessions through Thursday, and is now below where it started the year.
“That's a negative signal for the world's cyclical shares, which have begun to rollover but remain ahead of their defensive peers by over 5 percentage points this year, according to gauges from Goldman Sachs. Investors are now wagering a faster-than-expected pace of tightening from the Fed could temper economic growth and higher inflation, and weigh on the chances of an overshoot in both. A flatter yield curve would likely favor defensive names like healthcare and consumer staples stocks and could trigger a reversal of the inflows seen into cyclical shares since late last year.”
The part to pick out is that the risk of overshooting inflation is now curbed. That’s what the world expects of its central banks. We are not “defending” the Fed. We are seeing its words as perfectly appropriate for a world in which US inflation was coming in at 6-8% (depending on how it’s calculated). We think the Fed headed off a potential crisis and poured cold water on some bubbles. That’s what we pay it to do.
As for the dollar, it can hold gains after the usual correction. Commodity currencies will come back. EM’s may suffer from borrowing costs.
Be Careful What You Read Dept: The WSJ has a front-page article purporting to be news that says “A booming U.S. economy that is driving inflation higher around the world and pushing up the U.S. dollar is pressing some central banks to increase interest rates, despite still-high levels of Covid-19 infections and incomplete economic recoveries in their own countries.
“The world’s central banks are hanging on how the U.S. Federal Reserve will respond to a rise in inflation, wary of being caught in the crosscurrents of an extraordinary U.S. economic expansion. Global stock markets fell on Thursday after Fed officials signaled they expect to raise interest rates by late 2023, sooner than they anticipated in March, as the U.S. economy heats up.
“A global march toward higher interest rates, with the Fed at the center, risks stifling the economic recovery in some places, especially at a time when emerging-market debt has risen.” Turkey, Brazil, and Russia are raising rates when they can’t afford to and emerging market currencies suffer as their dollar borrowing costs go up. The WSJ fails to note that inflation is these countries is nearly all domestic-driven and many EM’s get the benefit of higher commodity export earnings also denominated in dollars.
To add insult to injury, the WSJ has an editorial criticizing the Fed for being led around by the nose by the market and failing to make the rate changes this week that the inflation data call for. In fact, the writer slams the way the Fed interacts with the market in every way, from meaningless dot-plots to forward guidance to frankness leading to tapering tantrums. He has a point in that the way the Fed interacts with the market is shot full of awkwardness and uncertainty, but he’s dead wrong that the Fed is not in charge. The cartoon accompanying the article shows Powell napping on a chaise longue while marketeers riot for attention.
This is like saying tennis is an invalid game because the score-keeping is stupid—what are ad-in and ad-out, deuce and “love,” anyway? We note that this guy used to be the Hong Kong correspondent and seemingly was never been a bond trader or a trader of any sort. Put him on a Big Bank trading desk for a few weeks and see how he changes his tune.
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