Will rising inflation expectations become a problem for the Fed?

Stocks moved broadly higher in early trade on Wednesday as investors pin their hopes on a double helping of deal-making before Christmas: a UK-EU trade deal and a US fiscal stimulus package. The dollar was offered this morning as the euro rose above $1.22, hitting its best level in almost three years with Eurozone flash December PMIs stronger than expected. UK inflation fell in November thanks to the second national lockdown, with CPI declining to an annual rate of +0.3% from +0.7% in October.

It’s a bit of a Ctrl + c, Ctrl + v job this morning re Brexit. Sterling jumped on hopes the UK and EU are close to a deal, with Ursula von der Leyen giving a broadly upbeat assessment of talks. GBPUSD advanced to 1.35 with the December 4th peak at 1.3540 offering the near-term resistance. To borrow central banker phrasing, clearly the trade deal risks are skewed to the upside with asymmetric risks to the pound on the outcome of talks. GBPUSD could move to 1.40 on a comprehensive deal, but risks collapsing to 1.20 on a no-deal cliff edge exit, before likely seeing some recovery towards 1.25. No deal is not an end state, but it would obviously spark massive volatility in sterling crosses. The spot market is inclined to think a deal is coming, while options markets also show traders are scaling back bets on a no-deal collapse.

Yesterday, stocks on Wall Street advanced amid hopes Congressional leaders are close to agreeing to a fiscal stimulus package before Christmas. The S&P 500 finished up 1.3% at a session high 3,694, close to its all-time record peak just above 3,700. The Dow Jones industrial average added over 1%, while the small cap Russell 2000 rose more than 2% for the day. The Nasdaq composite rose 1.3% for another record closing high.  Apple led the way with a 5% pop that helped lift broader market sentiment, after a Nikkei report indicating the company will increase iPhone production by 30% in the first half of 2021. It’s a bullish indicator for iPhone demand, and highlights the potentially very strong upgrade cycle driven by the iPhone 12 update. I noted in October that the launch of the iPhone 12 was going to be the moment many Apple users have been waiting for and it could mark a step-change in the device upgrade cycle as we saw with the X.  

On the other big deal that needs to be struck, there are clear signs of progress. US Senate Majority leader Mitch McConnell said lawmakers wouldn’t leave Washington this year without a Covid package “no matter how long it takes”. It may be a smaller package – worth $748bn – but it least it would be something. It does look like the main Democrat and Republican chiefs are almost in agreement. 

Look out for the final Fed meeting of the year later in the session – expect the central bank not to increase support but make sure the market knows it’s not about to reduce it and stands ready to more if required. The Fed is expected to pin its asset purchases to economic outcomes, assuring the market it is not going to prematurely taper its $120bn-a-month bond-buying programme. Anchoring expectations around policy support will be key for the Fed as it seeks to play down any signs of economic recovery amid worries that the roll-out of vaccines and a strong bounce back next year will call for it to withdraw some accommodation earlier than expected. The weakness in the latest nonfarm payrolls report will underline the need for continued policy support in the near-term and I expect Jay Powell will not wish to veer from a very dovish stance. 

The question for the Fed is starting to pivot towards the reflation trade and rising long-term rates, with US 10-year yields attempting to break 1% lately. Rising inflation expectations may be a problem for the Fed, but not yet – it's made it abundantly clear it will look through overshoots with average inflation targeting. The problem is the Fed risks allowing inflation expectations to become unanchored at a time of a massive cyclical bounce back in the economy. Rising bond yields at the longer end of the curve will likely push the Fed towards moving the focus of its bond buying to longer-dated debt, to keep a lid on yields and corporate borrowing costs.  

Rising economic optimism is helping crude oil prices make fresh multi-month highs. WTI (Jan) advanced close to $48, reversing an earlier slip on a surprise build in inventories. API data on Tuesday showed crude oil stocks rose by 1.973m barrels in the week ending Dec 11th, vs expectations for a draw of a similar magnitude. EIA data on tap later expected to show a draw of 2.8m barrels after a massive 15.2m-barrel build last week. It seems the market is prepared to overlook near-term demand weakness and inventory build-ups with sentiment underpinned by hopes for a vaccine-led recovery next year.