Back in January, I wrote the post below, outlining my views towards the 'amnesia' the market was experiencing, with irrational views about what the Fed would do next, and yes, that word 'inflation' was all important.
I think it's time to update my view on this with some added information - I have not waivered from the belief that the market is still seeing far too great a regime change when comparing to the past decade and a bit.
Many are still expecting there to be some sort of pent up demand from stimulus checks, savings and other lockdown related behaviours...
I still fail to see it.
What's going on now?
Just to display the 'concerns' over inflation (and as a more market related function of an increasing price level, bond yields), I've checked out the Google Trends data on searches for 'inflation' and 'bond yields'.
We're seeing multi year highs in searches for the two topics and you have to ask who is doing this searching, since it's unlikely to be people in finance, since they're going to know what the two are!
No, this is your everyday person; those outside of the financial world bubble, showing some concern over what's going on.
When I did a Google search for 'bond yields inflation site:cnbc' there are 320 articles containing those search terms JUST FROM THE START OF THE YEAR.
Then I looked at 'deflation site:cnbc'.
There are 30 articles since the start of the year.
Then when I added 'bond yields' to the deflation search, there is one analyst mentioning that deflation is a downside risk.
Contained in the articles with the search of 'inflation' are some commentators also expressing their lack of belief that there will be a big resurgence, but then majority are against this view.
Now, I am not saying that deflation is going to come - far from it.
What I am trying to get across is a picture painted that the mainstream financial media is viewing some sort of epic rise in inflation which will cause the Fed to act.
And we know what happens when the market is heavily opinionated to one side.
And I mean, just look at the episode summaries on the Macro Voices Podcast...
Literally all inflationistas...
And remember, I am not discounting the many that do think inflation will be transitory; I am merely having a go at those who are predicting we will face prolonged inflation, way past the base effects mechanism.
Setting the scene a bit...
Jerome Powell has been pretty solid on his view since the start of the year.
A view that, for once, makes policy very clear going forward - and the market is definitely throwing its toys out of the pram a little.
We expect that as the economy reopens and hopefully picks up, we will see inflation move up through base effects
On policy activity directly, he expects...
Transitory increases in inflation … I expect that we will be patient.
I do think it’s more likely that what happens in the next year or so is going to amount to prices moving up but not staying up and certainly not staying up to the point where they would move inflation expectations materially above 2%.
I don't think he could be more clear.
The market is in fact pricing in higher inflation at the moment, however.
Take a look at the 10 year breakeven inflation rate.
Here's a piece from PIMCO to understand what this shows.
There's a big problem with this measure.
The Fed has been buying Treasury Inflation-Protected Securities!
The Fed’s buying of TIPS could drive down TIPS yields and drive up the breakeven measure of inflation expectations.
So what we are perhaps seeing here is the market using a key measure of inflation expectations to gauge the macro picture moving forwards, without actually realising that it's distorted.
'But breakevens are high!' is probably the reply that you might get back if you mention a number of factors that contend with the longer term inflation view.
My question then would be to ask whether this would have some effect across the nominal yield curve, causing yields to spike higher and with greater speed, than they should?
This paper might prove key to answering what's going on here.
Such expectations proxy a situation in which the public does not understand the full structure of the economy and, hence, cannot anticipate the implications of policymakers’ intention to make up for past deviations of inflation from its objective.
By varying the number of economic agents (and, hence, components or blocks) in the FRB/US model who use VAR-based rather than model-consistent expectations, we can adjust the extent to which the public understands policymakers’ commitment to a makeup strategy and the degree to which aggregate economic variables react to news about the future.
The paper concludes with...
Makeup strategies work best when the public understands, believes, and reacts to policymakers’ commitment to offset misses in inflation from the 2 percent objective in the future.
To put this into context, we need to go back to Jackson Hole last year.
Back in late August last year, Powell stepped up to the podium at Jackson Hole (well, it was online), where he outlined a different policy path of Average Inflation Targeting.
Here's where an understanding of that above paper comes into play.
[I]f inflation runs below 2 percent following economic downturns but never moves above 2 percent even when the economy is strong, then, over time, inflation will average less than 2 percent.
Households and businesses will come to expect this result, meaning that inflation expectations would tend to move below our inflation goal and pull realized inflation down.
To prevent this outcome and the adverse dynamics that could ensue, our new statement indicates that we will seek to achieve inflation that averages 2 percent over time.
Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.
It's all about signalling.
The central bank can't automatically push prices up.
They can only provide behavioural signals to the market to either consume or save.
That is it.
The problem comes when there are broader issues at hand that might make the actual mechanism of achieving policy goals, defunct.
The main one that I have been focusing on of late is of course demographics, and the labour market, which are intertwined.
But now we're getting to more micro-macro (ha) factors that are alleviating some of the inflation narrative.
Check these charts out
Deutsche released this chart the other day.
To me, that's a pretty high proportion of people across the main working age groups, who are saying that they will spend their stimulus checks on a non-CPI affecting activity.
We can also look at the inflation risk premium (10y30y spread) vs the US10y.
If investors were indeed expecting inflation to be sustained, you would probably expect it to be far less stable through Q1 so far.
Instead, it hasn't budged.
This gives rise to a trade idea, which I am already in, which is to buy longer duration bonds.
This can be expressed through getting long TLT, perhaps not just yet, but I rebalanced a little because I reckon bonds are severely oversold between $130 and $140.
The dollar index is also one to watch.
The Eurozone growth revision just came out and it's not looking too pretty for the bloc.
Q4 was a revised miss at -0.7%, and with the euro up here, it's hardly helping EU exporters (read Germany).
YoY growth performed slightly better than expected, with a print of -4.9% vs 5.0% expected, but really in line with expectations.
I've mentioned before, but I don't think global central banks will be put under as much scrutiny from the Treasury with regards to weakening their currencies as they were under the Trump admin.
For me, this indicates a stronger push down for the euro, and as a product of this, the dollar should push higher, albeit choppy for the next month or so.
The ECB desperately want inflation, and they cannot do this without a weaker euro and this was indicated by the various members of the ECB referencing the exchange rate last year.
But then what does the converse mean for the dollar?
A stronger dollar dampens inflation prospects there too, and with the likelihood that the US will outperform other economies, that puts the Fed in a conundrum.
Back on Feb 8th, Janet Yellen said that she would not seek a weaker dollar and that exchange rate dynamics should be determined by the market.
A Biden transition team official did not respond to a request for comment about Yellen’s testimony. Biden, a Democrat, takes office on Wednesday.
The policy outlined by Yellen would be a return to a traditional posture after Republican President Donald Trump railed against the dollar’s strength for years, saying it gave other countries a competitive advantage.
That's a telling response from Biden, since it neither confirms nor denies that he is concerned about what other countries do.
But the disparity between what the ECB think about their currency and what the US thinks about theirs is grand.
Remember Draghi's 'whatever it takes' speech?
I don't believe the US has ever had to do that to maintain its status, since it is entrenched in the global economy and is not necessarily an integral political tool in the same way the euro is (without the Eurozone, the EU would succeed a lot of power).
This laissez-faire approach from Yellen is pretty indicative to me, especially at a time when the world is so heavily short USD.
Note the decrease in USD short positions at the end of February.
For me it signifies a change in thought amidst market participants.
The dollar had been battered through 2020 and now with the USD outperformance cropping up, we are seeing flows back...
A rotation after the 'rotation'?
Let's go back to yields.
We saw them peek above 1.6% on the 10y recently.
Why might this be significant?
Well, it means that large cap tech can no longer be seen as the blue chip, equity sovereign bond safe haven that they have been.
It makes them less attractive when a gilt-edged asset like treasuries can obtain a higher return.
Today though, we are seeing yields come off a little bit, and that 1.5% line in the sand could be a nice battleground to see whether tech can take back its mantle (I think it can and will do).
See I want to revert back to this chart which I've shoved down your throats a million times.
The 10 year yield has traded back to the 20y mean.
This isn't necessarily significant from a trading opportunity, but putting the first quarter's rate move into perspective is something we need to be continuing to do to ensure we don't get carried away with our view.
Yes, we've moved quickly.
But we are still looking at a deep downtrend amidst the backdrop of higher unemployment, lower savings and more people out of the workforce.
With regards to employment, NFP would have to increase MoM at the same pace it just did (376k) every month until April 2023.
Not only this, but the fertility rate has dropped over the last year.
People are cautious, and I do not see the rabid expansion in demand that is supposed to be out there.
Rather, it's a very valid return to the normal long term baseline, and that is certainly welcomed, although I think there is some change in policy that surely has to happen to alleviate risk distortions at the firm level.
I would not be averse to seeing a big bounce in tech today.
We had it in the Dow, the boomer index, yesterday so I reckon there's some opportunity here for the NASDAQ.
13,050 gun to my head for a target on NQ.
Let's wrap this up
I reckon we are still exhibiting both base rate effects and some signalling from the Fed in terms of 'make-up' policy.
Key for inflation is also the dollar dynamic and how that will effect consumption and trade.
But overriding both of these factors is the demographic change that we have experienced happen at an increased pace over the past year.
I think we will truly only be able to see the extent of this change at the end of this year, and taking stock of the labour market at every turn will be of vital importance.
This is a crazy demographic change and one in which is not mentioned enough.
We might become sociologists here at Macrodesiac since it seems that demographics and labour composition are what is at the forefront right now!