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Rising inflation to test Federal Reserve messaging

Powell set to lay out Feds view of US economy

While markets in Europe managed to see another positive session, US markets were less ebullient with the Dow falling for the sixth day in succession, although the S&P 500 did manage to post another record high before also finishing the session lower.

Despite the lower finish for US markets, European stocks look set to open higher as investors look towards today’s China data, US Federal Reserve meeting, as well as the latest UK inflation numbers.

Chinese retail sales are expected to slow slightly in May, down from the 17.7% year-on-year rise in April, with an increase of 14%. While this is high relative to the levels seen at the end of 2019, it must be remembered that consumer spending patterns were very subdued a year ago, with the Chinese economy slowly coming out of its February lockdown. May retail sales last year declined -2.8%, so the comparatives will be somewhat skewed for a while yet, although we do know consumer sentiment and demand is slowly improving. Industrial production is expected to rise 9.2%, a modest slowdown from April’s 9.8% rise.

Before that we have the latest UK inflation numbers, which aren’t expected to move the pound that much even if they do come in higher than expected. This is a significant shift in expectations than was the case a few weeks ago, when there were concerns that rising inflationary pressures might be more than transitory, and much more persistent. These concerns became more amplified at the start of the year in the wake of supply chain, as well as Brexit-related disruption, along with similarly big surges in US and Chinese CPI.

These concerns served to push bond yields up from where they were in January, with a lot more talk about when central banks might look at paring back some of their monetary policy support measures, over concerns about economic overheating. The Bank of England has already started to lean in this direction, recently cutting the amount of bonds it buys on a weekly basis, although it cited operational reasons.

The rise in factory gate and commodity prices have merely served to reinforce these concerns, and we are already starting to see early evidence of having to pay higher prices, notably in terms of higher air fares and other transport costs, however these appear to be merely a symptom of normalisation from the big falls we saw a year ago when the economy went into lockdown, and as such are unlikely to be repeated, which means they can be viewed as mostly transitory in nature.

Food prices more generally haven’t been showing obvious signs of upward pressure, which is probably the more important narrative. That’s not to say we won’t start to see sharp upward moves in headline CPI over the coming months. We’ve already started to see it in the PPI numbers which have been trending higher since the end of last year when they were at 0.2%, hitting 9.9% in April, with an expectation of moving to 10.6% in the May numbers this morning. If this translates into a leading indicator for CPI, we could start to see a move above 2% CPI over the summer months, even if we don’t get there today. In April, headline CPI jumped to 1.5, from 0.7%, while core prices rose to 1.3%. If the US experience is any guide, we will see further jumps in both of these numbers today, with May CPI expected to rise to 1.8% and core prices to 1.5%.  

Yesterday’s economic data from the US didn’t add that much to the sum of what we know about what’s going on in the US economy, and is likely to happen over the next few months, as we look to today’s Federal Reserve rate decision and chair Jerome Powell's press conference. The decline in US 10-year bond yields from their 1.77% peaks at the end of March would appear to suggest that investors are starting to believe the central bank narrative that the rise in inflation pressures are transitory in nature, despite rising evidence that it could be much more persistent than might be comfortable.

When the Federal Reserve last met at the end of April, the central bank was able to acknowledge the improvement in US economic data, while also reiterating that it remained a long way short of the type of “outcome-based” data needed to alter the current policy stance, nixing any prospect of a taper in the near term. It is this consistent stance that has helped mould the narrative that has seen yields come down from their highs this year.

Powell’s response that one bumper jobs report does not make a policy change when asked one particular question was instructive, when making reference to the March jobs report, which at the time saw 916,000 new jobs added to the economy. Since then, the picture has shifted somewhat with the figure revised lower to 770,000, and two subsequent below par jobs reports in April and May. Powell went on to mention at that April press conference that there were still over 8 million more Americans who were out of a job than there were in one in February last year, and as such the Fed would need to see “substantial further progress” on its full employment goals, for any change in policy to be considered. This holds as true now as it did then, although the picture is a little different now despite the two weaker-than-expected jobs reports.

If the number of jobs being added had been closer to an average of 1 million a month then we might well be having a different conversation, but even with the slower pace of jobs growth in the labour market, it is still becoming harder to make a case against a slight change in policy, particularly in terms of the beginnings of a discussion of a taper. This is important in terms of the current level of monetary accommodation, which at $120bn a month seems a little excessive when looking at the underlying economic numbers.

Job growth may well be on the low side, and while the number of Americans out of work is still over 7 million higher than it was in February last year, this ignores the fact there are over 9 million unfilled vacancies on the other side of the ledger, which means that there isn’t any labour market slack left in the economy, despite the higher unemployment rate.

We’ve already heard from the likes of Robert Kaplan of the Dallas Fed, who are now calling for there to be discussions on a policy taper with inflation currently trending at 5% on an annualised basis. The Fed currently believes that the recent increase in inflationary pressures is transitory, and should fall back as the year progresses, and base effects fall away. There is certainly a lot of evidence to support this, however central bankers seem to be making an awful lot of assumptions which could come back and bite them if they turn out to be wrong, especially when you look at the number of companies who are passing price increases on to consumers. This is hardly transitory if the rebound in prices overshoots the falls from last year and starts to constrict consumer demand.

With these concerns very much front of mind, it would not surprise if Fed policymakers start to lay the groundwork for a taper sometime in the autumn. If done properly this need not spook the market, as it would acknowledge that the Fed has a plan in place for its reaction function as the economy improves. For now, it would appear the Fed is on autopilot through the summer, and that’s fine for now with markets appearing to be giving it the benefit of the doubt. It wouldn’t take much for this to change if the data starts to consistently surprise to the upside, in turn helping to push yields back up again.

EUR/USD – holding above the 50-day MA for now, but the downside bias remains, while below 1.2200. A break below 1.2050 could well open a move towards 1.1850.

GBP/USD – slipped to the 1.4035 level yesterday, but still holding above the 1.4000 area, and the 50-day MA. A move through 1.4000 could see a move towards 1.3900. Resistance still at 1.4200 with a move through the 1.4240 area targeting the 2018 peaks at 1.4375.  

EUR/GBP – still has resistance at the 0.8640 area which keeps the bias towards the downside, and a test of the 0.8560 area. A break below 0.8550 opens up the recent lows at 0.8480.  

USD/JPY – while above the 109.80 area the bias remains for a move up through 110.40 to target the 111.00 area. A move below trend line support now at 109.50 opens a move back towards the 108.60 area on a break below 109.20.

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