Don't Panic, It's Transitory

Okay, very good morning to you. Hope you're doing well. It's Wednesday the 14th of July and going to have a chat with you about transitory inflation. I've got some graphics here that I think really sum up the rationale behind why the market moved in the fashion that it did yesterday. And then a quick look ahead, we've got another central bank decision. The Bank of Canada expected to taper for the third time, comes after a hawkish twist from the RBNZ overnight in New Zealand, which has promoted strength in their local currency. And then we've got Jerome Powell, of course, speaking today, speaking in front of the House Financial Services Committee in his semi-annual testimony. And what can we expect from that later on this afternoon? So just having a look at the charts overall in terms of market sentiment here at the European Open, and things are relatively flat. The major currency pairs just up ever so marginally. Uh, cable, you can see here, has had a bit of volatility on that wick extension. As you can see, if actually, if I put it down to a 5-minute time frame, you'll be able to see it better. We've had a bit of a pop in price and a fade. The pop, um, coming on the back of the latest UK CPI data, 2.5% for June, above expectations of 2.2%. So quite strong. In fact, very strong CPI numbers, upside surprise, but the market fading that move because don't forget the Bank of England said in its most recent policy meeting last month that inflation is likely to exceed 3% but would later fall back and should not affect monetary policy. So in a similar type of fashion, uh, somewhat to the Fed transitory argument, short-term price pressures like to lead to more increases there And so that number being somewhat after knee-jerk reaction faded on that initial move by the pivot level, um, by FX traders this morning. Otherwise, looking elsewhere, um, index futures are pretty flat overall, slightly negative. Comes after a touch softer close on Wall Street. The S&P and the Dow finished down about a third of 1%. The NASDAQ was basically unchanged, just slightly negative 0.02. Otherwise, um, oil had a bit of an extension yesterday, um, of recent gains. So we've moved right back up again to, to increase levels for WTI crude, and we're trading $75.08 at the moment, managing to get above— you can see, uh, that kind of double top of price action from the 7th and the 11th, and that's providing a bit of support. You've got the pivot tucked just just underneath there with that previous high seen yesterday morning. So quite a nice area of technical support now for price, and that'll be as we head in towards some oil inventory data a bit later on today. That did come with the— a few things yesterday to help promote some of the oil strength. Before I go into the APIs that came out last night, one was that supplies are set to remain significantly tight amid the deadlock among members of the OPEC+ alliance, as according to the IEA yesterday. And also the combination of that with the fact that the revival, if you like, of the Iranian nuclear deal is looking at a stalemate for the time being. Some commentary talking about they could meet in mid-August, nothing definitive as yet. And so any threat of a deluge of new supply hitting the market from Iran is looking ever increasingly less likely. Then we had the API oil inventories last night. So while I'm on the subject of oil, let's have a quick look at that. We had a drawdown of 4 million. Expectations were for a similar type number, a draw of 4.4 million. Cushing draw 1.585 million, gasoline draw 1.545 million, distillates at 3.699 million. So not really too much in the way of any reaction to the APIs, to be quite honest. And so yeah, technically I'm just keeping an eye on that as a range at the moment, that key area looking nice of support. Support on the downside. Fixed income definitely did see some moves yesterday, and this will take me into my charts then, and we can start talking a little bit about transitory inflation and why that argument is still alive and kicking and likely to be reaffirmed in summary by Powell later today, is my baseline kind of expectation. But here, this is the chart of the US 10-year. Or T-notes. And you can see here two distinct price movements yesterday, one being the US CPI shock and horror, very high number, knee-jerk reaction, and then recovery in pretty rapid fashion as the market turned around very quickly on the back of what was under the bonnet, which was again pressures emanating from more temporary factors. And then actually the more longer-lasting impact move came after we had a poor 30-year auction rounding off some of the supply this week. And actually, that is what really weighed on the more long end of the curve. And the curve is what we're going to talk about a little bit as well. So let me transition my screen and let's talk about inflation. So, um, definitely from a trading point of view, um, I, I was pretty quick to, to comment in our community and I was tweeting yesterday that as soon as that inflation number came out you always get that kind of algorithmic-led knee-jerk spike, and particularly when it deviates so far out of the consensus estimates and indeed the top end of the ranges. Yesterday's numbers on the year-on-year and core figures were exceedingly high, and you get that knee-jerk spike very much in reflection of that more binary process and the fact that then you get the traditional reaction, which is a shot higher in yields, the dollar, equities fall. They were particularly susceptible as well given they were sitting at record levels. But then the first thing to do, I think, with inflation metrics right now is go on to the BLS, the Bureau of Labor Statistics, and look at the actual report and identify where is it where these inflationary pressures are coming. And this is a look at quite a good graphic, I thought, which is talking about sharp price movements in a handful of categories accounting for a quarter of the total price index explain all of the unusually rapid inflation in June. And that has been the case in recent months. So here you've got three kind of distinct sections. You've got pandemic idiosyncrasies, underlying inflation, and then, then Jan '95 to Feb 2020 average inflation. Um, and so here you can see that tied to the pandemic, you've got used cars, new vehicles and parts, reopening categories. What is that? Well, that's things like restaurants, hotels, airline fares, recreation services, motor vehicle insurance, these types of things. And then you've got energy as well. And so if you actually look at just those, those areas alone, you can see it contributes largely to the, the bulk of the inflation pressure. And hence the reason why underlying inflation— so looking at groceries, housing, and all other areas— is still fairly benign in comparison when you extrapolate that out of the data. And hence the reason why the title, not to panic, and why the market faded that move very quickly. Um, even the used car vehicle section, you can see here, was such a large contributor, and even more so than the very high numbers that we had in previous two reports. So it was quite evidently clear quickly that the transitory argument would probably be kept alive on the back of those numbers. What goes up must come down. Most of the recent acceleration inflation compared to before the pandemic can be attributed to a handful of small categories facing idiosyncratic pressures. Now that should abate, and so too should the disinflation coming from the other side. And this is looking at contributions to change in yearly CPI inflation rate from Feb 2020 to June 2021. And as you can see here, energy, used cars, trucks, the successful reopening— all of these things have really been chiefly tied to that of the pandemic specifically. So taking that out, it's a lot more benign a picture than what the headlines would suggest. And so a few other things to be aware of then. Um, the movement in the yield curve was quite interesting yesterday. Effectively, if you think of the yield curve shape where a traditional curve means that the yield at the front end would be typically lower, and then it goes up in a uniform fashion the further out in time that you go— 10 years, 30, and beyond. What's happened yesterday is that the, the, the long end of the curve has been fairly fixed, whereas the short end has come up, and hence that curve shape has flattened a little bit. And what we've had here, as you can see, is the 2-year yield and the reaction that we had to inflation. So 2-year yields certainly did rise and maintain that move higher. Now, the ultimate understanding here is, is that in the short end, the timing for the Fed to taper is inevitable, and it is coming. And the fact that inflation is remaining at the levels that it is, irrespective of how much of that is transitory, the point being is, is that yields are going to rise in the short term. Now, if you actually start to look further out though, This is looking at the 10-year yield. You can see that the yield reaction was initially, as you would imagine, higher after inflation report, but then faded very quickly. And actually, it was weak demand in the 30-year bond auction, which didn't come until much later, 6 PM London time, that actually saw that move distinctly higher. So in fact, it's more that, um, we— the inflation figures are not really changing the longer-term outlook, but they're significantly altering the timing of short-term long-term policy tweaks. And so hence the reason why the short end has been more sensitive to hold on to those moves, where the long end is a little bit more questioning of what growth would look like in the longer term in that respect. The other final graphic then I thought was quite fitting with this kind of conversation is this, and this was looking at that timeline. You know, we've got a, we've got a predefined timeline with the semi-annual testimony today with Powell We've then got at the end of July the Fed meeting, the Fed minutes, then the Jackson Hole Symposium comes at the end of August, and then that leads us up into the September FOMC meeting where we get the new dot plots. So they're the, they're the, the predefined big events of time that we know. Now this is looking on the left-hand side at speculative dollar positioning, and what it's suggesting is it could turn, uh, net long ahead of Jackson Hole and this is based on the previous patterns of past hawkish Fed shifts. So this goes back and looks at things like the 2018 late cycle hikes, the '15-'16 cycle hikes, the taper tantrum back in 2013, and so on and so forth. You can access this graphic. I've shared it on my, my Twitter account. And what it's suggesting is that going into these events— and obviously this is just a function of what market positioning is— The Fed are kind of— have started to, I guess, accelerate conversations about tapering. And as such, then markets start to believe that that process is going to come in time. And so they start to build in a more long dollar position ahead of these big predefined events for then the confirmation to come. Now, what that would generally suggest then is that you get dollar positioning that tends to tighten around these events. And so subsequently lends its hand to more supportive dollar movements. And then you get that kind of profit taking as then the event in itself starts to transpire. And actually, when the Fed do begin, in effect, actual tapering, at that point, we've already way gone beyond pricing it in. And the confirmation of it is almost by the rumor, you know, by the pricing and anticipation of taper. Sell the fact that it's actually happening when it gets confirmed type movement. And as you can see here, this is looking at a price graph of looking at the weeks going in. You can see that dollar positioning typically takes about 4 weeks going into a major Fed event, and we're really within that window at the moment. And certainly these hot inflation numbers certainly build into that. And as you can see from the 2-year yield moving higher, but then as we go further out, we go 2 months out after. So let's say it gets formalized, by the time it gets to say end of this year when we're getting close to the point of the actual initiation physically of tapering, the dollar's already started to fade that move. So again, the market in simple terms is always forward-looking, and at the moment then the previous historical data points would suggest that the media— median change in dollar positioning around Fed tightening events. We're in that run-up phase at the moment, and certainly the CPI helped some of that yesterday. There was a Fed speaker yesterday who did comment. Fed's Mary Daly said that the June surge in US inflation will likely be temporary. She actually specifically referred to used cars, as we've just looked at, as a major contributing factor to the temporary nature of inflation. She did say she was bullish about the economy going into the fall and said it's now appropriate for the central bank to begin discussing scaling back its monthly asset purchases, which could start at the end of the year or early 2022. So again, in fitting with that explanation of that yield curve reaction. All right, well, that, you know, that's pretty much it on that side. For any of these graphics, if you do want to check them out, if you need them as a reference point, again, they're all available. I've tweeted them this morning from my account. A few things elsewhere overnight. The Kiwi dollar is really, uh, on fire at the moment. It's managed to break above a short-term technical top. Let me just bring up the chart and I can in fact show you. So just bear with me one second. It's looking at the Kiwi dollar. You can see this, this move we've had here initiated from the overnight session. Has propelled us above this double top that we've been trading here, and through the 9th and the 12th. And in fact, actually, if I squeeze that price, you can see that's been quite a significant level for the Kiwi, um, just above this 70 mark. And so we've seen some acceleration here, um, to the upside, and actually coming in close proximity to— if I just mark this up, you've got those highs that we've seen here on the 7th, and also these areas here. So Um, interested to see probably as a short-term target here for any further run-up in the Kiwi. Uh, 70.36 in the futures, we're trading within about a 10-pip range at the moment. So you can see we shot up, broke through that double top, used that as a bit of a floor of support, and then for this push-up as Europe has come into the market. So, you know, why is the Kiwi firming up? Well, this is the situation overnight. You had The RBNZ held the cash rate at 0.25%, but they said it would halt bond buying under its large-scale asset purchase program by July 23rd. The statement omitted a previous reference to the need for considerable time and patience to achieve its inflation and employment goals. Investors now actually, from a market perspective, are pricing in a hike, a rate hike in November, up from 82% chance before the statement. And in fact The market is now pricing a 76% probability of a move in August now that they've actually going to end their bond buying. Again, that sequence generally then a period to see how the economy performs and the market adapts to that removal of the stimulus and then looking to initiate the rate hiking cycle, which markets are quite bullish on in New Zealand at the moment given the way they've managed to contain the impacts of COVID the underlying inflationary risks and so forth, to then commence their tightening cycle. The other central bank we've got today, of course, is the Bank of Canada. They're also due to come out later on today. And what can we expect from the Bank of Canada? Well, they're set to announce another round of tapering, and in fact, this will be the third round of tapering from the BoC, and they're likely to reduce it from two to $2 billion Canadian worth of purchases from 3. They've basically gone from 5 to 4 to 3 and so forth, scaling it down in each taper. That I don't think will come as much a surprise. I think all economists surveyed are unanimously expecting that to materialize. So just keeping an eye out for the types of commentary that comes out and around that release later on today. And then a quick look at the calendar for today. So the UK CPI is already out. I said. So then we're looking for the next major releases, which isn't going to come to the afternoon. We get the US PPI numbers, the Bank of Canada comes at 3, the DOE oil inventories then following the APIs last night at 3:30. Got the Fed's Beige Book tonight at 7 PM. But obviously in front of that you've got Jerome Powell presenting the semiannual monetary policy report to the House Financial Services Committee. Remember, He'll repeat that to the Senate. The House is always the more important one because it just gets recycled to the other chamber of Congress on Thursday's session. So definitely keep an eye out for that. And of course, this comes after the biggest rise in US consumer prices for 13 years in America. So of course he's going to be challenged on this. But my expectation is he's not going to deviate given the aforementioned reasons about the transitory nature of these price pressures. So although it's important to monitor what he says, I don't think you're going to get too much out of it right now, to be honest. But the risk here is hints towards tapering. If it comes from Powell himself, you could see a bit of a hawkish reaction to that, further acceleration of dollar, perhaps a bit of movement in short-end yields. And that could weigh on things like gold, some of the precious metals. And some of the major currency pairs if that were to happen, because I would say it's probably a lesser expectation that he'll say anything too much today. So if he did come out a bit more explicit with the hints on tapering, certainly you might get a short-term more hawkish reaction. Other speakers: ECB Schnabel speaking at 1:45 this afternoon, Bank of England Ramsden speaking at 6 PM, and non-voting FOMC member Neel Kashkari speaks at 6:30. And then from an earnings perspective, following JP Morgan and Goldman Sachs, they did actually finish lower yesterday. They underperformed the general market by about a percent or so. Both of the banks pretty similar in terms of the composition. The lack of kind of volatility through Q2 saw their trading activity decrease, which we were talking about yesterday. It's very much expected, but IBD asset management divisions were particularly strong, and, and that was the kind of breakdown of the investment bank. And you've got Bank of America, Wells Fargo, Citi, and BlackRock all coming out today, so more financial names ahead of the opening bell a bit later on. All right, gonna leave it there, let you guys get on with the day. So hopefully that was useful, and any questions at all, just drop me a line, let me know, I'd be happy to help. Thanks very much. Take care.