Lurking Beneath the Surface, Global Reflation

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Updated July 30, 2017

Breaking: *IRON ORE FUTURES IN SINGAPORE SURGE 5.9% AFTER CHINA PMI DATA, 9:27pm ET.    PMI came in solid, above its 12-month average. The China’s yuan fixing was set at the strongest level since October – a sign the PBOC doesn’t see any major growth concerns around the corner. 

It was a picture perfect week in Manhattan.  Dry air, a light breeze, the birds were chirping in central park and we witnessed a high of just  72 degrees in late July?  It was a treasure to behold.

No Stress, Relax

St. Louis Fed’s Financial Stress Index is right on five year lows.  Since February 2016 – just as the Fed arrested the U.S. dollar’s vicious accent – month after month financial conditions have eased.  Which begs the question?  From 2014-2016, as the strong U.S. dollar contributed to global dis-inflation – lower commodity prices – won’t the weaker dollar contribute to a surprise burst of global inflation?  Central bankers think they can contain the beast inside the market, but he’s in there – the unintended consequences are a plenty.

All is calm, but something is lurking beneath the surface of the financial markets.  Investors expect no surprises from the Federal Reserve this summer – this week the chances of a September rate hike fell below 10%.  It’s motionless seas as far as the eye can see.

How Low is the Bar?

In recent weeks, Fed rate-hike expectations have plummeted given the market’s myopic focus  on the Fed’s long promised balance-sheet normalization kickoff.  The odds a December rate hike are now priced at less than 35%, down from 70% just six weeks ago.

At this week’s Federal Reserve Open Market Committee meeting, there were a few developments lifting  eyebrows on Wall St.  Officials removed references to inflation declining “recently” and being “somewhat” below their 2% target in a portion of their eager monitored statement.

Five Year Look at the Dollar Index DXY

After lofty promises, uncertain fiscal policy out of Congress and the White House has laid a beating on the dollar.  After a post election surge to 104, she touched 93 this week.  A weak dollar is fueling the reflation trade globally – commodities and emerging markets have been major beneficiaries.  The CRB (Commodity Research Bureau ) index is nearly 10% higher over the last year, while the $EEM (iShares MSCI Emerging Markets ETF) is 25% higher since January.

There’s something on Janet’s (Fed Chair Yellen) mind. Commodity prices are rising at the fastest pace in five years.  The global reflation picture is nearly on the Fed’s doorstep.  In our view, there’s a surging probability the Fed gets thrown off track in 2H 2017, they are behind the curve.

Calm Inflation Expectations?

What’s copper telling us about inflation expectations here?  Believe it or not, one of the keys to 2H equity market stability is a sustainable path of sleepy inflation expectations.  Wall St. has taken their inflation outlook lower and lower in recent months.  Any surprises to the upside – in inflation expectations – would motivate the Fed to put forth a more aggressive withdrawal of policy accommodation (employ more rate hikes).  This outcome would be would be fairly disruptive in our view – signal that the Fed is behind the curve. 

Majority of Rate Cuts Globally are coming from Emerging Market Central Banks

Central Banks Globally in 2017

Rate Cuts: 43*
Rate Hikes: 20

*majority from emerging markets

Central banks in Brazil and Colombia cut rates again this week – despite many developed market central banks signaling less accommodative (Canada, U.S., U.K., ECB) monetary policies looking ahead, emerging market central banks still have the punchbowl in “fill’er up” mode.  So we have a large group of EM central banks easing monetary policy  with the U.S. dollar in the middle of its sharpest decline in five years – how do you spell “over-heat” risk?  Developed market central banks are “trying” to remove accommodation while EM bankers are adding at a 2-1 pace (see above)?

Coal’s 24% Surge Since June 1st, Hello Janet… Can you Hear Me Now?

Calm CPI (inflation data) in the U.S.A. has the Fed in relax mode but when you look around the world – other forces are driving prices higher.

This week, copper surged to the highest level in more than two years on expectations that demand in China will fuel a global shortage.  There were even plans in the country to curb metal-rich waste imports reinforcing a bullish outlook.  Benchmark three-month prices rallied as much as 2.8% to $6,400 a metric ton, the highest since May 2015, and were at $6,296 at 11:09 a.m. in London. That’s a fourth day of gains, and adds to Tuesday’s 3.3% jump, Bloomberg noted.

An Unsustainable Divergence, Global Pressures are Coming at the Fed

2012 through 2017

Yesterday’s news? U.S. PCE Inflation – the orange line above – the Federal Reserve’s preferred measure of inflation has declined for three straight months, to 1.4%, from 2.1% in February.   Tomorrow’s news – the global inflation backdrop is a major problem for the Fed – there’s far too much attention focused on the sleepy U.S. inflation picture.

Strong infrastructure investment in the first five months of the year is helping China reflate their asset bubble in desperate search of maintaining 6.5% growth rate in 2017.   The question remains – did those ten “mad men” in a room in Beijing put too much pressure on the gas pedal this time?

Over the Last Year

Iron Ore +50%
Copper +30%
Oil +16%
Gold -6%

Bloomberg data, July 29 2016 to July 29, 2017

Oil: Best Month in 12 Years

Total petroleum deliveries moved up 2.6 percent from June 2016 and were up by 1.0 percent from May to average 20.3 million barrels per day in June. These deliveries were the highest this year and the best month in since 2007.  For the second quarter, total domestic petroleum deliveries increased 3.0 percent compared to the second quarter 2016. For year to date, total domestic petroleum deliveries increased 1.6 percent compared to the same period last year. API Data

Lessons from 2014-2016

If we look back at the 2014-2016 regime and ask what did the Wall St.’s economists get most wrong in trying to read the Fed?  Far and away the answer to this question lies in global economic (disinflation) pressures. Back then, U.S. economists we far too focused on “robust” domestic economic data and were looking for 12 (yes twelve!) rates hikes (2014-2016) while ultimately the Fed only delivered two. Economists were blinded by the positive U.S. data and couldn’t see the deteriorating global macro risk factors tied to the U.S. dollar’s violent surge.  Global economic weakness was a drag on Fed policy – eventually forced the central bankers to lay down on their loudly promised rate hikes.

Today, many U.S. economists are asleep at the switch again.  They’re far to focused on “goldilocks” calm U.S. inflation data (see the orange line above).   In a dramatic reversal from 2014-2016, the global inflation picture could very well force the Fed into surprise rate hikes.   That picture perfect view over the Manhattan skyline could very quickly turn to darkness.  If the Fed is forced to take Mr. Punchbowl away too quickly, the global reflation revival could be the a summer spoiler.

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One thought on “Lurking Beneath the Surface, Global Reflation”

  1. I would expect the FED will let inflation creep up and not kill it with significant rate hikes. Yellen made some comments in the last few months about allowing inflation rise above the 2% target. The decline in the dollar and corresponding rise in commodity prices is helping to solve the ‘inflation’ problem for the Fed. Alan Greenspan made comments recently that we’re exiting stagnation and entering stagflation.

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