Federal Reserve in focus after that inflation print, as the BOE shows signs of pulling away from the pack
The key theme of this week has been the dramatic rise in inflation in the US and the UK, signs of stickiness in price increases are starting to show, however, the Federal Reserve has doubled down on its message that inflation will be transitory.
Earlier this week, Jerome Powell, who spoke at separate Congressional and Senate hearings, said that higher levels of inflation are likely to persist for some months to come, however Powell also said that the jobs market is still some way off from the progress needed to begin to taper bond purchases. The reassurances from the Fed chair that record low interest rates and expansive monetary policy is not going to change any time soon has weighed on the dollar, however, it has not given stocks the boost that you may expect.
House prices - why inflation could be sticky
Looking at the US CPI in more detail, the annual rate of CPI was 5.4%, while the core CPI rate was 4.5%, the highest level since September 1991. The key drivers of stronger inflation remain used cars and food prices, this is a knock for the US consumer as they need to eat and most of them drive.
Added to that, real estate and shelter/ rental costs, continue to rise across the US along with oil prices, which remain extremely volatile on the back of the Opec + discussions. The rise in real estate prices are a problem globally, for example in Sydney Australia, house prices are rising at a ridiculous AU $900 per day. In the US, house prices make up 30% of the CPI index, so if demand continues to outpace supply, as we expect, then inflation is likely to remain high for some time.
Markets trust the Fed, for now…
The bond market seems to be buying into the Fed’s narrative on inflation. For example, the 10-year Treasury yield was 1.48% at the start of July, this has fallen to 1.37% on Wednesday. The 2-year yield, which is sensitive to near term interest rate expectations, has also fallen from 0.25% to 0.23%, which suggests that the market is now pricing in less than 1 rate hike in the medium term, a dramatic shift from the rapid re-pricing of bonds that we saw after the June FOMC meeting.
The Fed chair did highlight that balance sheets remain strong for both businesses and households, which is what will continue to drive inflation higher in the coming months, but ultimately high inflation will be its own worst enemy. As prices rise, household savings will be spent faster than expected, which should lead to a consumer and economic slowdown in the coming months, especially as the rise in CPI means that real wage growth is now in negative territory. This is the logic behind Powell’s decision to keep monetary policy on hold during this period of strong price rises.
FX market and disappearing volatility
We are at an interesting juncture for financial markets. The dollar fell sharply on the back of Powell’s comments. It has traded in a fairly tight range in the past month, between 91.0 and 93.00, the lack of appetite to push the dollar index higher suggests that until we see a shift in tone from the Fed and a change in direction for the bond market, the dollar will be on the backfoot. GBP/USD should be a beneficiary of a weaker dollar due to the contrasting stances of its central bankers, however, GBP bulls have been left frustrated this week as the pound has not been able to capitalise on the dollar’s weakness. This is partly because the decline in bond yields has been global, with UK yields also falling. It could also be down to a general lack of direction in the FX market in recent months. Volatility for GBP/USD has been subdued in recent months and has settled around the 11 mark recently, we will need a significant fundamental driver to get this pair moving, in our view.
All hope pins on Jackson Hole
The Jackson Hole symposium in late August could be the driver needed to get the FX market moving. We may start to hear those at the fringes of the FOMC have the confidence to talk about the strength of the US economy, the strong inflation increases and the need to change policy. If that happens then it could give the dollar a boost. As it stands, the Bank of England seems to be pulling away from the pack and is willing to talk about the need for tighter monetary policy before other major central banks.
Earlier this week it was the deputy governor, who has a hawkish bias and fervently opposes negative interest rates, said that the BOE has underestimated the strength of the rebound in prices and that monetary policy may have to be tightened sooner than expected. This increases the probability of a hawkish surprise at the August BOE meeting when the latest Monetary Policy Report will be released. While FX volatility is likely to remain subdued, we do think that GBP/USD could creep towards $1.40 in the lead up to this meeting in 3-weeks’ time.
What’s moving in the stock market
Elsewhere, stocks remain fairly subdued, albeit at strong levels. Apple was a clear winner in the tech space after the latest feature for its newest iPhone was warmly received. US banks have also beaten earnings expectations; however, this has not been reflected in their share prices. The likes of JP Morgan, Goldman Sachs and Morgan Stanley have fallen moderately over the week. The reason is twofold, firstly, the market is expecting earnings to have peaked in Q2, a slower pace of growth for earnings in the second half of the year is keeping their stock prices subdued right now.
Also, some of the earnings for the likes of Bank of America and JP Morgan were down to the release of loan loss reserves, which is not really earnings. Added to this, rising inflation without rising interest rates is bad news for the banking sector, thus we could see stock indices and the financial sector struggle to break fresh ground in the near term.
Interestingly, although social media companies have been in focus this week after the England footballers’ online racist abuse scandal, it’s had no effect on their share prices. Ultimately, the tech lobby is powerful, and they will fight any legislation that could curb their business activities. The market knows this, added to this, low interest rates remain extremely positive for tech firms and the value of future earnings. Thus, although Twitter and Facebook are receiving some harsh criticism in the press and from politicians, it’s unlikely to hurt their share prices.
Chart: Tech firms ignore racism criticism