Traders on the sidelines ahead of big events
Most financial assets have been stuck in a narrow trading range so far this week. The dollar is near where it started the week, US equities remain flirting with the record highs reached in early May, and European stocks are struggling for direction. This boredom is about to change in the next few hours when the European Central Bank meets, followed by US May inflation figures.
The only interesting price move was in bonds market. US 10-year Treasury yields closed below 1.5% on Wednesday for the first time in three months. The benchmark has dropped 17% from March’s peak of 1.78%. If someone is observing the moves in Treasury yields without knowledge of recently released economic data, it would feel like deflationary pressures are building and the Federal Reserve may be headed towards further easing in monetary policy.
Meanwhile, all data releases in the past several weeks are adding more evidence of increasing price pressures. The highest component of the US ISM manufacturing and services indices have been “prices paid” which represents business sentiment regarding future inflation. Rising inflation has also become a major concern for US small businesses according to the National Federation of Independent Business. Jobs openings reached a record 9.3 million in April according to the US Labor Department’s JOLTS report, suggesting further upward pressure on wages. The factory of the world “China” has seen its producer prices increasing 9% in May compared to a year earlier, which means imported goods will see significant price hike. Commodity prices remain elevated with Oil, base metals, grains, and softs trading near multiyear highs. Are we likely to see inflation becomes sustained over the next several months, quarters, and years? No one knows, but surely there are more reason to be concerned.
So why bond yields are dropping when they are supposed to do exactly the opposite? It’s because the Federal Reserve have been convincing market participants that employment is all what matters now and given jobs data disappointed for the second straight month in May, there will be no tightening in policy soon.
This narrative may change if inflation becomes a threat that may go out of control. If today’s CPI comes with a significant upside surprise, say above 5% or near 4% when excluding food and energy, this is likely to lead a huge spike in yields and the US dollar. However, a negative surprise will strengthen the Fed’s beliefs that inflation pressures will be transitory and hence, no rush in tightening anytime soon. That in turn should continue dragging the dollar lower, and equities likely to make new records.
Before the US CPI release, traders will be carefully watching the European Central Bank’s monetary policy announcement. The Eurozone outlook is definitely more optimistic in the second half of the year compared to the first. However, will it be enough to encourage tapering of asset purchase or signal any rate hike in the foreseeable future? Any talk of tapering asset purchases will encourage Euro bulls to send the single currency higher but avoiding such talks could drag it below 1.21.