Post date: 14/06/2021 13:08
The blow-out inflation report out of the US outshone the ECB June meeting, but the market reaction was counterintuitive, to put it mildly. Even though inflation in the US is now running at 5% on the year, and the price increases are broad based, US traders clearly bought the Federal Reserve line that it is all transitory and actually sent yields lower for the week. In the emerging market space, performances were mixed, and generally the worst-performing currencies of 2021 enjoyed a good week and vice versa, in what looks to us as generalized position squaring.
All eyes are now on the June meeting of the Federal Reserve this Wednesday. Fed officials pledge to ignore inflation readings in the short term will be severely tested given the ugly numbers we have seen in the last two months but we still expect the pledge to hold and serious discussion on tapering to be punted to September, when the outlook will be clearer. Also on tap is UK May inflation on Wednesday, which will show the degree to which reopening is causing similar price pressures to the US, and the Bank of Japan meeting Friday, where no significant action is expected.
The most important data point out last week in the UK, April monthly GDP growth, was fairly encouraging, bringing the 3-month running rate from -1.5% to +1.5% in a sign of the positive impact the reopening is having. The event was largely priced in by the market, and sterling did not move much against any of its G10 peers last week. This week’s employment report on Tuesday will be blurred by the various support schemes and we do not expect it to move markets. Inflation out Wednesday may be a different matter. Inflation surprises are becoming the norm everywhere, and if the UK follows suit, we could hear increasing market chatter about the Bank of England tightening earlier than expected, which would buoy the pound.
As we expected, the ECB made no changes to its policy settings and President Lagarde sounded alternatively noncommittal and modestly dovish. However, there were strong positive revisions to the 2021 forecasts for inflation and growth. Crucially, the ECB now expects the Eurozone economy to reach the pre-pandemic level by the end of 2021. The ECB also sees inflationary pressures as transitory. The pace of PEPP purchases was also left unchanged. All in all, a dovish outcome. We expect the debate between hawks and doves to pick up strength and become significant in the September meeting. It is likely that the inflation numbers between now and then will surprise to the upside.
The market reaction to the huge upward surprise in the May inflation report left us somewhat befuddled. We have no choice but to resort to the unsatisfactory explanation of “position adjustment” to explain it. Yields dropped massively in spite of an inflation rate that is running at a 5% annual rate, with the perhaps more meaningful core rate running at 3.8% for the year and a whopping 8.3% annualized rate over the last three months. The dollar rallied modestly on these developments, as traders keep their powder dry for this week’s key Federal Reserve meeting. While the rhetoric from Chair Powell will quite likely remain dovish and dismissive of the inflation surprises, we expect to see some move in the “dot plot” where each member puts down his or her best guess as to the level of rates in each of the next three years. We think there may be a majority that expects a hike no later than 2023, and see potential for the US treasury market to give up all of last week’s gains and then some, with a somewhat unpredictable effect on the dollar.