What might be true
Over the past several weeks, we’ve reported on various shades of the inflation debate since global vaccination efforts drove a global economic rebound. It seems that any time we receive some upward inflation signal, the financial press automatically suggests that a path of higher interest rates is likely to follow. It’s like a ‘bless you,’ if you will: an instinctive expression that requires no thought. The truth is that most people don’t distinguish between signals of inflation, they’re instead simply conditioned to believe that upward inflationary pressure leads to higher rates.
To briefly outline the dynamic, central banks raise interest rates—which raises the cost of borrowing—to combat an overheating economy. It’s known to be a blunt instrument that doesn’t allow for targeted adjustment to parts of an economy, although each sector of the economy has a different sensitivity to rates. Quantitative Easing (bond and, sometimes, equity purchases) is slightly more nuanced in its impact on the economy because most central banks have included purchases of private sector instruments as well as government securities into their programs at this stage. That said, neither tool improves the supply-side inflationary impacts which make up a large part of our current experience; in fact, they may make it worse. For example, a firm may be subject to higher costs of shipping, raw material inputs (supply-side inflation) and have their cost of financing increase as well (higher interest rates). The latter policy move simply doesn’t fix the former effect.
Viewed from that perspective, we need to see a specific, sustained type of economic expansion to warrant higher rates. Indeed, setting aside the muddy public discourse on inflation, we’ve not seen a compelling argument that this economic activity is waiting in the wings. Those that suggest a curtailment of QE purchases—the most likely upcoming policy move from the Federal Reserve—will lead to higher rates should reconsider the Bank of International Settlement studies. Among other conclusions, these suggest the total stock of a central bank’s securities is by far the larger driver of interest rates, not the size of monthly purchases. This means that the Fed winding down their asset purchases wouldn’t meaningfully lift interest rates; it would require a subsequent plan to sell their portfolio to do that.
Bottom Line: It’s the mark of any decent analyst that they can articulate the combination of effects that might make their forecast wrong. So, let us flip this coin and talk about what factors should be present for rates to move meaningfully higher.
- We’d wish to see a normalisation of commodity prices and transportation bandwidth; this is largely dependent on Covid variants and vaccination rates in emerging markets.
- We’d also like to see employment sustain its growth past the pre-Covid employment level. US labour force participation data implies that the US is down 5.25 million jobs since the onset of the Coronavirus pandemic and about 21m jobs short of the late 90’s highs.
- Lastly, we would expect to see a drop-off in asset prices—record amounts of cash sitting on the sidelines waiting for a productive purpose end up raising property prices, among other stores of value. For example, Gold topped out near $1900 per troy ounce in late 2020 and remains nearly 200% of the post-global financial crisis levels in 2009.
The week ahead
Sterling was muted last week as it failed to gain any real direction across pairs, trading range-bound against the Dollar and selling off against the Euro from highs of €1.1830 to €1.1750 this morning. Consumer Price Index data out on Wednesday will be in focus for markets. A higher reading could help support the Pound, with increased expectations of earlier tapering by the Bank of England. Conversely, a weaker reading than expected could be a damper on the Pound in the near term. Elsewhere, Coronavirus cases are beginning to tick higher once again, with 26,750 cases reported on Sunday. The rollout of the vaccine to 16 and 17-year-olds by the 23rd of August is a boost, as it's reported that 89% of people have now had one dose of the vaccine, while 76% have been fully inoculated.
- The asking price for homes in the UK has fallen over the last month according to the UK Rightmove House Price Index which read -0.3% in August versus 0.7% in July.
- The latest update in Unemployment Rate is scheduled to be announced tomorrow, with the current figure standing at 4.8%.
- UK CPI y/y is forecast to fall slightly lower to 2.3% in July, after printing at 2.5% in June. Meanwhile, Core CPI y/y is expected to move from the June figure of 2.3% to 2.1% in July.
- Retail Sales m/m are expected to remain unchanged in July from June’s 0.5%.
The Euro managed to gain 0.53% against the Dollar despite the weak Eurozone economic sentiment published last week. The European Central Bank also appears to be making a move regarding the Pandemic Emergency Purchase Programme (PEPP). George Buckley, Chief UK & EU Economist at Nomura, suggests that the ECB could start discussing tapering in September and reach a decision in December. With Coronavirus cases continuing to rise on the continent, many market participants expect the PEPP to remain unchanged until at least the end of the year to prevent a sharp rise in bond yields and the erosion of any economic progress made so far.
- Flash Employment Change q/q is expected to push 0.2% higher in Q2 2021 compared with the -0.3% contraction in Q1.
- Final CPI and Core CPI y/y are forecast to remain unchanged at 1.9% and 0.7% for July.
- German PPI m/m is scheduled for release on Friday with markets expecting 0.8% in July, following a reading of 1.3% in June.
The US Dollar Index finished 0.45% lower last week, as softer CPI and Consumer Sentiment dragged on the performance of the Greenback. Better-than-expected retail sales data tomorrow could help drive the monetary policy tapering narrative further this week, with the Federal Open Market Committee due to meet on Wednesday. Markets have all but priced in tapering, while the market reaction is likely to hinge on the timeline for interest rate hikes. Raphael Bostic has pencilled in late 2022 for the first-rate hike with Core Personal Consumption Expenditures inflation reaching, by his estimations, 2.00% in May. Coronavirus still has the potential to knock the shine off the economic recovery with case numbers rising 700% since the start of July, as 90 million people remain unvaccinated.
- US Retail and Core Retail Sales m/m are forecast at -0.2% and 0.2% for July after coming in at 0.6% and 1.3% respectively in June.
- Industrial Production m/m for July is expected to rise slightly to 0.5% from 0.4% in June.
- Federal Reserve Chairman Jerome Powell will be speaking on Tuesday and the latest FOMC Meeting Minutes will be released on Wednesday.
- Markets are expecting a slight increase in Unemployment Claims for the week ending August 14th to 381K, from 375k in the week ending August 7th.
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