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How Long is Transitory?

Summary:
The Bank of England meeting on June 24th finishes this round of major central bank meetings.  At its last meeting, Bailey & Co reduced the weekly bond-buying.  The extension of social restrictions well into July provides added reason to be cautious, though economic activity is accelerating and consumer prices are rising faster than the medium-term target of 2% for the first time in three years.   British growth is likely peaking this quarter, perhaps a little above 4%. It would put H1 21 growth around 2.6%.  The pace of activity is likely to slow to around 2% in H2.  Growth in H1 22 may be closer to 1.5%.  Return to normalcy, indeed!The same can roughly be said about the US as well.  The quarterly pace and the year-over-year increase are expected to peak here in Q2 21 also.  Both the

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How Long is Transitory?

The Bank of England meeting on June 24th finishes this round of major central bank meetings.  At its last meeting, Bailey & Co reduced the weekly bond-buying.  The extension of social restrictions well into July provides added reason to be cautious, though economic activity is accelerating and consumer prices are rising faster than the medium-term target of 2% for the first time in three years.   

British growth is likely peaking this quarter, perhaps a little above 4%. It would put H1 21 growth around 2.6%.  The pace of activity is likely to slow to around 2% in H2.  Growth in H1 22 may be closer to 1.5%.  Return to normalcy, indeed!

The same can roughly be said about the US as well.  The quarterly pace and the year-over-year increase are expected to peak here in Q2 21 also.  Both the Atlanta and St.Loius Fed tracking GDP models see Q2 GDP at a little more than a 9% annualized rate.  The slowing, however, will be moderated by the mid-July start of two new initiatives designed to help lower and middle-class families: the Child Tax Credit (~36 mln families qualify) and the Earned Income Tax Credit that will run at least through December. As a result, above 3% growth may be achievable into early 2022, but by H2 22 and the mid-term election, growth is likely to return to the status quo ante below 3%.  

The preliminary June PMI reports are the data highlight of the week. They may pose some headline risk, but in the reaction function of policymakers and private decision-makers, the news will be of little consequence, confirming what is already known. The vaccinations are making possible the gradual and uneven social and economic re-opening.   Low interest rates, the fiscal stimulus of various stripes, and rebuilt savings appear to provide a friendly environment for robust economic activity.  The PMI is a useful snapshot of this process.  

Japan is the only G7 country where the composite PMI is below the 50 boom/bust level (48.8 in May). Tokyo and several other prefectures' formal state of emergencies are set to lift on June 20, but reports suggest lighter restrictions may be imposed ahead of the start of the Olympics and Paralympics. Holding the games during Covid was terribly unpopular in Japan, though public opinion appears to have softened a little. Nevertheless, the G7 statement recognized the importance of  holding the event safely and securely "as a symbol of global unity in overcoming Covid-19."  

The central banks of Hungary and the Czech Republic meet next week.  The market anticipates rate hikes, which have very little to do with the Federal Reserve.  Hungary expanded by 2% quarter-over-quarter in Q1.  The multilateral organizations (IMF, World Bank, and OECD) estimate Hungary's growth this year between 4.3% and 6.0% and between 4.7% and 5.9% next year.  CPI is up about 5% from a year ago and is running closer to 8% at an annualized pace over the past three months.  Its key policy rate sits at 60 bp.  To lift it to 90 bp, which the market expects, is hardly a tight monetary policy.  Next week's move will likely begin a sequence of hikes, and the market anticipates two hikes in the second half of the year.  

After contracting by 2% in Q1, the Czech economy's recovery is underway.   The market (Bloomberg survey) anticipates 3.5% growth this year and 4.5% next.  CPI is running around 3%, while the official rate target is a lowly 25 bp.  It is great that the Czech Republic was able to push its overnight rate well below zero in real terms, but that period is coming to a close, and it has very little to do with decisions made in Washington, DC.  The 25 bp hike appears to be discounted, and the participants appear convinced of at least one more hike this year, and possibly two.    

II

The Federal Reserve, the European Central Bank, the Bank of England, and the Swiss National Bank have argued that the elevated inflation levels are temporary. But, of course, not everyone agrees, and some hedge fund managers seem to be talking their book.  One claimed that US inflation is closer to 12% than the 5% of the national CPI.  Another claimed that if the Fed did not respond more forcefully, he would go "all-in" on the inflation trade.  He defined this as commodities, gold, and crypto.

Central bankers can be lampooned and criticized, but they are not the outliers on this issue.  The June survey by Bank of America found that 72% of the asset managers see inflation as transitory, with 23% saying it is permanent.  Still, the allocation to bonds fell to a three-year low.  Moreover, fund managers see the long commodities trade as the most crowded, eclipsing Bitcoin, which 81% saw  in "bubble territory,"  

Although it has been claimed that crypto, and Bitcoin, in particular, is a good hedge against inflation, the evidence is not there.  For example, the 30-month rolling correlation of the change in US year-over-year inflation and the change in the price of Bitcoin has mostly been inverted in its brief history. Moreover, it peaked in mid-2017 and in Q1 21 in the 0.35-0.40 area when it spiked.  

Gold is not as correlated to US inflation as some may think.  Again, running the correlation at the level of differences of the US CPI and gold on a rolling 30-month basis shows an inversion for most of the past seven years.  The main exception was from August through September 2018, and even then, the correlation was insignificant (less than 0.05). The correlation is slightly positive (0.015) now.  

To avoid confusion, the fact that both gold and Bitcoin have been inversely correlated does not mean they are significantly correlated with each other.  The correlation had been positive (30-month changes) from July 2017 through February 2021. After that, however, it turned negative, and an inverse correlation of about -0.32 is the most extreme it has gotten.  The correlation on more granular time frames (daily and weekly) is also inverse.  

The CRB Index, a basket of commodities, enjoys a better statistical relationship with the US CPI.  Before the pandemic struck, though, the correlation (30-month differences) was a little less than 0.2.  The co-movement intensified after Q1 20 and has been hovering around 0.40 for the past year, which is the upper end of where it has been over the past decade.  Remember, CPI (and PCE deflator) represent a weighted basket of goods and services.  Almost two-thirds of the CPI basket has little to do with commodity prices: shelter (not construction), medical care, education, communication, and recreation.  

Inflation expectations last month seemed to have been egged on by the rise in oil prices.  Since the end of last October, crude oil prices have nearly doubled.  They are third higher than they were at the end of 2019.  However, the 10-year breakeven (the difference between the conventional bond yield and the inflation-protected security) fell from almost 2.6% on May 12 to nearly 2.3% on June 10, even as oil prices continued to climb.  At the end of 2019, the 10-year breakeven was slightly below 1.80%.  It had not been above 2%, the Fed's target, since late 2018. 

Some think a dramatic rise in oil prices is inflationary.  Under the guidance of Trichet, the ECB hiked rates in mid-2008 primarily because it was feared that the rapid rise in oil would spur a general increase in prices.  On the contrary, a dramatic increase in the price of oil is a negative shock for the economy.  In the US, oil shocks have preceded the end of expansions.  The rally in crude (~135%) in July-October 1990 helped knock the US into recession.  The price of oil doubled in 1999-2000, and the recession hit in 2001. The price almost doubled from the 2007 low to early 2008, as the financial crisis hit.  

Central bankers like to maximize their tactical flexibility.  There is a good reason why Powell and Lagarde loathe, to be more specific. The Fed has not even defined the period that its "average" inflation target applies.  Surveys of economists are more precise.  The headline PCE deflator, which the Fed targets, despite the media insisting on calling the core rate the Fed's preferred measure, is expected to return to the 2% target somewhere around the middle of next year.   Just like the pace of US growth is near its peak, the year-over-year rate of inflation is also seen by economists to be peaking soon.  Economists see the eurozone inflation reaching maximum acceleration in Q4 before falling back to below 1.5% for most of next year.  The UK's CPI is expected to peak around 2.3% late this year and early next, before falling below 2% by the end of next year.  

 

Disclaimer 



Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.

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