Spring, Summers, Nuclear Fall(out), Or Winter?

By Michael Every of Rabobank

Yesterday’s US CPI was radioactive. Headline and core were both 0.4% m-o-m, and 3.5% and 3.8% y-o-y. Energy prices were higher, which is bad. Shelter inflation was stuck at 5.7%, which is worse. But worst of all, services excluding shelter were 0.8% m-o-m and 4.8% y-o-y. In short, this is ammo for those who warned inflation risked getting stuck at 3-4%, especially against the backdrop of other data, including the small business survey earlier this week where inflation was seen as the #1 problem again.

Market reactions were extreme because it has been so very wrong this year – again. US 2-year yields shot up 23bp, and this morning are 4.97%. US 10-year yields soared 21bp, not helped by an ugly auction, and are 4.56% at time of writing. Stocks fell, and the dollar soared, with USD/JPY over 153 for the first time since 1990. Commodities were generally hit.

Then the Fed minutes’ tone, and that of President Biden, remained that rates are going to fall anyway at some point soon: I like the Seinfeld meme about that.

ladies and gentlemen, BRRRRANDON:
“Before the year is out, there’ll be a rate cut” pic.twitter.com/nZ5qjNEMQ8

— zerohedge (@zerohedge) April 10, 2024

Our Fed-watcher Philip Marey has now shifted his first expected Fed cut from June to September, with only two cuts seen in 2024. Moreover, if Trump wins the US election and introduces tariffs, Philip sees only another two cuts before the Fed has to stop. In other words, the Fed Funds floor would be 4.50%, where the US 10-year is trading, implying no term premium.

For markets drinking their own saliva for rate cuts in January, then spring, then summer, the prospect of having to wait until fall/autumn is awful: it’s almost a nuclear fallout for some. But it can be worse, as a cacophony of jaw-dropping rates commentary shows.

We just saw a call for a 50bp Fed cut in June, suggesting economic collapse; that shelter inflation can’t come down unless the Fed cut rates to free up the US housing market (Turkish President Erdogan will be feeling proud); Larry Summers warns the Fed should hike; and Mohammad El-Erian says it should raise its CPI target to 2-3% in a supply-constrained world.

Two years ago, I argued if we couldn’t keep past levels of goods deflation in a de/re-globalising world at war, which looked hard, more disinflation would have to come from services, which nobody would want to see when it actually had to happen, so very hard choices would loom. That’s very much the dynamic we appear to be facing, even if not all of us are facing up to it.

Will that stop other central banks from cutting, as their economies underperform the US? The Bank of Canada left rates at 5%, as expected, and Christian Lawrence notes they are still minded to start cuts in June or July. Today it’s the ECB, where Elwin de Groot and Bas van Geffen expect no change, and President Lagarde’s comments are seen keeping the door open to begin cuts in June. The BOE will follow: Stefan Koopman says in August. (Please also see his fantastic Bank of England review preview: the points he raises about how policy decisions are made apply to all central banks.) Then again, the BOJ are now predicting 2% CPI ahead, so they should presumably be hiking much more than just another 10bps.

Obviously, that rates dynamic favours USD vs. EUR, CAD, and GBP: and one also wonders how far any divergence can be pushed before G7 FX crosses start looking like JPY. On which, the Japanese authorities are not ruling out intervention: but what can that really do?   

Meanwhile, the real-world backdrop I was warning is not inflation-friendly risks getting far worse.

Both US and Israeli officials expect an imminent Iranian attack on Israel, which has made clear will see it retaliate directly against Iran; and there are suggestions the US might join Israel in a counterstrike as the US CENTCOM commander heads to Israel to coordinate. US President Biden, critical of Israel’s war in Gaza, has stressed an “ironclad” promise to stand behind Jerusalem if Tehran attacks it. Also, recall Iran is also a threshold nuclear state. Understandably, Brent oil, after dipping post-CPI, went straight back up again to $91. If we get escalation, where does one place US CPI? And Fed Funds? Or other central banks’ rates?

On another geopolitical front, the US is to deepen its defence pact with Japan. For one example, US Navy vessels will now be repaired in Japanese shipyards. Japan, a leading middle-power advocate for the “rules-based order”, is now part of “Team US”, and so stands behind the Philippines in its continued tense stand-off against China in the South China Sea. Bloomberg today refers to this pact, plus Australia (where the PM says, “Make more things here”), as NATO 2.0 for the Indo-Pacific: meanwhile, Russia and China warn NATO 1.0 to stay out of it. If you want a reason for the US to provide FX support for JPY, it would be this realpolitik – not the recent market dynamic.

China set CNY fixing at 7.0968, a record 1,579 pip spread to expectations. Clearly, Beijing doesn’t want to get into competitive FX devaluation under US CPI-related pressure. *If* it is going to act on the currency, expect it to happen when everyone is focused on something else. Yet as Chinese CPI rose only 0.1% y-o-y vs. 0.4% expected, and PPI was -2.8%, there seems to be a need to do something – and real stimulus has so far been ruled out despite Yellen telling China that’s what they should do when she was there: stimulate consumer demand, while the US stimulates its own supply. If only the world economy was coordinated like that, and the way the Chinese FX market clearly is!

Relatedly, Europe made a geopolitical splash in a bureaucratic way via a 703-page tome that shows China is not a market-based, but a state-capitalist economy: as 2/3rds of German firms in China complain they face unfair competition from locals. The report will likely open the door to far more EU trade actions against China, and subsidies to counteract it; that’s as the European Commission, the top EU competition regulator, approved a €2.2bn German state aid scheme for industry. So, yes, industrial policy and protectionism are here to stay; and they are both inflationary long before they are deflationary.

To conclude, the US CPI data were a shock; the flurry of wild rates commentary we have seen since underlines how tricky the path forward is for traditional thinkers and central banks alike; and geopolitics risks going from bad to much worse.

Spring – Summers – Nuclear Fall(out) – or Winter?