Out of the woods? Perhaps not

By David Morrison  |  15/02/2018 13:37

This article looks at the different forces trying to pull markets in different directions

Inflation concerns

Yesterday brought the latest update on US inflation with the release of January CPI. The data garnered considerably more interest than usual on concerns that inflation is finally breaking to the upside after years of moderation. Investors got a wake-up call less than a fortnight ago following the release of Average Hourly Earnings which came in way above expectations. This sparked concerns that higher wage growth would force the Federal Reserve to raise rates by 100 basis points this year, rather than the 75 basis points previously anticipated.

CPI above expectations

Yesterday’s CPI came in higher than expected, adding fuel to fears that the Fed is in danger of being behind the curve when it comes to tightening monetary policy. US Treasury yields soared on the news, yet the dollar sold off. After an initial dip the S&P 500 recovered sharply, bursting above its 100-day simple moving average around 2,670 and going on to test resistance at 2,700 by the close. The rally continued today suggesting that the February correction could be over. Certainly, buyers will be emboldened if the index can hold above 2,700 going into the weekend.

Contradictions

But there’s at least one major contradiction with the market reaction to the inflation number. Equities are rallying as deflation fears have effectively evaporated. At the same time, investors seem convinced that the pick-up in inflation is tame and controlled. On the surface this would appear a perfect environment to be invested in stocks, particularly given the fiscal stimulus coming through in the form of tax cuts, infrastructure spending and regulatory reform.

Fed behind the curve?

But bonds are selling off on fears that the pick-up in inflation isn’t so benign. The Fed may be behind the curve so forced to hike rates more aggressively than previously forecast. Of course, even if there’s four 25 basis point hikes this year rather than three that will still leave the fed funds rate below 2.5% - historically very low. But the Fed is also reducing its balance sheet, so is no longer a buyer of bonds in size. Add in the fact that those tax cuts agreed on at the end of last year are unfunded while all the other fiscal stimuli come as there’s growing evidence of a pick-up in synchronised global growth. In other words, this fiscal boost is coming at the wrong time and there are fears that the US economy will overheat. This is pushing up bond yields, and rising interest rates are rarely good for stock markets.

Dollar sell-off

What about the dollar? Usually the greenback would rally on a pick-up in US Treasury yields. However, investors are concerned at rising deficits thanks to unfunded tax cuts and Trump’s other spending plans. It looks as if there could soon be a glut of US Treasury bonds as the country issues more government debt to fund the deficit. And this is the environment into which the Federal Reserve is unwinding its balance sheet. So while we would expect the dollar to rally as the Fed tightens monetary policy relative to other central banks, investors are turning away in fear that US national debt is set to soar.

Something must give

Going into Thursday’s open, the S&P was trading above 2,700, the Dollar Index had fallen back below 89.00, the USDJPY was trading at a 15-month low while the 10-year Treasury yield was at a four-year high above 2.90%. This situation is unstable and something must give. The question though is “what”?


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