With inflation soaring and Powell praying for a ‘transitory’ miracle, the problems facing the Fed are accelerating, not slowing down.
“I have the blues, I have the inflation blues”
– BB King
To explain, I wrote on September 24:
I have repeatedly warned that the only way the Fed can control inflation is to increase the value of the US dollar and decrease the value of commodities. However, with the commodities fervor accelerating on September 23 – a day the USD index fell – price action should worry President Jerome Powell. Therefore, FOMC attendees’ inflation expectations for 2022 are likely wishful thinking, and they might find that a faster cash drain (which is bullish for the US dollar) is their only option to control price pressures.
At this point, with energy prices increasingly out of balance and WTI on track for its seventh straight week of weekly gains, the S&P Goldman Sachs Commodity Index (S&P GSCI) has been on fire recently. For context, the S&P GSCI contains 24 commodities from all sectors: six energy products, five industrial metals, eight agricultural products, three livestock products and two precious metals. However, energy accounts for about 54% of the index movement.
Please see below:
To explain, the green line above follows the current S&P GSCI rally from the bottom, while the red line above follows the S&P GSCI rally from the bottom in 2009-2010 (following the global financial crisis). If you analyze the middle of the chart, you can see that the S&P GSCI has moved completely away from the 2009-2010 analogue. For context, at this point in 2009-2010, the S&P GSCI had rebounded 77% from the low. However, at the end of October 5, S&P GSCI is now up 154% from April 2020 low.
Moreover, with rising energy and material prices exacerbating the inflationary spiral of rising costs, signs of stress remain abundant. For example, IHS Markit released its US Manufacturing PMI on October 1. And while the overall index fell from 61.1 in August to 60.7 in September, Chris Williamson, chief economist at IHS Markit, said that “the prices charged for these products leaving the factory gate also rose again in September, increasing at a rate exceeding anything seen in the survey’s nearly 15-year history. “
Please see below:
Source: IHS Markit
Singing a similar tune, the Institute for Supply Management (ISI) released its services PMI on October 5. For context, the US service sector has suffered the full brunt of the wrath of the Delta variant. And although the price pressures are not as feverish as in the US manufacturing sector, the report found that inflation has been rising at a “faster” rate and that “all 18 service industries have reported rising prices. prices paid during the month of September “.
Additionally, PepsiCo released its third quarter results on October 5. And after beating analysts’ earnings estimates, the beverage giant has raised its forecast for the full year. However, as demand remains resilient, the 11.6% year-over-year consolidated net sales growth coincided with a 3% decline in diluted earnings per share (EPS).
Despite this, the CEO Ramon Laguarta told analysts during the company’s third quarter earnings call that “what we are seeing around the world is a much lower price elasticity than we have seen historically, ”and therefore price increases are expected to start in the coming months. For context, “elasticity” attempts to quantify the change in demand that results from a change in price. And with the CFO Hugh johnston expecting expense inflation to exceed cost inflation in the future, “lower elasticity” is materially problematic for the Fed.
Please see below:
Source: PepsiCo / The Motley Fool
If that weren’t enough, BMO Harris Bank announced on Oct. 5 that it will increase its minimum hourly wage for all branch and call center employees from a “minimum of 20%” to $ 18 per hour. For context, BMO Harris Bank has over 500 branches and over 12,000 employees in the United States.
Please see below:
Source: BMO Harris Bank
More importantly, however, with Powell’s inflationary conundrum helping to swing the double-edged sword that fundamentally reduced PMs, the USD index rose 0.20% on October 5 and US Treasury yields fell. are reinforced in all areas.
Please see below:
As for the history of the dollar, the fundamental strength of the USD index is guaranteed by the “dollar smile”. To explain, when the US economy is struggling, the US dollar tends to underperform. However, when the US economy collapses and a safe haven supply emerges, the US dollar often outperforms. Conversely (and similarly), when the US economy is booming and higher interest rates materialize, the US dollar also outperforms.
By the way, I discussed the situation with the USD index at length in today’s video.
For the context, I indicated on September 22:
The USD index and US Treasury yields may move in the same direction or take different paths. However, while a stock market crash is probably the most bearish fundamental outcome that PMs could face, scenario # 2 is as follows. When the economic strength of the United States provides a fundamental thesis for the USD index and US Treasury yields to rise (along with real interest rates), the double-edged sword often leaves MPs with deep lacerations. .
At this point, with a mix of the two taking place in the present, Sébastien Galy, senior macro strategist at Nordea, signaled to clients that the dollar’s smile is alive and well:
“The dollar should continue to be supported by expectations of a possible series of Fed rate hikes and the value of the dollar as a safe haven against a possible equity correction…. The downtrend in EUR / USD is expected to return in the coming weeks and months, suggesting EUR / USD is around the 1.10 handle and potentially below before going higher.
Regarding the performance story, Lindsey Piegza, chief economist at Stifel Financial, told clients that “the markets look increasingly nervous as the realization of higher and sustained inflation results in finally a higher rate level seems to finally sink…. Against the backdrop of high inflation and rapidly rising energy costs, many market participants are skeptical that the FOMC will be able to keep these rates low for another year, let alone of them.
The bottom line? With inflation fleeing the Fed, removing commodity prices (by strengthening the US dollar and / or raising interest rates) is the only way to calm inflationary pressures. Otherwise, the surge in commodity prices is likely to further weaken consumer confidence, increase corporate profit margins, peak with destruction of demand, and the stock market is expected to suffer badly (which is also bullish for the US dollar). . As a result, with Powell creating an even bigger inflationary wildfire the longer he waits, PMs could face immense volatility in the medium term.
In conclusion, PMs were mixed on October 5, although problems loom on the horizon in the coming months. With the USD index and US Treasury yields ripe for an upward revaluation, the Fed’s “transitional” narrative has not aged well. And with the PM’s main villains doing a lot of their fundamental damage since Powell went hawkish, more upward catalysts are expected to emerge in the medium term. As a result, the outlook for PMs remains deeply bearish over the next few months.
Przemyslaw Radomski, CFA Founder, Editor-in-Chief Sunshine Profits: An Effective Investment Through Diligence and Care
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