Inflation moved to the front of the line of market worries, while pandemic hotspots in Asia were closely monitored. Rapid global growth, led by China and the U.S., combined with supply chain disruptions and surging consumer demand as economies reopen, are driving prices sharply higher, and fixed income and equity markets are worried that the main central banks will be forced to taper sooner rather than later. Repeated central bank assurances that the price spike is transitory eventually soothed markets, but doubts persist. The tension between growth, inflation, and the impact on policy expectations should continue to drive market sentiment in June.
Key Drivers for June 2021
- Inflation moved to the front of the line of market worries
- FOMC maintained that the inflation spike is transitory
- Fed’s VC Clarida: there may come a time at upcoming meetings to talk taper
- ECB focused on playing down the importance of the pick-up in annual inflation rates
- New Zealand’s central bank shook markets with a projection of a possible hike in 2022
- U.S. April CPI massively beat estimates, PPI surged to record high annual rates
- Eurozone HICP accelerated on an annual basis in April, but the core measure slowed
- China’s annual CPI growth rate more than doubled in April compared to March
- Global recovery expectations continued to firm, led by the U.S.
- U.S. economy pushing against capacity constraints for the goods sector
- Eurozone Q1 GDP fell -0.6% q/q but vaccination programs suggest better days ahead
- Japan’s GDP plunged -5.1% in Q1 (q/q, saar); heightened restrictions dim outlook
- China’s growth appeared to moderate in April, but activity remained strong
- Wall Street saw fresh record highs in early May, only to wobble on inflation concerns
- Bond yields perked up in mid-May on stronger than expected inflation reports
- WTI crude oil posted a post-pandemic high
- ECB’s Financial Stability Report Makes for Scary Reading
FOMC Maintains that Inflation Spike is Transitory
The FOMC minutes didn’t reveal any surprises relative to what was known from the April 27-28 policy statement and Chair Powell’s presser, the March SEP, or from recent Fedspeak. The meeting was held prior to the April jobs disappointment and the spike in CPI. The policy remains on hold for now. Yet, there was some talk from “a number of participants” that “if the economy continued to make rapid progress toward the Committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchase.” The dots from the March meeting told us there were some officials who were looking to unwinding accommodation sooner than later. However, the Fed also indicated, which all have repeated consistently, that “the economy was still far from the Committee’s longer-run goals. Moreover, the path ahead continued to depend on the course of the virus, and risks to the economic outlook remained. Consequently, participants judged that the current stance of policy and policy guidance remained appropriate to foster further economic recovery as well as to achieve inflation that averages 2% over time and longer-term inflation expectations that continue to be well anchored at 2%.” The minutes did highlight the improvement in the economy and the expectation that y/y inflation would be picking up near term due to base effects. Both downside and upside risks were acknowledged.
Fed VC Clarida, speaking late in May, echoed the FOMC minutes that there may come a time at upcoming policy meetings to talk taper. The economic outlook is “very, very positive,” he said, and he projects growth somewhere north of 6% and possibly 7%. There are upside and downside risks, while the data remain quite noisy. He expects the pace of the improvement in the labor market to pick up. Meanwhile, he acknowledged that the recent jump in CPI was a “very unpleasant surprise,” repeating prior thoughts. Of course, he believes inflation is likely to be mostly “transitory.” He is putting a lot of weight on inflation expectations. And he stressed that the Fed has the tools to address a persistent rise in prices should it occur.
The ECB, like most central bankers, remained focused on trying to play down the importance of the pick-up in headline inflation rates and assuring markets that monetary policy will remain accommodative for some time ahead. Against that background, there were more comments backing a possible move to a symmetric inflation target as part of the current review of the overall policy framework at the ECB. Given that the ECB’s current focus is a medium-term definition of price stability that already allows officials to see through temporary overshoots, this would not actually change the policy remit. However, after the lengthy period of inflation undershoots it would send a pretty strong signal that rates will not be raised any time soon. It may also help to take the sting out of any possible change in monthly asset purchase volumes. The ECB significantly widened monthly targets through the second quarter as economies struggled with a surge in virus cases. With the recovery looking well underway now, officials will have to decide in June whether to scale back levels again in the third quarter, within an unchanged overall PEPP envelope.
The usually under the radar Reserve Bank of New Zealand (RBNZ) shook the markets late in May. While the RBNZ kept the policy rate steady at 0.25%, as expected, bank projections showing a possible hike in the policy rate in the second half of 2022 caught the attention of global markets. Granted, the RBNZ left rates unchanged while downplaying inflation risks and stressing that “considerable time and patience” would be needed by policymakers before they could be confident that inflation and employment objectives were met. Nonetheless, the RBNZ’s rate projections are the latest tentative sign that some central banks — the Fed is a notable exception — are pivoting ever so slightly to cover the risk that inflationary pressures might sustain, and the associated risk that uber stimulus is setting up global asset markets for an eventual crash. The BoE’s recent decision to slow the pace of its asset purchase program, and the ECB’s reference of “remarkable exuberance” in markets, preceded the RBNZ announcement.
The BoE left the repo rate unchanged at 0.10% and the QE total unaltered, as had been widely anticipated. The repo rate decision was by unanimous vote at the nine-member Monetary Policy Committee, while the vote on the QE was by 8-1. The dissenting voter was Haldane, who is leaving the MPC, and who wanted to lower the size of the quantitative easing program. The BoE still affirmed that the rate of QE purchases would slow down, as previously signaled, which the Bank stressed was purely an operational decision that “should not be interpreted as a change in the stance of monetary policy.”
Inflation dynamics were the focus in May, as the data showed an acceleration in annual inflation growth during April for the U.S., Eurozone, UK, and China, with particular spikes in producer prices.
The U.S. CPI report massively beat estimates, with April gains of 0.8% for the headline and 0.9% for the core. The headline gain was the largest since 2009, while the core rise was the largest since 1981. A 4.2% y/y headline spike marked the biggest gain since 2008, while a 3.0% y/y core rise was the largest since 1995. The huge headline and core price surprises entirely reflected outsized April gains of 10.0% for used car prices and 10.2% for airfares. CPI was restrained by the expected -0.1% drop in energy prices, which broke a 10-month of solid gains. Gasoline prices fell -1.4%, while food prices rose 0.4%. Meanwhile, on a 12-month basis, the headline PPI surged to a 6.2% y/y clip, up from the 4.2% previously with the core PPI at 4.1% y/y from 3.1%. Both were new highs since the 2009 methodology change. The combination of increased demand from reopenings and supply chain disruptions and inventory shortages is pushing up producer prices sharply.
Eurozone HICP inflation was confirmed at 1.6% y/y, in line with the preliminary release and up from 1.3% y/y in the previous month. Core was revised slightly lower to 0.7% y/y from 0.9% y/y in March. The drop in the core number highlights that the acceleration reflected in the headline rate was mainly due to base effects from energy prices. Indeed, energy price inflation jumped to 10.4% y/y in April from 4.3% y/y in the previous month. Services price inflation fell back to 0.9% y/y from 1.3% y/y, as April was the month when the strictest lockdown measures were gradually eased last year. Prices for non-energy industrial goods rose a mere 0.4% y/y in April. The report backed the assertion of central banks that inflation pressures are transitory with no risk that inflation expectations will rise to an extent that would force the ECB into taking a less accommodative stance any time soon.
The UK’s April CPI rose to 1.5% y/y. Core inflation moved up to 1.3% from 1.1%, highlighting that this is not just due to base effects from energy prices, although the strict lockdown a year ago clearly is distorting the annual rate. More importantly, perhaps, PPI readings came in much higher than anticipated, with the input number reaching a whopping 9.9% y/y and output price inflation jumping to 3.9% y/y from 2.3% y/y. That will only add to concerns that underlying inflation pressures are building up as demand returns, although so far BoE officials including Governor Bailey are sticking to the line that the uptick will be transitory.
China’s CPI climbed to a 0.9% y/y clip in April, more than double the 0.4% y/y from March. That’s the fastest pace of acceleration since the 1.7% pace from September 2020, with much of the pick up a function of base effects (CPI dipped -0.3% on the month with weakness in pork prices). Consumer prices were in deflation last November, and in January and February this year. Concurrently, PPI registered a 6.8% y/y rate in April, versus 4.4% y/y in March. It is the strongest since October 2017. PPI had been in deflation from July 2019 through December 2020, with the exception of the 0.1% increase in January 2020. Much of the strength in factory gate prices resulted from rising commodity prices.
Japan’s CPI remained in negative territory, with total CPI falling -0.4% y/y in April after the -0.2% drop in March. The closely watched core CPI (excludes fresh food only, energy is included) fell -0.1% y/y after an identical -0.1% decline in March. Japan’s deflationary challenges continue at the consumer level. Meanwhile, PPI soared to a 3.6% y/y pace in April from 1.2% in March, driven partly by base effects but also by rising input costs — PPI grew 0.7% m/m after the 1.0% gain in March.
Expectations for a global recovery firmed further, led by strengthening and broadening recovery in the U.S., improving prospects for the Eurozone and the UK and ongoing expansion in China. Japan remains a laggard, with the economy hobbled by expanding lockdowns amid a sluggish vaccine rollout.
The U.S. economy is clearly pushing against capacity constraints for the goods sector, even as the service sector continues to re-open. The service sector industries may undershoot their pre-pandemic trajectories for a while, and we have yet to see how quickly former workers from the service sector will reenter the labor market as goods sector employees. Until then, pockets of joblessness in urban areas will coincide with tight national labor markets.
The 6.4% U.S. Q1 GDP growth pace failed to reveal the expected boost thanks to much weaker than expected inventory and net export data alongside a lift in the price indexes. The Q2 GDP estimate remains at 8.5% for now. The revised Q1 GDP figures still document the updraft from vaccine distributions and two rounds of fiscal stimulus during Q1, alongside a seasonal Q1 updraft after the Q4 downdraft attributable to the mismatch of seasonal factors with this year’s disrupted holiday activities. Much of the gyration was in consumption, which stalled in Q4 but surged in Q1, alongside moderating growth in residential and nonresidential fixed investment. Inventories subtracted sharply from GDP in Q1, as businesses were unable to keep up with demand. Imports were robust, though gains were restrained by port backlogs. Exports have been restrained by weak growth abroad. The bounce in GDP since Q2 of 2020 has reversed 92% of 2020’s Q1-Q2 plunge. The level of GDP as of Q1 is just -0.9% below the peak of the prior expansion in Q4 of 2019.
Eurozone Q1 GDP was confirmed at -0.6% q/q in the second estimate, in line with expectations and leaving the annual rate at -1.8% y/y. The monetary union is officially in recession once again — thanks to Covid-19, which weighed on consumption in particular. Vaccination programs are advancing though, and Germany’s stay home orders this time around have generally been less severe than during the first wave. While the services sector is finding its footing, manufacturing has remained very strong thanks to a rebound in global demand, with the sector increasingly running into supply chain constraints. The jump in commodity prices is also having an impact as the sharp drop in the Eurozone trade surplus to just EUR 13.0 bln in March highlights. The nominal import bill jumped sharply higher that month, and that will continue to feed through into PPI numbers, which are already elevated.
Japan’s Q1 GDP fell -5.1% (q/q, saar). The decrease in Q1 GDP was a bit more pronounced than expected, highlighting the challenge for Japan’s economy as the government implemented increasingly restrictive measures this year through May in order to contain the pandemic. Consumption spending contracted, and business investment declined after expanding in Q4. The contraction in Q1 GDP ended two-quarters of strong growth, as GDP grew 11.6% in Q4 and rebounded an all-time best 22.9% in Q3 as the economy emerged from the lockdowns in Q2 of 2020 that sunk GDP to a record -28.6%. Given the restrictions in place during Q2 of this year, there is an elevated risk that Japan suffers another technical recession (back-to-back quarters of falling GDP). Of course, the economy remains on track for growth in the second half of this year, as vaccines allow for a reopening and a strong recovery in the U.S., China, and Europe support Japan’s export sector.
China’s growth pace appeared to moderate in April but to still solid rates. Production and retail sales data were still strong, but the 9.8% rise in factory output was less impressive than the 14.1% y/y surge in March, and retail sales growth also came in below expectations at 17.7% y/y, versus expectations for a nearly 25% rise and compared to 34.2% y/y in the previous month. Base effects and the timing of restrictions clearly continue to have a huge impact on annual rates, but the numbers also indicate that the initially impressive rebound is starting to run into some problems, including chip shortages and the surge in commodity prices.
UK Q1 GDP contracted by -1.5% q/q in preliminary data, which was better than the consensus forecast for -1.7% q/q. The growth figure for March, which was the month that the UK started to emerge from draconian lockdown restrictions, exceeded expectations in rising by 2.1% m/m. The median had been for just 1.3% m/m growth, while the February figure was revised up to 0.7% m/m from the 0.4% m/m initially reported. The y/y Q1 GDP figure was -6.1% y/y, which was of course a reflection of the Covid restrictions that drove household consumption and business investment down.
Markets Developments: Equities and Bonds Wobble
Wall Street posted yet another round of record-high closes in early May before inflation worries and rising yields competed with a rosy growth outlook, leaving the indexes to meander in a narrow range. The Dow and S&P 500 posted all-time highs on May 7, edging lower into month-end in choppy action to leave just -1% declines relative to those all-time high closes. The NASDAQ’s all-time high was on April 26, with the index easing -3% lower through May. In Europe, optimism that the economy is on the recovery track (albeit behind the U.S.) lifted the Euro Stoxx 50 and Germany’s DAX to all-time peaks as May came to a close. The UK’s FTSE closed at its best-ever level on May 7, chopping around through the month to end just -1% weaker relative to the peak close. Extended lockdowns in Japan continued to weigh, with the index moving -6% below its high water mark from February. China’s CSI rebounded 5% in May after moving sideways through April. The index trimmed its losses relative to its February peak to -8% from the -12% drop seen in early May.
Bond yields perked up in mid-May as stronger than expected inflation reports from China, the U.S. and Eurozone made investors question the transitory nature of the spike, reigniting worries that tapering would have to begin sooner rather than later. Also, the mention in the Fed minutes that some participants thought it might be appropriate at some point in the upcoming meeting to discussing tapering aggravated the markets’ already raw nerves. However, a full-court press by the Fed to assure that policy is appropriate as the economy recovers and the spike inflation will prove transitory soothed those frayed nerves, sending yields lower into month-end. The 10-year Treasury rate saw a month-high close of 1.694% on May 12 (the same day as U.S. CPI was released), easing to 1.60% by late in the month. The German 10-year Bund saw a post-pandemic high of -0.105% in mid-May, easing to -0.180% by late in the month. The UK’s 10-year Gilt came up just short of 0.90% at mid-month before sliding to 0.805%. In Japan, the 10-year JGB traded in a narrow range just above zero as officials extended restrictions amid a surge in infections.
WTI crude hit a post-pandemic high of $66.27 in mid-May, holding just under that level by late in the month. Rising demand in the U.S. for jet fuel and gasoline is supporting prices. Demand in China remained firm as well, though India’s dire Covid situation has severely crimped demand there, and should limit crude gains for now, especially as OPEC+ incrementally raises production caps in May through July. The Refinitiv/CoreCommodity index saw a post-pandemic high on May 12, eroding around -2% into month-end. Lumber prices surged to record peaks in the U.S., adding to the sharply rising costs of housing.
ECB’s Financial Stability Report Makes for Scary Reading
After increasing monthly asset purchase volumes this quarter against the background of a sluggish start to the vaccination campaign and delayed recovery compared to the U.S., central bankers will soon face a decision. The ECB’s latest Financial Stability Report highlights the difficult balancing act the central bank will face on its way to policy normalization. The report made it clear that the ECB will want to keep all options open as long as the policy cycle hasn’t turned in the U.S.
The ECB’s crisis-fighting measures have helped governments to support the private sector during the pandemic by keeping refinancing costs very low. That of course has led to a sharp increase in debt levels and upward pressure on asset prices as cash holdings faced negative interest rates and investors searched for returns. A sudden correction now could post yet another shock to the system, especially if global markets correct in response to developments not in the Eurozone, but in the U.S. where the recovery is already further advanced than in the Eurozone.
Against that background, the ECB warned that “spillovers from U.S. equity market repricing could be substantial” if more upward surprises in inflation prompt investor bets on earlier monetary tightening and markets drive up bond yields in the Eurozone, where so far there isn’t the type of recovery that would justify a rapid turnaround in yields. Indeed, the central bank estimates that “a 10% correction in U.S. equity markets could therefore lead to a significant tightening of euro-area financial conditions, similar to around a third of the tightening witnessed after the coronavirus shock in March 2020.”
Substantial risks from potential corrections are possible, which explains why ECB officials are so eager to play down the importance of the recent rise in inflation and stress the commitment to ongoing monetary support, although the risk is that keeping easy money in place for too long will further fuel potential bubbles, which in turn increases the risk of sharp corrections. So far the ECB sees “some segments of overvaluation” but no asset bubble per se and officials are relying on macroprudential instruments to keep risks at bay. However, the ECB did note “remarkable exuberance”, which as Bloomberg pointed out echoed former Fed Chairman Greenspan’s “irrational exuberance” that referenced the dot come bubble in the 1990s.
The flip side of unsustainable asset prices is unsustainable debt levels not just at the government level, but also the corporate level. As the central bank highlights, the recovery from the crisis is once again very uneven across countries and sectors, which is adding to the problems the ECB is facing when it considers trying to scale back the substantial support. At the same time, the easy interest rate environment has underpinned a rise in so-called “zombie firms” in the Eurozone, firms that are kept artificially alive with the help of credit. The ECB in a special feature suggests that the share of zombie firms has increased significantly since the global financial crisis.
Ahead of the pandemic, the share of zombie firms remained above the levels of the early 2000s but was at least on the decline. However, the measures put in place to help healthy companies through the challenges of the pandemic could of course also have been accessed by companies that would not have survived even without the challenges posed by the pandemic. In the short term that helped to support the labor market and demand, but longer-term, this will lead to insufficient capital allocation as existing but unviable companies are kept alive through credit that otherwise may help to foster innovation and investment in new companies.
Furthermore, as the ECB highlights, this “leaves banks, sovereigns and investors exposed in the medium term should the viability of these firms be challenged.” Similar to over-corrections in asset markets, “catch up defaults” or large-scale downgrades could challenge the stability of the financial system if and when it feeds through to the banking sector and the financial system. The ECB already warned of early signs of a rise in loan impairments and suggested higher loan loss provisioning going forward.
Key central bank officials like Chief Economist Lane and Vice President de Guindos are not ready to tighten policy to keep these risks at bay. Indeed the Stability Report argues that “policies should remain broadly accommodative,” but argues that policies “could be more targeted” in order to support a robust economic recovery. Indeed, financing zombie firms or unsustainable house price bubbles would be detrimental to a sustainable recovery. But with fragmented political systems and different agendas across even the major Eurozone countries, relying on macroprudential and regulatory tools alone may not be sufficient to address the risk that accommodative policies only add to the already existing risks.
The ECB faces a very difficult balancing act as the economy recovers and emerges from the recession. What is very likely though is that the dovish leaning camp at the ECB will be eager to keep all options open as long as tapering hasn’t begun in the U.S. The recovery in the Eurozone will be lagging, while the risk of spillover effects if and when the cycle turns may need further ECB intervention to keep yields down and spreads in.