- While we aren’t necessarily calling for a demonstrable uptick yet, we do anticipate that reported inflation statistics will trend higher over the intermediate term.
- Monetary easing out of both the ECB and Federal Reserve is likely to continue to be bearish for the USD and bullish for commodity prices – the former over the most immediate of TRADE durations and the latter over the TRADE and TREND durations.
- Over the long-term TAIL, however, Europe’s monetary expansion and economic stagnation is likely to continue narrowing the spread between traditional EUR and USD fundamentals and that should continue to weigh on EUR/USD cross.
VIRTUAL PORTFOLIO POSITIONS: Long the US dollar (UUP); Short the euro (FXE).
IS THE GLOBAL TREND OF REPORTED DISINFLATION OVER?
In recent research notes, we’ve been calling for the economic tailwind of reported YoY disinflation to end as of JUL/AUG CPI readings. That is precisely what we’ve seen across a handful of economies in Asia and Latin America – where a growing multitude of central banks have already suspended their easing biases.
- Of the handful of AUG CPI reports that have been released across Asia and Latin America to-date, Australia, Philippines, Taiwan, Brazil, Colombia and Peru all reported accelerating YoY readings; Thailand and Indonesia’s YoY readings were flat MoM, suggesting a bottoming process is underway.
- Over the past month, the benchmark policy interest rate has only been reduced in only two of the 21 countries we actively follow across both regions (Brazil and Colombia). A few of our competitors have consistently alluded to “globally coordinated easing” in support of their bull theses; unfortunately, the data no longer supports this claim.
In the following chart, we take the YoY percentage change of monthly average prices across a variety of commodity markets and indices. From this, we are able to demonstrate that the trend of commodity price disinflation/deflation peaked in JUN. Moreover, in holding the current average for SEPT flat through year-end (a generous assumption given the threat of more central planning), the slope of the aforementioned YoY trends is demonstrably hawkish and will act as a tailwind for directionally-hawkish global CPI readings, on the margin, throughout 2H12 and 1H13. As always in Global Macro, what matters most occurs on the margin.
In the following chart, we plot our arithmetic mean (yellow line from chart above) against the median YoY CPI reading of the US, Eurozone and China and the relationship is both obvious and tight. Interestingly, you can see that commodity price pressures have gone from being largely coincident with these readings in early 2010 to leading by 1-2 months – which is precisely what we’d expect, given the role of commodity prices across global supply chains.
Net-net-net, our conclusions from the aforementioned data analysis are two-fold:
- Global commodity prices were supportive of reported disinflation, globally, up until JUL/AUG ‘12. Now commodity price trends are supportive of hawkish CPI readings, on the margin.
- The more central planning that continues to get priced into commodity markets (particularly food and energy prices), the more hawkish global CPI readings will become over the next 3-6 months. The Chinese know this and explicitly highlighted this risk in the PBOC’s latest quarterly monetary policy report.
We’re early in calling for this fundamental inflection point, just as we were early in 4Q10 making our post-QE2 call “Growth Slows as Inflation Accelerates” [globally]. We were also ahead of this current trend of reported disinflation with our theme “Deflating the Inflation” (introduced in 2Q11). We expect to be out front in preparing for the turn this time around as well, as our process has not changed. That’s certainly a lot more than we can say about the consensus bull case over the past few months.
ARE BERNANKE AND DRAGHI WEARING THE SAME JERSEY?
The fact that the EUR/USD cross traded up into and through Draghi’s aggressive attempt to counter market fears of the “reversibility of the euro” speaks volumes to how a throng of market participants may be trading the euro – on fear, not fundamentals. While certainly difficult to quantify, there is an argument to be made that a large number of EUR short positions across the hedge fund universe are betting on the currency’s ultimate demise.
If this wasn’t the case, it can also be argued that the market might otherwise be positioned net long of the EUR, as it remains a more sound currency than the USD on traditional fundamental metrics (monetary and fiscal policy; balance of payments). Moreover, the Eurozone has maintained its fundamental advantage even throughout its current financial and economic crises!
Consider two mature companies, A and B, where Company A has substantially healthier operating margins and posts greater returns on equity and assets, but is a candidate for bankruptcy because it can’t rollover its debt due to its creditor(s) being in financial distress. Absent the bankruptcy risk, we’d argue that the vast majority of investors would favor “Company A” over “Company B”. Moreover, we think there is a reasonably large segment of the multi-trillion dollar FX market that sees the EUR as “Company A”. Jim Rickards, author of Currency Wars and recent co-host of a Hedgeye Macro conference call falls squarely into this camp.
That being said, however, we are well aware that markets rarely, if ever, trade purely on their trailing fundamentals; expectations, fear, greed, sentiment and liquidity all play a major roles in price formation. In this vein, we argue that one cannot simply ignore the “bankruptcy risk” embedded in Europe’s common currency. As our European analyst, Matt Hedrick, routinely highlights in his research, the economic and social divides between Europe’s core and the peripheral countries aggressively call into question the sustainability of the euro experiment.
Net-net-net, given its obvious fundamental advantages, anything the Eurocrats do to protect the EUR from going away or at least to extend its shelf life is likely to continue to be bearish for the USD over the TRADE duration – even if their strategies involve monetary expansion! From a TREND and TAIL perspective, the aforementioned fundamental advantage could obviously inflect to the USD’s favor if a Strong Dollar = Strong America message is adopted by US policymakers or if the Eurocrats ever decide to pull the plug on the common currency (an outcome we do not currently view as probable).
The key takeaway from our thought experiment is that the monetary easing out of both the ECB and Federal Reserve is likely to continue to be bearish for the USD – the former over the most immediate of TRADE durations and the latter over the TRADE and TREND durations. Over the long-term TAIL, however, Europe’s monetary expansion and economic stagnation is likely to continue narrowing the spread between traditional EUR and USD fundamentals and that should continue to weigh on EUR/USD cross.