USDi: BEs still stuck in data-driven bad dream, but dip buyers surface

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BEs still stuck in data-driven bad dream, but dip buyers surface

The U.S. inflation market seems to be stuck in the same bad dream that starts somewhere filled with cherry blossoms but ends either on skid row (…like Monday & Tuesday) or somewhere much less unpleasant but still somewhat uninviting (…like today).

Indeed, for the third trading session in a row, another batch of weaker-than-expected data has knocked the inflation market off its tracks in the early goings.  Today, the ADP employment release came in at +145k in March, down from a revised +261k, and well below Bloomberg consensus of +210k. Meanwhile, the US ISM services PMI came in at 51.2 in March, down from 55.1 in February, and well below the forecasted 54.4.  Additionally, the prices paid (down to 59.5 from 65.6), the employment (down to 51.3 from 54), and new orders (down to 52.2 from 62.6) components all showed notable contraction.

Touching on the cost/prices/inflation aspect of the today’s ISM services data, strategists at Barclays highlight the following:

”… March estimates suggest that the pace of moderation in cost pressures may be intensifying. We see a number of encouraging signs in this release that cost pressures for services may be moderating. This would be a notable development, with supply bottlenecks taking much longer to resolve than in the manufacturing industry. March's reading for the supplier delivery delays index is the third contractionary reading in the past four months, and is the lowest since the depths of the GFC (April 2009). This was accompanied by the first contractionary reading for the order backlog index since the COVID-19 lockdowns in spring 2020. Although the input price index remained at a fairly robust 59.5 in March, it fell 6.1pts from February—the fastest decline in this expansion—and now stands at its lowest reading since the summer of 2020. This is certainly a step in the right direction in terms of relieving cost pressures for materials (particularly for commodities such as fuel), though respondents continue to report elevated labor cost pressures. Respondents' comments also suggest some progress on the supply front, with a number explicitly citing signs of easing and stabilization for materials, albeit with little relief from labor cost pressures.”

Post-data, TIPS breakevens and inflation swaps were already off their opening highs but fell further still once the data hit the tape.  And after a choppy intraday trade, the inflation curves are ending off their lows but still modestly softer on the day (~0.625-2.25bps) against the backdrop of a ~3-6bpps drop in nominal yields, narrowly mixed equities (Dow +0.24%, S&P -0.23%, Nasdaq -1.07%), and mixed energy prices (gasoline +2.96%, Brent -0.12%, WTI -0.33%).

“The ISM services low miss added to the recent spate of weak data, and if anything the immediate breakeven sell-off was surprisingly short-lived with buyers showing up once the duration spike subsided and the rest of the day was mostly a range,” one dealer explained.

In derivatives-space, inflation swap on the SDR today included 1y ZC swaps at 267bps and 271bps, 2y ZC swaps at 246bps and 248.5bps, 3y ZC swaps at 241bps, 239bps, 239.5bps and 240bps, 5y ZC swaps at 249bps, 245.625bps, 244.875bps,  and 245.5bps, 10y ZC swaps at 249.5bps, 247.5bps, 247.625bps, 248bps, and 249.25bps, 15y ZC swaps at 244.5bps, and 30y ZC swaps at 235.5bps, 234.125bps, 235bps and 234bps (for all of today’s trades, see Total Derivatives SDR, which now also includes information on broker/platform).

Heading into the final hour of trade, the 2y breakeven in the screens is seen at 259bps (-0.625bps), 5y at 237.125bps (-2.25bps), 10y at 223.875bps (-1.625bps) and 30y at 218.25bps (-0.875bps).

Deutsche Bank: Five ways this time is different

G7 core inflation peaked at 5.5%, a level not reached since the early 80s which is in stark contrast with the past 25 years during which G7 core inflation never exceeded 2%. Most notably, underlying inflation in Japan is above 4% and still rising.  Strategists at Deutsche Bank discuss the market implications of this simple observation below along with five ways in which this time is different from the past 25 years:

”…A hard landing should be base case. Central banks operate under considerable uncertainty (in fact a lot more than they care to admit). Estimates of neutral and NAIRU are imprecise and significantly revised ex-post. Monetary policy lags are famously long variable. There is even some debate as to whether it is the level or the change of real rates and central banks balance sheet that matters. Thus, unless central banks are extremely lucky, it is unlikely that monetary policy can be implemented with enough precision to bring inflation back to target without generating a recession. Moreover, Powell has repeatedly stated that the Fed does not want to repeat the mistake of the 70s. This implies that the Fed would rather over tighten rather than under tighten. As long as this is the case, the ex-ante probability distribution is skewed towards a hard landing.

 

“…- It will require a bigger growth shock for central banks to ease policy. When inflation is not far from target, slowing growth could be enough for central banks to expect inflation to be soon at target and the market to anticipate easier monetary policy. However, if inflation is significantly above target, there should be a ‘longer fuse’ between slowing growth and a central bank pivot. As a result, growth signals won't be enough to dictate the duration view. For instance, traditional growth and  cross-asset proxies of UST10y would have wrongly suggested being long duration almost a year ago and are currently consistent with sub 2% UST10y.

 

“…Once initiated, the easing cycle should be deeper. Higher underlying inflation should be reflected in a higher nominal neutral rate for the current hiking cycle. Moreover, as inflation is significantly above target, central banks will presumably need to adopt a more restrictive policy than in the most recent tightening cycles. Let's now assume that central banks stay true to their inflation mandate and maintain a restrictive policy until inflation comes back to target. At this point, underlying inflation will by definition be back to ~ 2%. As a result, the nominal neutral rate will be lower than for the current hiking cycle. Moreover, as argued above, it is likely that central banks will have to generate a severe recession to bring inflation back to target. Once this is achieved, they will want to set policy rates below neutral. Taken together, the peak-to-trough policy rate will be larger and money market curves should be more inverted than in recent history.

 

“…Risk parity is on shaky foundations. The concept of risk parity rests on bonds being a good hedge for equities. For that to be the case, bond and equity returns need to be negatively correlated, ie, the yield/equity correlation needs to be positive. This is only the case in benign inflation environments. When high inflation becomes an issue, a positive shock to inflation coincides with a negative shock to growth, leading to higher bond yields and lower equities. Empirically, when US core CPI is above ~3%, the subsequent 12m yield/equity correlation tends to be negative. With core CPI at 5.5%, it is likely that the yield/equity correlation will remain negative for now.

 

“…-Japan moving out of deflation will have significant implications. As mentioned above, underlying inflation is well above target even in Japan. The latest Shunto wage negotiation resulted in headline average wage growth of 3.8%, which is consistent in our framework with a ~40% probability of moving out of the post 98 deflation environment. Using the framework suggested in a recent flagship cross<1>asset piece on Japan, this in turn implies fair value on 10y JGB yields of 120bps, if YCC were to be dropped. More importantly, there is scope for a significant rotation out of foreign bonds and into JGBs by domestic investors. This should drive global term premia higher.”