By Michael Every of Rabobank

Not Transi-Tory

That was quite the Monday given there was no data to look to.

In the UK, PM BYO survived his no-confidence vote by 211 to 148, but meaning 40% of his Tory MPs did not back him. If you take out the front benchers obligated to vote for him, he didn’t even carry the majority. Just as opinion polls show the UK public wants rid of this government, but it’s still here, the Tory party wants rid of Johnson, but he’s still here – for now. However, he looks fatally wounded – “in office, but not in power.” On past form, he may well be gone within the year. Whether that can turn around the fortunes of the Tories in the next election remains to be seen. For now, more uncertainty, probably with dollops of populism to try to cover it up: what odds now a new crisis with the EU over sausage rolls?

In Israel, PM Bennett is also clinging on by his fingernails after the opposition passionately voted against a law they all passionately support, and so did some his own coalition: new elections or a new coalition there are also likely to usher in dollops of populism.

In markets, we saw a further push higher in bond yields: US 2s rose 7bp to 2.73%, 5s by 10bp to 3.03%, and 10s by 11bp to 3.04%. The 3% ceiling has been clearly breached again, and the curve is steepening. That may well have been helped by heavy invest-grade bond issuance ahead.

However, it’s also worth noting that commodity prices rose in tandem. Recall the repeated hypothesis here that higher bond yields, with a steeper tone, and higher commodity prices mean the Fed is behind the curve, not ahead of it. Indeed, US natural gas prices spiked to nearly $9, while WTI and Brent oil held at around $119: no sign of higher yields pushing down energy. Or food, despite reports Russia and Turkey may de-mine the Black Sea to allow a grain export corridor to run from Odessa: wheat futures rose over 5%, corn 2%, and soybeans 0.4%. Overall, the Bloomberg spot commodity index hit a new high.

There was more bad news for the “transitory” camp who, like equity bulls, tell you that because something is doing the opposite of what they said it would, it just means it must then reverse:  “it’s always time to buy stocks,” and “inflation always comes down.”

Larry Summers released a new paper finding a return to target core inflation will require “the same disinflation as achieved under Volcker.” Summers et al. argue that pre-1983, US shelter inflation used house prices and mortgage interest rates as inputs. Monetary policy thus mechanically affected inflation, due to the effect of the Fed Funds rate on mortgage rates. Yet in 1983, the BLS switched to owners’ equivalent rent (OER). Regular readers may recall that has been flagged here a few times of late, as I argued it would push CPI higher if rents went up as housing became less affordable. Summers, who I take it not a reader of mine, concurs.

The paper says since 1983 shelter CPI has become much less volatile and much more correlated with rent CPI. It then constructs a series that estimates what CPI inflation would have been if the BLS had used OER pre-1983, concluding, “housing will serve as a significant hindrance to rapid disinflation whereas it used to move the series lower…. The disinflation of the early 1980s achieved by Paul Volcker has served as the exemplum of the power of hawkish monetary policy. Our analysis reveals that current inflation, especially core inflation, is considerably closer to previous peaks than in the official series.”

Inflation is transitory if you strip out energy, food, commodities, and shelter. Similarly, speculation over BoJo resigning is transitory if you strip out the MPs who didn’t back him and the national opinion polls.

This implies more market volatility ahead as central banks try to square the circle of how to do what needs to be done, because markets, without blowing up things that aren’t allowed to be, like markets. Relatedly, there are three policy levers the market needs to keep an eye on, and each has three broad settings:

• Monetary policy – (looser, same, tighter)
• QE policy – (more, same, less/QT)
• Fiscal policy – (looser, same, tighter)

It’s obvious what we are seeing in terms of monetary policy – rates are rising (with the RBA in the spotlight today). We know what we have been promised on QE – that it will stop in some places and be reversed in the US. The fiscal position varies by country, but is leaning from expansionary to contractionary, albeit interspersed with dollops of populist help to consumers.

The key point is that most in markets presume that of the 3*3*3 (27) possible combinations above, many are ‘impossible’. After all, fiscal and monetary policy should be coordinated, right? Rates and QE policy likewise. However, this is changing – and that is no surprise to cynics.

Does it make sense to tighten monetary policy and loosen fiscal policy? Logically, no. Yet we may well see that happen politically. It just means monetary policy needs to do even more.

Does it make sense to raise rates and do more QE? Logically, no. And yet that is about to happen politically. The ECB are set to start hiking on Thursday, with our ECB watchers favouring 25bp, but recognising the risk of a 50bp step. However, the Financial Times reports the ECB is to support a new bond-buying program to suppress the yield spread between its core and periphery. Indeed, it is quoted that many of the ECB’s hawks have accepted they will have to provide more support to the bond market in order to be able to raise rates(!)

Those neck-deep in ECB acronym-ony (and acrimony) may see this as sage, in the same way equity bulls do every bailout of stocks. Others may see it as up is down – and not of a transitory nature. Welcome to a China-style financial system of hypothecated capital flows. Next up: credit that can only be spent on certain categories of investment or goods, or only at home. Digital currencies will help with that kind of thing.

Of course, the US will probably end up doing something similar. If the Fed keeps hiking and higher Treasury yields mean there is not enough money to pay for the military, then it may do more QE to fund the fiscal deficit, while letting the private sector slow down. Or it may bail out certain stocks, which are the US equivalent of an Italy or a Greece. Politics wins again either way – it’s just whose that is the issue.

In short, it appears time for the traditional view that rates and QE co-trend to go out the window(?)

In which case, watch exchange rates. Countries that run current-account deficits while suppressing yields below market-clearing levels are not going to attract the capital they need. That means a lower exchange rate. Ask Japan, where the Yen is now trading at a two-decade low on some measures. Also note that Germany’s mighty trade surplus is shrivelling away under the pressure of soaring commodity prices. Imagine if a weaker Euro meant higher inflation, but that meant the ECB intervening more to suppress peripheral spreads. Is the US an exception because of the global role of the dollar, while it lasts, and because there is  a big portfolio difference between suppressing a key peripheral bond yield and pushing up the price of a key US stock?

Meanwhile, for those rubbing their hands at an alternative ‘New World Order’, consider that what is being described above is how China already works. (See what even a hard-commodity mining publication had to say about China, commodities, and MMT recently.) It just has a larger current account surplus due to a past lack of Western geostrategic focus/“because markets”-ery, which is wearing off, and capital controls. Take them away and see what happens.

Those counting on ‘commodity-backed’ FX should also note ‘Traders in China rush to check metal stocks on pledging concerns’, as questions are asked over whether “the metal they hold in Chinese warehouses really exists, as allegations of irregular financing trigger a widespread loss of confidence in the world’s largest aluminium market.” Nothing like this has ever happened before with China and metals. Ever. And it never will if we shift to a global commodity-backed trading system. Ever. That, as the LME is sued for $486m for its recent actions in the nickel market. You want things to be *really* safe? Go back to physical barter without leverage. Imagine what that implies for the economy and markets. Blockchain or blockhead-chain?

An article from the weekend links the above at the meta level – historian Niall Ferguson arguing the US and China need to make nice but won’t. The summary: “Dust Off That Dirty Word Détente and Engage With China: Joe Biden’s grand strategy is setting the US and Beijing on a collision course. It’s bad foreign policy and terrible domestic politics.”

Ferguson implies Biden should ‘do a Nixon’ and:

1. End the trade war with China;
2. Begin the process of ending the war in Ukraine with a little Chinese pressure on Putin; and
3. Apply joint US-China pressure on the Arab oil producers to step up production in a serious way, instead of letting them play Washington and Beijing off against one another.

He then concludes, “I, too, would loathe to live in a world where China called the shots. But is Joe Biden’s deeply flawed grand strategy making such a world less likely? Or more? If the choice is between war over Taiwan and a decade of detente, I’ll take the dirty French word.” A few key points immediately spring to mind.

First, Ferguson’s argument is that President Biden is talking loudly and carrying a small stick rather than talking softly and carrying a big one, as Teddy Roosevelt advised. That’s not far off the mark, as we see from yesterday’s White House announcement freezing solar panel tariffs, which mostly originate from China’s Xinjiang, ahead of the June 21 start-date of US legislation that bans all imports from China’s Xinjiang unless firms can prove the goods are not made using forced labour.

Second, Ferguson suggests the talk needs to change, not the stick: Vegetius and many modern geostrategists argue it is the *stick* that needs up-sizing (as do US rates, relatedly).

Third, Ferguson has been far more hawkish until now. It isn’t clear if this is a Ukraine- and inflation-driven cri de cœur, a D.C. trial balloon, or a reflection that the well-connected author has been spooked by something he has seen or been told: after all, he is specifically suggesting we are heading to war over Taiwan on the present path.

Steering towards that ‘unthinkable’ –as unthinkable as raising rates and doing more QE?– or away from it, implies huge shifts in fiscal, monetary, and trade policy; and in markets it implies huge shifts in rates, FX, and commodities. In short, it’s likely we get volatility to match what we have seen in 2022 to date – and which is not going to prove transitory,… or Tory.