07 May 2021

Week Ahead: Thusspoke Zarathustra

Mikael Sarwe | Andreas Steno Larsen | Martin Enlund

With diverging statements from various Fed governors and Yellen being allover the place, it’s no wonder that markets get confused. Bifurcation time, butour macro view continues to point to higher yields. And did you know aboutthe 1970 tech wreck?

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Over the past week, it seems as if members of the Fed and the Biden administration have tried hard toconfuse the markets. We admit to getting confused, but at least confused on a higher level. In a way it’snatural that ocials’ signals start to diverge as the US economy is getting near a full re-opening. It’s basicallybifurcation time before it gets more obvious what will happen to inflation after the well-debatedcoming spike and, perhaps even more importantly, the labour market.

In a sense, it all started with Chairman Powell admitting at the press conference after the Fed meeting thathe saw signs of frothiness in certain parts of the markets, although not broadly and still with a main messagethat was dovish. But frothiness statements are clearly scores for the early tapering camp, such as us.Bullard had already before that said that tapering would be on the agenda when vaccinations reach 75%of the population. Kaplan went even further and noted “excesses and imbalances in financial markets” thataccording to him would make it appropriate to start talking about tapering now. As we push the publishbutton, we also not that Brainard finds that “vulnerabilities associated with elevated risk appetite is rising”.

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Chart 1. Is this one of many odd imbalances perhaps?

And thus spoke Zarathustra… or sorry, Janet Yellen: “It may be that interest rates will have to rise somewhatto make sure that our economy doesn’t overheat, even though the additional spending is relatively smallrelative to the size of the economy.”

Our interpretation is that the statement was meant to say that the administration will not criticize theFed for tapering or hiking when that day comes. That she understands that the fiscal policy road chosencould trigger such a scenario, even if it’s not her main view. Then journalists, wrongly, started interpreting itas if she was telling the Fed what to do and she had to backtrack, saying that she was neither predicting norrecommending a rate rise.

Then we had a string of more dovish statements from Fed governors Kashkari, Evans, Bowman and Mester,saying that there was no worry about the “temporary” inflation spike and that the economy was very far fromthe state where tapering and rate hikes would be on the table. Kashkari as an example noted that it “maytake a few years” to get back to full employment. Here we disagree. Our view remains that the inflationspike will be higher and remain longer, and once it’s possibly over the labour market will be tightagain with wages rising relatively fast.

What did economic data tell us last week?

True, a couple of disappointing headline ISM numbers. We do expect lower ISM by the end of 2021 and moreso in 2022. But it seems too early for that type of data to weaken materially now, even before economies haveopened up. Also, normally peaks in ISM include some zig-zagging on a high level before starting to trenddown, which we deem will happen this time as well.

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Chart 2. ISM should drop back more, but not yet

On the other side of the Atlantic, Euro-area GDP as expected fell 0.6 % q/q in Q1, burdened by lockdowns– vaccinations and warmer weather will turn those numbers in Q2 and German retail sales numbers wereextremely strong already in March.

More interesting was the combination of leading labour market and inflation data. ISM pricecomponents rose further from very high levels. The employment part of ISM services was the highest since2018 and according to NFIB, the share of small businesses with job openings remains the highest ever. Let’sjust say we believe that Kashkari will be awfully wrong on his full employment prediction. Do note that theemployment cost index shows no indication of falling through the floor, which would have been expected ifthe labour market was as weak as the Fed assumes. Wages and salaries in the private sector increased 3% y/y in Q1 2021.

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Chart 3. US wage increases and the quit rate

It seems like many have forgotten that upside wage pressures not seen since before the financial crisiswere building up in both the US and the Euro area in 2018/2019. The global manufacturing recessionderailed those pressures for a while and as the world started to exit the recession, COVID-19 struck.

Given that the 2020 recession was not an eect of grave imbalances being crushed by tighter monetarypolicy, but rather an external shock in the form of a disease that soon should be history, we remainconvinced that there will be a quick return to tight labour markets and upside wage pressures.

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Chart 4. Record-high share of small US companies with job openings

Also, digging a bit in the manufacturing ISM, we find a clear indication that the consensus assumptionthat the combination of supply chain disruptions, bottlenecks and too low inventories will correctitself quickly without any lasting inflation eects could be very wrong. When we look at the correlationbetween core inflation and order backlogs versus customer inventories, we find it could aect inflation overan 18-month period. Historically it hasn’t magically disappeared overnight.

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Chart 5. Supply/demand/inventory strains usually take time to sort out

Even if the Fed is trying to deflate the importance of short-term inflation numbers, next week’s CPI print couldnevertheless be of importance. The consensus forecasts of CPI at 3.6% y/y and core CPI 2.3% y/y are logical,but we see marked upside risks over the coming months. Our trusted old CPI model, which we admittedlydoubt despite working brilliantly for nearly 20 years, says that 5-6% inflation is more than possible.

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Chart 6. US CPI model has surged

We also know that used car prices, which are not included the CPI model, have surged and are yet to show upmore than marginally in the CPI and could add something like 0.8 percentage points to y/y core CPI in comingmonths. Rents (42% weight in core CPI), not in the model either, have a lot of catching up to do in relation tovacancy rates, house prices and landlords’ signals. The Fed’s Rosengren said this week that inflation reachinga number not starting with 2 would worry him. Strap yourself in Mr Rosengren, time to rock’n’roll.

Of course, price components of Euro-area PMIs are also sky-high. But perhaps more unknown, suddenlylabour shortages are also reappearing in survey data. Despite major parts of the Euro area in lockdownmode, Q1 service sector shortages have already risen above average. Last time that happened, wagegrowth started to accelerate. Maybe we should start thinking about upside risks to Euro-area inflation in late2021?

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Chart 7. Euro-area wage increases and labour shortages

In our new financial forecasts we predict tapering by both the Fed and ECB later this year, a first Fed rate hikemid-2022, the US 10-year bond yield at 2% and German at 0% by end-2021. The bond yield predictionsfeel low unless we enter a period of risk o. We still find that the most important reason for continuedfrothy equity markets remains the strong profit trend, where Q1 could break records in beating estimates.Equity markets have basically never fallen markedly with profits rising.

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Chart 8. Equities follow profits

But we do note that many companies with earnings beats actually are not rallying. Everyone is by now longequities. Also, the possible lagged eect of higher real rates on valuations is somewhat worrying. Nasdaqstarts to wobble every time someone of importance hints that real rates actually can go up. All of thishas made us remember the so-called “forgotten” tech wreck of 1970.

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Chart 9. Real rates and forward P/E

History never repeats itself, but it rhymes – the 1970 edition

I (Sarwe) remember it as if it was yesterday – two years old in 1968 and my nanny told me about the stockmarket, how easy it was to get rich. Just pile into any computer stock and see it head for the moon. So I didand had lost 80% by mid-1970. It was a brief day-trader career. I am joking of course, but there are someeerie similarities today with the build-up to that, nowadays forgotten, tech wreck. We will just list themand see if they set o any alarms for you. Ring a bell?

Low inflation since the Second World War (CPI increased 1.3% per year on average in 1953-1965) hadrelaxed authorities about the threat of inflation. Ring a bell?

The Fed had kept short-term real rates substantially below the potential GDP growth rate for a longperiod. Ring a bell?

There had been, by what was then, very high deficit spending due to President Johnson’s Great Societyprograms and the Vietnam War. Ring a bell?

Late-cycle fiscal spending and very easy monetary policy had continued despite the economy being at fullemployment. Ring a bell?

Inflation climbed in 1966 to levels not seen in 15 years, starting to trigger a shift in broad inflationpsychology. Ring a bell?

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The Fed eventually needed to tighten policy, which partly coincided with fiscal policy also forced to turnrestrictive. Ring a bell?

In June 1968, President Johnson signed what is still the largest US tax bill ever - if all Biden’s proposalspass Congress it will be the second largest. Ring a bell?

Geopolitical worries and domestic civil unrest, culminating in the campus riots and shootings at Kent Stateand Jackson State in 1970. Ring a bell?

Chart 10. The “forgotten” bear market of 1969-70

A fascination of a relatively small number of glamour stocks including some conglomerates, computer andtech stocks driving valuations into the stratosphere as the household equity share of financial assetsincreased to new all-time highs. Ring a bell?

A tendency to extend very high earnings growth estimates way into the future and a belief that lowbond yields were there to stay. Ring a bell?

As policies were tightened, a relatively mild recession occurred in 1969-70. S&P500 dropped 36% from late1968 to the bottom in 1970. The average decline for a selection of 30 of the most popular stocks wasmuch worse at -81%. We’ll see if that one will ring a bell further into the future?

There are of course dierences, demography being one, but maybe we should at least glance a bit atthe 1970 experience? Or in Carl Jung’s words – “no tree, it is said, can grow to heaven unless its roots reachdown to hell”. And we would hate to start thinking about our over-stimulating policy makers as a part of hell.

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A slightly changed view on the SEK

In our new financial forecasts we remain USD bulls based on the US economy outperforming all peers anda higher probability that the Fed is much earlier in tightening than the rest. We might currently also add thatMay usually is the seasonally strongest USD month of the year and that the new TGA projections from the USTreasury imply USD 300bn less surplus USD liquidity in Q2 than in their old plan.

Norges Bank’s statement yesterday, which we interpreted to signal less uncertainty about the economicoutlook, strengthened us in our view of a first rate hike already in September this year. Therefore we remainNOK bulls.

Across the border, however, we see a period of SEK weakness ahead. As we have pointed out many times,the SEK usually has problems performing when the USD strengthens. Also, the Riksbank has traditionallybeen very sensitive to low inflation and CPIF excluding energy is due to collapse to a 20-year low oversummer. The Swedish inflation outlook is quite dierent from elsewhere.

Chart 11. Low core inflation worrying for the SEK

First, direct stimulus to households has been much less than in the US and the Euro area. Second, low wagedeals have been locked in all the way to mid-2023. Third, the past 18 months have seen one of the largestSEK appreciations ever, which hasn’t fully leaked into the CPI yet.

More generally speaking, the inconsistency between the 2% inflation target and the Swedish wageformation process, where the manufacturing industry that is shedding labour over time is the wage anchorfor all other sectors, is intact. As long as that is the case, the SEK will need to perpetually weaken for theRiksbank to have even a minor chance of reaching its inflation target over time.e-markets.nordea.com/article/65417/week-ahead-thus-spoke-zarathustra

What’s most important in the week ahead?

As noted above, US CPI will steal most of the limelight (Wed). Before that, the NFIB’s small business survey isreleased, where we will focus on whether the sky-high share of companies reporting price increases is intact(Tue). US retail sales increased a massive 9.8% m/m in March, so there should be a bleaker start to Q2 (Fri).

Chart 12. US small businesses are hiking prices en masse

There could also be some focus on the 10-year (Wed) and 30-year (Thu) treasury auctions. After some veryweak auctions in February and March, auction demand improved markedly in April. Now when long-endyields have dropped back somewhat, it will be interesting to see if that bid is intact.

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Chart 13. Will treasury auction bids continue to improve?

In Norway, the NOK has strengthened since April last year, and this will weigh on core inflation ahead. Wesee April core inflation at 2.1% y/y in line with Norges Bank (Mon). Activity in the mainland economylikely fell in March due to the restriction measures (Norges Bank expects -0,6% m/m). Currently, theNorwegian economy is reopening gradually, so the upcoming GDP figures should be on the brighter side(Wed). The Government proposal for The Revised National Budget 2021 will include ample of fiscal policystimulus supporting the recovery (Wed).

We expect Swedish CPIF at 2.4% y/y in April, which is 0.1 percentage point higher than the Riksbank. CPIFexcluding energy should rise somewhat to 1.6%. Much suggests that inflation then will drop substantially thecoming months, while we may see a lower second peak later this year (Wed).

Nordea presents its new Economic Outlook on Tuesday.

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Calendar for next week

Recently published research from Nordea

Swedish April inflation preview: The peak (7 May)

SEK rates (THURSDAY1500): Low inflation supports relative receiving (6 May)

e-markets.nordea.com/article/65417/week-ahead-thus-spoke-zarathustra

Norges Bank Review: Uncertainty is no longer “substantial” (6 May)

Biweekly Corona Update: Europe catching up but still far behind (6 May)

SEK covereds: Supply update April (6 May)

SEK forecast update: No Country for Hawkish Men (5 May)

Major forecasts: Rise and shine (5 May)

More intervention from the Danish central bank – but at a much slower pace (4 May)

Market Pulse DKK: Time to bet against a rate cut? (4 May)

FX Weekly: Powell is right, in the end we are all going to die! (2 May)

Mikael SarweDirector, Head of Strategy Swedenmikael.sarwe@nordea.com+46 8 614 99 09

Andreas Steno LarsenChief Global FX/FI Strategistandreas.steno.larsen@nordea.com+45 55 46 72 29

Martin EnlundGlobal Chief FX StrategistMartin.Enlund@nordea.com

e-markets.nordea.com/article/65417/week-ahead-thus-spoke-zarathustra