Shmid warned that “while in theory, tariffs may have only temporary effects on inflation (although persistent effects on the level of prices) I would be hesitant to take too much solace from theory in this environment”. He tied recent tariff announcements to broader signs of economic stress, including “a decline in consumer sentiment and increases in near-term inflation expectations.” Schmid acknowledged that the current policy environment has become “considerably more complicated,” citing feedback from business contacts who see growing risks on both sides of the Fed’s dual mandate of maximum employment and stable prices.

Schmid’s skepticism around transitory inflation contrasts with recent remarks from Fed Chair Jerome Powell, who has leaned into a more reassuring message about the persistence of tariff-driven price pressures. In “Jerome Powell’s Fed Deftly Maneuvers Through a Stagflationary Minefield“, I admired Powell’s effectiveness in navigating a difficult policy landscape, but I also pointed out the problematic use of “transitory” to describe inflationary effects. Powell argued that “it can be the case that it’s appropriate sometimes to look through inflation if it’s going to go away quickly without action by us… and that can be the case in the case of tariff inflation.”

That assertion paralleled Treasury Secretary Scott Bessent’s line that tariffs are a “one-time price adjustment.” But as I wrote in “The Sleight of Hand Behind the ‘One-Time Adjustment’ and ‘Transitory’ Tariff Inflation Narrative“, for inflation to be transitory, expectations for price levels would need to revert after the initial tariff shock. Yet, “tariffs make price reversion unlikely by locking in a permanently higher cost base.” In that piece, I also pointed out how structural effects – such as wage responses, supply chain disruptions, and embedded cost pass-through behavior – make inflationary pressures from tariffs more persistent. Outcomes are also hard to anticipate as inflationary pressures cascade through the economy.

Schmid appears attuned to these systemic effects. He described “a marked increase in the upside risks around inflation along with elevated downside risks to the outlook for employment and growth,” and openly questioned the prudence of discounting these risks as fleeting. Unlike Powell, who focused on optionality and emphasized that longer-term inflation expectations remain anchored, Schmid directly acknowledged that business sentiment and price expectations are shifting in ways that could prove difficult to reverse.

Powell’s message was strategically designed to preserve policy flexibility and calm markets in the face of stagflationary fears, and in that moment, Powell succeeded. However, I remain concerned that Powell’s framing underestimates the lasting damage that tariff-related cost increases can impose on the economy. As I wrote in my critique, the idea of a “one-time adjustment” may be statistically correct but economically misleading. A new, higher price level, once established, may not simply fade away. The higher price level could reshape business behavior and household expectations for years to come.

Schmid seems to understand these risks. His closing words underscore the seriousness of the moment (emphasis mine): “With renewed price pressures likely, I am not willing to take any chances when it comes to maintaining the Fed’s credibility on inflation.” That statement signals a shift away from the complacency that defines the transitory inflation narrative on tariffs.

The Last Friendly Report on Inflation?

As the Fed slowly accepts increased inflationary risks in the future, the past provides fleeting reasons for optimism on inflation. While I have stuck by the persistent and sticky narrative on inflation, March’s CPI (Consumer Price Index) report signaled the potential start of the next leg down for core inflation…just in time for tariffs to pressure inflation upward again. From the report:

“The index for all items less food and energy rose 0.1 percent in March, following a 0.2-percent increase in February. Indexes that increased over the month include personal care, medical care, education, apparel, and new vehicles. The indexes for airline fares, motor vehicle insurance, used cars and trucks, and recreation were among the major indexes that decreased in March…

The all items less food and energy index rose 2.8 percent over the last 12 months, the smallest
12-month increase since March 2021.”

Notably, the shelter index was up 4.0% year-over-year.

The chart below suggests that, absent tariff inflationary pressures, core CPI would finally be on its last leg lower toward the Fed’s 2.0% target.

Ironically, this positive development in core CPI could give more confidence to policymakers in pressing forward with inflationary tariffs.

Bostic Concurs

In an interview on Marketplace, president and CEO of the Federal Reserve Bank of Atlanta, Raphael Bostic, appeared to concur with Schmid’s concerns:

“I think the pressures that are out there are not the best for our mandates. All the models say that the introduction to tariffs is going to put upward pressure on prices, and I’ve seen more reports of recession fears in the media and from our business contacts than I’ve heard in a year and a half or two years. And so that’s also going to put pressure on our mandate, the employment mandate, in a way that is not positive.”

Bostic’s tiny source of solace is that “the current environment today might not be the current environment tomorrow.”

Currency Correction

Typically I conclude these inflation reviews by teasing out some implications and impacts in currency markets via the U.S. dollar. This time around, there are too many tariff-related cross-currents and too much economic chaos to directly connect dots. So, instead, I take this time to describe a “currency correction” I had to make on the Canadian dollar (USD/CAD) and the Mexican peso (USD/MXN).

A month ago I explained:

“I am short USD/MXN out of a belief that economic relations with Mexico are about as bad as they can get. I could of course get proven wrong in due time. On the other hand, I am long USD/CAD because I do not think the market fully appreciates how much weaker the Canadian economy will get as it tries to match the U.S. in this economic warfare.”

I was correct for almost two weeks, but in due time I have been proven wrong. I have now closed out both trades in order to reassess my next moves. Surprisingly, the Canadian dollar has proven quite strong against the Mexican peso. The exact opposite of my expectations. That chart below shows how CAD/MXN is breaking out from an approximate triangle or wedge type pattern.

Even more importantly, USD/CAD has broken below a key support level at the same time the U.S. dollar looks poised for a fresh, major breakout against the Mexican peso. In other words, in the last 2-3 weeks, I could not have been more wrong! (Note how the 25% tariff on Canada and Mexico defined a PEAK for USD/CAD, a classic contrarian move).

While USD/CAD broke support at its 200-day moving average (DMA) (the blue line), USD/MXN HELD 200DMA support. Thus, USD/MXN looks likelyly to head even higher while USD/CAD looks likely to head even lower.

This currency correction took me by surprise. The move likely reflects the effectiveness and the robustness of Canada’s current resistance to U.S. economic warfare. Mark Carney, the new Prime Minister of Canada, has been quite clear in laying out a framework of Canadian resistance. The Governor of the Bank of Canada, Tim Macklem, has been similarly forthright in laying out the implications for monetary policy and bracing Canadians for the economic warfare ahead. Apparently, both men have, so far, succeeded in bolstering Canada’s defenses (symbolically through the Canadian dollar). The implications for inflation both here and in Canada remain to be seen as trade slows down between the two North American neighbors and former allies.

Be careful out there!

Full disclosure: no positions

The post Inflation Concerns Rise at the Federal Reserve Amid Tariff Unease appeared first on Inflation Watch.

However, a systemic perspective greatly weakens claims of a one-time adjustment. Over time, tariffs can create a cascading effect through the economy, especially when tariffs are broadly applied across a wide swath of goods and services. Over time, tariffs can embed and entrench inflationary pressure in the economy from the following:

• Wage pressures – workers may demand higher wages to compensate for persistently higher consumer costs.
• Supply chain adjustments – companies may shift to more expensive domestic or alternative suppliers.
• Cost pass-through effects – producers adjusting pricing behavior in response to permanently higher costs as they enjoy greater pricing power amid a reduction in alternatives.

Moreover, successive rounds of tariffs, as the economy is experiencing now, amplify inflationary ripple effects, making them harder to unwind.

Still, that one-time adjustment is higher and persistent. So I am skeptical as Bessent also tries to resurrect “team transitory” when explaining the impact of tariffs. For inflation to be transitory, price levels would need to revert after the initial tariff shock. Tariffs make price reversion unlikely by locking in a permanently higher cost base unless offset by productivity gains, currency shifts, or supply chain innovations. Again, all else being equal, as long as the tariff is in place, someone is paying the cost, this year, the next year, and so on. The price increase will not disappear on its own accord. If you are still complaining about how much higher prices are now compared to 2019, you will find yourself complaining years out about the higher prices brought on by tariffs passed on to the consumer level.

Can pandemic-era inflation be described as a one-time adjustment? Of course. All we need to do is extend the time period over which “one-time” applies. The chart below shows the year-over-year change in the average annual CPI. Even if inflation slows to its pre-pandemic pace by 2026, the accumulated price increases remain, permanently raising the cost of living (of course, I have my doubts about the pace of inflation’s decline given the underlying stickiness of key inflationary components). In 2027, a casual observer could look back and conclude this inflationary era was a one-time price adjustment that lasted about 5 years. While the conclusion would be technically correct, the broad price level remains significantly elevated, straining household budgets long after the inflationary event passes. In other words, a “one-time adjustment” in this context is only academically meaningful.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average [CPILFESL], retrieved from FRED, Federal Reserve Bank of St. Louis; March 7, 2025.

Terms like “transitory” and “one-time adjustment” do not speak to the direct and real-time impacts on consumers. These terms are sleights of hand to convince financial markets to look through the price dynamics. Consumers cannot look through these impacts. They must immediately adjust spending habits to account for the deterioration in spending power from tariffs, especially broad based ones (all else being equal).

Adjustments and Transitory Effects In Currency Markets

In foreign exchange, the Canadian dollar and the Mexican peso have served as ground zero for the current chaos over ever-changing policies on tariffs and economic warfare. However, overall, against the U.S. dollar, these currencies have stuck to a well-defined trading range. Against the U.S. dollar, the peso was trading at these same levels four months ago with a 5% trading range from bottom to top (excluding outliers). Against the U.S. dollar, the Canadian dollar was trading at these same levels three months ago with a 2.6% trading range from bottom to top (excluding outliers). On the biggest single-day of volatility, the day tariffs were delayed for a month right before they were scheduled to take effect, USD/MXN traded through a 4.7% range and USD/CAD traded through a 2.8% range. In other words, both currencies covered their entire range of volatility in one day.

These percentages are large in foreign exchange. The adjustments can be seen in the persistently elevated levels for both USD/MXN and USD/CAD. There is no transitory observation until the volatility dies down and/or the price adjustment itself reverses. In the meantime, I am short USD/MXN out of a belief that economic relations with Mexico are about as bad as they can get. I could of course get proven wrong in due time. On the other hand, I am long USD/CAD because I do not think the market fully appreciates how much weaker the Canadian economy will get as it tries to match the U.S. in this economic warfare. Combined, these two trades are good pair trades where I collect interest income from USD/MXN as I wait. Week-to-week volatility in USD/CAD allows me to execute a few swing trades.

Epilogue

Last week I spent more time understanding the economic theories and frameworks espoused by Bessent. The interview at the Economic Club of New York with Larry Kudlow was educational in that respect. Unfortunately, the recording started after the commentary on tariffs. Minus the cheap shots, the rest of the interview is worth watching and understanding.

Be careful out there!

Full disclosure: long USD/CAD, short USD/MXN

The post The Sleight of Hand Behind the ‘One-Time Adjustment’ and ‘Transitory’ Tariff Inflation Narrative appeared first on Inflation Watch.

The chart below from the Surveys of Consumers – University of Michigan shows another interesting element of the inflation story. Long-term consumer expectations for inflation have remained elevated since the pandemic. The surge in short-term expectations may be strong enough to push longer-term expectations into breakout territory.

Source for Data: the Surveys of Consumers – University of Michigan

The latest spike in inflation expectations may soon cool off like the previous ones, but I do not expect the downtrend to resume from there given the current macroeconomic and policy environment. For example, as tariff talk translates into action which in turn translates into higher prices, I fully expect inflation expectations, at least short-term, to rise above current levels.

A Tired and Topping Dollar?

Interestingly, for all the talk about how tariffs will boost the U.S. dollar, the greenback is now down for the year and looks like it will continue trending downward. The Yale Budget Lab explains how the dollar strengthens from tariffs when there is no retaliation. When countries retaliate, their domestic demand for U.S. goods may decline and as a result demand for U.S. dollars declines. Could it be that the currency market is starting to wrestle with a net impact on the dollar from tariff wars just as consumers are starting to fear inflationary impacts from tariffs?

The U.S. dollar index (DXY) topped out in mid-January and is now down 1.7% for the year. (Source: Tradingview.com)

Canadian Resistance

Perhaps the volatile action against the Canadian dollar is instructive. When I last wrote, I explained why I decided to take profits on a long USD/CAD position. That exit turned out to be timely. Just two days later, USD/CAD surged right to resistance from the double-top formed across 2016 and 2020 highs and quickly reversed. President Trump created wild currency volatility by announcing tariffs on Saturday, February 1, and then reversing two days later with a 30-day “pause” following concessions from Canada. During this episode and in its wake, an active “Buy Canadian” movement has taken hold. If tariffs are re-enacted I expect vigorous retaliation from Canada. In other words, the dollar’s rally against the Canadian dollar may have indeed peaked on February 3rd with the blow-off top.

USD/CAD broke down below support at its 50-day moving average (DMA) (the red line above) and could be on track to eventually reverse all its gains from November’s big breakout. Source: TradingView.com

Having said that, I am not yet ready to short USD/CAD. I am actually long again preparing for the possibility of one more rally (to the 50DMA or maybe even challenge the high?) before USD/CAD confirms its top. My long USD/CAD is also a small hedge against other bets against the dollar.

Be careful out there!

Full disclosure: long USD/CAD, long SPY put spread

The post Inflation Expectations Surge As the U.S. Dollar Tops Out appeared first on Inflation Watch.

• Inflation remains elevated (from the FOMC statement)
• The risks to achieving employment and inflation goals are roughly in balance (also from the FOMC statement)
• No one dissented to the decision

Taken together, the Fed looks resolute about what Powell explained in the press conference as “we see things as in a really good place for policy and for the economy and so we feel like we don’t need to be in a hurry to make any adjustments.” However, this decision sure felt like the calm before the storm given the bookends to this meeting with big AI headlines and tariffs.

Inflation Floating Into Tariff Pressures

Inflation’s profile continues to give the Fed reason to pause. However, Powell said the Fed sees a “pathway” for inflation getting to target. The current downtrend in inflation for owner’s equivalent rent and housing services continues to exert downward pressure on overall inflation. However, for now, the downtrends in core CPI and PCE have essentially stalled since last summer. Powell is fond of explaining “we want to see further progress on inflation” and further progress has not happened for several months.

Sources: U.S. Bureau of Economic Analysis, Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index) [PCEPILFE], retrieved from FRED, Federal Reserve Bank of St. Louis; U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average [CPILFESL], retrieved from FRED, Federal Reserve Bank of St. Louis. January 31, 2025.

While there is reason for optimism that inflation will eventually float downward to target, other forces are brewing that could disrupt the narrative. At the time of writing, the U.S. announced blanket tariffs on three of its major trading partners. Starting February 4, the U.S. will charge Canadian and Mexican imports a 25% tariff, with a reduction to 10% for Canadian oil. Chinese imports will have a 10% tariff. The announcement even includes an escalator in case of retaliation. Canada has already promised retaliation with a 25% tariff on various U.S. goods. While there is some unconventional thinking out there about the economic impact of such broad-based tariffs, I am leaning toward more, not less, inflation from all this economic warfare.

Bond Vigilantes Calm for Now

In my last post, I referred to the reaction of the bond market to monetary policy. In this latest decision, Powell was very clear that term premium, the additional return that investors demand based on perceived risks, is driving up long-term rates. He insisted these yields are not going up because of inflation expectations or policy expectations. Thus, Powell is instead blaming unsustainable deficits and expectations for future massive bond issuance. However, the jury is still out. The bond market responded to the last two cuts with swift increases in long-term yields. This time, with no rate cut, the bond yields remained well-behaved.

The reaction to tariffs will be interesting. Yields could decrease because of anticipated economic weakness. Yields could increase because of anticipated inflationary pressures. Of course, sitting in the middle is stagflation. Either way, my trading strategy to fade rallies in iShares 20+ Year Treasury Bond ETF (TLT) does not look nearly as good as before!

The iShares 20+ Year Treasury Bond ETF (TLT) held mostly steady for the week right under resistance from the bottom of the previous trading range.

The Canadian Dollar In A Storm

There is a lot to say about the U.S. dollar and the current volatility in currency markets. The Canadian dollar (FXC) is particularly interesting because I thought by now USD/CAD would have broken through major resistance from a major double top. Instead, USD/CAD has churned in a wide trading range. After wild trading on Thursday and Friday tariff headlines, USD/CAD settled just above the top of that range. I decided to take profits and just wait to get back in on a fresh breakout and clear trend.

Be careful out there!

Full disclosure: long TLT puts

The post A Fed Calm Before A Market Storm? appeared first on Inflation Watch.

The stock market woke up the next day after the Producer Price Index (PPI) came in hot and suggested once again that underlying price pressures in the economy continue to increase. The S&P 500 gapped down and lost 0.5%. More importantly, TLT lost another 1.2% and confirmed a breakdown below its 50-day moving average (DMA). The core PPI, Final Demand Less Foods and Energy, has trended upwards all year and is now at its highest level since February, 2023 at 3.5%.

Source: U.S. Bureau of Labor Statistics, Producer Price Index by Commodity: Final Demand: Final Demand Less Foods and Energy [PPIFES], retrieved from FRED, Federal Reserve Bank of St. Louis, December 12, 2024.

Assuming the Federal Reserve cuts rates next week as expected, I am guessing rate cuts will slow to a crawl if not come to an outright halt for the beginning of 2025. Accordingly, the Fed’s communications to the market will get about as tricky as ever. Fortunately for the bulls the market’s momentum carries a large amount of buffer from current Animal Spirits.

iShares 20+ Year Treasury Bond (TLT)

The fascinating contrast between stubbornly stable inflation and Fed rate cuts continues to keep me fading rallies in TLT. TLT’s earlier breakout above its 50DMA (the red line below) almost fooled me. TLT is now closing the gap up created by Trump’s pick to head the U.S. Treasury department, Scott Bessent. Assuming that gap closes, a true test of the bottom of the presumed trading range should finally unfold.

Gold

While TLT delivered, gold disappointed. I have a live short-term trade in PHYS and call spreads and call options in SPDR Gold Trust (GLD) that orbits my core long-term position in GLD shares. I was encouraged by GLD’s reaction to the CPI and just assumed the rally would continue into at least the end of this week. Instead, GLD reversed right back to 50DMA support. I do not have a ready hypothesis to explain this seemingly contrarian move. (I would love to hear yours!)

What Happens If the Fed Gets “Hawkish”

The Fed is currently dovish. It would not take much for the Fed to sound hawkish. A firm follow-up to the round of Fedspeak attempting to walk back market expectations for rates cuts could set off the alarm bells for the market. At that point, the short-term GLD trade gets less attractive. TLT will probably still be good for fades. The stock market will likely stall for at least the rest of the Santa rally season….just enough time to find the next reason to reinflate Animal Spirits.

The big wildcard for me in a “more hawkish Fed” scenario is the U.S. dollar. There are multiple countervailing catalysts that make the U.S. dollar attractive and unattractive. Thus, it is hard to develop conviction beyond the short-term technicals. Right now, I still like fading the euro against the U.S. dollar. At the same time, I finally gave up trying to catch a pullback in USD/CAD, a strengthening in the Canadian dollar (Invesco CurrencyShares Canadian Dollar Trust (FXC)). I am now playing the major breakout to the long side. USD/CAD is practically making a beeline to test a critical long-term double-top spanning 2016 and 2020.

Be careful out there!

Full disclosure: long USD/CAD, short EUR/USD: long GLD shares, calls, and call spread; long PHYS, long TLT puts

The post Bonds Try to Weigh on A Market Trying Harder to Look Past Stabilizing Inflation appeared first on Inflation Watch.

Nevermind that a read hotter than consensus has little impact on the current trend. The chart below from the U.S. Bureau of Labor Statistics shows that even as core CPI (all items less food and energy) is flattening out a bit (the red line), the “sticky” shelter component of inflation is still hurtling downward (the purple line).

With the trend still favoring the death of inflation, I think of “sticky” as a reference to people’s impatience with an inflation component taking too long to converge with the overall average inflation level. The CPI report highlighted the relative stubbornness of shelter inflation:

“The shelter index increased 0.6 percent in January, and was the largest factor in the monthly increase in the index for all items less food and energy. The index for owners’ equivalent rent rose 0.6 percent over the month, while the index for rent increased 0.4 percent. The lodging away from home index increased 1.8 percent in January…The shelter index increased 6.0 percent over the last year, accounting for over two thirds of the total 12-month increase in the all items less food and energy index.”

The bubble chart below from the U.S. Bureau of Labor Statistics shows the outsized influence of services less energy services on total inflation (the large purple bubble). This major component includes shelter. Its relative importance of 60.9 dwarfs the relative importance of all other major components of inflation.

Given the angst directed at the shelter component of inflation, I looked at what the National Association of Home Builders (NAHB) had to say about this CPI report. The industry group provided a reassuring conclusion: “the NAHB forecast expects to see shelter costs decline further in the coming months.  This is supported by real-time data from private data providers that indicate a cooling in rent growth.” So while the housing price picture is mixed with existing homes on the uptick and new homes on the downtick, overall rents should continue a cooling pace as expected.

Unfortunately for those traders and investors buying stocks and bonds in anticipation of rate cuts, this reminder of inflation’s stickiness pushed out expectations for the first rate cut from the Federal Reserve. Over-eager financial markets pushed out the first rate cut from May to June. This is a bitter pill to swallow for those who started buying stocks and bonds late last year in anticipation of a rate cut in March (because the Fed admitted to inflation’s death of course). The chart from the CME FedWatch Tool shows how the odds favoring a May rate cut immediately evaporated.

The Fizzle and Sizzle in Financial Markets

Interestingly, currency markets and the bond market have been moving counter to the rallies in the S&P 500 (SPY) and the NASDAQ (COMPX). The 2024 rally in the U.S. dollar index (DXY) has taken the index ABOVE the point where currency traders dumped the dollar in the wake of inflation’s death. The chart below from Tradingview.com shows a bullish breakout for the dollar last month above its 50-day moving average (DMA) (the red line) and a successful test of the trend line as support earlier this month.

The dollar’s rally complicates my bullish trades on the Canadian dollar but also provides my latest opportunity to fade USD/CAD (Invesco CurrencyShares Canadian Dollar Trust (FXC)) within the trading range. I am net long the U.S. dollar by being short EUR/USD (Invesco CurrencyShares Euro Currency Trust (FXE)).

Excluding a sharp countertrend rally at the end of January, iShares 20+ Year Treasury Bond ETF (TLT) has sold off most of 2024.

These trends further reinforce the notion and fear that perhaps earlier rate cut expectations were indeed premature. After the market’s pullback (the S&P 500 lost 1.4% and remains in an uptrend) will stocks also concede the point or will they return to ignoring deteriorating market breadth and other signs of caution in the stock market?

The volatility index (VIX) may have already blown off enough steam to soothe the groans of the bulls…for now. Note carefully how the VIX stopped going down this year and thus has an ever so slight uptrend going…

Be careful out there!

Full disclosure: net long U.S. dollar

The post From Inflation Fizzle to Sizzle appeared first on Inflation Watch.

This admonition is unsurprising given Macklem’s general reluctance to declare victory over inflation. While the Bank of Canada increasingly sees the elements needed to get inflation back down to 2%, Macklem stated that “we are not there yet.” They need to see sustained and further (for “a number of months”) downward momentum in core inflation.

Cautious About the Signs of Victory Over Inflation

December’s statement on monetary policy also reflected the Bank of Canada’s wavering. The statement estimated that “data and indicators for the fourth quarter suggest the economy is no longer in excess demand. The slowdown in the economy is reducing inflationary pressures in a broadening range of goods and services prices.” These conditions should have generated a declarative victory statement. Instead, the Bank of Canada proceeded to posture staunchly against inflation: “Governing Council is still concerned about risks to the outlook for inflation and remains prepared to raise the policy rate further if needed. Governing Council wants to see further and sustained easing in core inflation, and continues to focus on the balance between demand and supply in the economy, inflation expectations, wage growth, and corporate pricing behaviour.”

Still, in the interview, Macklem acknowledged that rates are likely to start coming down in 2024. He just refused to provide a timetable.

The Soft Landing

The interviewer pointed out that the scenario Macklem portrays sounds like a “soft landing” for the economy. Macklem was careful not to use that term. Instead he pointed out that much of the adjustment in the labor market has come through a reduction in vacancies instead of a large rise in unemployment. An anticipated weakness in growth for the next 2 to 3 quarters should not generate a “deep” recession. Macklem directly claimed that “we can get inflation back to 2% without a recession.”

This year will be a transition year. By the end of the year, the economy should be in soft landing mode if all goes well.

The Canadian Dollar

The Bank of Canada released its December statement on monetary policy just as the U.S. dollar was experiencing a slight relief rally against the Canadian dollar (USD/CAD) (or the Invesco CurrencyShares Canadian Dollar Trust (FXC)). The slide resumed with the Federal Reserve’s decision on monetary policy the following week and the resulting celebration over the implicit announcement that inflation in the U.S. is dead. I had long anticipated the decline at the time with a target of testing the lower part of a trading range in place since September, 2022.

After taking profits, I am back to accumulating a short position. I expect the Bank of Canada’s on-going caution and the Bank’s refusal to get dovish to act as a tailwind for the Canadian dollar. The chart below from TradingView.com shows volatility in USD/CAD distinctly driven by key events. The Bank of Canada’s next Monetary Policy Report will come on January 24th. The Fed comes around the week after.

So, overall, I continue to favor playing the trading range in USD/CAD as an eventual trip to or toward the bottom of the range. I currently cannot foresee catalysts that will push the currency pair to stray too far away from the range. If USD/CAD escapes the range, I think the odds favor a breakdown over a breakout.

Be careful out there!

Full disclosure: short USD/CAD

The post Bank of Canada’s Macklem: The End is In Sight But Rates Are Not Returning to Pre-Pandemic Levels appeared first on Inflation Watch.

The Bank of Canada is worried about higher energy prices, “structural pressures” in the housing market primarily related to supply shortages (which it acknowledged must first be addressed on the supply side), and “persistence in underlying inflation.” This underlying inflation consists of elevated “near-term inflation expectations and wage growth” and corporate pricing decisions that are “normalizing only slowly.” Core inflation on a year-over-year basis has come down, but the 3-month view shows little downward momentum. Accordingly, the Bank of Canada put the country on notice that it is leaving the door open to future rate hikes because of the stubborn uncertainty in getting inflationary pressures down.

Yet, the BoC did not proceed with a rate hike. Counterbalances to the increased inflation risks remain. Overall supply and demand in the Canadian economy is almost in balance with the trend favoring excess supply. The BoC also downgraded its outlook for economic growth because the economy slowed more than expected back in July; less excess demand exists than expected.

So while the BoC hiked its expectation for inflation from 3% to 3.5% for next year, the central bank is sticking to its longer-run projection of 2% in 2025. Thus, Macklem felt confident in reassuring Canadians: “with clearer evidence that monetary policy is working, Governing Council’s collective judgment was that we could be patient and hold the policy rate at 5%.“ Interest rates will stay higher for longer and the inflation target remains in sight.

Corporate and Government Behavior Working Against Monetary Policy

Companies and Canadian governments in aggregate are not cooperating with the objectives of monetary policy.

Canadian companies are still passing along price increases to consumers faster than normal. From the Monetary Policy Report:

“Corporate pricing behaviour has yet to normalize. Businesses continue to increase prices more frequently and by a larger amount than normal… This may indicate that households and businesses are, respectively, expecting to pay more and charge more for goods and services. High inflation expectations could also feed into wages.”

I assume this dynamic also comes from lingering excess demand which makes consumers less price sensitive. The coming era of excess supply should work counter to this effect.

During the Q&A Macklem pointed out that the fiscal spending plans are working against monetary policy. Aggregate government plans will grow spending by 500 basis points greater than the potential growth of the Canadian economy. Thus, the economy will add more demand than supply. In the past year, growth in government spending was below 2%. Macklem indicated that it would be helpful if fiscal and monetary policy were “rowing together.” The BoC’s forecasts take into account the potential future inflationary pressure from government spending.

The Canadian Dollar Trade

The bump higher in hawkish rhetoric did not benefit the Canadian dollar, perhaps because the BoC maintained its longer-term expectation for inflation. Weakness in the currency Invesco CurrencyShares Canadian Dollar Trust (FXC) or strength in USD/CAD continued until the Federal Reserve’s last policy announcement. Financial markets painted a dovish interpretation to the accompanying news even though it read like nothing materially changed.

I did not expect the drift higher (with high volatility) in USD/CAD as I accumulated a short position. I continue to hold the position as I see two main factors working against my thesis reaching their own individual extremes.

The biggest shift against my original setup was a big increase in the spread on 10-year yields between U.S. and Canadian bonds. Just over a month ago this spread sat at a level that looked like a potential bottom. Shortly thereafter, the bottom dropped out. The spread was last this wide back in March, 2019. This large spread serves advantage to the U.S. dollar over the Canadian dollar. From World Government Bonds:

Oil has also worked against my original thesis. Oil did not stabilize. While it soon spiked higher in response to Hamas’s attack on Israel, selling in oil resumed in about 10 days. Last week, the United States Oil Fund, LP (USO) hit a 3+ month low. While this decline should reduce the Bank of Canada’s fear that higher energy prices will bleed their way into pressures on core inflation, it also works against the Canadian dollar as a commodity currency. I have dropped any expectation on oil although I am net short USO. From TradingView.com:

From a technical perspective, USD/CAD remains well-supported by its uptrending 50-day moving average (DMA) (the red line below). I still expect this uptrend to break to the downside as the extremes working against the Canadian dollar lose steam. To the upside on USD/CAD I have a clear stop loss point above the peak created by the reaction to the Federal Reserve’s November 1st announcement on monetary policy. From TradingView.com:

Be careful out there!

Full disclosure: short USD/CAD, net short USO (short shares, long call spread)

The post Canada’s Version of Higher for Longer: Inflation Risks Have Increased appeared first on Inflation Watch.

Back in April, the Bank of Canada (BoC) described a goldilocks narrative on inflation. This narrative featured the annual change in the Consumer Price Index inflation (CPI) gradually returning to the 2% target at the end of 2024 with economic growth picking up alongside inflation’s downward glide path in 2024. Just two months later in June, the Bank of Canada raised concerns about stubborn inflation and on-going high excessive demand. Accordingly, the BoC took its finger off the pause button on rate hikes and wrote an insurance policy on inflation with one more rate hike. The latest stall in inflation’s trend caused market expectations of a rate hike in October to surge from 23% to 42%.

The Canadian dollar surged along with rate hike expectations. The Canadian dollar was already rallying against the U.S. dollar (USD/CAD) going into the inflation print despite the U.S. dollar’s strength against other major currencies. The chart below shows how the Invesco CurrencyShares Canadian Dollar Trust (FXC) gapped higher at the open but faded from the intraday high. While the intraday action may represent an element of sell on the news, I think the path of least resistance is higher for the Canadian dollar until some new inflation data contradicts the revival of inflation concerns. I sold a small position short on USD/CAD to take advantage of the small fade.

I am not expecting the Federal Reserve’s coming announcement on monetary policy to change the trajectory. Accordingly, I will add to my position if USD/CAD rebounds further.

Drivers of Core Inflation

Core inflation was supported by accelerating rent prices. Ironically, Statistics Canada partially blamed high mortgage rates which are of course higher thanks to the BoC’s rate hikes to fight inflation:

“Shelter prices were up 6.0% on a year-over-year basis in August, after increasing 5.1% in July. Faster growth in shelter prices was led by the rent index, which rose 6.5% year over year nationally, after a 5.5% gain in July. Among other factors, a higher interest rate environment, which may create barriers to homeownership, put upward pressure on the index.”

Presumably, the higher mortgage rates are forcing more people than usual to choose renting over buying and in turn pressuring vacancy rates. Lower vacancy rates tend to push rent prices higher.

I might next need to write about a Canadian inflation conundrum!

Be careful out there!

Full disclosure: short USD/CAD

The post A Stall in Canada’s Core Inflation Narrative appeared first on Inflation Watch.

“While CPI inflation has come down largely as expected so far this year, the downward momentum has come more from lower energy prices, and less from easing underlying inflation. With the large price increases of last year out of the annual data, there will be less near-term downward momentum in CPI inflation. Moreover, with three-month rates of core inflation running around 3½-4% since last September, underlying price pressures appear to be more persistent than anticipated. This is reinforced by the Bank’s business surveys, which find businesses are still increasing their prices more frequently than normal.”

I have seen more and more references to base effects regarding U.S. inflation. In the previous two years, base effects could be used to dismiss inflation’s threat. This year, base effects from more challenging comparables are looming as the end of the tailwinds for disinflation (on a year-over-year basis). The timing is poor. As the Bank of Canada noted, underlying inflation has gone nowhere for almost a year. At this point, sticky inflationary pressures cloak more uncertainty around prior inflation expectations:

“In the July MPR projection, CPI inflation is forecast to hover around 3% for the next year before gradually declining to 2% in the middle of 2025. This is a slower return to target than was forecast in the January and April projections. Governing Council remains concerned that progress towards the 2% target could stall, jeopardizing the return to price stability.”

Surprisingly, markets took the news in stride. At the same time the U.S. stock market celebrated a pleasing report on U.S. June inflation, the Bank of Canada’s rate hike did not dampen spirits about the prospects for a more dovish Federal Reserve. Currency markets reacted as though the Fed might even be closer to rate cuts as losses in the US. dollar continued apace.

In fact, the market almost seemed to skip right over the Bank of Canada’s news. While majors like the euro and the British pound rallied all day against the U.S. dollar, the Canadian dollar enjoyed just brief intraday strength in the wake of the Bank of Canada’s decision to hike rates another 25 basis points. At the time of writing, USD/CAD is only just now returning to its low point following the rate hike (and looks stalled right at support).

On a daily basis, the Canadian dollar looks set to resume its momentum against the U.S. dollar IF USD/CAD breaks below yesterday’s low. Otherwise, a countertrend rebound could take USD/CAD right back to downtrending resistance at the 50-day moving average (DMA) (the red line below) as the next move.

I remain bearish on USD/CAD (bullish the Canadian dollar), and I expect rallies to continue to fail just as they have since September. The path downward on USD/CAD (upward for Invesco CurrencyShares Canadian Dollar Trust (FXC)) has been slow and choppy yet ever so slightly biased toward more relative strength for the Canadian dollar. The next major test comes with the Federal Reserve’s meeting later this month. More Fed hawkishness at that time could refresh the U.S. dollar against all majors for a spell.

Be careful out there!

Full disclosure: no positions

The post Base Effects Add to the Bank of Canada’s Inflation Concerns appeared first on Inflation Watch.