What inflation I hear you cry? European inflation? The inflation everyone was worried about when QE was trotted out around the globe? Japan?
When trading fundamentals trying to get ahead of the curve is the most important task, seeing the signs that suggest events are going to take a certain path.
A lot was made over the last few years about inflationary pressures that would arise with central bank pumping. It didn’t come, not because QE had no effect, but because the major economies were slowing. If no one is buying then prices drop. It’s simple market economics. So inflation fell and the market and central banks crossed the inflation risk off the list. Just as the crisis was magnified in Europe so were the effects. Inflation fell/is falling more there than elsewhere.
Europe aside, now it’s coming back. We’ve been watching it happen in Canada. They have seen a big jump in inflation that is becoming more than the “temporary factors” the BOC has been telling us it is.
The US has seen signs of inflation growing, Japan is going hell for leather to get theirs up and, with the exception of last months numbers, the UK has stabilised around the 1.6%/1.8% mark.
Trading inflation can be looked at in its simplest form. Inflation goes up, so do interest rates. In this current low interest rate environment we really are at the bottom. Any signs of a pick up in inflation and the market is only going to be looking for rates to go one way.
Delving one layer down into the inflation trade we need to be aware of the differences in inflation. Domestic and imported. Domestic inflation (wages, house prices etc) is what the central banks can react to, imported (energy, food) they can’t. This will mark the difference in whether a central bank will or won’t raise rates.
At the moment ANY sign of sustained inflation will have the market looking at rates. A lot of the Canadian CPI can be put down to energy prices. That hasn’t stopped USD/CAD from losing 200 pips.
Inflation is a very lagging beast and I’ve warned that it may sneak up on countries quicker than they expect. Already today we’ve heard Plosser talking about it and it will only take a couple more like him to get the market’s attention. If Yellen gets the CPI bug then the market will scramble on the rate trade. What we also need to look out for is the risk that inflation may cause CB’s to raise higher and faster than they want.
So how do we play it?
The big trade is the US and so obviously the dollar. The market is still happy with rate forecasts but a big jump in prices may get them expecting an earlier move. I see inflation coming and coming quicker than expected so I’m looking for any decent dip in USD/JPY to load up, say to 101 or under. The stubborn beast that it is may mean that I’ll be waiting a while and may have to start scaling in at current levels.
The UK should start to see some of the effects of falling unemployment playing out in wages. As jobless numbers fall people feel more secure. Confidence grows in asking for pay rises and looking at other jobs. The balance of power shifts towards the employed from the employers.
We’re very much at the mercy of energy and food prices so the core is a more important gauge in the UK. The window between inflation having an effect and rate expectations is narrowing meaning that there may not be much room left to play. The dollar may hold sway over the pound by size alone but I don’t see cable giving up much unless it’s going to be second in the rate rise race.
Europe is still the wild card so there maybe a bit more room to trade the US against it. It puts my current longs in conflict with yet another negative euro event and one I’m going to have to seriously consider over the next few days. Whatever the play we know that selling euro’s is hard work even when the fundamentals are screaming a sell at us.
So, USD/JPY is going to be my main play. I’m always looking from the long side anyway and this is another brick in that wall. Today’s data has just reinforced the fact that the US is trotting along nicely and that will naturally lead to price rises. There may be a long way yet to go but it’s the early bird that catches the worm.
