From ECB Market Rebuff to PCE

The euro posted its biggest percentage weekly gain in five months as traders were unconvinced by ECB president Christine Lagarde's transitory inflation narrative. The euro was the top performer while the yen lagged. With US yield curve flattening further, markets are already doubting the extent of any taper from the Fed. The Core PCE price index, the Fed's preferred measure of inflation is due up next (see more below). 

Like market participants, central banks are now dividing themselves into separate camps regarding inflation. Christine Lagarde championed Team Transitory once again on Thursday after holding rates steady. She said the central bank did some 'soul searching' but is confident in the transitory view.

"Our analysis certainty does not support that the conditions of our forward guidance are satisfied at the time of liftoff as expected by markets, nor any time soon thereafter,” she said.

Contrast that with the Bank of Canada, which hiked its 2022 inflation forecast by a full point to 3.4% on Wednesday and market pricing that showing an ECB hike around this time next year and much more for other central banks.

The broader market is showing some of the same tensions as long-dated yields fell this week but there have been blowouts on the short end, including in Australia where 2s are now yielding 0.5%, much higher than the RBA's 0.10% yield curve control target.

Next week's Fed decision looms increasingly large with a hike now 90% priced in for June. The troubling part is that the $15B/monthly taper suggested in the FOMC minutes wouldn't end until July, which goes beyond the Fed's latest guidance. Pay close attention to the size and pace of the taper. 

The advance Q3 GDP was on the soft side at 2.0% compared to 2.7% expected but not as weak as feared. Notably, stripping out all the auto-related drops – which were largely due to chip shortages – and GDP grew 7.2%. That's a signal that supply is the problem, not demand.

The question that continues to plague market participants is inflation and we get the latest numbers for the US on Friday. The consensus is for a 4.3% y/y inflation rise and 3.6% on the core. It's tough to see it altering the Fed's view, it could light another fire under the bond market.