They’re All On Alert

Concerns the yield curve could invert
Has prompted the Fed to assert
That none of them think
The growth rate will sink
Regardless, they’re all on alert!

As the Treasury market curve continues to flatten, with the 2’s-10’s spread closing Wednesday at 42bps, a new low for the move, we have now heard four Fed speakers (Williams, Dudley, Evans and Kashkari) discuss the fact that they are aware of the history of inverted yield curves and ensuing recessions, and that they continue to believe that their actions will not trigger either inversion or recession. In fairness, Kashkari was a little less convinced than the others, but then he is one of the most dovish members of the FOMC. I guess a lot depends on just how inflation actually behaves going forward because if we start to see CPI tick up to 2.5% or higher, I think the fear of an inverted yield curve will quickly dissipate. That is because investors will be quick to sell the back end of the curve and wait for yields to rise to more attractive levels that take into account a higher inflationary environment. However, if inflation were to stall again, like we saw last year, then it is very possible the Fed, assuming they continue raising rates as currently expected, could invert the curve. At this point, there is no way to know how it will play out, which is just another reason that the most important data points these days are the inflation readings, not employment readings.

So what will happen to the dollar if the curve inverts? The last two times the yield curve inverted were in 2006, presaging the recession of 2007-8 and the financial crisis, and in 2000, presaging the tech crash and recession of 2001. In 2006, the dollar fell sharply during the inversion and only rallied after the crisis blossomed into the mother of all risk-off events. But in 2000, the dollar actually rallied modestly until after the recession ended and the series of Fed rate cuts seemed to finally unhinge the FX market so the dollar subsequently fell. The point is there is no clear precedent for the dollar to move in either direction simply due to the fact of the inversion. Rather, other circumstances are going to be critical to determining what may occur this time.

First let me say that as the curve has not yet inverted, none of this may matter. But second, if we assume that it does invert then my sense is it will be because the current inflation trajectory stalls and expectations for future growth moderate. In that event, and given the structural issues I discussed yesterday and which are not going to change any time soon, I would expect this situation to more closely resemble 2006 and that the dollar would lose ground rapidly. In fact, in this scenario a euro move toward 1.40 or beyond would be quite viable. Given the extended period that the dollar has been range trading, my take is that a convincing break of the range, so in the euro consider above 1.26-1.27 can lead to a very sharp additional move. Now I am not forecasting this outcome, merely trying to estimate what might happen in the event that the yield curve does invert. So a hypothetical based on a different hypothetical is hardly a strong position. Please take that for what it is worth! However, the one thing of which I am increasingly certain is that we are going to continue to hear a great deal about the shape of the yield curve for foreseeable future. On that you can bank!

The other notable news from yesterday was the Bank of Canada sounding somewhat dovish while leaving rates on hold. Although there was only very limited expectation of a rate hike, the fact that Governor Poloz sounded concerned about the future rather than upbeat was seen as a distinct negative for the Loonie. In the end, CAD fell 0.4% and has maintained those losses overnight.

Turning to the overnight session, things have been generally quiet on the FX front ( a theme that has been evident for quite some time now) with only two data releases of note. First, Australian employment data was a tad soft, with just 4900 net new jobs, far less than the 21K expected, but interestingly, AUD has managed to rally slightly, 0.2%, after the release. This looks more like a ‘sell the rumor, buy the news’ rally and I wouldn’t put much stock in it as a harbinger of the future. The other data was UK Retail Sales, which also disappointed, falling a greater than expected -1.2% in March. While this was largely attributed to the extremely cold weather during the month, it nonetheless resulted in an initial decline in the pound of about -0.3%. However, in the ensuing market activity, the pound has clawed back most of those losses and is essentially flat on the day now.

In the EMG bloc, KRW continues to benefit from two political stories related to North Korea. Not only is President Trump due to meet with Kim Jong-Un next month and ostensibly discuss denuclearization of the Korean Peninsula, but the North and South are in preliminary discussions to try to officially end the Korean War. The point is that if North Korea were actually to change its pugnacious stance, the market would likely imbue greater opportunities to South Korea. This would be analogous to when the two Germanies merged in the late 1980’s and the Deutschemark rallied sharply.

The other noteworthy story in this bloc is Turkey, where President Erdogan has called a snap election for June and the market has responded by aggressively buying Turkish assets including the lira. Yesterday saw TRY rally 2% on the news and it has largely maintained those gains as of this morning. The idea is that with a new term, Erdogan can stop pressuring the central bank to leave interest rates lower than they probably ought to be, and in the process rebuilding support for the currency based on a higher yield. Otherwise, there has been little of interest in emerging FX markets.

This morning brings two data points, Initial Claims (exp 230K) and Philly Fed (20.1) as well as several more Fed speakers including Brainerd, Quarles and Mester. Quarles continues his testimony to Congress on regulations, so is unlikely to delve into monetary policy, but Brainerd and Mester represent opposite ends of the spectrum in views, so it will be interesting to hear what they have to say. On the whole, the dollar is little changed as I write, as are both Treasuries and equity futures. In fact the one market that has been truly performing well, commodities, would indicate that we could see further pressure on the dollar. However, the dollar has actually gained while commodities have rallied, a highly unusual outcome. Arguably, this relationship will reassert itself soon, and given the weight of evidence, I suspect that we will see the dollar suffer somewhat in the near term, although not aggressively so.

Good luck