At Wit’s End

The worries from Europe have faded
As traders have now been persuaded
They needn’t divest
As further unrest
From Italy has been blockaded

So now much attention is turning
To whether the yield curve’s concerning
Its flattening trend,
Has some at wit’s end
With thoughts that recession’s returning

Markets this morning look quite different than they did Friday morning as we have seen two key changes. First, last week’s angst over the Italian government has essentially been forgotten, with yields on Italian government paper falling back further under the premise that the new coalition government is not going to try anything drastic. And second, the very strong jobs report on Friday has led to concerns that the Fed is going to increase its pace of tightening and potentially invert the yield curve.

Looking at Italy first, it seems to me that the idea that all is well is misplaced. After all, the same players are still there, and neither Five Star nor the League has changed their respective electoral platforms. In other words, while there doesn’t appear to be an immediate concern, I expect that we are going to see ongoing pressure from the Italian situation for many months to come. In the end, their proposed fiscal plans are extremely expensive and they just don’t have the money to pay for them. This will require a certain amount of creativity, which I expect will result in the eventual issuance of ‘mini-BOT’s’. These, you might recall, are Italian government issued Treasury notes in small denominations that would be usable for paying taxes and other bills to government institutions. Historically, when paper of this nature is issued, it becomes a medium of exchange for non-government items as well, although they tend to trade at a discount to the main currency. In fact, what will almost certainly happen is that people will hoard their euros and use these notes for everything they can, thus effectively creating a parallel currency in Italy. I’m pretty sure that the ECB will be extremely unhappy about this situation, and that there will be a lot of discussion about the issue. I’m also pretty sure that the euro will come under pretty significant pressure if it occurs.

What I find amazing is that the crisis last week occurred because the new government wanted to appoint Paolo Savona, an avowed euro skeptic, to the post of Finance Minister. If that was such a problem, how can his being appointed European Affairs Minister in the same cabinet be seen as so benign? The only thing of which I’m certain is that this story is not nearly over.

The other big news on Friday was the blowout jobs report, with Nonfarm payrolls jumping 223K and the Unemployment Rate falling to 3.8%. The market response to this data was a sharp equity rally, a sell-off in Treasuries and a dollar rally. Underpinning these moves was the idea that the US growth trajectory continues to outpace that of the rest of the developing world, and so US interest rates would continue to lead the way higher. But that was Friday’s story, not today’s.

This morning the dollar has retraced a decent portion of last week’s gains, with the euro up 0.6%, the pound 0.3% and both Aussie and Kiwi up around 1.0%. We have seen similar moves in emerging market currencies with ZAR +1.2%, TRY +0.5%, and even CNY +0.25%, a large move for the renminbi. This stems, in part, from fears abating and risk-off positions being unwound. However, it also seems to be related to the ongoing trade dialog, where the US has pissed off the entire world regarding the imposition of tariffs. The orthodox economic view of these tariffs is that it will weaken the US economy and drive up prices, both of which ought to undermine the dollar. And I think that is what we are witnessing this morning. Of course, if we have learned anything about the Trump administration, it is that policies can be changed on a whim, and so taking a long-term view on this process would be a mistake in my opinion. There is just too much variability possible.

There is, however, one other thing to watch closely, and that is the shape of the yield curve. The ongoing strong economic data has the market pricing in a more aggressive Fed, thus pushing up short-term yields. However, while Treasury prices have fallen a bit, yields there remain well below the levels seen two weeks ago, and this has led to the 2’s-10’s Treasury spread falling to just 38bps this morning. It is a universal fear that if the yield curve inverts it is a harbinger of a recession, and historically that has clearly been the case.

But I wonder if the signal has the same meaning in this environment. After all, in the past, the Fed’s balance sheet was much smaller relative to the economy, and they affected monetary policy by actually adjusting the quantity of reserves in the system. However, since QE, they no longer do that. Rather, there are still trillions of dollars of excess reserves in the system, and instead they adjust policy by paying interest on those reserves. In the meantime, their balance sheet holds trillions of dollars of Treasury bonds, which has reduced the available supply for investors. Remember, that was the entire purpose of QE, to drive down back end rates. Isn’t it possible, if not likely, that back end rates remain artificially low due to the amount on the Fed’s balance sheet? And if that were the case, wouldn’t the idea that the curve is inverting because back end rates are low result in a suspect signal with regards to a recession? My point is that given how different the monetary situation is in the US now compared to all the previous times the yield curve inverted, isn’t it possible that an inversion now is not a reliable signal? Food for thought.

Ok, a quick look at the very light data calendar this week shows that there is really nothing of note on the docket.

Today Factory Orders -0.4%
Tuesday ISM Non-Manufacturing 58.0
JOLTS Jobs Report 6.543M
Wednesday Trade Balance -$49.0B
Nonfarm Productivity 0.7%
Unit Labor Costs 2.8%
Thursday Initial Claims 225K

As well, there are no Fed speakers with the FOMC meeting upcoming next week, as they are now in their ‘quiet period’. We do hear from the RBA tonight, but there is no rate move expected. In fact, my sense is that this week is going to be dominated by stories like the ongoing Italian saga and the trade situation. The dollar has had a good run and it makes a lot of sense that it would take a breather and consolidate for a while. My take is that is what we will see until the FOMC meets next week.

Good luck