Yields Are Appalling

Though prices for oil keep falling
And Treasury yields are appalling
The stock market’s view
Is skies will be blue
If Covid’s spread’s finally stalling

The ongoing dichotomy between equity market performance, traditionally a harbinger of future economic activity, and commodity market performance, also a harbinger of future economic activity, remains glaring. The commodity markets are clearly signaling significant demand destruction amid the economic devastation that has followed the spread of Covid-19. At the same time, equity markets around the world continue to recover from the lows seen in March, telling a completely different tale; that the future is bright.

When two key leading indicators offer such different portents, we need to look elsewhere to build our case of likely future outcomes. Clearly, government bond markets are the next best indicator, but their signal has been clouded by the more than $15 trillion that central banks around the world have spent buying those bonds since the financial crisis in 2008-09. Absent those purchases, would 10-year Treasury yields really be 0.65% like they are this morning? Would 10-year German bund yields really be at -0.44%, their 356th consecutive day yielding less than zero? Consider how much new debt has been issued and how that debt would have been absorbed absent central bank intervention. My point is that perhaps, using bond yields now as a proxy for future economic activity may no longer be quite as useful.

Which leaves us with the FX markets as our last signal for future activity. What does the dollar’s value tell us about expectations for the future? The problem with the dollar as an indicator is, its track record is extremely unclear. Throughout history, the US economy has been strong with both a strong dollar and a weak dollar. If anything, the dollar is a far better coincident indicator than anything else. After all, what is the risk-off/risk-on characteristic other than a signal of investors’ current views of the market. Thus, when fear is rampant, which was evident last month, the dollar performed extremely well. A quick look at currency returns during the month of March showed the dollar rising against 9 of its G10 Brethren, from 0.2% vs. the Swiss franc, to 10.7% vs. the oil-linked Norwegian krone. Only the yen, which managed a 0.75% rise, was able to outperform the dollar.

Not surprisingly, the EMG space saw some much more significant declines led by the Mexican peso (-18.1%) and Russian ruble (-15.3%). The broad theme in this bloc was that the best performers, those that fell the least, were APAC currencies with closer links to China, while LATAM and EEMEA were generally devastated. But, again, this was a real-time response to coincident activities, not a harbinger of the future.

The lesson to learn from this brief look at recent history is that there is no consensus view as to how things are going to evolve from here. Both sides make their respective cases strongly, and both sides can point to a substantial amount of data that supports their argument. However, the only universal truth is that economic disruptions that have been caused by the response to Covid-19 are unprecedented in both size and speed, and econometric models built for a different environment are unlikely to be very effective. Modeling of complex systems, whether the economy, the climate or the spread of a pathogen is an extremely fraught undertaking. More often than not, models will produce useless results. Their benefits generally come from the need to define conditions and factors, thus helping to better think and understand a particular situation, not from spurious calculations that produce a result. And this is why hedging is an important part of risk management, because regardless of what certain harbingers indicate, the reality is nobody knows what the future will bring.

But back to today’s activity. As we have seen for the past several sessions, the prospect of the reopening of economies is being seen by the equity markets as a clear positive. Despite abysmal earnings results across most industries, once again equity markets are firmer this morning, with most of Europe higher by 1.5%-2.0% and US futures pointing to gains of more than 1.0% on the open. Countries throughout Europe are starting to announce their plans to reopen with May 11 seeming to be the date where things will really start. And of course, the same process is ongoing in the US, with Georgia dipping its toe into the water yesterday, and other states lining up to do the same. Of course, the end of the lockdown does not mean that that things will return to the pre-virus situation. Incalculable damage has been done to every nation’s economy as regardless of government attempts, thousands upon thousands of small businesses will never return. Arguably, the one thing we know about the future is that it is going to be different than what was envisioned on January 1st.

Bond markets are behaving consistently with a modest risk-on view as Treasury and bund yields edge higher, while yields for the PIGS continue to slide. And finally, the dollar remains under pressure this morning, sliding against most of its counterparts as short-term fears abate. The best performers today in the G10 bloc are SEK and NOK, with the former rallying on what was perceived as a more hawkish than expected message from the Riksbank, when they didn’t cut rates back below zero at today’s meeting, and merely promised to continue to buy more bonds. NOK is a bit more difficult to explain given that oil prices (WTI -7.7%) continue to suffer from either significant excess supply or a complete lack of demand, depending on your point of view. However, given that NOK has been the worst performing G10 currency this year, it is probably due for some recovery given the positive sentiment seen today.

EMG currencies are also generally firmer, with MXN (+1.5%) atop the charts, as it, too, is ignoring the declining price of oil and instead finding demand after a precipitous fall this year. but we are also seeing strength in ZAR (+1.2%) and most EEMEA currencies, as some of last month’s excesses seem to be unwinding as we approach the end of April.

On the data front this morning are two minor releases, Case Shiller Home Prices (exp 3.19%) and Consumer Confidence (87.0). Rather, with the FOMC’s two-day meeting beginning this morning at 9:00, discussions will continue to focus on expectations for the Fed tomorrow, as well as the first look at Q1 GDP. But for today, I expect that we will continue to see this mildly positive risk attitude and the dollar to remain under modest pressure. My view remains that there are still significant issues ahead and the market is not pricing in the length of how bad things are going to be, but clearly for now, I am in the minority.

Good luck and stay safe
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