Go Big

This morning, a former Fed chair
Will speak and is set to declare
It’s time to “go big”
In order to dig
The nation out from its despair

After a quiet holiday shortened session yesterday, markets are showing modest positivity overall, although European equity markets seem to be lacking any oomph.  However, most other risk indicators are pointing to a resumption of risk appetite with haven assets declining, commodity prices rising and the dollar under pressure.

Though we await the outcomes from three key central bank meetings later this week, there is little in the way of data to consider otherwise, so market participants are looking for other potential catalysts.  Chief among those catalysts today is the testimony by former Fed Chair, Janet Yellen, in the Senate as she is being vetted for Treasury Secretary in the new administration.

According to the release of the prepared statement, ahead of questions, she will explain that the US has been suffering from a K-shaped recovery for many years (in fact since she exacerbated that situation as Fed chair) and therefore the government needs to support policies that will help more people.  On the subject of issuing more Treasury debt, it appears she has weighed the consequences of excessive government debt and will say, with rates so low, it is time to “go big” and issue even more in order to fund the new administration’s priorities.  One other key topic of market interest is the dollar, where she will explain that a market set exchange rate is the best possible outcome, and that should be true of all nations.

For our purposes, the question is how these policies will impact markets overall, and the dollar specifically.  It is abundantly clear from the Treasury market’s performance ever since the Georgia run-off elections (10-year yields have risen 20.6 basis points, including 3.6 today) that the market is already anticipating the Treasury ‘going big’ when it comes to further debt issuance.  In fact, that is part and parcel of the reflation trade that has come back into vogue, with the expected further steepening of the yield curve.  In other words, while there may be some pushback from specific Senators, it seems implausible that reconfirming there will be significant new debt issuance to fund deficits will be seen as a mainstream concern.  Rather, the question will be how the Fed will respond when interest rates continue to rise and the cost of funding all that new debt issuance increases.

As to the dollar, while it appears she will not explicitly state a preference with respect to a weak or strong dollar, it seems pretty clear that the combination of the new administration debt policies with a Fed that is unlikely to allow interest rates to rise to true market-clearing levels will result in significantly more negative real yields as inflation continues to rise.  The result of this process will inevitably be a much weaker dollar.  While the market is currently in a consolidation phase, the dollar’s weakness has been manifesting since last spring.  And though positioning in this trade is huge, it does not mean the idea underpinning those positions is wrong.  As well, I believe there will be a very clear signal for when the dollar will begin it next leg lower; the Fed hinting at   whatever rate mitigation strategy they choose will be clear evidence that the negative real yield structure will expand, and the dollar will henceforth decline more substantially.  However, it could well be several months before that is the case, as we will need to see a continued climb in inflation data as well as the increased debt issuance to drive nominal interest rates higher thus forcing the Fed’s response.

But, as I said, that dollar story is still several months into the future, so let us focus on today’s happenings.  Overall, risk appetite is continuing to improve.  Asian equity markets were mostly stronger (Nikkei +1.4%, Hang Seng +2.7%) although Shanghai (-0.8%) didn’t manage to join in the fun.  While money is flowing rapidly into Hong Kong, it seems there is some concern that the PBOC may be tapping the brakes on liquidity in the real estate market in China, thus removing some of the spare cash and hurting equities as a side effect.  Europe, though, has had a different type of session this morning, with the three main markets all just marginally higher (DAX +0.3%, CAC +0.1%, FTSE 100 +0.2%) and several continental exchanges in the red.  The most notable piece of data from the Eurozone was the German ZEW Expectations survey, which was released slightly better than expected at 61.8, which while historically low, does indicate continue confidence in a recovery there.  US futures, though, are all in for more government spending and are currently higher by between 0.65% (DOW) and 1.0% (NASDAQ).  Clearly, there is no concern over too much debt there.

Speaking of debt, bond markets are behaving as you would expect in a risk-on scenario, with haven bonds declining around the world.  While Treasury yields have risen the most on the day, we seen Bunds (+1.1bps), OATs (+0.5bps) and Gilts (+1.5bps) all under pressure this morning.  Similarly, the PIGS are seeing demand grow on the back of increasing risk appetite with yields in those four nations’ bonds declining between 1 and 2 basis points.

Commodity prices are firmer with oil higher by 0.4% and the ags al looking at gains of between 0.25% and 2.0%, with most of them at multi-year highs.  And finally, the dollar is under pressure almost universally, with only JPY (-0.3%) weaker in the G10, the classic risk-on price action.  SEK (+0.9%) and NOK (+0.8%) are leading the way higher here, with oil clearly supporting the latter while the former is simply demonstrating its high beta with respect to the euro (+0.45%).

In the EMG bloc, ZAR (+1.3%) leads the way on the stronger commodity story, while BRL (+0.85%) and HUF (+0.8%) are next in line.  The real seems to be responding to both firmer commodity prices as well as news that the Covid vaccination program, which had been delayed through bureaucratic misfires, is finally set to get going, which is especially important given the surge in cases there.  As to HUF, the story is more about the CE4 rallying with the euro than with any specific economic or political stories from the country.  But the entire EMG bloc is higher, with the worst performers simply unchanged on the day.

On the data front, there is no mainstream data today, and no Fed speakers either as we are in the quiet period ahead of next Wednesday’s FOMC meeting.  Which brings us back to Yellen’s testimony as the most significant potential new information we are likely to see.  As Fed chair, she was one of the most dovish in history and there is no reason to believe that she will have changed that stance as Treasury secretary.  Instead, I fear we will see a virtual combination of the Fed and Treasury, and the resultant monetization of US debt will be a long term drag on the economy amid rising inflation.  That is not a dollar positive, I assure you, but not today’s problem.

Good luck and stay safe