To Sell or To Buy

As markets await CPI
For signals to sell or to buy
The Fed looks for ways
This reading to raise
But not for an outcome too high

Overnight activity in the markets has been fairly dull as investors and traders await a series of events that will unfold as the day progresses.  On the data front, Jan CPI readings are due with expectations as follows:

CPI (M/M) 0.3%
CPI (Y/Y) 1.5%
-ex food & energy (M/M) 0.2%
-ex food & energy (Y/Y) 1.5%

Source : Bloomberg

The one consistent thing about CPI readings since the nadir last May is that the outcome has been higher than forecast in 7 out of those 8 readings.  Perhaps it is time for economists to reconsider the variables in their forecasting models.  The implication is that inflation, which the Fed continues to avow is far too low, may not be as low as they say.

Now, despite the fact that the Fed (and pretty much every major central bank) has decided to ignore inflation readingsa until they get too high, instead focusing on supporting economic activity, the market still cares about inflation.  This is made clear by the ongoing discussion on real interest rates which are simply the result of the nominal interest rate less the inflation reading.  For example, while 10-year Treasury yields have risen to 1.15%, the real rate, using the December core CPI reading of 1.6%, is -0.45%.  When applied to the current 2-year Treasury yield of 0.115%, the real yield falls to -1.485%.

And this is where it starts to get interesting.  It turns out that investors are extremely focused on real yields as demonstrated by their correlation to different assets, notably the dollar and gold, but also stocks.  It is these negative real yields that continue to drive the search for yield which has resulted in non-investment grade (aka junk) bonds to be in such demand.  In fact, these less creditworthy instruments now yield less than 4.0%, a historic low, and not nearly enough to compensate for the risk of default.  But for investors, the real yield is +2.35%, far higher than they can receive elsewhere, and so worthy of the risk.  (When you read about those worrywarts who claim that central banks have distorted markets beyond recognition, this is the type of thing they are highlighting.)

But it is not just fixed income investors who focus on the real yield.  These yields impact virtually every investment.  Consider, for a moment, gold, an asset which pays no dividend and has no cash flow.  When real interest rates are high, there is a significant opportunity cost to holding the precious metal.  But as real yields decline below zero, that opportunity cost converts into a benefit which is why the correlation between real yields and gold is strongly negative (currently -0.31% with strong statistical significance).

Or consider the dollar.  There are many things that go into determining the dollar’s value at any given time, but clearly, interest rates are one of them.  After all, interest rates are a key feature of every currency discussion and define the activity in the carry trade.  Now, the dollar’s historic haven status along with that of Treasury bonds means that when things get bad, investors flock to both dollars and Treasuries which drives nominal, and therefore real, yields lower.  But in more benign circumstance, when there is no panic, relative real yields is a key driver in the FX market, with negative real US yields associated with a weaker dollar.  In fact, this is my main thesis for the second half of 2021, that inflation will continue to rise while the Fed will cap Treasury yields (because they have to) and the dollar will suffer accordingly.

Which brings us back to this morning’s CPI reading.  My sense is that we are reaching the point where the market will take higher inflation readings as a dollar negative, so beware any surprise in the data.

Adding to today’s mix, and arguably a key reason that overnight markets have been so dull, is that we are set to hear from three major central bank heads, starting with Madame Lagarde this morning, the BOE’s Andrew Bailey at noon and then our very own Chairman Jay at 2:00 this afternoon.  Keep in mind the following themes when listening: the ECB is carefully monitoring the exchange rate; the BOE has instructed banks to prepare for NIRP although claims this is not a policy change, and the Fed remains unconcerned if inflation were to rise to 2.5% or 3.0%.  All of this points to the idea that real yields, around the world, are going to decline further.  Sorry savers!

Now to the markets this morning.  While Asian equity markets performed well (Nikkei +0.2%, Hang Seng +1.9%, Shanghai +1.4%), the same is not true in Europe, where there is a mixture of red and green on the screen.  Here we see the FTSE 100 (+0.3%) as the leader, while both the CAC (-0.1%) and DAX (-0.2%) can find no traction today.  Finally, US futures are all higher by about 0.3% after consolidating yesterday at their recent closing highs.

Bond markets are under very modest pressure this morning with Treasury yields higher by 1 basis point and similar moves seen in Europe.  The one exception is Italy, which has seen 10-year yields decline to a new record low of 0.499% as investors anticipate great things from Mario Draghi’s turn as Prime Minister.

In the commodity markets, oil (+0.5%) continues to grind higher in its drive for $60/bbl, while gold is little changed on the day.  Base metals are all modestly higher but agriculturals are actually backing off a bit this morning.  Again, the picture is best described as mixed.

Finally, the dollar is also themeless today, with G10 currencies seeing modest strength from Europe (CHF +0.1%, GBP +0.1%, EUR flat) while NZD (-0.4%) leads the way lower for the Asian bloc.  However, there has been no data, or comments, yet, that would explain the movement.  This smacks of position adjustments as the recent dollar rebound tops out.

EMG currencies have similarly shown no general direction with both gainers and losers about equally split.  KRW (+0.9%) is the big winner after short positions were closed out ahead of the Lunar New Year holiday that begins tonight.  But beyond that, the winners saw gains of 0.2% or less, hardly the stuff of dreams.  Meanwhile, on the negative front, BRL (-0.6%) is opening in the worst spot as concerns grow over the fiscal situation as the country seems set to increase Covid related expenditures with no plans on how to pay for them.  The next worst performer is CZK (-0.5%) but this is more difficult to discern as there has been neither news nor data to drive the market.  This has all the earmarks of a significant flow that the market has not yet fully absorbed.

And that’s really it for the day.  The big picture remains that the dollar has bounced from its correction highs but has not yet been able to convincingly turn back down.  This argues for a few more sessions of choppiness unless we receive new news.  Perhaps CPI will be much higher (or lower) than expected, either of which can drive movement.  Or perhaps we will hear something new from one of the three central bank heads today which will change opinions.  But for now, choppy with nowhere to go seems the most likely outcome.

Good luck and stay safe