Fears to Assuage

When calendars all turned the page
To ‘Twenty-One, clearly the rage
Was bets on reflation
And more legislation
For stimulus, fears to assuage

The dollar was slated to fall
The yield curve, to grow much more tall
While stocks were to rally
And Covid’s finale
Was forecast, a popular call

But so far, while stocks have edged higher
And bond yields are truly on fire
The dollar remains
Ensconced in its gains
Its meltdown has yet to transpire

One cannot be but impressed with the dollar’s resilience so far this year amid such surety by so many that it was destined to fall sharply.  Consensus views at the beginning of January were that the vaccines would lead to significant reflation in the global economy, equity markets would benefit greatly, bond yields would rise amid trillions of dollars of new issuance, and the dollar would fall.  As I said from the start, higher bond yields and a steeper yield curve did not typically lead to dollar weakness.  And that is what we have begun to see in the past several sessions.

Global bond markets have really started to reprice the current situation.  While the US story is easy to understand; huge new stimulus bill with no tax increases means huge new Treasury issuance to pay for things and supply overwhelms demand, one needs to ask what is driving the price declines throughout Europe and Asia as well. Stimulus efforts elsewhere have been less substantial despite more severe lockdowns by most of Europe and many Asian nations.  So, perhaps it was not merely the supply-demand imbalance that had bond investors concerned, perhaps it was also inflation expectations.

Certainly, these have been rising sharply with US 5yr-5yr breakevens now at 2.40% this morning, the highest level since March 2013, and not merely trending higher, but exploding higher.  (Germany, too, has seen a sharp rise in breakeven inflation, albeit to much lower levels, rising from 0.2% at the lows last March to 1.06% today.)  While last week’s CPI readings were a touch softer than expected on a headline basis, the reality is that higher inflation remains almost assured going forward.  This is partly because of the way the data is calculated, where last year’s pandemic induced lows will fall out of the calculation to be replaced by this year’s much higher readings.  It is also evident in the rising price of commodities, specifically oil (+1.0% this morning) which is higher by 25% this year.  In fact, the entire energy sector has seen prices rise by roughly that amount, and we have seen gains across the board in both base metals and all agricultural products.  In other words, stuff costs more.

Perhaps, of more concern is the insouciance toward inflation shown by the Fed.  For example, just yesterday, SF Fed President Mary Daly, when asked about inflation getting out of hand replied, “I don’t think that’s a risk we should think about right now.  We should be less fearful about inflation around the corner and recognize that fear costs millions of jobs.”  If you think the Fed is going to respond to any inflation data, anytime soon, you are mistaken.  They have made it very clear that the only part of their mandate that currently matters is employment.

So, let’s recap; the price of stuff is going higher while the Fed is adamant that tighter policy is inappropriate at this time.  Bonds are doing their job, or perhaps that is; the bond vigilantes are doing their job.  They are forcing yields higher, and left unabated, probably have much further to go.  But will they be left unabated?  I think the definitive answer is, no, the Fed will not allow Treasury yields to rise very much further.  And this, of course, drives my view that the dollar, while strong now, will eventually reverse course, as the Fed halts the rise in Treasury yields.

But for now, those higher yields are attracting investors into dollar products, and by extension, into dollars.  And this story can play out for a while yet.  It is a mug’s game to try to guess at what point the Fed will become uncomfortable with Treasury yields, with current guesses ranging from 1.50% to 3.0% in the 10-year.  My sense is it will be toward the lower end of that range that will encourage the extension and expansion of QE, perhaps 1.75%-2.0%.  But I remain confident that at some point, they will respond.  And with inflation showing no signs of abating, it will happen sooner than you think.

What about the rest of the world?  Well, the one thing we know is that neither the ECB nor the BOJ can afford for their currencies to strengthen too much.  While Japan has shown more stoicism lately, I can easily envision Madame Lagarde, in the context of alleged lack of inflationary pressures, pushing the ECB to expand their largesse as well, at least enough to try to offset the Fed.  Will it work?  That, of course, is the $64 trillion question.

On to today’s activity.  Risk is under a bit of pressure this morning after what were truly impressive bond market declines yesterday.  but those declines were not so much risk on, as fear starting to spread.  So, a quick tour of equity markets shows that after a mixed US session, the Nikkei shed 0.6% overnight, although the Hang Seng managed a 1.1% gain.  Shanghai reopens tonight.  In Europe, screens are red wit the DAX (-0.55%) leading the way lower, although the CAC (flat) and the FTSE 100 (-0.1%) are not suffering that greatly.  Meanwhile, at this hour, US futures are essentially unchanged.

Bond yields, which rose sharply around the world yesterday (11bps in the US, 5-8bps throughout Europe) are consolidating a bit.  Treasuries are lower by 1.9 basis points, but they have already backed up from earlier levels.  In Europe, we see the same thing, where early yield declines have been virtually erased.  Bunds are flat, OATs are higher by 0.6bps and Gilts, one of the worst performers yesterday, have seen yields fall 1.0bp, but that is well off the levels earlier this morning. The point is, even if equities are under pressure, funds don’t appear to be flowing into bonds.

Rather, commodities are the market of choice, with oil now above $60/bbl (+1.0%) and base metals higher along with almost all agricultural products.  In fact, the only real laggards here are gold (-0.3%) and silver (-0.5%), which are arguably suffering from higher yields as a competitor.

Finally, the dollar is definitely feeling its oats this morning, rising against all its G10 brethren, with the weakest link SEK (-0.45%), although other than CAD (-0.1%) and JPY (-0.05%), the rest of the bloc is lower by at least 0.3%.  This is a broad dollar strength story, with virtually no idiosyncratic national issues to drive things.  In fact, the only data of note was UK inflation, which printed a tick higher than expected.

Emerging market currencies are similarly under pressure across the board, led lower by ZAR (-0.8%) and MXN (-0.8%), although there is broad weakness in APAC and CE4 currencies as well.  Again, one needn’t look too far afield to determine why these currencies are weak, it is simply a dollar strength day.

On the data front, we start the morning with Retail Sales (exp 1.1%, 1.0% ex autos), move on to IP (0.4%) and Capacity Utilization (74.8%) and finish the afternoon with the FOMC Minutes from the January meeting.  It seems hard to believe that the Minutes will have much impact as there were neither policy shifts nor even dissension in the ranks. Perhaps we will learn if YCC or QE extension has been a discussion topic, which would be hugely bond bullish and dollar bearish.  But I doubt it.

Rather, this dollar rebound, much to my surprise, seems to have a little more behind it and could well extend a bit further.  Looking at the euro, the technicians will focus on 1.2000, the 100-day moving average and 1.1950, the low touched in last week’s sell-off.  But if the Treasury curve continues to steepen, the euro could well move back to the 1.1750 level last seen prior to the US election in November.  That is not my base case, but the probability has certainly grown lately.

Good luck and stay safe
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