The Fed’s Nonchalance

The view from the Fed’ral Reserve
When viewing the present yield curve
Is that higher rates
Show, here in the States
The ‘conomy’s showing some verve

Contrast that with Europe’s response
To rising yields, where at the nonce
Ms Schanbel’s the third
Of speakers we heard
All lacking the Fed’s nonchalance

All I can say about yesterday’s market activity was that we cannot be too surprised that the imbalances that have been building up for the past year (or more accurately 13 years) resulted in some significant market volatility across every asset class.  Perhaps the most interesting thing was that virtually every asset class was sold aggressively, with no obvious havens available.  Stocks fell, bonds fell, gold fell, the dollar fell, Bitcoin fell; just what did people buy with those proceeds?

But of more interest to me was the central bank responses we have seen to the recent rise in long-term yields around the world.  Arguably, this has been the catalyst to all the market activity, so remains the first place we need to look for answers.

And what did we hear?  Well, four separate FOMC members (Williams, Bostic, Bullard and George) explained that rising yields were a good thing as it shows confidence in the economic growth story.  And oh, by the way, yields are still quite low so they shouldn’t have a negative impact on the economy.  While they may well be sincere in those views, these comments smack more of whistling past the graveyard than wholehearted support of market price action.  After all, the one thing the Fed has demonstrated since the GFC in 2008 is that unrestrained market price action is the last thing they want to see.  Rather, they want to make sure they control the game and the market price action proceeds slowly and calmly in their preferred direction.  You know, like watching paint dry.

And of course, in the broad scheme of things, yields do remain quite low.  Even at yesterday’s high point, the 10-year Treasury was yielding only 1.61%, which is still in the lowest decile of yields during the 10-year’s history.  Interestingly, the ECB has not been quite as sanguine regarding bond yields, despite the fact that bond yields throughout the entire continent are much lower than US yields.  On Monday Madame Lagarde explained they were “closely monitoring” bond yields.  Yesterday, ECB Chief Economist, and the ECB member with the most policy chops, Philip Lane, explained they would use the flexibility of the PEPP to prevent any undue tightening in financial conditions.  Then this morning, Isabel Schnabel, an Executive Board member, was more forthright, explaining the ECB may need to boost policy support if real long-term yields rise too early in the recovery process.  In other words, since they don’t believe that inflation is coming, rising yields need to be stopped.

What if, however, all these central bankers are completely wrong about the future of inflation?  What if, they have been reading their own narrative and now believe that there is no inflation on the way, thus rates should never need to rise?  That, my friends, has the chance to lead to some serious policy errors going forward.

So, let’s take a look at the most recent inflation indicators we have seen, and consider the situation.  Last night, Tokyo CPI was released at -0.3% Y/Y, which while obviously low, was higher than last month and forecast.  Then, this morning French PPI printed positive (+0.4%) for the first time in more than a year while French CPI rose a more than expected 0.7% in February.  Meanwhile, German Import Prices rose a much more than expected 1.9% in January, the biggest jump since September 1990!  And finally, here in the States, the GDP is released with a price index which rose to 2.1%, a tick above expectations.  Now, none of this is a description of raging inflation, but boy, there does seem to be a decent amount of price pressure building in the system.  Perhaps, just perhaps, bond yields are rising on rising inflation concerns, whether economic growth is present or not.

This idea is important because a key ingredient for market forecasts this year has been the trajectory of real interest rates.  At face value, the combined comments of Fed and ECB speakers this week tells us that the Fed is going to allow long-term yields to continue to rise while the ECB is going to step in and stop the madness.  If that is actually how things play out, I assure you that the euro will be hard pressed to move any higher, and that a sharp decline could be in the offing.  In fact, that is true for virtually every currency, where the dollar may very well reassert itself if that is the interest rate scenario that plays out.

Of course, I don’t believe the Fed will allow yields to simply rise unabated, as the cost to the Federal government in increased interest payments will be extremely uncomfortable, so I still look for QE to be expanded and extended, perhaps as soon as the March meeting if yields continue to rally from here.  At 1.75% on the 10-year, the Fed will be feeling the pinch, especially if equity markets continue to suffer under a rising yield scenario.  Thus, I am still in the camp of the dollar eventually falling more sharply as rising inflation rates outstrip capped interest rates.  But the latest comments from the central banks have certainly raised the risk on that view!

Ok, we all know that yesterday was a rout in the markets.  This morning, is unfortunately, not looking much better. Asian equity markets last night followed the US lead and fell sharply (Nikkei -4.0%, Hang Seng -3.6%, Shanghai -2.1%) and European markets, which all fell yesterday, are lower again this morning (DAX -0.8%, CAC -1.1%, FTSE 100 -1.4%).  And, don’t be looking for a bounce in the US as futures are pointing lower as well, between -0.3% and -0.6% at this hour.

Bonds?  Well, Asian yields continued to rise, notably Australia’s ACGBs (+17.2bps), but most of Europe has reversed course this morning after the trio of ECB speakers seem to have calmed some jitters.  So, Bunds (-1.6bps) and OATs (-1.7bps) have seen modest rallies.  Gilts (+4.0bps), though, have had no commentary to support them and continue to sell off.  Treasury yields are lower by 4.1bps at this hour, which feels very much like a trading reaction (after all yields rose 26bps since Tuesday), but all eyes will be on this morning’s Core PCE data, which if it does print higher than the expected 1.4%, could well start the selling all over again.

Oil prices (-2.2%) are having their worst session in more than two months, but the uptrend remains intact.  Precious metals prices continue to suffer as well, as real yields rise alongside nominal yields, although base metals are holding in a bit better.

And finally, the dollar is stronger pretty much across the board this morning. With AUD (-1.5%) the worst G10 performer and the two havens (CHF and JPY) both lower by just -0.1%.  Down Under, the market finally forced the RBA’s hand regarding their YCC, and the RBA bought $A3 billion of 3-year notes to push yields back below their 0.10% target.  This had the additional impact of discouraging FX investors from owning the currency.  In fact, this is exactly what I would expect of the euro if (when) the ECB does the same thing.

On the EMG side of things, Asian markets last night tried to catch up with the routs seen in LATAM and EEMEA markets yesterday, with INR (-1.4%) and KRW (-1.4%) the leading decliners, but substantial weakness even in the more stable currencies like SGD (-0.3%) and CNY (-0.2%).  This morning, CLP (-0.9%) and MXN (-0.7%) are leading the way lower in this time zone.  And, of course, this is all the same story of shedding risk.

On the data front, a bunch more is coming starting with Personal Income (exp 9.5%), Personal Spending (2.5%) and the aforementioned Core PCE (1.4%) all at 8:30.  Then later in the morning we see Chicago PMI (61.0) and Michigan Sentiment (76.5), but I believe the PCE number is the most important.  Mercifully, there are no further Fed speakers today, but after all, we already know what they think.  Accommodation is going to be with us for a looooong time and higher yields are a sign of confidence, so no problem.

The wrinkle in the higher inflation argument is if the Fed truly does let yields run higher and other countries cap theirs, the stronger dollar will rein in price pressures.  And for now, that appears to be what the market is starting to believe.  I maintain the Fed will not allow yields to continue running higher unabated, but until they act, the dollar should perform well.  Maybe we do retest the 1,1950 level in the euro, and who knows, 107.00 USDJPY is not out of the question.

Good luck, good weekend and stay safe
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