The narrative starting to form
Is bond market vol’s the new norm
But Jay and Christine
Explain they’re serene
Regarding this new firestorm
However, the impact worldwide
Is some nations must set aside
Their plans for more spending
As yields are ascending
And FinMins grow more terrified
Confusion is the new watchword as investors are torn between the old normal of central bank omnipotence and the emerging new normal of unfettered chaos. Now, perhaps unfettered chaos overstates the new normal, but price action, especially in the Treasury and other major government bond markets, has been significantly more volatile than what we had become used to since the first months of the Covid crisis passed last year. And remember, prior to Covid’s appearance on the world stage, it was widely ‘known’ that the Fed and its central bank brethren had committed to insuring yields would remain low to support the economy. Of course, there was the odd hiccup (the taper tantrum of 2013, the repo crisis of 2018) but generally speaking, the bond market was not a very exciting place to be. Yields were relatively low on a long-term historical basis and tended to grind slowly lower as
debt deflation central bank action guided inflation to a low and stable rate.
But lately, that story seems to be changing. Perhaps it is the ~$10 trillion of pandemic support that has been (or will soon be) added to the global economy, with the US at $5 trillion, including the upcoming $1.9 trillion bill working its way through Congress, the leading proponent. Or perhaps it is the fact that the novel coronavirus was novel in how it impacted economies, with not only a significant demand shock, but also a significant supply shock. This is important because supply shocks are what tend to drive inflation with the OPEC oil embargos of 1973 and 1979 as exhibits A and B.
And this matters a lot. Last week’s bond market price action was quite disruptive, and the terrible results of the US 7-year Treasury auction got tongues wagging even more about how yields could really explode higher. Now, so far this year we have heard from numerous Fed speakers that higher yields were a good sign as they foretold a strong economic recovery. However, we all know that the US government cannot really afford for yields to head that much higher as the ensuing rise in debt service costs would become quite problematic. But when Chairman Powell spoke last week, he changed nothing regarding his view that the Fed was committed to the current level of support for a substantially longer time.
Yesterday, however, we heard the first inkling that the Fed may not be so happy about recent bond market volatility as Governor Brainerd explained that the sharp moves “caught her eye”, and that movement like that was not appropriate. This is more in sync with what we have consistently heard from ECB members regarding the sharp rise in yields there. At this point, I count at least five ECB speakers trying to talk down yields by explaining they have plenty of flexibility in their current toolkit (they can buy more bonds more quickly) if they deem it necessary.
But this is where it gets confusing. Apparently, at least according to a top story in Bloomberg this morning which explains that ECB policymakers see no need for drastic action to address the rapidly rising yields of European government bonds, everything is fine. But if everything is fine, why the onslaught of commentary from so many senior ECB members? After all, the last thing the ECB wants is for higher yields to drive the euro higher, which would have the triple negative impact of containing any inflationary impulses, hurting export industries and ultimately slowing growth. To me, the outlier is this morning’s story rather than the commentary we have been hearing. Now, last week, because of a large maturity of French debt, the ECB’s PEPP actually net reduced purchases, an odd response to concerns over rising yields. Watch carefully for this week’s action when it is released next Monday, but my sense is that number will have risen quite a bit.
And yet, this morning, bond yields throughout Europe and the US are strongly higher with Treasuries (+5.3bps) leading the way, but Gilts (+3.6bps), OATs (+2.7bps) and Bunds (+2.4bps) all starting to show a near-term bottom in yields. The one absolute is that bond volatility continues to be much higher than it has been in the past, and I assure you, that is not the outcome that any central bank wants to see.
And there are knock-on effects to this price action as well, where less liquid emerging and other markets are finding fewer buyers for their paper. Recent auctions in Australia, Thailand, Indonesia, New Zealand, Italy and Germany all saw much lower than normal bid-to-cover ratios with higher yields and less debt sold. Make no mistake, this is the key issue going forward. If bond investors are unwilling to finance the ongoing spending sprees by governments at ultra-low yields, that is going to have significant ramifications for economies, and markets, everywhere. This is especially so if higher Treasury yields help the dollar higher which will have a twofold effect on emerging market economies and really slow things down. We are not out of the woods yet with respect to the impact of Covid and the responses by governments.
However, while these are medium term issues, the story today is of pure risk acquisition. After yesterday’s poor performance by US equity markets, Asia turned things around (Nikkei +0.5%, Hang Seng +2.7%, Shanghai +1.9%) and Europe has followed along (DAX +0.9%, CAC +0.6%, FTSE 100 +0.8%). US futures are right there with Europe, with all three indices higher by ~0.6%.
As mentioned above, yields everywhere are higher, as are oil prices (+1.5%). However, metals prices are soft on both the precious and base sides, and agricultural prices are mixed, at best.
And lastly, the dollar, which had been softer all morning, is starting to find it footing and rebound. CHF (-0.3%) and JPY (-0.25%) are the leading decliners, but the entire G10 bloc is lower except for CAD (+0.1%), which has arguably benefitted from oil’s rally as well as higher yields in its government bond market. In what cannot be a great surprise, comments from the ECB’s Pablo Hernandez de Cos (Spanish central bank president) expressed the view that they must avoid a premature rise in nominal interest rates, i.e. they will not allow yields to rise unopposed. And it was these comments that undermined the euro, and the bulk of the G10 currencies.
On the EMG front, overnight saw some strength in Asian currencies led by INR (+0.9%) and IDR (+0.55%) as both were recipients of foreign inflows to take advantage of the higher yield structure available there. On the downside, BRL (-0.7%) and MXN (-0.5%) are the laggards as concerns grow over both governments’ ongoing response to the economic disruption caused by Covid. We have seen the Central Bank of Brazil intervening in markets consistently for the past week or so, but that has not prevented the real from declining 5% during that time. I fear it has further to fall.
On the data front, ADP Employment (exp 205K) leads the day and ISM Services (58.7) comes a bit later. Then, this afternoon we see the Fed’s Beige Book. We also hear from three more Fed speakers, but it would be shocking to hear any message other than they will keep the pedal to the metal for now.
Given all the focus on the Treasury market these days, it can be no surprise that the correlation between 10-year yields and the euro has turned negative (higher yields leads to lower euro price) and I see no reason for that to change. The story about the ECB being unconcerned with yields seems highly unlikely. Rather, I believe they have demonstrated they are extremely concerned with European government bond yields and will do all they can to prevent them from moving much higher. While things will be volatile, I have a sense the dollar is going to continue to outperform expectations of its decline for a while longer.
Good luck and stay safe