Right From the Script

While last night, the 10-year yield slipped
It’s still reading right from the script
Of trading much higher
As growth does transpire
And vaccines are rapidly shipped
Investors, though, caution, have shown
As high yields have caused a full-blown
Correction in tech
And currency wreck
Just proving the future’s unknown
Price action throughout markets overnight has largely been a correction of what has turned out to be a surprising rout in tech stocks and a surprising rally in the dollar.  Quickly recapping the consensus views as the year began, the combination of more fiscal and monetary stimulus and a ramped up vaccination rate would lead to a reopening of the US (and world) economy, much faster growth, higher Treasury yields, rising stock prices and a weaker dollar as increased risk appetite led to dollar selling.  Positioning for those views was both widespread and large as investors looked forward to another banner year.  Oops!
As so often happens in markets, even if views are correct in the long run, when a new consensus is reached it means that, pretty much all the investment that is heading in that direction has already arrived, and the result is that those positions tend to lose out as the excitement fades.  And arguably, that is what we have seen in general, although not universally.  Despite last night’s modest bond rally (Treasury yields -5.9bps), the yield curve remains both higher and steeper than at the beginning of the year and appears to have room for further movement in that direction.
One of the strongest views that exists is that the Fed will not (cannot) allow Treasury yields to rise beyond a certain, unknown, point, as the cost to the government would be devastating.  That has certainly been my view and informs my belief that when that happens, the dollar will reverse its recent strength and decline sharply alongside real US yields.  But what if the Fed means what they say when describing the rise in long-term yields as a good thing?  How might that play out?
The first thing to note is that the yield curve (which I will define as the 2yr-10yr spread) is currently at 137bps, obviously well above the levels seen at the beginning of the year and showing no signs of stopping.  The one thing of which we can be confident right now is that the 2yr yield seems unlikely to move with the Fed maintaining ZIRP up front, so the spread will be entirely dependent on the movement in the 10-year.  But a quick look at the history of the spread shows that the current level is merely in the middle of the range with at least five different times in the past 30 years where this spread rose well over 200 basis points, the most recent being during the Taper Tantrum in 2013 when it reached 260 basis points.  Now, ask yourself what would happen if 10-year Treasury yields rose to 2.75%.  How do you think that would play out in the equity market?  In FX? And for the economy as a whole?
Arguably, this type of interest rate movement would be the result of much faster growth and inflation in the US than currently forecast and seen elsewhere in the world.  (As an aside, the OECD today raised their forecast for US GDP growth in 2021 to 6.5%).  If that forecast is accurate, and if inflation simply gets to the Fed’s 2.0% target, that means nominal GDP will be 8.5%!  How can that square with a 10-year yield of 2.75%, let alone today’s 1.55%.  It would seem that something has to give here.  Two potential relief valves are the dollar, which would need to rally much more sharply than we have seen (think EURUSD at 1.05-1.10) or inflation rising more than 2.0%, perhaps as high as 3.5%-4.0%.  History has shown that in situations like that, equity markets tend to underperform.  And maybe that’s the key.  Most of these forecasts for the strong equity, higher interest rate, weaker dollar outcome were based on the idea that central banks and governments could find the perfect mix of policies to achieve these goals.  If there is anything about which we can be sure, other than 2-year yields are not going to rise, it is that neither central banks nor governments have any idea what the proper mix of policies is to achieve those goals.  This is why economic and market activity remain volatile, because the constant tweaks and changes have many unexpected side effects.
This is not to imply that the yield curve is going to steepen that much, just that it cannot be ruled out, and if that happens, you need to be ready for a great deal more market volatility.
Which takes us to the current session. 
In China, the powers that be
Are worried they’re starting to see
A market decline
That could well define
New weakness in President Xi
Overnight saw mixed risk appetite with both the Nikkei (+1.0%) and Hang Seng (+0.8%) rising, but Shanghai (-1.8%) having a rough session.  In fact, the decline in stocks on the mainland has been so great that the Chinese government has called in the plunge protection team, which saw action last night to try to prevent a further rout (Shanghai -10% in pat 3 weeks), although obviously they were unable to prevent the process continuing.  As China continues to register concern over bubbles, it is reasonable to expect further declines in this market, as well as many of the other Asian markets that are linked.
Europe, on the other hand, is feeling better this morning with gains pretty much across the board (DAX +0.3%, CAC +0.3%, FTE 100 +0.6%), which seem to have ignored modes downward revisions to some Q4 economic data (GDP -0.7%).  And finally, US futures are all firmly higher, notably NASDAQ (+2.2%), which is rebounding from its 11% decline over the past 3 weeks.
European bond markets are rallying alongside Treasuries, with Bunds (-5.3bps) and OATs (-5.2bps) a good descriptor of the entire continent’s price action.  Given the type of movement we have seen throughout government bonds worldwide, it would not be a huge surprise to see a further correction before the next leg higher in yields.
On the commodity front, oil prices are leading things higher (+0.6%) although the decline in yields has also supported gold (+1.4%) which is coming off a very difficult stretch.  Base metals are mixed as are agriculturals, with the current price action almost certainly a consolidation before the next leg higher for both segments.
And finally, the dollar, which is almost universally weaker this morning.  In the G10, AUD (+0.65%) is the leading gainer, but is merely emblematic of the commodity price action as we have seen the other commodity linked currencies in this bloc perform well (NOK +0.6%, CAD +0.45%).  In the EMG space, TRY (+1.5%) is the leading gainer, which during a risk on session is quite normal, with ZAR (+0.9%) and MXN (+0.8%) joining in the fun.  CE4 currencies are also performing well (CZK +0.8%, PLN +0.6%).  However, there are a couple of laggards, notably BRL (-0.7%), KRW (-0.6%) and TWD (-0.5%).  The latter two suffered from ongoing equity outflows from international investors, linked to China’s equity woes, while BRL is suffering from concerns over new political problems President Bolsonaro.
On the data front, NFIB Small Business Optimism was released this morning at a worse than expected 95.8, which, while better than expected, demonstrates some still ongoing concerns over the state of the economy.  Clearly, there are no Fed speakers today, so FX is very likely to follow the risk appetite today.  This modest dollar correction lower seems more like a reaction to what had been a surprisingly powerful dollar rally than a reversal.  So my gut tells me that the dollar will rebound along with yields as the week progresses.
Good luck and stay safe