The Treasury Sec and Fed Chair
This morning are set to declare
While things are improving
They’re not near removing
The stimulus seen everywhere
Meanwhile, other Fedsters explained
Inflation may not be constrained
Though they’re all quite sure
The worry du jour
Will pass and cannot be sustained
While last week was actually Fed week, with the FOMC meeting and Powell press conference already six days past, it is starting to feel like this week is Fed week. We have so many scheduled appearances by a wide range of Fed governors and regional presidents, as well as by Chairman Powell, that the Fed remains the primary theme in the markets. Now, in fairness, the Fed has been a dominant part of any market discussion for the past decade plus (arguably since the GFC in 2008), but I cannot remember a week with this many Fed speeches lined up.
Of course, the question is, will we learn anything new from all these speeches? And the answer, sadly, is probably not. Chairman Powell and his acolytes have made it clear that they are not going to raise the benchmark Fed Funds rate until somewhere in the late 2023/early 2024 timeframe, and in any case, not until they see actual data, not forecasts, that unemployment has fallen and prices are rising. With that as a given, the only question unanswered is about the back end of the Treasury curve, where 10-year yields have risen more than 70 basis points so far in 2021, although are lower by about 5bps this morning. With the 2-year Treasury note stuck at about 0.15%, the steepening of the yield curve has been dramatic so far, but it must be remembered that historically, when the yield curve starts to steepen, it has gone much further than the moves so far, with a 2yr-10yr spread of 275 basis points quite common. Compared to the current reading of 150 basis points, and assuming the 2-year won’t be moving, that implies the 10-year Treasury could well move to a yield of 2.90%!
One of the key features driving equity market performance during the pandemic has been the promise of low rates forever, as any discounted cash flow analysis of a company’s future earnings was using a discount rate approaching 0.0%. However, if 10-year yields rise that much (which implies 30-year yields will be somewhere in the 3.50%-4.0% area), it will be far more difficult to justify the current market valuations and we could well see some corrective price action in the stock market. (That is a euphemism for stocks would tank!) Now, if stocks were to correct lower, that would have an immediate impact on financing conditions, tightening them substantially, which in conjunction with rising back end yields would move the Fed away from its preferred stance of easy money. Seemingly, it will be difficult for the Fed to allow that to occur and remain consistent with their stated objectives.
So, what might they do? Well, this is the argument for yield curve control (YCC), that the Fed cannot simply allow the market to dictate financing terms during the recovery. And it is the crux of the weaker dollar thesis. But so far this week, as well as Chairman Powell, we have heard from governor Michelle Bowman and Richmond Fed president Tom Barkin, and not one of them has even hinted they are concerned with the rise in the back end. As long as that remains the case, I expect that equity markets will have difficulty moving higher and I expect the dollar to benefit. We have previously discussed the fact that the carrying costs of Treasury debt as a percentage of GDP is currently declining due to the dramatic decline in interest rates, and that Secretary Yellen has explicitly highlighted that issue as a reason to be unconcerned with additional borrowing. Arguably, for as long as Yellen is okay with rising yields, the Fed will be okay as well. But at some point, it certainly appears likely that a very steep yield curve will not fit well with the recovery thesis and the Fed will be forced to act. However, until then, let us take them at their word and assume they are comfortable with the current situation. We hear from nine more individual speakers this week across 18 different venues, including Powell and Yellen testifying to the House today and the Senate tomorrow, so by the end of the week, if there are even subtle shifts in view, we should have an idea.
As to today’s session, risk is under some pressure with equity markets having fallen throughout Asia (Nikkei -0.6%, Hang Seng -1.3%, Shanghai -0.9%) and all red in Europe as well (DAX -0.6%, CAC -0.7%, FTSE 100 -0.5%). US futures are also pointing lower with declines on the order of 0.3% – 0.5% across the major indices. It is also worth noting that prices have been softening over the past hour or two, which is different price action than we have seen lately, where early losses tend to be erased.
Bond markets are clearly demonstrating their haven status this morning with European sovereigns all seeing yield declines (Bunds -3.5bps, OATs -3.3bps, Gilts -4.1bps) which is right in line with the Treasury story, where 10-year yields have fallen 6.5bps now.
Commodity prices are also under pressure, with oil (-3.75%) back below $60/bbl and testing some key technical support levels. Meanwhile, base metals are softer (copper 1.4%, Aluminum -1.7%) although the grains are mixed. Finally, gold has bounced back from early declines and is up a scant 0.1% at this hour.
Turning to the dollar, it is stronger pretty much across the board, with JPY (+0.3%) the only G10 currency able to gain, and simply demonstrating its haven characteristics. Otherwise, NZD (-1.7%) is the laggard, followed by AUD (-1.0%) and NOK (-0.8%). While the NOK is obviously being undermined by oil’s decline, the NZD story revolves around an announcement that the government is going to try to rein in housing price increases, which have seen prices rise 23% in the past year, as they try to stop a housing bubble. (Of course, they could simply raise rates to stop it, but that would obviously impact other things.) However, the result was an immediate assessment of declining inward investment, hence the kiwi’s decline. But away from the yen, the rest of the space is down at least 0.4%, so this is broad-based and significant.
Emerging market currencies are similarly under virtually universal pressure, with major losses seen in RUB (-1.4%), ZAR -1.1%) and MXN (-1.0%). Obviously, these are all impacted by the decline in oil and commodity prices and will continue to be so going forward. The CE4 are all much weaker as well, showing their high beta to the euro (-0.45%) and I would be remiss if I left out TRY (-0.9%) which was actually higher earlier in the session on what appears to have been a dead-cat bounce. TRY has further to fall, especially if risk is being unwound.
On the data front, New Home Sales (exp 870K) are the main release, although we also see the Richmond Fed Manufacturing Index (16), a less widely followed version of Philly or Empire State. But really, I expect the day’s highlight will be the Powell/Yellen testimony, and arguably, the Q&A that comes after their opening statements. While most Congressmen and women consistently demonstrate their economic ignorance in these settings, there are a few who might ask interesting questions. But for now, there is no change on the horizon, so there is no cap on yields. While they are falling today, they have plenty of room to rise, and with them, so too the dollar.
Good luck and stay safe