The story that’s now being told
Is growth worldwide’s now taking hold
So real rates are rising
And it’s not surprising
That havens are now being sold
Thus, this explains why sovereign debt
Is being sold, and is a threat
To central bank dreams
Or really, their schemes
Inflation to truly beget
Treasury yields, or perhaps more accurately, sovereign yields, remain the top story in markets as their movement continues to underpin most other action. The very sharp rise in yields seen year-to-date had been driven by rising inflation expectations. This is clear when looking at breakevens where the 5yr-5yr has climbed from 1.93% at the beginning of the year to 2.60% as of yesterday. This rise makes up the bulk of the rise in the 10-year Treasury yield, which has gone from 0.91% to 1.70% during the same time frame. And it has been the rise in inflation expectations that has been a key feature in many of the forecasts for rising inflation beyond the next several months, where base effects from the initial pandemic shutdowns will be seen.
Given the run of very strong data that has been recently released, with yesterday’s ISM Services print of 63.7 being the highest in the series’ 25-year history as the latest example, the narrative is starting to adjust slightly. Recently there have been a number of analyst reports discussing the idea that rising yields represent rising growth expectations and not rising inflation expectations. If this is true, it certainly alters the calculus of future market activity. It is also likely to alter the reaction functions of central banks.
Consider what we have heard from the major central banks since the GFC; the greatest threat to economic activity is deflation and each and every one of them has gone out of their way to try to stoke inflation. Of course, the underlying reason for a central bank to stoke inflation is to help debase the value of their government’s outstanding debt. This concept has grown dramatically in importance as the amount of government debt outstanding has skyrocketed during the past decade while trend growth has slowed. Thus, the only way to escape this debt trap was to inflate away the real value of that debt. This logic is part and parcel of the current central bank guidance regarding maintaining ZIRP or NIRP until inflation and employment goals are actually met, rather than acting when they are anticipated to be met.
Understand, monetary policy acts with a lag, generally considered to be in the 6mo-1yr time frame, so if a central bank does not adjust policy until a target is reached, the likelihood is that variable will continue on its recent trend for many months once the central bank acts. For example, if the Fed waits for inflation to average 2.0% for a period of time before tightening policy, inflation is likely to continue rising beyond that target for upwards of a year or more before beginning to slow down. It is for this reason that central banks pay such close attention to expectations data as it gives them clues to potential market responses to their actions. And it is for this reason that a change in the underlying driver of increasing yields will alter so much.
A key feature of the equity market rally has been the fact that real yields have been negative for quite a while driving investors to seek positive real returns. This is the TINA concept, there is no alternative. But if real yields start to climb because growth expectations are climbing with less concern over potential inflationary effects, suddenly there is an alternative to owning equities, especially for pension-type investors who generally seek the least risk available for a return. If there is an alternative, then a rethinking of the current multiples for equity markets is quite reasonable. In other words, stock prices could easily fall a fair amount. Now, declining stock prices have been a key signal to central banks that policy ease is in order, at least since October 1987 in the aftermath of Black Monday. But this begs the question, what if this process unfolds before central banks have begun raising rates?
As you can see, if this change in the narrative is accurate, and real yields begin climbing, central banks will simply find themselves in a different predicament but with the same tools available. In other words, policy ease may have a different nominal rationale, but that doesn’t help the fixed income investor. And how will this impact the FX market? That is probably the easiest short-term answer, the dollar will follow real yields higher, and if the Fed steps in to cap those yields, via YCC or expanded QE, then the dollar will reverse course lower. So, watch the movement in real yields for clues as to the dollar’s next steps.
Enough of that and on to markets. Risk is largely in vogue this morning, at least in Europe, although Asian equities had a more mixed session. Last night saw the Nikkei (-1.30%) soften while Shanghai (0.0%) went nowhere. The Hang Seng was closed, although we did see the ASX 200 rise 0.8% Down Under. Europe, however, is all green all the time, with the DAX (+1.2%) and FTSE 100 (+1.1%) leading the way while the CAC (+0.6%) is lagging but still having a good time. Interestingly, after more record highs yesterday in the US, futures markets are all pointing slightly lower, with the three main indices showing declines of -0.1% to -0.2%.
Bond markets, as would be expected in a risk-on session, are mostly declining, with European sovereigns trading with yields higher by about 2.5 basis points in the big three markets. Treasury yields are little changed at this time but remain right on that 1.70% yield level. There is much discussion as to whether the next leg higher in yields is coming soon, or if we have exhausted the drive higher. Arguably, if growth expectations continue to increase, the case for higher Treasury yields will be inexorable.
In the commodity space, oil prices (+1.35%) are rebounding but WTI has had trouble holding the $60/bbl level ever since its sharp decline two weeks ago. Precious metals are a bit firmer (Au +0.3%, Ag +0.4%), although Cu (-1.5%) has softened a bit on the day.
Finally, the dollar is broadly stronger this morning despite the increased risk appetite in equity markets. While the euro is little changed, we are seeing sharp declines in NZD (-0.6%), GBP (-0.5%) and NOK (-0.4%) with Kiwi simply retracing gains made in yesterday’s illiquid markets with similar price action seen in both Sterling and Nokkie. There is little fundamental driving these moves right now.
Emerging market currencies had a more mixed performance with KRW (+0.7%) as the big winner benefitting from an increase in foreign inflows to both the KOSPI and Korean bond markets. CNY (+0.25%) has responded to word from the PBOC that they are asking the major commercial banks to reduce their lending to prevent bubbles and other possible financial dislocations. This helped push Chinese interest rates a touch higher supporting the currency. On the downside, TRY (-0.4%) continues to be the worst performer in the space as inflation worries continue to grow in the country, but elsewhere, movement has been fairly tame.
On the Data front, we only see JOLTs Job Opening (exp 6.9M) which has not gained many market adherents as an important data point despite the Fed’s focus on employment, likely because the data is quite old, with this morning’s release describing February activity. As to Fed speakers, only Richmond’s Thomas Barkin is on the tape today, but there still seems little chance of a change in Fed expectations.
Many are claiming the dollar has put in a short-term top, although as discussed above, if real US yields continue to rise, I expect the dollar will rise right alongside them. And in truth, that remains the single key driver in the FX markets for now. Higher Treasury yields still portend a higher dollar and vice versa.
Good luck and stay safe