The story last quarter was prices
Would rise, leading up to a crisis
So, bond markets dropped
The dollar, she popped
And gold bugs all made sacrifices

But now a new narrative line
Explains that inflation’s benign
So, bonds are in favor
As Powell won’t waver
While dollars resume their decline

All year long the market story has been driven by the yield on the 10-year Treasury bond.  Ever since the run-off elections in Georgia in the beginning of January, market anticipation has been for significant growth in the US on the heels of increased vaccination rates and increased fiscal stimulus.  In Q1, Treasury yields rose dramatically, touching as high as 1.77% at their top toward the end of March.  Meanwhile, the dollar, which had been slated to decline all year, rallied versus every emerging market currency and all but CAD, GBP and NOK in the G10.

But, as of the first of this month, the world appears to be a different place, as Treasury bonds have rallied driving yields lower and supporting equity and commodity markets.  At the same time, the dollar has come under broad-based pressure and reversed a large portion of its Q1 gains.

Currently, the narrative appears to be along the following lines: US GDP growth in 2021 is going to be spectacular, well above 6.0% and its strongest since 1984.  Inflation, meanwhile, will print at higher levels for Q2 purely as a result of base effects, but will then resume its long-term downtrend and the Fed will be required to continue to support the economy aggressively in order to meet their goals.  By the way, the Fed’s newly articulated goal is for maximum employment, not full employment, and they have promised to become completely reactive, waiting for hard data to confirm positive results in employment and wages, before considering any efforts to rein in rising prices.

Equity markets still love the story as the implication is that interest rates will not be rising at all this year, nor next year for that matter, at least in the front end of the curve.  Treasury markets, which appeared to get a little panicked in Q1 have reverted to form and seem to be pricing one of two things; either less impressive economic growth, or anticipation that the Fed will expand QE or YCC as Powell and friends seek to prevent any significant rise in yields.  Meanwhile, the dollar is falling again, gold is rising and commodity prices (the one true constant) remain firm.

Have we reached economic nirvana?  Some skepticism might be in order given the myriad issues that can undermine this narrative.  The primary issue is, of course, another wave of Covid spreading throughout the US and the world.  As the virus mutates, it is not clear that the current vaccines are going to be effective preventatives to new strains.  While the vaccination progress in the US and UK has been excellent, with 40% and 50% of their respective populations receiving at least the first dose, the same cannot be said elsewhere in the world.  In fact, the newsworthy item of the day is that India reported 315,800 new cases just yesterday!  Alongside Brazil and Turkey, these three nations, with a combined population of nearly 1.7 billion find themselves in the midst of another serious wave of infection.  Remember that a huge part of the reopening and growth narrative is the ending of the pandemic.  It is still too early to make that claim, and so, perhaps a bit early to count the 2021 GDP growth figures as a given.

However, there is a second issue of note that cannot be ignored, and that is the inflation story.  While it is clear that the Fed has convinced themselves inflation is not a concern, that the elevated readings that are almost certain to come over the next three months will be ‘transitory’, there is a case to be made that rising inflation may have a more lasting impact.

Consider that oil prices have risen dramatically from their levels this time last year and continue to trend higher.  Now, while the Fed looks at core prices, ex food & energy, the reality is that rising energy prices feed into everyday items beyond the cost of filling your gas tank.  Given that virtually everything produced and consumed requires energy to create, eventually higher energy prices feed into the cost of all those products.  It can be even more direct for services such as shipping, where energy price surcharges are common.  But just because something is labeled a surcharge doesn’t mean it hasn’t raised the price of the item consumed.  The point is, rising energy prices and rising commodity prices in general, are leading to higher input costs which will eventually lead to higher prices.  We continue to see the evidence in data like PPI and the price indices in the PMI and ISM data.

And these are just the two largest known issues.  Less probable, but potentially highly significant, we could see increased tension in US-China relations, with a stepped-up trade war, or even a confrontation over the situation in Taiwan.  Neither can one rule out more mischief from Russia, or Middle Eastern strife that could easily impact the supply of oil and hence its price.  The point is, it seems early to declare that the worst is behind us and price securities and risk as though that is the case.

Market activity today is relatively muted as investors and traders await the latest word(s) from Madame Lagarde and the ECB.  Expectations are there will be no changes to policy, but the real hope is that she will give clearer guidance on their plans going forward.  You may recall at the last meeting they expressed some dismay that bond yields had risen as much as they had and promised to increase PEPP purchases.  Since then, while they have increased those purchases, the amount of increase has been less than impressive and yields in Europe, while not rising further, have not returned to previous lower levels.  At the same time, as US yields have fallen back more than 20bps from their recent highs, the euro (+0.2%) has resumed its climb and is back above 1.20 for the first time since early March.  One thing we know is that the ECB can ill afford a stronger euro, so some type of response may be forthcoming.

Speaking of central banks, yesterday’s big surprise came from north of the border as the Bank of Canada, while leaving policy on hold, changed their tune on the timing for the end of QE.  They brought forward their tapering timeline and the market brought forward the rate hike timeline in response.  It seems that the employment situation in Canada has returned far closer to pre-Covid levels than in the US, with more than 90% of the jobs lost having been regained.  While CAD has given up 0.1% this morning, this is after a nearly 1.0% rise yesterday in the wake of the BOC announcement.

A quick look at equity markets around the world shows that Asia had a pretty good session (Nikkei +2.4%, Hang Seng +0.5%, Shanghai -0.25%) while Europe is all green and has been steadily climbing all day (DAX +0.45%, CAC +0.6%, FTSE 100 +0.1%).  US futures, however, are ever so slightly softer, down about 0.15% across the board, although this was after solid rallies yesterday afternoon.  Meanwhile, bond markets are under the barest of pressures with yields edging higher in the US (+0.5bps) and Europe (Bunds +0.4bps, OATs +0.8bps, Gilts -0.4bps), really showing a market waiting for the next piece of data.

Energy prices are under modest pressure this morning (WTI -0.5%), as are precious metals (Au -0.3%, Ag -0.6%) and industrials (Cu 0.0%, Zn -0.2%, Al -0.2%).

It can be little surprise that the dollar is mixed this morning, given the lack of a coherent market theme, although there are some modest surprises.  NOK (+0.25%) for example is stronger in the face of weaker oil prices.  Meanwhile NZD (-0.3%) is the weak link in the G10, on the back of market internals and stop-loss selling.  EMG currencies have a few more substantial movers with RUB (+1.25%) the leading gainer by far after President Putin’s state of the nation address focused entirely on domestic issues rather than feared saber rattling.  This encouraged bond buying and strength in the ruble.  On the other end of the spectrum is TRY (-0.8%) which has seen further investor outflow after reports that the US administration is prepared to raise the issue of the Armenian genocide and put further pressure to isolate President Erdogan.  However, away from those two movers, the rest of the bloc is +/- 0.2% or less.

Aside from the ECB meeting, the US data slate brings Initial Claims (exp 610K), Continuing Claims (3.6M), Leading Indicators (1.0%) and Existing Home Sales (6.11M).  Clearly the Claims data is the most important of the bunch with a strong number possibly helping to halt the Treasury rally and potentially support the dollar.  We are in the Fed quiet period, so no speakers there.

The rest of the day will take its tone from Madame Lagarde, but if she is less than forceful, I would expect the current trend (modestly lower yields, modestly higher equities and modestly weaker dollar) to continue.

Good luck and stay safe
Adf