Somewhat Dismayed

The ECB’s somewhat dismayed
That risk appetite, as conveyed
By stocks is excessive
And has made a mess of
Their plans.  Now they’re really afraid

It is interesting that two of the most memorable battle cries in financial markets were coined by men of the driest character and background.  We all remember the beginning of the Eurozone debt crisis, not ten years ago, when the so-called doom loop created by banks in a given country owning excessive amounts of their own government’s debt and when that debt became suspect (Portugal, Italy, Greece, Spain) the banks in those nations went to the wall.  The ECB was forced to step in to save the day, and did so, but things did not calm down until Super Mario Draghi, then ECB President (and now Italian PM) uttered his famous, off-the-cuff, remark of the ECB doing “whatever it takes” to save the euro.

Less of us were involved in the markets in December 1996 when then Fed Chair Alan Greenspan uttered the other famous market expression, “irrational exuberance” while speaking about the inflating of the tech bubble (which inflated for another 3 ½ years) and questioning if prices at that time had run too far ahead of sensible valuations.

In hindsight, both of the problems about which these catch phrases were created were the result of policy failures on the part of governments (debt crisis) or the central bank itself (tech bubble), but in neither case was the speaker able to take an objective view, thus calling out forces beyond their control as the cause of the problem.

Since then, both phrases have become part of the financial lexicon as shorthand for a situation that exists and the willingness of central bankers to address a problem.  This leads us to this morning’s release by the ECB of their Financial Stability Review where a subsection was titled “Financial markets exhibited remarkable exuberance as US yields rose. (author’s emphasis)”  Arguably, the title pales in comparison to ‘irrational exuberance’, but more importantly, it highlights, once again, the inability of a central bank to recognize that the folly of their own policies is what is driving the problems in markets and economies.

Ostensibly they are concerned that a mere 10% decline in US equity markets could result in “…a significant tightening of euro-area financial conditions, similar to around a third of the tightening witnessed after the coronavirus shock in March 2020.”  Wow!  A 10% decline?  If one were looking for a prime example of a fragile economy, clearly the Eurozone is exhibit A.  Once again, what we see is a central bank that is unwilling, or unable, to recognize that the fallout from its own policies is the underlying problem while seeking an alternative scapegoat explanation in order to present themselves in the best possible light.  After all, if the US markets decline, its not the ECB’s fault!

Inadvertently, perhaps, but clearly, the ECB has outlined one truth; given the synchronicity of central bank policies around the world, all economies are more tightly linked together and will rise and fall together.  Although there are those who claim particular markets have better prospects than others, the reality has become that correlations between equity markets around the world are very high, with the only real question how equities correlate to bonds.  It is this last issue where we have seen significant changes lately.  For quite a long time, the correlation between the S&P 500 and the 10-year US Treasury was positive, meaning that both bond and stock prices rallied and fell together.  However, since about February 2021, that relationship has turned around and is now solidly negative, with bond prices rising and stock prices falling.  It is this latter relationship that is the classic risk-on / risk-off meme, something that had gone missing for years.  Apparently, it is coming back, and that terrifies the ECB.

The timing of the report’s release could not have been better as this morning is a very clear risk-off session.  Yesterday afternoon, US equity markets sold off pretty sharply in the last half-hour of the session.  That sell-off has persisted throughout Asia (Nikkei -1.3%, Shanghai -0.5%, Hong Kong was closed) and Europe (DAX -1.3%, CAC -1.1%, FTSE 100 -1.1%).  US futures are also in the red (Dow -0.6%, SPX -0.8%, Nasdaq -1.2%), so the concerns are global in nature.

A bit more interestingly is the bond market’s behavior, where it appears that owning sovereign paper from any nation is unpopular today.  Treasury yields have backed up 2 basis points and we are seeing higher yields throughout Europe as well (Bunds +1.3bps, OATs +0.5bps, Gilts +2.1bps).  Apparently, the bond market concerns stem from the UK’s inflation report which showed that while CPI rose, as expected to 1.5%, RPI (Retail Price Index) rose much more than expected to 2.9% Y/Y.  While both are designed to be measures of average price increases over time, the RPI considers housing prices and mortgages.  Not surprisingly, given the explosion in housing prices, RPI is much higher and rising faster.  It also may represent a more accurate representation of people’s cost of living.  (Here’s a thought experiment: what would US RPI be right now given CPI just jumped to 4.2%?)  At any rate, it appears investors are shunning both stocks and bonds this morning.

Are they buying commodities?  Not on your life!  Prices in this sector are down across the board led by WTI (-1.8%) but seeing Gold (-0.6%) and Silver (-2.0%) suffering along with base metals (Cu -2.4%, Al -0.9%, Zn -0.85%) and foodstuffs (Soy -0.8%, Wheat -1.7%, Corn -0.3%).  Oh yeah, bitcoin, which many believe is a hedge of some sort, is lower by 16% in the past 24 hours and more than one-third in the past week.

So, what are investors buying?  Pretty much the only thing higher today is the dollar which has rallied vs. every currency we track.  In the G10, NZD (-0.9%) is the laggard followed by NOK (-0.8%) and AUD (-0.7%) with the strong theme there being weakness in the commodity sector.  But the European currencies are all under pressure as well, with EUR (-0.2%) and GBP (-0.3%) suffering.  Even JPY (-0.4%) is not holding up its end of the risk-off bargain, declining vs. a robust dollar.

Emerging markets are seeing similar activity with every currency flat to down led by TRY (-0.6%), ZAR (-0.45%) and MXN (-0.4%), all suffering from commodity weakness.  CE4 currencies are also under pressure, following the euro down while APAC currencies had less angst overnight, sliding on the order of 0.2%.

On the data front, today only brings the FOMC Minutes from the April meeting, which will be scrutinized to see how much discussion on tapering took place, if any, but let’s face it, other than Robert Kaplan of Dallas, it seems pretty clear from everybody else that has spoken, that it is not a current topic of conversation.  As it happens, we will hear from 3 more Fed speakers (Bullard, Quarles and Bostsic) as well, but all of them have been on message since the meeting so don’t look for any changes.

Certainly, based on today’s price action, the idea that 10-year yields are driving the dollar remains alive and well.  If yields continue to back up, the dollar will remain bid, and after all, given its recent decline, it has room to move as a simple correction.  I continue to look at 1.2350 as the critical level in the euro, and by extension the dollar writ large.  A break above there opens the chance for a much more substantial dollar decline.  But that does not appear to be on the cards for today.

Good luck and stay safe