Yields Are Repressed

You have to be mighty impressed
The bond market’s not even stressed
Although CPI
Has reached a new high
One wonders if yields are repressed

Clearly, there is only one story of import these days, and that is whether or not inflation is transitory.  Chairman Powell and his minions have spent the last several months harping on this idea, and although there was a time when several FOMC members seemed to get nervous and wanted to discuss tapering QE, it seems highly likely that next week’s FOMC meeting will focus on the fact that “substantial progress” has not yet been made toward the Fed’s goals of maximum employment and 2% average inflation.  Well, at least on the goal of maximum employment.  It seems pretty clear that they have made some progress on the inflation front.

While the headline Y/Y print of 5.0% was clearly impressive, and the highest since August 2008, personally, I am more impressed with the core M/M print of 0.7% as that is not impacted by what happened during the pandemic.  And the fact that this followed last month’s 0.9% print could indicate that inflation is becoming a bit less transitory.  But the Fed has done a wonderful job of selling its story.  One has to believe that Chairman Powell could not have wanted a better outcome than yesterday’s market price action with the S&P 500 making new highs while the bond market rallied sharply with the 10-year yield falling 6 basis points to 1.43%.

For a moment, let us try to unpack this price action.  On the one hand, it is easy to understand the equity rally as the decline in nominal yields alongside the rising recorded inflation has led to a dramatic fall in real yields.  One view, which many utilize, is that real 10-year yields are simply the 10-year yield less the current headline CPI rate.  Of course, right now, that comes to -3.57%, a level only seen a handful of times in the past, all of which occurred during significant inflationary periods in the 1970’s and early 1980’s.  Negative real yields are a boon for stocks, but historically are awful for the dollar and yet the dollar actually rallied slightly yesterday.  It seems to me that a more consistent outcome would require the dollar to decline sharply from here.  After all, even using Bund yields, currently -0.284%, and Eurozone CPI (2.0%), one sees real yields in the Eurozone far higher (-2.284%) than here in the US.  Something seems amiss.

Something else to consider is bond positioning.  There continues to be a great deal of discussion pointing to the bond market rally as a massive short squeeze.  Last week’s CFTC data was hardly indicative of that type of movement, although we will learn more this afternoon.  However, there is another place where both hedge funds and retail investors play, the ETF market, and when it comes to bond speculation, TLT is the product of choice.  Interestingly, more than 37% of the shares outstanding have been shorted in this ETF, a pretty good indication that there were a lot of bets for a higher yield.  But the word is that a significant portion of these shorts were closed out yesterday, on the order of $7 billion in short covering in total, which would certainly explain the sharp rally in the bond market.  This begs the question, is the price action technical in nature rather than a reflection of the views that inflation is truly transitory?  The problem with this question is we will not be able to answer it with any certainty for at least another three to four months.  But for now, the Fed has the upper hand.  In fact, there doesn’t seem to be any reason for them to adjust policy next week at all.  Why taper if the current policy mix is working?

Speaking of policy mixes that seem to be working, I would be remiss if I didn’t mention that the ECB meeting yesterday resulted in exactly…nothing.  Policy was left unchanged, Madame Lagarde promised to continue to buy assets at a faster pace than the first quarter, and then she spent an hour in her press conference saying virtually nothing.  It may have been her finest performance in the role.

The bond market seems to have made up its mind that the Fed is correct although there remain many pundits who disagree.  I expect that we will be continuing this discussion all summer long and with every high CPI print, you can look for the punditry to pump up the volume of their critiques of the Fed. However, we need only see one dip in the data for the Fed to claim victory and move on from the inflation discussion.  Next month’s CPI report will truly be important as the base effects will have disappeared.  Last year, the June M/M CPI was 0.5%.  If inflation is truly with us, we need to see M/M in June 2021 to be at least that high, if not a repeat of the 0.6%-0.8% numbers we have been seeing lately.  Between now and then we will see a number of price indicators including the Fed’s favorite core PCE.  For the past several months, every price indicator has been high and surprising on the high side.  The next months’ worth of data will be very important to both the Fed and the markets.  Enjoy the ride.

With two of the three key near-term catalysts now out of the way, all eyes will turn to next Wednesday’s FOMC meeting.  But that leaves us 4 sessions to trade in the interim.  Right now, with the fed narrative of transitory inflation dominating, it is easy to expect continued risk-on market performance.  Interestingly, that was not actually the case in Asia as the Nikkei (0.0%) was flat and Shanghai (-0.5%) fell although the Hang Seng (+0.35%) managed to close higher on the day.  Europe, however, got the memo and is green across the board (DAX +0.4%, CAC +0.7%, FTSE 100 +0.5%).  US futures, too, are picking up buyers as they all trade 0.25% or so higher at this hour.  

Meanwhile, in the bond market, Treasury yields have backed up 1.3bps, which looks far more technical than fundamental.  After all, they have fallen 18 bps in the past week, a rebound is no surprise.  However, European sovereign markets were closed before the bond party really started yesterday afternoon and they are in catch up mode today.  Bunds (-2.0bps) and OATS (-2.1bps) are performing well, but nothing like Gilts (-4.6bps), nor like the PIGS, all of which are seeing yield declines of at least 4bps.

Commodity prices are generally higher led by oil (WTI +0.5%) with the industrial metals all performing well (Cu +1.9%, Fe +1.0%, Sn +0.6%) although despite the dramatic decline in yields, gold (-0.5%) continues to underperform.  That feels like it is going to change soon.

Finally, in FX markets, the dollar is king of the G10, rising against all of its counterparts here with NZD (-0.4%) and SEK (-0.4%) leading the way down.  While the kiwi price action appears to be technical after having seen a decent rally lately, Sweden’s krona continues to suffer from its lower CPI print yesterday, once again delaying any idea that they may need to tighten policy in the near term.  The rest of the bloc is softer, but the movement has been far less impressive.

What makes that price action interesting is the fact that EMG currencies have actually had a much better performance with IDR (+0.4%), KRW (+0.4%) and TRY (+0.4%) all showing modest strength.  In Turkey, FinMin comments regarding the divergence between CPI and PPI were taken somewhat hawkishly.  In Seoul, a BOK governor mentioned the idea that one or two rate hikes should not be seen as tightening given the current record low level of interest rates (currently 0.50%).  However, it seems the market would see 50bps of tightening as tightening.  And lastly, the rupiah continues to benefit from foreign buying of bonds with inflows rising for a third consecutive week.

Data this morning brings Michigan Sentiment (exp 84.4) and careful attention will be paid to the inflation expectation readings, with the 1yr expected at 4.7%.  Remember, the Fed relies on those well-anchored inflation expectations, so if they are rising here, that might cause a little indigestion in Washington.

At this stage, just as we are seeing the bond market rally ostensibly on short covering, my sense is the dollar is behaving in the same way.  The data and rates would indicate the dollar should fall, but it continues to grind higher right now.  In the end, “the fundamentals things apply, as time goes by”1, and right now, they all point to a weaker dollar.  

Good luck, good weekend and stay safe
Adf

1.	Apologies to Wilson Dooley 

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