According to every newspaper
The Fed’s getting ready to taper
With late Twenty-two
The popular view
Of when, QE, they will escape(r)
But what if, before they begin
To taper, to Powell’s chagrin
The bond market tanks
As traders and banks
Believe there’s no yang, only yin
The Fed begins its two-day meeting this morning and the outcome remains the primary topic of conversation within every financial market. The growing consensus is that there will be some discussion in the meeting of when the Fed should begin to reduce their QE purchases as well as what form that should take. Given the extraordinary heat in the housing market, there have been numerous calls for the Fed to stop buying mortgage-backed securities first as that market hardly needs any more support. In the end, however, the details of how they choose to adjust policy matters less than the fact that they are choosing to do so at all.
As pointed out yesterday, the bond market’s rally thus far in Q2 appears to be far more related to the lack of new Treasury supply than increasing demand and declining concerns over future inflation. If that view is correct, then discussing the timing of tapering QE will seem quite premature. It is true Treasury Secretary Yellen said that higher interest rates would be a good thing, but it seems highly likely she was not thinking of 10-year yields at 3.0% or more, rather somewhere just south of 2.0%. In other words, a modest increase from current levels. History, however, shows that markets rarely correct in a modest manner, rather they tend to move to extremes before retracing to a new equilibrium. Thus, even if 2.0% is a new equilibrium (and I don’t believe that will be the case) do not be surprised to see yields significantly higher first.
In this view, the impact on markets worldwide is likely to be significant. It seems unlikely that equity markets anywhere will respond positively to higher interest rates at all, let alone sharply higher rates. As well, bond markets will, by definition, have been falling rapidly with much higher yields, not just in the US but elsewhere as well. As to the dollar, it would seem that it will also be a big beneficiary of higher US yields, arguably with USDJPY the most impacted. A quick look at recent correlations between different currencies and US 10-year yields shows the yen is the only major currency that has a significant correlation to yields (0.46). But I would not discount the idea that the dollar will rally versus pretty much the rest of the G10 as well as the EMG bloc in a situation where dollar yields are rising sharply. Consider that in this situation, we will likely be looking at a classic risk-off scenario when the dollar tends to perform best.
Of course, there are many in the camp who believe that the central banking community will remain in control of markets and that inflation is transitory thus allowing them to adjust policy at their preferred pace. It is this scenario that Ms Yellen clearly is expecting, or at least describing in her desire for higher yields.
And this is the crux of the market’s future decisions; will central banks be able to slowly reduce monetary accommodation as economies around the world slowly return to pre-pandemic levels of activity, or will the dramatic increase in government debt issuance force central banks to maintain their QE programs in order to prevent the economic chaos that could result from sharply higher interest rates? While my money is on the latter, it remains too soon to determine which broad outcome will occur. It is also not clear to me that tomorrow’s FOMC announcement is going to be that big a deal in the long run, as it seems doubtful there will be any actual policy changes, even if they begin to discuss how they might do so in the future. Remember, talk is cheap, even central bank forward guidance!
Markets remain in a holding pattern ahead of tomorrow’s FOMC statement and Powell’s press conference, although there have been some idiosyncratic moves overnight. For instance, while Japanese equity markets continue to rally (Nikkei +1.0%) on the back of optimism regarding the Olympics and the idea that Covid inspired lockdowns will be ending soon, the same was not true in China where the Hang Seng (-0.7%) and Shanghai (-0.9%) markets both suffered after the PBOC failed to inject any additional liquidity into the money markets there. With quarter-end approaching, demand for funds by financial institutions is rising and the fact that the PBOC continues to be somewhat parsimonious has been a key support for the renminbi, but not really helped the equity markets there. Remember, China is quite concerned over what had been a growing housing bubble, and this is designed to help restrict the growth of that situation.
European equity markets are somewhat mixed this morning as the major indices have performed well (DAX +0.5%, CAC +0.4%, FTSE 100 +0.3%) but both Italy (-0.2%) and Spain (-0.5%) are lagging on the day. The data of note has been CPI which showed that Germany (+2.5%) continues to feel the most inflationary pressure, while both France (+1.8%) and Italy (+1.2%) remain unable to find much inflationary impulse at all. This is certainly a far cry from the situation here in the US and speaks to the idea that the ECB is not likely to begin tapering anytime soon. In fact, it would not be surprising if they wind up either extending PEPP or expanding the original QE known as APP. US futures, meanwhile, are little changed at this hour after yesterday’s mixed session.
Global bond markets are on hold this morning with none of the major nations seeing movement of even 1 basis point, despite yesterday’s Treasury sell-off raising 10-year yields by nearly 6 bps. That movement has been described as technical in nature given the complete lack of new information seen.
On the commodity front, oil (WTI +0.8%) continues to power higher driving the entire energy complex in that direction but the rest of the space has seen quite a different outcome. Precious metals (Au -0.2%, Ag -0.8%) continue their recent weak performance while industrial metals (Cu -3.5%, Al -1.3%, Sn -2.1%) have been absolutely crushed. Agricultural products are mostly softer on the weather story, although soybeans is bucking that trend with a modest gain on the day.
As to the FX market, the dollar is mixed in both G10 and EMG blocs. In the G10, AUD (-0.2%) has suffered on the back of dovish RBA Minutes released last night as they indicated it was premature to discuss tapering. CAD (-0.3%) appears to be suffering on the back of the base metals decline and the pound (-0.25%) is on its back foot after slightly disappointing employment data. Interestingly, NOK is unchanged on the day despite oil’s rally and CHF’s 0.1% gain, which leads the pack appears to be technical in nature.
In the EMG bloc, TRY (-1.3%) is suffering after the US-Turkey meeting at the G7 meetings was less fruitful than hoped with no breakthroughs achieved. HUF (-0.7%) is declining after conflicting statements from a central bank member regarding a short-term liquidity facility has traders uncertain if policy accommodation is going to be ended soon or not. Remember, uncertainty breeds contempt in markets. Away from those two, however, the rest of the block saw very small movements with no significant stories.
On the data front, we get two important pieces this morning; Retail sales (exp -0.7%, +0.4% ex autos) and PPI (6.2%, 4.8% ex food & energy). In addition, at 8:30 we see Empire Manufacturing (22.7) and then later we see IP (0.7%) and Capacity Utilization (75.1%). Retail Sales is likely to dominate the discussion unless PPI is really high, above 7.0%. But in the end, markets continue to wait for tomorrow’s FOMC, so large movement still seems unlikely today. That said, if we do see Treasury yields creeping higher, I expect the dollar to perform pretty well.
Good luck and stay safe