Author Archives: fxpoet

The Largesse They Bestow

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The status is clearly still quo
For central bank policy so
All rates are on hold
And markets consoled
By all the largesse they bestow

But Covid continues to spread
And Q1 growth seems to be dead
So, Christine and Jay
Will soon have to say
More QE is coming ahead

It has been an active week for central banks so far, at least with respect to the number of meetings being held.  By the end of today we will have heard from six different major central banks from around the world (Canada, Brazil, Japan, Indonesia, Norway and the ECB) although not one of them has changed policy one iota.  The implication is that monetary policy has found an equilibrium for now, with settings properly attuned to the current economic realities.

A summary of current central bank policies basically shows that whatever the absolute level of interest rates being targeted, it is almost universally at historically low levels, with 14 key banks having rates 0.25% or lower.  The point is, a central bank’s main tool is interest rate policy, and while negative nominal rates are clearly viable, after all the SNB, ECB and BOJ currently maintain them, central banks are clearly running out of ammunition.  (PS; the efficacy of negative rates has been widely argued and remains unproven.)  Interestingly, prior to this crisis, reserve requirements were seen as an important central banking tool, with a broad ability to inject more liquidity into the markets or remove it if so desired.  However, in the wake of the GFC, when banks worldwide were shown to be too-highly levered, it seems central banks are a bit more reluctant to open those floodgates.  Even if they did, though, it is unclear if it would make a difference.  Perhaps the lesson we should all learn from the Covid crisis, especially the central banks themselves, is that monetary policy is very good at slowing down economies all by itself, but when it comes to helping them pick up, they need help.

So, with interest rate policy basically at its limit, central banks have been forced to implement new and different tools in their quest to support their respective economies, with QE at the forefront.  Of course, at this point, QE has also become old hat, and has yet to be shown to support the economy.  It has, however, done a bang-up job supporting equity markets around the world, as well as other risk assets like commodities.  And that is exactly what it was designed to do.  QE’s transmission mechanism was to be a trickle-down philosophy, where the ongoing search for yield by investors pushed capital into riskier ventures, helping to support increased investment and more economic growth.  Alas, the only thing QE has really served to do is inflate a number of asset bubbles.  This was never clearer than when the data showed more money was spent by corporations on stock repurchases than on R&D.  Thus, if the stated goal of QE was to support economic growth, it is fair to say it has failed at that task.

At any rate, a recap of the central bank comments shows that economic forecasts and expectations have been tweaked lower for Q1 and higher for Q2 and Q3 with a universal assumption that the widespread inoculation of the population via the new vaccines will help reopen economies all over.  And yet, if anything, we continue to hear of more and more draconian measures being put into place to slow the spread of Covid.  This certainly confirms the idea of a weak Q1 growth pattern, but the leap to a stronger Q2 is harder to make in my mind.

Add it all up and it appears that central banks, globally, are pretty much all in the same position, promulgating extremely easy monetary policy with limited hope that it will, by itself, reignite economic growth.  In effect, until it is shown that the vaccines are really changing people’s behavior, assuming governments allow people back out of the house, central banks can do all they want, and it will not have much impact on the economy.  Markets, however, are a different story, as all that monetary largesse will continue to flow to the riskiest, highest yielding assets around.  Until they don’t!  It will not be pretty when this bubble deflates.

So, is that happening today?  Not even close.  Equity markets continue to rise almost universally, with the Nikkei (+0.8%) and Shanghai (+0.8%) leading the way in Asia.  Europe, meanwhile, is not quite as robust, but still largely in the green led by the DAX (+0.5%) and FTSE 100 (+0.25%) although the CAC (-0.1%) is lagging a bit.  And not surprisingly, US markets continue to power ahead on the ongoing belief that there will be yet more stimulus coming, so futures are all higher by roughly 0.3% or so.

Bond markets are playing their part as well, with 10-year yields higher in all the major markets, with Treasuries, Bunds, OATs and Gilts all seeing yields climb about 1 basis point.  The interesting thing about Treasuries, and truthfully all these markets, is that since the Georgia run-off election, when the market assumption for more stimulus was cemented, the yield has barely moved.  Let me say that the reflation trade seems to be on hold, at least for now.

For a change, oil prices have edged a bit lower this morning, with WTI down 0.6%, as it consolidates its spectacular gains since November.  Gold is little changed, although it had a big day yesterday, rising 1.5% as inflation concerns seem to be percolating.  And finally, as perhaps a harbinger of that deflating bubble, Bitcoin is lower this morning and has been falling pretty steadily, if with still spectacular volatility, for the past 2 weeks, and is now down 24% from its recent highs.

Finally, the dollar is under clear pressure this morning, falling against all its G10 peers and all but one of its EMG peers.  In G10, NOK (+0.8%) leads the way as the Norgesbank did not cut rates which some had expected and were less negative on the economy than expected as well.  But NZD (+0.7%) and SEK (+0.6%) are also putting in fine performances amid stronger commodities and hopes for more stimulus.  In fact, CAD (+0.15%) is the laggard, although it had a strong performance yesterday (+0.7%) after the BOC left rates on hold rather than performing a microcut (10 bps) as some analysts had expected.

In the EMG space, CLP (+1.15%) and BRL (+1.1%) lead the way with the former benefitting from strong investor demand in USD and EUR denominated government bonds, leading to a positive outlook, while the latter seems to be responding to hints that tighter policy may be coming soon given rising inflation forecasts.   But really, the dollar’s weakness is pervasive across all three major blocs.

We finally see some data today as follows: Initial Claims (exp 935K), Continuing Claims (5.3M), Housing Starts (1560K), Building Permits (1608K) and Philly Fed (11.8).  The Claims data has certainly deteriorated during the past several weeks given the renewed lockdowns around the country, which doesn’t bode well for the NFP report in 2 weeks’ time.  The housing market remains on fire given the ongoing exodus to the suburbs from large cities and the historically low mortgage rates.  Meanwhile, Philly Fed should show the strength of the manufacturing sector, which continues to far outperform services.

Still no Fed speakers, so beyond the data, which is all at 8:30, we will also hear from Madame Lagarde in her press conference at the same time.  The risk, to me, is that she comes off more dovish than the market anticipates, thus halting the euro’s modest rebound.  But otherwise, there is no obvious catalyst to stop the risk-on meme and dollar’s renewed decline.

Good luck and stay safe
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Desperate Straits

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When yield curve control was designed
Its goal was a rate be defined
Which can’t be exceeded
With bonds bought as needed
To help governments in a bind

Lagarde, though, when looking ahead
Must work at controlling the spread
So BTP rates
Don’t reach desperate straits
Vs. bunds, an outcome she would dread

Ahead of the inauguration of President Biden, the market has turned its focus to Europe and the ongoing situation in Italy.  Prime Minister Giuseppe Conte has been struggling to lead a fractious coalition from the left and was just subject to no-confidence votes in both houses of the Italian government.  (They have a House and Senate similar to the US.)  This occurred when one of his former allies, Matteo Renzi, split from the coalition triggering the vote.  Renzi leads the Viva Italia party, a center-left group focused on progressive reforms to the Italian government, and it appears Conte has become a little too status quo for his taste.  While Conte was able to cobble together a majority in the lower house, today’s vote in the Senate was less successful, with a majority of votes cast, but no majority in the Senate overall.  This means he has a minority government whose stability has now been called into question.  Estimates are that he has two weeks to develop a majority or the President may call for parliament to be dissolved and new elections held.

As this story has unfolded, investors have been focused on the bond market, specifically the spread between Italian BTP’s and German bunds.  This spread is seen as a key metric, by both the market and the ECB, as to the health of the European economy overall.  The narrower that spread, the healthier the situation.  This is based on the idea that investors are not demanding as great a yield premium to fund Italy’s debt as they are Germany’s.

A quick history shows that for the first eight years of the euro’s existence, that spread hovered between 25 and 45 basis points, with investors not particularly concerned by Italy’s profligate ways.  The GFC awakened many to the potential risks in Italy and the spread ballooned as high as 160 basis points at that time.  But that was nothing compared to the Eurozone bond crisis in 2012, when Greece was on the ropes and the term PIGS was invented.  At that time, Italian yields peaked at 5.525% higher than German yields.  The second time this level was reached, in July 2012, led to Mario Draghi’s famous words, “whatever it takes” regarding the ECB’s will to save the euro.  Since that time, the spread has only ever edged below 1.0% briefly, lately reaching a peak of 2.8% at the beginning of the Covid crisis and currently trading around 1.14%.

The point here is that the ECB watches this spread very carefully.  But now, it appears they are interested in more than merely watching the spread.  Rather, they want to control it.  Yield curve control (YCC) is currently ongoing in both Japan and Australia and has generated a good deal of discussion in the US.  But those three central banks have a single government rate to manage.  The ECB has no such luck, and so they need to find other ways to control things.  Hence, their newest idea is Yield spread control (YSC), where the ECB will buy whatever amount of bonds are necessary to prevent a particular spread from rising above a particular level.  Obviously, this means they will be looking at the bonds of the PIGS, as those are the nations with the biggest outstanding issues.  The problem Lagarde has is the ECB, by law, is not allowed to finance government spending, and QE in Europe was designed to be implemented along the lines of the ECB buying bonds in proportion to national economic size.  But this will require something completely different, as in order to prevent that spread from widening beyond whatever level they choose, the ECB will need to purchase an unlimited number of Italian BTP’s.  As such, this idea is not without controversy, but do not be surprised to hear about it tomorrow when the ECB meeting ends.  While it may not be implemented right away, it does appear they are actively considering the idea.

At this point you are likely asking yourself why you care about this esoteric concept.  And the answer is because it will have an impact on the value of the euro, and therefore the dollar, going forward.  Given the current draconian lockdowns throughout Europe and the significant negative impact they will have on the Eurozone economy, and combine that with a political morass in the 3rd largest economy in the Eurozone, and you have a recipe for a more severe downturn in a double dip recession in Europe.  As the ECB has already used up its basic toolkit of extraordinary measures, it needs to develop new ones if it is to keep the money flowing.  And that is the point.  Especially after yesterday’s testimony by Janet Yellen, where it is clear that the Treasury is not going to slow down spending and the Fed will be right there buying up those new bonds, the ECB is growing concerned that the dollar could fall much further.  They have recently been reminding us that they are paying attention to the exchange rate, and while intervention is not likely in the cards, a new easing policy that results in lower yields and a correspondingly weaker euro just might be.  One has to be impressed with central bank creativity when it comes to spending/printing more money.

But for now, investors remain sanguine to the risk inherent in this strategy and continue to add risk to their portfolios.  This can be seen in the continued rallies in equity markets around the world.  For instance, last night saw strength throughout Asia, except for the Nikkei (-0.4%).  Europe, this morning is showing far more green than red (DAX +0.5%, CC +0.3%. FTSE 100 -0.1%) and US futures, following yesterday’s tech inspired rally, are all higher again this morning.

Bond markets are under pressure generally, with Treasury yields backing up 1.4bps, although still unable to break the recent highs of 1.15%, Gilts are also softer with yields higher by 1.2bps while bunds and OATs are little changed. BTP’s, however, have fallen ¼ point with yields higher by 2.5bps, which means that spread has risen by the same amount.  Keep an eye on this.

Oil (WTI +1.3%) and gold (+0.5%) are both firmer this morning while the dollar is broadly under pressure.  However, the magnitude of that weakness is fairly minimal, with AUD (+0.35%) the biggest gainer in the G10 on the back of firmer commodity prices, while SEK (-0.35%) is the laggard on what appears to be position unwinding.  The euro (-0.15%) is definitely not following a classic risk-on pattern here, with some reason to believe traders are beginning to take the YSC into account.  In the EMG space, the moves are also limited, with TRY (+0.4%) and BRL (+0.25%) the leading gainers while CE4 currencies (CZK and PLN both -0.1%) are the laggards.  But overall, the risk theme does not appear to be having an impact in FX.

Once again there is no data released today and we are still in the quiet period, so no Fedspeak.  And we don’t even have Yellen to testify, so the FX market is going to be paying attention to equity movements and the bond market, probably in that order.  If risk continues to be acquired, I expect the dollar will have difficulty gaining any traction, but if we start to see a reversal, don’t be surprised to see some of the massive dollar short positions unwound.

Good luck and stay safe
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Go Big

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This morning, a former Fed chair
Will speak and is set to declare
It’s time to “go big”
In order to dig
The nation out from its despair

After a quiet holiday shortened session yesterday, markets are showing modest positivity overall, although European equity markets seem to be lacking any oomph.  However, most other risk indicators are pointing to a resumption of risk appetite with haven assets declining, commodity prices rising and the dollar under pressure.

Though we await the outcomes from three key central bank meetings later this week, there is little in the way of data to consider otherwise, so market participants are looking for other potential catalysts.  Chief among those catalysts today is the testimony by former Fed Chair, Janet Yellen, in the Senate as she is being vetted for Treasury Secretary in the new administration.

According to the release of the prepared statement, ahead of questions, she will explain that the US has been suffering from a K-shaped recovery for many years (in fact since she exacerbated that situation as Fed chair) and therefore the government needs to support policies that will help more people.  On the subject of issuing more Treasury debt, it appears she has weighed the consequences of excessive government debt and will say, with rates so low, it is time to “go big” and issue even more in order to fund the new administration’s priorities.  One other key topic of market interest is the dollar, where she will explain that a market set exchange rate is the best possible outcome, and that should be true of all nations.

For our purposes, the question is how these policies will impact markets overall, and the dollar specifically.  It is abundantly clear from the Treasury market’s performance ever since the Georgia run-off elections (10-year yields have risen 20.6 basis points, including 3.6 today) that the market is already anticipating the Treasury ‘going big’ when it comes to further debt issuance.  In fact, that is part and parcel of the reflation trade that has come back into vogue, with the expected further steepening of the yield curve.  In other words, while there may be some pushback from specific Senators, it seems implausible that reconfirming there will be significant new debt issuance to fund deficits will be seen as a mainstream concern.  Rather, the question will be how the Fed will respond when interest rates continue to rise and the cost of funding all that new debt issuance increases.

As to the dollar, while it appears she will not explicitly state a preference with respect to a weak or strong dollar, it seems pretty clear that the combination of the new administration debt policies with a Fed that is unlikely to allow interest rates to rise to true market-clearing levels will result in significantly more negative real yields as inflation continues to rise.  The result of this process will inevitably be a much weaker dollar.  While the market is currently in a consolidation phase, the dollar’s weakness has been manifesting since last spring.  And though positioning in this trade is huge, it does not mean the idea underpinning those positions is wrong.  As well, I believe there will be a very clear signal for when the dollar will begin it next leg lower; the Fed hinting at   whatever rate mitigation strategy they choose will be clear evidence that the negative real yield structure will expand, and the dollar will henceforth decline more substantially.  However, it could well be several months before that is the case, as we will need to see a continued climb in inflation data as well as the increased debt issuance to drive nominal interest rates higher thus forcing the Fed’s response.

But, as I said, that dollar story is still several months into the future, so let us focus on today’s happenings.  Overall, risk appetite is continuing to improve.  Asian equity markets were mostly stronger (Nikkei +1.4%, Hang Seng +2.7%) although Shanghai (-0.8%) didn’t manage to join in the fun.  While money is flowing rapidly into Hong Kong, it seems there is some concern that the PBOC may be tapping the brakes on liquidity in the real estate market in China, thus removing some of the spare cash and hurting equities as a side effect.  Europe, though, has had a different type of session this morning, with the three main markets all just marginally higher (DAX +0.3%, CAC +0.1%, FTSE 100 +0.2%) and several continental exchanges in the red.  The most notable piece of data from the Eurozone was the German ZEW Expectations survey, which was released slightly better than expected at 61.8, which while historically low, does indicate continue confidence in a recovery there.  US futures, though, are all in for more government spending and are currently higher by between 0.65% (DOW) and 1.0% (NASDAQ).  Clearly, there is no concern over too much debt there.

Speaking of debt, bond markets are behaving as you would expect in a risk-on scenario, with haven bonds declining around the world.  While Treasury yields have risen the most on the day, we seen Bunds (+1.1bps), OATs (+0.5bps) and Gilts (+1.5bps) all under pressure this morning.  Similarly, the PIGS are seeing demand grow on the back of increasing risk appetite with yields in those four nations’ bonds declining between 1 and 2 basis points.

Commodity prices are firmer with oil higher by 0.4% and the ags al looking at gains of between 0.25% and 2.0%, with most of them at multi-year highs.  And finally, the dollar is under pressure almost universally, with only JPY (-0.3%) weaker in the G10, the classic risk-on price action.  SEK (+0.9%) and NOK (+0.8%) are leading the way higher here, with oil clearly supporting the latter while the former is simply demonstrating its high beta with respect to the euro (+0.45%).

In the EMG bloc, ZAR (+1.3%) leads the way on the stronger commodity story, while BRL (+0.85%) and HUF (+0.8%) are next in line.  The real seems to be responding to both firmer commodity prices as well as news that the Covid vaccination program, which had been delayed through bureaucratic misfires, is finally set to get going, which is especially important given the surge in cases there.  As to HUF, the story is more about the CE4 rallying with the euro than with any specific economic or political stories from the country.  But the entire EMG bloc is higher, with the worst performers simply unchanged on the day.

On the data front, there is no mainstream data today, and no Fed speakers either as we are in the quiet period ahead of next Wednesday’s FOMC meeting.  Which brings us back to Yellen’s testimony as the most significant potential new information we are likely to see.  As Fed chair, she was one of the most dovish in history and there is no reason to believe that she will have changed that stance as Treasury secretary.  Instead, I fear we will see a virtual combination of the Fed and Treasury, and the resultant monetization of US debt will be a long term drag on the economy amid rising inflation.  That is not a dollar positive, I assure you, but not today’s problem.

Good luck and stay safe
Adf

Sh*t Out of Luck

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Consensus remains that the buck
This year is just sh*t out of luck
Though lately it’s jumped
It soon will be dumped
Or so say the bears run amok

This will be a holiday-shortened note to match our holiday shortened session today.  The broad theme in markets this morning is one of risk avoidance, with most European equity markets lower (CAC -0.4%, FTSE 100 -0.3%, DAX 0.0%), following the Nikkei (-1.0%) although we did see strength in China with both the Hang Seng (+1.0%) and Shanghai (+0.8%) putting in solid sessions.  The Chinese market activity comes on the heels of their latest data which showed that GDP in 2020 grew 2.3%, slightly better than forecast and certainly the only major economy that will show positive growth for the year.  Interestingly, the other data released was not quite as robust with Retail Sales rising a less than forecast 4.6%, down from November and investment activity rising more slowly than anticipated, both Fixed Asset (2.9%) and Property (7.0%).  However, no matter how you slice it, the Chinese economy seems to have weathered the pandemic better than most.

One of the interesting things we have seen of late is the seeming breakdown in the correlation between stocks and bonds.  Whereas the risk meme had generally been stocks falling led to haven asset buying, so Treasuries and the big 3 European government bonds would rally, that is not today’s story.  While the Treasury market is closed today, looking across Europe, despite the weakness in stocks, we are seeing weakness in bonds, with Bund (+1.2bps), OAT (+1.8bps) and Gilt (+0.8bps) prices all sliding a bit on the day.  The news from the PIGS is worse, with yields rising between 1.9 and 2.8 basis points, although given those assets are more risk than haven, this is no real surprise.

There have been three main stories out of Europe this morning, the election of a new CDU party leader in Germany, Armin Laschet, who will replace the retiring Angela Merkel.  However, there is concern that he is a weak candidate for Chancellor and may face a challenge amid slumping popularity ratings.  A weak German Chancellor is not a Eurozone positive, keep that in mind.  The second story is the French dismissal of the unsolicited bid for Carrefour, the largest grocery chain in the country.  Once again, they have proven they have little interest in a free market and will name any company critical to the national interest to prevent the loss of control.  And finally, in Italy, it appears PM Giuseppe Conte is losing his grip on power after a key ally, Matteo Renzi, took his party out of the ruling coalition.  The broader concern there is that if an election is called, Matteo Salvini, the head of the League, a right-wing party with nationalist tendencies could win the election outright, and wreak significant havoc on the Continent with respect to issues like monetary and fiscal policy, immigration and even addressing Covid.

However, at this point, the bulk of that news is fairly noncommittal and almost certainly not having a real impact on the FX markets…yet.  Rather, the story that caught my eye was that Janet Yellen, whose vetting by the Senate for her role as Treasury Secretary takes place tomorrow, will reputedly say she believes the dollar’s value should be determined by the market and that the Treasury will neither speak to it, nor attempt to weaken it directly in any manner.  Of course, the disingenuous part of that statement is that her other policies, which when combined with the Fed’s activity, will almost certainly drive real yields to greater and greater depths of negativity, will undermine the dollar without her having to ever mention the currency once.

Ironically, for now, the dollar continues its rebound from its nadir on January 6th, just three days into the year.  In fact, in the G10, it is stronger against the entire bloc except JPY (+0.1%), with the commodity bloc leading the way lower (NO -0.45%, AUD -0.45%, CAD -0.4%).  You won’t be surprised to know commodities are pulling back a bit as well today (WTI -0.3%).  In the EMG space, the screen is largely red as well, led by RUB (-0.85%) and ZAR (-0.65%) with only BRL (+0.15%) showing any support on the day.  That support seems to be emanating from a survey of Brazilian economists who are calling for a return to growth in 2021 alongside rising interest rates, with the Selic rate (their overnight rate) forecast to rise 125 basis points this year and a further 150 basis points next year to get back to 4.75%.  If that is the case, BRL will certainly find significant support as expectations remain that dollar rates are not going to rise at all.

On the data front, it is a pretty light week, and remember, there are no Fed speakers either.

Thursday ECB meeting -0.5%
Initial Claims 923K
Continuing Claims 5250K
Philly Fed 11.3
Housing Starts 1560K
Building Permits 1603K
Friday Existing Home Sales 6.55M

Source: Bloomberg

While the Fed doesn’t meet until next week, we do hear from the Bank of Canada (exp no change), BOJ (no change) and the ECB (no change) this week, although as you can tell from the forecasts, there is no anticipated movement on policy at this time.  So, adding it all up, it feels to me like the dollar’s short-term momentum remains modestly firmer, although this has not changed my longer-term view that the Fed will be forced to cap nominal yields and as real yields decline, so will the dollar.  But that is more of a summer phenomenon I believe, late Spring at the earliest.

Good luck and stay safe
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Truly Sublime

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The Chairman said, now’s not the time
To offer a new paradigm
More debt we will buy
Til we certify
The data is truly sublime

Then later, with, kudos, widespread
The new president clearly said
He’d give out more dough
To soften the blow
We’ll suffer from lockdowns ahead

It appears that the question of whether or not the Fed will consider tapering bond purchases by the end of this year has been answered…No!  Yesterday, Fed Chair Powell made it crystal clear that it was way too early to consider the idea of reducing QE purchases, and that eventually, if such time arrives, the Fed would be signaling their actions well in advance of any changes.  This is broadly the message that we heard from vice-Chairman Clarida two days ago, as well as from Governor Brainerd and some of the more dovish regional presidents.  Thus, the comments of the four regional presidents from earlier this week, indicating that tapering could happen as soon as the end of 2021, are likely to seem diminished in the eyes of the market, and the idea of a much more rapid sell-off in Treasuries needs to be rethought.

Beyond that specific question, the Chairman waxed about the good job the Fed has been doing, all the tools they have available to address any future issues, and, remarkably, that the record high levels of debt in the non-financial sector are really no big deal at all given the current level of interest rates.  Low rates obviously allow more debt to be serviced easily.  The problem, of course, is that if rates do rise in the future, servicing that debt will not be so easy, and the ramifications for the economy would be quite negative.  This is the primary factor in the thought that the Fed may never raise rates again, because doing so would result in significant economic stress throughout the country, and truly, the world.

The market response to Powell’s comments was modest at best, with the dollar softening a bit, while equity and bond markets didn’t really react at all.  Then last night, President-elect Biden made his first policy speech promising a new approach to things.  But one thing that is clearly not set to change is the political view that spending more money is always the right action.  He thus unveiled a $1.9 trillion spending program designed to address the ongoing economic impacts of Covid and the concurrent lockdowns around the country.  As well, he talked about another $3 trillion program for longer term needs like infrastructure and environmental issues that need to be addressed.

Interestingly, the market appears a bit disappointed in this proposed spending bill, and not because it is going to increase the debt load.  Rather, it appears expectations were high for more immediate spending to help goose the economy and by extension, the profit profile of the market.  However, the combination of Fed confirmation only that they would not be tightening, rather than expanding programs, and the disappointing cash outlay in the Biden proposal has forced a bit of reconsideration about the future trajectory of the economy and equity markets.  After all, if the Fed is not adding to the size of its balance sheet, where is the money going to come from to support buying more stocks?  Of course, it could simply be that the Friday before a holiday weekend has encouraged a bit of profit-taking by traders, who will be back in force on Tuesday, but whatever the cause, this morning is opening with a clear risk-off tone.

Looking at equity markets in Asia, the Nikkei (-0.6%) was the laggard, but Shanghai (0.0%) and the Hang Seng (+0.3%) hardly inspired.  Meanwhile, European screens are filled with red, led by the CAC (-0.95%) but seeing both the DAX and FTSE 100 falling -0.8%.  It is interesting to note that there was a bit of data this morning which arguably could have been construed as positive, yet clearly has not been seen that way.  UK November GDP fell only -2.6% M/M, a better than expected performance, especially given the ravages of Covid on that economy. While IP was a bit softer than forecast Services was clearly better, which for the UK economy will be crucial going forward.  The other data point showed French CPI at 0.0% in December, which remarkably, helps raise the Eurozone number!  But equity investors are having none of it today, and shedding positions into the weekend.  As to US futures markets, they are pointing lower as well, between -0.35% and -0.5% at this hour.

One cannot be surprised that Treasury prices are rallying given the risk stance, with the 10-year up ¼ of a point and yields lower by 2.7bps.  While I continue to believe that there is a near term cap in yields, at least at 1.1%, the idea of the bond offering safety makes a bit more sense than when the yield was 0.7% like most of the summer.  Remember, part of the safety of the bond is that it pays a steady income stream.  As to European markets, the big 3 are essentially unchanged at this hour, although all of them have rallied from early session lows where yields had climbed a bit.  This behavior is a bit unusual as I would have expected increased demand for these havens, but markets can be perverse on a regular basis.

Oil prices are under pressure this morning, with WTI lower by 1.3%, although that remains simply a consolidation of the large move higher we had seen over the past two plus months.  As to gold, it is little changed on the day, firmly in the middle of its recent trading range.

Finally, the dollar is definitely the beneficiary of today’s risk stance, rising against most currencies, with only the havens of JPY (+0.1%) and CHF (+0.05%) managing to eke out any gains.  However, the commodity bloc is weak; NOK (-0.6%), AUD (-0.6%) and CAD (-0.5%), and the euro (-0.3%) and pound (-0.45%) are under pressure as well.  There doesn’t need to be a more specific story than risk-off to explain these movements.

Emergers, too, are broadly under pressure led by the commodity linked currencies there.  ZAR (-0.9%), BRL (-0.8%) and CLP (-0.6%) are leading the charge lower, although pretty much every currency in the space has fallen except IDR (+0.3%).  The story here was that exports climbed a more than expected 14.6% leading to a larger trade surplus.  The indication that the economy could weather then Covid storm better than many peers has increased the attractiveness of the rupiah, especially given the yield there, which is amongst the highest in the world these days at 3.75%.

On the data front, yesterday saw much worse than expected Initial Claims data, a potential harbinger of weaker data to come.  This morning brings PPI (exp 0.8% Y/Y, 1.3% Y/Y -ex food & energy), Retail Sales (0.0%, -0.2% -ex autos), Capacity Utilization (73.6%), IP (0.5%), and Michigan Sentiment (79.5).  So, lots of things, but really Retail Sales is the one that matters most here, I think.  Certainly, yesterday’s Claims data has put the market on notice that things slowed down in Q4 and are likely starting Q1 in the same state.  However, do not be too surprised if a bad number is met with a rally as expectations grow that the Fed could, in fact, step up the pace of purchases.  We shall see.

Beyond that, Minneapolis Fed president Kashkari, the uber-dove, is the last Fed speaker before the quiet period begins ahead of the January 27 meeting.  But we already know he is going to say not enough is being done.

As long as risk remains on the back foot, the dollar can certainly maintain its modest bid here.  However, if things turn around, notably if equities climb into the green, look for the dollar to give up its gains.  At this point, the dollar’s strength does not seem to be built on a strong foundation.

Good luck, good weekend and stay safe
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Pending A-pocalypse

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Inflation’s on everyone’s lips
As traders now need come to grips
With data still soft
But forecasts that oft
Point to pending a-pocalypse

Is inflation really coming soon?  Or perhaps the question should be, is measured inflation really coming soon?  I’m confident most of us have seen the rise in prices for things that we purchase on a regular basis, be it food, clothing, cable subscriptions or hard goods.  And of course, asset price inflation has been rampant for years, but apparently that doesn’t count at all.  However, the focus on this statistic has increased dramatically during the past several months which is a huge change from, not only the immediate post-pandemic economy, but in reality, the past thirty years of economic activity.  In fact, ever since Paul Volcker, as Fed Chair, slew the inflationary dragon that lived in the 1970’s, we have seen a secular move lower in measured consumer prices alongside a secular move lower in nominal interest rates.

But the pandemic has forced a lot of very smart people (present company excluded) to reconsider this trend, with many concluding that higher prices, even the measured kind, are in our future.  And this is not a discussion of a short-term blip higher due to pent up demand, but rather the long-term trend higher that will need to be addressed aggressively by the Fed lest it gets out of hand.

The argument for inflation centers on the difference between the post GFC financial response and the post Covid shock financial response.  Back in 2009, the Fed cut rates to zero and inaugurated their first balance sheet expansion of note with QE1.  Several more bouts of QE along with years of near zero rates had virtually no impact on CPI or PCE as the transmission mechanism, commercial banks, were not playing their part as expected.  Remember, QE simply replaces Treasuries with bank reserves on a commercial bank balance sheet.  It is up to the commercial bank to lend out that money in order for QE to support the economy.  But commercial banks were not finding the risk adjusted returns they needed, especially compared to the riskless returns they were receiving from the Fed from its IOER program.  So, the banking sector sold the Fed their bonds and held reserves where they got paid interest, while enabling them to have a riskless asset on their books.  In other words, only a limited amount of QE wound up in the public’s pocket.  The upshot was that spending power did not increase (remember, wages stagnated) and so pricing pressures did not materialize, hence no measured inflation.

But this time around, fiscal policy has been massive, with the CARES act of nearly $2 trillion including direct payments to the public as well as forgivable small business loans via the PPP program.  So, banks didn’t need to lend the money to get things moving, the government solved that part of the equation. Much of that money wound up directly in the economy (although certainly some found its way into RobinHood accounts and Bitcoin), thus amping up demand.  At the same time, the lockdowns around the world resulted in broken supply chains, meaning many goods were in short supply.  This resulted in the classic, more money chasing fewer goods situation, which leads to higher prices.  This helps explain the trajectory of inflation since the initial Covid impact, where prices collapsed at first, but have now been rising back sharply.  While they have not yet reached pre-Covid levels, it certainly appears that will be the case soon.

Which leads us back to the question of, what will prevail?  Will the rebound continue, or will the long-term trend reassert itself?  This matters for two reasons.  First, we will all be impacted by rising inflation in some manner if it really takes off.  But from a markets perspective, if US inflation is rising rapidly, it will put the Fed in a bind with respect to their promise to keep rates at zero until the end of 2023.  If the market starts to believe the Fed is going to raise rates sooner to fight inflation, that will likely have a very deleterious effect on equity and bond prices, but a very positive effect on the dollar.  The combination of risk-off and higher returns will make the dollar quite attractive to many, certainly enough to reverse the recent downtrend.

Lately, we are seeing the beginnings of this discussion, which is why the yield curve has steepened, why stock markets have stalled and why the dollar has stopped sliding.  Fedspeak this week has been cacophonous, but more importantly has shown there is a pretty large group of FOMC members who see the need for tapering policy, starting with reducing QE, but eventually moving toward higher rates.  Yesterday, uber-dove Governor Lael Brainerd pushed back on that story, but really, all eyes will be on Chairman Powell this afternoon when he speaks.  To date, he has not indicated a concern with inflation nor any idea he would like to taper purchases, so any change in that stance is likely to lead to a significant market response.  Pay attention at 12:30!

With that as backdrop, a quick tour of the markets shows that risk appetite is moderately positive this morning.  While the Nikkei (+0.85%) and Hang Seng (+0.9%) both did well, Shanghai suffered (-0.9%) despite data showing record export performance by China last year.  Europe is far less exciting with small gains (DAX +0.2%, CAC +0.1% and FTSE 100 +0.7%) following Germany’s release of 2020 GDP data showing a full-year decline of “just” -5.0%, slightly less bad than expected.  US futures are mixed at this hour, but the moves are all small and offer no real news.

Bond markets show Treasury yields higher by 2bps, while European bonds have all seen yields slip between 1.0 and 1.7bps, at least the havens there.  Italian BTP’s are selling off hard, with yields rising 5.7bps, and the rest of the PIGS have also been under pressure.  Oil prices are little changed this morning, still holding onto their gains since November.  Gold prices are slightly softer and appear to be biding their time until the next big piece of news hits.

Finally, the dollar is somewhat mixed this morning, with the G10 basically split between gainers and losers, although the gains have been a bit larger (AUD +0.4%, SEK +0.3%) than the losses (CHF -0.2%, JPY -0.1%).  But this looks like position adjustments and potential order flow rather than a narrative driven move.  EMG currencies are also split, but there are clearly more gainers than losers here, with the commodity bloc doing best (ZAR +0.85%, RUB +0.65%, BRL +0.6%) and losses more random led by KRW (-0.25%) and CZK (-0.2%).  If pressed, one needs look past oil and gold to see agricultural commodities and base metals still performing well and supporting those currencies.  KRW, on the other hand is a bit more confusing given the growth in China, it’s main exporting destination.  Again, position adjustments are quite viable given the won’s more than 11% gain since May.

This morning’s data slate includes only Initial Claims (exp 789K) and Continuing Claims (5.0M), which if far from expectations could wiggle markets, but seem unlikely to do so as everyone awaits Powell’s speech.  Until then, I expect that the dollar will continue to remain supported, but if Powell reiterates a very dovish stance, we could easily see the dollar head much lower.  Of course, if he gives credence to the taper view, look for some real market fireworks, with both bonds and stocks selling off and the dollar jumping sharply.

Good luck and stay safe
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What Will the Fed Do?

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To taper, or not, is the new
Discussion.  What will the Fed do?
One group sees next winter
As when the Fed printer
Will slow down if forecasts come true

But yesterday doves answered back
It’s premature to take that tack
There’s no need to shrink
QE, the doves think
‘Til growth has absorbed all the slack

Remember just last month when the Fed tightened the wording in the FOMC statement to explain they would buy “at least $80 billion per month” of Treasuries and “at least $40 billion per month” of agency mortgage-backed securities “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.”  This was clearly more specific than their previous guidance of buying securities at “the current pace” to achieve the same ends.  It would be easy to read that December statement and conclude that reducing asset purchases was quite a long way off in the future, arguably years.  This is especially so when considering the fact that the US government cannot afford for interest rates to rise very far given the extraordinarily large amount of debt they have outstanding and need to service.  After all, it is much easier to service debt when interest rates are 0.25% than when they are 2.5%.

Granted, the first Covid vaccine had just been approved the weekend before that meeting, so the question of how it would be rolled out was still open, but it had to be clear that the vaccine was going to become widely available in the following months.  And yet, the statement seems to imply QE could increase going forward if there was to be any change at all.  Yet here we are just four weeks later, and we have heard a virtual chorus of Fed regional presidents explaining that tapering purchases may be appropriate before the end of the year.  In the past seven days, Chicago’s Evans, Philly’s Harker, Dallas’s Kaplan and Atlanta’s Bostic all said tapering purchases would be appropriate soon, with Harker explaining it could easily be this year.

That’s pretty powerful stuff, if the Fed is truly considering changing its stance on policy and the ramifications are huge.  Arguably, if the Fed truly announced they were going to be reducing purchases, the bond market would sell off much harder than recently, the stock market would sell off quite hard and the dollar would reverse course and rally sharply.  But of those three reactions, the only thing ongoing is the steepening of the yield curve, with stocks continuing their slow move higher and the dollar, while consolidating for the past week, hardly on a tear.

Naturally, there is a counterpoint which was reiterated by St Louis’s Bullard and Boston’s Rosengren yesterday, and earlier this week by Cleveland’s uber-hawk, Loretta Mester and Fed vice-Chair Richard Clarida, that there is no sign a taper is appropriate any time soon, and that the Fed will have the printing presses running at full tilt until the pandemic is behind us.

So, which is it?  Well, that is the question that will be debated in and by the markets for the foreseeable future, or at least until the Fed tells us.  This week, we will hear from nine more Fed speakers, including Chairman Powell, but then the quiet period starts and there will be no word until the FOMC meeting two weeks from today.  The list of speakers spans the spectrum from hawkish to dovish, but arguably, all eyes will be on Powell.  Many analysts have highlighted the 2013 Taper Tantrum, which resulted after then Fed Chair Bernanke mentioned that the Fed would not be buying bonds forever.  The market response then was to drive 10-year Treasury yields from 1.62% on May 1 2013 to 2.99% on September 15 2013!  I find it incredibly hard to believe that the current Fed will allow anything like that at all.  As I pointed out earlier, the US government simply cannot afford that outcome, and the Fed will prevent it from happening.  The implication is that at some point soon, the Fed is going to discuss yield curve control, likely as a method to help finance all the mooted infrastructure spending that is supposed to be coming from the new Administration and Congress.  Or something like that.  But they will not allow yields to rise that much more, they simply can’t.

How has this argument discussion played out in the markets today?  The picture has been mixed, at best, with perhaps a tendency to reduce risk becoming the theme.  Looking at equities, the Nikkei (+1.0%) was the outstanding performer overnight, while we saw marginal declines in the Hang Seng (-0.2%) and Shanghai (-0.3%).  European bourses, which had been slightly higher earlier in the session, have slipped back to either side of unchanged with the DAX (-0.15%) and FTSE 100 (-0.1%) a touch lower while the CAC (+0.1%) has edged higher.  The CAC has been supported by the news that Alimentation Couche-Tarde is bidding for Carrefours, the French grocery store chain, and a key member of the index.  In truth, this performance is a bit disappointing as well, given comments from ECB member Villeroy that they would be supporting the economy with easy money as long as necessary, and that they were carefully watching the exchange rate of the euro. (more on this later).  Finally, US futures, which had been slightly higher earlier in the session, are all slightly lower now, but less than 0.1% each.

As to the bond market, safety is clearly in demand, at least in Europe, where yields have fallen by between 1.8bps (Gilts) and 2.7bps (Bunds) with most other markets somewhere in between.  Treasuries, meanwhile, have edged higher by just a tick with the yield a scant 0.3bps lower at this time.  As I said, this is going to be the battle royal going forward.

In the commodity space, oil is basically unchanged this morning, holding on to recent gains, while gold is also unchanged, holding on to recent losses.

And finally, the dollar is somewhat higher this morning, seeming to take on its traditional role of haven asset.  It should be no surprise the euro (-0.3%) is under pressure, which is exactly what the ECB wants to see.  Remember, the other sure thing is that the ECB cannot afford for the euro to rally very far as it will negatively impact the Eurozone export community as well as import deflation, something they have been trying to fight for years.  Elsewhere in the G10, SEK (-0.95%) is the worst performer after the Riksbank announced they would be selling SEK 5 billion per month to buy foreign currency reserves, and coincidentally weaken their currency.  And they will be doing this until December 2023, which means they will be creating an additional SEK 180 billion in the market, a solid 13.5% of GDP.  Look for further relative weakness here.  But beyond SEK, the rest of the G10 has seen lesser moves, all of a piece with broad dollar strength.

In the emerging markets, CLP (-2.1%) is today’s big loser after announcing that they, too, would be selling CLP each day to increase their FX reserves to the tune of 5% of the Chilean economy.  Of course, liquidity in CLP is far worse than that in SEK, so a larger move is no surprise.  Regardless, we can expect continued pressure on this peso for a while.  But away from this story, the overnight session saw modest strength in most APAC currencies led by IDR (+0.5%) and KRW (+0.4%), while the morning session has seen CE4 currencies suffer alongside the euro, and LATAM currencies give up some ground as well.  BRL (-0.6%) seems to be responding to the extremely high inflation print seen yesterday, while HUF (-0.7%) is reacting to the news of an increase in QE there as the central bank expanded its corporate bond purchases to HUF 1.15 trillion from HUF 750 billion previously.

On the data front, today brings CPI (exp 0.4% M/M, 0.1% core) and the afternoon brings the Fed’s Beige Book.  With the inflation story gaining traction everywhere, all eyes will be on the data there.  If we see a higher than expected print, the pressure will increase on the Fed, but so far, they have been quite clear they are unconcerned with rising prices and are likely to stay that way for quite a while.  Ultimately, I fear that is one of the biggest risks out there, rising inflation.

Looking ahead, I believe the dollar’s consolidation of its losses will continue but would be surprised if it rallied much more at all.  Rather, a choppy day seems to be in store.

Good luck and stay safe
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The UK’s Current Plight

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In England, the doves are in flight
Explaining that NIRP is alright
But hawks keep maintaining
That zero’s restraining
Despite the UK’s current plight

What we’ve learned thus far in 2021 is that Monday is risk-off day, at least, so far.  Yesterday, for the second consecutive week, risk was under pressure as equity markets everywhere fell, while the dollar rallied sharply.  But just like last week, where risk was avidly sought once Monday passed, this morning has seen a rebound in many equity markets, as well as renewed pressure on the dollar.

But aside from a very early assessment of a potential pattern forming, this morning brings a dearth of market-moving news.  Perhaps the most interesting is the battle playing out inside the BOE, where Silvana Tenreyo, one of the more dovish MPC members, has been making the case that in the current situation, the UK should cut the base rate into negative territory.  Her analysis, as well as that of other central banks like the ECB, SNB and Danish central bank, have shown that there are many benefits to the policy and that it has been quite effective.  Of course, those are three of four central banks (the BOJ is the other) that currently maintain negative rates, so it would be pretty remarkable if those studies said NIRP was a failure.  The claim is that NIRP increases the amount of lending that banks extend, thus encouraging spending and investment as well as weakening the currency to help the export industries in the various countries.  And the studies go on to explain that all these factors help drive inflation higher, a key goal of each of those central banks.

Now, there is no question that those are the theoretical underpinnings of NIRP, alas, it is hard to find the data to support this.  Rather, these studies tend to give counterfactual analyses, that indicate if the central banks had not gone negative, things would have been worse.  For instance, let’s look at CPI in the Eurozone (-0.3%), Switzerland (-0.8%) and Denmark (+0.5%).  Not for nothing, but those hardly seem like data that indicate inflation has been supported.  In fact, in each of these countries, inflation was going nowhere fast before the pandemic, although I will grant that Covid has depressed the numbers further to date.  And how about the currency?  Well, one of the biggest stories of the past six months has been how the dollar has declined nearly 10% against these currencies.  Once again, the concept of a weaker currency seems misplaced.

The point here is that the discussion is heating up in the UK, with the independent MPC members pushing for a move below zero, while the BOE insiders are far more reluctant, explaining that the banking system would see serious harm.  (I think if one looks at the banking system in Europe, it is a fair statement that the banks there are not performing all that well, despite (because of?) 6 years of NIRP.  The BOE counterpoint was made this morning by Governor Bailey who explained there were still many issues to be addressed and implied NIRP was not likely to be implemented in the near future.  With all this as background, it should be no surprise that the pound has been the best performer in the G10 today, rising 0.6%, after Bailey’s comments squashed ideas NIRP was on its way soon.

But the dollar, overall, is softer today, not nearly reversing yesterday’s gains (except vs. the pound), but generally under pressure.  However, there is precious little that seems to be driving markets this morning, other than longer term stories regarding fiscal stimulus and Covid-19.

So, a quick tour of markets shows that Asian equity markets shook off the weakness in the US yesterday and rallied nicely.  The Nikkei (+0.1%) was the laggard, as the Hang Seng (+1.3%) and Shanghai (+2.1%) showed real strength.  Europe, on the other hand, is showing a much more mixed picture, wit the DAX (+0.1%) actually the best performer of the big 3, while the CAC (0.0%) and FTSE 100 (-0.6%) are searching for buying interests.  The FTSE is likely being negatively impacted by the pound’s strength, as there is a narrative that the large exporters in the index are helped by a weak pound and so there is a negative correlation between the pound and the FTSE.  The problem with that is when running the correlation analysis, over the past two years, the correlation is just 0.08% and the sign is positive, meaning they move together, not oppositely.  But it is a nice story!  And one more thing, US futures are green, up about 0.25% or so.

Bond markets are selling off this morning as yields continue to rise on expectations that the future is bright.  10-year Treasury yields are up to 1.16%, which is a new high for the move, having rallied a further 1.2bps this morning.  But we are seeing the same type of price action throughout Europe, with yields higher by between 1.7 bps (Bunds) and 4.0bps (Italian BTP’s), with Gilts (+2.3bps) and OATs (+2.0bps) firmly in between.  What I find interesting about this movement is the constant refrain that H1 2021 is going to be much worse than expected, with the Eurozone heading into a double dip recession and the US seeing much slower than previously expected growth as many analysts have downgraded their estimates to 1.0% from 4.0% before.  At the same time, the message from the Fed continues to be that tighter policy is outcome based, and there is no indication they are anywhere near thinking about raising rates.  With that as background, the best explanation I can give for higher yields is concerns over inflation.  Remember, CPI is released tomorrow morning, and since the summer, almost every release was higher than forecast.  As I have written before, the Fed is going to be tested as to their tolerance for above target inflation far sooner than they believe.

The inflation story is supported, as well, but this morning’s commodity price moves, with oil higher by 1.3% and gold higher by 0.8%.  In fact, I believe that inflation is going to become an increasingly bigger story as the year progresses, perhaps reaching front page news before the end of 2021.

Finally, as mentioned above, the dollar is under broad-based, but generally modest pressure this morning.  After the pound, AUD (+0.35%) and CAD (+0.25%) are the leading gainers, responding to the firmer commodity prices, although NOK (0.0%) is not seeing any benefit from oil’s rise.  In the EMG space, it is also the commodity linked currencies that are leading the way, with ZAR (+0.9%), RUB (+0.8%) and MXN (+0.5%) topping the list.  Also, of note is the CNY (+0.3%) which is back to levels last seen in June 2018, as the strengthening trend their continues.

On the data front, the NFIB Small Business Optimism index showed less optimism, falling to 95.9, well below expectations, again pointing to a slowing growth story in H1.  The only other data point from the US is JOLT’s Job Openings (exp 6.4M), which rarely has any impact.  I would like to highlight, in the inflation theme, that Brazilian inflation was released this morning at a higher than expected 4.52% in December, which is taking it back above target and to levels last seen in early 2019.  If this continues, BRL may become a high yielder again.

Finally, we hear from 6 different Fed speakers today, but again, unless they all start to indicate tighter policy, not just better economic outcomes, in H2, while the dollar may benefit slightly, it will not turn the current trend.  And that’s really the story, the medium-term trend in the dollar remains lower, but for now, absent a catalyst for the next leg (something like discussion of YCC or increased QE), I expect a bit of choppiness.

Good luck and stay safe
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Compelled

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Just last week the narrative spoke
And told us the world would soon choke
On dollars they held
Thus, would be compelled
To sell them, ere they all went broke

But funnily, this week it seems
The selling had reached its extremes
So, shorts are now squeezed
And traders displeased
As they now must look for new themes

It had been the number one conviction trade entering 2021, that the dollar would sell off sharply this year.  In fact, there were some who were calling for a second consecutive year of a 10% decline in the dollar versus its G10 counterparts, with even more gains in some emerging market currencies.  The market, collectively, entered the new year short near record amounts of dollars, riding the momentum they had seen in Q4 of last year and looking for another few percentage points of decline.  Alas, one week into the year and things suddenly seem quite different.

The first thing to highlight is that while a few percent doesn’t seem like much of a move, certainly compared to equities or bitcoin, the institutional trading community, consisting of hedge funds and CTA’s, lever up their positions dramatically.  In fact, 10x capital is quite common, with some going even further.  So, that 2% move on a 10x leverage position results in a 20% gain, certainly very respectable.  The second thing to highlight is that if a short-term trading reversal is able to cause this much angst in the trading community, conviction in the trade must not have been that high after all.

But let us consider what has changed to see if we can get a better understanding of the market dynamics.  Clearly, the biggest change was the run-off election in Georgia, which had been expected to result in at least one seat remaining in Republican hands, and thus a Republican majority in the Senate.  This outcome of a split government was seen to be a general positive for risk, as it would prevent excessive increases in debt financed stimulus, thus force the Fed to maintain low US interest rates.  And of course, we all know, that low rates should undermine the currency.

But when the Democrats won both seats, and the Senate effectively flipped, the new narrative was that there would be massive stimulus forthcoming, encouraging the reflation trade.  The thing is, the reflation trade is part and parcel of the steepening yield curve trade based on the significant amount of new Treasury debt that would need to be absorbed by the market, with the result being declining prices and higher Treasury yields.  (One thing that I never understood about the weak dollar trade in this narrative was the idea that a steeper yield curve would lead to a weaker dollar, when historically it was always the other way around; steep curve => strong dollar.)

Last week, of course, we saw Treasury yields back up 20 basis points in the back end of the curve, exactly what you would expect in a reflation trade.  And so, it cannot be surprising that the dollar has found a bottom, at least in the short-term, as higher yields are attracting investors.  But what does this say about the future prospects for the dollar?

My thesis this year has been the dollar will decline on the back of declining real yields in the US, which will be driven by rising inflation and further Fed support.  Neither the US, nor any G10 country for that matter, can afford for interest rates to rise as they continue to issue massive amounts of debt, since higher rates would ultimately bankrupt the nation.  However, inflation appears to be making a comeback, and not just in the US, but in many places around the world, specifically China.  Thus, the combination of higher inflation and capped yields will result in larger negative real rates, and thus a decline in the dollar.  Last week saw real yields rise 15 basis points, so the dollar’s rally makes perfect sense.  But once the Fed makes it clear they are going to prevent the back end of the curve from rising, the dollar will come under renewed pressure.  However, that may not be until March, unless we see a hiccup in the equity market between now and then.  For now, though, as long as US yields rise, look for the dollar to go along for the ride.

Of course, higher US yields and a stronger dollar do not encourage increased risk appetite, so a look around markets today shows redder screens than that to which we have become accustomed.  The exception to the sell-off rule was Tokyo, where the Nikkei (+2.35%) rallied sharply as the yen continues to weaken.  Remember, given the export orientation of the Japanese economy, a weaker yen is generally quite positive for stocks there.  The Hang Seng (+0.1%) managed a small gain, but Shanghai (-1.1%), fell after inflation data from China showed a much larger rebound than expected with CPI jumping from -0.5% to +0.2%.  Obviously, that is not high inflation, but the size and direction of the move is a concern.

European markets, however, are all underwater this morning, with the DAX, CAC and FTSE 100 all lower by 0.5%.  US futures are pointing down as well, between 0.4%-0.6% to complete the sweep.  Bond markets are modestly firmer this morning, with Treasury yields slipping 1.5 bps, while Bunds, OATS and Gilts have all seen yields fall just 0.5bps.  Do not be surprised that yields for the PIGS are rising, however, as they remain risk assets, not havens.

In the commodity space, oil is under modest pressure, -0.65%, while gold is essentially unchanged, although I cannot ignore Friday’s 2.5% decline, and would point out it fell another 1.5% early in today’s session before rebounding.  Since I had highlighted Bitcoin’s remarkable post-Christmas rally, I feel I must point out it is down 17% since Friday, with some now questioning if the bubble is popping.

Finally, the dollar continues its grind higher, with commodity currencies suffering most in the G10 (NOK -1.1%, NZD -0.7%, AUD -0.6%) as well as the pound (-0.6%) which is feeling the pain of Covid-19 restrictions sapping the economy.  In the EMG space, we are also seeing universal weakness, with the commodity focused currencies under the most pressure here as well.  So, ZAR (-1.0%), MXN (-0.85%) and BRL (-0.8%) are leading the pack lower, although there were some solid declines out of APAC (IDR -0.75%, KRW -0.7%) and CE4 (PLN -0.75%, HUF -0.7%).

On the data front, this week brings less info than last week, with CPI and Retail Sales the highlights:

Tuesday NFIB Small Biz 100.3
JOLTs Job Openings 6.5M
Wednesday CPI 0.4% (1.3% Y/Y)
-ex food & energy 0.1% (1.6% Y/Y)
Fed’s Beige Book
Thursday Initial Claims 785K
Continuing Claims 5.0M
Friday Retail Sales 0.0%
-ex autos -0.2%
PPI 0.3% (0.7% Y/Y)
-ex food & energy 0.1% (1.3%)
Empire Manufacturing 5.5
IP 0.4%
Capacity Utilization 73.5%
Business Inventories 0.5%
Michigan Sentiment 80.0

Source: Bloomberg

Aside from that, we also will hear a great deal from the Fed, with a dozen speakers this week, including Powell’s participation in an economics webinar on Thursday.  Last week, you may recall that Philadelphia’s Patrick Harker indicated he could see a tapering in support by the end of the year, but the market largely ignored that.  However, if we hear that elsewhere, beware as the low rates forever theme is likely to be questioned, and the dollar could well find a lot more support.  The thing is, I don’t see that at all, as ultimately, the Fed will do all they can to prevent higher yields.  For now, the dollar has further room to climb, but over time, I do believe it will reverse and follow real yields lower.

Good luck and stay safe
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Perfect Right Here

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Said Harker, by end of this year
A taper could be drawing near
But Mester explained
No cash would be drained
As policy’s perfect right here

Ahead of this morning’s payroll report, I believe it worthwhile to recap what we have been hearing from the FOMC members who have been speaking lately.  After all, the Fed continues to be the major force in the market, so maintaining a clear understanding of their thought process can only be a benefit.

The most surprising thing we heard was from Philadelphia Fed president Harker, who intimated that while he saw no reason to change things right now, he could see the Fed beginning to taper their asset purchases by the end of 2021 or early 2022.  Granted, that still implies an additional $1 trillion plus of purchases, but is actually quite hawkish in the current environment where expectations are for rates to remain near zero for at least the next three years.  Given what will almost certainly be a significant increase in Treasury issuance this year, if the Fed were to step back from the market, we could see significantly higher rates in the back end of the curve.  And, of course, it has become quite clear that will not be allowed as the government simply cannot afford to pay higher rates on its debt.   As well, Dallas Fed President Kaplan also explained his view that if the yield curve steepened because of an improved growth situation in the US, that would be natural, and he would not want to stop it.

But not to worry, the market basically ignored those comments as evidenced by the fact that the equity market, which will clearly not take kindly to higher interest rates in any form, rallied further yesterday to yet more new all-time highs.

At the same time, three other Fed speakers, one of whom has consistently been the most hawkish voice on the committee, explained they saw no reason at all to adjust policy anytime soon.  Regional Fed presidents from Cleveland (Loretta Mester), Chicago (Charles Evans) and St Louis (James Bullard) were all quite clear that it was premature to consider adjusting policy as a response to the Georgia election results and the assumed increases in fiscal stimulus that are mooted to be on the way.

Recapping the comments, it is clear that there is no intention to adjust policy, meaning either the Fed Funds rate or the size of QE purchases, anytime soon, certainly not before Q4.  And if you consider Kaplan’s comments more fully, he did not indicate a preference to reduce support, just that higher long-term rates ought to be expected in a well-performing economy.  Vice-Chairman Clarida speaks this morning, but it remains difficult to believe that he will indicate any changes either.  As I continue to maintain, the government’s ability to withstand higher interest rates on a growing amount of debt is limited, at best, and the only way to prevent that is by the Fed capping yields.  Remember, while the Fed has adjusted its view on inflation, now targeting an average inflation rate, they said nothing about allowing yields to rise alongside that increased inflation.  Again, the dollar’s performance this year will be closely tied to real (nominal – inflation) yields, and as inflation rises in a market with capped yields, the dollar will decline.

Turning to this morning’s payroll release, remember, Wednesday saw the ADP Employment number significantly disappoint, printing at -123K, nearly 200K below expectations.  As of now, the current median forecasts are as follows:

Nonfarm Payrolls 50K
Private Payrolls 13K
Manufacturing Payrolls 16K
Unemployment Rate 6.8%
Average Hourly Earnings 0.2% (4.5% Y/Y)
Average Weekly Hours 34.8
Participation Rate 61.5%
Consumer Credit $9.0B

Source: Bloomberg

These numbers are hardly representative of a robustly recovering economy, which given the cresting second wave of Covid infections and the lockdowns that have been imposed in response, ought not be that surprising.  The question remains, will administration of the vaccine be sufficient to change the trajectory?  While much has been written about pent up demand for things like travel and movies, and that is likely the case, there has been no indication that governments are going to roll back the current rules on things like social distancing and wearing masks.  One needs to consider whether those rules will continue to discourage those very activities, and thus, crimp the expected recovery.  Tying it together, a slower than expected recovery implies ongoing stimulus

But you don’t need me to explain that permanent stimulus remains the basic premise, just look at market behavior.  After yesterday’s US equity rally, we have seen a continuation around the world with Japan’s Nikkei (+2.35%) leading the way in Asia, but strength in the Hang Seng (+1.2%) and Australia (+0.7%), although Shanghai (-0.2%) didn’t really participate.  Europe, too, is all green, albeit in more measured tones, with the DAX (+0.8%) leading the way but gains in the CAC (+0.5%) and FTSE 100 (+0.2%) as well as throughout the rest of the continent.  And finally, US futures are all pointing higher at this hour, with all three indices up by 0.25%-0.35%.

The Treasury market, which has sold off sharply in the past few sessions, is unchanged this morning, with the yield on the 10-year sitting at 1.08%.  In Europe, haven assets like bunds, OATs and gilts are little changed this morning, but the yields on the PIGS are all lower, between 1.6bps (Spain) and 3.9bps (Italy).  Again, those bonds behave more like equities than debt, at least in the broad narrative.

In the commodity space, oil continues to rally, up another 1.3% this morning, and we continue to see strength in base metals and ags, but gold is under the gun, down 1.1%, and clearly in disfavor in this new narrative of significant new stimulus and growth.  Interestingly, bitcoin, which many believe as a substitute for gold has continued to rally, vaulting through $41k this morning.

And lastly, the dollar, which everyone hates for this year, is ending the week on a mixed note.  In the G10, NOK (+0.3%) is the best performer, as both oil’s rise and much better than expected IP data have investors expecting continued strength there.  But after that, the rest of the bloc is +/- 0.2% or less, implying there is no driving force here, rather that we are seeing position adjustments and, perhaps, real flows as the drivers.

In the emerging markets, ZAR (+1.2%) and BRL (+0.6%) are the leading gainers, while IDR (-0.8%) and CLP (-0.6%) are the laggards.  In fact, other than those, the bloc is also split, like the G10, with winners and losers of very minor magnitude.  Looking first at the rand, today’s gains appear to be position related as ZAR has been under pressure all week, declining more than 5.6% prior to today’s session.  BRL, too, is having a similar, albeit more modest, correction to a week where it has declined more than 5% ahead of today’s opening.  Both those currencies are feeling strain from weakening domestic activity, so today’s gains seem likely to be short-lived.  On the downside, IDR seems to be suffering from rising US yields, as the attractiveness of its own debt starts to wane on a relative basis.  As to Chile, rising inflation seems to be weighing on the currency as there is no expectation for yields to rise in concert, thus real yields there are under pressure.

And that’s really it for the day.  We have seen some significant movement this week, as well as significant new news with the outcome of the Georgia election, so the narrative has had to adjust slightly.  But in the end, it is still reflation leads to higher equities and a lower dollar.  Plus ça change, plus ça meme chose!

Good luck, good weekend and stay safe
Adf