Flames of Concern

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In Turkey, the president canned
The central bank chief, and has fanned
The flames of concern
As traders now spurn
The lira in lieu of the rand

The top FX story this morning clearly revolves around the abrupt firing of the Turkish central bank’s governor, Naci Agbal, after he had the audacity to raise rates a surprising 2.0% last week in his effort to combat rising inflation.  The market had applauded the rate move and TRY had risen sharply, more than 4%, in the aftermath.  Unfortunately for him, Turkish president Erdogan is strongly of the opinion that rising inflation is caused by higher interest rates and is adamantly against the idea of raising rates.  (It appears that Erdogan is an MMTer at heart).  Arguably this is because it costs his government more to borrow for his spending plans, but whatever the rationale, this is at least the second central bank governor he has fired after a rate hike.  It cannot be a surprise that the lira has fallen dramatically in markets this morning and is down more than 10% as I type.  I highlight this to remind readers that abrupt and very large movements remain quite feasible in the FX markets.

Meanwhile, it’s the Treasury bond
About which most markets respond
Two camps have emerged
Where one side has urged
A cap, while the other side’s yawned

But really, the story that matters the most in markets right now continues to be the future price action in US Treasury markets.  The battle lines have been drawn with the inflationistas convinced that the combination of massive money printing by the Fed (M2 +25.8% Y/Y as of January 31) combined with the recently passed $1.9 trillion Covid bill is going to lead to significant price rises and much higher yields in the bond market.  In this camp, many expect the Fed to be forced to cap yields, either tacitly, by extending the maturity of QE purchases, or explicitly by telling us so, thus driving real yields lower and the dollar down as well.

In the other camp are the deflationists, a shrinking group, who nevertheless believe that the underlying drivers of declining inflation over the past 40 years; namely globalization, technology and demographics, remain firmly in place and will reassert themselves in the medium term.  This camp will also point to the fact that the ratio of interest payments to GDP, a key metric determining the affordability of government debt loads, continues to decline in the US and so a short-term rise in Treasury yields is no cause for concern.   Arguably, Treasury Secretary Yellen lives in this camp as she has consistently expressed her belief that the risks to the economy now are not doing enough to support growth and has been completely unconcerned with the rapid growth of Treasury debt to fund the serial government programs that have been enacted.  In this telling, the current price action in bonds is temporary and will soon be corrected as it becomes clear inflation is not a significant problem.

Ultimately, what this means is that the rest of us are beholden to the outcome of this situation and need to remain vigilant for clues as to how the situation will evolve.  Perhaps this week we will get some clues, if not from the data, then from the twenty-two different Fed speeches that are on the calendar.  Almost every FOMC member will be regaling us with their views following last week’s FOMC meeting.  In fact, the first, Richmond Fed president Barkin, has already spoken overnight and dismissed concerns over rising yields as an issue, rather explaining they were a vote of confidence in the economy and no problem at all.  We shall see!

Ok, on to markets, where the overriding theme is… there is no theme.   Equity markets were mixed overnight (Nikkei -2.1%, Hang Seng -0.4%, Shanghai +1.1%) and European bourses are showing a similar spread (DAX +0.25%, CAC -0.25%, FTSE 100 0.0%). US futures?  Same thing here with NASDAQ up 0.8% while DOW futures are slightly softer, -0.1% and SPUs are +0.1%.

Bond markets, however, are rallying somewhat after last week’s gyrations with the 10-year Treasury yield down 4.6bps and back below 1.70%.  The yield declines in Europe are far more muted (Bunds -1.5bps, OATs -1.0bps, Gilts -1.5bps) although we did see JGB’s (-2.9bps) rally last night.  If pressed, I would say that investors, given the lack of theme are taking advantage of the recent rise in yields to earn a bit more.

In the commodity space, earlier price action saw much deeper declines, but as New York is walking in, oil (-0.2%) is just marginally lower; gold (-0.4%) has retraced some early losses and the base metals are mixed at this time with copper (+0.6%) higher while aluminum (-0.2%) is lagging.

Finally, looking at the dollar, aside from TRY’s collapse, the rest of the EMG space is far less dramatic with MXN (-0.75%) the laggard on a combination of weaker oil and the ongoing border crisis being seen as a negative for the economy there.  On the positive side, the gains are de minimis (PLN +0.3%, KRW +0.25%, PLN +0.2%) with CE4 currencies tracking the euros modest gains and Korea benefitting from comments about a faster than previously expected recovery.

G10 currencies, which had been mixed earlier, have started to gain a bit, led by CHF (+0.3%) and SEK (+0.3%) although the rest of the bunch have seen much smaller movement overall.  The interesting CHF story was that the SNB executed $118 billion of FX intervention last year, which may come under further scrutiny by the US Treasury given the fact that Switzerland was named a currency manipulator last year.  In the end, though, given the remarkably small size of the Swiss economy, it is hard to believe that there has been any real impact on the US economy by their actions.  The SNB meets this week and will almost certainly defend their activities as a requirement to prevent further strength in the currency which could drive a significant deflationary spiral, at least so they believe.

On the data front, there is a good deal coming up as follows:

Today Existing Home Sales 6.49M
Tuesday Current Account Balance -$188.3B
New Home Sales 873K
Wednesday Durable Goods 0.7%
-ex transport 0.6%
PMI Manufacturing (prelim) 59.5
Thursday Initial Claims 730K
Continuing Claims 4.0M
GDP Q4 4.1%
Friday Personal Income -7.2%
Personal Spending -0.8%
Core PCE Deflator 1.5%
Michigan Sentiment 83.6

Source: Bloomberg

In truth, the Friday data seems the most important, as the Personal Spending and PCE are keys being watched most closely.  We all know that the housing market is hot, and that PMI is likely to be strong as the economy reopens.  But what will happen with the Fed’s key measure of inflation?

And then, amidst all the Fed speak, we have Chair Powell in two joint appearances with Treasury Secretary Yellen, first before the House tomorrow and then the Senate on Wednesday, but given the sheer breadth of commentary we are going to hear, it will be important to see if a theme regarding the bond market’s recent declines with ensuing yield increases becomes a key topic.  Certainly, market participants are highly focused on the subject.

So, adding it all up, we have a decent amount of data and a lot of Fed speakers coming our way.  As I strongly believe the dollar’s direction will be driven by the bond market for the near-term, at least, listen carefully to those comments.  Powell actually starts the commentary this morning at 9:00.  The more unconcerned the Fed speakers are with rising yields, the more likely, in my estimation, the dollar is to rise.

Good luck and stay safe
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His New Paradigm

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No longer will we
Buy stocks every month.  Instead
We will surprise you

Last night, the final major central bank meeting of the week was held, and in it the BOJ announced the results of its policy review.  The two most notable features of this review were the scrapping of the annual ¥6 trillion target of equity ETF purchases, although they did explain that if they felt it necessary and conditions warranted, they could purchase up to ¥12 trillion, and a formalized range of the targeted yield in 10-year JGB’s at 0.25% either side of 0.00%.  As an addendum, they also indicated that any equity purchases going forward would be linked to the TOPIX Index, which tracks the entire first section of the Japanese stock market, rather than the Nikkei 225, which is far more concentrated.  Remember, one of the concerns registered by investors has been that the BOJ is not only the largest holder of JGB’s, but also the largest holder of Japanese equities in the country/world.  Regarding the JGB market, the market’s working assumption has been the acceptable trading range was +/- 0.20%, so this is a bit wider despite Kuroda-san’s insistence that nothing had changed.

In what cannot be a terribly surprising outcome, the Nikkei 225 fell on the news, -1.4%, although the TOPIX actually edged higher by 0.2%.  I guess when the biggest, and least price sensitive, buyer shifts from one index to another, this outcome is to be expected.  As to the JGB market, pretty much nothing happened with yields rising a scant 0.5bps and well within the new formal range at +0.10%.  Finally, the yen is essentially unchanged on the day as well, although the dollar’s broad-based strength of the past several weeks has really helped the BOJ here as the yen has declined more than 5% year-to-date, something the BOJ had been singularly unable to engineer on its own.

The bond market wasted no time
In forcing a major yield climb
Responding to Jay
And all he did say
Defining his new paradigm

While Treasury yields have backed off a touch this morning, the damage has clearly been done by Chairman Powell.  His Wednesday press conference, where he doubled down on just how dovish he was going to remain regardless of the bond market’s performance, has set the stage for what will ultimately be his biggest test.  After all, as a policy response, it is not a great leap to dramatically cut interest rates in the face of a pandemic driven economic collapse. However, once a policymaker insists that they are unconcerned with inflation and they are going to allow the economy to “run hot” for a while, it is a MUCH harder problem to determine when too much movement has occurred and to rein in potential excesses that can prevent the ultimate goals from being reached.

It is this set of conditions in which we currently find ourselves and which will be the lead story for months to come.  If history is any guide, the bond market will continue to sell off, ostensibly on the back of stronger economic data, but in reality, as an ongoing test of Powell and the new Fed stance.  Jay was extremely clear on Wednesday that he was unconcerned with the movement in the bond market, describing financial conditions as very accommodative.  Starting next month, the inflation data is going to be rising much more rapidly as the comparison from 2020 will show much stronger price pressures on a Y/Y basis.  This is THE battle for the next six months, with all other markets destined to react to the outcome.

The two possible outcomes shape up as follows: the Fed will be forced to respond to rising yields as the pressure on the Treasury grows and financing costs increase too rapidly thus resulting in expanded QE, Operation Twist, or YCC; or Powell stays true to his word and allows 10-year yields to rise much higher (think 2.8%-3.0%) with a corresponding steepening in the yield curve which drives the equity bus over a cliff and forces a Fed response to a cratering stock market under the guise of tightening financial conditions that need to be addressed.  Through our FX lens, the first will result in the dollar topping out much sooner than the second, as it will cap real yields and ultimately send them farther into negative territory.  But in either case, it appears that the dollar has room to run for the time being.  It will be an epic battle and my money is on the market forcing the Fed to blink before they would like.

Now to today’s markets.  After yesterday’s tech led US sell-off, we already saw that Japanese stocks were under pressure, but there was weakness across the board in Asia (Hang Seng -1.4%, Shanghai -1.7%) and we are entirely red in Europe as well (DAX -0.4%, CAC -0.4%, FTSE 100 -0.6%).  US futures, on the other hand, are pointing higher at this hour, up between 0.2%-0.5%.  We shall see if that holds up.

Bonds have reversed some of yesterday’s declines (higher yields) with Treasuries 1 basis point lower and European sovereigns seeing larger yield declines (Bunds -3bps, OATs -3bps, Gilts -4.5bps).  However, if the Treasury market resumes its decline, I would expect European yields to track higher as well, albeit at a slower pace.

Oil prices got smoked yesterday, falling more than 10% at one point before closing down 7.5% on the day.  That puts this morning’s modest 0.6% rise into context.  It appears that the oil market had gotten a bit ahead of itself.  As to the rest of the commodity bloc, metals are generally lower this morning although most ags are firmer.

Finally, the dollar is beginning to edge higher as New York walks in, with SEK (-0.3%) and NOK (-0.25%) leading the way down, although the entire G10 bloc in negative territory.  As neither nation had new news, these moves appear to be simple follow-ons to the resuming dollar trend of modest strength.  The EMG space is a bit different, with several currencies faring well this morning, notably TRY (+1.15%) on continued buying after the surprising rate hike, and MXN (+0.65%) as traders start to bet on Banxico raising rates more aggressively, following in the footsteps of Brazil.  On the downside, KRW (-0.6%) essentially gave up yesterday’s gains on the broad risk-off sentiment in Asia, which also dragged TWD (-0.5%) lower.  After that, the bulk of the movement in this space has been modest, at best, in either direction.

There is no US data to be released today, and no Fed speakers either.  Rather, the big story in the market is the triple witching in equities (expiration of options, futures and futures options), which oftentimes has a significant market impact.  And meanwhile, all eyes will remain on the Treasury market, as it is currently the single most important signal available.

Good luck, good weekend and stay safe
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Tempting the Fates

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What everyone now can assume
Is Jay and his friends in the room
Will never raise rates
Thus, tempting the fates
In search of a ne’er ending boom

Well, that’s that!  To anyone who thought that the Fed was concerned over rising back-end yields and a steeper yield curve, Chairman Powell made it abundantly clear that it is not even on their radar.  No longer will the Fed be concerned with mere forecasts of economic strength or pending inflation.  As in the Battle of Bunker Hill, they will not “…fire until they see the whites of [inflation’s] eyes”.   “Until we give a signal, you can assume we are not there yet,” Powell explained when asked about the timing of tapering asset purchases and tightening policy.  It would seem that is a pretty clear statement of intent on the Fed’s part, to maintain the current policy for years to come.

To recap, the Fed raised their forecasts for GDP growth to 6.5% in 2021, 3.3% in 2022 and 2.2% in 2023, while increasing their inflation forecasts (core PCE) to 2.2%, 2.0% and 2.1% respectively for the same years.  Finally, their view on unemployment adjusted to 4.5% this year with declines to 3.9% and 3.5% in ’22 and ’23.  All in all, they have quite a rosy view of the future, above trend growth, full employment and no inflation.  I sure hope they are correct, but I fear that the world may not turn out as they currently see it through their rose-tinted glasses.  The market’s biggest concern continues to be inflation, which, after decades of secular decline, appears to be at an inflection point for the future.  This can be seen in the bond market’s reaction to yesterday’s activities.

Prior to the FOMC statement, (which, by the way, was virtually verbatim with the January statement, except for one sentence describing the economic situation), risk was under pressure as equity markets were slipping, 10-year Treasury yields were rallying to new highs for the move and the dollar was firming up.  But the statement release halted those movements, and once the press conference got underway, Powell’s dovishness was evident.  This encouraged all three markets to reverse early moves and stocks closed higher, bonds flat and the dollar softer.  It seems, there was a great deal of positive sentiment at that time.

However, over the ensuing 16 hours, there has been a slight shift in sentiment as evidenced by the fact that the 10-year Treasury is now down 2/3’s of a point with the yield higher by 8 basis points, rising to 1.72%.  This is the highest yield seen since January 2020, pre-pandemic, but certainly shows no sign of stopping here.  In fact, 30-year Treasuries now yield 2.5%, their highest level since July 2019, and here, too, there is no evidence that the move is slowing down.  If anything, both of these bonds appear to be picking up speed in their race to higher levels.  Meanwhile, TIP yields are climbing as well, but not quite as quickly taking the 10-year breakeven to 2.31%.  In other words, that is the market forecast for inflation.  FYI, this is the highest level in this measure since May 2013.  As mentioned above, it appears there is a secular change in inflation on the way.

Perhaps what makes this most remarkable is the dramatic difference in the Fed’s stance and that of some other major central banks.  On the one hand, Madame Lagarde informed us last week that the ECB would be speeding up their PEPP purchases to counter the effect of rising yields.  Again, this morning she explained, “what we are responding to is a yield increase that could get ahead of the expected economic recovery.”   On the other hand, the Norges Bank, while leaving rates on hold at 0.00% this morning predicted it would start raising rates in the “latter half” of this year, far sooner than previous expectations.  Meanwhile, in the emerging markets, we have an even more aggressive story, with the Banco Central do Brazil raising the overnight SELIC rate by a more than expected 0.75% last night, as despite Covid continuing to ravage the country and the economy stuttering, inflation is starting to move higher at a faster pace.

The point here is that after almost a full year of synchronous monetary policy around the world, things are starting to change at different rates in different places.  The one thing almost certain to follow from this change in policies is that market volatility, across all asset classes, is likely to increase.  And since most markets either get measured in dollars, or versus dollars, and the inherent volatility in the US bond market is increasing, we may soon be testing central bank limits of control, especially the Fed’s.  After all, if the 2yr-10-yr spread widened to 2.75%, a level it has reached numerous times in the past, will the Fed remain sanguine on the subject?  Will the stock market implode?  Will the dollar race higher?  These are the questions that are likely to be on our lips going forward.  The fun is just beginning as the Fed embarks on its new policy roadway.

With all that in mind, what is this morning’s session doing?  Based on the different central bank activities, things are performing as one would expect.  The initial warm glow following the FOMC meeting followed into Asia with gains in most major markets there (Nikkei +1.0%, Hang Seng +1.3%, Shanghai +0.5%) although Australia’s ASX 200 fell 0.7% during the session.  Meanwhile, Lagarde’s comments, reiterating that the ECB would be buying more bonds has encouraged equity investors in Europe with gains across the board led by the DAX (+1.2%), although the rest of the set are far less impressive (CAC +0.25%, FTSE 100 +0.1%).  However, US futures tell a different story, as the rising long bond yields are continuing to have a severe impact on the NASDAQ with futures there -1.0% and dragging SPX (-0.3%) down with it although DOW futures have actually edged higher by 0.2%.  This is the ongoing rotation story, out of growth/big tech and into value and cyclical stocks.

In the bond market, the damage is severe with Treasuries leading the way followed by Gilts (+5.5bps) as the market awaits the BOE meeting results, and then much smaller rises in yields on the continent (Bunds +2.6bps, OATs +1.9bps, Italian BTPs +1.7bps) as traders recognize that the ECB is going to prevent a dramatic decline there.

Perhaps the most surprising outcome this morning is in the commodity bloc, where virtually all commodity prices are lower, albeit not by too much.  Oil (-0.3%), gold (-0.5%) and copper (-0.3%) are uniformly under pressure.  This could be a response to the Fed’s benign inflation forecasts, but I think it is more likely a response to the dollar’s strength.

Speaking of the dollar, it is mostly stronger this morning, recouping the bulk of yesterday afternoon’s losses.  In the G10, only AUD (+0.25%) is higher of note after the employment report released overnight showed far more strength than expected (Unemployment Rate fell to 5.8%).  But otherwise, the rest of the bloc is under pressure, once again led by SEK (-0.45%) and CHF (-0.35%), with both currencies seeing outflows on the back of higher USD yields.  In the EMG bloc, TRY (+2.0%) has just jumped higher after the central bank there surprised the market and raised rates by 2.0% rather than the 1.0% expected.  So, like Brazil, despite economic concerns, inflation is rearing its ugly head. However, beyond that, last night saw strength in KRW (+0.6%) after the BOK indicated they will not allow excessive market volatility (read declines) in the wake of the FOMC meeting.  And that was really the extent of the positives.  On the downside, PLN (-0.9%) is the laggard, as the market is concerned over additional Covid closures slowing any comeback and encouraging easier monetary policy further into the future than previously thought.  The rest of the CE4 are in similar, if not as dire straits this morning as the euro’s softness is undermining the whole group.  As to LATAM, the peso is starting the day unchanged and the rest of the continent has not yet opened.

On the data front, today brings Initial Claims (exp 700K), Continuing Claims (4.034M), Philly Fed (23.3) and Leading Indicators (0.3%).  In addition, we hear from the BOE, with no policy change expected, and then Chairman Powell speaks around noon at the BIS conference.  My guess is that there will be a great deal of interest in what he has to say and if he tries to walk back the idea that the Fed is comfortable with the yield curve steepening as quickly as it is. One thing to recognize is that markets can move much faster than anticipated when given a green light.  With the 10-year yield currently at 1.737%, a move to 2.0% by the end of the month is quite realistic.  And my sense is that might raise a few eyebrows at the Mariner Eccles building.

As to the dollar, follow the yields.  If they continue to rise, so will the dollar.  If they stop, I expect the dollar will as well.

Good luck and stay safe
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Nothing to Fear

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There is an old banker named Jay
Who, later, this St Patrick’s Day
Will tell us that rates
Right here in the States
Won’t change ‘til the jobless get pay

Inflation is nothing to fear
As there’s no sign it will appear
But should it arise
More tools he’ll devise
To kill it by end of this year

Welcome to Fed day folks, with the eyes of all market participants anxiously awaiting the stilted prose that is presented every six weeks.  At this point, there is no concern that the Fed is going to actually change policy as it stands, rather the anticipation is all about what they imply about the future path of activity.

Generally, the Fed statement will start off discussing the nature of the economy and their subjective assessment before going on to describe the actions they are taking.  As this is a quarter-end meeting, their team of PhD’s will have produced new economic forecasts, which based on the recently passed stimulus bill, as well as the recent trend of improving economic activity, is likely to highlight real GDP growth in 2021 of at least 5.0%.  There are many calls on the Street for growth rates topping 7% this year, so 5% would hardly be seen as aggressive.  In addition, while the Fed is acutely aware that inflation numbers are going to rise in the near-term, as the base effects of last year’s Covid inspired economic disaster will now form the comparison, we have consistently heard that any inflation will be transitory and so is of no concern at this time.

The question is, how will they justify continued ZIRP and QE with GDP growth of 5% or more?  And, the answer is that Chair Powell will simply focus on the unemployment situation and once again explain that until those 10 million jobs that were lost to Covid are regained, the Fed will be striving to achieve maximum employment.  It is doubtful there will be any mention of rising yields in the statement, but you can be sure that the first question in the press conference will take up the subject, as will a number of others.

The other thing we get at this quarter-end meeting is the latest dot plot, which is a compilation of each of the FOMC members’ views of where interest rates will be over the next 3 years as well as in the ‘long run’.  The median outcome for each year has become the key statistic and last time it showed that rates were not expected to rise until after 2023, although the longer term view was that 2.5% was likely over time.  However, currently the market is pricing a 0.25% rate hike by December 2022 and two more in 2023 which is far more than the Fed had indicated.  Of great interest to all will be whether this view is changing at the Fed, and some tightening is expected prior to 2023.  Certainly, the bond market is pushing that narrative, with yields continuing to press higher (10-year treasuries are +3bps this morning and, at 1.65%, trading at a new high for the move.)

Remember, too, that prior to the Fed’s quiet period, when the bond market was selling off and yields rising, Powell and friends showed insouciance over the issue, declaring it a vote of confidence in the economy.  At least two weeks ago, there was little concern over rising yields and how they might impact the Fed’s efforts to stimulate further job growth.  Is that still the case?  Since Powell last spoke, the 10-year yield has risen another 9 basis points and shows no signs, whatsoever, of stopping soon.

So, there you have it, the Fed needs to walk that fine line of explaining things are getting better but there is no reason for them to stop providing stimulus.  History has shown that the market reaction comes from the press conference, not the statement, as the nuance of some comment or answer to a question can easily be misinterpreted by market players, and more importantly these days, by algorithms.  FWIW, I anticipate that Powell will continue to slough off any concerns about rising yields and a steepening yield curve and remain entirely focused on the front end.  While I expect several more ‘dots’ to highlight a rise in rates, it would truly be shocking if the median changed.  And in the end, if the Fed looks comfortable with rising yields, they will continue to rise, and with them, I would look for the dollar to follow.

Ahead of the news, markets have been in a holding pattern.  In Asia, the major equity markets were essentially unchanged overnight, with no movement of even 0.05%.  European bourses are generally ever so slightly softer this morning (CAC -0.2%, FTSE 100 -0.3%) although the DAX (+0.1%) has managed to eke out a gain so far.  As to US futures, they too are mixed, with NASDAQ futures (-0.5%) amongst the worst performing of all markets today, although the other two main indices are little changed.

Not only are Treasury yields higher, but we are seeing that price action throughout Europe, with Bunds (+1.9bps), OATs (+2.0bps) and Gilts (+3.3bps) all following the Treasury market.  Either inflation concerns are starting to pick up, or belief in a rebound is starting to pick up, although given the continuation of lockdowns in Europe, and their recent extensions, the latter seems like a harder story to swallow.

Commodity prices are softer pretty much across the board, with oil (-1.15%) leading the way, although weakness in both the base and precious metals is evident as well as in the agricultural space.  And lastly, the dollar is beginning to edge higher as I type, although not by any significant amounts.  In the G10 space, AUD (-0.35%), SEK (-0.3%) and CHF (-0.3%) are the leading decliners although one would be hard pressed to find a fundamental rationale for the movement.  With all eyes on the Fed, essentially all movement so far has been position adjustments amid much lighter than normal trading activity.

In the Emerging markets, RUB (-1.25%) is the weakest of the bunch after a surprising comment by President Biden hit the tape, “Biden says he thinks Putin is a killer.”  Them’s fightin’ words, and it would not be surprising to see an escalation of a war of words going forward, although it is not clear this would impact any currency other than the ruble.  Beyond that, MXN (-0.5%) is the next worst performer, arguably following oil as well as the growing concerns that rising inflation in emerging markets is going to force policy tightening and slowing growth.  This evening, the Banco do Brazil will be announcing their policy with the market anticipating a 0.50% rate hike, the first of many as inflation there continues to run higher than target.  This is being seen as a harbinger of other central bank actions, where they will be forced to fight inflation at the expense of economic activity, and that typically is negative for a currency at the beginning of the battle.

On the data front, today brings Housing Starts (exp 1560K) and Building Permits (1750K) ahead of the FOMC decision this afternoon.  While those numbers are a bit softer than last month, the longer-term trend remains firmly upward.  And then it’s the Fed and Mr Powell’s comments that will drive everything.  Ahead of the Fed, I anticipate limited movement overall, but my expectations are that Powell will continue to ignore rising yields and focus strictly on the front end of the curve as well as the unemployment situation.  If the stories about Secretary Yellen being unconcerned about rising yields are correct, and they are quite believable, then look for the curve to steepen further, and the dollar to test key resistance levels against most of its counterparts.

Good luck and stay safe
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Central Banks Fear

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The one thing that’s been crystal clear
Is yields have exploded this year
The question at hand
Since this wasn’t planned
Is what, most, do central banks fear?

For Jay and the FOMC
The joblessness rate is the key
For Christine its growth
And prices, as both
Refuse to respond to her plea

While the bond market has taken a respite from its headlong rush to higher yields, there is no evidence we have seen the top.  Rather, it feels very much like the market has positioned itself for the next leg higher in yields, potentially to kick off after tomorrow’s FOMC meeting.  If you recall, the last Fedspeak on the topic was by Chairman Powell and he was essentially dismissive of the issue as a non-event.  The consistent story has been that higher yields in the back end of the curve is a sign that the economy is picking up and they are doing their job properly, in other words it is a vote of confidence in the Fed.  And he was unambiguous in his discussion regarding the potential to tighten policy; it ain’t gonna happen for at least two to three more years, which is their timeline as to when the employment situation will recover to pre-Covid levels.  Remember, Powell has been explicit that he will not be satisfied until another 10 million jobs have been created and filled.

It has been this intense focus on the employment situation that has driven the Fed narrative that neither inflation or higher yields are of consequence for now or the foreseeable future.  Thus, all the positive US data, both economic and vaccine related, has served to increase expectations of a strong economic rebound consistently supported by front end interest rates remaining at zero.

But the interplay between rising yields and the speed of the recovery remains open to question.  In addition, there is the question of just how high yields can go before the Treasury gets uncomfortable that financing all this deficit spending is going to become problematic.  After all, if yields continue to rise, at some point the cost of carrying all the debt is going to become quite painful for the government.

In fact, it is this issue that has been a key feature of many forecasts of market behavior for the rest of this year and next; at some point, probably sooner rather than later, the Fed is going to step in and cap yields.  But what if the Treasury is looking at this problem from a different perspective, not what actual yields are, but the size of their debt service relative to the economy?  On that measure, despite a more than doubling of Treasury debt outstanding since 2007, interest expense is currently a smaller percentage of GDP than it was back then.  It is important to remember that Treasury debt matures monthly, not just T-bills, but also old notes and bonds, and when those notes and bonds were issued, ZIRP didn’t exist so many carry coupons much higher than the current replacements.  The upshot is that debt service costs have been declining despite the growth in the nominal amount of debt outstanding and are forecast to continue declining for the next 3 years according to the CBO.  So, maybe, Jay is serious that he is unworried about the current level of yields in the 10-year bucket and beyond.

If this thesis is correct, the implications for other markets going forward are significantly different than I believe many are currently considering.  For instance, a further rise in yields will start to have a significant negative impact on equity prices as all of the discounted cash flow models that currently assume zero rates forever to justify the current level of valuations will come crashing back to reality and there will be a realization that price-earnings multiples are unsustainable at current levels.  As well, the dollar bearish theme will likely get destroyed, as it is predicated on the idea that real yields will decline with rising inflation and capped yields.  If yields are not capped, but instead respond to rising inflation expectations by going higher unchecked, the dollar will be a huge beneficiary.  Precious metals?  They will suffer, although base metals should hold their own as growth will support demand and supply continues to be lacking, especially new supply.  And I would be wary of EMG debt as that rising dollar will wreak havoc on emerging market economies.

Perhaps it is the last thing that will cause the Fed to blink, since if the rest of the world slides into another recession amid increased demand for dollars, history has shown the Fed will ease policy to halt that slide.  Of course, for the past thirty years, any significant decline in the US equity market has been sufficient to get the Fed to ease policy, with Q4 2018 the most recent pre-pandemic episode.  But that means those valuations will compress, at least somewhat, before the Fed responds.

Add it all up and we have the opportunity for significantly more volatility in markets going forward, something hedgers need to heed.

As to today, ahead of the Retail Sales release this morning, and of course the FOMC tomorrow, markets are continuing in their quiet consolidation overall, though with a modest risk-on bias.

Equity market screens are all green with gains in Asia (Nikkei +0.5%, Hang Seng +0.7%, Shanghai +0.8%) and Europe (DAX +0.5%, CAC +0.1%, FTSE 100 +0.5%) pretty solid everywhere.  US futures are showing gains in the NASDAQ (+0.5%), but little movement in the other two indices.

Bond markets are also quietly higher, with very modest yield declines in Treasuries (-0.5bps), Bunds (-0.5bps) and Gilts (-1.0bp).  In fact, looking at my screen shows only Italian BTP’s (+1.9bps) and Greek 10-years (+2.8bps) falling as both nations impose stricter lockdowns.  Even JGB’s (-1.0bp) are a bit firmer as market participants await the BOJ’s policy framework Friday.

Commodity prices are under a bit of pressure this morning with oil (-1.3%) leading the way but base metals pretty much all lower as well.  As to the precious metals, they are little changed on the day and are the market with, perhaps, the keenest interest in the Fed meeting tomorrow.  If yields are going to continue to climb unabated, gold and silver will decline.

Finally, the dollar is having a mixed session as well, with a pretty equal split of gainers and losers against the greenback.  In the G10, SEK (+0.3%) and CHF (+0.3%) lead the way higher although both appear to be continuing a consolidation move of the past week.  On the downside, GBP (-0.3%) is the laggard after the EU brought new legal action against the UK on a Brexit related matter.  As to the rest of the space, the movements have been even smaller and essentially irrelevant.

In Emerging Markets, TRY (+0.8%) is the leading gainer as bets grow that the central bank will be raising rates later this week.  Next in line was KRW (+0.6%) which benefitted from large net inflows into the bond market, but after that, things are much less interesting.  On the downside, while there are a number of currencies that have declined this morning, the movements, all 0.2% or less, just don’t need a rationale, they are simply trading activity.

Data wise, we see Retail Sales this morning (exp -0.5%, 0.1% ex autos) a far cry from last month’s stimulus check induced jump of 5.3%.  We also see IP (0.3%) and Capacity Utilization (75.5%) a little later, but the reality is that if Retail Sales is uninteresting, markets are likely to continue to drift until tomorrow’s FOMC meeting.

For today, there seems very little likely to occur, but beware the Fed, if they really are going to allow yields to rise further, we could see some real changes in viewpoint for both equity markets and the dollar.

Good luck and stay safe
Adf

Hubris

Posted on by

Said Janet, the risk remains “small”
Inflation could come to the ball
But if that’s the case
The tools are in place
To stop it with one conference call

hu∙bris
/ (h)yoobrəs/
noun: excessive pride or self-confidence

“Is there a risk of inflation?  I think there’s a small risk and I think it’s manageable.”  So said Treasury Secretary Janet Yellen Sunday morning on the talk show circuit.  “I don’t think it’s a significant risk, and if it materializes, we’ll certainly monitor for it, but we have the tools to address it.”  (Left unasked, and unanswered, do they have the gumption to use those tools if necessary?)

Let me take you back to a time when the world was a simpler place; the economy was booming, house prices were rising, and making money was as easy as buying a home with 100% borrowed money (while lying on your mortgage application to get approved), holding it for a few months and flipping it for a profit. This was before the GFC, before QE, before ZIRP and NIRP and PEPP and every acronym we have grown accustomed to hearing.  In fact, this was before Bitcoin.

In May 2007, Federal Reserve Chairman Ben Bernanke, responding to a reporter’s question regarding the first inklings of a problem in the sector told us,  “Given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the sub-prime sector on the broader housing market will likely be limited.”  Ten months later, as these troubles had not yet disappeared, and in fact appeared to be growing, Bennie the Beard uttered his most infamous words, “At this juncture, however, the impact on the broader economy and financial markets of the problems in the sub-prime market seems likely to be contained.”

Notice anything similar about these situations?  A brewing crisis in the economy was analyzed and seen as insignificant relative to the Fed’s goals and, more importantly, inimical to the Fed’s desired outcomes.  As such, it is easily dismissed by those in charge.  Granted, Janet is no longer Fed chair, but we have heard exactly the same story from Chairman Jay and can look forward to hearing it again on Wednesday.

Of course, Bernanke could not have been more wrong in his assessment of the sub-prime situation, which was allowed to fester until such time as it broke financial markets causing a massive upheaval, tremendous capital losses and economic damage and ultimately resulted in a series of policies that have served to undermine the essence of capital markets; creative destruction.  While hindsight is always 20/20, it does not detract from the reality that, as the proverb goes, an ounce of prevention is worth a pound of cure.

But right now, the message is clear, there is no need to be concerned over transient inflation readings that are likely to appear in the next few months.  Besides, the Fed is targeting average inflation over time, so a few months of above target inflation are actually welcome.  And rising bond yields are a good thing as they demonstrate confidence in the economy.  Maybe Janet and Jay are right, and everything is just ducky, but based on the Fed’s track record, a lot of ‘smart’ money is betting they are not.  Personally, especially based on my observations of what things cost when I buy them, I’m with the smart money, not the Fed.  But for now, inflation has been dismissed as a concern and the combination of fiscal and monetary stimulus are moving full speed ahead.

Will this ultimately result in a substantial correction in risk appetite?  If Yellen’s and Powell’s view on inflation is wrong, and it does return with more staying power than currently anticipated, it will require a major decision; whether to address inflation at the expense of slowing economic growth, or letting the economy and prices run hotter for longer with the likelihood of much longer term damage.  At this stage, it seems pretty clear they will opt for the latter, which is the greatest argument for a weakening dollar, but perhaps not so much vs. other fiat currencies, instead vs. all commodities.  As to general risk appetite, I suspect it would be significantly harmed by high inflation.

However, inflation remains a future concern, not one for today, and so markets remain enamored of the current themes; namely expectations for a significant economic rebound on the back of fiscal stimulus leading to higher equity prices, higher commodity prices and higher bond yields.  That still feels like an unlikely trio of outcomes, but so be it.

This morning, we are seeing risk acquisition with only Shanghai (-1.0%) falling of all major indices overnight as Tencent continues to come under pressure after the government crackdown on its financial services business.  But the Nikkei (+0.2%) and Hang Seng (+0.3%) both managed modest gains and we have seen similar rises throughout Europe (DAX +0.2%, CAC +0.3%, FTSE 100 +0.3%) despite the fact that the ruling CDU party in Germany got clobbered in weekend elections in two states.  US futures are also pointing higher by similar amounts across the board.

Bond markets, interestingly, have actually rallied very modestly with Treasury yields lower by 1.2 basis points, and similar yield declines in both Bunds and OATs.  That said, remember that the 10-year did see yields climb 8 basis points on Friday amid a broad-based bond sell-off around the world.  In other words, this feels more like consolidation than a trend change.

Commodity markets have also generally edged higher, with oil (+0.35%), gold (+0.1%) and Aluminum (+1.0%) showing that the reflation trade is still in play.

Given the modesty of movement across markets, it seems only right that the dollar is mixed this morning, with a variety of gainers and laggards, although only a few with significant movement.  In the G10 this morning, SEK (-0.7%) is the worst performer as CPI was released at a lower than expected 1.5% Y/Y vs 1.8% expected.  This has renewed speculation that the Riksbank may be forced to cut rates back below zero again, something they clearly do not want to do.  But beyond this, price action has been +/- 0.2% basically, which is indicative of no real news.

In EMG currencies, it is also a mixed picture with ZAR (+0.7%) the biggest gainer on what appear to be carry trade inflows, with TRY (+0.6%) next in line as traders anticipate a rate hike by the central bank later this week.  Most of LATAM is not yet open after this weekend’s change in the clocks, but the MXN (+0.3%) is a bit firmer as I type.  On the downside, there is a group led by KRW (-0.3%) and HUF (-0.25%), showing both the breadth and depth (or lack thereof) of movement.  In other words, movement of this nature is generally not a sign of new news.

On the data front, all eyes are on the FOMC meeting on Wednesday, but we do get a few other releases this week as follows:

Today Empire Manufacturing 14.5
Tuesday Retail Sales -0.5%
-ex autos 0.1%
IP 0.4%
Capacity Utilization 75.5%
Wednesday Housing Starts 1555K
Building Permits 1750K
FOMC Decision 0.00% – 0.25%
Thursday Initial Claims 700K
Continuing Claims 4.07M
Philly Fed 24.0
Leading Indicators 0.3%

Source: Bloomberg

While Retail Sales will garner some interest, the reality is that the market is almost entirely focused on the FOMC and how it will respond to, or whether it will even mention, the situation in the bond market.  Certainly, a strong Retail Sales report could encourage an even more significant selloff in bonds, which, while seemingly embraced by the Fed, cannot be seen as good news for the Treasury.  After all, they are the ones who have to pay all that interest. (Arguably, we are the ones who pay it, but that is an entirely different conversation.)

As to the dollar, while it has wandered aimlessly for the past few sessions, I get the sneaking suspicion that it is headed for another test of its recent highs as I believe bond yields remain the key market driver, and that move is not nearly over.

Good luck and stay safe
Adf

Our Fear and Our Dread

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Said Madame Lagarde, don’t misread
The fact that our PEPP has lost speed
The quarter to come
A good rule of thumb
Is twice as much is guaranteed
 
This morning, though, markets have said
That’s just not enough to imbed
The idea your actions
Of frequent transactions
Will offset our fears and our dread
 
As we walk in this morning, there is a distinct change in tone in the markets from yesterday.  It seems that the initial impressions of yesterday’s two big events, the ECB meeting and the 30-year auction, were fleeting, and fear, once again, has taken over.
 
A quick recap shows that ECB President Lagarde, in responding to the growing questions about the reduced pace of ECB PEPP purchases, promised to significantly increase them during the next quarter.  While she refused to quantify ‘significantly’, the analyst community is moving toward the idea that means at least doubling the weekly purchase amounts to ~€25 billion.  At the same time, we heard from several ECB members this morning that this action did not presage increasing the size of the PEPP, which still has approximately €1 trillion in firepower remaining.  Lagarde emphasized the flexible nature of the program and explained that varying the speed of purchases is exactly why that flexibility was created.  However, despite today’s comments, Lagarde also assured us that, if necessary, the ECB could recalibrate the program, which is lawyer/central bank speak for increase the size.
 
The market liked what it heard, and the result was a bond rally on both sides of the Atlantic.  Several hours later, the results of the Treasury’s 30-year auction were released and, while not fantastic, were also not as disastrous as the 7-year auction from two weeks ago.  In the end, bond yields basically ended the day flat, equities rallied, and the dollar was under pressure all day.  Risk had regained its allure and the bulls were back in command.
 
Aahh, the good old days.  This morning, it is almost as though Madame Lagarde never said a word, or perhaps said too many.  Bond markets are selling off sharply, with 10-year Treasury yields higher by 7 basis points and above 1.60%, while European sovereigns are weaker across the board, led by UK gilts (+5.4bps), but with most continental bonds showing yield gains of 2.0-3.0 basis points.  So, what happened to all the goodwill from yesterday?
 
Perhaps that goodwill has fled from fears of rising inflation after President Biden (sort of) laid out his plan for vaccinating the entire nation by May and reopening the economy by summer.  Many analysts have pointed to the massive increase in savings and combined that with the newest stimulus checks to come (as soon as this weekend according to Treasury Secretary Yellen) and forecast a huge spending surge, significant economic growth and rising inflation. After all, the Atlanta Fed’s GDPNow forecast is at 8.35%, which while slightly lower than a few weeks ago, is still an extremely rapid pace for the US economy.  This pundit, however, questions whether or not that spending surge will materialize.  Historically, after a deeply shocking financial event like we have just experienced, behaviors tend to change, with the most common being a tendency to maintain a higher savings ratio.  As such, expectations for a massive consumer boom may be a bit optimistic.
 
Or, perhaps the goodwill has disappeared after further crackdowns by Chinese authorities on its most successful companies, with TenCent now under the gun, receiving fines and being reined in following their efforts to crush Ant Financial.  The Hang Seng certainly felt it, falling 2.2% overnight, although Shanghai (+0.5%) and the Nikkei (+1.7%) were still euphoric from yesterday’s US equity rally.  Rapidly rising Brazilian inflation (5.2% vs. 3.0% target) could be the cause, as concerns now increase that the central bank, when it meets next week, will be raising rates 0.50% to battle that, despite the economic weakness and ongoing Covid related stresses.
 
There is, however, one other potential cause of the bond market’s poor performance, which I believe is leading to the general risk-off attitude; but it is a sort of inside baseball issue.  The Supplementary Leverage Ratio (SLR) is part of bank regulation that was designed to insure banks would remain stable during hard times and not need to be bailed out, a la 2008.  However, during the initial stresses of the Covid crisis, the Fed suspended the need for banks to count Treasury securities and bank reserves as part of that ratio, thus allowing banks to hold more of those assets on their books while remaining within the regulations.  But this exemption is due to expire on March 31, which means banks either need a LOT more equity capital, or they need to shrink their balance sheet by selling off those excess Treasuries.  And, of course, selling Treasuries is much easier and exactly what we have seen in the past two weeks.  If the Fed does not give further guidance on this issue, and lets it expire, bonds probably have further to fall.  Ironically, that doesn’t seem to fit with what the Fed really wants to happen, as the higher yields would result in tighter financial conditions, especially if equity markets sold off in sync.  So, my guess is the Fed blinks and rolls the exemption over for at least 6 months, but until we know, look for bouts of selling in bonds and all the ensuing market reactions that come with that.
 
Just like today’s, where European markets are lower (DAX -0.6%, CAC -0.1%, FTSE 100 -0.1%) although in the latter two cases not by much and US futures are also lower, especially the tech laden NASDAQ (-1.4%) although also SPX (-0.4%). 
 
Commodity prices are also under a bit of pressure with oil (-0.25%) slipping a bit as well as precious (gold -1.0%) and base (copper -1.25%) metals.  In fact, today is also seeing weakness throughout the agricultural sector, with declines of the 0.75%-1.75% range across the board.
 
And what of the dollar, you ask?  Stronger across the board, with yesterday’s leading gainers showing the way lower today.  NZD (-0.75%), SEK (-0.7%) and CHF (-0.7%) are in the worst shape, but in truth, the entire G10 is under pretty significant pressure with only CAD (-0.15%) showing any signs of holding up as Canadian government bond yields rise right along with US yields. 
 
Emerging market currencies are also under significant pressure this morning, led by TRY (-1.5%) but seeing MXN (-1.3%) and ZAR (-1.0%) also suffering greatly.  In fact, all of LATAM and the CE4 are under significant pressure today but then all of them had seen substantial strength yesterday.  In fact, the two-day movement in many of these currencies is virtually nil.  Their futures will depend on a combination of the ongoing evolution of US interest rates and their unique  domestic situation.  If rising inflation is ignored in order to support these economies, look for much further weakness in that nation’s currency.  In other words, there is every chance that the dollar gains strength broadly against this bloc in the next several months.
 
On the data front, today brings PPI (exp 2.7%, 2.6% core) and Michigan Sentiment (78.5).  Certainly, that PPI data looks like inflation is in the pipeline, but the relationship between PPI and CPI is not nearly as strong as you might think, with just a 0.079% correlation over the past 5 years, although it does have a stronger relationship to core PCE (0.228%).  But if history is any guide, the market will not be flustered by any print at all. 
 
So, today is shaping up as risk-off with both bonds and stocks selling and no commentary from the Fed coming.  Just like yesterday’s risk appetite fed stronger currencies, it appears the opposite is true today.  I don’t expect to see substantial further gains, but a modest continuation of the dollar rally does feel like it is in the cards.
 
Good luck, good weekend and stay safe
Adf
 

On Edge

Posted on by

Two fears have the market on edge
Inflation that many allege
Will drive bond yields higher
Thus, causing a dire
Result, pushing stocks off the ledge

But right now, the bulls rule the roost
As inflation has not been produced
So, Jay and Christine
Have no need to wean
The market from QE’s large boost

Yesterday morning’s CPI release was a touch softer than expected, thus helping to abate fears of the much-mooted inflationary surge arriving soon.  (PS, it is clear that starting next month the CPI data will be much higher, given the year over year comps, with the key question being will that continue through the summer and beyond.)  In the meantime, bond investors, who had clearly been concerned over the rising inflation story, relaxed a bit and bought more Treasuries.  The result was that the early morning rise in yields was unwound.  Of course, the other big news yesterday was the 10-year Treasury auction which was received by the market with general aplomb.  While there was a 1 basis point tail, the bid-to-cover ratio at 2.37 was right in line with recent averages.  One little hiccup, though, was indirect bidders (usually foreign governments) continued their declining participation, falling to 56.8%, with the implication that natural demand for Treasuries is truly sinking.  This latter point is critical because, given the amount of new money the Treasury will need to borrow this year and going forward, it will increase pressure on the Fed to absorb more (i.e. increase QE), or yields will definitely climb.

However, that apparently, is a story for another day.  Equity markets reveled in the low inflation print and modest bond market rally, while the dollar fell pretty much across the board, reversing all of its early gains.

Which brings us to this morning’s ECB meeting, where the question is not about a change in policy, as quite clearly no policy change is in the offing, but rather about the ECB’s utilization and reaction function of its current policy programs.  While sovereign yields have stabilized for the past several sessions, the fact remains that they have not fallen back anywhere near the levels seen at the beginning of the year.  The question market participants have is exactly what will constitute a tightening in financial conditions that might bring a response.

As mentioned yesterday, the ECB has been consistently underutilizing the PEPP compared to recent months, with weekly purchases falling to a net €12 billion despite the rise in yields.  So, it would seem that the ECB does not believe the current yield framework is a hindrance to the economy.  However, you can be sure that Madame Lagarde will field several questions on the topic at this morning’s press conference as market participants try to determine the ECB’s pain threshold.  The last we heard on the topic was that they were carefully watching the market with some of the more dovish members calling for a more active stance to prevent a further climb in yields.

And remember, the ECB is not only focused on sovereign yields, but on the exchange rate as well, which is also officially a key indicator.  With the US inflation story getting beaten back, and US yields slipping, the euro’s concomitant rise will not be welcome.  Now, we remain well below the early January highs in the single currency, but if the euro has bottomed, and more importantly starts that long-term rise that is so widely expected, the ECB will find themselves in yet another sticky situation.  These, however, are stories for a future date, as today the euro is firmly in the middle of recent ranges while sovereign yields are slipping a bit.

With two potential landmines behind us, risk appetite has been reawakened, with asset purchases across virtually all classes.  For instance, overnight saw equity market strength across the board (Nikkei +0.6%, Hang Seng +1.65%, Shanghai +2.4%) although Europe’s early gains have mostly diminished and markets are little changed ahead of the ECB (DAX -0.1%, CAC +0.1%, FTSE 100 -0.35%).  US futures, though, are largely booming, led by the NASDAQ (+1.9%) but seeing solid gains in the other indices as well.

On the bond front, Treasury yields are lower by 1.9 basis points, back to 1.50%, while we are seeing more modest declines in the major European bond markets, on the order of 0.5bps for all of them.

Oil prices are firmly higher (WTI +1.2%) as is the entire energy complex.  Metals prices, too, are rising with both precious and base seeing a resumption of demand.  Meanwhile agricultural prices are generally moving up in sync.  Once again, to the extent that commodity price rises are a harbinger of future inflation, the signs are clearly pointing in that direction.

The dollar, meanwhile, which reversed yesterday’s early gains to close lower across the board, has continued in that direction with further losses this morning.  CHF (+0.5%) leads the way in the G10, which given the fact it had been the biggest loser over the past month, falling more than 5.6%, should be no surprise.  But the rest of the bloc is seeing gains in the commodity focused currencies with AUD (+0.45%), NZD (+0.4%) and CAD (+0.3%) next in line.  Perhaps the biggest surprise is that NOK (0.0%) is not along for the ride.

EMG currencies are also broadly firmer led by BRL (+1.6%) which is following on yesterday’s 2.5% rally as the central bank has been actively intervening to stem the real’s recent weakness.  Concerns remain over rising inflation, and expectations for rising policy rates are growing there, which would likely support the currency even more.  But we are seeing strength in ZAR (+1.0%), CLP (+1.0%) and MXN (+0.65%) as well, clearly all benefitting from the commodity story.  However, virtually the entire bloc is firmer given today’s increasing risk-on attitude.

Aside from the ECB meeting, with the statement published at 7:45 and the press conference at 8:30, we see Initial Claims (exp 725K), Continuing Claims (4.2M) and the JOLTs Job Openings survey (6.7M).  Again, no Fed speakers so look for the dollar to follow risk attitude and the movement in real yields.  Those are both pointing toward a lower dollar as the day progresses, and I see no reason to fight that absent comments from a surprising source.  Unless Madame Lagarde fumbles the press conference, look for this little risk bounce to continue.

Good luck and stay safe
Adf

Powell’s Dismay

Posted on by

The ECB’s Christine Lagarde
Is finding that markets are hard
As bond yields keep climbing
She needs more pump priming
Or Europe will truly be scarred

Meanwhile in the US today
The 10-year sale gets underway
A sloppy result
Just might catapult
More QE, to Powell’s dismay

Markets have had a relatively uneventful evening as participants await some important new information.  The first clue will come this afternoon when the results of the US 10-year bond auction are released.  Remember, this interest rate is arguably the most important rate in the world, as it serves as the basis for trillions of dollars of debt in both the public and private sectors.  And while the on-the-run 10-year bond is probably the single most liquid security in the world, its recent volatility belies that statement.  In fact, this morning, ahead of the auction, we are seeing selling pressure with the yield rising 3.3 basis points to 1.56%, within spitting distance of its recent highs and up a pretty remarkable 65 basis points year-to-date.

The reason today’s auction of $38 billion is being so keenly watched is that two weeks ago, the 7-year note auction was flat out awful, with a long tail and low indirect interest.  This means that there wasn’t really that much demand, especially from investors, as opposed to the primary dealers who are forced to bid.  That auction served as the catalyst for the 15-basis point rise in the 10-year the last week of February.  You may recall that coincided with a 100-point decline in the S&P 500 and commensurate declines in equity markets around the world.

And that is why this is seen as so critical.  With the knowledge that the House is voting on the $1.9 trillion stimulus bill today, and it will certainly pass along a party-line vote, investors recognize that there is going to be a lot more issuance upcoming.  After all, the government will need to borrow a lot of money to fund that stimulus.  If this benchmark auction goes poorly, meaning it doesn’t generate substantial bidding interest outside the primary dealers, we could well be in for another sharp decline in equity markets as the bond market sells off further.  Remember, too, the Fed is in its quiet period so will not be able to make comments in order to support the market.

Yesterday saw an impressive rebound by equity markets around the world after a serious bout of selling almost everywhere.  A good result today is likely to help keep that going, but a poor auction will almost certainly show that yesterday was the proverbial “dead cat bounce.”  And folks, if the auction goes poorly, look for the dollar to make new highs against pretty much every currency, especially emerging market counterparts., but the G10 too.

Which brings us to the ECB and Madame Lagarde.  Today is the first day of the ECB’s March meeting and the market is putting pressure on them as well.  As Treasury yields have climbed, so too have European government bond yields, with, for instance, 10-year bund yields 30 basis points higher on the year, albeit still firmly in negative territory at -0.30%.  But the question being raised is why the ECB hasn’t been more active with its PEPP program during this yield rally.  After all, we have heard from a number of different ECB members that they are closely monitoring sovereign yields and they explicitly told us that was a key benchmark for them.  And yet, their net purchases through the PEPP have declined during the past several weeks to €14.8 billion a week, down from the more than €18 billion they had been purchasing previously.  So, clearly, they have the capacity to do more.  Why then haven’t they been more active?  At this point, nobody really knows, and you can be certain that at tomorrow’s press conference it will be a hot topic.

Of course, it may be that they want to leave themselves extra ammunition in the event the Treasury auction goes poorly and there is another bond market rout.  But that is a far more cynical stance than I would attribute to any central bank.  The risk for the ECB is that European sovereign yields begin to rise faster than Treasury yields both crimping economic support and simultaneously supporting the euro.  And the one thing we know is the ECB wants a weaker euro, in fact they desperately need a weaker euro to help their exporting economies as well as to try to stoke their much-desired inflation.  As Ricky Ricardo used to say, ‘Christine, you got some ‘splainin’ to do!’

So, as we await the results of the auction, let’s take a quick tour of the overnight price action.  The best description of markets is mixed, with modest overall activity.  In the equity space, the Hang Seng (+0.5%) led the way on the high side, while both the Nikkei and Shanghai were essentially flat on the session.  Australia’s ASX 200, meanwhile, fell 0.8%.  As I said, mixed.  The story is no different in Europe with the CAC (+0.6%) the leader with the DAX (+0.3%) doing fine but the FTSE 100 (-0.2%) slipping back a bit.  And so, it cannot be surprising that US futures are behaving in the same manner, with NASDAQ (-0.3%) suffering while DOW (+0.25%) is slightly higher and SPX futures are little changed.

Other than the Treasury market, the yield picture is also mixed, with major European bond markets +/- 0.5bps or less.  This looks like a market biding its time for the two big stories to come.  Intrigue continues to build in Japan where the results of the BOJ’s review will be announced at their meeting next week and we have heard from Kuroda-san that there will be no change in the 10-year yield curve target while a key deputy, Amamiya-san, has left the door open to a widening of that 0.20% range around 0.0%.

In the commodity world oil (+0.5%) is firmer, but just looking at the products, that modest rally is not universal.  Metals are mixed (that word keeps coming up) with copper and aluminum both higher while tin and zinc are lower.  Precious metals are modestly softer as well after a huge rally yesterday.

And finally, the dollar is the one thing not really mixed, but rather broadly higher this morning.  Against the G10, only NOK (0.0%) has managed to hold its own on the back of the oil rally, while CHF (-0.4%) and JPY (-0.3%) are both suffering on what appears to be their lagging interest rate performance.  In the EMG bloc, TRY (+0.5%) is the only gainer of note, however, its movement appears to be positioning related rather than fundamental.  On the downside, there is a broad range of weaker currencies across all three main geographies, although none is weaker by more than 0.3%.  Again, it appears that traders are biding their time for news.

On the data front, today is CPI day with expectations for a 0.4% M/M (1.7% Y/Y) headline rise and a 0.2% M/M (1.4% Y/Y) ex food & energy print.  Based on the past 9 months, I would expect the odds are for a beat on the high side as we have seen in 6 of those readings.  And then it’s the auction.  We remain in the Fed’s quiet period, so look for the dollar to meander this morning and take its cues from the auction like every other market starting at 1:00pm when the results are released.  My money is on a less than stellar auction, higher yields, lower stocks and a stronger dollar.  We shall see.

Good luck and stay safe
Adf

Right From the Script

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While last night, the 10-year yield slipped
It’s still reading right from the script
Of trading much higher
As growth does transpire
And vaccines are rapidly shipped
 
Investors, though, caution, have shown
As high yields have caused a full-blown
Correction in tech
And currency wreck
Just proving the future’s unknown
 
Price action throughout markets overnight has largely been a correction of what has turned out to be a surprising rout in tech stocks and a surprising rally in the dollar.  Quickly recapping the consensus views as the year began, the combination of more fiscal and monetary stimulus and a ramped up vaccination rate would lead to a reopening of the US (and world) economy, much faster growth, higher Treasury yields, rising stock prices and a weaker dollar as increased risk appetite led to dollar selling.  Positioning for those views was both widespread and large as investors looked forward to another banner year.  Oops!
 
As so often happens in markets, even if views are correct in the long run, when a new consensus is reached it means that, pretty much all the investment that is heading in that direction has already arrived, and the result is that those positions tend to lose out as the excitement fades.  And arguably, that is what we have seen in general, although not universally.  Despite last night’s modest bond rally (Treasury yields -5.9bps), the yield curve remains both higher and steeper than at the beginning of the year and appears to have room for further movement in that direction.
 
One of the strongest views that exists is that the Fed will not (cannot) allow Treasury yields to rise beyond a certain, unknown, point, as the cost to the government would be devastating.  That has certainly been my view and informs my belief that when that happens, the dollar will reverse its recent strength and decline sharply alongside real US yields.  But what if the Fed means what they say when describing the rise in long-term yields as a good thing?  How might that play out?
 
The first thing to note is that the yield curve (which I will define as the 2yr-10yr spread) is currently at 137bps, obviously well above the levels seen at the beginning of the year and showing no signs of stopping.  The one thing of which we can be confident right now is that the 2yr yield seems unlikely to move with the Fed maintaining ZIRP up front, so the spread will be entirely dependent on the movement in the 10-year.  But a quick look at the history of the spread shows that the current level is merely in the middle of the range with at least five different times in the past 30 years where this spread rose well over 200 basis points, the most recent being during the Taper Tantrum in 2013 when it reached 260 basis points.  Now, ask yourself what would happen if 10-year Treasury yields rose to 2.75%.  How do you think that would play out in the equity market?  In FX? And for the economy as a whole?
 
Arguably, this type of interest rate movement would be the result of much faster growth and inflation in the US than currently forecast and seen elsewhere in the world.  (As an aside, the OECD today raised their forecast for US GDP growth in 2021 to 6.5%).  If that forecast is accurate, and if inflation simply gets to the Fed’s 2.0% target, that means nominal GDP will be 8.5%!  How can that square with a 10-year yield of 2.75%, let alone today’s 1.55%.  It would seem that something has to give here.  Two potential relief valves are the dollar, which would need to rally much more sharply than we have seen (think EURUSD at 1.05-1.10) or inflation rising more than 2.0%, perhaps as high as 3.5%-4.0%.  History has shown that in situations like that, equity markets tend to underperform.  And maybe that’s the key.  Most of these forecasts for the strong equity, higher interest rate, weaker dollar outcome were based on the idea that central banks and governments could find the perfect mix of policies to achieve these goals.  If there is anything about which we can be sure, other than 2-year yields are not going to rise, it is that neither central banks nor governments have any idea what the proper mix of policies is to achieve those goals.  This is why economic and market activity remain volatile, because the constant tweaks and changes have many unexpected side effects.
 
This is not to imply that the yield curve is going to steepen that much, just that it cannot be ruled out, and if that happens, you need to be ready for a great deal more market volatility.
 
Which takes us to the current session. 
 
In China, the powers that be
Are worried they’re starting to see
A market decline
That could well define
New weakness in President Xi
 
Overnight saw mixed risk appetite with both the Nikkei (+1.0%) and Hang Seng (+0.8%) rising, but Shanghai (-1.8%) having a rough session.  In fact, the decline in stocks on the mainland has been so great that the Chinese government has called in the plunge protection team, which saw action last night to try to prevent a further rout (Shanghai -10% in pat 3 weeks), although obviously they were unable to prevent the process continuing.  As China continues to register concern over bubbles, it is reasonable to expect further declines in this market, as well as many of the other Asian markets that are linked.
 
Europe, on the other hand, is feeling better this morning with gains pretty much across the board (DAX +0.3%, CAC +0.3%, FTE 100 +0.6%), which seem to have ignored modes downward revisions to some Q4 economic data (GDP -0.7%).  And finally, US futures are all firmly higher, notably NASDAQ (+2.2%), which is rebounding from its 11% decline over the past 3 weeks.
 
European bond markets are rallying alongside Treasuries, with Bunds (-5.3bps) and OATs (-5.2bps) a good descriptor of the entire continent’s price action.  Given the type of movement we have seen throughout government bonds worldwide, it would not be a huge surprise to see a further correction before the next leg higher in yields.
 
On the commodity front, oil prices are leading things higher (+0.6%) although the decline in yields has also supported gold (+1.4%) which is coming off a very difficult stretch.  Base metals are mixed as are agriculturals, with the current price action almost certainly a consolidation before the next leg higher for both segments.
 
And finally, the dollar, which is almost universally weaker this morning.  In the G10, AUD (+0.65%) is the leading gainer, but is merely emblematic of the commodity price action as we have seen the other commodity linked currencies in this bloc perform well (NOK +0.6%, CAD +0.45%).  In the EMG space, TRY (+1.5%) is the leading gainer, which during a risk on session is quite normal, with ZAR (+0.9%) and MXN (+0.8%) joining in the fun.  CE4 currencies are also performing well (CZK +0.8%, PLN +0.6%).  However, there are a couple of laggards, notably BRL (-0.7%), KRW (-0.6%) and TWD (-0.5%).  The latter two suffered from ongoing equity outflows from international investors, linked to China’s equity woes, while BRL is suffering from concerns over new political problems President Bolsonaro.
 
On the data front, NFIB Small Business Optimism was released this morning at a worse than expected 95.8, which, while better than expected, demonstrates some still ongoing concerns over the state of the economy.  Clearly, there are no Fed speakers today, so FX is very likely to follow the risk appetite today.  This modest dollar correction lower seems more like a reaction to what had been a surprisingly powerful dollar rally than a reversal.  So my gut tells me that the dollar will rebound along with yields as the week progresses.
 
Good luck and stay safe
Adf