Yield Hawks Reappear

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The market is starting to fear
Inflation is soon coming here
So, tech stocks got hammered
But nobody clamored
For bonds as yield hawks reappear

European markets are having a tough day as it appears investors want nothing to do with either stocks or bonds and only commodities have seen any demand.  Apparently, despite a strong desire for higher inflation, the ECB is not enamored of higher bond yields.  This was made abundantly clear yesterday when Madame Lagarde explained the ECB is “closely monitoring” the government bond market, with a special emphasis on German bunds.  Clearly, this was prompted by the fact that 10-year bund yields have risen nearly 25 basis points in less than a month, similar to the rise in 10-year Treasury yields and are now well above the ECB’s deposit rate.  As Banque de France Governor Villeroy noted, the ECB will ensure financing conditions remain favorable, and seemingly, -0.306% 10-year yields have been determined to be too tight.

This is a perfect indication of the difficulty that the central banks have brought upon themselves by constantly easing monetary policy into every market hiccup and then getting upset when investors don’t obey their every wish.  After all, if the underlying problem in Europe is that inflation is too low (a story they have been pushing for more than a decade) then one would think that rising bond yields, signaling rising inflation expectations would be a welcome sight.  Of course, the flaw is that rising bond yields often lead to declining share prices, something that apparently no major central bank can countenance.  Thus, the conundrum.  Essentially central banks want higher inflation but simultaneous low yields and high stock prices.  That’s not so much a goldilocks scenario as a Dungeons and Dragons fantasy where they are the Dungeon Master.  In other words, it cannot occur in the real world, at least for any extended period of time.

Hence, the comments by Lagarde and Villeroy, and the great expectations for those from Chairman Powell later this morning.  Exactly what can the central banking community do to achieve their desired goals?  Markets are beginning to question the narrative of central bank omnipotence, and those central banks are starting to fear that they will lose control over the situation.  As I have written before, at some point, the Fed, or ECB or some other central bank will implement some new program and the market will ignore it and continue on its merry way.  And when that is happening, that ‘way’ will be down.  At the end of the day, while central banks have shown they have extraordinary power to sway markets, they are not bigger than markets.

Back in the 1990’s, the term bond vigilantes was quite popular as a description of bond market traders who responded negatively to budget deficits and drove yields higher and stocks lower accordingly, thus keeping government spending in line.  In fact, that was the last time the US ran budget surpluses.  With the proposed $1.9 trillion stimulus bill still seemingly on its way, it is entirely possible that those long-dead vigilantes may be rising from the grave.  Back then, the Maestro would never consider capping yields or QE as a response, but the world is a different place today.  If bonds continue to sell off further, the $64 billion question is, how will the Fed respond?  It is this scenario, which could well be starting as we speak, that has brought the idea of YCC to the fore.  We have already seen tech stocks begin to suffer, weighing heavily on major indices, and those other harbingers of froth, Bitcoin and Tesla, have reversed course lately as well.  As I wrote last week, long tech stocks is like being short a Treasury bond put, as they will suffer greatly with higher yields.  At what point will the Fed decide yields are high enough?  Perhaps Chairman Powell will give us a hint today, but I doubt it.

Ahead of his testimony, here is what is happening in markets, where I would characterize things as inflation concerned rather than risk off.  Bond markets in Europe, as mentioned, are selling off sharply, with Bunds (+4.1bps), OATs (+4.8bps) and Gilts (+4.0bps) all feeling the pain of rising inflation expectations.  In fact, every country in Europe is seeing their bonds suffer today.  Treasuries, at this hour, are relatively flat, but continue to hover at their highest level in a year.  Interestingly, the first clue of central bank response came from Australia last night, where the RBA was far more aggressive buying the 10-year sector and pushed yields back down by 4.1bps.  However, their YCC on the 3-year is still in trouble as yields there remain at 0.12%.

Equity markets are almost universally weaker in Europe (only Spain is showing life at +0.6% as a raft of holiday bookings by frustrated UK citizens has seen strength in the tourist sector of the economy).  But otherwise, all red with the DAX (-1.1%) leading the way, followed by the FTSE 100 (-0.3%) and CAC (-0.2%).  Asia was a bit of a different story, as the Hang Seng (+1.0%) managed to benefit from ongoing inflows from the mainland, although Shanghai (-0.2%) was more in line with the global story.  The Nikkei was closed for the Emperor’s birthday.  As to US futures, tech stocks remain under pressure with NASDAQ futures lower by 1.5%, although SPU’s are down by just 0.5%.

Commodities are where its at this morning, though, with oil, after a powerful rally yesterday, up another 0.7% and over $62/bbl for WTI now.  Copper is up a further $200/ton and pushing to the all-time high of $9600/ton set back in 2010.  With all the talk of the elimination of combustion engine vehicles, it turns out EV’s need 3 times as much copper, hence the demand boost.  Meanwhile, the rest of the base metals are also performing well although precious metals are little changed on the day.  Of course, gold at flat is a lot better off than Bitcoin, which is down more than 16% on the day.

And lastly, the dollar, is having a mixed session.  The pound is the leading gainer, +0.2%, as plans for the reopening of the economy as the vaccine rate continues to lead the G10, has investors looking on the bright side of everything.  On the flip side, CHF (-0.45%) is the laggard on what appear to be market technical movements as price action has taken USDCHF above the top of a downtrend channel.  Otherwise, the G10 space is showing little movement in either direction.

As to emerging market currencies, after some terrible performances yesterday, BRL (+0.3%) and MXN (+0.3%) are opening firmer on a rebound along with CLP (+0.4%) following Copper prices higher.  However, the rest of the bloc is +/-0.2% which is the same thing as unchanged in this context.

On the data front, yesterday saw Leading Indicators a touch better than expected and two lesser followed Fed regional indices print strongly.  This morning Case Shiller home prices (exp 9.90%) and Consumer Confidence (90.0) are the highlights, neither of which is that high.  In fact, the true highlight comes at 10:00 when Chairman Powell testifies to the Senate Banking Committee.  It will be interesting to see if he touches on the recent rise in yields, especially expressing concern over their movement.  But more likely, in my view, is that he will simply agree that more fiscal stimulus is critical for the economy and that the Fed will continue to support the economy until “substantial further progress” is made on their objectives.

Adding it all up tells me that risk is going to continue under pressure for now, although given the magnitude of the move we have seen in bond yields, it would not be surprising to see them consolidate or reverse for a while in a trading correction.  As to the dollar, higher yields ought to prevent any sharp declines, but it still looks like we have seen the extent of the correction already and it will continue to trade in its recent range.

Good luck and stay safe
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Crash Landing

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The Narrative tells us the Fed
Will let prices rise up ahead
But if that’s the case
Then how will they pace
The rise in the 2’s-10’s yield spread

And what if this spread keeps expanding
Will stocks markets see a crash landing?
Or will Chairman Jay
Once more save the day
And buy every bond that’s outstanding?

Remember when the Narrative explained that record high traditional valuation measures of the stock market (like P/E or CAPE or P/S) were irrelevant because in today’s world, permanently low interest rates guaranteed by the Fed meant there was no limit for valuations?  That was soooo last month.  Or, remember when economists of all stripes explained that all the slack in the economy created by the government shutdowns meant that inflation wouldn’t reappear for years?  (The Fed continues to push this story aggressively as every member explains there is no reason for them to consider raising rates at any time in the remotely near future.)  This, too, at least in the bond market’s eyes, is ancient history.  So, something is changing in the market’s collective perception of the future, and prices are beginning to reflect this.

The bond market is the appropriate place to begin this conversation as that is where all the action is lately.  For instance, this morning, 10-year Treasury yields have risen another 2.4bps and are trading at their highest level in almost exactly one year, although remain far below longer-term averages.  Meanwhile, 30-year Treasuries have risen even more, and are now yielding 2.155%.  Again, while this is the highest in a bit more than a year, it is also well below longer term averages.  The point is, there seems to be room for yields to run higher.

Something else that gets a lot of press is the shape of the yield curve and its increasing steepness.  Today, the 2yr-10yr spread is 125bps.  This is the steepest it has been since the end of 2016, but nowhere near its record gap of 8.42% back in late 1975.  The Narrative tells us this is the reflation trade, with the bond market anticipating the reopening of the economy combined with a flood of new stimulus money driving business activity higher and prices along with that business.

Now, the question that has yet to be answered is how the Fed will respond to these rising yields.  We are all aware that Federal debt outstanding has been growing rapidly as the Treasury issues all that paper to fund the stimulus packages.  And we have all heard the argument that the size of the debt doesn’t matter because debt service costs have actually fallen over time as interest rates have collapsed with the Fed’s help.  The last part is true, at least over the past several years, where in 2020, it appears Federal debt service amounted to 2.43% of GDP, a decline from both 2018 and 2019, although modestly higher than 2017.  But, if the yield curve continues to steepen as 10yr through 30yr yields continue to rise, as long as the Treasury continues to issue debt in those maturities, the cost to the Federal government is going to rise as well.  The question is, how much can the government afford?  And the answer is, probably not much.  A perfect anecdote is that the increased interest cost of a 50 basis point rise in average Treasury yields will cost the government the same amount as funding the US Navy for a year!  If yields truly begin to rise across the curve, Ms Yellen will have some difficult choices to make.

But this is not just a US phenomenon, it is a global phenomenon.  Yields throughout the developing world are rising pretty rapidly, despite central bank efforts to prevent just that from occurring.  As an example, we can look at Australia, where the RBA has established YCC in the 3yr space, ostensibly capping yields there at 0.10%.  I say ostensibly because as of last night, they were trading at 0.12%.  Now, 2 basis points may not seem like much, but what it shows is that the RBA cannot buy those bonds fast enough to absorb the selling.  And the problem there is it brings into question the RBA’s credibility.  After all, if they promise to keep yields low, and yields rise anyway, what is the value of their promises?  Oh yeah, Aussie 10yr yields jumped 16.9 basis points last night!  It appears that the RBA’s QE program is having some difficulty.

In fact, despite pressure on stocks throughout the world, bond yields are rising sharply.  In other words, the haven status of government bonds is being questioned right now, and thus far, no central bank has provided a satisfactory answer.  Perhaps, the bigger question is, can any central bank provide that answer?  As influential as they are, central banks are not larger than the market writ large, and if investor psychology changes such that bonds are no longer seen as worthwhile investments because those same central banks get their wished for inflation, all financial securities markets could find themselves in some difficult straits.  This is not to imply that a collapse is around the corner, just that the working assumption that the central banks can always save the day may need to be revised at some point.

So, can yields continue to go higher without a more substantive response from the Fed or ECB or BOE or RBA or BOC?  Certainly, all eyes will be on Chairman Powell to see his response.  My view has been the Fed will effectively, if not explicitly, try to cap yields at least out to 10 years.  If I am correct, the dollar should suffer substantially.  Again, this is not to say this is due this morning, just that as this story unfolds, that is the likely trend.

And what else is happening in markets?  Well beyond the bond market declines (Gilts +2.3bps, Treasuries now +4.1bps, even Bunds +0.5bps), European bourses are falling everywhere (DAX -0.6%, CAC -0.5%, FTSE 100 -0.7%) after weakness throughout most of Asia (Hang Seng -1.1%, Shanghai -1.5%, although Nikkei +0.5% was the outlier).  US futures? All red and substantially so, with NASDAQ futures lower by 1.3% although the other indices are not quite as badly off, between -0.5% and -0.7%.

Commodity prices, however, continue to rise, with oil (+1.0%) leading energy mostly higher while both base and precious metals are higher as well.  So, too, are prices of grains rising, as we continue to see the price of ‘stuff’ rise relative to the price of financials.

Finally, turning to the dollar, it is broadly stronger against its EMG counterparts, but more mixed vs. the G10.  In the former, MXN (-1.4%) and ZAR (-1.35%) are leading the way lower, although BRL is called down by more than 2.0% at the opening there.  But the weakness is pervasive in this space with APAC and CE4 currencies also suffering.  However, G10 is a bit different with AUD (+0.2%) leading the way higher on the back of the record high prices in tin and copper alongside the rising rate picture and reduced covid infection rates.  On the flip side, NOK (-0.3%) is the weakest of the bunch, despite oil’s rebound, which appears to be a reaction to strength seen late last week.  In other words, it is market internals, not news, driving the story there.

On the data front we do get a fair amount of new information this week as follows:

Today Leading Indicators 0.4%
Tuesday Case Shiller House Prices 9.90%
Consumer Confidence 90.0
Wednesday New Home Sales 855K
Thursday Durable Goods 1.0%
-ex transport 0.7%
Initial Claims 830K
Continuing Claims 4.42M
GDP Q4 4.2%
Friday Personal Income 9.5%
Personal Spending 2.5%
PCE Core 0.1% (1.4% Y/Y)
Chicago PMI 61.0
Michigan Sentiment 76.5

Source: Bloomberg

Beyond the data, with GDP and Personal Spending likely the keys, we hear from a number of Fed speakers, most importantly from Chairman Powell tomorrow and Wednesday as he testifies before the Senate Banking Committee and then the House Financial Services Committee.  The one thing about which you can be sure is that Congress will ask him to support their stimulus plan and that he will definitely do so.  It strikes me that will just push Treasury yields higher.  In fact, perhaps the March FOMC meeting is starting to shape up as a really important one, as the question of higher yields may need to be addressed directly.  We shall see.

For now, yield rises are outstripping inflation prints and so real yields are rising as well.  This is supporting the dollar and will undermine strength in some securities markets.  However, history has shown that the Fed is unlikely to allow real yields to rise too far before responding.  For now, the dollar remains in its trading range and is likely to stay there.  But as the year progresses, I continue to see the Fed stopping yields and the dollar falling accordingly.

Good luck and stay safe
Adf

Misled

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Said Janet, do not be misled
Strong growth is no sub for widespread
Support from the bill
In Congress which will
Insure budget’s stay in the red
Insure higher yields lay ahead
Insure every table has bread

Treasury Secretary Janet Yellen, who polished her dovish bona fides as Fed Chair from 2013 to 2017, has taken her act to the executive branch and is vociferously trying to make the case that recent positive data is of no concern at this time and that the $1.9 trillion package that is slowly wending its way through Congress remains critical for the economy.  “It’s very important to have a big package that addresses the pain this has caused.  The price of doing too little is much larger than the price of doing something big,” was her exact quote in an interview yesterday.  I wonder, is ‘going big’ the new zeitgeist, replacing YOLO?  After all, not only has Ms Yellen been harping on this theme, which has been taken up by others in government, but there is even a weekly TV Show with that name that opens the door to some of the more remarkable, if ridiculous, things people are willing to do to get on TV.

But go big it is, with no indication that the current administration is concerned about potential longer term negative fiscal outcomes.  The pendulum has swung from the Supply Side rationale for fiscal stimulus (cutting taxes to drive incentives) to the MMT rationale for fiscal stimulus (as long as we borrow in our native currency, we can always repay any amount).  History will almost certainly show that this side of the pendulum is no less damaging than the other side, but given that politics is a short-term phenomenon, only concerned with the time until the next election, we are virtually guaranteed to continue down this road to perdition.

Thus far, the results have been relatively benign, first off because the bill has not yet been made into law, although markets clearly assume it will be, and secondly because the depths of the government induced recession from which we are emerging were truly historic, so it takes some time to go from collapse to explosive growth.  The gravest concern for some (this author included) is that we are going to see significant price inflation in the real economy, not just in asset prices, and in the end, the economy will simply suffer from different problems.  But then, isn’t that what elections are really about?  When administrations change it is a cry to address different issues, not improve the overall situation.

So, with that in mind on this Friday, let’s take a tour of the markets.  Today is one of the few sessions so far this year where the major themes entering 2021 are actually playing out according to plan.  As such, we are seeing continued support in the equity space, with yesterday’s modest sell-off being reversed in most markets.  We are seeing bond markets continue to come under pressure with yields rising on the reflation narrative, and we are watching the dollar decline, albeit still firmly in the middle of the trading range it has traced out this year.

In the equity space, while the Nikkei (-0.7%) was under modest pressure, we saw small gains in the Hang Seng (+0.2%) and Shanghai (+0.5%).  Also noteworthy was the Sydney /ASX 200 (-1.3%) which fell after a widely followed analyst Down Under increased his forecast for interest rates by nearly 50 basis points by year end.  Not surprisingly, this helped AUD (+1.0%) which is the best performing currency today.  As to Europe, the gains are more broad-based with both the CAC and DAX rising by 0.5% although the FTSE 100 is basically flat on the day.  Here, too, there was data that helped drive the market narrative with UK Retail Sales disastrous in January (-8.2%, -8.8% ex fuel) weighing on the FTSE despite stronger than expected preliminary PMI data from the UK (Composite PMI rising to 49.8, up more than 8 points from last month).  Meanwhile, German PPI data jumped sharply (+1.4% in Jan), its largest rise since 2008.  I find it quite interesting that we saw a similarly large rise in the US earlier this week.  It appears that inflationary pressures are starting to bubble up, at least in some economies.  French and Italian CPI data remain mired well below 1.0%, a sign that neither economy is poised to rebound sharply quite yet.  As to US futures, they are all green, but with gains on the order of 0.2%-0.3%, so hardly earth-shattering.

Bond markets, however, continue to sell off around most of the world which is feeding a key conundrum.  One of the rationales for the never-ending stock market rally is the low yield environment, but if bond yields keep rising, that pillar may well be pulled out with serious consequences to the bull case.  But in true reflationary style, Treasury yields have backed up 1 basis point and we are seeing larger yield gains in Europe (Bunds +1.7bps, OATs +1.2bps, Gilts +2.1bps).  In fact, the only bonds in Europe rallying today are Super Mario bonds Italian BTPs (-1.5bps) as the market continues to give Draghi the benefit of the doubt with respect to his ability to save Italy’s economy.

In the commodity space, oil has ceded some of its recent gains with WTI (-2.25%) back below $60/bbl, although still higher by 22% this year.  Precious metals are slightly softer and base metals are mixed with Copper (+1.9%) the true outperformer.

Finally, in the FX market, the dollar is under pressure against the entire G10 space and much of the emerging market space.  In G10, we already discussed Aussie, which has helped drag NZD (+0.7%) higher in its wake.  But the rest of the bloc is seeing solid gains of the 0.3%-0.4% variety with the pound (+0.15%) the laggard after that Retail Sales data.  However, the pound did trade above 1.40 briefly this morning for the first time since April 2018, nearly three years ago.

In the Emerging markets, CNY (+0.5%) has been the biggest gainer with CLP (+0.4%) right behind on the strong copper showing.  However, the CE4 have all tracked the euro higher and are performing well today.  On the downside, BRL (-0.6%), ZAR (-0.5%) and MXN (-0.4%) are the laggards, with the real suffering after cryptic comments from President Bolsonaro regarding fuel price rises by Petrobras and potential government action there.  Meanwhile, the peso has been under pressure of late after Banxico’s 25bp rate cut last week, and growing talk that there could be others if inflation remains quiescent.  And lastly, South Africa suffered almost $1 billion of outflows from the local bond market there, with ensuing pressure on the rand.

On the data front this morning we get Existing Home Sales (exp 6.6M) and the preliminary US PMI data (58.8 Mfg, 58.0 Composite), although as we already learned, strong US data is irrelevant in the fiscal decision process right now.  Two more Fed speakers, Barkin and Rosengren, are on the docket for today, but again, until we hear of a change from Chairman Powell, it is unlikely that the other Fed speakers are going to have much impact.

Summing things up, right now, the reflation trade, as imagined on January 1st, is playing out.  Quite frankly, the dollar is simply trading in a new range (1.1950/1.2150) and until the euro can make new highs, above 1.2350, I would not get too excited.  The one thing that is very true is that market liquidity is shallower than it has been in the past which explains the choppiness of trading, but also should inform hedging expectations.

Good luck, good weekend and stay safe
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Suspicions

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Fed staffers relayed their suspicions
That ease in financial conditions
Could lead to distress
Which could make a mess
For Powell and all politicians

But Jay heard the story and said
The risks when we’re looking ahead
Are growth is too slow
Inflation too low
So, money still pours from the Fed

Yesterday’s Fed Minutes left us with a bit of a conundrum as there appears to be a difference of opinion regarding the current state of the economy and financial markets between the Fed staffers and their bosses.  The bosses, of course, are the 19 members of the FOMC, 7 governors including the Chair and vice-Chair and the 12 regional Fed presidents.  The staffers are the several thousand PhD economists who work for that group and develop and run econometric models designed, ostensibly, to help better understand the economy and predict its future path.  On the one hand, based on the Fed’s prowess, or lack thereof, in forecasting the economy’s future path, it is understandable how the bosses might ignore their staffers.  When looking at past Fed forecasts, they are notoriously poor at determining how the economy is progressing, seemingly because the models upon which they rely do not represent the US economy very well.  On the other hand, the willful blindness exhibited by the bosses with respect to the current financial conditions is disqualifying, in itself, of trusting their views.  As I said, quite the conundrum.

This was made a little clearer yesterday when the FOMC Minutes showed that the staff had indicated the following:

The staff provided an update on its assessments of the stability of the financial system and, on balance, characterized the financial vulnerabilities of the U.S. financial system as notable. The staff assessed asset valuation pressures as elevated. In particular, corporate bond spreads had declined to pre-pandemic levels, which were at the lower ends of their historical distributions. In addition, measures of the equity risk premium declined further, returning to pre-pandemic levels. Prices for industrial and multifamily properties continued to grow through 2020 at about the same pace as in the past several years, while prices of office buildings and retail establishments started to fall. The staff assessed vulnerabilities associated with household and business borrowing as notable, reflecting increased leverage and decreased incomes and revenues in 2020. Small businesses were hit particularly hard. [author’s emphasis].

And yet, after hearing the staff reports, neither the FOMC statement nor Chairman Powell at the ensuing press conference referred to elevated asset values or financial system vulnerabilities.  Rather, those, and most other concerns, were described as moderate, while explaining that downside outcomes to inflation still dominated their thinking.  In the intervening 3 weeks, we have seen Treasury yields rise 30 basis points in the 10-year and inflation breakevens rise 22 basis points.  In other words, it is beginning to appear as though the Fed and the market are watching two different movies.  The risk to this scenario is that the Fed can fall dangerously behind the curve with respect to keeping the economy on their preferred path, and may be forced to dramatically shift policy (read raise rates) if (when) it becomes clear rising inflation is not a temporary phenomenon.  Now, while it is likely to take the Fed quite a while to recognize this discrepancy, I assure you, when it occurs and the Fed feels forced to act, the market response will be dramatic.  But for now, that is just not on the cards.  If anything, as we continue to hear from various Fed speakers, there is no indication they are going to consider tighter policy for several years to come.

In the meantime, there is no reason to suspect that market participants will change their short-term behavior, so ongoing manias will continue.  Just be careful with your personal accounts.  Remember, when things turn, return OF capital is far more important than return ON capital!

Now to today’s session.  Once again, the traditional risk memes are a bit confused this morning.  Equity markets have not had a good session with Asia mostly lower (Nikkei -0.2%, Hang Seng -1.6%, although Shanghai reopened with a gain, +0.5%).  European markets are also under pressure (DAX -0.1%, CAC -0.4%, FTSE 100 -0.9%) despite the fact that today marks the beginning of the disbursement of EU-wide support funded by EU-wide bond issuance.  You may remember last July when, to great fanfare, the EU agreed a €750 billion joint debt issuance, to be backed by all members.  Well, we are now seven months later, and they are finally starting to disburse the funds.  And do not seek respite in US futures markets as they are all lower by between 0.25% (DOW) and 0.8% (NASDAQ).

What is interesting is that despite the equity market weakness, bond markets are falling as well.  It appears that growing concerns over rising inflation are outweighing the risk aversion theme.  Thus, 10-year Treasury yields are higher by 1.9bps this morning and we are seeing even larger rises in some European markets (Gilts +4.1bps, OATs +2.6bps, Bunds +1.8bps).  So, I ask you, which market is telling us the true risk story today?

Perhaps if we look to commodities we will get a hint.  Alas, the information here is muddled at best.  Oil prices continue to rise, up another 0.3% this morning, as up to 4 million barrels of daily production in Texas and the Midwest have been shut in because of the winter storms.  That is 36% of US production, and clearly making an impact. Meanwhile, base metals have been mixed with Aluminum higher and Copper lower.  Precious metals?  Mixed as well with gold (+0.4%) rebounding from a couple of really bad sessions while silver (-0.75%) continues to slide.

Thus far, making a claim as to the risk sense of markets is essentially impossible.  So, now we turn to the dollar.  If tradition is a guide, the dollar’s broad weakness, lower vs. all G10 counterparts and many EMG ones as well, would indicate a risk on session.  But if investors are moving into risky assets, why are stocks under uniform pressure? Perhaps they are all moving their money into Bitcoin (+0.2% today, +11.2% in the past week).

But back to the fiat world where we see GBP (+0.6%) as the leading G10 gainer which appears to be a result of traders expecting the UK to recover much faster than Europe given the relative success of their Covid vaccination program.  But even the worst performers, CAD and JPY are higher by 0.15% this morning.  NOK (+0.4%) seems to be benefitting from the ongoing oil rally, and the rest of the bloc may be beginning to see the resumption of the dollar short trade.

EMG currencies are a bit more mixed, with most APAC currencies softening overnight, but LATAM and CE4 currencies benefitting from the dollar’s overall softness.  CLP (+0.5%) leads the way on the strength of rising copper prices, with ZAR (+0.45%) following closely behind.

Yesterday’s US data was surprisingly good, with Retail Sales exploding higher by 5.3% on a monthly basis (I guess the most recent stimulus checks were spent!) and PPI jumping by a full percent, to a still low 1.7%, which may well foreshadow the future of CPI.  We also saw strong IP and Capacity Utilization data.  This morning brings Initial Claims (exp 770K), Continuing Claims (4.425M), Housing Starts (1660K), Building Permits (1680K) and Philly Fed (20.0) all at 8:30. We also have two more Fed speakers, the hyper dovish Lael Brainerd and a more middle of the road dove Rafael Bostic.

Wrapping it all up shows a weak dollar, weak bond prices and weak stock prices.  It feels like at least one of these needs to adjust its trajectory for the day to make any sense, but as of now, I am not willing to bet which.  As far as the FX market goes, we appear to be rangebound for now, although any eventual break still feels like it will be for a lower dollar.

Good luck and stay safe
Adf

Fears to Assuage

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When calendars all turned the page
To ‘Twenty-One, clearly the rage
Was bets on reflation
And more legislation
For stimulus, fears to assuage

The dollar was slated to fall
The yield curve, to grow much more tall
While stocks were to rally
And Covid’s finale
Was forecast, a popular call

But so far, while stocks have edged higher
And bond yields are truly on fire
The dollar remains
Ensconced in its gains
Its meltdown has yet to transpire

One cannot be but impressed with the dollar’s resilience so far this year amid such surety by so many that it was destined to fall sharply.  Consensus views at the beginning of January were that the vaccines would lead to significant reflation in the global economy, equity markets would benefit greatly, bond yields would rise amid trillions of dollars of new issuance, and the dollar would fall.  As I said from the start, higher bond yields and a steeper yield curve did not typically lead to dollar weakness.  And that is what we have begun to see in the past several sessions.

Global bond markets have really started to reprice the current situation.  While the US story is easy to understand; huge new stimulus bill with no tax increases means huge new Treasury issuance to pay for things and supply overwhelms demand, one needs to ask what is driving the price declines throughout Europe and Asia as well. Stimulus efforts elsewhere have been less substantial despite more severe lockdowns by most of Europe and many Asian nations.  So, perhaps it was not merely the supply-demand imbalance that had bond investors concerned, perhaps it was also inflation expectations.

Certainly, these have been rising sharply with US 5yr-5yr breakevens now at 2.40% this morning, the highest level since March 2013, and not merely trending higher, but exploding higher.  (Germany, too, has seen a sharp rise in breakeven inflation, albeit to much lower levels, rising from 0.2% at the lows last March to 1.06% today.)  While last week’s CPI readings were a touch softer than expected on a headline basis, the reality is that higher inflation remains almost assured going forward.  This is partly because of the way the data is calculated, where last year’s pandemic induced lows will fall out of the calculation to be replaced by this year’s much higher readings.  It is also evident in the rising price of commodities, specifically oil (+1.0% this morning) which is higher by 25% this year.  In fact, the entire energy sector has seen prices rise by roughly that amount, and we have seen gains across the board in both base metals and all agricultural products.  In other words, stuff costs more.

Perhaps, of more concern is the insouciance toward inflation shown by the Fed.  For example, just yesterday, SF Fed President Mary Daly, when asked about inflation getting out of hand replied, “I don’t think that’s a risk we should think about right now.  We should be less fearful about inflation around the corner and recognize that fear costs millions of jobs.”  If you think the Fed is going to respond to any inflation data, anytime soon, you are mistaken.  They have made it very clear that the only part of their mandate that currently matters is employment.

So, let’s recap; the price of stuff is going higher while the Fed is adamant that tighter policy is inappropriate at this time.  Bonds are doing their job, or perhaps that is; the bond vigilantes are doing their job.  They are forcing yields higher, and left unabated, probably have much further to go.  But will they be left unabated?  I think the definitive answer is, no, the Fed will not allow Treasury yields to rise very much further.  And this, of course, drives my view that the dollar, while strong now, will eventually reverse course, as the Fed halts the rise in Treasury yields.

But for now, those higher yields are attracting investors into dollar products, and by extension, into dollars.  And this story can play out for a while yet.  It is a mug’s game to try to guess at what point the Fed will become uncomfortable with Treasury yields, with current guesses ranging from 1.50% to 3.0% in the 10-year.  My sense is it will be toward the lower end of that range that will encourage the extension and expansion of QE, perhaps 1.75%-2.0%.  But I remain confident that at some point, they will respond.  And with inflation showing no signs of abating, it will happen sooner than you think.

What about the rest of the world?  Well, the one thing we know is that neither the ECB nor the BOJ can afford for their currencies to strengthen too much.  While Japan has shown more stoicism lately, I can easily envision Madame Lagarde, in the context of alleged lack of inflationary pressures, pushing the ECB to expand their largesse as well, at least enough to try to offset the Fed.  Will it work?  That, of course, is the $64 trillion question.

On to today’s activity.  Risk is under a bit of pressure this morning after what were truly impressive bond market declines yesterday.  but those declines were not so much risk on, as fear starting to spread.  So, a quick tour of equity markets shows that after a mixed US session, the Nikkei shed 0.6% overnight, although the Hang Seng managed a 1.1% gain.  Shanghai reopens tonight.  In Europe, screens are red wit the DAX (-0.55%) leading the way lower, although the CAC (flat) and the FTSE 100 (-0.1%) are not suffering that greatly.  Meanwhile, at this hour, US futures are essentially unchanged.

Bond yields, which rose sharply around the world yesterday (11bps in the US, 5-8bps throughout Europe) are consolidating a bit.  Treasuries are lower by 1.9 basis points, but they have already backed up from earlier levels.  In Europe, we see the same thing, where early yield declines have been virtually erased.  Bunds are flat, OATs are higher by 0.6bps and Gilts, one of the worst performers yesterday, have seen yields fall 1.0bp, but that is well off the levels earlier this morning. The point is, even if equities are under pressure, funds don’t appear to be flowing into bonds.

Rather, commodities are the market of choice, with oil now above $60/bbl (+1.0%) and base metals higher along with almost all agricultural products.  In fact, the only real laggards here are gold (-0.3%) and silver (-0.5%), which are arguably suffering from higher yields as a competitor.

Finally, the dollar is definitely feeling its oats this morning, rising against all its G10 brethren, with the weakest link SEK (-0.45%), although other than CAD (-0.1%) and JPY (-0.05%), the rest of the bloc is lower by at least 0.3%.  This is a broad dollar strength story, with virtually no idiosyncratic national issues to drive things.  In fact, the only data of note was UK inflation, which printed a tick higher than expected.

Emerging market currencies are similarly under pressure across the board, led lower by ZAR (-0.8%) and MXN (-0.8%), although there is broad weakness in APAC and CE4 currencies as well.  Again, one needn’t look too far afield to determine why these currencies are weak, it is simply a dollar strength day.

On the data front, we start the morning with Retail Sales (exp 1.1%, 1.0% ex autos), move on to IP (0.4%) and Capacity Utilization (74.8%) and finish the afternoon with the FOMC Minutes from the January meeting.  It seems hard to believe that the Minutes will have much impact as there were neither policy shifts nor even dissension in the ranks. Perhaps we will learn if YCC or QE extension has been a discussion topic, which would be hugely bond bullish and dollar bearish.  But I doubt it.

Rather, this dollar rebound, much to my surprise, seems to have a little more behind it and could well extend a bit further.  Looking at the euro, the technicians will focus on 1.2000, the 100-day moving average and 1.1950, the low touched in last week’s sell-off.  But if the Treasury curve continues to steepen, the euro could well move back to the 1.1750 level last seen prior to the US election in November.  That is not my base case, but the probability has certainly grown lately.

Good luck and stay safe
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Tempt the Fates

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For everyone, here’s a hot flash
The Treasury’s bagful of cash
May soon start to shrink
And analysts think
That could lead to quite the backlash

The Fed might be forced to raise rates
A prospect that could tempt the fates
How might stocks respond
If the 10-year bond
Sees yields rise as growth now reflates?

You cannot scan the financial headlines these days without seeing a story about either, the extraordinarily low interest rates that non-investment grade credits are paying for money (the average junk bond yield is now below 4.0%, a record low) or about the remarkable bullishness exhibited by investors regarding the future of the stock market given the ongoing reflation story and expected future growth once the pandemic subsides.  In other words, risk is on baby!

But is it really that simple?  There are those, present company included, who believe that the current situation is untenable, and that the future (for markets anyway) may not be as rosy as currently believed.

Consider the following: last summer, as Treasury bond yields were making new all-time lows, we saw a spectacular amount of investment in the stock market, with a particular concentration in companies that were deemed to be beneficiaries of the lockdowns and evolution toward working from home.  These (mostly) tech names have carried the broad indices to record after record and, quite frankly, don’t seem to be slowing down.  Essentially, it could be argued that the tech mega-cap stocks were acting as a substitute for Treasuries, and that the relationship between the stock and bond markets had evolved.  After all, if interest rates were going to remain permanently low, courtesy of the central banks, then it was far better to seek yield in the stock market.  and the situation was that the yield from the S&P 500, at 1.57%, was substantially higher than the yield on 10-year Treasuries, which traded between 0.6%-0.85% for months.  One could define this ‘equity risk premium’ as ~0.80%, give or take, and when combined with the growth prospects it was deemed more than sufficient.

But that was then.  Lately, as the reflation story has really started to pick up, we have seen the Treasury steepener trade come to the fore.  The spread between 2y and 10y Treasuries has risen to 1.13%, its highest level since early 2017 and up from the ~0.50% level seen last summer.  Not only that, but the strong consensus view is that there is further room for 10-yr and longer yields to rise.  After all, expectations are that the Treasury will be issuing another $1.9 trillion of bonds to pay for the mooted stimulus package, and all that supply will simply add pressure to the bond market, driving yields higher.

However, if the bond market story is correct, what does that say about the future of the equity market?  From a positioning perspective, it can be argued that being long the stock market, especially the NASDAQ, is akin to being short a put on the Treasury market (h/t Julian Brigden for the analogy).  In other words, if the premium required to own stocks over bonds is 0.8% of yield, and if the 10-year yield continues to rise to 1.50% (it is higher by 4 more basis points this morning), that means the dividend yield on stocks needs to rise to 2.3% to restore the relationship.  Doing the math shows that stock prices would need to decline by…33% to drive yields that much higher!  I’m pretty sure, that is not in the reflation story playbook, but then I’m just an FX salesman.

Which brings us back to the Treasury and the Fed.  The Treasury, during the pandemic, has maintained an extraordinarily high level of cash balances at the Fed, roughly $1.6 trillion, far above its more normal $500-$600 billion.  It seems that Secretary Yellen is looking to draw down those balances (arguably to spend money), which means that the likely market response will be much lower front-end yields, with the possibility of negative rates in the T-bill market quite realistic.  This outcome is something which the Fed would deeply like to avoid, and so they may find themselves in a situation where they need to raise IOER and the reverse repo rates in order to encourage banks to maintain the cash as reserves, like they currently are, instead of having them flow to the T-Bill market driving rates lower.  But how will the markets respond if the Fed raises rates, even if it is IOER and even though it will surely be described as a technical adjustment?  It could be completely benign.  But given that this is truly ‘inside baseball’ with respect to the markets functioning, it could also easily be misinterpreted as the Fed starting to remove liquidity from the markets.  And that, my friends, would not be taken lightly.

Summing all this up leaves us with the following: Treasury yields continue to rise on the reflation trade and pressure is coming to the front end of the curve which could result in the Fed acting to make technical adjustments to raise rates there.  The combination of these two events could easily result in a repricing of equity markets of some substance.  It would also result in a tightening of financial conditions, something the Fed is very keen to prevent, which means the story would not end here.

And how would this impact the dollar?  Well, the combination of higher rates and risk reduction would likely see a strong, initial bid in the buck.  But this is where the idea of the Fed capping yields comes into play.  A reflating (inflating) economy with rising yields will be quite problematic for the US government and with the justification of tighter financial conditions, the Fed will smoothly pivot to extending QE tenors if not outright YCC.  And that will halt the dollar’s rise, although not inflation’s, and the much-vaunted dollar weakness is likely to be a result.  But as I have said consistently, that is a H2 event for this year.

So, has that impacted markets negatively today?  Not even close.  Risk remains in favor as we saw the Nikkei (+1.3%) and Hang Seng (+1.9%) both rise sharply.  Shanghai remains closed until Thursday.  Europe, however, has been a bit more circumspect with very modest equity gains there (CAC +0.1%, DAX 0.0%, FTSE 100 +0.15%) although US futures are higher by roughly 0.5% across the board.

Bond markets are continuing to sell off, even after yesterday’s sharp declines.  Treasuries, this morning, are higher by 5bps now, while bunds (+2.1bps), OATs (+2.5bps) and Gilts (+3.7bps) are following yesterday’s moves further.  In fact, bund yields are now pushing toward their post-pandemic highs.

On the commodity front, oil continues to perform well, although WTI is benefitting from the ongoing problems in the Midwest where production is being shut in because of the bitter cold and ice thus reducing supply further.  Meanwhile, base metals are modestly higher, but precious metals are unchanged.

Finally, the dollar remains under pressure and for those who thought that the correction had further to run, it is becoming clear that this gradual depreciation is back.  Of course, with risk in demand, the dollar typically suffers.  In the G10, NZD (+0.5%) is the leading gainer although the entire bloc of European currencies is higher by about 0.3%.  The kiwi story seems to be expectations for eased pandemic restrictions to enable further growth, and hence reflation.  But given the dollar’s broad-based weakness, I don’t ascribe too much to any particular story here.

In the EMG bloc, there are more winners than losers, but the gains are not that substantial.  TRY (+0.6%) continues to benefit from the tighter monetary stance of the new central bank governor, while CLP (+0.6%) seems to be the beneficiary of higher copper prices.  On the downside, PHP (-0.6%) is the laggard, falling after both a sharp rise yesterday and news that foreign remittances and foreign reserves both declined in January.  But the rest of the movement here is much smaller in either direction and the main story remains broad dollar weakness

On the data front, this morning we saw that the German ZEW Expectations Survey was much better than expected despite the ongoing lockdowns across the continent.  Here, at home, we get Empire Manufacturing (exp 6.0), which seems unlikely to move things, but then we hear from three Fed speakers, ranging from the erstwhile hawkish Esther George to the unrequited dove Mary Daly.  But any change of message would be shocking.

And that’s it for the day.  With risk continuing to be embraced, the dollar is likely to remain under pressure.

Good luck and stay safe
Adf

A Wonderful Place

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The world is a wonderful place
As evidenced by today’s race
Twixt stock market gains
And bond market strains
While dollars proceed to debase

It seems a bit unusual, but the animal spirits are out in force today as risk is being snapped up everywhere in the world while haven assets are being shunned.  It is unusual because there is no discernible catalyst for this behavior, but the risk impulse is strong.  For instance, a quick scan of the headlines shows that there was a powerful (magnitude 7.3) earthquake in Fukushima, Japan this weekend, although fortunately, while there has been some property damage, there has been no reported loss of life.  Ten years ago, almost to the day, Japan suffered the Tohoku earthquake in the same region, with a much more powerful reading (magnitude 9.3, and remember the Richter Scale is logarithmic, so 9.3 is 100x more powerful than 7.3).  At any rate, it seems hard to believe that was a signal to buy risk.

Other stories are the deep freeze throughout the middle of the US, with Texas suffering greatly, as up to 2 million residents will have lost power today.  Again, hardly a catalyst to buy risk, although it has certainly helped push up energy prices as WTI (+2.1%) is back above $60/bbl for the first time since November 2018.  On the virus front, infection rates seem to be declining and vaccinations are slowly increasing, so that is certainly a positive, but that has been ongoing for the past several weeks, this is not new news, and so doesn’t seem a likely candidate as a risk-on catalyst.  On the political front, former President Trump was acquitted, again, on an impeachment proceeding, but markets have been pretty clear in the fact that they do not respond to purely political memes.  Politics only matters when it impacts policies that will impact markets, like the fight over the current stimulus package.

And yet, risk is clearly in demand today as evidenced by equity market price action around the world, (Nikkei +1.9%, FTSE 100 +1.6%, CAC +1.25%, DAX +0.35%) and bond market price action in Europe (Treasury markets are closed today) with Gilts (+5.4bps), Bunds (+4.0bps), OATs (+3.9bps) all selling off sharply and the rest of the continent following suit.  Even JGBs (+1.3bps) sold off and Australian government bonds had the biggest move (+10.1bps, despite YCC in place in the 3-year space) as not only did the government issue more debt, but there was increased talk of the reflation trade with expectations that economic growth was going to pick up sooner led by the US.

And I guess, this is the story driving markets today, an increasing confidence that we are past the worst impact of the coronavirus and that the continuous fiscal and monetary support that is coming from governments and central banks around the world will feed into risk assets and drive prices ever higher.  So, it is not one catalyst, but a confluence of stories that are doing the job.  In the end, it would seem there are two questions to be answered though; first, have equity markets already priced in all the benefits of the recovery in economies worldwide?  And second, will all of that excess financial support, from both fiscal and monetary policy ease, result in higher, and possibly much higher, measured inflation?

As of today, neither of these seem to be a concern, but many very smart folks, with long experience in markets and economics, are asking those two questions as the answers will have a huge impact on our lives going forward.  We will try to explore these starting tomorrow.

In the meantime, the risk impulse is quite evident in major markets around the world.  In fact, the only one I have not discussed is FX, where the traditional risk-on behavior is in full bloom.  The dollar is weaker vs. essentially all its major counterparts except the yen, which has weakened 0.35%.  But looking at the rest of the G10, we see NOK (+0.5%) leading the way on the oil rally, followed by GBP (+0.4%), which has rallied to its strongest level, above 1.39, since April 2018.  The pound’s strength seems predicated on the ongoing success the UK has had in vaccinating its population, with more than 15 million doses of the vaccine having been given, meaning upwards of a quarter of the population as been given at least the first dose.  That pace is far ahead of anywhere except Israel, and certainly dominates the large nations.  As to the rest of the G10, gains are uniform, but small.

Turning to EMG currencies, TRY (+1.0%) is the leader today followed by ZAR (+0.8%), with the former continuing to benefit from the strong words of the new central bank chief who has been adamant that he will maintain higher rates to fight inflation, which helps to draw investors in a ZIRP world.  ZAR, too, is the beneficiary of its relatively higher interest rates and remains a destination of choice for those seeking yield.  But essentially, the entire bloc is firmer barring two currencies, THB and HUF that have fallen less than 0.1%.  This is a risk-on, dollar selling day, it is that simple.

On the data front, with today’s holiday, nothing is to be released here in the US, but we do get several interesting reports this week:

Tuesday Empire Manufacturing 6.0
Wednesday PPI 0.4% (0.9% Y/Y)
-ex food & energy 0.2% (1.1% Y/Y)
Retail Sales 1.0%
-ex autos 0.9%
IP 0.4%
Capacity Utilization 74.8%
Business Inventories 0.5%
FOMC Minutes
Thursday Initial Claims 773K
Continuing Claims 4.423M
Housing Starts 1658K
Building Permits 1677K
Philly Fed 20.0
Friday Existing Home Sales 6.61M

Source: Bloomberg

Aside from this data, with arguably Retail Sales being the highlight, and the FOMC Minutes, we also hear from 9 different Fed speakers this week, although none of the big guns, and given Chairman Powell is clearly uninterested in even thinking about thinking about tighter policy, I don’t think we will learn too much.  The next big Fed issue will arise when inflation readings start to rise much faster than expected and the yield curve continues to steepen.  At that point, will the Fed watch and wait?  Or will they act?  But that is a summer question, not a Q1, or even Q2 event.

So, on this President’s Day holiday, I see nothing that will stop the risk-on meme, thus, a modestly softer dollar seems quite reasonable.  We are here to help if you need something, although I assure you, come noon, when London goes home, markets will be essentially done.

Good luck and stay safe
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Pent-Up Demand

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The one thing consistently heard
Is growth in H2 will be spurred
By pent-up demand
Throughout all the land
As people buy things they’ve deferred

But what if the virus has wrought
Some changes in what people sought
Perhaps now it’s saving
That people are craving
Not spending, as routinely thought

There appears to be one universal view regarding economic activity going forward; there is an enormous amount of pent-up demand for things that people have been craving since the onset of the widespread government lockdowns as a result of the spread of Covid-19.  This includes eating out, going to the gym, going to the movies and traveling on vacation.  And it seems pretty clear that there is some truth to this idea.  But given the trauma that governments around the world inflicted on their populations via the inconsistent messaging and lockdown mania, isn’t it possible that many people have reevaluated what they deem as most important?  I know that this author has certainly reconsidered what is really necessary to live a happy and fulfilling life, and I imagine I am not the only one.

But the point is, virtually every economist’s assumption in their econometric models is that there will be a substantial pick-up in activity, especially in those service sectors that have been decimated by the ongoing restrictions, in the second half of the year.  There is no doubt that savings rates are higher now than they were before the pandemic, with the latest BEA data showing a 13.7% rate at the end of 2020 vs. a 7.3% rate at the end of 2019.  But the 2019 data was below the long-term (75 year) average savings rate of 9.0%, and two-thirds the rate seen from the end of WWII to1989.  The point is recent profligacy by the American people is something of a historical anomaly.  While Americans never saved like some other cultures, where savings rates would hover in the 20% range, historically, people really did try to save some money.

The other thing to remember is the past twelve months have been remarkably traumatic to the entire nation, if not the entire world, with a generation of children having their educations disrupted and changed significantly.  As was evident in the wake of the Great Depression, an entire generation altered their behavior, as the Roaring 20’s morphed into the Depression.  The one thing that hasn’t changed is human nature, with peoples’ response to trauma informing their future activities.  This is all a long-winded way of saying that, perhaps, there isn’t nearly as much pent-up demand for things as is currently assumed.  Perhaps, the increase in savings rate is a way for people, in general, to feel a bit more secure about their situation.  While FOMO will never completely disappear, it certainly could wane.

With this in mind, it is possible to turn a more critical eye at forecasts for GDP growth around the world going forward.  For instance, the UK reported that Q4 GDP rose 1.0%, well above forecasts of a 0.5% increase, and insuring that despite likely negative growth in Q1, there will be no double-dip recession.  But BOE Chief Economist, Andy Haldane was positively effusive in his forecasts, saying, “A year from now, annual growth could be in the double digits.”  Wow is all I can say.  That is an optimistic point of view, but it is not an isolated one.  Here in the US, forecasts now indicate that GDP will grow 4.9% in 2021, well above trend and enough to offset 2020’s 3.5% decline.  And maybe they are right.  Certainly, equity markets are all-in on the idea.  However, I would be cautious in blindly accepting these numbers as gospel given no econometric model takes into account the changes wrought in perceptions by Covid-19.  I fear growth could be much less impressive as 2021 evolves which means markets will need to adjust their thinking.  Stay nimble!

On to today’s session, which has seen another lackluster performance across markets.  With most of Asia closed for the New Year holiday, only the Nikkei (-0.15%) was trading and it displayed a general lack of interest.  European bourses are mixed with the DAX (-0.5%) a key underperformer while the CAC and FTSE 100 are both flat on the day.  Given the better than expected data from the UK, it would seem that performance is a bit disappointing, but there are ongoing Brexit travails which seem to be putting a damper on things.  US futures, meanwhile, had spent the bulk of the overnight session in the green, but are now all lower by about 0.2%.  It appears we may be seeing some risk being unloaded into the holiday weekend.

Bond markets are ever so slightly firmer this morning, with the biggest mover Italian BTP’s (-1.5bps) after the FiveStar party voted to support Super Mario for PM.  Otherwise, Treasury yields are essentially unchanged as are bunds and Gilts.

Oil (WTI -1.0%) is under pressure again today, for the second consecutive session, but the uptrend remains firmly in place.  This has all the hallmarks of a modest correction.  Gold, however, is under pressure as well, and has been lagging most other commodities.  Base metals are mixed as are agriculturals, which, again, tells you that there is no strong theme in the markets.

As to the dollar, it is broadly higher this morning, albeit not dramatically so.  In the G10, the commodity currencies are under the most pressure (NZD (-0.5%, AUD -0.3%, CAD -0.3%) but we are also seeing weakness in the two havens with both JPY and CHF softer by 0.3%.  In the emerging markets, RUB (-1.0%) is the weakest of the bunch after the central bank explained they won’t be cutting rates further amid concerns over new sanctions to be imposed by the EU as well as the ongoing spread of Covid.  But aside from the ruble, while most currencies in the bloc are softer, the movement has been relatively small, on the order of -0.1% to -0.3%, indicating this is really a dollar story.

On the data front, the only thing we see today is the preliminary Michigan Sentiment Survey (exp 80.9), which would need to be wildly different to change any views.  As well, we continue to lack Fed speakers, and the data has clearly not shown “substantial further progress” on the Fed’s efforts to support the economy, so policy changes are not in the air.

The dollar’s consolidation after a nearly year-long decline continues, although, as I mentioned yesterday, there seems little impetus for the dollar to extend its corrective rally.  Rather, it feels like we are going to see a little more market chop with no direction into the holiday weekend,

Good luck, good weekend and stay safe
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Our Dovish Song

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Said Powell, you all would be wrong,
Til progress moves further along,
On jobs and inflation
To think there’s causation
For us to change our dovish song

I challenge anyone to put forward the name of a central bank board member, from any major central bank, who is anything but dovish.  Once upon a time there was a spectrum of views ranging from neo-Keynesians, who believed it was the central bank’s job to continually support economic activity to the Austrian scholars, who believed that the less central bank activity, the better.  The neo-Keynesians pushed to maintain the lowest interest rates possible to encourage capital investment and by extension further economic growth.  They were far less concerned with price implications and far more concerned with the employment situation.  The Austrians were highly focused on price stability and believed that stable prices allowed people to have the confidence to create products and services demanded by the public, which would drive economic growth.  And there was a great middle with central bankers adhering to some of those views, but willing to be pragmatic.

But that is all ancient history now as there is only one type of central banker left in the world, the uber-dove.  Literally, every comment made by any central banker, whether from the Fed, the ECB, the BOJ, the BOE or anyplace else, describes the need, not only for ongoing easy money, but for massive fiscal stimulus as well.  There isn’t even a lone, voice in the wilderness, arguing the other side anymore.  The financialization of economies, which itself is the result of more than a decade of easy money, has resulted in an evolution of views.  In essence, interest rates, per se, are not the focus, but financial conditions.  And one of the key variables in every central bank measure of financial conditions is the price of the stock market indices.  A higher stock market means easier money, in this model, and so leads to further growth.  I fear they have the causality backwards (easy money leads to a higher stock market), but my views don’t matter.  Even formerly staunch monetary hawks, notably the Bundesbankers, are all-in for more stimulus and see no reason to consider any potential negative consequences of these actions.

This was made clear once again yesterday by comments from Lagarde, Powell and Bailey, all of whom continue to explain that their respective central bank will do whatever is necessary to support the economy, and, oh by the way, more fiscal stimulus is necessary as they can’t do it all by themselves.  While current central bank messaging tells us rates will remain low until at least 2023, look for that terminal date to continue to get pushed back.  We have already seen this play out for the ECB, where in 2018, they tried to explain that rates would begin to normalize by the end of 2020.  We all know that never happened.  Now they claim when the PPE uses up its authorization in 2022, that will be enough.  But it won’t.  They will simply expand and extend the terms again.  Here at home, we have already heard from numerous Fed speakers that if inflation were to rise to 2.5% or 3.0%, they wouldn’t be concerned.  And Powell, yesterday, was clear that more fiscal stimulus was needed to help the economy, and that the Fed would be adding even more liquidity until “substantial further progress” is made toward their goals.

So, what does this mean for markets?  It means that the inflation of asset price bubbles will continue, and that when looking at foreign exchange, the question will be which nation will maintain the easiest (or tightest) relative policy.  The broad view remains the Fed has more firepower than any other central bank, which is a key reason so many (present company included) believe the dollar will eventually decline.  But it will not be without a fight.  No other country believes they can afford for their own currency to appreciate or they won’t be able to achieve their goals.  Perhaps the real question is, what will be the catalyst to stop the flow of easy money?  And truthfully, I cannot see one on the horizon.  Traditionally, it would have been a rise in inflation, but that would be warmly welcomed by the current central bank heads, so there is really nothing left.

But perhaps, we are seeing a bit of fatigue on investors’ parts, as the trend higher in asset prices seems to have stalled for a time.  Certainly, there has been no decline of note, but it is not racing up like it had previously.  Does this mean the end is near?  I doubt it.  But remember this, when the last black swan appeared, Covid, central banks, notably the Fed, had some monetary policy room to adjust rates and try to address the problem.  When that next rare black avian appears, with rates already at zero or negative throughout the G10, what do they do next?

And on that cheery thought, let’s take a quick tour of what has been a pretty dull overnight session, where the Lunar New Year has begun to be celebrated.  In Asia, only the Hang Seng (+0.45%) was open with Japan closed for Coming of Age day, and Shanghai celebrating New Year’s.  PS, the Chinese celebration lasts for a full week.  In Europe, stocks started off mixed, but have edged higher over the past few hours with the DAX (+0.6%) leading the way followed by the FTSE 100 (+0.1%) and finally the CAC essentially unchanged on the day.  US futures markets are all higher, led by the NASDAQ (+0.5%) with the other two key indices up around 0.3%.

Bond markets, despite the growing positivity in stocks, are pretty healthy today as well.  Perhaps the never-ending promises by central bankers to continue to buy bonds is helping.  So, while Treasury yields are essentially unchanged, in Europe, Bunds, OATs and Gilts have all seen yields decline by about 2.3 basis points, and that price action is consistent across the smaller markets as well.

Oil (-0.7%) is lower today for a true change of pace, as it has rallied for the previous eight consecutive sessions.  Arguably, this is simply a trading pause, as there is no news of note that would drive the market.  Meanwhile, gold is unchanged on the day, although there is strength in the base metals space while ags remain mixed.

As to the dollar, it is under very modest pressure this morning, with AUD (+0.35%) the leading gainer in the G10 after mildly positive comments from the Treasury Secretary there.  But away from this, no other currency has moved even 0.2%, indicating there is nothing happening.  In the emerging markets, LATAM currencies are the leaders (CLP +0.8%, BRL +0.6%, MXN +0.5%) although don’t count out ZAR (+0.75%) either.  The ZAR story is a response to much better than expected mining production data while CLP has seen investor inflows into the bond market increase and Brazil is benefitting from a bill just passed granting autonomy to the central bank.  Be careful on MXN, as Banxico meets today and is expected to cut interest rates again, with a 25bp cut priced into the market, but some looking for more.

On the data front, yesterday’s CPI data was a bit softer than forecast, but didn’t seem to have much impact on the markets, although the dollar did edge lower after the release.  This morning, Initial Claims (exp 760K) and Continuing Claims (4.42M) are all we get and there are no Fed speakers slated.  So, on this snowy day in the northeast, I would look for the dollar to remain rangebound as it seeks its next catalyst.  To my eyes, the correction appears to be over, but we will need something else to get the dollar selling bandwagon rolling again.

Good luck and stay safe
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To Sell or To Buy

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As markets await CPI
For signals to sell or to buy
The Fed looks for ways
This reading to raise
But not for an outcome too high

Overnight activity in the markets has been fairly dull as investors and traders await a series of events that will unfold as the day progresses.  On the data front, Jan CPI readings are due with expectations as follows:

CPI (M/M) 0.3%
CPI (Y/Y) 1.5%
-ex food & energy (M/M) 0.2%
-ex food & energy (Y/Y) 1.5%

Source : Bloomberg

The one consistent thing about CPI readings since the nadir last May is that the outcome has been higher than forecast in 7 out of those 8 readings.  Perhaps it is time for economists to reconsider the variables in their forecasting models.  The implication is that inflation, which the Fed continues to avow is far too low, may not be as low as they say.

Now, despite the fact that the Fed (and pretty much every major central bank) has decided to ignore inflation readingsa until they get too high, instead focusing on supporting economic activity, the market still cares about inflation.  This is made clear by the ongoing discussion on real interest rates which are simply the result of the nominal interest rate less the inflation reading.  For example, while 10-year Treasury yields have risen to 1.15%, the real rate, using the December core CPI reading of 1.6%, is -0.45%.  When applied to the current 2-year Treasury yield of 0.115%, the real yield falls to -1.485%.

And this is where it starts to get interesting.  It turns out that investors are extremely focused on real yields as demonstrated by their correlation to different assets, notably the dollar and gold, but also stocks.  It is these negative real yields that continue to drive the search for yield which has resulted in non-investment grade (aka junk) bonds to be in such demand.  In fact, these less creditworthy instruments now yield less than 4.0%, a historic low, and not nearly enough to compensate for the risk of default.  But for investors, the real yield is +2.35%, far higher than they can receive elsewhere, and so worthy of the risk.  (When you read about those worrywarts who claim that central banks have distorted markets beyond recognition, this is the type of thing they are highlighting.)

But it is not just fixed income investors who focus on the real yield.  These yields impact virtually every investment.  Consider, for a moment, gold, an asset which pays no dividend and has no cash flow.  When real interest rates are high, there is a significant opportunity cost to holding the precious metal.  But as real yields decline below zero, that opportunity cost converts into a benefit which is why the correlation between real yields and gold is strongly negative (currently -0.31% with strong statistical significance).

Or consider the dollar.  There are many things that go into determining the dollar’s value at any given time, but clearly, interest rates are one of them.  After all, interest rates are a key feature of every currency discussion and define the activity in the carry trade.  Now, the dollar’s historic haven status along with that of Treasury bonds means that when things get bad, investors flock to both dollars and Treasuries which drives nominal, and therefore real, yields lower.  But in more benign circumstance, when there is no panic, relative real yields is a key driver in the FX market, with negative real US yields associated with a weaker dollar.  In fact, this is my main thesis for the second half of 2021, that inflation will continue to rise while the Fed will cap Treasury yields (because they have to) and the dollar will suffer accordingly.

Which brings us back to this morning’s CPI reading.  My sense is that we are reaching the point where the market will take higher inflation readings as a dollar negative, so beware any surprise in the data.

Adding to today’s mix, and arguably a key reason that overnight markets have been so dull, is that we are set to hear from three major central bank heads, starting with Madame Lagarde this morning, the BOE’s Andrew Bailey at noon and then our very own Chairman Jay at 2:00 this afternoon.  Keep in mind the following themes when listening: the ECB is carefully monitoring the exchange rate; the BOE has instructed banks to prepare for NIRP although claims this is not a policy change, and the Fed remains unconcerned if inflation were to rise to 2.5% or 3.0%.  All of this points to the idea that real yields, around the world, are going to decline further.  Sorry savers!

Now to the markets this morning.  While Asian equity markets performed well (Nikkei +0.2%, Hang Seng +1.9%, Shanghai +1.4%), the same is not true in Europe, where there is a mixture of red and green on the screen.  Here we see the FTSE 100 (+0.3%) as the leader, while both the CAC (-0.1%) and DAX (-0.2%) can find no traction today.  Finally, US futures are all higher by about 0.3% after consolidating yesterday at their recent closing highs.

Bond markets are under very modest pressure this morning with Treasury yields higher by 1 basis point and similar moves seen in Europe.  The one exception is Italy, which has seen 10-year yields decline to a new record low of 0.499% as investors anticipate great things from Mario Draghi’s turn as Prime Minister.

In the commodity markets, oil (+0.5%) continues to grind higher in its drive for $60/bbl, while gold is little changed on the day.  Base metals are all modestly higher but agriculturals are actually backing off a bit this morning.  Again, the picture is best described as mixed.

Finally, the dollar is also themeless today, with G10 currencies seeing modest strength from Europe (CHF +0.1%, GBP +0.1%, EUR flat) while NZD (-0.4%) leads the way lower for the Asian bloc.  However, there has been no data, or comments, yet, that would explain the movement.  This smacks of position adjustments as the recent dollar rebound tops out.

EMG currencies have similarly shown no general direction with both gainers and losers about equally split.  KRW (+0.9%) is the big winner after short positions were closed out ahead of the Lunar New Year holiday that begins tonight.  But beyond that, the winners saw gains of 0.2% or less, hardly the stuff of dreams.  Meanwhile, on the negative front, BRL (-0.6%) is opening in the worst spot as concerns grow over the fiscal situation as the country seems set to increase Covid related expenditures with no plans on how to pay for them.  The next worst performer is CZK (-0.5%) but this is more difficult to discern as there has been neither news nor data to drive the market.  This has all the earmarks of a significant flow that the market has not yet fully absorbed.

And that’s really it for the day.  The big picture remains that the dollar has bounced from its correction highs but has not yet been able to convincingly turn back down.  This argues for a few more sessions of choppiness unless we receive new news.  Perhaps CPI will be much higher (or lower) than expected, either of which can drive movement.  Or perhaps we will hear something new from one of the three central bank heads today which will change opinions.  But for now, choppy with nowhere to go seems the most likely outcome.

Good luck and stay safe
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