Not If But When

Eight years ago, when Chairman Ben
Suggested t’was not if but when
The Fed would reduce
Its purchase, profuse,
Of bonds, traders sold bonds, bought yen

But these days when taper’s discussed
The bond market doesn’t seem fussed
The reason could be
There’s now nobody
The market invests with its trust

Yesterday’s CPI data printed a tick higher than forecast indicating that, yes, prices are rising relative to last year.  The headline print of 2.6% was the beneficiary of a substantial rise in energy prices compared to last year, but the core price index indicated that both goods and services prices are rising in price.  One data point is not enough to make any claims in either direction, but it will certainly keep the discussion going for a while.  The market response was somewhat counterintuitive as by the end of the day, 10-year Treasury yields had fallen 6 basis points and the dollar was softer amid modestly firmer equity prices.  While the link between the dollar and Treasuries remains intact, the question is why would bonds rally (yields decline) if inflation was rising?

One possible answer is that the market had gotten far ahead of itself with respect to pricing in rising inflation.  Historically, inflation takes time to manifest itself as prices on many things are sticky, meaning they remain stable for a time amid broad pressures and then shift in a relatively large step, rather than a gradual daily or weekly increase.  We are all familiar with the situation when an item regularly purchased suddenly rises in price to catch up to the broad underlying price pressures.  But when taken over the totality of all goods purchased, while any given good or service may see prices rise in discrete steps, the index moves up in a relatively smooth manner.  This fact is why yesterday’s data are interesting, because the headline jump of 0.6% M/M certainly tests the definition of smooth.  Consider that a monthly increase of 0.6% would result in annual inflation of 7.4%, a level that even the Fed would consider too hot.  FYI, yesterday’s core print, which was actually 0.34%, would represent 4.2% core CPI over a year.  So, yes, the base effects were instrumental in the much higher Y/Y data, but the monthly increases were pretty high in any accounting.

And yet, the bond market ultimately rallied all day, having touched 1.7% in early European trading and closing the session at 1.615%.  If this wasn’t a classic case of buy the rumor, sell the news, I don’t know what is.  And, as we have seen consistently all year, the dollar dutifully followed yields lower while equity markets ultimately rallied, although the euphoria over the value trade seems to be waning.

Perhaps of more interest is the fact that we have now had 3 key central bankers, two from the ECB, Knot and Villeroy, and the Fed’s Bullard all start to discuss the idea of tapering bond purchases.  This seems incongruous given the adamant claims on both sides of the pond that current monetary policy is necessary and appropriate to ensure the respective economies return to form.  And yet each of these discussed how tapering of QE could begin before the year is out.  You may recall that Bullard wanted to tie the idea of tapering to the level of vaccinations in the economy, indicating that when 75% of the population is vaccinated, it could be time to start slowing purchases with the implication being the economy would then be able to stand on its own two feet.

This morning, Banque de France Governor Villeroy de Galhau explained that there could be an evolution in monetary policy at the ECB, which while remaining accommodative would shift the burden back to the APP (the original QE plan) from PEPP, which will ostensibly run its course in March 2022.  Last week, Knot, the Dutch Central Bank president expressed his view that the current expectations of robust growth in the second half of the year could be a signal to begin tapering asset purchases.  Now, understand that there were members from both central bank committees pushing back on the idea, but the fact remains that there is some consideration of tapering.  Today, we hear from Chairman Powell again, but we will not hear from Madame Lagarde until her press conference after the ECB meeting next week.

Adding up the disparate facts is quite difficult.  On the one hand, we have the first trial balloons floated regarding tapering of asset purchases as a response to the forecasts for extremely robust growth this year.  On the other hand, the market appears to have indicated that, at least for now, the idea of much faster growth leading to much higher inflation has run its course.  It strikes me that the market is unlikely to worry too much about these trial balloons until they hear from Powell and/or Lagarde.  Until then, it appears that a short period of higher inflation readings is on the cards and unless they really start to spike, that is unlikely to have a big impact on either equities or bonds.

Speaking of equities, yesterday saw the S&P 500 close at yet another new all-time high with the NASDAQ pushing back to within 1% of its February record.  Clearly, there is no inflation scare there.  Rather, all eyes are turning to the first earnings releases due today.  Overnight saw the Nikkei slide (-0.4%) but elsewhere in Asia equities rallied (Hang Seng +1.4%, Shanghai +0.5%).  European markets are mixed with the DAX (-0.1%) lagging while both the CAC (+0.4%) and FTSE 100 (+0.3%) continue to grind higher.  Apparently, Villeroy’s comments about tapering have not been seen as a danger.  US futures are modestly higher at this point, just 0.2% or so as the market bides its time ahead of Powell’s comments at noon.

In the bond market, after a big rally yesterday, the 10-year has seen yields back up slightly, by 1.1 bps, although European bonds are all looking at modest yield declines (Bunds -1.0bps, OATs -1.2bps, Gilts -0.3bps).  It has become pretty clear that the rush higher in yields has stalled for now, with important implications for all the other markets, especially the dollar.

Oil prices are continuing their recent rebound, with WTI +1.6%, although the price action in the metals markets remains confusing.  Precious metals rallied sharply yesterday but are little changed this morning.  Base metals continue to trade both ways with Cu (+1.1%) leading the way higher, but Al (-0.3%) lagging.  It all seems very much like a consolidation period ahead of the next leg higher.

As to the dollar, after sliding all day yesterday alongside Treasury yields, it is continuing lower this morning.  The leading gainer is NZD (+0.8%) which has rallied based on the market’s interpretation that standing pat by the RBNZ last night was actually hawkish, which has helped drag AUD (+0.65%) higher as well.  Oil is supporting NOK (+0.45%) but the rest of the moves are far less significant.  EMG currencies are also performing well this morning, led by KRW (+0.85%) and TRY (+0.5%).  The won was a beneficiary of the generally falling dollar as well as foreign inflows into the KOSPI.  TRY, on the other hand, simply offers yields that are too high to resist for certain investors, despite rising inflation there.

The only data today is the Fed’s Beige Book, to be released at 2:00, but aside from Powell at noon, we hear from four other Fed speakers including vice-chairman Clarida at 3:45 this afternoon.  Come Friday, the Fed will enter their quiet period ahead of the next FOMC meeting, so it seems everyone wants to get their thoughts aired ahead of that.

In the end, the dollar remains beholden to 10-year Treasury yields, so we could be in for a period of very limited movement, if Treasuries have found a new home.  Unless we hear something new from the Chairman today, I expect we are looking at a period of quiet for the next two weeks.  The calm before the storm.

Good luck and stay safe
Adf

A Simple Statistic

There once was a simple statistic
That people used as a heuristic
Of whether or not
The things that they bought
Cost more as a characteristic

But central banks worldwide decided
That view about costs was misguided
Instead they created
A world that inflated
The price of most all things provided

The market’s (and this author’s) virtual obsession with inflation continues and will receive the latest important data point at 8:30 this morning.  At that time, CPI will be released with the following median forecasts according to Bloomberg:

CPI MoM 0.5%
-ex food & energy MoM 0.2%
CPI YoY 2.5%
-ex food & energy YoY 1.5%

The last time CPI printed as high as 2.5% was January 2020, and prior to that it was October 2018.  As I wrote yesterday, the fact that the comparison on a YoY basis is so incredibly low due to the initial government lockdowns last year at this time, mathematically, this number is destined to be high.  After all, last month CPI YoY printed at 1.7%, so this is a big jump.  We also know that the Fed has made it clear that not only do they understand base effects, so will not get excited by today’s print regardless of its outcome, but that they remain essentially unconcerned about rising inflation anyway as they have interpreted their dual mandate to mean maximum employment at all costs.  Oh yeah, they don’t even consider CPI a worthy statistic for their own models, instead preferring Core PCE, which has a somewhat different philosophical background as well as a substantially different makeup as to the weights it assigns to the various items in its basket of goods and services.

Markets, however, do care about CPI as it appears to do a better job of reflecting the state of prices than PCE, and perhaps more importantly, CPI is the actual number used in most inflation adjusted products, notably TIPS and Social Security’s COLA.  My good friend Mike Ashton (@inflation_guy) is actually the best source of information on the topic and you should all follow him on Twitter as he produces thoughtful commentary on CPI the day of its release, breaking down the data.  What I have gleaned from his recent commentary is that there are many more things pointing to sustainably higher prices than simply the base effects of the calculation.  And I can’t help but notice how the price of things that I buy seem to continue to rise as well.  While the plural of anecdote is not data, at some point, enough anecdotes about higher prices has to have meaning.  Whether it is the cost of plywood, or a meal at your favorite restaurant or that bottle of ketchup at the supermarket, I am hard pressed to find anything that has fallen in price.  Certainly not gasoline, and even tech items cost more.  If you need a new laptop, while the hedonic adjustments made by the BLS may make theoretical sense, the reality is it still costs more dollars (or euros or yen) to actually walk out of the store with the new computer.

Alas, Chairman Powell and his band of Merry Men (and Women) have made it abundantly clear that rising prices are not of interest now or in the near future.  In fact, given the Fed’s current stance, why would they even discuss the idea of tapering QE at all.  If rising prices don’t matter, then lower interest rates will be a permanent support for the economy and offer the best insurance that not only will maximum employment be achieved but maintained.

Of course, there is the little matter of the Treasury bond market to contend with, as investors may have qualms over the interest rate at which they will lend to the US government in the face of rising prices.  We are all aware of how much Treasury yields have risen this year, especially in the 10-year and 30-year maturities.  Those higher yields are a result of both rising inflation concerns as well as significantly greater issuance.  Yesterday, for instance, the Treasury issued a total of $96 billion in new debt, $58 billion of 3-year and $38 billion of 10-year.  The 10-year auction results were about average, except for the fact that the yield they are paying, 1.68%, is more than 50 basis points higher than the average of the previous 5 auctions.  Remember, a key tenet of the Yellen Treasury is that they can afford to borrow much more since the debt service costs are so low.  However, if yields continue to rise, those debt service costs are going to rise with them, so this is not a permanent situation.

Tying it all together, despite the Fed’s current obsession with employment and its corresponding indifference to inflation, the inflation debate will not go away anytime soon.  This morning will simply be the latest volley in the ongoing ‘war’ between central banks and reality.  In the end, I’m confident reality will win, but the central banks have made it clear they will not go down without a fight.

As to markets this morning, after a very dull session yesterday, things remain quiet as this data point continues to be the global market focus.  So equity markets have been mixed in Asia (Nikkei +0.7%, Hang Seng +0.1%, Shanghai -0.5%) and Europe (DAX +0.1%, CAC +0.2%, FTSE 100 -0.1%) with US futures actually starting to slide as all three major indices are now lower by 0.4%-0.5% as I type.

Bond markets are modestly softer with Treasury yields higher by 0.5bps, and similar rises in the major European sovereign markets.  The PIGS are having a tougher day here, with Italy (+2.9bps) and Greece (+4.3bps) selling off a bit harder.  We also saw yields rise in Australia overnight.

Yesterday morning I mentioned oil’s struggle at $60/bbl and it continues as while prices are higher compared to yesterday’s close (WTI +0.75%), the price is right on that big round number, which tells us it fell back in yesterday’s session from early morning gains.  Metals markets are similarly mixed (Au -0.2%, Ag +0.6%, Cu +0.2%, Sn -0.3%) and it can be no surprise that grain markets have traded the same way.  In other words, pretty much every market is waiting for CPI to take their cues.

FX markets are starting to bias toward dollar strength as NY walks in, with NOK (-0.75%) the laggard in the G10, although on precious little news or data.  This is especially odd given oil’s gains in the session.  But pretty much the entire G10 is softer, albeit with less emphasis than the krone, as CAD (-0.45%) is the next worst performer and then the rest are simply drifting lower ahead of the number.  EMG markets are also biased toward USD strength here, with PLN (-0.8%) and HUF (-0.65%) the two outliers, both on the back of commentary that ongoing easy monetary policy remains appropriate and the central banks are comfortable with the weaker currencies.

The CPI data is the only release, but we will hear from 6 more Fed speakers today as pretty much all members of the FOMC are on the calendar this week.  Yesterday’s most notable comments came from St Louis Fed President Bullard as he floated a tapering trial balloon, hinting that when 75% of the population has been vaccinated, that might be an appropriate time to consider that option.  While it is clear that is Bullard’s proxy for a return to economic growth, it seems an odd data point on which to base monetary policy decisions, as the relationship between vaccinations and economic activity is not that direct.

At any rate, nothing has changed with respect to markets with 10-year Treasury yields remaining the key driver.  If today’s CPI is strong, and yields rise, look for the dollar to continue to rise as well, with a weak print, and lower yields likely softening the buck.  These days, it is truly binary.

Good luck and stay safe
Adf

Prices Are Rising

While Jay and the Fed are persuaded
Inflation won’t soon be upgraded
The press keeps advising
That prices are rising
How long can rate hikes be evaded?

Chairman Powell gave yet another interview this weekend, this time to a national audience on 60 Minutes last night.  A cynic might believe that the Chairman is concerned the Fed’s message, inflation is still quite low and will not present any problems, is not getting across to the general public.  While those of us in the financial markets are well aware of everything he utters, his fame amongst the general populace is far less significant.  (After all, I’m pretty certain he doesn’t have either an Instagram or TikTok presence!)  The problem for the Fed if they are unable to get their message across is that people might start to believe their own eyes what they read in the papers and lately, that is not synching well with the Fed’s message.  The number of stories on inflation has been inflating along with a clearly growing interest by the general population, at least as evidenced by the number of Google searches on the subject.  The fear here is that all of this talk of rising prices might result in a change in inflation expectations by the general population, and according to the Fed’s models, that is when inflation starts to rise.

The Fed is not the only central bank in this position as evidenced by comments this morning from Banca’d’Italia, and ECB Executive Board Member, Fabio Panetta’s comments, “We cannot be satisfied with inflation at 1.2% in 2022 and 1.4% in 2023.”  Here, too, the concern is over too low inflation although, in fairness, the inflationary impulse on the Continent is far less consistent than in the US.

One need not look too deep beneath the surface to find a viable explanation for this lack of concern over rising prices.  Clearly the ongoing need for central banks to continue to monetize purchase government debt issuance in order to support the government in power economy is the catalyst.  And there is no better rationale for a central bank to continue QE than a strong belief that inflation is too low along with a commitment to raise it.

That cynic might also question the timing of this 60 Minutes interview as it was aired just two days before the CPI data is to be released.  We are all aware that CPI prints for the next several months will be quite a bit higher than the Fed’s 2.0% target as the base effects from the initial impacts of the Covid-inspired lockdowns are now the comparison.  The month-on-month rate of CPI in March 2020 was -0.4% with it declining to -0.8% in April 2020.  Given the very real increases in price pressures we have observed in the past months, you can be sure that CPI tomorrow, currently expected at 0.5% M/M, 2.5% Y/Y will be quite high.  All told, Powell and the Fed will have to work overtime in order to ensure their message on inflation gets across, because if the general population starts to anticipate rising prices, even though the Fed ‘has tools’ to combat inflation, given the fragility of the economy, their ability to use those tools is highly suspect.  Inflation, once it gets rolling, has a history of being more persistent than desired, and as much as the Fed claimed to fear deflation, I’m pretty sure they are not looking forward to having to fight inflation either.  Especially as that would require actions that will slow the economy down, meaning they will be an easy political target for both sides of the aisle.

But CPI is tomorrow’s release, despite the fact that there are no less than ten stories on major media sites on the subject today.  In the meantime, markets are starting the week generally on their back foot, with risk definitely under some pressure today.  Equity markets in Asia, for instance, were all red (Nikkei -0.8%, Hang Seng -0.9%, Shanghai -1.1%) while European markets have been more mixed, but the mix is flat to down (DAX +0.1%, CAC 0.0%, FTSE 100 -0.4%).  US futures markets are also pointing slightly lower, with all three major indices off by about 0.15% as I type.

Bond market activity has been fairly quiet, with the 10-year Treasury yield unchanged on the day, although we are seeing very modest gains (yield declines) in most of Europe (Bunds -1.3bps, OATs -1.5bps).  Gilts are the lone exception here, with yields rising 1.0 basis point as the UK economy, despite a surprise spring snowstorm, welcomes the reopening of pubs for outdoor drinking/dining.  As the UK economy reopens, there is a great deal of focus on the £150 billion of savings that have accrued during the lockdown and how much of that will be quickly spent.  After all, that represents nearly 7% of GDP in the UK, and obviously, if spent would have a remarkable impact on growth there.

Commodity prices show oil rebounding from its recent lows (WTI +1.1%) as it pushes back to $60/bbl.  Metals prices, however, have been far more mixed with precious largely unchanged, and base metals showing both gains and losses (Cu -0.4%, Al +0.2%).

Finally, the dollar is edging lower this morning in general, but by no means universally.  G10 markets are led by GBP (+0.4%) on the economy reopening news and corresponding growth in confidence there, as well as JPY (+0.4%) which some will attribute to haven demand as equity markets suffered in Asia overnight, but I might attribute to Hideki Matsuyama’s fantastic win at the Masters yesterday.  On the downside, SEK (-0.25%) is the weakest of the bunch, which looks more like position trading than fundamentally driven activity.

EMG currencies are also mixed this morning, but most of the movement remains modest at best.  HUF (+0.6%) is the leading gainer followed by RUB (+0.3%) and PLN (+0.3%).  The HUF seems to be rallying on the news that the central bank will be buying the soon to be issued government green bonds as part of their QE exercise, helping to add demand there.  As to the other two, given the euro’s modest climb, it is no surprise to see EEMEA currencies rise.  On the downside, it is all APAC currencies that fell last night, led by INR (-0.4%) and KRW (-0.35%), which were victims of local equity market disposals by international investors.

Data wise, there is important information beyond tomorrow’s CPI as follows:

Today Monthly Budget Statement -$658B
Tuesday CPI 0.5% (2.5% Y/Y)
-ex food & energy 0.2% (1.5% Y/Y)
Wednesday Fed Beige Book
Thursday Initial Claims 700K
Continuing Claims 3700K
Retail Sales 5.5%
-ex autos 4.8%
Empire Manufacturing 18.8
Philly Fed 40.0
IP 2.5%
Capacity Utilization 75.6%
Business Inventories 0.5%
Friday Housing Starts 1600K
Building Permits 1750K
Michigan Sentiment 89.0

Source: Bloomberg

So, there is much to learn this week, especially on Thursday, although if the CPI data is large enough, it is likely to dominate conversation for a while.  The FOMC is back on tour this week with ten more speakers, including Chairman Powell on Wednesday, across at least 15 different venues.  I expect there will be a great deal of effort downplaying any thoughts that inflation is making a permanent comeback and that current policy is perfect for right now.

In the end, though, the dollar remains beholden to the Treasury bond, as do most markets, and so all eyes will continue to be on its movement going forward.  Strong data that pushes it to its recent high yield at 1.75% or beyond will result in the dollar rallying.  On the other hand, if the data goes the other way, look for the dollar to retreat a bit further.

Good luck and stay safe
Adf

On Edge

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

Covid’s Predations

There once was a time when reflation
Was cause for widespread celebration
Because it implied
That growth nationwide
Recovered from Covid’s predation

But lately concerns have been rising
That markets are destabilizing
As data that’s good
Does more than it should
To raise yields, thus need tranquilizing

There is an ongoing battle in markets these days, between the G10 central banks, led by the Fed, and the bond market and its investors and traders.  What we know with certainty is that the central banks are keen to maintain their easy money policies for a much longer period of time as they await clear economic recovery and a higher, but steady, inflation level.  In the past week we have heard from a number of different central bank speakers, notably Jay Powell and Christine Lagarde, that current policy settings are appropriate, and that while the sharp move higher in 10-year yields has “caught their eye” there is no indication they will respond.

But the other thing of which we are pretty certain is that markets love to test central banks when they think they have an edge.  And while the equity market mantra for the past decade has been, ‘don’t fight the Fed’, that is not really a bond market sentiment.  Rather, bond investors and traders will frequently make their collective views known via significant selling pressure driving interest rates up to a point where the central bank blinks.  And it certainly feels like that is an apt description of the current market price action.

The problem for the central banks is that they currently find themselves fighting this battle with one hand tied behind their back, and it is their own fault.  Remember, one of the key ‘tools’ that central banks use is forward guidance and verbal intervention to sway market opinion.  But the current timing is such that both the ECB and Fed have meetings upcoming and are in their self-imposed quiet periods, where central bank members are not supposed to make public comments that could impact markets.  And this means that they are unable to make comments implying imminent action if markets continue to misbehave.  Of course, the Fed could simply start buying longer dated debt in the market without announcing that is what they are doing, but while that may have been an acceptable methodology thirty years ago, the Fed’s MO these days is that they feel they must explain everything they do, so seems highly unlikely.

Thus we have a situation where bond investors see news stories like the passage by the Senate of the $1.9 trillion stimulus bill, the increased rate of vaccinations throughout the US population and the rapidly declining pace of infection and have jumped to the conclusion that the recovery in the US is going to be both sooner and more robust than earlier forecasts.  This, in turn, has them believing that inflation is going to pick up and that the Fed will be forced to raise rates to cool the economy.  At the same time, Powell (and Lagarde) could not have been more explicit in their comments that current policy is appropriate, and they have no intention of adjusting it until they achieve their goals.  And, by the way, those goalposts have moved quite a bit since the last tightening cycle, such that headline gains in economic data is not nearly good enough, instead they are focused on subsectors of that data like minority employment and wage growth, historically the last part of the economy to benefit from a recovery.

Add it all up and you have a situation where the bond market is observing much faster growth and raising rates accordingly while the Fed is looking at the pockets of the economy where things move more slowly and trying to boost them.  The Fed’s problem is higher rates are not helping their cause, nor are they helping to maintain easy financial conditions.  And their other current problem is they can’t even talk about it for another 9 days.  Markets can wreak a great deal of havoc in a period that long as evidenced by this morning’s rising 10-year yields and declining stock futures during the first day of that quiet period.

Which is a perfect segue into today’s session, where risk is largely under pressure.  Last night saw weakness throughout Asian equity indices with the Nikkei (-0.4%), Hang Seng (-1.9%) and Shanghai (-2.3%) all lower although there were pockets of strength in the commodity producing countries.  Europe, on the other hand, is broadly higher this morning led by Italy’s FTSE MIB (+2.0%) but seeing strength elsewhere (DAX +1.3%, CAC +0.9%) on news that the European vaccination program is scheduled to pick up the pace.  US futures, though, are continuing to feel the pressure from higher US yields, especially in the tech space as the NASDAQ (-1.5%) leads the decline with the S&P (-0.5%) and DOW (-0.1%) not nearly as badly impacted.

But Treasury yields continue to rise with the 10-year higher by another 2.5 basis point this morning and pressing 1.60% again, a level it touched Friday after the much better than expected payroll report.  However, in Europe, bonds are mixed with Bunds (+0.7bps) a bit softer while OATs and Gilts have both seen yields edge lower by 0.5bps.

Commodity prices continue to perform well in response to the improving data and increasing vaccination rates with oil (+0.3%) modestly higher and maintaining the highest levels seen in more than 2 years.  In the metals markets, base metals are mixed while precious metals continue to suffer from rising US yields.  And finally, agricultural products continue their steady rise higher.

Lastly, the dollar continues to benefit from higher yields as it is higher vs. literally every one of its counterparts in both the G10 and EMG.  There is no need to discuss specific stories here as this is a universal dollar strength situation, where investors are beginning to unwind emerging market positions as well as their short dollar views.  While those positions remain elevated in comparison to historical levels, they have been reduced by about 40% from the peak shorts seen last
August.

On the data front, arguably the most important data point this week is Wednesday’s CPI, but there is a bit more than that coming out.

Tuesday NFIB Small Biz Optimism 96.5
Wednesday CPI 0.4% (1.7% Y/Y)
-ex food & energy 0.2% (1.4% Y/Y)
Thursday ECB meeting -0.5% (unchanged)
Initial Claims 725K
Continuing Claims 4.2M
JOLTs Job Openings 6650K
Friday PPI 0.4% (2.7% Y/Y)
-ex food & energy 0.2% (2.6% Y/Y)
Michigan Sentiment 78.0

Source: Bloomberg

I think it could be instructive to see that PPI data as well, which could be a harbinger of CPI in the coming months.  Now I know that Jay has explained this will be transient, and he may well be right, but history shows the bond market will need to see proof inflation is transient before calming down.

Obviously, there are no Fed speakers scheduled and we don’t hear from the ECB until Thursday, so market participants have free reign to do what they see is correct.  Currently, rising rates has called into question the validity of the tech stock boom and seen a rotation into value stocks.  Meanwhile, rising rates has also seen general pressure on stock indices and the dollar continues to benefit from that scenario.  As I have written many times, historically a steeper US yield curve meant a strong dollar, and as the curve continues to bear steepen, it is hard to call a top for the greenback.

Good luck and stay safe
Adf

To Sell or To Buy

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
Adf

De Minimis Sellin’

There once was a Fed Chair named Yellen
Whose term saw di minimis sellin’
Of bonds or of stocks
As from her soapbox
She promised a balance sheet swellin’

But now she’s the Treasury Sec
And her goal’s to get a blank check
For spending, not saving
Though that might be paving
The way to a financial wreck

Investors continue to add to their risk portfolios this morning amid the never-ending hopes for yet more fiscal stimulus from the US.  This can be seen most clearly from the combination of rising stock prices and rising bond yields.  In classic risk-on fashion, the ongoing speculative mania continues to drive equity markets higher around the world.  Asia is uniformly green, with the Nikkei (+2.1%) leading the way but strength in Shanghai (+1.0%) and Hong Kong (+0.1%).  The concern for the latter has to do with the upcoming Lunar New Year holiday and the fact that the link between the mainland and Hong Kong stock markets will be turned off during that period, thus reducing inflows. Meanwhile, Europe is also firmer across the board with Italy’s FTSE MIB (+1.4%) the leader as investors gain confidence that Super Mario Draghi will be as “successful” a PM as he was an ECB President.  But the FTSE 100 (+0.95%), CAC (+0.6%) and DAX (+0.3%) are all firmer with the DAX lagging on the back of weaker than expected IP data (0.0%, exp +0.3%) indicating that the ongoing lockdowns in Germany, which are slated to continue for another 6 to 8 weeks, are taking a toll.  And don’t worry, US futures are all green too, higher by roughly 0.4% each.

The second piece of this puzzle is the bond market, which is behaving exactly as expected in a risk-on session by selling off nicely.  In fact, Treasury yields have touched new highs for the move with the 10-year at 1.19% (+2.9bps) while 30-year bonds have just traded to 2.00% for the first time since Feb 19 of last year, right as the Covid crisis was beginning.  But this is not an isolated US feature, we are seeing higher yields throughout Europe, Italy excepted, as Bunds (+2.6bps), OATs (+2.5bps) and Gilts (+3.3bps) are all under pressure today.  Why, you may ask, are European bond markets selling off if the story is US stimulus?  Because it’s one big global trade, and if the $1.9 trillion stimulus package gets passed, the idea is a faster US recovery will support European and Asian companies that sell into the US.

Of course, politics being what it is, even control of the House and Senate doesn’t mean that passing a bill this large is easy.  And this is where Ms Yellen comes in, she needs to forcefully make the case passage is critical for the nation’s economy.  The problem is that the recent data trend, which has been generally better than expected (excluding Friday’s jobs data) points to the fact that perhaps not so much stimulus is needed.  So, on the Sunday morning talk shows she was emphatic in her comments that it is critical, and that erring by spending too much is a significantly better mistake than spending too little.  Interestingly, even some left-leaning economists don’t back that view.  Notably, Larry Summers, former director of the National Economic Council for President Obama, and Olivier Blanchard, former chief economist at the IMF, have highlighted the risks to this package on two fronts; first, it could result in inflation and second, it may prevent the passage of other legislation focused on infrastructure and green investment deemed more important.

Now, the one thing we know about Congress is that virtually none of the members of either the House or Senate have any understanding of economics or finance.  As such, they take their cues from their financial backers staffers and the pronouncements of eminent economists from their side of the aisle.  And this is what makes the Summers and Blanchard comments noteworthy, they are both clearly left of center and both are arguing for less Covid stimulus. Janet has her work cut out for her to get what she wants.  Ironically, the fact that this package may not be passed until March is probably a positive for stocks, after all, that means another 4-6 weeks of stimulus hopes!

A quick look at commodity prices shows that virtually every commodity price is higher this morning led by oil (+1.3%), but with strength in precious metals (gold +0.4%, silver +1.0%) and agriculturals (wheat +0.7%, corn +0.6%).  Again, this is a risk-on market.

The one piece of the relation trade narrative that continues to fail, however, is the weak dollar story.  For now, before inflation data starts to rise sharply and real yields tumble, rising US rates are leading to a rising US dollar.  So, this morning the pound (-0.4%) is the laggard, but the weakness is across the board.  Even NOK (-0.1% and CAD (-0.15%) are softer despite the ongoing oil price rally.  In fact, the entire commodity bloc is suffering despite firmer commodity prices.  This is true in emerging markets as well which is led lower by ZAR (-1.0%) and both BRL (-0.7%) and MXN (-0.7%) today.  The rand story continues to be virus related as the vaccine rollout stalls given the realization that the new strain of virus is not responding well to the AstraZeneca vaccines they have.  In fact, the vaccine story is part of the LATAM problems, but of greater consequence is the fact that as US yields rise, the carry trade is becoming less attractive, and both these currencies are beneficiaries of carry.  On the plus side in EMG, KRW (+0.35%) is the best performing currency around after virus restrictions were eased somewhat amid declining infection statistics.

Speaking of statistics, it is a very quiet week on the data front, with CPI the marquis number on Wednesday.

Tuesday NFIB Small Biz Optimism 97.5
JOLTs Job Openings 6.4M
Wednesday CPI 0.3% (1.5% Y/Y)
-ex food & energy 0.2% (1.5% Y/Y)
Thursday Initial Claims 760K
Continuing Claims 4.41M
Friday Michigan Sentiment 80.9

Source: Bloomberg

Regarding the CPI data, it has printed higher than the survey in all but one month since June and given the ongoing inflationary pressures of higher commodity prices and supply chain issues, my sense is we will see that again.  On the speaking front, just three Fed speakers this week, Mester today, Bullard tomorrow and then Chairman Powell speaks Wednesday afternoon.  This makes Wednesday the day to watch.  Until then, I expect the market will focus on stimulus matters and equity prices.  If US yields continue to rise I suspect the dollar will test resistance again, with the key level in the euro at 1.1910.  Once again, nothing has changed my medium-term view about dollar weakness, and last week did see a halving of the long euro positions in the CFTC data, but for now, I feel like the dollar still has the upper hand.

Good luck and stay safe
Adf

What Will the Fed Do?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
Adf

The UK’s Current Plight

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
Adf

Compelled

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: Bloomberg

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

Good luck and stay safe
Adf