Tag Archives: #dollardown

As Much As They Want

Posted on by

Said Madame Lagarde with some jaunt
“They can test us as much as they want”
We’ve exceptional tools
And we still make the rules
These are words that could come back to haunt

If there were any questions as to the key driver in the markets, Madame Lagarde answered them tacitly this morning in a televised interview.  The number one driver of all things financial continues to be the yield on the 10-year Treasury bond and its knock-on effects for other markets.  Hence, when asked about the rising yields in the European sovereign markets, where similar to the Treasury market, yields are broadly at or near one-year high levels, she uttered what almost seemed like a challenge, “They can test us as much as they want.  We have exceptional circumstances to deal with at the moment and we have exceptional tools to use at the moment, and a battery of those.  We will use them as and when needed in order to deliver on our mandate and deliver on our pledge to the economy.”  While this doesn’t quite rise to Signor Draghi’s famous “whatever it takes” comment, it is certain that Lagarde was trying for the same impact.

Perhaps, however, something is lost in the translation from Italian to French, as the bond market stifled a collective yawn at her comments and yields continue to climb higher this morning, albeit not quite as dramatically as yesterday. So, a quick tour of European bond markets shows yields on the Bunds, OATs and Gilts all about 1 basis point higher, following right along with Treasury yields which are 2.2bps above yesterday’s close as I type.  While there is no doubt that this move higher in yields is getting a bit long in the tooth, and it would not be surprising to see a short-term respite, the underlying drivers, which remain a combination of anticipated excess new supply and rising prices, are still very much in place.  In fact, later today apparently President Biden is going to introduce his newest spending bill with a $2.25 trillion price tag.  This merely adds fuel to that fire of excess supply expectations.

There is one other thing that seems to belie the image of strength put forth by Lagarde, as well as by Chair Powell; the fact that they both go out of their way to explain that if when the time ever comes that they are actually going to slow down monetary injections, let alone actually reverse them, they will do so only after having given ample warning well in advance of such actions.  In other words, they remain terrified that taper tantrums are going to occur if they ever stop expanding their balance sheet, with a resulting decline in asset prices.  Now, the one thing that is abundantly clear, especially in the US, is that while there is a great deal of Fedspeak about achieving maximum employment, the Fed’s key indicator is the S&P 500.  Thus, a falling stock market will bring about a change in Fed policy faster than anything else.  However, it seems to me advance notice of tapering would not change the market reaction, merely its timing, so it is not clear what benefit they see in the idea.

Nonetheless, it remains the working thesis of central banks everywhere, that they must give significant forward guidance in order to be effective.  Yet once the market perceives an inflection point in that guidance, it is going to react immediately, even if the promised policy change is not until some future date.  My personal belief is that central banks would be far better off simply changing policies as they deem necessary without forward guidance and allow markets to find a new equilibrium after the policy change.  But that is a radical idea in today’s world.

In any case, there has been nothing new to change the ongoing narrative which remains the reflationary story is driving yields higher and the dollar along with them.  meanwhile, equity prices are beginning to struggle in the face of those rising yields as fixed income has started to become a viable alternative investment to equities, and the discount factor for future growth continues to point to lower current prices.  Thus, while markets this morning are taking a pause on their recent trajectory, with the dollar modestly softer along with most equity markets and commodities, much of this can be attributed to the fact that it is month and quarter end (and fiscal year end for many Asian nations), so recent positions may be reduced for balance sheet purposes.

So, let’s take a look at markets today.  Equity markets in Asia were mostly under pressure with the Nikkei (-0.9%), Hang Seng (-0.7%) and Shanghai (-0.4%) all weaker on the close.  Europe has seen a more mixed picture as the DAX (0.0%) has recovered from mild early losses, but the CAC (-0.2%) and FTSE 100 (-0.3%) are both feeling a bit of pressure.  US futures, meanwhile, continue their bipolar activities, this time with the NASDAQ (+0.65%) rising while the DOW (-0.2%) is under the gun.  However, remember that much rebalancing is likely to be seen again today given the calendar, so do not be surprised if there are short-term reversals to recent trends.

As to commodities, oil prices (-0.4%) are a touch softer this morning while gold (+0.1%) and silver (+0.25%) seem to have stabilized for the time being.  The base metal story is more mixed with Cu (+0.7%) on the day, but the rest of the main trading metals generally softer by a similar amount.

Finally, the dollar is under some pressure today, although given its run over the past week, this appears merely to be a short-term corrective.  In the G10, NOK (+0.5%) is the leading gainer, despite oil’s modest decline, as the market continues to look at the Norwegian economy and forecast Norgesbank may be the first G10 bank to raise interest rates. Inflation pressures appear to be building in the country and growth remains on the upswing.  Away from the krone, the rest of the bloc is firmer by between 0.2% and 0.3% with modest impact from CPI data across Europe showing prices rising compared to February, but a tick less than forecast in the major countries.  The one exception is JPY (-0.25%) which is simply cratering of late and has now declined about 7.5% in 2021. It appears that we are beginning to see an increase in unhedged Treasury buying by Japanese investors, with the 10-year yield spread now above 165 basis points, a level that historically has seen significant interest from the Japanese investment community.  In fact, if drawing a long-term trend line from its recent peak in early 2017, USDJPY appears to be breaking higher with a target of 112.00 a very real near-term possibility.

Regarding EMG currencies, there is general strength there as well, led by ZAR (+0.7%) and RUB (+0.6%) which have been two of the overall better performers for the week.  But in a broader sense, we are seeing modest reversals of what had been EMG currency weakness for the past week or more.

On the data front, ADP Employment (exp 550K) is the first part of the employment picture this morning with some whisper numbers growing for the NFP on Friday to over 1 million new jobs as the economy reopens.  We also see Chicago PMI (61.0), which should show continued growth in the manufacturing sector.  Overnight, Chinese PMI data (Composite 55.3) was much better than expected and indicates that the Chinese economy has moved past the Lunar New year lull.  There are no Fed speakers, but really, people will be focused on the new spending package, and more importantly, the indications of how it will be funded.  The less tax discussion, the likelihood of the bigger negative impact on the bond market.

As to the dollar today, the current trend remains clearly higher, but with month-end rebalancing taking place here as well, a touch of further weakness is quite viable on the day.

Good luck and stay safe
Adf

No Need to be Austere

Posted on by

From every Fed speaker we hear
That prices might rise some this year
But they all confirm
It will be short-term
So, there’s no need to be austere

I feel like today’s note can be very short as there really has been nothing new of note to discuss.  Risk is on the rise as market participants continue to absorb the Federal Reserve message that monetary stimulus is going to continue, at least at the current pace, for at least the next two years.  That’s a lot of new money, nearly $3 trillion more to add to the Fed balance sheet, and if things hold true to form, at least 60% of it will wind up in the equity market.

This was confirmed by four Fed speakers yesterday, including Powell and Vice Chair Clarida, who made it quite clear that this was no time to start tapering, and that rising bond yields were a vote of confidence in the economy, not a precursor to rising inflation.  What about inflation you may ask?  While they fully expect some higher readings in the short run due to base effects, they will be transitory and present no problem.  And if inflation should ever climb to a more persistent level that makes them uncomfortable, they have the tools to address that too!  I know I feel a lot better now.

Europe?  The big news was the German IFO Expectations index printing at a much better than expected 100.4, despite the fact that Covid continues to run rampant through the country.  While they have managed to avoid the massive Easter lockdown that had been proposed earlier this week, the ongoing failure to vaccinate the population remains a damper on activity, or at least the perception of activity.  Otherwise, we learned that Italy is struggling to pay its bills, as they need to find €15 billion quickly in order to continue the present level of fiscal support, but have a much tougher time borrowing, and have not yet received the money from the Eurozone fiscal support package.  In the end, however long the Fed is going to be expanding its balance sheet, you can be sure the ECB will be doing it longer.

The UK?  Retail Sales were released showing the expected gains relative to last month (+2.
1% M/M. -3.7% Y/Y) and excitement is building that given the rapid pace of vaccinations there, the economy may be able to reopen more fully fairly soon.  Certainly, the pound has been a beneficiary of this versus the euro, with the EURGBP cross having declined more than 5% this year, meaning the pound has appreciated vs. the euro by that much.  Perhaps Brexit is not as big a deal as some thought.

Japan?  The latest $1 trillion budget is being passed, which simply adds to the three supplementary budgets from last year totaling nearly $750 billion, with most observers expecting more supplementary budgets this year.  But hey, the Japanese have perfected the art of borrowing unfathomable sums, having the central bank monetize them and maintaining near zero interest rates.  Perhaps it should be no surprise that USDJPY has been rising, because on a relative basis, the Japanese situation does seem worse than that here in the US.

Other than these stories, things are just not that exciting.  The Suez Canal remains closed and we are starting to see ships reroute around the Cape of Good Hope in Africa, which adds more than a week to transit times and considerable expense.  But I’m sure these price rises are transitory too, just ask the Fed.

So, let’s take a quick tour of markets.  Equities are all green right now and were so overnight.  The three main Asian indices, Nikkei, Hang Seng and Shanghai, all rose 1.6% last night after US markets turned around in the afternoon.  European bourses are looking good, with the DAX (+0.6%), CAC (+0.4%) and FTSE 100 (+0.7%) all solidly higher on the day.  As to US futures, both Dow and S&P futures are a touch higher, 0.2% or so, but NASDAQ futures are under a bit of pressure at this hour, -0.3%.

In the bond market, 10-year Treasury yields are higher by 4.1bps in the wake of yesterday’s really mediocre 7-year auction.  While it wasn’t as bad as the last one of this maturity, it continues to call into question just how able the Treasury will be to sell sufficient bonds to fund all their wish list.  Even at $80 billion per month of purchases, the Fed is falling behind the curve here and may well need to pick up the pace if yields start to climb more.  I know that is not their current story, but oversupply is certainly at least part of the reason that Treasuries have been so weak.  And today, despite ECB support, European sovereign bonds are all lower with yields higher by 4.5bps or more virtually across the board.  Either the ECB has taken today off, or there are bigger worries afoot.  One little known fact is that alongside the ECB, European commercial banks had been huge buyers of their own country’s debt for all of last year.  However, that pace has slowed, so perhaps today’s movement is showing a lack of natural buyers here as well.

Commodity prices are pretty much firmer across the board with the exception of precious metals, which continue to suffer on the back of higher US yields.  But oil (+2.3%) is back at $60/bbl and base metals and agricultural prices are all firmer this morning.

Finally, the dollar is broadly weaker at this hour, with the commodity bloc of the G10 leading that group (NZD +0.5%), NOK (+0.4%), (AUD +0.4%), although the pound (+0.3%) is also doing well after the Retail Sales numbers.  Meanwhile, the havens are under pressure (JPY -0.5%), CHF (-0.15%), as there is no need for a haven when the central bank has your back!

EMG currencies are a bit less interesting, although the APAC bloc was almost uniformly higher by small amounts.  That was simply on the back of the risk-on attitude that was manifest overnight.  The one exception here is TRY (-1.1%) which continues to suffer over the change of central bank leadership and concerns that inflation will run rampant in Turkey.  Two other noteworthy things here were in LATAM, where Banxico left rates on hold at 4.0%  yesterday afternoon and reaffirmed they were entirely focused on data, and that S&P downgrade Chile’s credit rating to A from A+ on the back of the changes in government structure and concerns about the medium term fiscal position.

On the data front we see Personal Income (exp -7.2%), Personal Spending (-0.8%), Core PCE (1.5%) and then at 10:00 Michigan Sentiment (83.6).  To me, the only number that matters is the PCE print, but this is a February number, so not expected to be impacted by the significant base effects from last year’s events.  Of course, given the constant chorus of any rising inflation will be transitory, we will need to see a lot of high prints before the market gets nervous…or will we?  After all, the bond market seems to be getting nervous already.

At any rate, while the dollar is under pressure this morning, my take is that if US yields continue to climb, we are likely to see it retrace its steps.  At this point, I would argue the dollar’s trend is higher and will be until we see much higher inflation readings later this spring and summer.

Good luck, good weekend and stay safe
Adf

Flames of Concern

Posted on by

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: Bloomberg

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

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

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

Good luck and stay safe
Adf

On Edge

Posted on by

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

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
Adf

Right From the Script

Posted on by

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

Cash Will Be Free

Posted on by

The Chairman was, once again, clear
The theory to which they adhere
Is rates shall not rise
Until they apprise
That joblessness won’t reappear

The market responded with glee
Assured, now, that cash will be free
The dollar got whacked
And traders, bids, smacked
In bonds, sending yields on a spree

It does not seem that Chairman Powell could have been any clearer as to what the future holds in store for the FOMC…QE shall continue, and Fed Funds shall not rise under any circumstance.  And if there was any doubt (there wasn’t) that this was the committee’s view, Governor Brainerd reiterated the story in comments she made yesterday.  The point is that the Fed is all-in on easy money until maximum employment is achieved.

What is maximum employment you may ask?  It is whatever they choose to make it.  From a numerical perspective, it appears that the FOMC is now going to be looking at the Labor Force Participation rate as well as the U-6 Unemployment Rate, which counts not only those actively seeking a job (the familiar U-3 rate), but also those who are unemployed, underemployed or discouraged from looking for a job.  As an example, the current Unemployment Rate, or U-3, is 6.8% while the current U-6 rate is 12.0%.  Given the current estimated labor force of a bit over 160 million people, that difference is more than 8 million additional unemployed.

When combining this goal with the ongoing government lockdowns throughout the country, it would seem that the Fed will not be tightening policy for a very long time to come.  There is, of course, a potential fly in that particular ointment, the inflation rate.  Recall that the Fed’s mandate requires them to achieve both maximum employment and stable prices, something which they have now defined as average inflation, over an indefinite time, of 2.0%.  As I highlighted yesterday, the Fed remains sanguine about the prospects of inflation rising very far for any length of time.  In addition, numerous Fed speakers have explained that they have the tools to address that situation if it should arise.

But what if they are looking for inflation in all the wrong places?  After all, since 1977, when the Fed’s current mandate was enshrined into law, the U-3 Unemployment Rate was the benchmark.  Now, it appears they have determined that no longer tells the proper story, so they have widened their focus.  In the same vein, ought not they ask themselves if Core PCE is the best way to monitor price movement in the economy?  After all, it consistently underreports inflation relative to CPI and has done so 86% of the time since 2000, by an average of almost 0.3%.  Certainly, my personal perspective on prices is that they have been rising smartly for a number of years despite the Fed’s claims.  (I guess I don’t buy enough TV’s or computers to reap the benefits of deflation in those items.)  But the word on the street is that the Fed’s models all “work” better with PCE as the inflation input rather than CPI, and so that is what they use.

Carping by pundits will not change these things, nor will hectoring from Congress, were they so inclined.  In fact, the only thing that will change the current thinking is a new Fed chair with different views, a reborn Paul Volcker type.  Alas, that is not coming anytime soon, so the current Fed stance will be with us for the foreseeable future.  And remember, this story is playing out in a virtually identical manner in every other major central bank.

Which takes us to the market’s response to the latest retelling of, ‘How to Stop Worrying (about prices) and Start Keep Easing.’ (apologies to Dale Carnegie).  It can be no surprise that after the Fed chair reiterated his promise to keep the policy taps wide open that equity markets around the world rallied, that commodity prices continued to rise, and that the dollar has come under pressure.  Oh yeah, bond markets worldwide continue to sell off sharply as yields, from 10 years to 30 years, all rise.

Let’s start this morning’s tour in the government bond market where yields are not merely higher, but mostly a LOT higher in every major country.  The countdown looks like this:

US Treasuries +7.5bps
UK Gilts +7.3bps
German Bunds +5.4bps
French OATs +5.9bps
Italian BTPs +8.0bps
Australian ACGBs +11.8bps
Japanese JGBs +2.5bps

Source: Bloomberg

Folks, those are some pretty big moves and could well be seen as a rejection of the central banks preferred narrative that inflation is not a concern.  After all, even JGB’s, which the BOJ is targeting in the YCC efforts has found enough selling pressure to move the market.  Suffice it to say that current yields are the highest in the post-pandemic markets, although there is no indication that they are topping anytime soon.

On the equity front, Asia looked great (Nikkei +1.7%, Hang Seng +1.2%, Shanghai +0.5%) but Europe, which started off higher, is ceding those early gains and we now see the DAX (-0.4%), CAC (0.0%) and FTSE 100 (+0.2%) with quite pedestrian showings.  Perhaps a bit more ominous is the US futures markets where NASDAQ futures are -1.0%, although the S&P (-0.3%) and DOW (0.0%) are not showing the same concerns.  It seems the rotation from tech stocks to cyclicals is in full swing.

Commodity prices continue to rise generally with oil up, yet again, by a modest 0.25%, but base metals all much firmer as copper leads the way higher there on the reflation inflation trade.  Precious metals, though, are suffering (Gold -1.0%, Silver -0.2%) as it seems investors are beginning to see the value in holding Treasury bonds again now that there is actually some yield to be had.  For the time-being, real yields have been rising as nominal yields rise with no new inflation data.  However, once that inflation data starts to print higher, and it will, look for the precious metals complex to rebound.

Finally, the dollar is…mixed, and in quite an unusual fashion.  In the G10, the only laggard is JPY (-0.25%) while every other currency is firmer.  SEK (+0.55%) leads the way, but the euro (+0.5%) is right behind.  Perhaps the catalyst in both cases were firmer than expected Confidence readings, especially in the industrial space.  You cannot help but wonder if the central banks even understand what the markets are implying, but if they do, they are clearly willing to ignore the signs of how things may unfold going forward.

Anyway, in the G10 space, currencies have a classic risk-on stance.  But in the EMG space, things are very different.  The classic risk barometers, ZAR (-1.8%) and MXN (-1.4%) are telling a very different story, that risk is being shunned.  And the thing is, there is no story that I can find attached to either one.  For the rand, there is concern over government fiscal pledges, but I am confused by why fiscal prudence suddenly matters.  The only Mexican news seems to be a concern that the economy there is slower in Q1, something that I thought was already widely known.  At any rate, there are a number of other currencies in the red, BRL (-0.3%), TRY (-0.9%) that would also have been expected to perform well today.  The CE4 is tracking the euro higher, and Asian currencies were generally modestly upbeat.

As to data today, we see Durable Goods (exp 1.1%, 0.7% ex transport), Initial Claims (825K),  Continuing Claims (4.46M) and GDP (Q4 4.2%) all at 8:30.  Beware on the Claims data as the deep freeze and power outages through the center of the country could easily distort the numbers this week.  On the Fed front, now that Powell has told us the future, we get to hear from 5 more FOMC members who will undoubtedly tell us the same thing.

While the ECB may be “closely monitoring” long-term bond yields, for now, the market does not see that as enough of a threat to be concerned about capping those yields.  As such, all FX eyes remain on the short end of the curve, where Powell’s promises of free money forever are translating into dollar weakness.  Look for the euro to test the top of its recent trading range at 1.2350 in the coming sessions, although I am not yet convinced we break through.

Good luck and stay safe
Adf

More Havoc

Posted on by

Said Jay, ‘don’t know why you believe
That just because people perceive
Inflation is higher
That we would conspire
To raise rates, that’s really naïve

Instead, interest rates will remain
At zero until we attain
The outcome we seek
Although that may wreak
More havoc than financial gain

“The economy is a long way from our employment and inflation goals, and it is likely to take some time for substantial further progress to be achieved.”  So said Federal Reserve Chairman Jerome Powell at his Senate testimony yesterday morning.  If that is not a clear enough statement that the Fed will not be adjusting policy, at least in a tightening direction, for years to come, I don’t know what is.  Essentially, after he said that, the growing fears that US monetary policy would be tightening soon quickly dissipated, and the early fears exhibited in the equity markets, where the NASDAQ fell almost 4% at its worst level, were largely reversed.

However, the much more frightening comment was the hubris he demonstrated regarding inflation, “I really do not expect that we’ll be in a situation where inflation rises to troubling levels.  Inflation dynamics do change over time, but they don’t change on a dime, and so we don’t really see how a burst of fiscal support or spending that doesn’t last for many years would actually change those inflation dynamics.” [author’s emphasis].  Perhaps he has forgotten the 2017 tax cut package or the $2.2 trillion CARES act or the $900 billion second stimulus package last December, but it certainly seems like we have been adding fiscal support for many years.  And, of course, if the mooted $1.9 trillion stimulus bill passes through Congress, that would merely be adding fuel to the fire.

If one wanted an explanation for why government bond yields around the world are rising, one needs look no further than the attitude expressed by the Chairman.  Bond investors clearly see the threat of rising prices as a much nearer term phenomenon than central bankers.  The irony is that these rising prices are the accompaniment to a more robust recovery than had been anticipated by both markets and central bankers just months ago.  In other words, this should be seen as good news.  But the central banks fear that market moves in interest rates will actually work against their interests and have made clear they will fight those moves for a long time to come.  We have heard this from the ECB, the BOE, the RBA and the RBNZ just in the past week.  Oh yeah, the BOJ made clear that continued equity market purchases on their part will not be stopping either.  History has shown that when inflation starts to percolate, it can rise extremely rapidly in a short period of time, even after central bank’s change their policies.  Ignoring this history has the potential to be quite problematic.

But for now, the central banks have been able to maintain their control over markets, and every one of them remains committed to keeping the monetary taps open regardless of the data.  So, while the longest dated debt is likely to continue to see rising yields, as that is the point on the curve where central banks generally have the least impact, the fight between inflation hawks and central banks at the front of the curve is very likely to remain a win for the authorities, at least for now.

Turning our attention to today’s session we see that while Asian equity markets were uniformly awful (Nikkei -1.6%, Hang Seng -3.0%, Shanghai -2.0%), part of the problem was the announcement of an increased stamp duty by the Hong Kong government, meaning the tax on share trading was going higher.  Look for trading volumes to decrease a bit and prices to lag for a while.  Europe, however, has shown a bit more optimism, with the DAX (+0.6%) benefitting from a slightly better than expected performance in Q4 2020, where GDP was revised higher to a 0.3% gain from the original 0.1% estimate.  While Q1 2021 is going to be pretty lousy, forecast at -1.5% due to the lockdowns, Monday’s IFO Survey showed growing confidence that things will get better soon.  Meanwhile, the CAC (0.0%) and FTSE 100 (-0.1%) are not enjoying the same kind of performance, but they are certainly far better than what we saw in Asia.  And finally, US futures are mixed as NASDAQ futures (-0.2%) continue to lag the other indices, both of which are flat at this time.  Rising bond yields are really starting to impact the NASDAQ story.

Speaking of bonds, Treasury yields, after a modest reprieve yesterday, are once again selling off, with the 10-year seeing yields higher by 2.6bps.  Similarly, Gilts (+2.6bps) are under pressure as inflation expectations rise in the UK given their strong effort in vaccinating the entire population.  However, both Bunds and OATs are little changed this morning, as the ECB continues to show concern over rising yields, “closely monitoring” them which is code for they will expand purchases if yields rise too much.

On the commodity front, oil continues to rally, up a further 0.5%, and we are seeing a bit of a bid in precious metals as well (gold +0.2%).  Base metals have been more mixed, although copper continues to soar, and the agricultural space remains well bid.  Food costs more.

As to the dollar, mixed is a good description today with NZD (+0.7%) the leading gainer after some traders read the RBNZ comments as an indication less policy ease was needed.  As well, NOK (+0.5) is benefitting from oil’s ongoing rally, with CAD (+0.25%) a lesser beneficiary.  On the flip side, JPY (-0.5%) is the laggard, as carry trades using the yen as funding currency are gaining adherents again.  I would be remiss if I did not mention the pound (+0.2%), for its 13th trading gain in the past 15 sessions, during which it has risen over 4.3%.

In the EMG bloc, it is the commodity currencies that are leading the way higher with RUB (+1.2%) on the back of oil’s strength on top of the list, followed by CLP (+0.7%) on copper’s continued rally, MXN (+0.7%), oil related, and ZAR (+0.5%) on general commodity strength.  The only notable loser today is TRY (-0.8%), after comments by President Erdogan that Turkey is determined to reduce inflation and cut interest rates.

On the data front, New Home Sales (exp 856K) is the only release, although we hear from Chairman Powell again, as well as vice-Chairman Clarida.  Powell’s testimony to the House is unlikely to bring anything new and he will simply reiterate that their job is not done, and they will maintain current policy for a long time to come.

It seems to me that the dollar is trapped in its recent trading range and will need a significant catalyst to change opinions.  If the US yield curve continues to steepen, which seems likely, and that results in equity markets repricing to some extent, I think the dollar could retest the top of its recent range.  However, as long as the equity narrative continues to play out, that the Fed will prevent any sharp declines and the front end of the yield curve will stay put for years to come, I think an eventual break down in the dollar is likely.  That will be accelerated as inflation data starts to print higher, but that remains a few months away.  So, range trading it is for now.

Good luck and stay safe
Adf

Misled

Posted on by

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
Adf

Suspicions

Posted on by

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

Tempt the Fates

Posted on by

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