Tag Archives: #dollarup

Central Banks Fear

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
Adf

Our Fear and Our Dread

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

Powell’s Dismay

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

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
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Covid’s Predations

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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
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Not On His Watch

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Rumors were rampant
Kuroda would let yields rise
Oops! Not on his watch
 
Perhaps Chairman Powell should look east for clues on how to manage bond market expectations, as his efforts yesterday can only be termed a disaster.  However, Haruhiko Kuroda was quite successful in talking down the back end of the JGB curve, and the BOJ didn’t have to spend a single dime yen. 
 
Last night, Kuroda-san was speaking to parliament on a number of issues when he was asked, point blank, if the BOJ was considering widening the yield band on 10-year JGB’s.  He replied, “Personally, I believe it’s neither necessary nor appropriate to expand the band.  There’s no change in the importance of keeping the yield curve stable at a lower level.”  And just like that, JGB yields tumbled across the board with 10-year yields falling 5bps to 0.05%.  The genesis of the question came about as rumors have been constant that during the ongoing BOJ policy review, with conclusions set to be announced later this month, the BOJ would allow a wider band around their 10-year YCC target of 0.0% as a means of steepening the yield curve to help the banking sector.  But clearly, that is not on the cards, so whatever changes may be announced next month, it seems that portion of the current policy is remaining unchanged. The market response was immediate in bond markets, but also in FX as the yen quickly fell 0.5% and is now trading at its weakest level since last June.  Perhaps what is more interesting about the yen’s move is the trajectory of its declines, which are starting to go parabolic.  Beware a much weaker yen, with a short-term test of 110 seemingly on the cards.
 
Chair Jay tried quite hard to explain
That joblessness is still the bane
Of policy goals
Thus, rising payrolls
Are needed ere rates rise again
 
But what he said, and markets heard
Was different and that is what spurred
A bond market rout
And stock buying drought
While dollar buys were undeterred
 
Meanwhile, back at the ranch…Chairman Powell made his last comments yesterday before the quiet period begins ahead of the mid-March FOMC meeting.  In an interview he explained that the FOMC remains quite far from its goals of maximum employment and stable (2% inflation) prices and that they would not be altering policy until those goals are achieved.  However, he did not indicate that they would be expanding their current easy money stance, either by expanding QE or extending the tenor of purchases, and he remained sanguine when asked about the steepening of the yield curve, explaining that it was a positive sign of growth expectations.
 
Alas, it is not that simple for the Fed as they have put themselves in a very difficult position.  Financial conditions, while seemingly an amorphous term, actually has some precision.  The Chicago Fed has an index with 105 variables but Goldman Sachs has created a much simpler version with just 4 variables; riskless interest rates (10-year yields), equity valuations (S&P 500), Credit Spreads (CDX) and the exchange rate (DXY).  Directionally, conditions are tightening when yields rise, stocks fall, credit spreads widen and the dollar rises, which is exactly what is happening right now!  In fact, in the wake of the Powell comments, they all got tighter.  Now, I’m pretty sure that was not Powell’s intention, but nonetheless, it was the result. 
 
The problem Powell and the Fed have is that, like Pavlov’s dogs, markets begin to drool at the sound of a Powell speech in anticipation of further easy money to prop things up.  But the market has extended this concept to the back end of the curve, not just the front, and the Fed, unless they change policy, has far less control out there.  It was this setup that put the pressure on Powell to ease policy further, and when he did not change his tune, the market had a little fit. 
 
Now, remember, the Fed is in its quiet period for the next 12 days, 8 of which will see markets open and trading.  Markets have a history of testing the Fed when they want something, and the Fed’s reaction function, ever since Maestro Alan Greenspan was Fed Chair in 1987 during the Black Monday stock market rout, has been to flood the market with more liquidity when markets sell off.  With that in mind, I would not be surprised to see 10-year yields test 2.0% in the next two weeks as the market tries to force the Fed’s hand.  Be prepared for more volatility and tighter financial conditions as defined by the index I described above.
 
Which leads us to today’s market activity, where risk is clearly under some pressure ahead of the payroll report this morning.  In Asia, equities were broadly, but not deeply, lower (Nikkei -0.25%, Hang Seng -0.5%, Shanghai -0.1%) while in Europe, early losses every where have eased and the picture is now mixed (DAX -0.6%, CAC -0.3%, FTSE 100 +0.4%).  US futures, which had been in negative territory all evening have turned higher and are currently up by roughly 0.15%.
 
Bonds, however, are universally softer with yields rising everywhere (except JGB’s last night).  So, Bunds (+1.2bps), OATs (+1.5bps) and Gilts (+4.2bps) lead the yield parade higher with Treasuries currently unchanged, although this is after yesterday’s 8bp rout.  Australian ACGBs continue to sell off sharply with yields higher by another 6bps overnight which takes that move to 63bps in the past month.
 
On the commodity front, OPEC+ surprised markets yesterday by leaving production unchanged vs. an expectation that they would increase it by 1 million bpd, which resulted in a sharp rally in oil prices which has continued this morning.  WTI (+2.5%) is now above $65/bbl for the first time since October 2018.  Base metals have rallied as well while precious metals are still suffering from the higher real yields attached to higher nominal yields.
 
And finally, the dollar, which is higher vs. almost every one of its counterparts this morning, with only NOK (+0.2%) and RUB (+0.3%) benefitting from the oil rally enough to overcome the dollar’s yield effect.  But elsewhere in the G10, AUD (-0.7%) and NZD -0.75%) are leading the way lower with GBP (-0.55%) also under the gun.  Now, we are seeing yields rise in all these currencies, but a big part of this move is clearly position unwinding as the massive short dollar positions that have been evident since Q4 2020 are starting to feel more pressure and getting unwound.  The euro, too, is softer, -0.3%, which has taken it below its previous correction lows, and technically opens up a test of the 200-day moving average at 1.1825.
 
In the EMG bloc, the weakness is widespread with CE4 currencies leading the euro lower, LATAM currencies (CLP -0.65%, MXN -0.6%, BRL -0.25%) all under pressure and most APAC currencies having performed poorly overnight, including CNY (-0.3%) which fell despite the new Five Year plan forecasting GDP growth above 6.0% this year.
 
And finally, the data story where we have payrolls this morning:
 

Nonfarm Payrolls

198K

Private Payrolls

195K

Manufacturing Payrolls

15K

Unemployment Rate

6.3%

Participation Rate

61.4%

Average Hourly Earnings

0.2% (5.3% Y/Y)

Average Weekly Hours

34.9

Trade Balance

-$67.5B


Source: Bloomberg
 
The thing is, while this number usually means a lot, I think there is asymmetric risk attached today.  A weak number will not do anything, while a strong number could well see the next leg of the bond market rout and ensuing stock market weakness.  Traders, when they are in the mood to test the Fed, will jump on any excuse, and this would be a good one.
 
For right now, the dollar has the upper hand, and I see no reason for that to change until we hear something different from the Fed.  And that is two weeks away!
 
Good luck, good weekend and stay safe
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No Paradox

Posted on by

In Europe, the ECB hawks
Explained in their most recent talks
The rising of late
In THE 10-year rate
Was normal and no paradox

At home, hawks are also reduced
To cheering the 10-year yield’s boost
Since Powell’s a dove
And rules from above
The hawks can’t shake him from his roost

In a world where every central bank is adding massive amounts of liquidity, how can you determine which central bankers are hawks and which are doves?  Since no one is allowed to make the case that short-term rates should be raised to try to slow down rising inflation, the next best thing for the hawks to do is to cheer on the rise in longer term yields.  And that continues to be the number one story in markets around the world, rising bond yields.  Yesterday saw Treasury yields rise 9 basis points as investors continue to see US data point to rising inflationary pressures.  The ISM Services Price Index rose to its highest level since 2008, just like we saw in the Manufacturing Index on Monday.  Even official inflation measures continue to print a bit higher than forecast, a sign that underlying price pressures are quite widespread.

In the past, this type of economic data would encourage the hawkish contingent of every central bank to argue for raising the short-term rate.  But hawkish views appear to have been written by Dr Seuss, as they have been removed from the canon of financial discussion.  Which leaves the back end of the curve the only place where they can express their views.  And so, we now hear from Klaas Knot, Dutch central bank president that rising government bond yields are a “positive story”, while Jens Weidmann, Bundesbank president explained that these moves are not “a particularly worrisome development.”  We have heard the same thing from Fed speakers as well, although not universally, as the doves, notably Lael Brainerd, hint at Fed action to prevent an unruly market.  My take is an unruly market is one that goes in the opposite direction to their desires.

But despite the central bank commentary, it is becoming ever clearer that inflationary pressures are rising around the world.  We have spent the past 40 years in an environment of constantly decreasing inflation as a combination of globalization and technological advancement have reduced the cost of so many things.  And while technology continues to march forward, globalization is under severe attack, even from its previous political cheerleaders.  This is evident in the current US administration, where strengthening and localizing supply chains is a goal, something that will clearly increase costs.  Add to that increased shipping costs alongside capacity shortages and rising energy costs, and you have the makings of a higher price regime.  (An anecdote on rising price pressures: a friend of mine who lives in Paris told me the prices of the following foods; fresh salmon €60/kg, 1 grapefruit €2.25 and 1 avocado €2.65.  I checked my supermarket app and found the following prices here in New Jersey; fresh salmon $9.99/lb, 1 grapefruit $1.00 and 1 avocado $2.50.  Prices are high and rising everywhere!)

The final piece of this puzzle is broad economic activity, which the data continues to show has seen a real burst in the US, although there is still concern over the employment situation.  Every survey has shown the US economy growing rapidly in Q1 with the Atlanta Fed’s GDPNow forecast currently at 10%.  Adding it all up leads to the following understanding; it is not only the Fed that is willing to run the economy hot, but every G10 central bank, which means that monetary support will continue to flow for years to come.  Combining that activity with the massive fiscal support and the still significant supply bottlenecks that were a result of the government shutdowns in response to Covid brings about a scenario where there is a ton of money in the system and not enough goods to satisfy the demand.  If central banks don’t tap the breaks, rising prices and price expectations will lead to rising yields, and ultimately to declining equities.  The only asset class that will continue to perform is commodities, because owning “stuff” will be a better trade than owning paper assets.  And that’s enough of those cheery thoughts.

On to today’s markets, where, alas, risk is being jettisoned around the world.  After yesterday’s tech led selloff in the US, Asian equity markets really got hammered (Nikkei -2.1%, Hang Seng -2.1%, Shanghai -2.1%) and European markets are also under the gun (DAX -0.45%, CAC -0.3%, FTSE 100 -1.0%).  US futures?  All red at this hour, down about 0.3%, although that is off the lows seen earlier this morning.

Bond yields, meanwhile, despite my discussion of how they are rising, have actually slipped back a bit this morning in classic risk-off price action.  So, Treasuries (-1.9bps), Bunds (-2.6bps), OATs (-2.1bps) and Gilts (-4.1bps) are all rallying.  But this is not a trend change, it is merely indicative of the fact that now that yields have backed up substantially, the concept of government bonds as an effective risk mitigant is coming back in vogue.  After all, when 10-yr Treasuries yield 0.7%, it hardly offers protection to a portfolio, but at more than double that rate, it is starting to help a little in times of stress.

Commodity prices are mixed this morning with oil taking back early session losses to sit unchanged as I type, but base metals in the midst of a modest correction after a remarkable rally for the past several months.  This morning copper (-4.1%) and Nickel (-8.2%) are leading the way lower, but with the ongoing economic activity and absence of new capacity, these are almost certainly temporary moves.  Gold, which has been under significant pressure lately seems to have found a floor, perhaps only temporarily, at $1700, but given the dollar’s ongoing strength, it cannot be surprising gold remains under pressure.

As to the dollar, I would say it is very modestly stronger today, although what had earlier been virtually universal has now ebbed back a bit.  In the G10, CHF (-0.4%) and JPY (-0.3%) are the worst performers, which given the risk attitude is actually quite surprising.  I think the Swiss story is actually a Polish one, where Poland has refused to support local banks who took out CHF loans and have been suffering from currency strength far outstripping the interest rate benefits.  It seems, concern is growing that these loans may be restructured and ultimately impact the Swiss banks and Swiss economy.  Meanwhile, the yen’s weakness stems from a poor response to a 30-year bond sale last night, where yields rose 3.5 bps amid a very weak bid-to-cover ratio for the sale.  Perhaps even the Japanese are getting tired of zero rates!  But away from those two currencies, the rest of the bloc is +/- 0.2% or less, indicating nothing of real interest is going on.

EMG currencies are also mixed with Asian currencies suffering amid the broad risk off environment overnight and CE4 currencies lower on the back of euro weakness.  On the plus side, BRL (+0.7%) and MXN (+0.6%) are the leading gainers, which appears to be an ongoing reaction to aggressive central bank of Brazil intervention to try to prevent further weakness there.  In this space too, the broad risk appetite will continue to remain key.

On the data front we see a bunch of stuff starting with Initial Claims (exp 750K) and Continuing Claims (4.3M), but we also see Nonfarm Productivity (-4.7%), Unit Labor Costs (6.6%) and Factory Orders (2.1%) this morning.  Perhaps of more importance we hear from Chairman Powell today, right at noon, and all eyes and ears will be focused on how he describes recent market activity as well as to see if he hints at any type of Fed response.  Many pundits, this one included, believe there is a cap to how high the Fed will allow yields to rise, the question is, what is that cap.  I have heard several compelling arguments that 2.0% is where things start to become uncomfortable for the Fed, but ultimately, I believe that it will depend on the data.  If the data starts to show that the economy is under pressure before 2.0% is reached, the Fed will step in at that time and stop the madness.  Until then, as we have heard from central bankers worldwide, higher yields in the back end are a good thing, so they will continue to be with us for the foreseeable future.  And yes, that means that until US inflation data starts to print higher, and real yields start to decline, the dollar is very likely to retain its bid.

Good luck and stay safe
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More Terrified

Posted on by

The narrative starting to form
Is bond market vol’s the new norm
But Jay and Christine
Explain they’re serene
Regarding this new firestorm

However, the impact worldwide
Is some nations must set aside
Their plans for more spending
As yields are ascending
And FinMins grow more terrified

Confusion is the new watchword as investors are torn between the old normal of central bank omnipotence and the emerging new normal of unfettered chaos.  Now, perhaps unfettered chaos overstates the new normal, but price action, especially in the Treasury and other major government bond markets, has been significantly more volatile than what we had become used to since the first months of the Covid crisis passed last year.  And remember, prior to Covid’s appearance on the world stage, it was widely ‘known’ that the Fed and its central bank brethren had committed to insuring yields would remain low to support the economy.  Of course, there was the odd hiccup (the taper tantrum of 2013, the repo crisis of 2018) but generally speaking, the bond market was not a very exciting place to be.  Yields were relatively low on a long-term historical basis and tended to grind slowly lower as debt deflation central bank action guided inflation to a low and stable rate.

But lately, that story seems to be changing.  Perhaps it is the ~$10 trillion of pandemic support that has been (or will soon be) added to the global economy, with the US at $5 trillion, including the upcoming $1.9 trillion bill working its way through Congress, the leading proponent.  Or perhaps it is the fact that the novel coronavirus was novel in how it impacted economies, with not only a significant demand shock, but also a significant supply shock.  This is important because supply shocks are what tend to drive inflation with the OPEC oil embargos of 1973 and 1979 as exhibits A and B.

And this matters a lot.  Last week’s bond market price action was quite disruptive, and the terrible results of the US 7-year Treasury auction got tongues wagging even more about how yields could really explode higher.  Now, so far this year we have heard from numerous Fed speakers that higher yields were a good sign as they foretold a strong economic recovery.  However, we all know that the US government cannot really afford for yields to head that much higher as the ensuing rise in debt service costs would become quite problematic.  But when Chairman Powell spoke last week, he changed nothing regarding his view that the Fed was committed to the current level of support for a substantially longer time.

Yesterday, however, we heard the first inkling that the Fed may not be so happy about recent bond market volatility as Governor Brainerd explained that the sharp moves “caught her eye”, and that movement like that was not appropriate.  This is more in sync with what we have consistently heard from ECB members regarding the sharp rise in yields there.  At this point, I count at least five ECB speakers trying to talk down yields by explaining they have plenty of flexibility in their current toolkit (they can buy more bonds more quickly) if they deem it necessary.

But this is where it gets confusing.  Apparently, at least according to a top story in Bloomberg this morning which explains that ECB policymakers see no need for drastic action to address the rapidly rising yields of European government bonds, everything is fine.  But if everything is fine, why the onslaught of commentary from so many senior ECB members?  After all, the last thing the ECB wants is for higher yields to drive the euro higher, which would have the triple negative impact of containing any inflationary impulses, hurting export industries and ultimately slowing growth.  To me, the outlier is this morning’s story rather than the commentary we have been hearing.  Now, last week, because of a large maturity of French debt, the ECB’s PEPP actually net reduced purchases, an odd response to concerns over rising yields.  Watch carefully for this week’s action when it is released next Monday, but my sense is that number will have risen quite a bit.

And yet, this morning, bond yields throughout Europe and the US are strongly higher with Treasuries (+5.3bps) leading the way, but Gilts (+3.6bps), OATs (+2.7bps) and Bunds (+2.4bps) all starting to show a near-term bottom in yields.  The one absolute is that bond volatility continues to be much higher than it has been in the past, and I assure you, that is not the outcome that any central bank wants to see.

And there are knock-on effects to this price action as well, where less liquid emerging and other markets are finding fewer buyers for their paper.  Recent auctions in Australia, Thailand, Indonesia, New Zealand, Italy and Germany all saw much lower than normal bid-to-cover ratios with higher yields and less debt sold.  Make no mistake, this is the key issue going forward.  If bond investors are unwilling to finance the ongoing spending sprees by governments at ultra-low yields, that is going to have significant ramifications for economies, and markets, everywhere.  This is especially so if higher Treasury yields help the dollar higher which will have a twofold effect on emerging market economies and really slow things down.  We are not out of the woods yet with respect to the impact of Covid and the responses by governments.

However, while these are medium term issues, the story today is of pure risk acquisition.  After yesterday’s poor performance by US equity markets, Asia turned things around (Nikkei +0.5%, Hang Seng +2.7%, Shanghai +1.9%) and Europe has followed along (DAX +0.9%, CAC +0.6%, FTSE 100 +0.8%).  US futures are right there with Europe, with all three indices higher by ~0.6%.

As mentioned above, yields everywhere are higher, as are oil prices (+1.5%).  However, metals prices are soft on both the precious and base sides, and agricultural prices are mixed, at best.

And lastly, the dollar, which had been softer all morning, is starting to find it footing and rebound.  CHF (-0.3%) and JPY (-0.25%) are the leading decliners, but the entire G10 bloc is lower except for CAD (+0.1%), which has arguably benefitted from oil’s rally as well as higher yields in its government bond market.  In what cannot be a great surprise, comments from the ECB’s Pablo Hernandez de Cos (Spanish central bank president) expressed the view that they must avoid a premature rise in nominal interest rates, i.e. they will not allow yields to rise unopposed.  And it was these comments that undermined the euro, and the bulk of the G10 currencies.

On the EMG front, overnight saw some strength in Asian currencies led by INR (+0.9%) and IDR (+0.55%) as both were recipients of foreign inflows to take advantage of the higher yield structure available there.  On the downside, BRL (-0.7%) and MXN (-0.5%) are the laggards as concerns grow over both governments’ ongoing response to the economic disruption caused by Covid.  We have seen the Central Bank of Brazil intervening in markets consistently for the past week or so, but that has not prevented the real from declining 5% during that time.  I fear it has further to fall.

On the data front, ADP Employment (exp 205K) leads the day and ISM Services (58.7) comes a bit later.  Then, this afternoon we see the Fed’s Beige Book.  We also hear from three more Fed speakers, but it would be shocking to hear any message other than they will keep the pedal to the metal for now.

Given all the focus on the Treasury market these days, it can be no surprise that the correlation between 10-year yields and the euro has turned negative (higher yields leads to lower euro price) and I see no reason for that to change.  The story about the ECB being unconcerned with yields seems highly unlikely.  Rather, I believe they have demonstrated they are extremely concerned with European government bond yields and will do all they can to prevent them from moving much higher.  While things will be volatile, I have a sense the dollar is going to continue to outperform expectations of its decline for a while longer.

Good luck and stay safe
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The Fed’s Nonchalance

Posted on by

The view from the Fed’ral Reserve
When viewing the present yield curve
Is that higher rates
Show, here in the States
The ‘conomy’s showing some verve

Contrast that with Europe’s response
To rising yields, where at the nonce
Ms Schanbel’s the third
Of speakers we heard
All lacking the Fed’s nonchalance

All I can say about yesterday’s market activity was that we cannot be too surprised that the imbalances that have been building up for the past year (or more accurately 13 years) resulted in some significant market volatility across every asset class.  Perhaps the most interesting thing was that virtually every asset class was sold aggressively, with no obvious havens available.  Stocks fell, bonds fell, gold fell, the dollar fell, Bitcoin fell; just what did people buy with those proceeds?

But of more interest to me was the central bank responses we have seen to the recent rise in long-term yields around the world.  Arguably, this has been the catalyst to all the market activity, so remains the first place we need to look for answers.

And what did we hear?  Well, four separate FOMC members (Williams, Bostic, Bullard and George) explained that rising yields were a good thing as it shows confidence in the economic growth story.  And oh, by the way, yields are still quite low so they shouldn’t have a negative impact on the economy.  While they may well be sincere in those views, these comments smack more of whistling past the graveyard than wholehearted support of market price action.  After all, the one thing the Fed has demonstrated since the GFC in 2008 is that unrestrained market price action is the last thing they want to see.  Rather, they want to make sure they control the game and the market price action proceeds slowly and calmly in their preferred direction.  You know, like watching paint dry.

And of course, in the broad scheme of things, yields do remain quite low.  Even at yesterday’s high point, the 10-year Treasury was yielding only 1.61%, which is still in the lowest decile of yields during the 10-year’s history.  Interestingly, the ECB has not been quite as sanguine regarding bond yields, despite the fact that bond yields throughout the entire continent are much lower than US yields.  On Monday Madame Lagarde explained they were “closely monitoring” bond yields.  Yesterday, ECB Chief Economist, and the ECB member with the most policy chops, Philip Lane, explained they would use the flexibility of the PEPP to prevent any undue tightening in financial conditions.  Then this morning, Isabel Schnabel, an Executive Board member, was more forthright, explaining the ECB may need to boost policy support if real long-term yields rise too early in the recovery process.  In other words, since they don’t believe that inflation is coming, rising yields need to be stopped.

What if, however, all these central bankers are completely wrong about the future of inflation?  What if, they have been reading their own narrative and now believe that there is no inflation on the way, thus rates should never need to rise?  That, my friends, has the chance to lead to some serious policy errors going forward.

So, let’s take a look at the most recent inflation indicators we have seen, and consider the situation.  Last night, Tokyo CPI was released at -0.3% Y/Y, which while obviously low, was higher than last month and forecast.  Then, this morning French PPI printed positive (+0.4%) for the first time in more than a year while French CPI rose a more than expected 0.7% in February.  Meanwhile, German Import Prices rose a much more than expected 1.9% in January, the biggest jump since September 1990!  And finally, here in the States, the GDP is released with a price index which rose to 2.1%, a tick above expectations.  Now, none of this is a description of raging inflation, but boy, there does seem to be a decent amount of price pressure building in the system.  Perhaps, just perhaps, bond yields are rising on rising inflation concerns, whether economic growth is present or not.

This idea is important because a key ingredient for market forecasts this year has been the trajectory of real interest rates.  At face value, the combined comments of Fed and ECB speakers this week tells us that the Fed is going to allow long-term yields to continue to rise while the ECB is going to step in and stop the madness.  If that is actually how things play out, I assure you that the euro will be hard pressed to move any higher, and that a sharp decline could be in the offing.  In fact, that is true for virtually every currency, where the dollar may very well reassert itself if that is the interest rate scenario that plays out.

Of course, I don’t believe the Fed will allow yields to simply rise unabated, as the cost to the Federal government in increased interest payments will be extremely uncomfortable, so I still look for QE to be expanded and extended, perhaps as soon as the March meeting if yields continue to rally from here.  At 1.75% on the 10-year, the Fed will be feeling the pinch, especially if equity markets continue to suffer under a rising yield scenario.  Thus, I am still in the camp of the dollar eventually falling more sharply as rising inflation rates outstrip capped interest rates.  But the latest comments from the central banks have certainly raised the risk on that view!

Ok, we all know that yesterday was a rout in the markets.  This morning, is unfortunately, not looking much better. Asian equity markets last night followed the US lead and fell sharply (Nikkei -4.0%, Hang Seng -3.6%, Shanghai -2.1%) and European markets, which all fell yesterday, are lower again this morning (DAX -0.8%, CAC -1.1%, FTSE 100 -1.4%).  And, don’t be looking for a bounce in the US as futures are pointing lower as well, between -0.3% and -0.6% at this hour.

Bonds?  Well, Asian yields continued to rise, notably Australia’s ACGBs (+17.2bps), but most of Europe has reversed course this morning after the trio of ECB speakers seem to have calmed some jitters.  So, Bunds (-1.6bps) and OATs (-1.7bps) have seen modest rallies.  Gilts (+4.0bps), though, have had no commentary to support them and continue to sell off.  Treasury yields are lower by 4.1bps at this hour, which feels very much like a trading reaction (after all yields rose 26bps since Tuesday), but all eyes will be on this morning’s Core PCE data, which if it does print higher than the expected 1.4%, could well start the selling all over again.

Oil prices (-2.2%) are having their worst session in more than two months, but the uptrend remains intact.  Precious metals prices continue to suffer as well, as real yields rise alongside nominal yields, although base metals are holding in a bit better.

And finally, the dollar is stronger pretty much across the board this morning. With AUD (-1.5%) the worst G10 performer and the two havens (CHF and JPY) both lower by just -0.1%.  Down Under, the market finally forced the RBA’s hand regarding their YCC, and the RBA bought $A3 billion of 3-year notes to push yields back below their 0.10% target.  This had the additional impact of discouraging FX investors from owning the currency.  In fact, this is exactly what I would expect of the euro if (when) the ECB does the same thing.

On the EMG side of things, Asian markets last night tried to catch up with the routs seen in LATAM and EEMEA markets yesterday, with INR (-1.4%) and KRW (-1.4%) the leading decliners, but substantial weakness even in the more stable currencies like SGD (-0.3%) and CNY (-0.2%).  This morning, CLP (-0.9%) and MXN (-0.7%) are leading the way lower in this time zone.  And, of course, this is all the same story of shedding risk.

On the data front, a bunch more is coming starting with Personal Income (exp 9.5%), Personal Spending (2.5%) and the aforementioned Core PCE (1.4%) all at 8:30.  Then later in the morning we see Chicago PMI (61.0) and Michigan Sentiment (76.5), but I believe the PCE number is the most important.  Mercifully, there are no further Fed speakers today, but after all, we already know what they think.  Accommodation is going to be with us for a looooong time and higher yields are a sign of confidence, so no problem.

The wrinkle in the higher inflation argument is if the Fed truly does let yields run higher and other countries cap theirs, the stronger dollar will rein in price pressures.  And for now, that appears to be what the market is starting to believe.  I maintain the Fed will not allow yields to continue running higher unabated, but until they act, the dollar should perform well.  Maybe we do retest the 1,1950 level in the euro, and who knows, 107.00 USDJPY is not out of the question.

Good luck, good weekend and stay safe
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Yield Hawks Reappear

Posted on by

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
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Crash Landing

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: Bloomberg

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

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

Good luck and stay safe
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