Tag Archives: #Fed

Retrogression

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To taper or not is the question
Resulting in much indigestion
For traders with views
The Minutes were cues
The Fed’s ready for retrogression

“A number of participants suggested that if the economy continued to make rapid progress toward the committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.”  This is the money quote from yesterday’s FOMC Minutes, the one which has been identified as the starting point for the next step in Federal Reserve activity.  Its perceived hawkish tilt led to a decline in both stocks and bonds and saw the dollar rebound nicely from early session weakness.

No one can ever accuse the Fed of speaking clearly about anything, and this quote is full of weasel words designed to hint at but not actually say anything.  So, is this really as hawkish as the commentariat would have us believe?  Let us remember that the April meeting occurred before the surprisingly weak May Nonfarm Payroll report.  Since that report, we have heard many Fed speakers explain that there was still a long way to go before they saw the “substantial progress” necessary to begin to change policy.  Since the meeting, the Citi Economic Surprise Index (an index that seeks to track the difference between economic forecasts and actual data releases) has fallen quite sharply which implies that the economy is not growing as rapidly as forecast at that time.  Of course, since the meeting we have also seen the highest CPI prints on a monthly basis in 15 years (headline) and 40 years (core).

The growing consensus amongst economists is that at the Jackson Hole symposium in August, Chairman Powell will officially reveal the timeline for tapering and by the end of 2021, the Fed will have begun reducing the amount of asset purchases they make on a monthly basis.  That feels like a pretty big leap from “it might be appropriate at some point…to begin discussing…”

Remember, too, the discussion that is important is not what one believes the Fed should do, but rather what one believes the Fed is going to do.  The case for tighter policy is clear-cut in my mind, but that doesn’t mean I expect them to act in that fashion.  In fact, based on everything we have heard from various Fed speakers, it seems apparent that there is only a very small chance that the Fed will even consider tapering in 2021. The current roster of FOMC voters includes the Chair, Vice-Chair and Governors, none of whom could be considered hawkish in any manner, as well as the Presidents of Atlanta, Chicago, Richmond and San Francisco.  Of that group, Chicago’s Evans and SF’s Daly are uber-dovish.  Richmond’s Barkin is a middle-of-the-roader and perhaps only Atlanta’s Bostic could be considered to lean hawkish at all.  This is not a committee that is prepared to agree to tighter policy unless inflation is running at 5% and has been doing so for at least 6 months.  Do not get overexcited about the Fed tapering.

Markets, on the other hand, did just that yesterday, although the follow through has been unimpressive.  Yesterday’s session saw US equity markets open lower on general risk aversion and they had actually been climbing back until the Minutes were released.  Upon release, the S&P fell a quick 0.5%, but had recouped all that and more in 25 minutes and then chopped back and forth for the rest of the session.  In other words, it was hardly a rout based on the Minutes.  The overnight session was, in truth, mixed, with the Nikkei (+0.2%) climbing slightly while the Hang Seng (-0.5%) and Shanghai (-0.1%) slipped a bit.  Europe, which fell pretty sharply yesterday, has rebounded this morning (DAX +0.4%, CC +0.5%, FTSE 100 0.0%) although US futures are all in the red this morning by about -0.4%, so whatever positives traders in Europe are seeing have not yet been identified in the US.

As to the bond market, it should be no surprise that it sold off sharply yesterday, with 10-year yields rising 5 basis points at their worst point but closing higher by 3bps, at 1.67%.  But this morning there is no follow through at all as the 10yr has actually rallied with yields slipping 0.5bps.  This is hardly the sign of a market preparing for a Fed change of heart.  European sovereign markets are under modest pressure this morning, with yields a bit higher throughout the continent (bunds +1.8bps, OATs +1.0bps, gilts +1.5bps).  Neither did the Minutes cause much concern in Asia with both Australia and Japan seeing extremely muted moves of less than 1 basis point.

Commodity prices, on the other hand, have definitely seen some movement led by oil (WTI -1.5%) and Iron Ore (-2.8%).  However, the oil story is more about supply and the news that Iranian crude may soon be returning to the market as a deal to lift sanctions is imminent, while iron ore, and steel, were impacted by strong comments from China designed to halt the runaway price train in both, as they seek to reduce production in an effort to mitigate greenhouse gas emissions.  The non-ferrous metals are very modestly lower (Cu -0.1%, Al -0.2%, Zn -0.4%) while precious metals are little changed on the day.  Agricultural products, though, maintain their bids with small gains across the board.

Perhaps the most interesting market yesterday was cryptocurrencies where there was a very significant decline across the board, on the order of 20%-30%, which has reduced the value of the space by about 50% since its peak in early April.  This largely occurred long before the FOMC Minutes and was arguably a response to China’s announcement that payment for goods or services with any digital currency other than yuan was illegal rather than a response to any potential policy changes. This morning is seeing Bitcoin rebound very slightly, but most of the rest of the space still under pressure.

Finally, the dollar is under modest pressure today, after rallying nicely in the wake of the FOMC Minutes.  Versus the G10, only NOK (-0.1%) is in the red, suffering from the oil price decline, while the rest of the bloc is rebounding led by CHF (+0.4%) and AUD (+0.3%).  Swiss movement appears to be technically oriented while AUD’s rally is counterintuitive given the modestly worse than expected Unemployment report last night.  However, as a key risk currency, if risk appetite is forming, Aussie tends to rally.

Emerging market currencies that are currently trading have all rebounded led by PLN (+0.5%), TRY (+0.5%) and HUF (+0.45%).  All of these are benefitting from the broad based, but mild, dollar weakness.  The story was a bit different overnight as Asian currencies fell across the board with IDR (-0.6%) the leading decliner, as the highest beta currency with the biggest C/A deficit, but the rest of the space saw weakness on the order of -0.1% to -0.2%.

Data today starts with Initial Claims (exp 450K), Continuing Claims (3.63M) and the Philly Fed (41.0).  Then at 10:00 we see Leading Indicators (1.3%).  On the Fed front, only Dallas’s Kaplan speaks, but we already know that he has to have been one of the voices that wanted to discuss tapering, as he has said that repeatedly for the past month.

Frankly, this market has several cross currents, but my gut tells me that the ostensible hawkishness from yesterday’s Minutes will soon be forgotten and the doves will continue to rule the airwaves and sentiment.  Look for the dollar to drift lower on the day.

Good luck and stay safe
Adf

Don’t Get Carried Away

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The data released yesterday
Had Fed speakers try to downplay
The idea that prices
Are causing a crisis
They said, don’t get carried away

But markets worldwide have all swooned
As traders are highly attuned
To signals inflation
In every location
Will quickly show that it’s ballooned

Wow!  That’s pretty much all you can say about the CPI data yesterday, where, as I’m sure you are by now aware, the numbers were all much higher than expected.  To recap, headline CPI rose 0.8% M/M which translated into a 4.2% Y/Y increase.  Ex food & energy, the monthly gain was 0.9%, with the Y/Y number jumping to 3.0%.  To give some context, the core 0.9% gain was the highest print since 1981.  It appears, that at least for one month, the combination of unlimited printing of money and massive fiscal spending did what many economists have long feared, awakened the inflation dragon.

The Fed was in immediate damage control mode yesterday, fortunately having a number of speakers already scheduled to opine, with Vice-Chair Richard Clarida the most visible.  His message, along with all the other speakers, was that this print was of no real concern, and in truth, somewhat expected, as the reopening of the economy would naturally lead to some short-term price pressures as supply bottlenecks get worked out.  As well, they highlighted the fact that much of the gain was caused by just a few items, used car prices and lodging away from home, neither of which is likely to rise by similar amounts again next month.  That may well be true, but the elephant in the room is the question regarding housing inflation and its relative quietude.

House prices, at least according to the Case Shiller Index, are screaming higher, up 12% around the country in the past 12 months and showing no signs of slowing down.  The pandemic has resulted in a significant amount of displacement and as people move, they need some place to live.  The statistics show that there is the smallest inventory of homes available in decades.  As well, the rocketing price of lumber has added, apparently, $34,000 to the price of a new house compared to where it was last year, which given the median house price in the US is a touch under $300,000, implies a more than 10% rise in price simply due to the cost of one material.  And yet, Owners Equivalent Rent, the housing portion of the CPI data, rose only at 0.21% pace.  A great source of inflation information is Mike Ashton (@inflation_guy), someone you should follow as he really understands this stuff better than anyone else I know.  As he explains so well, this is likely due to the eviction moratorium that has been in place for more than a year, so rents paid have been declining.  However, that moratorium has just been overturned in a court decision and so we should look for the very hot housing market to soon be reflected in CPI.  That, my friends, will be harder to pass off as transitory.

The reason all this matters is because the entire Fed case of maintaining ZIRP in their efforts to achieve maximum employment, is based on the fact that inflation is not a problem, so they have no reason to raise rates.  However, if they are wrong on this issue, which is the only issue on which they focus, it results in the Fed facing a very difficult decision; raise rates to fight inflation and watch securities prices deflate dramatically or stay the course and let inflation continue to rise until it potentially gets out of control.  While we all know they have the tools, the decision to use them will be far more challenging than I believe most of them expect.

The market’s initial reaction to the data was a broad risk-off session, as equity prices fell sharply in Europe and the US yesterday and then overnight in Asia (Nikkei -2.5%, Hang Seng -1.8%, shanghai -1.0%) they followed the trend. Europe this morning (DAX -1.4%, CAC -1.1%, FTSE 100 -2.0%) is still under pressure as the global equity bubble is reliant on never-ending easy money.  Rising inflation is the last thing equity markets can abide, so these declines can not be surprising.  The question, of course, is will they continue?  A one- or two-day hiccup is not really a problem, but if investors start to get nervous, it is a completely different story.  It is certainly true that valuations for equities, at least as measured by traditional metrics like P/E and P/S are at extremely high levels.  A loss of confidence that the past is prologue could well see a very sharp correction.

Despite the risk off nature of the equity market price action, bonds were also sold aggressively yesterday and in the overnight session.  It ought not be surprising given that bonds should be the worst performing asset in an inflationary spike, but still, the 10-year Treasury jumped more than 7 basis points yesterday, a pretty big move.  While this morning it is essentially unchanged, the same cannot be said for the European sovereign market where yields have risen again, between 1.5bps (Bunds) and 5.1bps (Italian BTPs) with the rest of the continent sandwiched in between.  Nothing has changed my view that the 10-year Treasury yield remains the key market driver, at least for now, thus if yields continue to rally, look for more downward pressure on stocks and commodities and upward pressure on the dollar.

Speaking of commodities, they are under pressure across the board this morning with WTI (-2.1%) leading the way lower but Cu (-1.7%) having its worst day in months.  The entire base metal complex is lower as are virtually all agriculturals, although the precious metals are holding up as a bit of fear creeps into the investor psyche.

Finally, the dollar, which rallied sharply yesterday all day in the wake of the CPI print, is more mixed this morning gaining against the G10’s commodity bloc (NOK -0.3%, AUD -0.2%) while suffering against the European bloc (CHF +0.25%, EUR +0.1%) although the magnitude of the movements have been small enough to attribute them to modest position adjustments rather than an overriding narrative.  We are seeing a similar split in the EMG currencies, with APAC currencies all under pressure (THB -0.5%, KRW –0.4%, TWD -0.2%) while the CE4 hold their own (PLN +0.3%, HUF +0.3%, CZK +0.2%).  At this time, LATAM currencies, which all suffered yesterday, are either unchanged or unopened.

This morning’s data brings Initial Claims (exp 490K) and Continuing Claims (3.65M) as well as PPI (0.3% M/M, 5.8% Y/Y) headline and (0.4% M/M, 3.8% Y/Y ex food & energy).  Of course, with the CPI already out, this is unlikely to have nearly the impact as yesterday.  In addition, we get three more Fed speakers to once again reiterate that yesterday’s CPI data was aberrational and that any inflation is transitory.  I guess they hope if they say it often enough, people may begin to believe them.  But that is hard to do when the prices you pay for stuff continues to rise.

Treasuries remain the key.  If yields rally again (and there is a 30-year auction today) then I expect the dollar to take another leg higher.  If, on the other hand, yields drift back lower, look for the dollar to follow as equity buyers dip their toes back into the water.

Good luck and stay safe
Adf

Far From our Goals

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Said Brainerd, “we’re far from our goals”
Of helping to max out payrolls
So, patience is needed
Else we’ll be impeded
And Biden might drop in the polls
Thus, we must maintain the controls

There is a single hymnal at the Marriner Eccles Building in Washington, DC and every FOMC member continues to read from that gospel.  In short, the current view is that things are getting better, but there is still a long way to go before the economy can continue to grow without Fed support, therefore, the current policy mix is appropriate and will be for a long time to come.  On the subject of inflation, when it was even mentioned by any of the six Fed speakers yesterday, it was pooh-poohed as something of no concern, widely recognized that it will rise in the short-term, but universally expected to be ‘transitory’.  I don’t know about you, but it certainly makes me feel much better that a group of 6 individuals, each extremely well-paid with numerous perks accorded to their office, and each largely out of touch with the world in which the rest of us live, are convinced that they can see the future.  After all, the Fed’s forecasting record is unparalleled…in its futility.

However, that is the situation as it currently stands, the Fed remains adamant that there is no need to taper its QE program, no need to raise interest rates anytime soon and that the current policy mix will address what ails the US economy.

The problem with this attitude is that it seems to ignore the reality on the ground.  Exhibit A is the news today that average gasoline prices across the nation crossed above $3.00/gallon for the first time since 2014.  In fairness to the Fed, some portion of this is a result of the shutdown of the Colonial Pipeline, where a number of states on the East Coast find themselves with no gasoline to pump.  But do not be mistaken, as I’m sure everyone is aware, gasoline prices have been rising sharply for the past 6 months, at least.  At issue now is just how much higher they can go before having more deleterious effects on the economy, let alone on many individuals’ personal situation.

It is not just gasoline, but pretty much all commodities that have been rallying sharply since the pandemic induced lows of April 2020.  Since its nadir, for example, the GSCI has more than doubled, but that merely brings it back to its level of the prior five years, when there was no concern over commodity driven inflation.  The difference this time is that due to a combination of the Covid-induced breakdown in supply chains and a massive reduction in Capex by the mining and extraction sector, the prospect of equilibrium in this space in the near term is limited.  There is a growing belief that we are embarking on a so-called commodity super-cycle.  This would be defined as a long-term period where commodity demand outstrips supply and commodity prices rise continually, generally doubling or tripling from the previous lows.

This discussion is an excellent prelude to this morning’s CPI release, where the analyst community is looking for a 0.2% M/M rise which translates into a 3.6% Y/Y rise.  Ex food and energy, expectations are for 0.3% M/M and 2.3% Y/Y.  The sharp rise in the annual headline rate is exactly what the Fed has been discussing as base effects, given this time last year, the economy was seeing price deflation on the back of the economy’s shutdown, with transportation, hospitality and leisure prices collapsing due to a forced lack of demand.  As such, the market seems entirely prepared for a very large number.  From my vantage point, the Y/Y number is not so important today, but the M/M number is.  Consider that a 0.3% reading, if strung over twelve months, comes to an annual inflation rate of more than 3.6%, considerably above the Fed’s target.

We continue to hear one Fed speaker after another explain that while the economy is improving, they must still maintain ultra-easy monetary policy.  We continue to hear them explain that any inflation readings will be transitory.  And maybe they are correct.  However, if they are not, and inflation embeds itself more deeply into the national psyche, the Fed will find themselves in an unenviable position; either raise interest rates to combat inflation (you know, the tools they have) and watch the financial markets fall sharply; or let inflation run hot, and allow the dollar to fall sharply while eventually watching financial markets fall sharply.  Talk about a Hobson’s Choice!

Now to markets, which after yesterday’s selloff in the US equity space, albeit with a close that was well off session lows, we saw a mixed Asian session (Nikkei –1.6%, Hang Seng +0.8%, Shanghai +0.6%) and are seeing a similar performance in Europe (DAX +0.25%, CAC 0.0%, FTSE 100 +0.35%).  US futures, on the other hand, are uniformly pointing lower at this hour, down between 0.35% (DOW) and 0.6% (NASDAQ).

Bond markets, after yesterday’s worldwide rout, have seen a small rebound with Treasury yields edging lower by 0.5bps, although still hanging around the 1.60% level.  There is an overwhelming consensus that 10-year Treasury yields are set to rise substantially, but so far, that has just not been the case.  European markets are seeing yield declines of between 1bp (Bunds and OATs) and 2bps (Gilts).  Today brings two critical data points, first the US CPI data shortly and then the US 10-year Treasury auction will be closely scrutinized to determine if there is a crack in demand for our seemingly unlimited supply of Treasury paper.

Commodity prices are broadly higher led by oil (WTI +1.3%) with base metals continuing to climb as well (Cu +0.7%, Al +0.5%, Ni +1.0%).  The same cannot be said of the precious metals space, though, with both gold (-0.2%) and silver (-0.8%) seeing some selling on profit taking.

The dollar is in fine fettle this morning, rallying against 9 of its G10 counterparts with only CAD (+0.1%) holding its own.  NZD (-0.6%) and AUD (-0.5%) are in the worst shape as both respond to weaker than expected Chinese monetary growth which implies that the Chinese economy may not be growing as quickly as previously thought.  However, the European currencies are all modestly softer as well on worse than expected Eurozone IP data (0.1% vs. 0.8% expected).  EMG currencies are also under pressure this morning, with the APAC currencies feeling it the worst.  KRW (-0.45%), THB (-0.4%) and SGD (-0.25%) are leading the way lower, also on the back of the Chinese monetary data.  Interestingly, TWD (-0.03%) is barely changed despite an equity market rout (TAIEX -4.1%) and concerns about growth in China.

Other than the CPI data and the Treasury auction, there is no other news or data.  Well, that’s if you exclude the continuing parade of Fed speakers, with today’s roster of 4 positively sparse compared to what we have seen lately.  The one thing we know is that they are unlikely to change their tune.

Which brings us back to the 10-year Treasury.  It continues to be the market driver in my view, with higher yields leading to a stronger dollar and vice versa.  I suspect that this morning’s CPI data may print higher than forecast, but it is not clear to me if that will truly have an impact.  My bigger fear is that broad risk appetite may be waning given the leadership of the equity rally has been suffering of late.  In this situation, we could easily go back to a classical risk-off framework of lower stocks, higher bond prices (lower yields) and a stronger dollar.  Just beware.

Good luck and stay safe
Adf

An Untimely End

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Should risk appetite ever fall
The asset price rally could stall
And that could portend
An untimely end
To trust in the Fed overall

Yesterday afternoon the Fed released their annual financial stability report.  In what may well be the most unintended ironic statement of all time, on the topic of asset valuations the report stated, “However, valuations for some assets are elevated relative to historical norms even when using measures that account for Treasury yields.  In this setting, asset prices may be vulnerable to significant declines should risk appetite fall.” [Author’s emphasis.]  Essentially, the Fed seems to be trying to imply that for some reason, having nothing to do with their policy framework, asset prices have risen and now they are in a vulnerable place.  But for the fact that this is very serious, it is extraordinary that they could make such a disingenuous statement.  The reason asset prices are elevated is SOLELY BECAUSE THE FED CONTINUES TO PURCHASE TREASURIES VIA QE AND FORCE INVESTORS OUT THE RISK CURVE TO SEEK RETURN.  This is the design of QE, it is the portfolio rebalance channel that Ben Bernanke described a decade ago, and now they have the unmitigated gall to try to describe the direct outcome of their actions as some exogenous phenomenon.  If you wondered why the Fed, and truly most central banks, are subject to so much criticism, you need look no further than this.

In Europe, a little-known voice
From Latvia outlined a choice
The ECB may
Decide on one day
In June, and then hawks will rejoice

In a bit of a surprise, this morning Latvian central bank president, and ECB Governing Council member, Martins Kazaks, explained that the ECB could decide as early as their June meeting to begin to scale back PEPP purchases.  His view was that given the strengthening rebound in the economy as well as the significant progress being made with respect to vaccinations of the European population, overall financial conditions may remain favorable enough so they can start to taper their purchases.  This would then be the third major central bank that is on the taper trail with Canada already reducing purchases and the BOE slowing the rate of weekly purchases, although maintaining, for now, the full target.

This is a sharp contrast to the Fed, where other than Dallas Fed president Kaplan, who is becoming almost frantic in his insistence that it is time for the Fed to begin discussing the tapering of asset purchases, essentially every other FOMC member is adhering to the line that the US economy needs more monetary support and any inflation will merely be transitory.  As if to reaffirm this view, erstwhile uber-hawk Loretta Mester, once again yesterday explained that any inflation was of no concern due to its likely temporary nature, and that the Fed has a long way to go to achieve its new mission of maximum employment.

A quick look at the Treasury market this morning, and over the past several sessions, shows that the 10-year yield (currently 1.577%, +0.7bps on the day) seems to have found a new equilibrium.  Essentially, it has remained between 1.54% and 1.63% for about the last month despite the fact that virtually every data release over that timespan has been better than expected.  Thus, despite a powerful growth impulse, yields are not following along.  It is almost as if the market is beginning to price in YCC, which is, of course, exactly the opposite of tapering.  Given the concerns reflected in the Financial Stability Report, maybe the only way to prevent that asset price decline would be to cap yields and let inflation fly.  History has shown bond investors tend to be pretty savvy in these situations, so do not ignore this, especially because YCC would most likely result in a sharply weaker dollar and sharply higher commodity and equity prices.

This morning the market will see
The labor report, NFP
Expecting one mill
The Fed’s likely, still,
To say they’ll continue QE

Finally, it is payroll day with the following current expectations according to Bloomberg:

Nonfarm Payrolls 1000K
Private Payrolls 938K
Manufacturing Payrolls 57K
Unemployment Rate 5.8%
Average Hourly Earnings 0.0% (-0.4% Y/Y)
Average Weekly Hours 34.9
Participation Rate 61.6%

The range of forecasts for the headline number is extremely wide, from 700K to 2.1 million, just showing how little certainty exists with respect to econometric models more than a year removed from the initial impact of Covid-induced shutdowns.  As well, remember, even if we get 1 million new jobs, based on Chairman Powell’s goal of finding 10 million, as he stated back in January, there are still another 7+ million to find, meaning the Fed seems unlikely to respond to the report in any manner other than maintaining current policy.  In fact, it seems to me the bigger risk today is a disappointing number which would encourage the Fed to double down!  We shall learn more at 8:30.

As to markets ahead of the release, Asian equities were mixed (Nikkei +0.1%, Hang Seng -0.1%, Shanghai -0.65%) although Europe is going gangbusters led by Germany’s DAX (+1.3%), with the CAC (+0.3%) and FTSE 100 (+0.8%) also having good days.  German IP data (+2.5% M/M) was released better than expected and has clearly been a catalyst for good.  At the same time, French IP (+0.8% M/M) was softer than expected, arguably weighing on the CAC.

Away from Treasuries, European sovereign bonds are all selling off as risk appetite grows, or so it seems.  Bunds (+1.0bps) and OATs (+2.8bps) are feeling pressure, although not as much as Italian BTPs (+4.8bps).  Gilts, on the other hand, are little changed on the day.

Commodity prices continue to rally sharply, at least in the metals space, with gold (+0.3%, +1.5% yesterday), silver (+0.1%, +3.5% yesterday), copper (+2.6%), aluminum (+1.0%) and nickel (+0.2%) all pushing higher.  Interestingly, oil prices are essentially unchanged on the day.

Lastly the dollar is mixed on the session, at least vs. the G10.  SEK (+0.35%) is the leading gainer on what appears to be positive risk appetite, while NZD (-0.25%) is the laggard after inflation expectations rose to a 3-year high.  The other eight are all within that range and split pretty evenly as to gainers and losers.

EMG currencies, though, are showing more positivity with only two small losers (ZAR -0.25%, PLN -0.15%) and the rest of the bloc firmer.  APAC currencies are leading (KRW +0.4%, INR +0.35%, TWD +0.3%) with all of them benefitting from much stronger than forecast Chinese data. We saw Caixin PMI Services rise to 56.3 and their trade balance expand to $42.85B amid large growth in both exports and imports.  Models now point to Chinese GDP growing at 9.0% in 2021 after these releases.

At this point, we are all in thrall to the NFP release later this morning.  The dollar response is unclear to me, although I feel like a strong number may be met with a falling dollar unless Treasury yields start to climb.  Given their recent inability to do so, I continue to believe that is the key market signal to watch.

Good luck, good weekend and stay safe
Adf

Rates May Have to Rise

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Said Janet, “rates may have to rise”
Which really should be no surprise
The money we’ve spent
Has markets hell bent
On constantly making new highs

But right after this bit of diction
The market ran into some friction
So quick as a wink
She had a rethink
And said “this is not a prediction”

Just kidding!  What was amply demonstrated yesterday is that the Fed, and by extension the US government, has completely lost control of the narrative.  The ongoing financialization of the US economy has resulted in the single most powerful force being the stock market.  Policymakers are now in the position of doing whatever it takes, to steal a phrase, to prevent a decline of any severity.  This includes actual policy decisions as well as comments about potential future decisions.

A brief recap of yesterday’s events shows that Treasury Secretary Yellen, at a virtual event on the economy said, “rates may have to rise to stop the economy from overheating.”  Now, on its surface, this doesn’t seem like an outrageous statement as it hews directly to macroeconomic theory and is widely accepted as a reasonable idea. However, Janet Yellen is no longer a paid consultant for BlackRock, but US Treasury Secretary.  And the only market fundamental that matters currently is the idea that the Fed is not going to raise interest rates for at least another two years.  Thus, when a senior administration financial official (has a Freudian slip and) talks about rates needing to rise, investors take notice.

So, in a scene we have observed numerous times in the past, immediately after the comments equity markets started to sell off even more sharply than their early declines and the market discussion started to turn to when rates may be raised.  But a declining stock market is unacceptable, so in a later WSJ interview, Yellen recanted clarified those remarks explaining that she was neither predicting nor recommending rate hikes.  It was merely an observation.

However, what was made clear was just how few degrees of freedom the Fed has to implement the policy they see fit.  It is for this reason that every time an official explains the Fed ‘has the tools’ necessary to fight inflation should it arise, there is a great deal of eye-rolling.  The first tool in fighting inflation is raising interest rates, and that will not go down well in the equity world, regardless of the level of inflation.  And what we know is that the Fed clearly doesn’t have the stomach to watch stocks decline by 10% or 20%, let alone more, in the wake of their policy decisions to raise interest rates.  We know this because in Q4 2018, when they were attempting to normalize policy, raising rates and shrinking the balance sheet simultaneously, the stock market fell 20% and was starting to gain serious downside momentum.  This begat the Powell Shift on Boxing Day, which saw the Fed stop tightening and stocks stop falling.

It is with this in mind that we view the comments of other Fed speakers.  Most are hewing to the party line, with NY’s Williams and SF’s Daly both right on script explaining that while growth will be strong this year, there is still a great deal of slack in the economy and supportive (read easy) monetary policy is still critical in achieving their goals.  It is also why Dallas Fed president Kaplan is roundly ignored when he explains that tapering purchases later this year may be sensible given the strength of the economy.  But Kaplan isn’t a voter nor will he be one until 2023, so no matter how passionate his pleas are in the FOMC meeting room, it will never be known as he cannot even dissent on a policy choice.

In summary, yesterday’s Yellen comments and corrections simply reinforce the idea that the Fed is not going to raise rates for at least another two years and that tapering of asset purchases is not on Powell’s mind, nor that of most of his FOMC colleagues.  So…party on!

And that is exactly what we are seeing today in markets.  While the Hang Seng had a poor showing (-0.5%) which followed yesterday’s tech heavy selloff in the US, Europe, which of course lacks any tech sector to speak of, is sharply higher this morning (DAX +1.35%, CAC +0.9%, FTSE 100 +1.1%) as a combination of Services PMI data strength and optimism about the ending of lockdowns has investors expecting superior profit growth going forward.  US futures are also pointing higher (DOW +0.3%, SPX +0.4%, NASDAQ +0.5%) as confirmation that rates will remain low added to rising growth forecasts continue to underpin the equity case.  As an example of the growth optimism, the Atlanta Fed’s GDPNow forecast tool has risen to 13.567% as of yesterday, up from just 7.869% a week earlier!  Now, as more data is released, that will fluctuate, but if that data continues to be as strong as recent outcomes, do not be surprised to see Q2 GDP forecasts move a lot higher everywhere.

Turning to the bond markets, Treasury yields this morning are higher by 1.3 basis points, although that is after having slipped 3 bps on Monday and ultimately remaining unchanged yesterday.  But in this risk-on meme, bonds do lose their appeal.  European sovereigns are also generally lower with Bunds (+1.9bps), OATs (+2.3bps) and Gilts (+3.0bps), all seeing sellers converting their haven money into stock purchases.

Risk appetite in commodities remains robust this morning as oil prices continue to escalate (+1.1%) and are pushing back near their recent highs above $67/bbl.  While precious metals continue to lack traction, the base metal space is back in high gear this morning (Cu +0.5%, Al +0.65%, Sn +1.1%).  Agriculturals?  Wheat +0.3%, Soybeans +1.0%, Corn +0.85%.  It’s a good thing the price of what we eat has nothing to do with inflation!  As an example, Corn is currently $7.50/bushel, a price which has only been exceeded once in the data set going back to 1912, when it touched $8.00 in July 2012.  And looking at the chart, there is no indication that it is running out of steam.

Finally, the dollar has evolved from a mixed session to one where it is now largely under pressure.  This fits with the risk-on theme so should be no surprise.  NZD (+0.65%) leads the way higher but the commodity bloc is all firmer (AUD +0.4%, NOK +0.35%, CAD +0.3%) on the back of the commodity rally.  The rest of the G10, though, is little changed overall.  In the EMG space, PLN (-0.4%) is the outlier, falling ahead of the central bank’s rate announcement, although there is no expectation for a rate move, there is concern over a change in the dovish tone.  As well, the Swiss franc mortgage issue continues to weigh on the nation as a decision is due to be released next week and could result in significant bank losses and concerns over the financial system there.  But away from the zloty, there are a handful of currencies that are ever so slightly weaker, and the gainers are unimpressive as well (ZAR +0.35%, RUB +0.2%), both of which are commodity driven.

Two data points this morning show ADP Employment (exp 850K) and ISM Services (64.1) with more attention to be paid to the former than the latter.  We also have three more Fed speakers, Evans, Rosengren and Mester, with the previously hawkish Mester being the one most likely to discuss things like tapering being appropriate.  But in the end, there remains a very clear majority on the FOMC that there is no reason to change policy for a long time to come.

It is difficult to develop a new narrative on the dollar at this stage.  Rising Treasury yields on the back of rising inflation expectations are likely to offer short term support for the buck but can undermine it over time.  For today, however, it seems that the traditional risk-on theme is pushing back on its modest gains from yesterday.

Good luck and stay safe
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The Specter of Growth

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The specter of growth’s in the air
So, pundits now try to compare
Which central bank will
Be next to instill
The discipline they did forswear

In Canada, they moved last week
On Thursday, Sir Bailey will speak
Now some pundits wonder
In June, from Down Under
The RBA will, easing, tweak

But what of Lagarde and Chair Jay
Will either of them ever say
Our goals are achieved
And so, we’re relieved
We’ve no need to buy bonds each day

On lips around the world is the question du jour, has growth rebounded enough for central banks to consider tapering QE and reining in monetary policy?  Certainly, the data continues to be impressive, even when considering that Y/Y comparisons are distorted by the government-imposed shutdowns last Spring.  PMI data points to robust growth ahead, as well as robust price rises.  Hard data, like Retail Sales and Personal Consumption show that as more and more lockdowns end, people are spending at least some portion of the savings accumulated during the past year. Meanwhile, bottlenecks in supply chains and lack of investment in capacity expansion has resulted in steadily rising prices adding the specter of inflation to that of growth.

While no developed market central bank head has yet displayed any concern over rising prices, at some point, that discussion will be forced by the investor community.  The only question is at what level yields will be sitting when central banks can no longer sidestep the question.  But after the Bank of Canada’s surprise move to reduce the amount of weekly purchases at their last meeting, analysts are now focusing on the Bank of England’s meeting this Thursday as the next potential shoe to drop.  Between the impressive rate of vaccination and the substantial amount of government stimulus, the UK data has been amongst the best in the world.  Add to that the imminent prospect of the ending of the lockdowns on individual movement and you have the makings of an overheating economy.  The current consensus is that the BOE may slow the pace of purchases but will not reduce the promised amount.  Baby steps.

Last night, the RBA left policy on hold, as universally expected, but the analyst community there is now looking for some changes as well.  Again, the economy continues to rebound sharply, with job growth outstripping estimates, PMI data pointing to a robust future and inflation starting to edge higher.  While the inoculation rate in Australia has been surprisingly low, the case rate Down Under has been miniscule, with less than 30,000 confirmed cases amid a population of nearly 26 million. The point is, the economy is clearly rebounding and, as elsewhere, the question of whether the RBA needs to continue to add such massive support has been raised.  Remember, the RBA is also engaged in YCC, holding 3-year yields to 0.10%, exactly the same as the O/N rate.  The current guidance is this will remain the case until 2024, but with growth rebounding so quickly, the market is unlikely to continue to accept that as reality.

These peripheral economies are interesting, especially for those who have exposures in them, but the big question remains here in the US, how long can the Fed ignore rising prices and surging growth.  Just last week Chairman Powell was clear that a key part of his belief that any inflation would be transitory was because inflation expectations were well anchored.  Well, Jay, about that…5-year Inflation breakevens just printed at 2.6%, their highest level since 2008.  A look at the chart shows a near vertical line indicating that they have further to run.  I fear the Fed’s inflation anchor has become unmoored.  While 10-year Treasury yields (+2.3bps today) have been rangebound for the past two months, the combination of rising prices and massively increased debt issuance implies one of two things, either yields have further to climb (2.0% anyone?) or the Fed is going to step in to prevent that from occurring.  If the former, look for the dollar to resume its Q1 climb.  If the latter, Katy bar the door as the dollar will fall sharply as any long positions will look to exit as quickly as possible.  Pressure on the Fed seems set to increase over the next several months, so increased volatility may well result.  Be aware.

As to today’s session, market movement is mostly risk-on but the dollar seems to be iconoclastic this morning.  For instance, equity markets are generally in good shape (Hang Seng +0.7%, CAC+0.5%, FTSE 100 +0.6%) although the DAX (-0.35%) is lagging.  China and Japan remain on holiday.  US futures, however, are a bit under the weather with NASDAQ (-0.4%) unable to shake yesterday’s weak performance while the other two main indices hover around unchanged.

Sovereign bond markets have latched onto the risk-on theme by selling off a bit.  While Treasuries lead the way, we are seeing small yield gains in Europe (Bunds +0.5bps, OATs +0.6bps, Gilts +0.5bps) after similar gains in Australia overnight.

Commodity markets continue to power higher with oil (+1.9%), Aluminum (+0.4%) and Tin (+1.0%) all strong although Copper (-0.1%) is taking a breather.  Agricultural products are also firmer but precious metals are suffering this morning, after a massive rally yesterday, with gold (-0.5%) the worst of the bunch.

Of course, the gold story can be no surprise when looking at the FX markets, where the dollar is significantly stronger across the board.  For instance, despite ongoing commodity strength, and the rally in oil, NZD (-0.9%), AUD (-0.6%) and NOK (-0.5%) are leading the way down, with GBP (-0.25%) the best performer of the day.  The pound’s outperformance seems linked to the story of a modest tapering of monetary policy, but overall, the dollar is just quite strong today.

The same is true versus the EMG bloc, where TRY (-1.0%) is the worst performer, but the CE4 are all weaker by at least 0.4% and SGD (-0.5%) has fallen after announcing plans for a super strict 3-week lockdown period in an effort to halt the recent spread of Covid in its tracks.  The only gainer of note is RUB (+0.4%) which is simply following oil higher.

Data this morning brings the Trade Balance (exp -$74.3B) as well as Factory Orders (1.3%, 1.8% ex transport), both of which continue to show economic strength and neither of which is likely to cause any market ructions.

Two more Fed speakers today, Daly and Kaplan, round out the messaging, with the possibility of Mr Kaplan shaking things up, in my view.  He has been one of the more hawkish views on the FOMC and is on record as describing the rise in yields as justified and perhaps a harbinger of less Fed activity.  However, he is not a current voter, and Powell has just told us clearly that there are no changes in the offing.  Ultimately, this is the $64 trillion question, will the Fed blink in the face of rising Treasury yields?  Answer that correctly and you have a good idea what to expect going forward.  At this point, I continue to take Powell at his word, meaning no change to policy, but if things continue in this direction, that could certainly change.  In the meantime, nothing has changed my view that the dollar will follow Treasury yields for the foreseeable future.

Good luck and stay safe
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Clearly Reviving

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The positive news keeps arriving
Explaining the ‘conomy’s thriving
Last Friday’s report
Was of such a sort
That showed growth is clearly reviving

The Nonfarm data on Friday was a generally spectacular report that was released into a near vacuum.  All of Europe was closed for the Good Friday holiday as were US equity markets.  The Treasury market was open for an abbreviated session and there were some futures markets open, but otherwise, it was extremely quiet.  And the thing is, this morning is little different, as Europe remains completely closed and in Asia, only Japan, South Korea and India had market activity.  Granted, US markets are fully open today, but as yet, we have not seen much activity.

A quick recap of the report showed Nonfarm Payrolls rose by 916K with revisions higher to the past two months of 156K.  The Unemployment Rate fell to 6.0%, its lowest post pandemic print and the Participation Rate continues to edge higher, now at 61.5%, although that remains a far cry from the 64% readings that had existed for the previous decade.  Arguably, this is one of the biggest concerns for the economy, the fact that the labor force may have permanently shrunk.  This is key because, remember, economic growth is simply the product of population growth and productivity gains.  In this case, population growth means the labor force population, so if that segment has shrunk, it bodes ill for the future of the economy.  But that is a longer-term issue.

Let’s try to put the employment situation into context regarding the Fed and its perceived reaction functions.  It was less than two months ago, February 23 to be exact, when Chairman Powell testified to Congress about the 10 million payroll jobs that had been lost and needed to be recovered before the Fed would consider they have achieved their maximum employment mandate.  At that time, expectations were this would not be accomplished before a minimum of two more years which was what helped inform the Fed’s broad belief that ZIRP would be appropriate through the end of 2023.  And this was the FOMC consensus view, with only a small minority of members expecting even a single rate hike before that time.

But since then, 1.6 million jobs have been created, a remarkable pace and arguably quite a bit faster than anticipated.  The bond market has seen this data, along with the other US economic information and determined that the recovery is moving along far faster than previously expected.  This is evident in the fact that the 10-year yield continues to climb.  Even in Friday’s abbreviated session, yields rose 5 basis points, and as NY is waking up, they have maintained those gains and appear to be edging higher still.  Similarly, the Fed Funds futures market is now pricing in its first full rate hike in December 2022, a full year before the Fed’s verbal guidance would have us believe.

The point here is the tension between the Fed and the markets is growing and the eventual outcome, meaning how the Fed responds, will impact every market significantly.  So, not only will the bond market have an opportunity to gyrate, but we will see increased volatility in stocks, commodities and the FX markets.  The Fed, however, has made it abundantly clear they are uninterested in inflation readings as they strongly believe not only will any inflation be ‘transitory’, but that if it should appear, they have the tools to thwart it quickly (they don’t). More importantly, they have a very specific view of what constitutes maximum employment.  And they have been explicit in their verbal guidance that they will give plenty of warning before they start to alter policy in any way.  The problem with this thesis is that economic surprises, by their very nature, tend to happen more quickly than expected.

This combination of facts has created the very real possibility of putting the Fed in a position where they need to choose between acting in a timely fashion or giving all that warning before acting.  If they choose door number one, they risk impugning their credibility and weakening their toolkit while door number two leaves them even further behind the curve than normal with negative economic consequences for us all.  If you wondered why many pundits have used the metaphor of the Fed painting itself into a corner, this is exactly what they are describing.

For now, though, there is precious little chance the Fed is going to change their stance or commentary until forced to do so, which means that we are going to continue to hear that they believe current policy is appropriate and they will give plenty of warning before any changes.  I hope they are right, but I fear they are not.

Markets take less time to discuss this morning as most of them are closed.  Of the major equity indices, only the Nikkei (+0.7%) was open last night as Commonwealth countries were closed for Easter Monday while China was closed for Tomb Sweeping Day (the Chinese version of Memorial Day).  US futures are pointing higher, which given Friday’s data should be no surprise.  So right now, we are looking at gains between 0.4% and 0.7%, with both the Dow and S&P sitting at all-time highs.

Bond markets were similarly closed pretty much everywhere, with the US market now edging higher by 0.4bps as traders sit down at their desks.  The current 10-year yield of 1.725% is at its highest level since January 2020, but remember, it remains far below the average seen during the past decade and even further below levels seen prior to that.  The point is yields are not constrained on the high side in any real way.

Oil prices (-1.7%) are under pressure this morning after OPEC+ indicated they would be increasing production somewhat thus taking pressure off of supplies.  However, given the speed of recovery in the US and China, the two largest consumers of oil, I expect that there is more upside here as well.

As to the dollar, it is a pretty dull session overall.  That is mostly because so many financial centers have been closed, so trading volumes and activity has been extremely light.  In the G10 space, there is a mix of gainers (GBP +0.25%, AUD +0.2%) and losers (SEK -0.25%, NOK -0.15%) but as can be seen by the limited movement, this is really just a bit of position adjustment.  In the EMG bloc, TRY (+0.6%) is the leading gainer after a slightly higher than expected inflation print and more hawkish words from the new central bank governor.  Otherwise, these currencies are also trading in a range with limited movement in either direction.  We will need to wait until tomorrow to see how other markets react to the US data.

Speaking of data, this week sees a mix of indicators as well as the FOMC Minutes.

Today ISM Services 59.0
Factory Orders -0.5%
Tuesday JOLTs Job Openings 6.9M
Wednesday Trade Balance -$70.5B
FOMC Minutes
Thursday Initial Claims 690K
Continuing Claims 3638K
Friday PPI 0.5% (3.8% Y/Y)
-ex food & energy 0.2% (2.7% Y/Y)

Source: Bloomberg

Away from this data, we hear from a handful of Fed speakers, including Chair Powell.  Powell, however, will be speaking at the virtual IMF/World Bank meetings being held this week.  In fact, that should remind us to all be aware of the tape, as we will be hearing from many global financial policymakers this week, and you never know what may come from that.

In the end, the bond market continues to be the key driver of markets, and the US Treasury market remains the driver of global bond markets.  I see no reason for US yields to back off given the consistent data story and the increased price pressures.  And that, my friends, means the dollar has further room to rise.

Good luck and stay safe
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No Need to be Austere

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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
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The Worry du Jour

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The Treasury Sec and Fed Chair
This morning are set to declare
While things are improving
They’re not near removing
The stimulus seen everywhere

Meanwhile, other Fedsters explained
Inflation may not be constrained
Though they’re all quite sure
The worry du jour
Will pass and cannot be sustained

While last week was actually Fed week, with the FOMC meeting and Powell press conference already six days past, it is starting to feel like this week is Fed week.  We have so many scheduled appearances by a wide range of Fed governors and regional presidents, as well as by Chairman Powell, that the Fed remains the primary theme in the markets.  Now, in fairness, the Fed has been a dominant part of any market discussion for the past decade plus (arguably since the GFC in 2008), but I cannot remember a week with this many Fed speeches lined up.

Of course, the question is, will we learn anything new from all these speeches?  And the answer, sadly, is probably not.  Chairman Powell and his acolytes have made it clear that they are not going to raise the benchmark Fed Funds rate until somewhere in the late 2023/early 2024 timeframe, and in any case, not until they see actual data, not forecasts, that unemployment has fallen and prices are rising.  With that as a given, the only question unanswered is about the back end of the Treasury curve, where 10-year yields have risen more than 70 basis points so far in 2021, although are lower by about 5bps this morning.  With the 2-year Treasury note stuck at about 0.15%, the steepening of the yield curve has been dramatic so far, but it must be remembered that historically, when the yield curve starts to steepen, it has gone much further than the moves so far, with a 2yr-10yr spread of 275 basis points quite common.  Compared to the current reading of 150 basis points, and assuming the 2-year won’t be moving, that implies the 10-year Treasury could well move to a yield of 2.90%!

One of the key features driving equity market performance during the pandemic has been the promise of low rates forever, as any discounted cash flow analysis of a company’s future earnings was using a discount rate approaching 0.0%.  However, if 10-year yields rise that much (which implies 30-year yields will be somewhere in the 3.50%-4.0% area), it will be far more difficult to justify the current market valuations and we could well see some corrective price action in the stock market.  (That is a euphemism for stocks would tank!)  Now, if stocks were to correct lower, that would have an immediate impact on financing conditions, tightening them substantially, which in conjunction with rising back end yields would move the Fed away from its preferred stance of easy money.  Seemingly, it will be difficult for the Fed to allow that to occur and remain consistent with their stated objectives.

So, what might they do?  Well, this is the argument for yield curve control (YCC), that the Fed cannot simply allow the market to dictate financing terms during the recovery.  And it is the crux of the weaker dollar thesis.  But so far this week, as well as Chairman Powell, we have heard from governor Michelle Bowman and Richmond Fed president Tom Barkin, and not one of them has even hinted they are concerned with the rise in the back end.  As long as that remains the case, I expect that equity markets will have difficulty moving higher and I expect the dollar to benefit.  We have previously discussed the fact that the carrying costs of Treasury debt as a percentage of GDP is currently declining due to the dramatic decline in interest rates, and that Secretary Yellen has explicitly highlighted that issue as a reason to be unconcerned with additional borrowing.  Arguably, for as long as Yellen is okay with rising yields, the Fed will be okay as well.  But at some point, it certainly appears likely that a very steep yield curve will not fit well with the recovery thesis and the Fed will be forced to act.  However, until then, let us take them at their word and assume they are comfortable with the current situation.  We hear from nine more individual speakers this week across 18 different venues, including Powell and Yellen testifying to the House today and the Senate tomorrow, so by the end of the week, if there are even subtle shifts in view, we should have an idea.

As to today’s session, risk is under some pressure with equity markets having fallen throughout Asia (Nikkei -0.6%, Hang Seng -1.3%, Shanghai -0.9%) and all red in Europe as well (DAX -0.6%, CAC -0.7%, FTSE 100 -0.5%).  US futures are also pointing lower with declines on the order of 0.3% – 0.5% across the major indices.  It is also worth noting that prices have been softening over the past hour or two, which is different price action than we have seen lately, where early losses tend to be erased.

Bond markets are clearly demonstrating their haven status this morning with European sovereigns all seeing yield declines (Bunds -3.5bps, OATs -3.3bps, Gilts -4.1bps) which is right in line with the Treasury story, where 10-year yields have fallen 6.5bps now.

Commodity prices are also under pressure, with oil (-3.75%) back below $60/bbl and testing some key technical support levels.  Meanwhile, base metals are softer (copper 1.4%, Aluminum -1.7%) although the grains are mixed.  Finally, gold has bounced back from early declines and is up a scant 0.1% at this hour.

Turning to the dollar, it is stronger pretty much across the board, with JPY (+0.3%) the only G10 currency able to gain, and simply demonstrating its haven characteristics.  Otherwise, NZD (-1.7%) is the laggard, followed by AUD (-1.0%) and NOK (-0.8%).  While the NOK is obviously being undermined by oil’s decline, the NZD story revolves around an announcement that the government is going to try to rein in housing price increases, which have seen prices rise 23% in the past year, as they try to stop a housing bubble.  (Of course, they could simply raise rates to stop it, but that would obviously impact other things.)  However, the result was an immediate assessment of declining inward investment, hence the kiwi’s decline.  But away from the yen, the rest of the space is down at least 0.4%, so this is broad-based and significant.

Emerging market currencies are similarly under virtually universal pressure, with major losses seen in RUB (-1.4%), ZAR -1.1%) and MXN (-1.0%).  Obviously, these are all impacted by the decline in oil and commodity prices and will continue to be so going forward.  The CE4 are all much weaker as well, showing their high beta to the euro (-0.45%) and I would be remiss if I left out TRY (-0.9%) which was actually higher earlier in the session on what appears to have been a dead-cat bounce.  TRY has further to fall, especially if risk is being unwound.

On the data front, New Home Sales (exp 870K) are the main release, although we also see the Richmond Fed Manufacturing Index (16), a less widely followed version of Philly or Empire State.  But really, I expect the day’s highlight will be the Powell/Yellen testimony, and arguably, the Q&A that comes after their opening statements.  While most Congressmen and women consistently demonstrate their economic ignorance in these settings, there are a few who might ask interesting questions.  But for now, there is no change on the horizon, so there is no cap on yields. While they are falling today, they have plenty of room to rise, and with them, so too the dollar.

Good luck and stay safe
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Central Banks Fear

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
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