Tag Archives: #Fed

Crash Landing

Posted on by

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: Bloomberg

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

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

Good luck and stay safe
Adf

Tempt the Fates

Posted on by

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
Adf

To Sell or To Buy

Posted on by

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

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

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

Source : Bloomberg

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

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
Adf

Pending A-pocalypse

Posted on by

Inflation’s on everyone’s lips
As traders now need come to grips
With data still soft
But forecasts that oft
Point to pending a-pocalypse

Is inflation really coming soon?  Or perhaps the question should be, is measured inflation really coming soon?  I’m confident most of us have seen the rise in prices for things that we purchase on a regular basis, be it food, clothing, cable subscriptions or hard goods.  And of course, asset price inflation has been rampant for years, but apparently that doesn’t count at all.  However, the focus on this statistic has increased dramatically during the past several months which is a huge change from, not only the immediate post-pandemic economy, but in reality, the past thirty years of economic activity.  In fact, ever since Paul Volcker, as Fed Chair, slew the inflationary dragon that lived in the 1970’s, we have seen a secular move lower in measured consumer prices alongside a secular move lower in nominal interest rates.

But the pandemic has forced a lot of very smart people (present company excluded) to reconsider this trend, with many concluding that higher prices, even the measured kind, are in our future.  And this is not a discussion of a short-term blip higher due to pent up demand, but rather the long-term trend higher that will need to be addressed aggressively by the Fed lest it gets out of hand.

The argument for inflation centers on the difference between the post GFC financial response and the post Covid shock financial response.  Back in 2009, the Fed cut rates to zero and inaugurated their first balance sheet expansion of note with QE1.  Several more bouts of QE along with years of near zero rates had virtually no impact on CPI or PCE as the transmission mechanism, commercial banks, were not playing their part as expected.  Remember, QE simply replaces Treasuries with bank reserves on a commercial bank balance sheet.  It is up to the commercial bank to lend out that money in order for QE to support the economy.  But commercial banks were not finding the risk adjusted returns they needed, especially compared to the riskless returns they were receiving from the Fed from its IOER program.  So, the banking sector sold the Fed their bonds and held reserves where they got paid interest, while enabling them to have a riskless asset on their books.  In other words, only a limited amount of QE wound up in the public’s pocket.  The upshot was that spending power did not increase (remember, wages stagnated) and so pricing pressures did not materialize, hence no measured inflation.

But this time around, fiscal policy has been massive, with the CARES act of nearly $2 trillion including direct payments to the public as well as forgivable small business loans via the PPP program.  So, banks didn’t need to lend the money to get things moving, the government solved that part of the equation. Much of that money wound up directly in the economy (although certainly some found its way into RobinHood accounts and Bitcoin), thus amping up demand.  At the same time, the lockdowns around the world resulted in broken supply chains, meaning many goods were in short supply.  This resulted in the classic, more money chasing fewer goods situation, which leads to higher prices.  This helps explain the trajectory of inflation since the initial Covid impact, where prices collapsed at first, but have now been rising back sharply.  While they have not yet reached pre-Covid levels, it certainly appears that will be the case soon.

Which leads us back to the question of, what will prevail?  Will the rebound continue, or will the long-term trend reassert itself?  This matters for two reasons.  First, we will all be impacted by rising inflation in some manner if it really takes off.  But from a markets perspective, if US inflation is rising rapidly, it will put the Fed in a bind with respect to their promise to keep rates at zero until the end of 2023.  If the market starts to believe the Fed is going to raise rates sooner to fight inflation, that will likely have a very deleterious effect on equity and bond prices, but a very positive effect on the dollar.  The combination of risk-off and higher returns will make the dollar quite attractive to many, certainly enough to reverse the recent downtrend.

Lately, we are seeing the beginnings of this discussion, which is why the yield curve has steepened, why stock markets have stalled and why the dollar has stopped sliding.  Fedspeak this week has been cacophonous, but more importantly has shown there is a pretty large group of FOMC members who see the need for tapering policy, starting with reducing QE, but eventually moving toward higher rates.  Yesterday, uber-dove Governor Lael Brainerd pushed back on that story, but really, all eyes will be on Chairman Powell this afternoon when he speaks.  To date, he has not indicated a concern with inflation nor any idea he would like to taper purchases, so any change in that stance is likely to lead to a significant market response.  Pay attention at 12:30!

With that as backdrop, a quick tour of the markets shows that risk appetite is moderately positive this morning.  While the Nikkei (+0.85%) and Hang Seng (+0.9%) both did well, Shanghai suffered (-0.9%) despite data showing record export performance by China last year.  Europe is far less exciting with small gains (DAX +0.2%, CAC +0.1% and FTSE 100 +0.7%) following Germany’s release of 2020 GDP data showing a full-year decline of “just” -5.0%, slightly less bad than expected.  US futures are mixed at this hour, but the moves are all small and offer no real news.

Bond markets show Treasury yields higher by 2bps, while European bonds have all seen yields slip between 1.0 and 1.7bps, at least the havens there.  Italian BTP’s are selling off hard, with yields rising 5.7bps, and the rest of the PIGS have also been under pressure.  Oil prices are little changed this morning, still holding onto their gains since November.  Gold prices are slightly softer and appear to be biding their time until the next big piece of news hits.

Finally, the dollar is somewhat mixed this morning, with the G10 basically split between gainers and losers, although the gains have been a bit larger (AUD +0.4%, SEK +0.3%) than the losses (CHF -0.2%, JPY -0.1%).  But this looks like position adjustments and potential order flow rather than a narrative driven move.  EMG currencies are also split, but there are clearly more gainers than losers here, with the commodity bloc doing best (ZAR +0.85%, RUB +0.65%, BRL +0.6%) and losses more random led by KRW (-0.25%) and CZK (-0.2%).  If pressed, one needs look past oil and gold to see agricultural commodities and base metals still performing well and supporting those currencies.  KRW, on the other hand is a bit more confusing given the growth in China, it’s main exporting destination.  Again, position adjustments are quite viable given the won’s more than 11% gain since May.

This morning’s data slate includes only Initial Claims (exp 789K) and Continuing Claims (5.0M), which if far from expectations could wiggle markets, but seem unlikely to do so as everyone awaits Powell’s speech.  Until then, I expect that the dollar will continue to remain supported, but if Powell reiterates a very dovish stance, we could easily see the dollar head much lower.  Of course, if he gives credence to the taper view, look for some real market fireworks, with both bonds and stocks selling off and the dollar jumping sharply.

Good luck and stay safe
Adf

What Will the Fed Do?

Posted on by

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
Adf

Perfect Right Here

Posted on by

Said Harker, by end of this year
A taper could be drawing near
But Mester explained
No cash would be drained
As policy’s perfect right here

Ahead of this morning’s payroll report, I believe it worthwhile to recap what we have been hearing from the FOMC members who have been speaking lately.  After all, the Fed continues to be the major force in the market, so maintaining a clear understanding of their thought process can only be a benefit.

The most surprising thing we heard was from Philadelphia Fed president Harker, who intimated that while he saw no reason to change things right now, he could see the Fed beginning to taper their asset purchases by the end of 2021 or early 2022.  Granted, that still implies an additional $1 trillion plus of purchases, but is actually quite hawkish in the current environment where expectations are for rates to remain near zero for at least the next three years.  Given what will almost certainly be a significant increase in Treasury issuance this year, if the Fed were to step back from the market, we could see significantly higher rates in the back end of the curve.  And, of course, it has become quite clear that will not be allowed as the government simply cannot afford to pay higher rates on its debt.   As well, Dallas Fed President Kaplan also explained his view that if the yield curve steepened because of an improved growth situation in the US, that would be natural, and he would not want to stop it.

But not to worry, the market basically ignored those comments as evidenced by the fact that the equity market, which will clearly not take kindly to higher interest rates in any form, rallied further yesterday to yet more new all-time highs.

At the same time, three other Fed speakers, one of whom has consistently been the most hawkish voice on the committee, explained they saw no reason at all to adjust policy anytime soon.  Regional Fed presidents from Cleveland (Loretta Mester), Chicago (Charles Evans) and St Louis (James Bullard) were all quite clear that it was premature to consider adjusting policy as a response to the Georgia election results and the assumed increases in fiscal stimulus that are mooted to be on the way.

Recapping the comments, it is clear that there is no intention to adjust policy, meaning either the Fed Funds rate or the size of QE purchases, anytime soon, certainly not before Q4.  And if you consider Kaplan’s comments more fully, he did not indicate a preference to reduce support, just that higher long-term rates ought to be expected in a well-performing economy.  Vice-Chairman Clarida speaks this morning, but it remains difficult to believe that he will indicate any changes either.  As I continue to maintain, the government’s ability to withstand higher interest rates on a growing amount of debt is limited, at best, and the only way to prevent that is by the Fed capping yields.  Remember, while the Fed has adjusted its view on inflation, now targeting an average inflation rate, they said nothing about allowing yields to rise alongside that increased inflation.  Again, the dollar’s performance this year will be closely tied to real (nominal – inflation) yields, and as inflation rises in a market with capped yields, the dollar will decline.

Turning to this morning’s payroll release, remember, Wednesday saw the ADP Employment number significantly disappoint, printing at -123K, nearly 200K below expectations.  As of now, the current median forecasts are as follows:

Nonfarm Payrolls 50K
Private Payrolls 13K
Manufacturing Payrolls 16K
Unemployment Rate 6.8%
Average Hourly Earnings 0.2% (4.5% Y/Y)
Average Weekly Hours 34.8
Participation Rate 61.5%
Consumer Credit $9.0B

Source: Bloomberg

These numbers are hardly representative of a robustly recovering economy, which given the cresting second wave of Covid infections and the lockdowns that have been imposed in response, ought not be that surprising.  The question remains, will administration of the vaccine be sufficient to change the trajectory?  While much has been written about pent up demand for things like travel and movies, and that is likely the case, there has been no indication that governments are going to roll back the current rules on things like social distancing and wearing masks.  One needs to consider whether those rules will continue to discourage those very activities, and thus, crimp the expected recovery.  Tying it together, a slower than expected recovery implies ongoing stimulus

But you don’t need me to explain that permanent stimulus remains the basic premise, just look at market behavior.  After yesterday’s US equity rally, we have seen a continuation around the world with Japan’s Nikkei (+2.35%) leading the way in Asia, but strength in the Hang Seng (+1.2%) and Australia (+0.7%), although Shanghai (-0.2%) didn’t really participate.  Europe, too, is all green, albeit in more measured tones, with the DAX (+0.8%) leading the way but gains in the CAC (+0.5%) and FTSE 100 (+0.2%) as well as throughout the rest of the continent.  And finally, US futures are all pointing higher at this hour, with all three indices up by 0.25%-0.35%.

The Treasury market, which has sold off sharply in the past few sessions, is unchanged this morning, with the yield on the 10-year sitting at 1.08%.  In Europe, haven assets like bunds, OATs and gilts are little changed this morning, but the yields on the PIGS are all lower, between 1.6bps (Spain) and 3.9bps (Italy).  Again, those bonds behave more like equities than debt, at least in the broad narrative.

In the commodity space, oil continues to rally, up another 1.3% this morning, and we continue to see strength in base metals and ags, but gold is under the gun, down 1.1%, and clearly in disfavor in this new narrative of significant new stimulus and growth.  Interestingly, bitcoin, which many believe as a substitute for gold has continued to rally, vaulting through $41k this morning.

And lastly, the dollar, which everyone hates for this year, is ending the week on a mixed note.  In the G10, NOK (+0.3%) is the best performer, as both oil’s rise and much better than expected IP data have investors expecting continued strength there.  But after that, the rest of the bloc is +/- 0.2% or less, implying there is no driving force here, rather that we are seeing position adjustments and, perhaps, real flows as the drivers.

In the emerging markets, ZAR (+1.2%) and BRL (+0.6%) are the leading gainers, while IDR (-0.8%) and CLP (-0.6%) are the laggards.  In fact, other than those, the bloc is also split, like the G10, with winners and losers of very minor magnitude.  Looking first at the rand, today’s gains appear to be position related as ZAR has been under pressure all week, declining more than 5.6% prior to today’s session.  BRL, too, is having a similar, albeit more modest, correction to a week where it has declined more than 5% ahead of today’s opening.  Both those currencies are feeling strain from weakening domestic activity, so today’s gains seem likely to be short-lived.  On the downside, IDR seems to be suffering from rising US yields, as the attractiveness of its own debt starts to wane on a relative basis.  As to Chile, rising inflation seems to be weighing on the currency as there is no expectation for yields to rise in concert, thus real yields there are under pressure.

And that’s really it for the day.  We have seen some significant movement this week, as well as significant new news with the outcome of the Georgia election, so the narrative has had to adjust slightly.  But in the end, it is still reflation leads to higher equities and a lower dollar.  Plus ça change, plus ça meme chose!

Good luck, good weekend and stay safe
Adf

Slipping Away

Posted on by

Last week it appeared conversations
On Brexit, had built expectations
To broker a deal
That both sides would feel
Was fruitful for all Europe’s nations

Alas, based on headlines today
That good will is slipping away
Concern has now grown
That both sides condone
No deal, to the market’s dismay

Apparently, Brexit talks have reached their denouement, with the weekend efforts of PM Johnson and European Commission President Von der Leyen unable to bridge the final gaps.  The key issues regarding fishing in UK waters and state support for UK companies remain outstanding and neither side has yet been willing to budge.  There is clearly a great deal of brinksmanship ongoing here, but with the timeline so compressed, the chance for a No-deal outcome is still remarkably high.  In fact, as of a bit past 6am in NY, the headlines claim that negotiations might end by this evening in Europe, after one final call between the two leaders.

So, is this the end?  Is Brexit upon us, three weeks early?  And if so, what can we expect going forward?

The first thing to remember about international negotiations is they are never over, even when they have ended, especially in a situation of this nature.  The economic impact in both the UK and throughout Europe will be significant in a no-deal outcome, and this is something that neither side really wants to occur, despite any rhetoric to the contrary.  The most recent analyst estimates indicate that the UK’s economy will suffer a long-term reduction of 3.0% in GDP compared to the situation if a deal is completed.  Meanwhile, the EU’s impact will be a much smaller 0.5% of GDP, but that impact will be unevenly distributed, with Ireland expected to suffer a 6% decline in economic activity, while various other nations see much smaller effects.  Germany, too, will feel the pain, as German auto exports to the UK are one of the most lucrative parts of German industry, and with tariffs imposed, they will certainly decline.

And, ultimately, that is why the best bet remains that a deal will be done.  Especially given the economic disruption of the pandemic, the ability for either the UK or EU to blithely sit by and allow a critical trade relationship to crumble is virtually nil.  So, even if the talks ostensibly end later today, they will not have ended.  Both sides will still be seeking a deal, as both sides desperately need one.

However, investors are clearly worried, as evidenced by this morning’s price action across markets.  Perhaps the most obvious outcome is that of the pound, which has fallen 1.3% on the news.  Last week I was making the case that the market had not fully priced in a positive deal, and any agreement was likely to see the pound rally.  At the same time, a true collapse in talks with a no-deal outcome is likely to see a further decline, with 5%-7% seen as a reasonable result.  This morning’s movement is just a down payment on that, if no deal actually is the outcome.

But this news seems to have forced investors across markets to reconsider their current positioning and potential market responses to negative news.  Perhaps you are not old enough to remember what negative news actually is, so I will give a brief refresher here.  Negative news is a situation where not only is the economic impact indisputably harmful to a (country, company, currency), but that a central bank response of further policy ease will be unable to change the outcome.  Thus, Friday’s weaker than expected NFP number was not really negative because it encouraged the view that the Fed will ease further next week, thus offsetting any bad economics.  But Brexit changes the structure, not just the data, and no matter what the BOE does, customs checks are still going to slow down trade and commerce.

It is with this in mind that we look at markets this morning and see that risk is broadly being reduced.  Asian equity markets started the move as the Nikkei (-0.75%), Hang Seng (-1.25%) and Shanghai (-0.8%) all showed solid declines.  And this was despite Chinese data showing that exports from the mainland had increased a much greater than expected 21% and fostered a record large trade surplus.  In Europe, the situation is similar with one real exception.  The DAX (-0.3%) and CAC (-0.8%) are leading the Continent lower as investors react to the potential crimp in economic activity.  However, the FTSE 100 (+0.5%) is higher as most members of the index will benefit greatly from a weaker pound, and so are responding to the pound’s market leading decline.

Speaking of the pound, it has fallen 1.3% from Friday’s closing levels and is the leading decliner across all major currencies.  But weakness is evident in the commodity bloc as AUD (-0.5%), NZD (-0.4%) and CAD (-0.2%) are all suffering alongside oil (WTI -0.9%) and gold (-0.4%).  EUR (-0.1%) has been a relative outperformer as the market continues to estimate a much smaller impact of a no-deal scenario.  Meanwhile, in the EMG bloc, losses are virtually universal, but the magnitude is not that substantial.  For example, MXN (-0.7%) is the worst performer today, obviously suffering from oil’s decline, but we have also seen weakness throughout the CE4 (HUF -0.4%, CZK -0.3%, PLN -0.2%) along with ZAR and RUB, both having fallen 0.3%.  In fact, the one bloc that has outperformed today is APAC, where only two currencies (MYR -0.2% and SGD -0.15%) are in the red.  Given the genesis of the problems is in Europe, this should not be that surprising.

Bond markets are taking the risk-off theme seriously with Treasury yields lower by 2.2 basis points and European govvies seeing substantial demand.  Gilts lead the way, with a 5.6bps decline, but Bunds (-3.0bps) and OAT’s (-2.6bps) are also rallying nicely.  Remember, too, that the ECB meets Thursday with expectations built in for a €500 billion increase in PEPP as well as a maturity extension of between six and twelve months in addition to an increase in the TLTRO program, with a maturity extension there as well.  One other thing to watch from the ECB is whether or not they mention the euro and its recent rally.  Madame Lagarde and her colleagues cannot countenance a significant rally from current levels, and I expect they will make that clear.

As to data this week, aside from the ECB, CPI is the biggest thing in the US:

Tuesday NFIB Small Business 102.5
Nonfarm Productivity 4.9%
Unit Labor Costs -8.9%
Wednesday JOLTs Job Openings 6.325M
Thursday Initial Claims 725K
Continuing Claims 5.27M
CPI 0.1% (1.1% Y/Y)
-ex food & energy 0.1% (1.6% Y/Y)
Friday PPI 0.1% (0.7% Y/Y)
-ex food & energy 0.2% (1.5% Y/Y)
Michigan Sentiment 76.0

Source: Bloomberg

With the last FOMC meeting of the year next Wednesday, the Fed is in their quiet period so there will be no commentary on that front.  With this in mind, the dollar, which continues to trend lower, will likely need some new catalyst to take the next step.  At this point, the biggest surprise is likely to be a positive conclusion to the Brexit talks, but given what we have seen over the past eight months, it is pretty clear that investors remain hugely bullish on the idea of the post-pandemic economy and will not be denied in their belief that stocks can only go up.  My gut tells me that US equities, where futures are currently lower by 0.3% or so, will finish the day higher, and the dollar will cede much of its overnight gains, even without a deal.

Good luck and stay safe
Adf

Further Afflictions

Posted on by

Each day there is growing conviction
The buck is due further affliction
More views now exist
The Fed will soon ‘Twist’
Thus, slaking the market’s addiction

But even if Powell and friends
Do act as the crowd now contends
Does anyone think
Lagarde will not blink
And cut rates at which her group lends?

You cannot read the financial press lately without stumbling across multiple articles as to why the dollar is due to fall further.  There is no question it has become the number one conviction trade in the hedge fund community as well as the analyst community.  There are myriad reasons given with these the most common:

1.     The introduction of the vaccine will lead to a quicker recovery globally and demand for risk assets not havens like the dollar
2.     The Biden administration will be implementing a new, larger stimulus package adding to the global reflation trade
3.     The Fed is going to embark on a new version of Operation Twist (where they swap short-dated Treasuries for long-dated Treasuries) in order to add more stimulus, thus weakening the dollar
4.     The market technical picture is primed for further dollar weakness in the wake of recent price action breaking previous dollar support levels.

Let’s unpack these ideas in order to try to get a better understanding of the current sentiment.

The vaccine story is front page news worldwide and we have even had the first country, the UK, approve one of them for use right away.  There is no question that an effective vaccine that is widely available, and widely taken, could easily alter the current zeitgeist of fear and loathing.  If confidence were to make a comeback, as lockdowns ended and people were released from home quarantines, it would certainly further support risk appetite.  Or would it?

Consider that risk assets, at least equities, are already trading at record high valuations as investors have priced in this outcome.  You may remember the daily equity rallies in October and November based on hopes a vaccine would be arriving soon.  The point is, it is entirely possible, and some would say likely, that the vaccine implementation has already been priced into risk assets.  One other fly in this particular ointment is that so many businesses have already permanently closed due to the government-imposed restrictions worldwide, that even if economic demand rebounds, supply may not be available, thus driving inflation rather than activity.

How about the idea of a new stimulus package adding to global reflation?  Again, while entirely possible, if, as is still widely expected, the Republicans retain control of the Senate, any stimulus bill is likely to disappoint the bulls.  As well, if this is US stimulus, arguably it will help support the US economy, US growth and extend the US rebound further and faster than its G10 and most EMG peers.  Yes, risk will remain in favor, but will that flow elsewhere in the world?  Maybe, maybe not.  That is an open question.

Certainly, a revival of Operation Twist, where the Fed extends the maturity of its QE purchases in order to add further support to the economy by easing monetary policy further would be a dollar negative.  I thought it might be instructive to see how the dollar behaved back in 2011-12 when Ben Bernanke was Fed Chair and embarked on the first go-round of this policy.  Interestingly enough, from September 2011 through June 2012, the first leg of Operation Twist, the dollar rallied 8.7% vs. the euro.  When the Fed decided to continue the program for another six months, the first dollar move was a continuation higher, with another 2.75% gain, before turning around and weakening about 6%.  All told, through two versions of the activity, the dollar would up slightly firmer (2.5%) than when it started.

And this doesn’t even consider the likelihood that if the Fed eases further, all the other major central banks will be doing so as well.  Remember, FX is a relative game, so relative monetary policy moves are the driver, not absolute ones.  And once again, I assure you, that if the euro starts to rally too far, the ECB will spare no expense to halt that rally and reverse it if possible.  Currently, the trade-weighted euro is back to levels seen in early September but remains 1.75% below the levels seen in 2018.  It is extremely difficult to believe that the ECB will underperform next week at their meeting if the euro is climbing still higher.  Deflation in Europe is rampant (CPI was just released at -0.3% in November), and a strong currency is not something Lagarde and her compatriots can tolerate.

Finally, looking at the technical picture, it may well be the best argument for further dollar weakness.  To the uninitiated (including your humble author) the variety of technical indicators observed by traders can be dizzying.  However, some include satisfying the target of an “inverted hammer” pattern, recognition of the next part of an Elliott Wave ABC correction and DeMark targets now formed for further dollar weakness.  While that mostly sounded like gibberish, believe me when I say there are many traders who base every action on these indicators, and when levels are reached in the market, they swarm in to join the parade.  At the same time, the hedge fund community, while short a massive amount of dollars, is reputed to have ample dry powder to increase those positions.

In sum, ironically, I would contend that the technical picture is the strongest argument for the dollar to continue its recent decline.  Risk assets are already priced for perfection, the vaccine is a known quantity and any Fed move is likely to be matched by other central banks.  This is not to say that the dollar won’t decline further, just that any movement is likely to be grudging and limited.  The dollar is not about to collapse.

A quick recap of today’s markets shows that risk appetite, not unlike yesterday’s lack of enthusiasm, remains satisfied for now.  Asian equities were mixed with the Hang Seng (+0.7%) the leader by far as both the Nikkei (0.0%) and Shanghai (-0.2%) showed no life.  European bourses are mostly lower (DAX -0.4%, CAC -0.25%) although the FTSE 100 is flat on the day.  And US futures are also either side of flat.

Bond markets, are rebounding a bit from their recent decline, with Treasuries seeing yields lower by 1 basis point and European bonds all rallying as well, with yields falling between 2bps and 3bps.  The latter may well be due to the combination of weaker than expected Services PMI releases as well as the news that Germany is extending its partial lockdown to January 10.  (Tell me again why the euro is a good bet here!)

Gold continues to rebound from its correction last week, up another $10 while the dollar, overall, this morning is somewhat softer, keeping with the recent trend.  GBP (+0.6%) is the leading gainer in the G10 on continued hopes a Brexit deal will soon be reached, but the rest of the bloc is +/-0.2%, or essentially unchanged.  EMG gainers include HUF (+0.7%) as the government there expands infrastructure spending, this time on airports, while the rest of the bloc has seen far smaller gains, which seem to be predicated on the idea of US stimulus talks getting back on track.

Initial Claims (exp 775K) data leads the calendar this morning with Continuing Claims (5.8M) and then ISM Services (55.8) at 10:00.  Yesterday’s Beige Book harped on the negative impact that government shutdowns have had on companies with no sign, yet, of vaccine hopes showing up in businesses.  At the same time, Chairman Powell, in his House testimony yesterday, explained that there was no rift between the Fed and the Treasury, and the Fed response when Treasury Secretary Mnuchin said he was recalling unused funds from the CARES act, was merely reinforcement of the idea that the Fed was not going to back away from their stated objectives.

In the end, the dollar remains under pressure and the trend is your friend.  With that in mind, though, it strikes that a decline of more than another 1%-2% will be very difficult to achieve without a more significant correction first.  Again, for receivables hedgers, these are good levels to consider.

Good luck and stay safe
Adf

Nothing but Cheerful

Posted on by

While yesterday traders were fearful
Today they are nothing but cheerful
The vaccine is coming
While Bitcoin is humming
It’s only the bears who are tearful

Risk is back baby!!  That is this morning’s message as a broad-based risk-on scenario is playing out across all markets.  Well, almost all markets, oil is struggling slightly, but since according to those in the know (whoever they may be) we have reached so-called ‘peak oil’, the oil market doesn’t matter anymore.  So, if it cannot rally on a day when other risk assets are doing so, it is of no consequence.

Of course, this begs the question, what is driving the reversal of yesterday’s theme?  The most logical answer is the release of the newest batch of Manufacturing PMI data from around the world, which while not universally better, is certainly trending in the right direction.  Starting last night in Asia, we saw strength in Australia (55.8), Indonesia (50.6), South Korea (52.9), India (56.3) and China (Caixin 54.9).  In fact, the only weak print was from Japan (49.0), which while still in contractionary territory has improved compared to last month.  With this much renewed manufacturing enthusiasm, it should be no surprise that equity markets in Asia were all bright green.  The Nikkei (+1.35%), Hang Seng (+0.85%) and Shanghai (+1.75%) led the way with New Zealand the only country not to join in the fun.

Turning to European data, it has been largely the same story, with Germany (57.8) leading the way, but strong performances by the UK (55.6) and the Eurozone (53.8) although Italy (51.5) fell short of expectations and France (49.6) while beating expectations remained below the key 50.0 level.  Spain (49.8), too, was weak failing to reach expectations, but clearly, the rest of the Continent was quite perky in order for the area wide index to improve.  Equity markets on the Continent are also bright green led by the FTSE 100 (+1.95%) but with strong performances by the DAX (+1.0%) and CAC (+1.1%) as well.  In fact, here, not a single market is lower.  Even Russian stocks are higher despite the weakest PMI performance of all (46.3).

The point is, there is no risk asset that is not welcome in a portfolio today.  However, while the broad sweep of PMI data is certainly positive, it seems unlikely, given the market’s history of ignoring both good and bad data from this series, that this is the only catalyst.  In fairness, there was some other positive data.  For example, German Unemployment fell to 6.1%, a tick below last month and 2 ticks below expectations.  At the same time, Eurozone CPI was released at a slightly worse than expected -0.3% Y/Y in November, which only encourages the bullish view that the ECB is going to wow us next week when they unveil their latest adjustments to PEPP.

And perhaps, that is a large part of the story, expectations for ongoing central bank largesse to support financial markets continue to be strong.  After all, the buzz in the US is that the combination of Fed Chair Jay Powell alongside former Fed Chair Janet Yellen as Treasury Secretary means that come January or February, the taps will once again open in the US with more fiscal and monetary assistance.  Alas, what we know is that the bulk of that assistance winds up in the equity markets, at least that has been the case to date, so just how much this new money will help the economy itself remains in question.

But well before that, we have a number of key events upcoming, notably next week’s ECB meeting and the Fed meeting the following week.  Focusing first on Frankfurt, recall that Madame Lagarde essentially promised action at their late October get together, and the market wasted no time putting numbers on those expectations.  While no rate cut is anticipated, at least not in the headline Deposit rate (currently -0.50%), the PEPP is expected to be increased by up to €600 billion with its tenor expected to be extended by an additional six months through the end of 2021.  However, before we get too used to that type of expansion, perhaps we should heed the words of Isabel Schnabel, the German ECB Executive Board member who today explained that while further support would be forthcoming, thoughts that the ECB would take the Mario Draghi approach of exceeding all expectations should be tempered.  Of course, the question is whether a disappointing outcome next week, say just €250 billion additional purchases, would have such a detrimental impact on the markets economy.  Remember, while Madame Lagarde has a great deal of political nous, she has thus far demonstrated a tin ear when it comes to market signals.  The other topic on which she opined was the TLTRO program, which she seems to like more than PEPP, and which she implied could see both expansion and even a further rate cut from the current -1.00%.

And perhaps, that is all that is needed to get the juices flowing again, a little encouragement that more money is on its way.  Certainly, the bond markets are exhibiting risk on tendencies, although yield increases of between 0.2bps (Germany) and 1.1bps (Treasuries) are hardly earth shattering.  They are certainly no indication of the reflation trade that had gotten so much press just a month ago.

And finally, the dollar, which is definitely softer this morning, but only after having rallied all day yesterday, so is in fact higher vs. yesterday morning’s opening levels.  The short dollar trade remains one of the true conviction trades in the market right now and one where positioning is showing no signs of abating.  Almost daily there seems to be another bank analyst declaring that the dollar is destined for a great fall in 2021.  Perhaps they are correct, but as I have repeatedly pointed out, no other central bank, certainly not the ECB or BOJ is going to allow the dollar to decline sharply without some action on their part to try to slow or reverse it.

A tour of the market this morning shows that CHF (+0.4%) is the leading gainer in the G10, although followed closely by SEK (+0.4%) and EUR (+0.35%).  Of course, if you look at the movement since Friday, CHF and EUR are higher by less than 0.1% and SEK is actually lower by 0.45%.  In other words, do not believe that the dollar decline is a straight-line affair.

Emerging markets are seeing similar price action, although as the session has progressed, we have seen more currency strength.  Currently, CLP (+0.9%), ZAR (+0.85%) and BRL (+0.8%) are leading the way here, all three reliant on commodity markets, which have, other than oil, performed well overnight.  The CE4 are also higher (HUF +0.6%, CZK +0.5%), tracking the euro’s strength, and Asian currencies had a fair run overnight as well, with INR (+0.5%) the best performer as a beneficiary of an uptick in stock and bond investments made their way into the country.

On the data front, today brings ISM Manufacturing (exp 58.0) and Construction Spending (0.8%), with the former certainly of more interest than the latter.  This is especially so given the PMI data overnight and the market response.  But arguably, of far more importance is Chairman Powell’s Senate testimony starting at 10:00 this morning, which will certainly overshadow comments from the other three Fed speakers due later.

Yesterday at this hour, with the dollar under pressure, it seemed we were going to take out some key technical levels and weaken further.  Of course, that did not happen.  With the dollar at similar levels to yesterday morning, and another dollar weakening sentiment, will today be the day that we break 1.20 in the euro convincingly?  As long as CNY remains strong, it is certainly possible, but I am not yet convinced.  Receivables hedgers, these are the best levels seen in two years, so it may not be a bad time to step in.

Good luck and stay safe
Adf

Pandemic Support

Posted on by

Til now the direction’s been clear
As Jay and Mnuchin did fear
If they didn’t spend
The US can’t mend
And things would degrade through next year

But now, unless there’s a breakthrough
It seems Treasury won’t renew
Pandemic support
Which likely will thwart
A rebound til late Twenty-Two

Just when you thought things couldn’t get more surprising, we wind up with a public disagreement between the US Treasury Secretary and the Federal Reserve Chair.  To date, Steve Mnuchin and Jay Powell have seemed to work pretty well together, and at the very least, were both on the same page.  Both recognized that the impact of the pandemic would be dramatic and there was no compunction by either to invent new ways to support both markets and the economy.  As well, both were appointed by the same president, and although their personal styles may be different, both seemed to have a single goal in mind, do whatever is necessary to maintain as much economic activity as possible.

Aah, but 2020 is unlike any year we have ever seen, especially when it comes to policy decisions.  The legalities of the alphabet soup of Fed programs (e.g. PMCCF, SMCCF, MMLF, etc.) require that they expire at the end of the year and must be renewed by the Treasury Department.  And in truth, this is a good policy as expiration dates on spending programs require continued debate as to their efficacy before renewal.  The thing is, given the rapid increase in covid infections and rapid increase in state economic restrictions and shutdowns, pretty much every economist and analyst agrees that all of these programs should continue until such time as the spread of the coronavirus has slowed or herd immunity has been achieved.  Certainly, every FOMC member has been vocal in the need for more fiscal stimulus as they know that their current toolkit is inadequate.  (Just yesterday we heard from both Loretta Mester and Robert Kaplan with exactly that message.)  But to a (wo)man, they have all explained that the Fed will continue to do whatever it can to help, and that means continuing with the current programs.

Into this mix comes the news that Secretary Mnuchin sent a letter to the Fed that they must return the funds made available to backstop some of the Fed’s lending programs, as they were no longer needed.  The Fed immediately responded by saying “the full suite” of programs should be maintained into 2021.

Let’s consider, for a moment, some of the programs and what they were designed to do.  For instance, the Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility do seem superfluous at this stage.  After all, more than $1.9 trillion of new corporate debt has been issued so far in 2020 and the Fed has purchased a total of $45.8 billion all year, just 2.4%, mostly through ETF’s.  It seems apparent that companies are not having any difficulty accessing financing, at very low rates, in the markets directly.  In the Municipal space, the Fed has only bought $16.5 billion while more than $250 billion has been successfully issued year to date.  Mnuchin’s point is, return the unused funds and deploy them elsewhere, perhaps as part of the widely demanded fiscal policy support.  The other side of that coin, though, is the idea that the reason the market’s have been able to support all that issuance is because the Fed backstop is in place, and if it is removed, then markets will react negatively.

In fairness, both sides have a point here, and perhaps the most surprising outcome is the public nature of the spat.  Historically, these two agencies work closely together, especially during difficult times.  But as I said before, 2020 is unlike any time we have seen in our lifetimes.  There is one other potential driver of this dissension, and that could be that politically, the Administration is trying to get Congress to act on a new stimulus plan quickly by threatening to remove some of the previous stimulus.  However, whatever the rationale, it clearly has the market on edge, interrupting the good times, although not yet resulting in a significant risk-off outcome.

If this disagreement is not resolved before the next FOMC meeting in three weeks’ time, the market will be looking for the Fed to expand its stimulus measures in some manner, either by increasing QE purchases or by purchasing longer tenor bonds, thus weighing on the back end of the curve as well as the front.  And for our purposes, meaning in the FX context, that would be significant, as either of those actions are likely to see a weaker dollar in response.  Remember, while no other central bank is keen to see the dollar weaken vs. their own currency, as long as CNY continues to outperform all, further dollar weakness vs. the euro, yen, pound, et al, is very much in the cards.

So, with that as our backdrop, markets today don’t really know what to do and are, at this point, mixed to slightly higher.  Asia, overnight, saw further weakness in the Nikkei (-0.4%), but both the Hang Seng and Shanghai exchanges gained a similar amount.  European bourses have slowly edged higher to the point where the CAC, DAX and FTSE 100 are all 0.5% higher on the day, although US futures are either side of unchanged as traders try to figure out the ultimate impact of the spat.  Bonds are mixed with Treasury yields higher by 1 basis point, but European yields generally lower by the same amount this morning.  Of course, a 1 basis point move is hardly indicative of a directional preference.

Both gold and oil are essentially flat on the day, and the dollar can best be described as mixed, although it is starting to soften a bit.  In the G10 space, NZD (+0.45%) leads the way with the rest of the commodity bloc (AUD, NOK, CAD) all higher by smaller amounts.  Meanwhile, the havens are under a bit of pressure, but only a bit, with JPY and CHF both softer by just (-0.1%).  EMG currencies have seen a similar performance as most Asian currencies strengthened overnight, but by small amounts, in the 0.2%-0.3% range.  Meanwhile, the CE4 were following the euro, which had been lower most of the evening but is now back toward flat, as are the CE4.  And LATAM currencies, as they open, are edging slightly higher.  But overall, while there is a softening tone to the dollar, it is modest at best.

On the data front, there is none to be released in the US today, although early this morning we learned that UK Retail Sales were a bit firmer than expected while Italian Industrial activity (Sales and Orders) was much weaker than last month.  On the speaker front, four more Fed speakers are on tap, but they all simply repeat the same mantra, more fiscal spending, although now they will clearly include, don’t end the current programs.

For the day, given it is the Friday leading into Thanksgiving week, I expect modest activity and limited movement.  However, if this spat continues and the Treasury is still planning on ending programs in December, I expect the Fed will step in to do more come December, and that will be a distinct dollar negative.

One last thing, I will be on vacation all of next week, so there will be no poetry until November 30.

Good luck, good weekend, stay safe and have a wonderful holiday
Adf