In Washington, chaos prevailed
As Congress’s job was derailed
Investors, though, thought
‘Twas nothing, and bought
More stocks with the 10-year was assailed

One of the more remarkable aspects of the chaotic events in Washington, DC yesterday was the fact that the market reaction was completely benign.  On the one hand, given the working assumption that the theatrics would not affect the ultimate outcome, it is understandable.  On the other hand, the fact that there continues to be this amount of discord in the nation in the wake of a highly contentious election bodes ill for the ability of things to quickly return to normal.  In the end, though, market activity indicates the investment community firmly believes there will be lots more fiscal stimulus as the new Biden administration tries to address the ongoing pandemic driven economic issues.  Hence, the idea behind the reflation trade remains the current narrative, with more stimulus leading to faster economic growth, while increased Treasury supply to fund that stimulus leads to higher long end yields and a steeper yield curve.

However, now that the formalities of the electoral vote counting have concluded, focus has turned back to the narrative on a full-time basis, with the ongoing argument over whether inflation or deflation is in our future, as well as the question of whether assets, generally, are fairly valued or bubblicious.  The thing is, away from the politics, nothing has really changed very much lately.

Covid-19 continues to spread and the resultant lockdowns around the world continue to be expanded and extended.  Just last night, for instance, Japan declared a limited state of emergency in Tokyo and three surrounding prefectures in an effort to stem the spread of Covid.  That nation has been dealing with its highest caseload since April, and the Suga government was responding to requests for help from the local governments.  Meanwhile, in Germany, on Tuesday lockdowns were extended through the end of January and restrictions tightened to prevent travel of more than 15km from one’s home.  And yet, this type of news clearly does not dissuade investors as last night saw the Nikkei rally 1.6% while the DAX, this morning, is higher by 0.4% after a 1.75% rally yesterday.  In the end, the narrative continues to highlight the idea that the worse the Covid situation, the greater the probability of further fiscal and monetary stimulus, and therefore the bigger the boost to growth.

At the same time, the reflation piece of the narrative continues apace with Treasury yields continuing to climb, edging higher by one more basis point so far this morning after an eight basis point rise yesterday.  Something that has received remarkably little attention overall is the fact that oil prices have been rallying so steadily of late, having climbed more than 40% since the day before the Presidential election, and given the pending supply reductions, showing no signs of backing off.  This, along with the ongoing rallies in most commodities, is part and parcel of the reflation trade, as well as deemed a key piece of the ultimate dollar weakness story.

Regarding this last observation, there is, indeed, a pretty strong negative correlation between the dollar’s value and the price of oil.  Of course, the question to be answered is the direction of causality.  Do rising oil prices lead to a weaker dollar?  Or is it the other way round?  If it is the former, then the dollar’s future is likely to be one of weakness as the supply reductions in US shale production alongside the Saudi cuts can easily lead to further gains of $10-$15/bbl.  However, the dollar is impacted by many things, notably Fed policy, and if the dollar is the driver of oil movement, the future of the black, sticky stuff is going to be far less certain.  If, for example, inflation rises more rapidly than currently anticipated, and forces the market to consider that the Fed may react by reducing policy ease, the dollar could easily find support, especially given the massive short positions currently outstanding.  Would oil continue to rise into that circumstance?  The point is, correlations are fine to recognize, but as a planning tool, they leave something to be desired.  Understanding the fundamentals underlying price action remains critical to plan effectively.

As to today’s session, the risk picture has turned somewhat mixed.  As mentioned above, Asian equity prices had a pretty good day, with Shanghai (+0.7%) rising alongside the Nikkei, although the Hang Seng (-0.5%) struggled.  European bourses are mixed, with the DAX (0.4%) leading and the CAC (+0.1%) slightly higher although the FTSE 100 (-0.5%) is under pressure.  There is one outlier here, Sweden, where the OMX has rallied 2.1% this morning, although there is no general news driving the movement.  In fact, PMI Services data was released at its weakest level since the summer, which hardly heralds future strength.

We’ve already discussed Treasury weakness but the picture in Europe is more mixed, with bunds (-1bps) and OATs (-0.5bps) rallying slightly while Gilts (+1.7bps) are under pressure alongside Treasuries.

And finally, the dollar is showing some solid gains this morning, higher against all its G10 counterparts and most of the EMG bloc.  Despite ongoing strength in the commodity space, AUD (-0.75%) leads the way lower with NZD (-0.6%) next in line.  Clearly, the market did not embrace the Japanese news on the lockdown, as the yen has declined 0.6% as well.  As to the single currency, it has fallen 0.5%, with a very strong resistance level building at 1.2350.  It will take quite an effort to get through that level in the short run.

Emerging markets declines are led by CLP (-1.85%) and ZAR (-1.0%), although the weakness is nearly universal.  Interestingly, the Chile story is not about copper, which continues to perform well, but rather seems to be a situation where the currency is being used as a funding currency for carry trades in the EMG bloc.  ZAR, on the other hand, is suffering alongside gold, which got hammered yesterday and is continuing to soften.

On the data front, today brings Initial Claims (exp 800K), Continuing Claims (5.2M), the Trade Balance (-$67.3B) and ISM Services (54.5).  Remember, tomorrow is payrolls day, so there may be less attention paid to these numbers this morning.  One cautionary tale comes from the Challenger Job Cuts number, which is released monthly but given limited press.  Today, it jumped 134.5% from one year ago, a significant jump on the month, and a bad omen for the employment picture going forward.  With this in mind, it seems highly unlikely the Fed will do anything but ease policy further in the near term.  One other thing, yesterday the December FOMC Minutes were released but had no market impact.  Recall, the December meeting occurred prior to the stimulus bill or the Georgia run-off election, so was missing much new information.  But in them, the FOMC made clear that the bias was for a dovish stance for a long time to come.  Based on what we heard from Chicago’s Evans on Tuesday, it doesn’t seem that anything has changed since then.

Given the significant short dollar positions that are outstanding in the investment and speculative communities, the idea that the dollar could rally in the near term is quite valid.  While nothing has changed my longer-term view of rising inflation and deeper negative real yields undermining the dollar, that doesn’t mean we can’t jump in the near term.

Good luck and stay safe
Adf