As Much As They Want

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
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More Terrified

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
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