Somewhat Concerned

Investors seem somewhat concerned
That risk, in all forms, has returned
Thus, stocks are backsliding
While Jay is deciding
If QE should soon be adjourned

With the FOMC beginning its two-day meeting this morning, and PPI data due at 8:30am, it is clear that investors are taking a more precautionary view of the world today.  Certainly, yesterday’s US equity market price action, where the major indices all closed on their session lows, has not helped sentiment, nor has the current market narrative of imminently tighter policy from the Fed.  As such, it should be no great surprise that risk assets across the board are under pressure while more traditional havens have found some support.

But let us ask ourselves, is this current market (not Fed) narrative realistic?  Again, I would contend the market expectations for tomorrow are that the Fed will double the pace of its QE tapering come January, which will have them finish QE by the end of March.  And it is easy to see the merits of the argument given the persistence and magnitude of price gains seen over the past twelve to fifteen months.  This is especially so given there is no obvious reason to believe prices will decline other than the economists’ mantra that supply will be created to fill the demand.  (While this is certainly true in the long run, as Keynes pointed out back in 1923, in the long run we are all dead, so timing matters here.)

However, there are counterarguments also being made that will carry weight, especially with the political bent of the current administration.  Specifically, the maximum employment piece of the Fed mandate, which Mr Powell highlighted last year when announcing the Fed’s new policy initiatives, remains an open question.  It appears that the current Fed view is that NAIRU (full employment) is reached when the Unemployment Rate reaches 3.8%.  The November NFP report showed Unemployment has declined to 4.2%, as measured, and recall that pre-pandemic, the Unemployment Rate had fallen to 3.5%, its lowest point in half a century.  Thus, the new view is that full employment will only be reached at near historic lows.  Yet, is that maximum employment in the current vernacular?

The Fed’s policy review used the terms “broad-based and inclusive” to describe maximum employment, by which they were considering not merely the statistical headline, but the makeup of the data when broken down by various subcategories, notably race.  That November report indicated that the Unemployment rate for minorities was 6.7%, considerably higher than for the white cohort which saw Unemployment of just 3.7%.  That disparity is at the heart of the question as to whether the Fed believes its employment mandate has been fulfilled.

You will not be surprised to know that there is vocal advocacy by some that the ratio that currently exists reflects bias and the Fed must do more to alleviate the problem, even at the expense of higher inflation.  Nor would you be surprised that others make the case that rising inflation is a greater burden on the lower and middle classes, so seeking those last few jobs results in a significantly worse outcome for all, especially those for whom the policies are intended to help.

The point is it is not a slam-dunk that the Fed is going to be as aggressively hawkish as the current market narrative claims.  While Chairman Powell clearly indicated that the pace of tapering would increase, do not be surprised if it rises from $15B/month to $20B or $25B/month rather than the baseline market assumption of $30B/month.  If that is the case, then another repricing in markets will be coming, with risk assets getting a reprieve while the dollar is likely to suffer.  While this is not my base case, I would ascribe at least a 30% probability to the idea that tomorrow’s FOMC is less hawkish than currently priced.  Stay on your toes.

In the meantime, here is what has been happening since you all went home last evening.  As mentioned, risk is under pressure with Asian equity markets (Nikkei -0.7%, Hang Seng -1.3%, Shanghai -0.5%) all following the US markets lower while European markets opened in a similar vein.  However, it appears that recent omicron news regarding the efficacy of current vaccinations with respect to moderating illness has begun to turn sentiment around and we now see both the DAX and CAC flat on the day while the FTSE 100 (+0.4%) has risen, embracing the new omicron news along with better than expected employment data from the UK (Unemployment fell to 4.2% with Weekly Earnings rising 4.9%).  Alas, US futures remain lower despite that Covid news, led by the NASDAQ (-0.6%).

Bond markets, which had earlier been modestly firmer (yields lower) have reversed course on the omicron news and we now see Treasury yields (+1.9bps) rising alongside the European sovereign market (Bunds +1.5bps, OATs +1.2bps, Gilts +2.3bps).  It seems market participants continue to be whipsawed between concerns over tighter policy and positive omicron news.

Commodity prices, too, have begun to reverse course as early session declines have now been erased with oil (0.0%) back to flat on the day from a nearly 1% decline a few hours ago.  While NatGas (-2.6%) in the US remains stable and under $4/mmBTU, the situation in Europe remains dire with prices rising another 3.6% as ongoing concerns over Nordstream 2 pressure the situation.  In the metals’ markets, there is mostly red with precious (Au -0.1%) softer and base (Cu -0.1%, Al -0.7%) also under pressure.  Agricultural products are falling as well today.

The dollar is on its back foot this morning as positivity permeates the markets with only NOK (-0.15%) softer in the G10, still feeling the lingering pain of oil while we see CHF (+0.35%) and EUR (+0.3%) lead the way higher.  Much of this movement, I believe, is position related as there has been little data or commentary to drive things, and the broader dollar gains that we have seen over the past months are seeing some profit-taking ahead of the FOMC and ECB meetings in the event that my case above for a more dovish outcome occurs.  Remember, too, given the market’s long dollar positioning, even a hawkish Fed could see a ‘sell the news’ result.

EMG currencies are showing similar trends with TRY (-3.3%) the true outlier as the lira quickly melts on ongoing policy concerns.  But elsewhere, HUF (+0.8%) has gained as the central bank reduced its QE purchases and expectations of further rate hikes are rampant.  CZK (+0.5%) is also benefitting from hawkish central bank news as the head there explained he saw rates closer to 4.0% than 3.0% next year (current 2.75%).  After those stories, there is much less movement overall.

Data this morning showed the NFIB Small Business Optimism Index edge slightly higher to 98.4 while PPI (exp 9.2%, 7.2% ex food & energy) is due at 8:30.  If the market takes hold of the latest omicron news, I would expect the equity market to turn around, but also the dollar as less Covid worries allows the Fed to be more hawkish.  But really, all eyes are on tomorrow afternoon, so don’t look for too much movement in either direction today.

Good luck and stay safe
Adf

Filled With Froth

Said Jay, markets seem filled with froth
But let me tell you, we are loth
To even discuss
The tapering fuss.
To ZIRP and QE we are troth

Now, ask yourself what markets heard
Jay cooed like his favorite white bird
So, dollars were sold
Investors bought gold
With equity bulls undeterred

The Chairman was very clear yesterday afternoon in his press conference, the Fed is not anywhere near thinking about changing their current policy mix.  While paying lip service to the idea that if inflation turns out not to be ‘transitory’ they have the tools to address it, the overwhelming belief in the Mariner Eccles Building appears to be that by autumn, inflation will be a thing of the past and the Fed will still have their foot on the proverbial accelerator.

This does raise the question that, if economic growth is rebounding so smartly, why does the Fed need to buy $120 billion of assets each month and maintain their policy rate at 0.00%?  While I am just an FX guy, it seems to me that the current policy stance is more appropriate for an apocalyptic economic crisis, something like we suffered last year or in 2008-9, rather than for an economy that is growing at 7.0% or more.  But that’s just me.  Clearly, Chairman Powell and his committee are concerned that the economy cannot continue to grow on its own, else they wouldn’t be doing what they are doing.

When it comes to the tapering of asset purchases, Powell was also explicit that it is not nearly time to consider the idea.  Yes, we had one good NFP number, but we need a string of them to convince the Fed that we are past the worst of things.  Remember, the opening two lines of the Fed statement continue to be about Covid.  “The Federal Reserve is committed to using its full range of tools to support the U.S. economy in this challenging time, thereby promoting its maximum employment and price stability goals.  The COVID-19 pandemic is causing tremendous human and economic hardship across the United States and around the world.”  Until such time as that statement changes, we don’t need to hear the press conference to know that nothing is going to change.

With this in mind, let us consider the potential impact on markets.  Starting with Treasuries, it seems reasonable to assume that yields are reflective of investors collective view on inflation going forward.  The Fed has been purchasing $120 billion / month since last June and is not about to change.  At this stage, it would appear the market has factored those purchases into the current yield.  This means, future movements are far more likely to be indicative of the evolving view on inflation.  Yesterday, after the press conference, 10-year yields slipped by 4bps, but this morning, they have recouped those losses and we currently sit at 1.65%.  With commodity prices clearly still on a massive roll (WTI +1.4%, Cu +0.8%), while the Fed is convinced that any inflation will be transitory, it is not obvious that the rest of the market agrees.  Powell said the Fed would need to see a string of strong data.  Well, next week the early expectations for NFP are 888K, which would be two very strong months in a row.  Is that a string?  Certainly, it’s a line.  But I doubt it will move the needle at the Fed.  Maximum employment is still a long way off, and there will be no changes until then.  As inflation readings climb, and they will, Treasury yields will continue to climb as well.  There is nothing magical about 1.75%, the level reached at the end of March, and I expect that by the end of Q2, we will be looking at 10-year yields close to, or above 2.0%.

If Treasury yields are at 2.0%, what happens to equity markets?  In this case, it is not as clear cut as one might think.  First off, this Fed clearly has a different reaction function to data than previous iterations as they have been explicit that pre-emptive tightening to prevent potential future inflation is not going to happen.  This implies that any rise in yields is not reflective of expected Fed policy changes, but rather as a response to rising inflationary pressures.  History has shown that when inflation rises but stays below 3.0%, equity markets can remain buoyant, but once that threshold has been breached, it is a different story.  Remember, especially in the tech sector, but in truth quite generally, the reason low rates boost the stock market is because any discount cash flow model, when discounting at ultra-low rates means current values should be higher.  This is why rising yields become a problem for equity prices. In fact, it is reasonable to analogize being long growth stocks to being long bond duration, so when bond prices fall and yields rise accordingly the same thing happens to those stocks.  If this relationship holds going forward, and inflationary concerns do continue to percolate in the market, it would appear equity prices could be in for a bumpy ride.

Clearly, that is not yet the case (after all, inflation hasn’t yet reared its ugly head), as evidenced by the overnight price action in the wake of Powell’s comments.  Asia was strong (Nikkei +0.2%, Hang Seng +0.8%, Shanghai +0.5%) and most of Europe is as well (CAC +0.55%, FTSE 100 +0.7%) although the German DAX (-0.25%) is a bit of a laggard this morning as concerns over Q1 GDP rise due to the third Covid wave.  US futures, though, are all-in with Jay, rising between 0.5% (Dow) and 1.0% (NASDAQ).  That makes sense given the assurances that there will be no tapering forever the foreseeable future.

As to the dollar, there are two different narratives at odds here.  On the one hand, the fundamentalists continue to point to a weaker dollar in the future as rising inflation tends to devalue a currency, and when combined with the massive fiscal deficit policy, a dollar decline becomes the only outlet available for pressure on the economy.  On the other hand, rising yields tend to support the dollar, so as Treasury yields continue to rise, if they stay ahead of the inflation statistics, there is reason to believe that the dollar has further to gain from here.  Of course, if inflation outstrips the rise in nominal yields such that real yields decline, we could easily have a situation with higher nominal Treasury yields and a much weaker dollar.  For now, the inflation data is lagging the Treasury market, but I suspect that by the end of May, that will not be the case, meaning the long-awaited dollar decline has a much better chance to get started then.

In the meantime, the dollar has softened ever so slightly this morning.  Versus G10 currencies, only JPY (-0.25%) has declined as the rebound in Treasury yields this morning seems to be garnering interest in the Japanese investment community.  But, while the dollar is softer vs. everything else, nothing has even moved 0.2%, which implies there is no news beyond the Fed.  In the EMG space, the dollar is also largely softer, led by HUF (+0.5%), THB (+0.45%) and INR (+0.45%).  HUF continues to benefit from the relatively hawkish stance of the central bank, while the baht rallied despite a reduction in the 2021 GDP estimate to 2.3% as Covid infections increase in the nation.  Meanwhile, INR appears to be the beneficiary of the Fed’s stance as clearly, the ongoing domestic disaster regarding its response to the latest wave of Covid infections cannot be seen as a positive.

On the data front, we start with Initial Claims (exp 540K) and Continuing Claims (3.59M) but also see the first look at Q1 GDP (6.6%), with a range of estimates from 4.5% to 10.0%!  With the Fed meeting behind us, we should start to hear from FOMC members again, but today only has Governor Quarles discussing financial regulation, a much drier subject than inflation.  Tomorrow, however, we will see the latest Core PCE data, and that has the chance to move things around.

As of now, the dollar remains on its back foot given the Fed’s clear message that tapering is a long way off and easy money is here for now.  However, if Treasury yields start to rise further, especially if they get back toward the 1.75% level, I expect the dollar will rebound.  On the other hand, if Treasuries remain quiet, the dollar probably has further to fall.

Good luck and stay safe
Adf

Clearly Reviving

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: Bloomberg

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

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

Good luck and stay safe
Adf