Tag Archives: #negativerealyields

Policy, Tighter

Posted on by

Apparently, seven percent
Defined for Chair Jay the extent
Of just how high prices
Can rise in this crisis
Ere hawkishness starts to foment

But is it too little too late?
As he’s not yet out of the gate
Toward, policy, tighter
Despite a speechwriter
That claims he won’t fail his mandate

There is no shame in being confused by the current market situation because, damn, it is really confusing!  On the one hand we see inflation not merely rising, but fairly streaking higher as yesterday’s 7.04% Y/Y CPI reading was the highest since June 1982.  With that as a backdrop, and harking back to our Economics 101 textbooks, arguably we would expect to see interest rates at much higher levels than we are currently experiencing.  After all, in its simplest form, real interest rates, which are what drive investment decisions, are simply the nominal interest rate less inflation. As of today, with effective Fed Funds at +0.08% and the 10-year Treasury at 1.75%, the calculated real interest rates are -6.96% in the front end and -5.29% in the 10-year, both of which are the lowest levels in the post WWII era.  The conclusion would be that investment should be climbing rapidly to take advantage.  Alas, most of the investment we have seen has been funneled into share repurchases rather than capacity expansion.

With this in mind, it makes sense that dollar priced assets are rising in value, so stocks and commodities would be expected to climb, as would the value of other currencies with respect to the dollar.  However, the confusion comes when looking at the bond market, where not only are real yields at historically depressed levels, but there is no indication that investors are selling bonds and seeking to exit the space.

Our economics textbook would have us believe that negative real yields of this magnitude are unsustainable with two possible pathways to adjustment.  The first pathway would be nominal yields climbing as investors would no longer be willing to hold paper with such a steep negative yield.  Back in the 1990’s, the term bond vigilantes was coined to describe how the bond market would not tolerate this type of activity and investors would sell bonds aggressively thus raising the cost of debt for the government.  So far, that has not been evident.  The second pathway is that the inflation would lead to significant demand destruction and ultimately a recession which would slow inflation and allow bondholders to get back to a positive real yield outcome.  Not only would that be hugely painful for the economy, it will take quite a while to complete.

The problem is, neither of those situations appear to be manifest.  The question of note is, is the bond market looking at the current situation and pricing in much slower growth ahead?  Certainly, the punditry is not looking for that type of outcome, but then, the punditry is often wrong.  Neither is the Fed looking for that type of outcome, at least not based on their latest economic projections which are looking for GDP growth of 3.6%-4.5% this year and 2.0%-2.5% next with nary a recession in sight in the long run.

This brings us back to the $64 trillion question, why aren’t bonds selling off more aggressively?  And the answer is…nobody really knows.  It is possible that investors are still willing to believe that this inflationary spike is temporary, and we will soon see CPI readings falling and the Fed declaring victory, so bond ownership remains logical.  It is also possible that given the fact that the BBB bill was pulled and seems unlikely to pass into legislation, that Treasury issuance this year will decline such that the fact the Fed will no longer be purchasing new debt will not upset the supply/demand balance and upward pressure on yields will remain absent.  At least from a supply perspective.  The problem with this idea is that pesky inflation reading, which, not only remains at extremely high levels, but is unlikely to decline very much at all going forward.

Ultimately, something seems amiss in the bond market which is disconcerting as bond investors are typically the segment that pays closest attention to the reality on the ground.  While the hawkish cries from Fed members are increasing in number and tone (just yesterday both Harker and Daly said they expected raising rates in March made sense and 4 rate hikes this year would be appropriate), that implies Fed Funds will be 1.0% at the end of the year, still far below inflation and not nearly sufficient to slow those rising prices.

It seems to me there are three possible outcomes here; 1) bond investors get wise and sell long-dated Treasuries steepening the yield curve significantly; 2) the Fed gets far more aggressive, raising rates more than 100 basis points this year and pushes to invert the yield curve and drive a recession; or 3) as option 1) starts to play out, and both stocks and bonds start to decline sharply, the Fed decides that YCC is the proper course of action and caps Treasury yields while letting inflation run much hotter.  My greatest fear is that 3) is the answer at which they will arrive.

With all that cheeriness to consider, let’s look at how markets are behaving today.  Despite a modest equity rally in the US yesterday, risk has been less in demand since.  Asia (Nikkei -1.0%, Shanghai -1.2%, Hang Seng +0.1%) was generally lower and Europe (DAX 0.0%, CAC -0.5%, FTSE 100 -0.1%) is also uninspiring.  There has been virtually no data in either time zone, so this price action is likely based on growing concerns over the inflationary outlook.  US futures at this hour are basically unchanged.

As to the bond market, no major market has seen a move of even 0.5 basis points today with inflation concerns seeming to balance risk mitigation for now.

Commodity markets are mixed with oil (-0.1%) edging lower albeit still at its highest levels since 2014, while NatGas (-4.5%) has fallen as temperatures in the NorthEast have reverted back to seasonal norms.  Gold (-0.1%) has held most of its recent gains while copper (-0.7%) seems to have found a short-term ceiling after a nice rally over the past few sessions.

Finally, turning to the dollar, it is somewhat softer vs. most of its G10 brethren with NZD (+0.35%) leading the way, followed by CHF (+0.3%) and CAD (+0.2%) as demand for any other currency than the dollar begins to show up.  In EMG currencies, excluding TRY (-2.5%) which remains in its own policy driven world, the picture is more mixed.  RUB (-0.75%) has fallen in the wake of the news from Geneva that there was no progress between Russia, the US and NATO regarding the escalating situation in the Ukraine with the threat of economic sanctions growing.  BRL (-0.55%) is also under some pressure although this looks more like profit taking after a nearly 3% rally in the past two sessions.  On the plus side, THB (+0.5%) and PHP (+0.3%) are leading the way as they respond to the broadly weaker dollar sentiment.

Data today brings Initial (exp 200K) and Continuing (1733K) Claims as well as PPI (9.8%, 8.0% ex food & energy), but the latter would have to be much higher than expected to increase the pressure on the inflation narrative at this point. From the Fed we hear from Governor Brainerd as she testifies in her vice-chair nomination hearing, as well as from Barkin and Evans.  Given the commentary we have been getting, I expect that the idea of 4 rate hikes this year is really going to be cemented.

The dollar has really underperformed lately and quite frankly, it feels like it is getting overdone for now.  While I had always looked for the dollar to eventually decline this year, I did expect strength in Q1 at least.  However, given positioning seemed to be overloaded dollar longs, and with the Treasury market not participating in terms of driving yields higher, it is beginning to feel like a modest correction higher in the dollar is viable, but that the downtrend has begun.

Good luck and stay safe
Adf

Covid Comes Calling

Posted on by

The German economy’s stalling
In Q1, as Covid comes calling
But still there’s belief
That fiscal relief
Will stop it from further snowballing

Consensus is hard to find this morning as we are seeing both gains and losses in the various asset classes with no consistent theme.  Perhaps the only significant piece of news was the German IFO data, which disappointed across the board, not merely missing estimates but actually declining compared with December’s data.  This is clearly a response to the renewed lockdowns in Germany and the fact that they have been extended through the middle of February.  The item of most concern, is that the manufacturing sector, which up until now had been the brightest spot, by far, is also seeing softness.  Now part of this problem has to do with the fact that shipping has been badly disrupted with insufficient containers available to ship products.  This has resulted in higher shipping costs and reduced volumes, hence reduced sales.  But part of this issue is also the fact that since virtually all of Europe is in lockdown, economic activity on the continent is simply slowing down.  It is the latter point that informs my view of the ECB’s future activities, namely non-stop monetary ease for as far as the eye can see.

When combining that view, the ECB will continue to aggressively ease policy, with the fact that the Fed is also going to continue to ease policy, it becomes much more difficult to estimate which currency is going to underperform.  Heading into 2021, the strongest conviction trade across markets was that the dollar was going to decline sharply, continuing the descent from its March 2020 highs.  And that’s exactly what we saw…for the first week of the year.  However, since then, the dollar has reversed those losses and currently sits higher on the year vs. most currencies.  My point is, and has consistently been, that in the FX market, the dollar is a relative game, and the policies of both nations are critical in establishing its value.  Thus, if every nation is aggressively easing policy, both monetary and fiscal, then the magnitude of those policy efforts are critical.  Perhaps, the fact that Congress has yet to pass an additional stimulus bill, especially given the strong belief that the Blue Wave would quickly achieve that, has been sufficient to change some views of the dollar’s future strength (weakness?).  Regardless, the one thing that is clear is that the year has just begun and there is plenty of time for more policy action as well as more surprises.  In the end, I do believe that as inflation starts to climb in the US, and real interest rates fall to further negative levels, the dollar will ultimately fall.  But that is a Q2-Q3 outcome, not really a January story.

And remarkably, that is basically the biggest piece of news from overnight.  At this point, traders and investors are turning their attention to the FOMC meeting on Wednesday, although there are no expectations for policy shifts yet.  However, the statement, and Chairman Powell’s press conference, will be parsed six ways to Sunday in order to try to glean the future.  Based on what we heard from a majority of Fed speakers before the quiet period began, there is no current concern over the backup in Treasury yields, and there is limited sentiment for the Fed to even consider tapering their policy of asset purchases, with just four of the seventeen members giving it any credence.  One other thing to remember is that the annual rotation of voting regional presidents has turned more dovish, with Cleveland’s Loretta Mester, one of the two most hawkish members, being replaced by Chicago’s Charles Evans, a consistent dove.  The other changes are basically like for like, with Daly for Kashkari (two extreme doves) and Barkin and Bostic replacing Harker and Kaplan.  These four are the minority who discussed the idea that tapering purchases could be appropriate by the end of the year, so, again, no change in voting views.

With this in mind, we can see the lack of consistent message from overnight activity.  Asian equity markets were all firmer, led by the Hang Seng (+2.4%), with the Nikkei (+0.7%) and Shanghai (+0.5%) trailing but in the green.  However, Europe has fared less well after the soft IFO data with all three major markets (DAX, CAC and FTSE 100) lower by -0.6%.  As to US futures, they are the perfect embodiment of a mixed session with NASDAQ futures higher by 0.8% while DOW futures are lower by 0.2%,

Bond markets, though, have shown some consistency, with yields falling in Treasuries (-1.0bp) and Europe (Bunds -1.7bps, OATs -1.5bps, Gilts -2.2bps).  The biggest winner, though, are Italian BTPs, which have rallied more than half a point and seen yields decline 5.3 basis points.  It seems that concerns over the government falling have abated.  Either that or the 0.70% yield available is seen as just too good to pass up.

On the commodity front, oil prices have edged up by the slightest amount, just 0.1%, as the consolidation of the past three months’ gains continues.  Gold has risen 0.4%, but there is a great deal of discussion that, technically, it has begun a downtrend and has further to fall.  Again, consistent with my view that real interest rates are likely to decline sharply in Q2, when inflation really starts to pick up, we could easily see gold slide until then, before a more emphatic recovery.

And lastly, the dollar, where both G10 and EMG blocs show a virtual even split of gainers and losers.  Starting with the G10, NZD (+0.3%) is today’s “big” winner, with SEK (+0.25%) next in line.  Market talk is about the reduction of restrictions in Australia’s New South Wales state as a reason for optimism in AUD (+0.15%) and NZD.  As for SEK, this is simply a trading move, with no obvious catalysts present.  On the flip side, the euro (-0.1%) is the worst performer, arguably suffering from that German IFO data, with other currencies showing little movement in either direction.

The EMG bloc is led by TRY (+0.4%), as it seems discussions between Turkey and Greece to resolve their competing claims over maritime boundaries is seen as a positive.  After the lira, though, no currency has gained more than 0.2%, which implies there is nothing of note to describe.  On the downside, ZAR (-0.4%) is the worst performer, which appears to be a positioning move as long rand positions are cut amid concerns over the spread of Covid and the lack of effective government response thus far.

On the data front, the week is backloaded with Wednesday’s FOMC clearly the highlight.

Tuesday Case Shiller Home Prices 8.65%
Consumer Confidence 89.0
Wednesday Durable Goods 1.0%
-ex transport 0.5%
FOMC Meeting 0.00%-0.25% (unchanged)
Thursday Initial Claims 880K
Continuing Claims 5.0M
GDP Q4 4.2%
Leading Indicators 0.3%
New Home Sales 860K
Friday Personal Income 0.1%
Personal Spending -0.4%
Core PCE 1.3%
Chicago PMI 58.0
Michigan Sentiment 79.2

Source: Bloomberg

So, plenty of stuff at the end of the week, and then Friday, two Fed speakers hit the tape.  One thing we know is that the housing market continues to burn hot, meaning data there is assumed to be strong, so all eyes will be on the PCE data on Friday.  After all, that is the Fed’s measuring stick.  The other thing that we have consistently seen during the past six months is that inflationary pressures have been stronger than anticipated by most analysts.  And it is here, where the Fed remains firmly of the belief that they are in control, where the biggest problems are likely to surface going forward.  But that is a story for another day.  Today, the dollar is wandering.  However, if the equity market in the US can pick up its pace, don’t be surprised to see the dollar come under a little pressure.

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