Before Omicron

There once was a narrative told
Explaining the Fed still controlled
The market’s reaction
Preventing contraction
Thus, making sure stocks ne’er got sold

But that was before Omicron
Evolved and put more pressure on
The future success
Of Fed’ral largesse
With no real conclusion foregone

So, later this morning we’ll hear,
When Janet and Jay both appear,
In front of the Senate
If they’ve still the tenet
That all will be well by next year

Perhaps all is not right with the world.  At least that would be a conclusion easily drawn based on market activity this morning.  Once again, risk is being shed rapidly and across the board.  Not only that, but the market is completely rethinking the idea of tighter monetary policy by the Fed with the growing conclusion that it is just not going to happen, at least not on the timeline that had been assumed a few short days ago.

It seems that the Omicron variant of Covid is proving to be a bigger deal in investor’s eyes than had been originally assumed.  When this variant was first identified by South African scientists, the initial belief was it was more virulent but not as acute as the Delta variant.  So, while it was spreading quite rapidly, those who were infected displayed milder symptoms than previous variants.  (If you think about the biology of this, that makes perfect sense.  After all, every organism’s biologic goal is to continue to reproduce as much as possible.  If a virus is so severe that its host dies, then it cannot reproduce very effectively.  Thus, a more virulent, less severe strain is far more likely to remain in the world than a less virulent, more deadly strain, which by killing its hosts will die off as well.)

In the meantime, financial markets have been trying to determine just what type of impact this new strain is going to have on economies and whether it will induce another series of lockdowns slowing economic activity, or if it will be handled in a different manner.  And so far, there is no clear conclusion as evidenced by the fact that we saw a massive sell-off in risk assets Friday, a major rebound yesterday and another sell-off this morning.  If pressed, I would expect lockdowns to come back into vogue as despite questions over their overall efficacy, their imposition allows government officials to highlight they are ‘doing something’ to prevent the spread.  Additional bad news came from the CEO of Moderna, one of the vaccine manufacturers, when he indicated that the nature of this variant would likely evade the vaccines’ defense.

So, story number one today is Omicron and how this new Covid variant is going to impact the global economy.  Ironically, central bankers around the world must be secretly thrilled by this situation as the focus there takes the spotlight off their problem, rapidly rising inflation.

For instance, after yesterday’s higher than expected CPI prints in Spain and Germany, one cannot be surprised that the Eurozone’s CPI printed this morning at 4.9%, the highest level since the Eurozone was born in 1997, and far higher than any of the 40 economist forecasts published.  Madame Lagarde wasted no time explaining that this was all temporary and that by the middle of next year inflation would be back to its pre-pandemic levels, but it seems fewer and fewer people are willing to believe that story.  Do not mistake the run to the relative safety of sovereign bonds as a vote of confidence in the central bank community.  Rather that is simply seen as a less risky place to park funds than the equity market, which by virtually every measure, remains significantly overvalued.

This leads to the third major story of the day, the upcoming testimony by Chairman Powell and Treasury Secretary Yellen in front of the Senate Banking Committee.  The pre-released opening comments focus on Omicron and how it can be a risk for both growth and inflation thus once again trying to divert attention from Fed policies as a problem by blaming exogenous events beyond their control.  Of course, this story will resolve itself starting at 10:00, so we will all listen in then.

Ok, with all that as prelude, a quick tour of markets shows just how much risk is in disfavor this morning.  Overnight in Asia we saw broad weakness (Nikkei -1.6%, Hang Seng -1.6%) although once again Shanghai was flat.  Europe is completely in the red (DAX -1.45%, CAC -1.25%, FTSE 100 -1.0%) and US futures are also pointing lower (DOW -1.2%, SPX -1.0%, NASDAQ -0.5%).

Meanwhile, bond markets are ripping higher with Treasuries (-5.1bps) leading the way as yields fall back to levels last seen in early September.  In Europe, Bunds (-2.1bps), OATs (-2.2bps) and Gilts (-4.0bps) are all seeing demand pick up with the rest of the Continent all looking at lower yields despite rising inflation.  Fear is clearly a powerful motivator.  Even in Asia we saw JGB’s (-1.9bps) rally as did Australian and New Zealand paper.

Commodity markets are having quite a day with some really mixed outcomes.  Oil (-2.5%) is back in the red after yesterday’s early morning rebound faded during the day, and although oil did close higher, it was well of the early highs.  NatGas (-5.0%) is falling sharply, which at this time of year is typically weather related.  On the other hand, gold (+0.5%) is bouncing from yesterday and industrial metals (Cu +1.4%, Al +1.6%, Sn +2.7%) are in clear demand.  It seems odd that on a risk-off day, these metals would rally, but there you have it.

Finally, the dollar can only be described as mixed this morning, with commodity currencies under pressure (NOK -0.4%, CAD -0.25%) while financial currencies (EUR +0.5%, CHF +0.5%, JPY +0
4%) are benefitting on receding expectations for a tighter Fed.  PS, I’m sure the risk off scenario is not hurting the yen or Swiss franc either.

Emerging market currencies are demonstrating a broader based strength with TRY (-1.6%) really the only major loser as further turmoil engulfs the central bank there and expectations for lower interest rates and higher inflation drive locals to get rid of as much lira as possible.  Otherwise, PLN (+0.8%) is leading the way higher as expectations for the central bank to raise rates grow with talk now the rate hike will be greater than 50 basis points.  But MYR (+0.8%) and CZK (+0.75%) are also showing strength with the ringgit simply rebounding after a 10-day down move as bargain hunters stepped in, while the koruna has benefitted from hawkish comments from the central bank governor.  It appears that most EMG central banks are taking the inflation situation quite seriously and I would look for further rate hikes throughout the space.

Aside from the Powell/Yellen testimony, this morning brings Case Shiller House Prices (exp 19.3%), Chicago PMI (67.0) and Consumer Confidence (111.0).  As well, two other Fed speakers, Williams and Clarida, will be on the tape, but it is hard to believe they will get much notice with Powell front and center.

The dollar appears to be back following the interest rate story, which means that if expectations of Fed tightening dissipate, the dollar will likely fade as well, at least versus the financial currencies.  Commodities have a life of their own and will continue to dominate those currencies beholden to them.  The tension between potential slower growth and rising inflation has not been solved, and while my view is the Fed will allow inflation to burn still hotter, keep in mind that if they do act to tighten policy, the dollar should find immediate support.

Good luck and stay safe
Adf

Future Pratfalls

In Germany, and too, in Spain
The people are feeling the pain
Of prices exploding
And therefore corroding
Their standards of living again

Meanwhile from the ECB’s halls
The comments from those know-it-alls
Show lack of concern
As each of them spurn
The idea of future pratfalls

In trading, ‘the trend is your friend’ is a very common sentiment and an idea backed with strong evidence.  One can think of this as analogous to Newton’s first law, i.e. a body in motion stays in motion.  So, when the price action in some market has been heading in one direction over time, it tends to continue in that direction.  This is the genesis of the moving average as a trading tool as the moving average is what defines the trend.  I highlight this because the concept is not restricted to trading but is also evident in many other price series, notably inflation.  When one looks at the history of inflation, it tends to trend in one direction for quite some time with major reversals relatively infrequent.  That is not to say a reversal cannot occur, but if one does, it tends to be the result of a long period of adjustment, not a quick flip of direction.

And yet, when listening to both Fed and ECB speakers lately, they would have you believe that the currently entrenched trend higher for prices is the aberration and that in a matter of months they will be back to their old concerns about deflation being the biggest problem for the economy.  One has to wonder at what evidence they are looking to come to that determination as certainly the recent data does not point in that direction.  Just this morning Spanish CPI (5.6%) printed at the highest level since 1992 while Italian PPI (25.3%) printed at the highest level in its history.  From Germany, we have seen CPI prints from several of its states (Hesse 5.3%, Baden Wuerttemberg 4.9%, Bavaria 5.3%, Saxony 5.0%) with the national number (exp 5.5%) due at 8:00 this morning.

Still, none of this seems to be having an impact on the thoughts of ECB members with Lagarde, Schnabel, Villeroy and de Cos all out explaining that this is a temporary phenomenon and that by the middle of next year CPI will be back at their 2.0% target or lower.  Maybe it will be so, but as Damon Runyon so aptly explained, “The race is not always to the swift, nor the battle to the strong; but that is the way to bet.”  In other words, looking at the current trends, it seems far more likely that inflation remains high than suddenly turns around lower.  The biggest problem the central banks have now is that it has become common knowledge that inflation is rising, which means that individual behaviors are adjusting to a new price regime.  And if you listen to the central bank thesis that inflation expectations are a critical input, then they are really in trouble as inflation expectations are clearly rising.

At least the Fed has begun to discuss the idea of removing accommodation, although the Omicron variant of Covid may given them pause, but in Europe, it is not even on the table.  A discussion point that has been raised numerous times lately is the idea of a central bank policy error, either raising rates prematurely to battle phantom inflation or waiting too long to tighten policy and allowing inflation to become more entrenched.  While my money is on the latter, it is very clear that the ECB, at least, and still many Fed members, are far more concerned with the former.  Perhaps they are correct, and all these rising prices will quickly dissipate, and that would be great.  However, I am not counting on that outcome, nor should anyone else at this point until there is ANY proof the Fed or ECB are correct.

Meanwhile, Friday’s dramatic events seem to have been erased from memory as while there are still headlines regarding the Omicron variant, the collective market view appears to be that it is not going to result in another wave of lockdowns and therefore the economic impact will be relatively minor.  As such, we are seeing a reversal of fortune across most markets from their Friday price action.  It should be no surprise that the biggest change comes from oil (+4.75%) which has recouped about one-third of its losses and seems set to continue rebounding.  After all, if the consensus is that Omicron is not going to have much of an impact, then the supply/demand story hasn’t changed and that bodes well for oil prices moving higher.  Elsewhere in the commodity space NatGas (+7.4%) is rising sharply on the back of colder than normal weather, while metals prices (Au +0.1%, Ag +0.5%, Cu +1.7%, Al +1.2%) are all rebounding as well.

In the equity markets, Asia never got a chance to sell off like Europe and the US on Friday so caught up (down?) with the Nikkei (-1.6%) leading the way although the Hang Seng (-1.0%) also suffered.  Shanghai traded flat for the day.  Europe, however, which sold off sharply on Friday, with many markets down more than 4%, has rebounded somewhat this morning (DAX +0.7%, CAC +1.1%, FTSE 100 +1.2%) although these markets are obviously well lower than Thursday’s closing levels.  Finally, US equities sold off sharply in Friday’s abbreviated session, with all three indices down about 2.3% but this morning futures are all rebounding as well, up between 0.6% and 0.8%.

Bonds saw the most dramatic move on Friday, with Treasury yields tumbling 16 basis points while European yields all fell as well, albeit less dramatically.  This morning, with risk back in vogue, bonds are back under pressure with Treasuries (+6.8bps) leading the way but all of Europe (Bunds +2.7bps, OATs +1.5bps, Gilts +3.9bps) also seeing higher yields.

It should come as no surprise that the dollar is also reversing some of Friday’s price action with the commodity bloc doing well (SEK +0.4%, CAD +0.3%, AUD +0.3%) while the financials are under modest pressure (EUR -0.2%).  This movement is nothing more than a reaction to the Friday movement.  EMG currencies are seeing similar price action with the best performers the commodity bloc here (RUB +0.9%, ZAR +0.7%) while weakness has been seen in TRY (-3.45%) and CLP (-0.7%).  The former continues to suffer from President Erdogan’s comments about never raising interest rates to fight inflation while the peso is reacting to early polls showing the leftist, Gabriel Boric, leading ahead of the runoff presidential election in 3 weeks.

It is a week full of data culminating in Friday’s payroll report although it starts out slowly.

Tuesday Case Shiller Home Prices 19.35%
Chicago PMI 67.0
Consumer Confidence 110.7
Wednesday ADP Employment 525K
Construction Spending 0.4%
ISM Manufacturing 61.1
ISM Prices Paid 85.8
Fed Beige Book
Thursday Initial Claims 250K
Continuing Claims 2000K
Friday Nonfarm Payrolls 535K
Private Payrolls 525K
Manufacturing Payrolls 45K
Unemployment Rate 4.5%
Average Hourly Earnings 0.4% (5.0% Y/Y)
Average Weekly Hours 34.7
Participation Rate 61.7%
ISM Services 65.0
Factory Orders 0.5%

Source: Bloomberg

In addition to all that data, we hear from Chairman Powell (and Secretary Yellen) in front of the Senate and House on Tuesday and Wednesday as well as eight more Fed speakers during the week.  If I were a betting man, I would expect that the broad message will continue to be that while inflation is not a long-term problem, it is appropriate to continue to normalize monetary policy now.  And that will be the message right up until markets force them to make a choice by either selling off sharply and forcing an end to policy tightening or running to new highs dragging inflation expectations, as well as inflation, along with them.

Meanwhile, the dollar remains beholden to the latest whims.  If tightening is back on the table, then look for the dollar to resume its uptrend.  However, if Omicron, or something else, causes a change in the message, the dollar seems likely to pull back smartly.

Good luck and stay safe
Adf

A Gordian knot

Now, what if inflation is not
As transit’ry as Powell thought?
And what if there’s slowing
Instead of more growing?
Would that be a Gordian knot?

Well, lately the bond market’s view
Appears to be, in ‘Twenty-two
Inflation will soar
Much higher before
The Fed figures out what to do

The Fed has been pushing the transitory inflation narrative for quite a while now, but lately, they have been struggling to get people to accept it at face value.  You can tell this is the case because pretty much every third story in any newsfeed is about rising prices in some product or service.  Commodities are particularly well represented in these stories, especially energy, as oil, NatGas and coal have all seen dramatic price rises in the past month or so.  It is also important to understand that despite the durm und strang regarding the continued use of coal as an energy source, it remains the largest source of electricity worldwide.  I bring this up because the situation in China is one where the country is restricting energy use due to a lack of coal available to burn.  (Perhaps one of the reasons for this is the Chinese, in a snit over Australia calling them out as to the origins of Covid-19, banned Australian coal imports.)

From an inflation perspective, this has the following consequences: less coal leads to less electricity production which leads to restrictions on electricity use by industry which leads to reduced production of everything.  Given China’s importance in the global supply chain for most products, less production leads to shortages and, presto, higher prices.  And this is not going to end anytime soon.  Much to the Fed’s chagrin, they can print neither coal nor NatGas and help mend those broken supply chains.  Thus, despite their (and every other central bank’s) efforts to repeal the laws of supply and demand, those laws still exist.  So, just as April showers lead to May flowers, less supply leads to higher prices.

The difference in the past week or so is that bond markets worldwide have started to cotton on to the idea that inflation is not transitory after all.  Yields have been rising and curves steepening, but even the front end of yield curves, where central banks have the most impact, have seen yields rise.  So, a quick look at global bond markets today shows yields higher in every major market around the world.  Treasuries (+1.1bps) have not moved that far overnight but are higher by 12bps in the past week.  Gilts (+4.8bps) on the other hand, have seen real selling in today’s session, also rising 12bps in the past week, but on a lower base (10-year Gilts yield 1.125% vs. 1.58% for Treasuries.)  And the same situation prevails in Bunds (+2.6bps, +6.6bps in past week), OATs (+2.5bps) and the rest of Europe.  Asia is not immune to this with even JGB’s (+1.2bps, +4bps in past week) selling off.  The point is that bond investors are starting to recognize that inflation may be more persistent after all.  And if the Fed loses control over their narrative, they have much bigger problems.  Forward guidance remains a key monetary policy tool, arguably more important that the Fed Funds rate these days, so if that is no longer effective, what will they do?

Needless to say, risk attitudes are starting to change somewhat as concern grows that almost the entire central banking community, certainly the Fed and ECB, will be too slow to react to very clear inflation signals.  In this situation, financial assets will definitely suffer.  Keep that in mind as you look ahead.

OK, next we need to look to this morning’s NFP report as that has been a key element of the recent market inactivity.  Investors are looking for confirmation that the Fed is going to begin tapering next month and have certainly been encouraged by both the ADP Employment number as well as yesterday’s much lower than expected Initial Claims data.  Here’s what current median forecasts look like:

Nonfarm Payrolls 500K
Private Payrolls 450K
Manufacturing Payrolls 25K
Unemployment Rate 5.1%
Average Hourly Earnings 0.4% (4.6% Y/Y)
Average Weekly Hours 34.7
Participation Rate 61.8%

Source: Bloomberg

Powell explained that as long as this report was not terrible, he felt the tapering would begin.  Interestingly, the range of forecasts is 0K to 750K, a pretty wide range of disagreement as to how things might play out.  Certainly, a number like last month’s 235K could throw a wrench into the tapering process.  Personally, my take is slightly weaker than median, but not enough to change the taper idea.

On a different note, I cannot help but look at the Average Hourly Earnings forecasts and wonder how any Fed speaker can argue that wages aren’t growing rapidly.  Absent the Covid induced gyrations, 4.6% is the highest number in the series by far going back to early 2007.  Again, this speaks to persistent inflationary pressures, not transient ones.

But we will know shortly how things turn out, so a quick recap before then shows that equity markets had a good session in Asia (Nikkei +1.3%, Hang Seng +0.55%, Shanghai +0.7%) but are less giddy in Europe (DAX -0.1%, CAC -0.4%, FTSE 100 0.0%).  Meanwhile, US futures are essentially unchanged ahead of the data.

We’ve already discussed the bond market selloff and cannot be surprised that commodity prices are mostly higher led by oil (+0.8%) and NatGas (+0.1%), but also seeing strength in gold (+0.3%).  Industrial metals are having a rougher go of it (Cu -0.3%, Al -0.4%) and Ags are a bit firmer this morning with all three major grains higher by about 0.55%.

As to the dollar, it is mixed this morning ahead of the data with the largest gainer NOK (+0.4%) on the back of oil’s strength, while SEK (+0.3%) is also firmer although with no clear driver other than positioning ahead of the data.  On the downside, JPY (-0.15%) continues under pressure as higher US yields continue to attract Japanese investors.

EMG currencies have seen a more negative session with PLN (-0.6%), TRY (-0.5%) and RUB (-0.5%) all under pressure and the APAC bloc mostly falling, albeit not quite as far.  The zloty story seems to be concerns over a judicial ruling that puts Poland further at odds with the EU which has been sufficient to offset the boost from yesterday’s surprise rate hike.  In Turkey, a story that President Erdogan is “cooling” on his view toward the central bank governor seems to have markets nervous while in Russia, rising inflation and limited central bank response has investors concerned despite oil’s rally.

There are no Fed speakers on the calendar today so it will all be about the NFP number.  Until then, don’t look for much, and afterwards, there is typically a short burst of activity and a slow afternoon.  I don’t think the big trend of dollar strength has ended by any means, but it is not clear today will see much of a gain.

Good luck, good weekend and stay safe
Adf

Prices Ascend

As energy prices ascend
More problems they seem to portend
Inflation won’t quit
While growth takes a hit
When will this bad dream ever end?

Another day, another new high in the price of oil.  We have now reached price levels not seen in seven years and there is no indication this trend is going to end anytime soon.  Rather, given the supply and demand characteristics in the marketplace, it is not hard to make a case that we will be seeing $100/bbl oil by Q1 2022, if not sooner.  OPEC+ just met and, not surprisingly, decided that they were quite comfortable with rising oil prices thus saw no reason to increase production at this time.  Meanwhile, Western governments continue to do everything in their power to prevent the expansion of energy production, at least the production of fossil fuels.  This combination of policies seems likely to have some serious side effects, especially as we head into winter.

For instance, while I have highlighted the price of energy in Europe and Asia, which remains far higher than in the US, it is worth repeating the story.  Natural gas in Europe is now trading at $37.28/mmBTU, compared with just under $6/mmBTU in the US.  Storage levels are at 74% of capacity which means that any cold snap is going to put serious pressure on the Eurozone economy as NatGas prices will almost certainly rise further in response.  In addition, Europe remains highly dependent on Russia as a supplier which seems to open them to some geopolitical risk.  After all, Vladimir Putin may not be the friendliest supplier in times of crisis.

China, too, is having problems as not only has the price of oil risen sharply, but so, too, has the price of thermal coal (+5.25% today, +200% YTD).  China still burns a significant amount of coal to produce electricity throughout the country with more than 1000 plants still operating and nearly 200 more under construction.  It is this situation which causes many to question President Xi Jinping’s commitment to reining in carbon emissions.  Unsurprisingly, the inherent conflicts in the desire to reduce carbon, thus capping coal production, while trying to generate enough electricity for a growing economy have resulted in the Chinese abandoning the carbon issues.  Last week, Xi ordered coal mines to produce “all they can” rather than adhere to the strict quotas that had been put in place.  Right now, there is a power crisis as utilities have cut back electricity production reducing service to both industrial and residential users.  Again, winter is coming, and insufficient electricity is not going to be acceptable to President Xi.  When push comes to shove, you can be sure that the primary goal is generating enough electricity for the economy not reducing carbon emissions.

Ultimately, this story is set to continue worldwide, with the tension between those focused on economic activity and growth continually at odds with those focused on carbon dioxide.  Until nuclear power is accepted as the only possible way to create stable baseload power with no carbon emissions, nothing in this story will change.  The implication is that energy prices have further, potentially much further, to run given the inelasticity of demand for power in the short-term.  And this matters for all other markets as it will impact both growth and inflation for years to come.

Consider bond markets and interest rates.  While the Fed and other central banks may choose to ignore energy prices in their policy decisions, the market does not ignore rising energy prices.  The ongoing increase in inflation around the world is going to result in higher interest rates around the world.  While central banks may cap the front end, absent YCC, back end yields will rally.  A rising cost of capital is going to have a negative impact on equity markets as well, as both future earnings are likely to suffer and the discount factor for those who still consider DCF models as part of their equity analysis, is going to reduce the current value of those future cash flows.  The dollar, however, seems likely to benefit from rising oil and energy prices, as most energy around the world (in wholesale markets) is priced in USD.  Essentially, people will need to buy dollars to buy oil or gas.  Adding all this up certainly has the appearance of a more substantial risk-off period coming soon.  We shall see.

This morning, however, that is not entirely clear.  While Asian equity markets saw more red than green (Nikkei -2.2%, Sydney -0.4%, Hang Seng +0.3%, Shanghai closed), Europe is feeling positively giddy with gains across the board (DAX +0.35%, CAC +0.8%, FTSE 100 +0.65%) as PMI data showed more winners than losers although it also showed the highest price pressures seen since 2008, pre GFC.  US futures, after markets had a tough day yesterday, are pointing higher at this hour, with all three main indices higher by about 0.35%.

Bond markets are a bit schizophrenic this morning as Treasury (+1.9bps) and Gilt (+2.0bps) yields climb while we see modest declines in Europe (Bunds -0.2bps, OATs -0.3bps).  While yields remain low on a historic basis, and real yields remain extremely negative, it certainly appears that the trend in yields is higher.  There is every possibility that central banks blink when it comes to fighting inflation and ultimately do prevent yields from rising much further, but so far, they have not felt compelled to do so.  This is something we will be watching closely going forward.

Turning to commodities, oil (WTI +1.05%) shows no signs of slowing down.  Nor does NatGas (+3.0%) or coal (+5.25%).  Energy remains in demand.  Precious metals, on the other hand, continue to flounder with both gold (-0.85%) and silver (-0.7%) under pressure.  Copper (-1.75%) too, is feeling it today along with the rest of the industrial metal space save aluminum (+0.6%).  Ags are softer as well.

The dollar, however, is having a much better day, rallying against most of its major counterparts.  For instance, JPY (-0.3%) continues to suffer as the market demonstrates a lack of excitement over the new PM and his team.  Meanwhile, EUR (-0.2%) has reversed its consolidation gains and appears set to resume its recent downtrend.  Technically, the euro looks pretty bad with a move toward 1.12 quite realistic before the end of the year.  AUD (-0.2%) found no support from the RBA’s message last night as they continue to look toward 2024 before interest rates may start to rise.  On the plus side, only NOK (+0.2%) on the back of oil’s gains, and GBP (+0.2%) on the back of a stronger than expected PMI release are in the green.

EMG currencies have also seen many more laggards than gainers led by HUF (-0.5%) and PLN (-0.3%) both high beta plays on the euro, and MXN (-0.2%) and RUB (-0.2%) both of which are somewhat surprising given oil’s continued rise.  The bulk of the APAC currencies also slid, albeit only in the -0.1% to -0.2% range, with several simply adjusting after several days with local markets closed.  ZAR (+0.35%) is the only gainer of note as the Services PMI data printed at a better than expected 50.7.

On the data front, the Trade Balance (exp -$70.8B) and ISM Services (59.9) are on the slate and we hear from Vice-Chair Quarles on LIBOR transition.  In other words, not much of note here.  While I believe oil prices remain the key driver right now, there is certainly some focus turning to Friday’s payroll data as that is the last big data point before the Fed’s November meeting.

The dollar’s trend remains higher and I see no reason for anything to halt that for now.  My take is the modest correction we saw Friday and Monday is all there is for now, and a test of the recent highs is coming soon to a screen near you.

Good luck and stay safe
Adf

At All Costs#

Ahead of the winter’s white frosts
The Chinese told firms, “at all costs”
Get oil and gas
And coal, so en masse
Our energy never exhausts

In Europe, as prices keep rising
For Nat Gas, most firms are revising
The prices they charge
Which has, by and large
Helped CPI keep on surprising

Ostensibly, the reason that the Fed, and any central bank, looks at prices on an -ex food & energy basis is because they realize that they have very little control over the prices of either one.  The only tool they have to control them is extremely blunt, that of interest rates.  After all, if they raise interest rates high enough to cause a recession, demand for food & energy is likely to decline, certainly that of energy, and so prices should fall.  Of course, precious few central bankers are willing to cause a recession as they know that their own job would be on the line.

And yet, central banks cannot ignore the impact of food & energy prices on the economy.  This is especially so for energy as it is used to make or provide everything else, so rising energy prices eventually feed into rising prices for non-energy products like computers and washing machines and haircuts.  As has become abundantly clear over the past months, energy prices continue to rise sharply and alongside them, we are seeing sharp rises in consumer prices as well.

Protestations by Lagarde and Powell that inflation is transitory do not detract from the fact that energy prices are exploding higher and that those charged with securing energy for their country or company are willing to continue to pay over the odds to do so.  Yesterday, an edict from the Chinese government to all its major companies exhorted them to get energy supplies for the winter “at all costs.”  This morning, they followed up by telling their coal mining companies to produce at maximum levels and ignore quotas.  Clearly, there is concern in Beijing that with winter coming, there will not be enough energy to heat homes and run factories, an unmitigated disaster.  But this price insensitive buying simply drives the price higher.  (see Federal Reserve impact on bonds via QE for an example.)

And higher these prices continue to go.  Nat Gas, which is the preferred form of fossil fuel, continues to rise dramatically in both Europe and Asia.  In both geographies, it has risen to nearly $35.00/mmBTU, almost 6x as expensive as US Nat Gas.  On an energy equivalent basis, that comes out to $190/bbl of oil.  And you wonder why the Chinese want to dig as much coal as possible.  The problem they are already having, which is adding to their overall economic concerns, is that they have run into an energy shortage and have been restricting power availability to the industrial sector in order to ensure that households have enough.  Of course, starving industry is going to have a pretty negative impact on the economy, hence the call for obtaining energy at all costs.  But that has its own problems, as driving prices higher will divert spending to energy from both investment and consumption.  In other words, as is often the case, there is no good answer to this problem.

If you are wondering how this impacts foreign exchange, let me explain.  First, energy is priced in dollars almost everywhere in the world, at least at a wholesale level.  So, buying energy requires having dollars to spend to do so.  I would contend one reason we have seen the dollar maintain its strength recently, and break out of a medium-term range, is because countries are panicking over their winter energy needs and need dollars to secure supplies.  Second, as energy prices rise, so too does inflation.  And while Mr Powell continues to refuse to accept that is the case, the market is not so stubborn on the issue.  We have seen the yield curve steepen sharply over the past several weeks, something which is historically a dollar positive, and with expectations for the taper firmly implanted into the market’s collective conscience, the strong view is interest rates in the US are going higher.  This, too, is very dollar supportive.  While I remain unconvinced that the Fed will ultimately be willing to tighten policy in any significant manner, that remains the current market narrative.  We shall see how things evolve, but for now, the dollar has legs alongside interest rates and energy prices.

Ok, to today’s price action.  The notable thing is the reduction in risk appetite that has been evident for the past several sessions.  For instance, yesterday we finally achieved a 5% correction in the S&P 500 for the first time in more than 200 sessions.  While prices remain extremely overvalued on traditional measures, it is not yet clear if the ‘buy the dip’ mentality will prevail as we enter a new fiscal quarter.  We shall see.

Overnight, Asia was mostly lower (Nikkei -2.3%, Hang Seng -0.4%) but Shanghai (+0.9%) managed to rally.  Of course, remember, Shanghai has been massively underperforming for quite a while.  Other than China, though, the rest of Asia was all red.  Europe, too, is bright red this morning (DAX -0.8%, CAC -0.8%, FTSE 100 -1.0%) as the broad risk-off sentiment combines with modestly weaker than expected PMI data and higher than expected Eurozone CPI data.  As to the latter, the 3.4% headline print is the highest since Sept 2008, right at the beginning of the GFC.  Yesterday, German CPI printed at 4.1%, which is the highest level since the wake of the reunification in 1993.  For a culture that still recalls the Weimar hyperinflation, things must be pretty uncomfortable there.  It is a good thing this inflation is transitory!

Not surprisingly, with risk being jettisoned, bonds are in demand this morning and although Treasuries are unchanged in this session, they did rally all day yesterday with yields declining nearly 5bps.  As to Europe, Bunds (-3.2bps) and OATs (-3.2bps) are firmly higher with the rest of the continent while Gilts (-1.5bps) are not seeing quite as much love despite an underperforming stock market.  I think one reason is that UK PMI data was actually better than expected and higher than last month, an outlier versus the continent.

Commodity prices are mixed this morning as despite my opening monologue, oil (WTI -0.9%) and Nat Gas (-0.7%) are both under pressure.  Of course, both have been rallying sharply for months, so nothing goes up in a straight line.  Precious metals are little changed on the day, but industrial metals are strong (Cu +1.6%, Al +0.5%, Sn +1.2%).  Ags, on the other hand, are mixed with no pattern whatsoever.

As to the dollar, it is under modest pressure this morning in what appears to be a consolidation at the end of the week.  The one noteworthy mover in the G10 is NOK (+0.75%) which is rallying despite oil’s decline as the market reacted to a surprisingly large decline in the Unemployment rate there to 2.4%.  But otherwise, GBP (+0.3%) is the next best performer and the rest of the bloc is +/-0.2%, with CAD (-0.2%) the laggard on weak oil prices.

EMG currencies have many more gainers than losers this morning with only RUB (-0.6%) on oil weakness, and KRW (-0.35%) on a smaller than expected trade surplus, declining of note, while THB (+0.6%), PLN (+0.6%) and HUF (+0.4%) all have shown some strength.  In Bangkok, the central bank vowed to monitor the baht, which has been falling steadily over the past 9 months to its weakest point in more than 4 years.  PLN saw higher than expected CPI data (5.8%) which has the market looking for higher rates from the central bank, while HUF was the beneficiary of central bank comments that the monetary tightening campaign was “far from the end.”

There is a veritable trove of data to be released this morning starting with Personal Income (exp 0.2%), Personal Spending (0.7%) and the Core PCE (3.5%) at 8:30.  Then at 10:00 we see ISM Manufacturing (59.5) and Prices Paid (78.5) as well as Michigan Sentiment (71.0).  If the PCE number prints on plan, the Fed will be crowing about how it, too, is falling and has peaked.  However, that is crow they will ultimately have to eat, as the peak is not nearly in.

The underlying picture for the dollar remains quite positive on both a technical and fundamental basis, but it appears today is a consolidation day.  Perhaps, a good time to buy dollars still needed to hedge.

Good luck, good weekend and stay safe
Adf

On Command

As Covid infections expand
Worldwide, and more meetings get banned
The worry is that
Growth’s surge will fall flat
And stocks will not rise on command

But Monday’s price action was fleeting
As dip buyers now are competing
To add to their stash
Of low value trash
Before the Fed’s next monthly meeting

Come with me on a journey to the past.  A time when investors considered risks as well as rewards and if those risks seemed elevated, those very same investors would consider actually selling stocks and running to the (relative) safety of the government bond market.  Risks could include slower growth, higher inflation or even the recurrence of a global pandemic.  Naturally, under circumstances of that nature, investors displayed caution.  Now, fortunately, situations like that don’t seem to happen very often anymore, although if you think back to…Monday, that seemed to be the developing narrative.   Ahh, but as Dinah Washington crooned so fantastically in 1959, What a Difference a Day Makes.

Monday’s price action and narrative might as well have occurred in 2008 during the GFC given how long ago it seems and how short memories have become over time.  So, all of the angst regarding the spread of the delta variant and additional lockdowns around the world, as well as the impact that would have on the global growth scenario has essentially been expunged from the record and it’s now all sunshine, lollipops and rainbows going forward.  At least, that’s the way it seems this morning.

Yesterday saw a significant rebound in the equity market and a sharp sell-off in Treasury and other government bond markets as the bargain hunters were out in force taking advantage of the 2% dip seen Monday.  After all, it’s not as though there was any new news released to encourage a change in view.  The only data release was Housing Starts which were marginally better than expected, but then everybody knows the housing market is en fuego.  With both the Fed and ECB in their quiet periods ahead of upcoming meetings, there were no central bank statements to help ameliorate concerns that had become manifest on Monday.  Which leads to the conclusion that nothing in the zeitgeist has changed; buy the dip because there is no alternative remains the single most powerful underlying force in markets today.

Which brings us to this morning’s situation, where the rally continues in equity markets, bond markets continue to retreat from their recent highs and commodity markets are getting their feet under themselves again.  What about inflation you may ask?  Bah, old news.  Clearly it is transitory as there hasn’t been a higher than expected print in more than a week!  (Well, that’s not strictly true as this morning South African CPI was released at a higher than expected 4.9% which has pushed back on the growing narrative that the SARB might be able to back off its mooted tightening.)  But South Africa is insignificant in the broad scheme of things, so the combination of increasing infections there along with rioting over the imprisonment of former president Jacob Zuma has just not been enough to concern investors in other markets.

One has to give props to the central banking community for their ability to convince economists, politicians and investors that the worsening inflation situation is really a very short-term blip, and that the big problem remains deflation.  Of course, it is not hard to convince politicians once they understand this stance allows for more spending.  Economists tend to be lost in their models so aren’t that important anyway.  Investors, however, have historically taken these things with a bit more skepticism, and the fact that the market is responding in exactly the manner central banks want is the truly surprising outcome.  Nothing has changed my view that this entire house-of-cards-like market will come tumbling down at some point, but it is very clear that as John Maynard Keynes explained in 1924, “the market can stay irrational longer than you can stay solvent.”  In other words, calling the timing of any significant pullback is a fool’s errand, and I will endeavor not to be foolish today.

As to markets today, it is very clear by now that risk is back on.  Equities in Asia were generally higher (Nikkei +0.6%, Hang Seng -0.1%, Shanghai +0.7%) and are quite strong in Europe (DAX +0.9%, CAC +1.4%, FTSE 100 +1.7%).  US futures you ask?  Generally higher as well, with DOW +0.4%, although NASDAQ futures are actually -0.1% at this hour.  The rotation into value seems to be this morning’s view.

The bond market is behaving as expected with investors quickly getting out of their recently added long positions.  Treasury yields are higher by 2.2bps, while Bunds, OATs and Gilts are all about 1.5bps higher this morning.  There is certainly no reason to own bonds when stocks are on the move!

Commodity markets are mixed this morning, although the most important of the bunch, oil, is higher by 1.5% and continuing to rebound from Monday’s substantial declines.  That price action on Monday was clearly technical in nature and shook out a great many weak hands.  The case for higher oil prices remains strong in my view, as the lack of capex in the sector as well as the ESG efforts to starve the industry of capital will result in a supply demand mismatch over time that will only resolve itself with higher prices.  As to the rest of the commodity space, precious metals are mixed (Au -0.5%, Ag 0.7%), as are base metals (Cu -0.2%, al +0.2%) and Ags (Soybeans -0.4%, Wheat +0.4%).  In other words, there is no directional bias here.

Finally, in the currency markets, movement has been a bit more muted overall, and mixed just like elsewhere.  In the G10 bloc, NOK (+0.35%) is following oil higher and JPY (-0.25%) is seeing its haven status work against it as it reverts to form, with the rest of the bloc +/- 0.1% meaning there is nothing to discuss.  In the emerging markets, there is a bit more weakness with ZAR (-0.4%) still suffering from the increased spread of Covid as are KRW (-0.3%) and the CE4 (HUF -0.3%, CZK -0.3%, PLN -0.25%).  On the plus side there is only CNY (+0.2%) which was supported by comments from the central bank claiming they will keep the yuan “basically stable”.

There is no data and no speakers today which means that the FX market is left to watch other markets for its cues.  With risk back in vogue, I expect that the dollar could cede some ground against the majors, but the ongoing issues throughout different emerging markets are likely to continue to weigh on currencies in that sector.

Good luck and stay safe
Adf

Quite Unforeseen

When OPEC, a group of fifteen

Producers, all gathered in Wien

Nobody assumed

The meeting was doomed

To failure, t’was quite unforeseen

Alas, for the group overall

The UAE prince had the gall

To strongly demand

Their quota expand

The Saudis, though, wouldn’t play ball

The big story this morning revolves around the failure to agree, by OPEC+, on new production quotas going forward.  While expansion of output was on the agenda as each member was keen to take advantage of the rising price of crude and its products, it seems the UAE demanded a much larger share of the increase than the Saudis wanted to give.  Ordinarily, this type of horse trading takes place in the background as OPEC likes to show its unity, but for some reason, this particular situation burst into plain sight.  Undoubtedly there are many underlying issues between Saudi Arabia and the UAE, but right now, this is the one that matters.  The result has been that oil continues to rise sharply, up another 1.75% this morning taking the gains this year to nearly 60%.  As is frequently the case in a bullish commodity market, the price curve is in steep backwardation, with the front month contracts being significantly more expensive than the outer months.  This is an indication of a lack of short-term supply, something borne out by the continued drawdown of reserves in storage.

What makes this situation so interesting is the fact that the dollar has not fallen sharply while the price of oil has risen.  Historically, rising commodity prices go hand in hand with a weaker dollar, at least versus its counterpart currencies, but that is not really the case this time.  Thus, for those nations that import oil, their local costs have increased more than proportionally as the lack of dollar weakness means it costs much more local currency to procure each barrel.  For instance, since the start of 2021, the Japanese yen has weakened 6.8% and the Swiss franc has fallen 4.1% while oil’s price has soared.  Neither of these nations produces a drop of oil, so their energy costs have climbed substantially.  In the emerging markets, TRY (-14.1%), ARS (-12.2%), PEN (-8.0%) and THB (-7.0%) are the worst performers this year, none of whom have a significant oil industry and all of whom rely on imports for the bulk of their usage.  A weaker currency and higher oil prices are very damaging to those economies.

The question at hand is whether or not this internecine spat will end soon, with some sort of compromise, or if the UAE will stand its ground under increasing pressure.  One thing to consider is that the US shale producers are not likely to come to the market’s rescue in the near term, if ever, as it appears that even at these prices, the capital flowing into the sector to increase production has not expanded, and if anything, given the green initiatives and demands to stop funding fossil fuel production, is likely to decrease.  We may be approaching a scenario where the US, which continues to pump about 11 million barrels/day, will find itself in very good stead relative to many other developed nations that import a higher percentage of their energy needs.  Arguably, this will help the dollar, which means that for some countries, things are only going to get tougher.

As an aside, there is another commodity that has been performing pretty well despite the dollar’s strength, gold.  Here, too, history has shown that a rising dollar price of gold is highly correlated with a weaker dollar on the foreign exchange markets.  But that is not the current situation, as after a very short-term drop in the wake of the FOMC meeting’s alleged hawkishness, gold has rebounded while the dollar has retained virtually all of its gains from the same meeting.  My sense is that there are larger underlying changes in market perception, one of which is that inflation expectations are becoming embedded.

Of course, that is not evident in the bond market, where Treasury yields remain in their downtrend that began in early May in the wake of the massively disappointing NFP report that month.  Since then, yields have fallen more than 20 basis points and show no sign of slowing down.  Oddly, if the market was pricing in a tapering by the Fed, I would have anticipated bond yields to rise somewhat, so this is simply another conundrum in the market right now.  

Turning to the overnight session, one might argue we are looking at a very modest risk-off session.  Equity markets have been desultory with Asia (Nikkei +0.15%, Hang Seng -0.25%, Shanghai -0.1%) not showing much activity while European bourses (DAX -0.4%, CAC -0.3%, FTSE 100 -0.15%) are a bit softer.  Arguably, the European markets have responded to much weaker than expected German data with Factory Orders falling -3.7% ad the ZEW Expectations Survey falling to 63.3, well below the expected 75.2 reading.  Questions about whether or not the global economy has peaked are starting to be asked as stimulus measures fade away.  By the way, US futures are essentially unchanged at this hour.

While today’s Treasury movement has been nil, we are seeing yields decline across Europe with Bunds (-1.5bps), OATs (1.9bps) and Gilts (-1.1bps) all seeing a bit of demand on the back of waning risk appetite.  Remember, too, that the inflation impulse in Europe remains far less substantial than that in the US.

Aside from oil (+1.75%) and gold (+0.8%), the rest of the commodity bloc is also pretty firm this morning with Copper (+1.5%) and Iron ore (+1.6%) leading the base metals higher.

Finally, in the FX market, the best way to describe things would be mixed.  The RBA met last night and was more hawkish than anticipated.  They not only indicated they were going to reduce the amount of QE purchases when the current program comes up for renewal, but they appear to be ending YCC as well, explaining that they would not be supporting the November 2024 bonds when they become the 3-year maturity.  Not surprisingly, we saw AUD (+0.6%) rally, which dragged NZD (+0.8%) up even more as traders speculate the RBNZ is going to raise rates as well.  Away from that, though, the bulk of the G10 bloc was softer led by NOK (-0.55%), which given oil’s continued rise makes little sense.  At this point, I will chalk it up to trading technicals as I see no strong rationale.  As to the rest of the bloc, modest declines are the name of the game.

Emerging markets have also seen similar mixed price action with ZAR (+0.25%) the leading gainer on the back of gold’s strength while HUF (-0.65%) is the laggard as the market awaits comments from the central bank regarding its green policy ideas.  The next weakest currency in this bloc is PHP (-0.5%) as the central bank confirmed it would not be reducing stimulus until it had further confidence the economy there would be picking up.

On the data front, there are only a few releases due although we do see the FOMC Minutes tomorrow.

TodayISM Services63.5
WednesdayJOLTs Job Applications9313K
 FOMC Minutes 
ThursdayInitial Claims350K
 Continuing Claims3325K

Source: Bloomberg

Aside from this limited information, we hear from just one Fed speaker tomorrow.  Perhaps the market will have the opportunity to make up its own mind about where things are going to go.

At this point, the Fed narrative remains that inflation is transitory and that they will continue to support the economy going forward.  However, there is a group of FOMC members who clearly believe that it is time to cut back on QE.  That will be the major discussion for the next several months, to taper or not, and if so, how quickly it will occur.  My view continues to be that the core of the Fed is not nearly prepared to taper QE purchases as they know that the ongoing expansion of Federal debt will require the Fed to remain an active part of the market lest things get more concerning for bond traders.

As to the dollar, it remains in its trading range having reached the top of that range last week.  I would not be surprised to see a bit of dollar weakness overall, if for no other reason than the dollar is likely to slip back toward the middle of its range.

Good luck and stay safe

Adf

Negative Views Have Been Banned!

It’s not clear why anyone thought
That Covid, much havoc had wrought
At least based on stocks
Who’s heterodox
Response ignores data quite fraught

Thus, once more with bulls in command
The stock market’s flames have been fanned
So, risk is appealing,
The dollar is reeling
And negative views have been banned!

Acquiring risk continues to be at the top of investor to-do lists as, once again, despite ongoing calamities worldwide, stock markets continue on their mission to recoup all the losses seen in March. It remains difficult for me to understand the idea that company valuations today should be the same as they were in February, before the global economy came to a screeching halt. Aside from the hundreds of millions of people worldwide who have been thrown out of work, millions of companies will disappear forever, whether it is JC Penney (long overdue) or your favorite local bistro (a calamity if there ever was one.) The commonality between the two is that both employed people who were also consumers, and sans an income, they will be consuming much less.

Given that consumption represented more than 60% of the global economy (>68% in the US), all those companies that cater to consumers are going to find it extremely difficult to generate profits if there are no consumers. It is why the hospitality/leisure sectors of the economy have been devastated world-wide, and all the industries that service those companies, like aircraft manufacturing or construction, have also been hit so hard. If you remove the rose-tinted lenses, it appears that the ongoing risk acquisition remains painfully ignorant of the reality on the ground, and that a revaluation seems more likely than not.

One other thing to consider is this, tax rates. US equity markets have been a huge beneficiary of the tax cuts from 2018 with corporate earnings broadly exploding higher. However, even if one looks past the abyss of the next several quarters of economic destruction, it seems quite likely that we are going to see some big picture changes around the world with regard to distribution of income, i.e. higher corporate (and personal) tax rates and lower EPS. Again, my point is that even if, by 2021, economic activity returns to the level seen in 2019, the share of that value that will be attributed to the corporate sector is destined to be much lower, and with after-tax earnings declines ordained it will be extremely difficult to justify high valuations. So, yes, risk is in the ascendancy today, but it continues to feel as though its time is coming to an end.

And with that sobering thought, let us look at just how risk is performing today. Equity markets around the world followed yesterday’s modest US rally higher with both the Nikkei and Hang Seng rallying a bit more than 1.1%, although Shanghai managed only a 0.2% gain. Meanwhile, Europe is feeling quite perky this morning as funds from around the world are flowing into the single currency as well as equity markets throughout the region. The DAX is leading the way higher, up 4.0%, as plans for a mooted €100 billion government support program are all over the tape. And this is in addition to the EU plan for a €750 billion support package. Thus, talk of a cash for clunkers program is supporting the auto manufacturers, while increases in childcare subsidies and employment support are destined to help the rest of the economy.

But the rest of Europe is also rocking, with the CAC +2.2% and both Italy and Spain seeing 2.5% gains in their major indices. Surprisingly, the FTSE 100 is the laggard, up only 1.1%, as concerns over a hard Brexit start to reappear. The current thinking seems to be that even if a hard Brexit causes a poor economic outcome, Boris will be able to blame everything on Covid-19 thus hiding the costs, at least to the bulk of the population. After all, it will not be easy to disentangle the problems caused by Covid from those caused by a hard Brexit for the average bloke.

As I type, US futures are also reversing earlier losses and are now higher by roughly 0.5% across the board. Bond markets, once again, remain extremely uninteresting, at least in the 10-year sector, as yields continue to trade in narrow ranges. In fact, since mid-April, the 10-year Treasury has had a range of just 15bps top to bottom, again, despite extraordinary economic disruption. This same pattern holds true for all the haven bonds as central banks around the world control the activity there and prevent any substantial volatility. In fact, it is becoming increasingly clear that the signaling effect of government bond yields is diminishing rapidly. After all, what information is available regarding investor preferences if yields are pegged by the central bank?

Finally, turning to the dollar we see another day of virtually universal weakness. AUD is the top G10 performer today after the RBA appeared a tad more hawkish last night, leaving policy unchanged but also describing a wait and see approach before making any further decisions. So, while some are calling for further ease Down Under, that does not appear to be on the cards for now. NOK is next on the list, rallying 0.65% as oil prices continue their strong performance of the past 6 weeks. Then comes the pound, up 0.6% this morning after a more than 1% rally yesterday. This is far more perplexing given the growing concerns over a hard Brexit, which will almost certainly result in the pound declining sharply. Remember, as it currently stands, if there is no agreement between the UK and EU by the end of June to extend the current trade negotiations, then a deal must be done by December 31, 2020 or it’s a hard Brexit. Discussions with traders leads me to believe that we have seen a massive short squeeze in the pound vs. both the euro and the dollar. If this is the case, then we are likely looking at some pretty good levels for hedgers to take advantage.

In the EMG space, the board is almost entirely green as well, with IDR (+1.35%) atop the list with MYR (+1.0%) and MXN (+0.9%) following close behind. The rupiah has gained as Indonesia is preparing plans to reopen the economy as soon as they can, deciding that the economic devastation is worse than the disease. Meanwhile, both MYR and MXN are beneficiaries of the oil rally with the ruble (+0.65%) not far behind. In fact, the entire space save the TWD (-0.15%) is firmer this morning. As an aside, TWD seems to be feeling a little pressure from the ongoing US-China trade spat, but despite its modest decline, it has been extremely stable overall.

There is no US data on the schedule for today, so FX markets will continue to take their cues from equities. At this point, that still points in the direction of a weaker dollar as risk continues to be acquired. Despite the currency rallies we have seen in the past weeks, most currencies are still lower vs. the greenback YTD. If you are convinced that the worst is behind us, then the dollar has further to fall. But any reversion to a risk-off sentiment is likely to see the dollar reassert itself, and potentially quite quickly.

Good luck and stay safe
Adf

To Aid and Abet

The treaties that built the EU
Explain what each nation should do
The German high court
Ruled that to comport
A challenge was in their purview

But politics trumps all the laws
And so Lagarde won’t even pause
In buying up debt
To aid and abet
The PIGS for a much greater cause

Arguably, the biggest story overnight was just not that big. The German Constitutional Court (GCC) ruled that the Bundesbank was wrong not to challenge the implementation of the first QE program in 2015 on the basis that the Asset Purchase Program (APP) was a form of monetary support explicitly prohibited. Back when the euro first came into existence, Germany’s biggest fear was that the ECB would finance profligate governments and that the Germans would ultimately have to pay the bill. In fact, this remains their biggest fear. While technically, QE is not actually debt monetization, that is only true if central banks allow their balance sheets to shrink back to pre-QE sizes. However, what we have learned since the GFC in 2008-09 is that central bank balance sheets are permanently larger, thus those emergency purchases of government debt now form an integral part of the ECB structure. In other words, that debt has effectively been monetized. The essence of this ruling is that the German government should have challenged QE from the start, as it is an explicit breach of the rules preventing the ECB from financing governments.

The funny thing is, while the court ruled in this manner, it is not clear to me what the outcome will be. At this point, it is very clear that the ECB is not going to be changing their programs, either APP or PEPP, and so no remedy is obvious. Arguably, the biggest risk in the ruling is that the GCC will have issued a binding opinion that will essentially be ignored, thus diminishing the power of their future rulings. Undoubtedly, there will be some comments within the three-month timeline laid out by the GCC, but there will be no effective changes to ECB policy. In other words, like every other central bank, the ECB has found themselves officially above the law.

While the actuality of the story may not have much impact on ECB activities, the FX market did respond by selling the euro. This morning it is lower by 0.5%, which takes its decline this month to 1.2% and earns it the crown, currently, of worst performing G10 currency. The thought process seems to be that there is nothing to stop the ECB in its efforts to debase the euro, so the path of least resistance remains lower.

Beyond the GCC story though, there is little new in the way of news. Equity markets have a better tone on the strength of oil’s continuing rebound, up nearly 10% this morning as I type, as production cuts begin to take hold, as well as, I would contend, the GCC ruling. In essence, despite numerous claims that central banks have overstepped their bounds, it is quite clear that nobody can stop them from buying up an ever larger group of financial assets and supporting markets. So, yesterday’s late day US rally led to a constructive tone overnight (Hang Seng +1.1%, Australia +1.6%, China and Japan are both closed for holidays) which has been extended through the European session (both DAX and CAC +1.8%, FTSE 100 +1.4%) with US futures pointing higher as well.

In the government bond market, Treasury yields are 3.5bps higher, but the real story seems to be in Europe. Bund yields have also rallied a bit, 2bps, but that can easily be attributed to the risk-on mentality that is permeating the market this morning. However, I would have expected Italian and Spanish yields to have fallen on the ruling. After all, they have become risk assets, not havens, and yet both have seen price declines of note with Italian yields higher by 10bps and Spanish (and Portuguese) higher by 5bps. Once again, we see the equity and bond markets looking at the same news in very different lights.

As to the FX market, it is a mixed picture this morning. While the Swiss franc is tracking the euro lower, also down by 0.5% this morning, we are seeing NOK (+0.4%) and CAD (+0.2%) seeming to benefit from the oil price rally. Aussie, too, is in better shape this morning, up 0.2% on the broad risk-on appetite and news that more countries are trying to reopen after their Covid inspired shutdowns.

The EMG space is similarly mixed with ZAR (+1.25%), RUB (+1.0%) and MXN (+0.6%) the leading gainers. While the ruble’s support is obviously oil, ZAR has benefitted from the overall risk appetite. This morning, the South African government issued ZAR 4.5 billion of bonds in three maturities and received bid-to-cover ratios of 6.8x on average. With yields there still so much higher than elsewhere (>8.0%), investors are willing to take the risk despite the recent credit rating downgrade. Finally, the peso is clearly benefitting from the oil price as well as the broad risk-on movement. The peso remains remarkably volatile these days, having gained and lost upwards of 5% several times in the past month, often seeing daily ranges of more than 3%. Today simply happens to be a plus day.

On the downside, the damage is far less severe with CE4 currencies all down around the same 0.5% as the euro. When there are no specific stories, those currencies tend to track the euro pretty tightly. As to the rest of APAC, there were very modest gains to be seen, but nothing of consequence.

On the data front, yesterday’s Factory Orders data was even worse than expected at -10.3% but did not have much impact. This morning brings the Trade Balance (exp -$44.2B) as well as ISM Non-Manufacturing (37.9). At this point, everybody knows that the data is going to look awful compared to historical releases, so it appears that bad numbers have lost their shock value. At least that is likely to be true until the payroll data later this week. The RBA left rates unchanged last night, as expected, although they have reduced the pace of QE according to their read of what is necessary to keep markets functioning well there. And finally, we will hear from three Fed speakers today, Evans, Bostic and Bullard, but again, it seems hard to believe they will say anything really new.

Overall, risk appetite has grown a bit overnight, but for the dollar, it is not clear to me that it has a short-term direction. Choppiness until the next key piece of news seems the most likely outcome. Let’s see how things behave come Friday.

Good luck and stay safe
Adf

 

Yields Are Appalling

Though prices for oil keep falling
And Treasury yields are appalling
The stock market’s view
Is skies will be blue
If Covid’s spread’s finally stalling

The ongoing dichotomy between equity market performance, traditionally a harbinger of future economic activity, and commodity market performance, also a harbinger of future economic activity, remains glaring. The commodity markets are clearly signaling significant demand destruction amid the economic devastation that has followed the spread of Covid-19. At the same time, equity markets around the world continue to recover from the lows seen in March, telling a completely different tale; that the future is bright.

When two key leading indicators offer such different portents, we need to look elsewhere to build our case of likely future outcomes. Clearly, government bond markets are the next best indicator, but their signal has been clouded by the more than $15 trillion that central banks around the world have spent buying those bonds since the financial crisis in 2008-09. Absent those purchases, would 10-year Treasury yields really be 0.65% like they are this morning? Would 10-year German bund yields really be at -0.44%, their 356th consecutive day yielding less than zero? Consider how much new debt has been issued and how that debt would have been absorbed absent central bank intervention. My point is that perhaps, using bond yields now as a proxy for future economic activity may no longer be quite as useful.

Which leaves us with the FX markets as our last signal for future activity. What does the dollar’s value tell us about expectations for the future? The problem with the dollar as an indicator is, its track record is extremely unclear. Throughout history, the US economy has been strong with both a strong dollar and a weak dollar. If anything, the dollar is a far better coincident indicator than anything else. After all, what is the risk-off/risk-on characteristic other than a signal of investors’ current views of the market. Thus, when fear is rampant, which was evident last month, the dollar performed extremely well. A quick look at currency returns during the month of March showed the dollar rising against 9 of its G10 Brethren, from 0.2% vs. the Swiss franc, to 10.7% vs. the oil-linked Norwegian krone. Only the yen, which managed a 0.75% rise, was able to outperform the dollar.

Not surprisingly, the EMG space saw some much more significant declines led by the Mexican peso (-18.1%) and Russian ruble (-15.3%). The broad theme in this bloc was that the best performers, those that fell the least, were APAC currencies with closer links to China, while LATAM and EEMEA were generally devastated. But, again, this was a real-time response to coincident activities, not a harbinger of the future.

The lesson to learn from this brief look at recent history is that there is no consensus view as to how things are going to evolve from here. Both sides make their respective cases strongly, and both sides can point to a substantial amount of data that supports their argument. However, the only universal truth is that economic disruptions that have been caused by the response to Covid-19 are unprecedented in both size and speed, and econometric models built for a different environment are unlikely to be very effective. Modeling of complex systems, whether the economy, the climate or the spread of a pathogen is an extremely fraught undertaking. More often than not, models will produce useless results. Their benefits generally come from the need to define conditions and factors, thus helping to better think and understand a particular situation, not from spurious calculations that produce a result. And this is why hedging is an important part of risk management, because regardless of what certain harbingers indicate, the reality is nobody knows what the future will bring.

But back to today’s activity. As we have seen for the past several sessions, the prospect of the reopening of economies is being seen by the equity markets as a clear positive. Despite abysmal earnings results across most industries, once again equity markets are firmer this morning, with most of Europe higher by 1.5%-2.0% and US futures pointing to gains of more than 1.0% on the open. Countries throughout Europe are starting to announce their plans to reopen with May 11 seeming to be the date where things will really start. And of course, the same process is ongoing in the US, with Georgia dipping its toe into the water yesterday, and other states lining up to do the same. Of course, the end of the lockdown does not mean that that things will return to the pre-virus situation. Incalculable damage has been done to every nation’s economy as regardless of government attempts, thousands upon thousands of small businesses will never return. Arguably, the one thing we know about the future is that it is going to be different than what was envisioned on January 1st.

Bond markets are behaving consistently with a modest risk-on view as Treasury and bund yields edge higher, while yields for the PIGS continue to slide. And finally, the dollar remains under pressure this morning, sliding against most of its counterparts as short-term fears abate. The best performers today in the G10 bloc are SEK and NOK, with the former rallying on what was perceived as a more hawkish than expected message from the Riksbank, when they didn’t cut rates back below zero at today’s meeting, and merely promised to continue to buy more bonds. NOK is a bit more difficult to explain given that oil prices (WTI -7.7%) continue to suffer from either significant excess supply or a complete lack of demand, depending on your point of view. However, given that NOK has been the worst performing G10 currency this year, it is probably due for some recovery given the positive sentiment seen today.

EMG currencies are also generally firmer, with MXN (+1.5%) atop the charts, as it, too, is ignoring the declining price of oil and instead finding demand after a precipitous fall this year. but we are also seeing strength in ZAR (+1.2%) and most EEMEA currencies, as some of last month’s excesses seem to be unwinding as we approach the end of April.

On the data front this morning are two minor releases, Case Shiller Home Prices (exp 3.19%) and Consumer Confidence (87.0). Rather, with the FOMC’s two-day meeting beginning this morning at 9:00, discussions will continue to focus on expectations for the Fed tomorrow, as well as the first look at Q1 GDP. But for today, I expect that we will continue to see this mildly positive risk attitude and the dollar to remain under modest pressure. My view remains that there are still significant issues ahead and the market is not pricing in the length of how bad things are going to be, but clearly for now, I am in the minority.

Good luck and stay safe
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