To Sell or To Buy

As markets await CPI
For signals to sell or to buy
The Fed looks for ways
This reading to raise
But not for an outcome too high

Overnight activity in the markets has been fairly dull as investors and traders await a series of events that will unfold as the day progresses.  On the data front, Jan CPI readings are due with expectations as follows:

CPI (M/M) 0.3%
CPI (Y/Y) 1.5%
-ex food & energy (M/M) 0.2%
-ex food & energy (Y/Y) 1.5%

Source : Bloomberg

The one consistent thing about CPI readings since the nadir last May is that the outcome has been higher than forecast in 7 out of those 8 readings.  Perhaps it is time for economists to reconsider the variables in their forecasting models.  The implication is that inflation, which the Fed continues to avow is far too low, may not be as low as they say.

Now, despite the fact that the Fed (and pretty much every major central bank) has decided to ignore inflation readingsa until they get too high, instead focusing on supporting economic activity, the market still cares about inflation.  This is made clear by the ongoing discussion on real interest rates which are simply the result of the nominal interest rate less the inflation reading.  For example, while 10-year Treasury yields have risen to 1.15%, the real rate, using the December core CPI reading of 1.6%, is -0.45%.  When applied to the current 2-year Treasury yield of 0.115%, the real yield falls to -1.485%.

And this is where it starts to get interesting.  It turns out that investors are extremely focused on real yields as demonstrated by their correlation to different assets, notably the dollar and gold, but also stocks.  It is these negative real yields that continue to drive the search for yield which has resulted in non-investment grade (aka junk) bonds to be in such demand.  In fact, these less creditworthy instruments now yield less than 4.0%, a historic low, and not nearly enough to compensate for the risk of default.  But for investors, the real yield is +2.35%, far higher than they can receive elsewhere, and so worthy of the risk.  (When you read about those worrywarts who claim that central banks have distorted markets beyond recognition, this is the type of thing they are highlighting.)

But it is not just fixed income investors who focus on the real yield.  These yields impact virtually every investment.  Consider, for a moment, gold, an asset which pays no dividend and has no cash flow.  When real interest rates are high, there is a significant opportunity cost to holding the precious metal.  But as real yields decline below zero, that opportunity cost converts into a benefit which is why the correlation between real yields and gold is strongly negative (currently -0.31% with strong statistical significance).

Or consider the dollar.  There are many things that go into determining the dollar’s value at any given time, but clearly, interest rates are one of them.  After all, interest rates are a key feature of every currency discussion and define the activity in the carry trade.  Now, the dollar’s historic haven status along with that of Treasury bonds means that when things get bad, investors flock to both dollars and Treasuries which drives nominal, and therefore real, yields lower.  But in more benign circumstance, when there is no panic, relative real yields is a key driver in the FX market, with negative real US yields associated with a weaker dollar.  In fact, this is my main thesis for the second half of 2021, that inflation will continue to rise while the Fed will cap Treasury yields (because they have to) and the dollar will suffer accordingly.

Which brings us back to this morning’s CPI reading.  My sense is that we are reaching the point where the market will take higher inflation readings as a dollar negative, so beware any surprise in the data.

Adding to today’s mix, and arguably a key reason that overnight markets have been so dull, is that we are set to hear from three major central bank heads, starting with Madame Lagarde this morning, the BOE’s Andrew Bailey at noon and then our very own Chairman Jay at 2:00 this afternoon.  Keep in mind the following themes when listening: the ECB is carefully monitoring the exchange rate; the BOE has instructed banks to prepare for NIRP although claims this is not a policy change, and the Fed remains unconcerned if inflation were to rise to 2.5% or 3.0%.  All of this points to the idea that real yields, around the world, are going to decline further.  Sorry savers!

Now to the markets this morning.  While Asian equity markets performed well (Nikkei +0.2%, Hang Seng +1.9%, Shanghai +1.4%), the same is not true in Europe, where there is a mixture of red and green on the screen.  Here we see the FTSE 100 (+0.3%) as the leader, while both the CAC (-0.1%) and DAX (-0.2%) can find no traction today.  Finally, US futures are all higher by about 0.3% after consolidating yesterday at their recent closing highs.

Bond markets are under very modest pressure this morning with Treasury yields higher by 1 basis point and similar moves seen in Europe.  The one exception is Italy, which has seen 10-year yields decline to a new record low of 0.499% as investors anticipate great things from Mario Draghi’s turn as Prime Minister.

In the commodity markets, oil (+0.5%) continues to grind higher in its drive for $60/bbl, while gold is little changed on the day.  Base metals are all modestly higher but agriculturals are actually backing off a bit this morning.  Again, the picture is best described as mixed.

Finally, the dollar is also themeless today, with G10 currencies seeing modest strength from Europe (CHF +0.1%, GBP +0.1%, EUR flat) while NZD (-0.4%) leads the way lower for the Asian bloc.  However, there has been no data, or comments, yet, that would explain the movement.  This smacks of position adjustments as the recent dollar rebound tops out.

EMG currencies have similarly shown no general direction with both gainers and losers about equally split.  KRW (+0.9%) is the big winner after short positions were closed out ahead of the Lunar New Year holiday that begins tonight.  But beyond that, the winners saw gains of 0.2% or less, hardly the stuff of dreams.  Meanwhile, on the negative front, BRL (-0.6%) is opening in the worst spot as concerns grow over the fiscal situation as the country seems set to increase Covid related expenditures with no plans on how to pay for them.  The next worst performer is CZK (-0.5%) but this is more difficult to discern as there has been neither news nor data to drive the market.  This has all the earmarks of a significant flow that the market has not yet fully absorbed.

And that’s really it for the day.  The big picture remains that the dollar has bounced from its correction highs but has not yet been able to convincingly turn back down.  This argues for a few more sessions of choppiness unless we receive new news.  Perhaps CPI will be much higher (or lower) than expected, either of which can drive movement.  Or perhaps we will hear something new from one of the three central bank heads today which will change opinions.  But for now, choppy with nowhere to go seems the most likely outcome.

Good luck and stay safe


Just last week the narrative spoke
And told us the world would soon choke
On dollars they held
Thus, would be compelled
To sell them, ere they all went broke

But funnily, this week it seems
The selling had reached its extremes
So, shorts are now squeezed
And traders displeased
As they now must look for new themes

It had been the number one conviction trade entering 2021, that the dollar would sell off sharply this year.  In fact, there were some who were calling for a second consecutive year of a 10% decline in the dollar versus its G10 counterparts, with even more gains in some emerging market currencies.  The market, collectively, entered the new year short near record amounts of dollars, riding the momentum they had seen in Q4 of last year and looking for another few percentage points of decline.  Alas, one week into the year and things suddenly seem quite different.

The first thing to highlight is that while a few percent doesn’t seem like much of a move, certainly compared to equities or bitcoin, the institutional trading community, consisting of hedge funds and CTA’s, lever up their positions dramatically.  In fact, 10x capital is quite common, with some going even further.  So, that 2% move on a 10x leverage position results in a 20% gain, certainly very respectable.  The second thing to highlight is that if a short-term trading reversal is able to cause this much angst in the trading community, conviction in the trade must not have been that high after all.

But let us consider what has changed to see if we can get a better understanding of the market dynamics.  Clearly, the biggest change was the run-off election in Georgia, which had been expected to result in at least one seat remaining in Republican hands, and thus a Republican majority in the Senate.  This outcome of a split government was seen to be a general positive for risk, as it would prevent excessive increases in debt financed stimulus, thus force the Fed to maintain low US interest rates.  And of course, we all know, that low rates should undermine the currency.

But when the Democrats won both seats, and the Senate effectively flipped, the new narrative was that there would be massive stimulus forthcoming, encouraging the reflation trade.  The thing is, the reflation trade is part and parcel of the steepening yield curve trade based on the significant amount of new Treasury debt that would need to be absorbed by the market, with the result being declining prices and higher Treasury yields.  (One thing that I never understood about the weak dollar trade in this narrative was the idea that a steeper yield curve would lead to a weaker dollar, when historically it was always the other way around; steep curve => strong dollar.)

Last week, of course, we saw Treasury yields back up 20 basis points in the back end of the curve, exactly what you would expect in a reflation trade.  And so, it cannot be surprising that the dollar has found a bottom, at least in the short-term, as higher yields are attracting investors.  But what does this say about the future prospects for the dollar?

My thesis this year has been the dollar will decline on the back of declining real yields in the US, which will be driven by rising inflation and further Fed support.  Neither the US, nor any G10 country for that matter, can afford for interest rates to rise as they continue to issue massive amounts of debt, since higher rates would ultimately bankrupt the nation.  However, inflation appears to be making a comeback, and not just in the US, but in many places around the world, specifically China.  Thus, the combination of higher inflation and capped yields will result in larger negative real rates, and thus a decline in the dollar.  Last week saw real yields rise 15 basis points, so the dollar’s rally makes perfect sense.  But once the Fed makes it clear they are going to prevent the back end of the curve from rising, the dollar will come under renewed pressure.  However, that may not be until March, unless we see a hiccup in the equity market between now and then.  For now, though, as long as US yields rise, look for the dollar to go along for the ride.

Of course, higher US yields and a stronger dollar do not encourage increased risk appetite, so a look around markets today shows redder screens than that to which we have become accustomed.  The exception to the sell-off rule was Tokyo, where the Nikkei (+2.35%) rallied sharply as the yen continues to weaken.  Remember, given the export orientation of the Japanese economy, a weaker yen is generally quite positive for stocks there.  The Hang Seng (+0.1%) managed a small gain, but Shanghai (-1.1%), fell after inflation data from China showed a much larger rebound than expected with CPI jumping from -0.5% to +0.2%.  Obviously, that is not high inflation, but the size and direction of the move is a concern.

European markets, however, are all underwater this morning, with the DAX, CAC and FTSE 100 all lower by 0.5%.  US futures are pointing down as well, between 0.4%-0.6% to complete the sweep.  Bond markets are modestly firmer this morning, with Treasury yields slipping 1.5 bps, while Bunds, OATS and Gilts have all seen yields fall just 0.5bps.  Do not be surprised that yields for the PIGS are rising, however, as they remain risk assets, not havens.

In the commodity space, oil is under modest pressure, -0.65%, while gold is essentially unchanged, although I cannot ignore Friday’s 2.5% decline, and would point out it fell another 1.5% early in today’s session before rebounding.  Since I had highlighted Bitcoin’s remarkable post-Christmas rally, I feel I must point out it is down 17% since Friday, with some now questioning if the bubble is popping.

Finally, the dollar continues its grind higher, with commodity currencies suffering most in the G10 (NOK -1.1%, NZD -0.7%, AUD -0.6%) as well as the pound (-0.6%) which is feeling the pain of Covid-19 restrictions sapping the economy.  In the EMG space, we are also seeing universal weakness, with the commodity focused currencies under the most pressure here as well.  So, ZAR (-1.0%), MXN (-0.85%) and BRL (-0.8%) are leading the pack lower, although there were some solid declines out of APAC (IDR -0.75%, KRW -0.7%) and CE4 (PLN -0.75%, HUF -0.7%).

On the data front, this week brings less info than last week, with CPI and Retail Sales the highlights:

Tuesday NFIB Small Biz 100.3
JOLTs Job Openings 6.5M
Wednesday CPI 0.4% (1.3% Y/Y)
-ex food & energy 0.1% (1.6% Y/Y)
Fed’s Beige Book
Thursday Initial Claims 785K
Continuing Claims 5.0M
Friday Retail Sales 0.0%
-ex autos -0.2%
PPI 0.3% (0.7% Y/Y)
-ex food & energy 0.1% (1.3%)
Empire Manufacturing 5.5
IP 0.4%
Capacity Utilization 73.5%
Business Inventories 0.5%
Michigan Sentiment 80.0

Source: Bloomberg

Aside from that, we also will hear a great deal from the Fed, with a dozen speakers this week, including Powell’s participation in an economics webinar on Thursday.  Last week, you may recall that Philadelphia’s Patrick Harker indicated he could see a tapering in support by the end of the year, but the market largely ignored that.  However, if we hear that elsewhere, beware as the low rates forever theme is likely to be questioned, and the dollar could well find a lot more support.  The thing is, I don’t see that at all, as ultimately, the Fed will do all they can to prevent higher yields.  For now, the dollar has further room to climb, but over time, I do believe it will reverse and follow real yields lower.

Good luck and stay safe

Their Siren Song

The trend ‘gainst the dollar is strong
With bears playing their siren song
As long as real rates
Are in dire straits
‘Twould be a mistake to go long

While there is usually some interesting tidbit on which to focus regarding market behavior that is not specifically FX related, this morning that does not seem to be the case. In fact, today’s most noteworthy story is that the dollar continues to drive lower vs. almost all its counterparts. As there was no specific news or data that appears to be driving other currencies higher, I can only attribute this broad resumption of the dollar downtrend to the fact that real interest rates in the US have turned back lower.

Looking back a few weeks, 10-year US real interest rates (nominal – CPI) bottomed at -1.08% on August 6th. That coincided with the peak price in gold, as well as the euro’s local high. But then Treasury yields began to back up as the bond market started getting indigestion from the Treasury issuance schedule ($316 billion total since then, of which $112 billion were Notes and Bonds.) The problem is that not merely is the size of the issuance unprecedented, but that it shows no signs of slowing down as the government continues to run massive deficits.

At any rate, real yields backed up by 14 basis points in the ensuing week, which resulted in both a sharp correction in the price of gold, and support for the dollar. But it seems that phase of the market may be behind us as Treasury yields have been sliding on both a nominal and real basis, and we have seen gold (and silver) recoup those losses while the dollar has ceded its gains and then some.

At this point, the question becomes, what is driving real yields? Is it fears of rising inflation? Is it hope that the Fed will maintain ultra-easy monetary policy even if the economy recovers strongly? Or is it something else?

Regarding the pace of inflation, while last week’s CPI data was certainly a shock to most eyes, it doesn’t seem as though it is the driver. I only point this out because the nadir in real yields occurred a week before the CPI data was released. Now it is certainly possible that bond investors were anticipating a higher inflation print, but there was absolutely no indication it would be as high as it turned out to be. In fact, based on the CPI release, I would have anticipated real yields to fall further, as the combination of higher inflation and a Fed that is essentially ignoring inflation at the current time is a recipe for further declines there. Remember, everything we have heard from the Fed is that not merely are they unconcerned with inflation, but that they welcome it and are comfortable allowing it to run hotter than their target for a time going forward.

This latter commentary implies that there is not going to be any change in the Fed’s policy stance in the near future either. Rather, Chairman Powell has made it clear that the Fed is going to provide ongoing support and liquidity to the markets economy for as long as they deem it necessary. Oh, and by the way, they have plenty of tools left with which to do so.

If these are not viable explanations for the change in trend, one other possible driver is the vagaries of the ongoing pandemic. Perhaps there is a relationship between increases in infection rates and investor assessments of the future. Logically, that would not be far-fetched, and there is growing evidence that there is a correlation between market behavior and covid news. Specifically, when it appears that covid is in retreat, bond yields tend to rise, and so real rates have been moving in lockstep. As well, when the news indicates that the virus is resurgent, the yield complex tends to head lower. Thus, in a convoluted way, perhaps the dollar bearishness that has become so pervasive is being driven by the idea that the US continues to suffer the most from Covid-19, and as long as that remains the case, this trend will remain intact.

Now, I would not want to base all my trading and hedging decisions on this idea, but it is certainly worth keeping in mind when looking at short-term risk exposures and potential timing to manage them.

But as I said at the top, overall, there is very little of note in the financial press and not surprisingly, market activity has been fairly muted. For example, equity markets in Asia basically finished either side of unchanged on the day (Nikkei -0.2%, Hang Seng +0.1%, Shanghai +0.3%). Europe, which had been largely unchanged all morning has been on a late run and is now nicely higher (DAX +0.9%, CAC +0.6%) and US futures have also edged up from earlier unchanged levels. As discussed, Treasury yields continue to drift lower (-1.5 basis points) and gold is rocking (+1.0% and back over $2000/oz.)

And the dollar? Well, it is definitely on its back foot this morning, with the entire G10 complex firmer led by GBP (+0.5%) on the strength of optimism over the resumption of Brexit talks and JPY (+0.45%) which seems to be benefitting from the ongoing premium for owning JGB’s and swapping back to USD.

In the EMG bloc, RUB (+0.8%) is the leader today, followed by ZAR (+0.7%) and MXN (+0.65%). All of these are benefitting from firmer commodity prices which, naturally are helped by the dollar’s broad weakness. But other than TRY (-0.2%) which has fallen in nine of the past ten sessions as President Erdogan and the central bank undermine the lira, and IDR (-0.3%), which has also seen a string of suffering, but this based on difficulty dealing with Covid effectively, the rest of the bloc is modestly firmer vs. the greenback.

On the data front, this morning brings Housing Starts (exp 1245K) and Building Permits (1326K), which if wildly different than expectations could have a market impact, although are likely to be ignored by traders. Rather, the trend in the dollar remains lower, with the euro actually setting new highs for the move this morning, and until we see a change in the rate structure, either by US real rates rising, or other real rates falling more aggressively, I expect this trend will continue. Hedgers, choose your spots, but don’t miss out.

Good luck and stay safe

Hardly a Sign

The thing that I don’t understand
Is why people think it’s not planned
The dollar’s decline
Is hardly a sign
The FOMC’s lost command

Based on the breathless commentary over the weekend and this morning, one would have thought that the dollar is in freefall.  It’s not!  Yes, the dollar has been sliding for the past two months, but that is a blink of an eye compared to the fact that it has been trending higher since its nadir a bit more than twelve years ago.  In fact, if one uses the euro as a proxy, which many people do, at its current level, 1.1725 as I type, the single currency remains below the average rate over its entire life since January 1999.  The point is, the current situation is hardly unprecedented nor even significant historically, it is simply a time when the dollar is weakening.

It is, however, instructive to consider what is happening that has the punditry in such a tizzy.  Arguably, the key reason the dollar has been declining lately is because real US interest rates have been falling more rapidly than real rates elsewhere.  After all, the Eurozone has had negative nominal rates since 2014.  10-year German bunds went negative in May 2019 and have remained there ever since.  Given that inflation has been positive, albeit weak, there real rates have been negative for years so the world is quite familiar with negative rates in Europe.  The US story, however, is quite different.  While nominal rates have not yet crossed the rubicon, real rates have moved from positive to negative quite recently and done so rapidly.  So, what we are really witnessing is the FX market responding to this relative change in rates, at least for the most part.  Undoubtedly, there are dollar sellers who are bearish because of their concerns over the macro growth story in the US, the second wave of Covid infections in the South and West and because of the growth in US debt issuance.  But history has shown that the most enduring impacts on a currency’s value are driven by relative interest rates and their movement.  And that is what we are seeing, US rates are falling relative to others and so the dollar is falling alongside them.

In other words, the current price action is quite normal in the broad scheme of things, and not worthy of the delirium it seems to be inspiring.  As I mentioned Friday, this is also what is driving the precious metals complex, which has seen further strength this morning (XAU +$40 or 2.1%, XAG +$1.50 or 6.7%).  And it must be noted that gold is now at a new, all-time nominal high of $1943/oz.  But since we are focusing on the concept of real valuation, while the price is higher than we saw in 2011 on a nominal basis, when adjusted for inflation it still lags pretty substantially, by about 18%, and both current and 2011 levels are significantly below gold’s inflation adjusted price seen in 1980 right after the second oil crisis.

However, the fact that the current reporting of the situation appears somewhat overhyped does not mean that the dollar cannot fall further.  And in fact, I expect that to be the case for as long as the Fed continues to add liquidity, in any form, to the economy.  Markets move at the margin, and the current marginal change is the decline in US real interest rates, hence the dollar is likely to continue to fall if US rates do as well.

The current dollar weakness begs the question about overall risk attitude.  So, a quick look around equity markets globally today shows a mixed picture at best, certainly not a strong view in either direction.  For instance, last night saw the Nikkei edge lower by 0.2% (after having been closed since Wednesday) and the Hang Seng (-0.4%) also slide.  But Shanghai (+0.25%) managed to eke out small gains.  In Europe, the DAX (+0.3%) is pushing ahead after the IFO figures bounced back much further than expected, although the CAC and FTSE 100 (-0.2% each) have both suffered slightly.  A special mention needs to be made for Spain’s IBEX (-1.3%) as the sharp increase in Covid infections seen in Catalonia has resulted in several European nations, notably the UK and Sweden, reimposing a 14-day quarantine period on people returning from Spain on holiday.  Naturally, the result is holidays that had been booked are being quickly canceled.  As to US futures, they are currently in the green, with the NASDAQ up 1.0%, although the others are far less enthusiastic.

Bond markets continue to show declining yields, with Treasuries down another basis point plus and now yielding 0.57%.  Bunds, too, are seeing demand, with yields there down 3 bps, although both Spanish and Italian debt are being sold off with yields edging higher.  In other words, the bond market is not pointing to a risk-on session.

Finally, the dollar is weak across the board, against both G10 and EMG currencies.  In the latter bloc, ZAR is the leader, up 1.3% on the back of the huge rally in precious metals, but we are also seeing the CE4 currencies all keeping pace with the euro, which is higher by 0.6% this morning.  As a group, those four currencies are higher by about 0.65%.  Asian currencies also performed well, but not quite to the standards of the European set, but it is hard to find a currency that declined overnight.  In G10 space, the SEK is the leader, rising 1.0%, cementing its role as the highest beta G10 currency.  But we cannot forget about the yen, which has rallied 0.75% so far this morning, and is now back to its lowest level since the Covid spike, and before that, prices not seen since last August.  A longer-term look at the yen shows that 105 has generally been very strong support with only the extraordinary events of this past March driving it below that level for the first time in four years.  Keep on the lookout for a move toward those Covid inspired lows of 102, although much further seems hard to believe at this point.

On the data front, this week’s highlight is undoubtedly the FOMC meeting on Wednesday, but there is plenty to see.

Today Durable Goods 7.0%
  -ex Transport 3.6%
Tuesday Case Shiller Home Prices 4.10%
  Consumer Confidence 94.4
Wednesday FOMC Rate Decision 0.0% – 0.25%
Thursday GDP Q2 -35.0%
  Personal Consumption -34.5%
  Initial Claims 1.445M
  Continuing Claims 16.3M
Friday Personal Income -0.5%
  Personal Spending 5.4%
  Core PCE 0.2% (1.0% Y/Y)
  Chicago PMI 43.9
  Michigan Sentiment 72.8

Source: Bloomberg

Of course, the GDP data on Thursday will be eye opening, as a print anywhere near forecasts will be the largest quarterly decline in history.  However, that is backward looking.  Of more importance, after the Fed of course, will be the Initial Claims data, which last week stopped trending lower.  Another tick higher there and the V-shaped recovery narrative is likely to be mortally wounded.  As to the Fed, while we will discuss it at length later this week, it seems unlikely they will do or say anything that is going to change the current market sentiment.  And that sentiment continues to be to sell dollars.

Good luck and stay safe