Tag Archives: #riskoff

Higher For Longer is Key

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As markets await CPI
Some folks have begun to ask why
The Fed needs to keep
Inversion so deep
Since ‘flation is no longer high

Instead, what these folks want to see
Is rates heading back down to three
But Jay’s been quite clear
Throughout this whole year
That higher for longer is key

It has been an extremely quiet evening session with very little in the way of new information for market participants as all eyes are on tomorrow morning’s CPI print in the US.  There were only two pieces of mildly noteworthy data, UK Unemployment rose one tick to 4.3%, as expected and the overall employment report was largely in line with expectations.  As well, the German ZEW Survey showed that while the current situation has actually deteriorated, falling to Covid-like levels, Expectations were marginally less awful than forecast.  But in the end, it is hard to make the case that either of these releases had much of an impact on the market.

On the geopolitical front, much is being made of North Korean leader Kim Jung-Un’s trip to Moscow to meet with President Putin, and ostensibly promise to sell him weapons and ammunition.  But again, this doesn’t appear to have any market impact.  Arguably, of much more importance to the market are two US tech firm stories; first Oracle giving disappointing guidance in their earnings last night indicating that perhaps AI is not actually going to rain money into every tech firm right away, and, second the anticipation of Apple’s release of the iPhone 15 today, as analysts try to determine if that company can continue to deserve its current valuation.  At this hour (7:30), Oracle stock is much lower, about -10%, and the entire US equity futures market is marginally under water as well, but just -0.2% or so.

If I had to characterize today’s market it would be stagnant with a flavor of risk-off.  Given the perceived importance of tomorrow’s data release, and the fact that its timing was well-known in advance, it appears that positions have already been established based on individual views.  The result has been lower volumes and less movement ahead of the release.  As well, absent any Fed speakers it is hard to come up with a reason to adjust any views at this point in time.  So, my sense is we are set for quite a dull session overall.

Perhaps this is a good time to recap the current narrative, at least as I see it.  I believe a majority of market participants believe the Fed is done hiking rates and it is only a matter of time before they start cutting them.  There is a strong belief that the Fed will achieve the much-vaunted soft landing despite the long odds of success on that front and a history that shows they have only ever been able to do so once.  The odd thing about this soft-landing belief is the idea that if the Fed is successful in achieving that outcome with interest rates at 5%, that they would suddenly cut rates afterwards.  I need someone to explain to me why the Fed would change the policy that achieved their goals.  A correlating narrative remains that AI is not merely the future, but the present and that tech stocks can grow to the sky.  And maybe they can, but I would bet the under there.  

And lastly, there is a conundrum in this narrative as the de-dollarization story continues to get a great deal of play.  However, if the Fed is successful and AI really is going to drive tech stocks higher forever, why would the dollar lose its luster?  It seems to me, especially given the fact that Europe and probably China are heading into recession, that the dollar will be in huge demand.  At any rate, my take is those are the underlying theses driving markets right now.

So, a tour of markets overnight shows that bond markets are essentially unchanged, stock markets were mixed in Asia, with Chinese shares under pressure but Japanese and Australian shares ok while European shares are under some pressure, and the dollar is rebounding a bit from yesterday’s sell-off.  Arguably, yesterday’s dollar move was a result of the news from Japan and China, both of whom were unhappy over their respective currency’s weakness, but that is, literally, yesterday’s news.  One last thing shows oil (+0.8%) rallying again with WTI above $88/bbl this morning, a new high for this move, which continues to support all energy prices.  In fact, it is this story, a continued lack of supply in the oil market relative to demand that, regardless of the much-hyped transition to renewables, continues to grow, is going to support the price for a long time to come.  And that is going to continue to pressure prices higher as energy is an input into everything we do, both manufacturing and services.

And that’s really it for today, a very quiet session ahead of the next big data drop tomorrow morning.  Before I end, though, I think it is important to understand the nature of economic forecasting and there is a perfect example right now.  I have frequently mentioned the Atlanta Fed’s GDPNow forecast as a potential harbinger of things to come.  Certainly, the market sees it that way.  Well, other regional Fed banks wanted to have their own versions of that GDP Nowcast and this is what we are currently seeing:

  • Atlanta Fed:     5.7%
  • NY Fed:            2.3%
  • St Louis Fed:    -0.3%

To me, that is a perfect picture of the current situation, proof that nobody has any idea what is going on in the economy.

Good luck

Adf

On the Schneid

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While data at home is robust
In Europe and China the thrust
Is weakness abounds
Which seems to be grounds
For traders, their risk, to adjust

So, equities are on the schneid
While bond yields have been amplified
The dollar’s on fire
Continuing higher
And oil’s climb won’t be denied

Another day, another wave of bad economic news from elsewhere in the world.  However, the US continues to surprise with better than expected results.  Yesterday’s ISM Services data was far better than forecast with a headline print of 54.5, 2 points above both last month and expectations for this month, while the sub-indices all showed significant strength, including the Prices Paid index.  The latter is clearly a concern for Chairman Powell and his crew as it is an indication that inflationary tendencies have not yet been snuffed out.  Ultimately, the market response was to sell stocks and bonds while increasing the probability of a November Fed funds rate hike a few points.  Interestingly, the market pricing for a September hike has fallen to just a 7% probability despite the hotter than expected data.  My sense is that the big market adjustment is going to come as traders come to understand that higher for longer means no cuts until 2025 on the current basis, especially if we continue to see data like the ISM print yesterday.

But the US storyline is clearly not the same as the storyline elsewhere in the world.  Last night, for example, Chinese trade data was released and both imports (-7.3%) and exports (-8.8%) fell sharply again, with the Trade Surplus falling to $68.3B.  Granted, the declines were not as bad as last month, nor quite as bad as expectations, but there is no way to spin the data as indicating a positive economic impulse in China right now.  While Chinese equity markets fell sharply (Hang Seng and CSI 300 both -1.4%) we also saw further weakness in the renminbi.  

The PBOC is still desperately trying to prevent the renminbi from weakening too quickly, but they are having a hard time at this stage.  The difference between the CFETS fixing and the onshore spot market is now 1.8%, dangerously close to the 2.0% boundary.  At the same time, the offshore renminbi, CNH, is pushing back to its highs from last October, now trading above 7.3400, which is 1.97% above the fixing.  This is a losing battle for the PBOC unless they change their monetary policy, but given the Chinese economy’s weakness, tighter money seems an unlikely step.  7.50 is still on the cards here.

China, though, is not the only problem.  European data this morning was uniformly lousy with German IP (-0.8%) and Eurozone GDP (Q2 revised lower to 0.1% Q/Q, 0.5% Y/Y) highlighting the problems facing the old world.  Alas, price pressures have not yet abated there, and stagflation is the new watchword on the continent.  

When the US was faced with stagflation in the 1970’s, Paul Volcker opted to fight inflation first, sending the country into a double dip recession in 1980 and 1981-82, before things turned around.  But that was a different time…and Christine Lagarde is no Paul Volcker!  Is it even possible for an “independent” central bank to knowingly create a recession to slay inflation these days?  I suspect inflation would need to be far higher, stable in double digits, before politicians would accept that it is a bigger problem than a recession, at least electorally.  The upshot of this scenario is that the ECB, despite ongoing higher than targeted inflation, is very likely at the end of its hiking cycle.  This, combined with the overall weak economy there, is going to continue to undermine support for the euro.  While the movement will be gradual, I expect that the single currency will slide below 1.05 and possibly get to parity by the end of the year.

And I would be remiss if I didn’t touch quickly on Japan, where they released their Leading Indicators at a weaker than expected 107.6, continuing the two-year downtrend.  Slowing growth in Japan and still extraordinarily loose monetary policy is going to continue to weigh on the yen.  While it has bounced slightly this morning, 0.2%, it continues to weaken steadily closer to the psychological 150.00 level.  

So, with all that happy news, let’s tour the overnight session to see the results.  The rest of the APAC equity markets also were under pressure overnight with Japan, Australia and South Korea all in the red as well.  In Europe this morning, the picture is more mixed with some gainers and some losers but no large movements overall, mostly +/- 0.2%.  US futures, after a lousy session yesterday, are all pointing lower at this hour (7:30) as well.

In the bond market, Treasury yields are essentially unchanged on the day, holding onto their gains for the past week and just below the 4.30% level.  European sovereigns, though, are seeing a bit of support as the weak economic data has engendered hope that inflation will stop rising and the ECB will be okay to pause.  The latter remains to be seen.  I cannot get over the idea that the uninversion of the yield curve is going to come because long rates are going to rise, not because short rates are going to be cut, and I’m pretty sure nobody is ready for that outcome.

Oil (-0.5%) is consolidating its recent gains with WTI north of $87/bbl and showing no signs of backing off.  If OPEC+ keeps a lid on production, you have to believe that prices will continue to rise.  In the metals markets, both copper and aluminum are soft today, responding to the weak Chinese and German data, while gold, after a selloff this week, is bouncing slightly.

Finally, the dollar remains king of the hill, stronger against virtually all its counterparts in both the G10 and EMG blocs.  I’m old enough to remember when the prevailing narrative was the dollar was dead and would be replaced by the euro, or the yuan, or a BRICS currency and yet, it continues to be subject to more demand than virtually every other currency around.  The broad story is the US economy continues to lead the global economy and the prospects for Fed rate cuts are diminished relative to other nations.  Tight monetary and loose fiscal policy combinations have historically been very supportive of a currency and clearly that is the current US state.

Two quick stories in the EMG bloc are from Poland (-0.7%), where yesterday’s surprising 75bp rate cut has undermined the zloty amid concerns that inflation is going to remain unhindered there, and MXN (+0.75%) where traders are unwinding some positions after a sharp decline over the past week.  The peso has been one of the few currencies that has outperformed the dollar this year as Banxico has been ahead of the curve on inflation and tight monetary policy.  However, with an election upcoming it appears there may be a change in attitude there.  If that is the case, then look for the dollar to regain some lost ground.

On the data front, Initial (exp 234K) and Continuing (1719K) Claims are released along with Nonfarm Productivity (3.4%) and Unit Labor Costs (1.9%).  As traders and investors bide their time ahead of next week’s CPI and the following week’s FOMC meeting, it is not clear that today’s numbers will have much impact.  As such, I see no reason for the dollar to cede its recent gains, especially if equities remain under pressure.

Good luck

Adf

A Gaggle of Bankers

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At altitude 8000 feet
A gaggle of bankers will meet
All eyes are on Jay
And what he might say
Regarding the Fed’s balance sheet

Now, pundits galore have opined
But something we need bear in mind
Is policy tweaks
Are still several weeks
Away, and will like be refined

Well, at 10:00 this morning, Chairman Powell will speak to the world regarding his latest views on “Structural Shifts in the Global Economy.”  At least that is the theme of the entire event where there will be numerous speeches by central bankers including Madame Lagarde later today, as well as papers presented by economists.  The reason this event is so widely discussed is in the past, Fed Chairs have used the forum to signal a shift in policy.  

Is that likely today?  This poet’s view is no, it is unlikely.  The message from the July meeting was that the Fed was still concerned about inflation running too hot and that the higher for longer mantra still applied.  Since then, the data has, arguably, been somewhat better than expected, although certainly not universally so.  At the same time, 10-yr yields are some 40bps higher and the S&P 500 is lower by about 4% since the last FOMC meeting, market moves that indicate investors are listening.  I do not believe Chairman Powell is keen to rock the boat.  As well, I don’t believe he feels the need to imply any major changes are necessary and I have a feeling that he is actually going to speak about the global economy, and not the US one specifically.

Summing up, I have a feeling this is going to be a complete non-event, with no useful information forthcoming, at least from Powell.  As it happens, Madame Lagarde speaks at 3:00 this afternoon NY time, and there is considerably more uncertainty as to the ECB’s path forward given the fact that the economic data in the Eurozone continues to be weak (today, German GDP in Q2 was confirmed as 0.0% Q/Q, -0.2% Y/Y, with Private Consumption also at 0.0% and the Ifo sentiment fell to 85.7, several points below expectations) while inflation remains far above their target.  While the ECB hawks are still claiming it is far too early to consider a pause in rate hikes, the ECB doves have been clear they are ready to stop.  Remember, too, Lagarde is a dove at heart.  It would not be difficult to believe that Lagarde discusses the slowing growth in China and the assumed knock-on effects for Europe as a rationale for expecting inflation to continue to fall without further ECB actions.

But as always, this is merely speculation ahead of the speeches, which is why we all listen.  Away from this meeting, though, investors are demonstrating some concerns about the overall situation, at least as evidenced by recent market activity.

Yesterday, in what was clearly something of a surprise to most pundits, equities sold off sharply in the US, led by the NASDAQ which was down -1.9%.  The surprise comes from the fact that the Nvidia earnings the night before were so strong and the stock rallied sharply on the news.  And this weakness was spread across all the major US indices.  Adding to the confusion was the fact that the US data yesterday generally pointed to more economic growth, with lower Claims data, and a strong Durable Goods -ex transport print with survey data looking up as well.  I guess this is a ‘good news is bad’ situation as continued economic strength informs the idea the Fed is not going to change their stance on higher for longer.

That weakness fed into Asia, where markets were lower across the board led by the Nikkei (-2.05%).  But in Asia, the interesting thing was that China announced, during the session, additional support for the property market by altering some mortgage and tax rules to encourage more home buying as Beijing tries to grapple with the increasing speed of the property implosion.  Alas for President Xi, the positive impact in the stock market lasted…10 minutes only!  After that, selling resumed and all the major indices in Asia finished lower on the day.  Now, European bourses have reversed that trend and are higher by roughly 0.6% across the board, perhaps anticipating a Lagarde ease, while US futures at this hour (7:30) are edging higher by 0.2% or so.

In the bond market, yields, which had fallen sharply earlier in the week, bottomed on Wednesday and are now higher in the US and throughout Europe.  While the move largely occurred in the US yesterday, with a 5bp bounce, and this morning we are little changed, Europe is seeing yields climb by 5bp-6bp across the board today.  The one place where yields remain dull is Japan, which has seen the 10yr JGB hover either side of 0.65% for the past week or two.

In the commodity space, oil (+1.5%) is rebounding again, arguably on the better than expected US data.  This is consistent with firmer prices in base metals, which are rising despite the rise in yields.  Ultimately, what this tells me is that there remains a great deal of uncertainty as to the near future regarding the economy.  The battle over whether a recession is coming soon or never coming continues apace.  The thing about commodities is that the supply piece of the puzzle continues to be undermined (pun intended) by ESG focused investors and governmental actions, and so the ultimate direction remains higher in my mind. 

Finally, the dollar is mixed to slightly stronger this morning, with most of the G10 a touch weaker vs. the greenback except for NOK (+0.4%) which is clearly benefitting from oil’s rally.  In the EMG sector, ZAR (+0.9%) is the outlier on the high side as allegedly traders are betting on increased investment flows to the country in the wake of the expansion of the BRICS nations.  (As an aside, can somebody please tell me why adding Argentina, a nation with a history of hyperinflation and serial debt defaulter, would inspire confidence in a BRICS currency?). But other than the rand, movement in this space has also been limited, arguably with everyone waiting for Powell.

On the data front, just ahead of Powell’s speech, we get the Michigan Sentiment Survey (exp 71.2), but that will clearly be overshadowed by Powell.  While I anticipate very little activity in the market ahead of 10:00, I also anticipate very little after the speech as I don’t believe he is going to change any perceptions at this point.  There is still a lot of data before the next meeting, another NFP, CPI and PCE reading, so it is too early to look for a change.  

Good luck and good weekend

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Lacking In Gains

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The PMI data remains
A place clearly lacking in gains
At least cross the pond
And Asia beyond
But will the US feel those pains?

The hard data hasn’t supported
That weakness, but is it distorted?
The latest we hear
Is NFP’s near
Revisions that show growth’s been thwarted

As market participants look ahead to Friday’s Powell speech at Jackson Hole, and seemingly more importantly to Nvidia’s earnings report and forecasts this afternoon, we must look at a few things that are going on in the economy.  The most noteworthy situation is that there remains, at least in the US, a wide gap between the survey data and the actual data.  We continue to see weak readings from the regional Fed manufacturing surveys, as well as PMI and ISM data, yet the key numbers, like NFP and Retail Sales continue to perform at a better than expected rate consistently.  While we await this morning’s Flash PMI data (exp Mfg 49.0, Services 52.2, Composite 51.5), which are essentially unchanged from last month’s readings and perhaps the best in the G10, there is a story this morning that the NFP data is going to be revised down by 650K jobs at the preliminary revisions today.  That is a huge adjustment and one that would certainly call into question the ongoing strength in the labor market.

It is not yet clear if it will impact the Unemployment Rate but if this story is accurate, it will almost certainly impact some of the thinking at the Eccles Building.  Consider that, after revisions, the seven NFP numbers have totaled 1807K so far this year, with the last two months showing 185K and 187K respectively.  If that 650K number is correct, and it comes from the past two months, then they will be revised into negative territory, a very different indication than anyone has considered to date.  However, even if it is more evenly spread across the year, it still represents more than one-third of the alleged jobs created.  This feels important to me.  While I have no way of determining if this story is accurate, it is important to understand it is making its way through the markets.  If this is the case, I would expect that the market’s view on the economy, as well as the Fed’s is likely to change somewhat.  

Arguably, the market response would be to alter pricing for interest rates going forward with more rate cuts priced in and priced in sooner than the middle of next year.  At the same time, though, former St Louis Fed President Bullard was interviewed by the WSJ yesterday and was crowing about how the market got the recession call wrong and the economy is doing much better than expected.  These diametrically opposed views are the norm in the markets these days, with no clear consensus that things are going to improve or worsen.  Again, it is this situation that informs why hedges for natural exposures are so important.

Turning to the other PMI’s released this morning, the story in Europe remains one of desultory growth or outright shrinkage.  The German manufacturing sector PMI printed at 39.1, better than last month’s 38.8, but still deep in recessionary territory.  While the French and Eurozone numbers were a bit better, they were both well in recession territory.  In fact, given the weakness of this data, and the fact that the ‘hard’ data in Europe has also been soft, the new narrative is the ECB is finished.  What had been a 50:50 probability for a hike in September has fallen to a one-third chance and if we continue to see weaker data, I expect that will fall further.  As to the UK, it also saw weak PMI data, with both Services and Manufacturing below the key 50 level, and the market has pulled back to just two 25bp rate hikes over the next 6 months despite the fact that inflation in the UK remains the highest in the developed world at 6.9% core, while the base rate sits at 5.25%.

It is not hard to look at this data and understand why the dollar continues to perform well.  Despite all the problems in the US, especially regarding the debt and massive interest payments, as well as the recent credit downgrade by Fitch, the US remains the most attractive opportunity around in the G10.  In fact, this is why that story about the massive downward revision in NFP data is so important.  Without it, the distinction is very clear, buy the USD, but if it is true, opinions are likely to change somewhat.

Turning to the overnight session, while most markets managed to do reasonably well in Asia, the mainland equity markets continue to suffer with the CSI 300 down -1.6%.  In Europe, the picture is mixed with some early gains being ceded and only the UK (+0.7%) managing to stay positive while the continent slips slightly into the red.  US futures, meanwhile, are barely in the green as all eyes await the Nvidia earnings after the close.

In the bond market, it is a one-way street with yields falling across the board and in a meaningful way.  Treasuries are actually the laggard with yields only down by 5bps while European sovereigns have seen yield declines of 9bps and UK gilts of 11bps.  Clearly, the bond market is responding to the weak PMI data and anticipating weakness in the US as well.  One other interesting thing is that the yield curve inversion, which had been unwinding for the past week or two, widened again yesterday and is back above the -75bp level, having traded as low as -65bps just a few days ago.

Recession is the view in the commodity space as well, at least in energy, as oil prices (-1.5%) fall again and are now back below the $80/bbl level.  Stories of more Iranian crude making its way to the market as well as fears over reduced demand are having an impact.  Interestingly, the metals markets are holding up this morning with both base and precious varieties all in the green led by copper (+1.0%).  This is a harder outcome to square with the recession fears.

Finally, the dollar is doing quite well this morning, which given the growing risk-off attitude makes some sense.  Vs. the G10, only the yen (+0.25%) has managed any gains, and they are small.  Meanwhile, the rest of the bloc is weaker across the board led by the pound (-0.9%) and NOK (-0.9%) for obvious reasons.  In the EMG bloc, ZAR (+0.5%) is the lone gainer of note after South African data implied better times ahead.  On the flipside, though, weakness is broad based with APAC, EEMEA and LATAM currencies all under pressure amidst the risk sentiment today.

Yesterday’s Existing Home Sales data was a bit softer than expected and as well as the PMI data due, we also see New Home Sales (exp 703K) and that NFP revision.  Clearly, all eyes will be on that last piece of data given the rumors of a large decrease.  So, we will need to see how that comes.  If it is benign, then I expect risk appetite may return as the bulls look for a big Nvidia story this afternoon.  However, if that huge revision appears, I suspect risk will remain in abeyance for now.

Net, nothing has changed the medium-term view of dollar strength, but the day to day remains open to the news.

Good luck

Adf

Problems Galore

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The story continues to be
The China of President Xi
Has problems galore
With more still in store
So, traders, as such, want to flee

The issue for markets elsewhere
Is knock-on effects aren’t rare
Protecting the yuan
Means it is foregone
Bond sales will send yields on a tear

For yet another day, China is offering the biggest market stories.  In no particular order we have seen the following overnight; China Evergrande filed for Chapter 15 bankruptcy, a process by which foreign entities can access the US bankruptcy court system, regarding $19 billion of their offshore debt; the PBOC set their CFETS fixing more than 1000 pips lower than market expectations, the largest gap since the process began in 2018, in their effort to arrest the yuan’s consistent decline; and Chinese police visited the homes of the protesters who were complaining about Zhongzhi’s missed payments (I wrote about these Monday in Risks Were Inbred).  And this doesn’t include the fact that Country Garden, the largest property developer in China is losing money quite rapidly and may also be on the brink of bankruptcy.  It seems the Chinese property bubble is deflating.

Ultimately, there appear to be two main impacts of the gathering storm in China, market participants are increasingly leery of taking on risk in general, and the PBOC’s efforts to stem the decline of the yuan means they must sell their holdings of Treasuries to generate the dollars to deliver into the FX market thus adding downward pressure to the bond market.  Of course, one of the typical outcomes of a risk-off attitude is that bond markets rally as investors exit equities and run to bonds.  This stands at odds to the recent bond market behavior, although it is quite evident this morning.  In fact, after touching yields above 4.30% in the 10yr Treasury yesterday, this morning we have seen a half-point rally with yields declining about 5bps in the US.  In Europe, the yield declines have been even greater, mostly around -10bps, so this is a real reprieve for bond markets everywhere.

The key question here is whether we have seen the worst, or if other potential selling catalysts will appear.  Consider for a moment the fact that between China and Japan, they represent >26% of foreign owned US Treasury debt, and that both of these nations are dealing with rapidly weakening currencies.  Not only that, but both have demonstrated they are quite willing to intervene in FX markets to arrest those declines, and as mentioned above, that typically requires selling Treasuries.  It’s a self-reinforcing cycle as higher yields beget currency sales which beget Treasury sales to intervene, which results in higher yields starting the cycle all over.  

With this in mind, we need to consider, what can break the cycle?  Well, if the Fed were to turn dovish and indicate they agreed with the futures markets that rate cuts are coming early next year, I suspect the dollar would fall against most currencies, especially these two, and the cycle would break.  Alternatively, China could step up and guarantee the debt of Countrywide and Evergrande thus removing the investor risk and reduce pressure dramatically.  Finally, I suppose the Fed could make a deal with the BOJ and PBOC and directly absorb their bond sales, so they never hit the market while restarting QE.  That, too, would likely end the cycle.  It is possible there are other ways to break the cycle, but I doubt we will see any of these occurring anytime soon and so the cycle will have to wear out naturally.  That will occur when either or both of the currencies decline far enough so the market believes the trade has ended and unwinds their short positions.  In other words, none of this has changed my view that 7.50 is on the cards for USDCNY as the year progresses, very possibly with 10yr yields getting to 4.5% or more.  And don’t be surprised if we see another move to 150.00 in USDJPY.

But, away from the China connection, things are very much in the summer doldrums.  Equity markets have been treading fearfully and continue to do so this morning.  However, while we have seen several days of declines, there has been no panic selling of note.  So, yesterday’s US weakness was followed by selling throughout Asia and this morning in Europe with most markets down about -1.0%.  US futures, too, are softer, down about -0.5% at this hour (8:00).

Oil prices (-0.85%) which stabilized yesterday, are back under a bit of pressure on the overall negative risk sentiment as they continue to trade either side of $80/bbl.  Metals prices, meanwhile, are mixed with precious metals finding a bit of support while base metals suffer today.  The most interesting story here I saw today was that CODELCO, the world’s largest copper miner in Chile, may be going bankrupt as previous projects didn’t pan out.  That strikes me as a very large potential problem, but one for the future.  

Finally, the dollar is mixed this morning.  It had been softer overall in the overnight session, but as risk is getting marked down, the dollar is gaining strength.  The biggest mover has been PHP (+1.1%) which rallied after the central bank indicated they were going to put a floor under the currency and adjust rates accordingly.  After that, the EMG bloc has not done very much, +/- 0.25% type activity.  However, just recently, G10 currencies started to slide with NOK (-0.8%) the laggard as oil slides, but the entire bloc now coming under pressure.  This is all about risk off.  

There is no US data today nor are there any Fed speakers.  As such, the dollar will take its cues from the equity markets, and the bond market to some extent.  Right now, equity weakness is driving the risk attitude and that means the dollar is likely to remain bid into the weekend.  Next week brings the Fed’s Jackson Hole meeting where everybody will be looking for any policy hints by Chairman Powell on Friday morning.  But for now, the dollar is on top of the mountain.

Good luck and good weekend

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Risk Were Inbred

Posted on by 
In China, the problems have spread
From property company dread
To shadow finance
Where folks took a chance
To earn more though risks were inbred

And elsewhere, the Argentine voters
Surprised governmental promoters
By choosing a man
Whose primary plan
Is ousting Peronist freeloaders

While the goal of this commentary is to remain apolitical, there are times when the politics impacts the markets and expectations for future movement so it must be addressed, though not promoted on either side.  Today, amid general summer doldrums, it seems there are more political stories around that are either having or have the potential to impact financial markets.

But first, a quick look in China where the latest problem to bubble to the surface comes from Zhongzhi Enterprise Group Company, one of the many shadow banking companies in the country.  These firms are conduits for investment by wealthier individuals and corporations who offer structured products and investments promising higher returns than the banking sector.  And they are quite large, with an estimated $2.9 trillion invested in the sector.  Well, Zhongzhi has roughly $138 billion under management and last week they apparently missed some coupon payments on several of these high-yielding investments.  While this is the first that we have heard of problems in the sector, given the terrible performance of the Chinese equity market as well as the ongoing collapse of the Chinese property market, my guess is this won’t be the last firm with a problem.  As has often been said, there is never just one cockroach when you turn on the lights.

As proof positive that there is really no difference between the Chinese and US governments, the first response by the Chinese was to set up a task force to investigate the risks at Zhongzhi and its brethren shadow banks.  That sounds an awful lot like what would happen here, no?  Anyway, depending on who is invested in Zhongzhi and whether they are politically important enough to bail out, I suspect that there will be government intervention of some sort.  Do not be surprised to hear about Chinese banks making extraordinary loans to the sector or guarantees of some kind put in place.  The last thing President Xi can afford at this time is a meltdown in a different sector of the financial space.

It can be no surprise that Chinese equity markets were under pressure again last night, with both the Hang Seng and CSI 300 falling sharply, nor that the renminbi has fallen to its weakest levels since the dollar’s overall peak last October.  I maintain that 7.50 is in the cards here and that it is simply a matter of time before we get there.  In the end, a weaker CNY is the least painful way for China to support its economy, especially since it is a big help to its export industries which remain the most important segment of the economy.  Later this week we will see the monthly Chinese data on investment and activity so it will be interesting to see how things are ostensibly progressing there.  However, this data must always be consumed with an appropriate measure of salt (or something stronger) as there is no independent way to determine its veracity.

Meanwhile, on the other side of the world, a presidential primary in Argentina resulted in a huge surprise with Javier Milei, a complete outsider and ostensible free market advocate, winning the most votes, more than 30%.  The election comes in October and the ruling Peronist party is at risk of being eliminated in the first round.  What struck a chord in the country was his plan to dollarize the economy and close the central bank as well as to shut down numerous government agencies.  Inflation there remains above 115% so it can be no surprise that someone who promised to change the process garnered a lot of support.

I raise this issue because in Germany, the AfD (Alternative für Deutschland) party is currently polling at >21%, the second largest party in the country, and that has a lot of people very concerned.  Like Senor Milei, the AfD’s platform is based on destruction of much of the current government setup.  Because this party is on the right, and given Germany’s dark history with the far right, the latest idea mooted has been to ban the party completely.  Now, certainly the idea of a resurrection of the Nazi party is abhorrent to everyone except some true extremists, but simply banning the party seems a ridiculous idea.  After all, the members will either create a new party with the same support or take over a smaller existing party and drive the platform in the desired direction.  

Support for Marine LePen in France continues to grow, as does support for right of center parties throughout Europe, especially Eastern Europe.  And of course, here in the US, the upcoming election has fostered even more polarization along partisan lines with the Republican party seeming to gain a lot of support of late.  All this implies that there is a chance of some real changes in the financial world that will accompany these political changes.  At this point, it is too early to determine how things will play out, but as we are currently in the Fourth Turning, as defined by historian Neil Howe, the part of civilization’s cycle when there is great unrest, I expect there will be a lot more change coming.  Food for thought.  And it is for this reason that hedging exposures is so critical.

Ok, last week’s inflation readings were mixed, with CPI a bit softer than forecast while PPI was a bit firmer.  But the one consistency was that Treasury yields rose regardless of the situation.  After a further 5bp rise on Friday, 10yr yields are unchanged at 4.15% this morning, an indication that inflation concerns remain front of mind for most investors.  I expect that the peak yields seen back in October will be tested again soon.  As to European sovereigns, while yields there are down a tick this morning, the trend there remains higher as well.

Equity markets, too, have had some trouble of late, sliding a few percent over the past several weeks.  While the move lower has been modest so far, there is clearly concern over a technical break lower should the indices break below their 50-day moving averages.  With yields heading higher, I fear that is the path of least resistance for now.

Oil prices are a touch softer this morning but remain well above $80/bbl and appear to be consolidating before their next leg higher.  Supply is still a consideration and given economic activity continues to outperform, I suspect higher is still the path going forward.  Metals prices are little changed this morning despite some incipient dollar strength, so keep that in mind as well.

Finally, the dollar is much stronger against its Asian counterparts and modestly stronger against most others this morning.  Continuing rises in US yields offer support for the greenback and increased turmoil elsewhere, along with the US economy seemingly outperforming all others have been the hallmarks of the dollar’s strength.  I don’t see that changing soon.

Data this week brings the following:

TuesdayRetail Sales0.4%
 -ex autos0.4%
 Empire Manufacturing-0.7
 Business Inventories0.1%
WednesdayHousing Starts1445K
 Building Permits1468K
 IP0.3%
 Capacity Utilization79.1%
 FOMC Minutes 
ThursdayInitial Claims240K
 Continuing Claims1700K
 Philly Fed-10.5

Source: Bloomberg

While Retail Sales will be watched for their economic portents, I think the Minutes will be the most interesting part of the week, especially as we have now had at least two FOMC voters, Harker and Williams, talk about cutting rates next year.  

For today, while US equity futures have edged higher so far, I feel like the dollar has legs for now.  This will be confirmed if yields continue to rise.

Good luck

Adf

Xi Jinping’s Dreams

Posted on by 
The 30-year bond was a flop
Which helped cause an interest rate pop
Though CPI rose
A bit less than pros
Expected, risk prices did drop

Then early this morning we learned
That lending in China’s been spurned
It certainly seems
That Xi Jinping’s dreams
Of rebounds might soon be o’erturned

For all the bulls out there, yesterday must be just a bit disconcerting.  First, the highly anticipated July CPI data was released at a slightly lower than expected 3.2% headline number with core falling 0.1% to 4.7%, as expected.  As always when it comes to CPI data, there were two immediate takes on the result.  On one side, inflationistas pointed out that the future will be filled with higher numbers going forward as base effects for the rest of 2024 kick in with very low comparables in 2022.  They also point to the medical care issue, a detail I have not discussed, but which has to do with a change made by the BLS that has been indicating medical care prices have fallen all year, but which will fall out of the mix starting in September, thus reversing one of the drags we have seen on CPI.  And finally, the rebound in energy prices is continuing (oil +0.4% today) and will be a much bigger part of future readings.  This story was underpinned today by the IEA reporting a new record demand for oil in July of 103 million bbl/day.  Demand continues to support prices here.

Meanwhile, the deflationistas point to the recent trend in prices, which shows that on a 3-month basis, or a 6-month basis, if annualized, CPI is really only running at 2.4% or 2.9% or something like that.  The implication is because we have seen a reduction in the monthly number lately, that will continue.  As well, they make the case that China’s deflation is a precursor to lower US inflation with, I believe, a roughly 6-month lag.  Perhaps the most interesting take I saw was that the Fed has now achieved their goal of an average PCE of 2% if you take the last 14 years of data.  The idea is that Average Inflation Targeting was designed to have the economy run hot for a while to make up for the ‘too low’ inflation that has been published since the GFC.  And now, that average is 2.07% for the past 14 years.  (To me, the last idea is a chart crime, but I digress.)

The problem, though, for the bulls, is that the market’s behavior was not very bullish.  Although the initial move in Treasury yields was lower, with the 10-year yield falling 6bps right after the release, the 30-year Treasury auction that came later in the day was not nearly as well-received as the shorter dated paper seen earlier in the week.  The bid/cover ratio was only 2.42 and it seems that the market may be feeling a little indigestion from all the new paper just issued, as well as the prospects for the additional nearly $1.5 trillion left to come in 2023.  It is not hard to believe that longer end yields could rise further as the year progresses.  The upshot was 10-year yields rose 10bps on the day and are unchanged from there this morning.

Similarly, in the equity markets, the initial surge on the back of the slightly softer CPI was unwound throughout the day and though all three major indices ended the day in the green, the gains were on the order of 0.1% or less, so effectively unchanged.  Looking at futures there today, all three indices are unchanged from the close as investors and traders look for their next inspiration.  Meanwhile, I cannot ignore that overnight, Asian equity markets all fell, with the CSI 300, China’s main index, down -2.30%.  As well, European bourses are all lower this morning, mostly on the order of -1.0%.  Overall, this is not a positive risk day.

One of the things adding to the gloom is the financing data from China released early this morning.  New CNY Loans fell to CNY 345.9 billion, less than half the expected amount and down from >CNY 3 trillion in June.  M2 Money Supply there also grew more slowly than expected at just 10.7% as it seems that China’s debt woes are increasing.  China Evergrande was the first Chinese property company that gained notoriety for its problems, but Country Garden was actually the largest property company in China and now that looks to be heading toward bankruptcy.  

A quick tour of China shows it has a number of very big problems with which to contend.  Probably the biggest problem is demographics as the population begins to shrink.  However, two other critical issues are the massive amount of debt that is outstanding there (not dissimilar to the US situation) but much of it is more opaque sitting on the balance sheet of local government funding vehicles.  Just like in the West, this debt will not be repaid in full.  The question is, who is going to take the losses?  In China, the central government is trying to foist those losses on the local governments, but that will be a long-term power struggle despite President Xi’s ostensible powers.  Finally, the massive youth unemployment situation is simply dry tinder added to a very flammable mixture already.  This is not a forecast that China is going to implode, just that the claims that it is set to ascend to global superpower status may be a bit premature.

(By the way, for all of you who think a BRICS gold backed currency is on the way, ask yourself this question.  Why would India and Brazil want to link up with a nation with awful demographics and a gargantuan debt problem and link their currency to that?)

Finishing up, we have a bit more data this morning led by PPI (exp 0.7% Y/Y, 2.3% Y/Y ex food & energy) and then Michigan Sentiment (71.3) at 10:00.  With CPI already released, PPI would need to be dramatically different from expectations to have much of an impact at all.  There are no Fed speakers today, but yesterday we heard that there is still more to do by the Fed from both Daly and Bostic, and Harker did not repeat his idea that cuts were coming soon.

The dollar is mixed today, with Asian currencies under pressure, EEMEA and LATAM currencies performing well and the G10 all seeming in pretty good shape, although NOK (-0.7%) is under pressure after a much softer than expected CPI number yesterday has traders unwinding some future interest rate hikes.

Speaking of future interest rate hikes, the Fed funds futures market is down to a 10% chance of a September rate hike by the Fed, although there is still a ton of data yet to come, so that is likely to change a lot going forward.  My sense is that a little bit of fear is building in risk assets as despite some ostensible good news, with lower inflation and less chance of a Fed rate hike, risk is under pressure.  One truism is if a market cannot rally on good news, then it is likely to fall, especially if something negative shows up.  In that case, I suspect that we could see weakness in equities today, weakness in bonds and strength in the dollar before it is all over for the week.

Good luck and good weekend

Adf

Failed to Inspire

Posted on by 
Consider poor President Xi
Whose efforts in his ‘conomy
Have failed to inspire
The quickening fire
Of growth for his people to see

It seems that the latest reports
Show signs of collapsing exports
Implying that growth
In China is sloth
And helping inspire yuan shorts

Chinese exports fell 14.5% Y/Y in July.  Imports also underperformed, falling -12.4%.  Perhaps of greater concern to President Xi is that they fell 23.1% to the US and 20.3% to the EU.  Now, they did rise aggressively to one place, Russia, where the increase was 52% Y/Y.  Alas for the Chinese, their business with Russia was always a fraction of that with the West, so, net, things are not looking too good on the mainland.  Ultimately, the problem for Xi is that despite years of effort to change the nature of the Chinese economy from a mercantilist model focused on export growth to a domestic consumption led model, they have not yet achieved that adjustment.  This has resulted in some very difficult decisions for President Xi which have yet to be made.

Consider that the Chinese growth miracle was built on three pillars, cheap labor, massive infrastructure spending and residential property investment.  For 18 years following the entry of China into the WTO this model was killer with average GDP growth over 10%.  It was remarkable in its ability to lift hundreds of millions of people out of poverty, a true humanitarian good.  But transition is always difficult, and China has now grown to the point where the old model is no longer effective and a new one needs to be implemented for the country’s future.

The first problem is the price of labor has risen in China to the point where it is no longer the cheapest place to manufacture goods as both India and Vietnam offer better value on this score.  Add to that the current tensions between China and the West and the efforts of western nations to reshore or friendshore manufacturing, and it seems unlikely that China is going to see a big boost in manufacturing for export anytime soon.

The second and third legs are intertwined in the following manner.  Historically, infrastructure spending has actually been financed by local governments, not by the national government except in some specific situations.  Those local governments would borrow money in the local bond markets and would use land sales as a means of repaying that debt over time.  So, as long as the property market was rising, these entities had access to additional investment funds.  When Beijing wanted to increase economic activity, they would simply instruct the local governments to pick up the pace of activity.

But now that the Chinese property market has been sinking for the past two years, which came to light with the problems at China Evergrande, but continue to this day, the Chinese people are not keen to continue to buy property as an investment vehicle, and in fact, many are looking to sell.  This has dramatically reduced the funds available for investment by local government entities and is weighing on economic activity.  This has hit both infrastructure and property investment and can be seen in the declining numbers for both Fixed Asset and Property investment that are released each month.

Thus, President Xi has very few levers to rekindle growth, especially if the west is heading into a recession.  Adding to his woes is the unemployment rate of the 16-24 set, which is currently > 21%.  In the end, China has only a limited ability to generate activity domestically at this point, and if things are slow elsewhere, they will remain slow there.

There are likely to be several direct impacts of this situation.  First, slowing growth in China is going to weigh on commodity prices as China has, for the past 20 years, been the largest consumer of commodities around.  As well, this will clearly be a deflationary impulse and weigh on price pressures, at least for certain parts of the economy going forward.  While I expect manufactured products will not rise much in price, it will probably not have much of an impact on services prices in the west, so don’t look for a collapse in inflation just yet.  And finally, a very common tactic for governments facing domestic difficulties is to try to distract their population with foreign issues.  I fear this elevates the chance for bigger problems in Asia, either with Taiwan or perhaps the South China Sea.  Xi needs to demonstrate he is still in charge so be wary.

As to the market response to this data, it was pretty negative all around.  Yesterday’s US equity rally had no real follow through with just the Nikkei managing a small gain overnight.  Not surprisingly, Chinese markets were lower along with the Hang Seng (-1.8%).  European bourses are all in the red this morning led by Italy’s FTSE MIB (-2.5%) after the Italian government imposed a 40% windfall profit tax on Italian banks.  Banks are in the firing line in Germany as well as the interest paid on reserves by the Bundesbank has been cut to 0.0%.  Do not be surprised to see this type of behavior in the US going forward, especially as the budget deficit swells.  US futures are also under pressure, down around -0.75% across the board at this hour (8:00).

In classic risk-off fashion, bond yields are falling aggressively this morning as the weak Chinese data has the recession talk back on top again.  10-year Treasury yields are lower by 10bps and now trading at 3.99%.  yield declines throughout Europe are much larger, on the order of 15bps and even JGB yields fell 3bps overnight. Suddenly there is real fear in the markets.

In keeping with the risk-off theme, commodity prices are under pressure with oil (-2.5%) leading the way and just now edging below $80/bbl.  Metals markets are also soft with copper (-2.7%) really feeling the heat although gold and aluminum are both under pressure as well.

Finally, the dollar is king of the hill this morning, rallying against all its G10 and EMG counterparts.  NOK (-1.5%) is the G10 laggard on the back of oil, but all the commodity currencies are lower by at least 1% and even the yen is softer by -0.4%.  As to the EMG bloc, again all the currencies are under pressure with the commodity bloc softest here as well.  This is a unified risk-off so buy dollars story today.

On the data front, NFIB Small Business Optimism was released at 91.9, slightly better than expected and now we await the Trade Balance (exp -$65.0B) at 8:30.  We have two speakers this morning, Philadelphia’s Harker and Richmond’s Barkin so continue to look for subtle changes in message.  Yesterday we heard from Bowman and Bostic, both indicating that more hikes might be needed to quell inflation.  I don’t believe we have seen a change there yet.

While the dollar has rallied a lot today, if equities start to retreat more aggressively, do not be surprised if this move continues.  It seems pretty clear that there is a growing concern over risk assets and, at the very least, a correction there.  That should help the dollar for now.

Good luck

Adf

Demimonde

Posted on by 
There once was a government bond
About which investors were fond
Regardless of yield
Their safety appealed
But lately, they’ve turned demimonde

So, as we await Payroll data
Demand has just started to crate-a
As yield keeps on rising
More folks are downsizing
Positions today and not late-a

It’s Payrolls Day and market participants are all anxiously awaiting the news at 8:30. Recall, last month, for the first time in more than a year, the NFP number printed slightly lower than the median forecast and that was seen as proof positive that the soft landing was on its way.  Subsequently, headline CPI fell to its lowest in two years as a confirmation of that process, and market participants decided, as one, that risk was the thing to own.  Equities rallied, bond yields fell and there was joy around the world markets. 

But lately, that story is having a rougher go of things as 10-year Treasury yields have jumped 43bps from their levels following the CPI release even though the PCE data was similarly soft.  What gives?  Arguably, part of this is because energy prices have rebounded sharply since last month, so it is increasingly clear that next week’s CPI data is going to higher than last month’s number.  As well, the growing confidence in the soft-landing scenario, which is touted across mainstream media constantly, implies that rate cuts may not be necessary.  After all, if Fed funds are at 5.5% and GDP is growing at 2.5% and Unemployment remains below 4.0%, why would the Fed change its policy rate?  The answer is, they wouldn’t.  At the same time, in the event the economy is clearly growing with positive future prospects, it is very likely that the yield curve will steepen back to a ‘normal’ shape with longer dated yields higher than short-dated yields.  If the Fed is not going to cut, that means the back end of the curve must see yields rise.  The current 2yr-10yr inversion is down to -74bps, so another 100bp rise in 10-year yields would seem realistic.

Of course, the question is, how would risk assets behave in that scenario?  And the answer there is likely to be far less positive.  After all, if risk free returns for 10 years were at 5+%, equities would need to offer a very good return opportunity to attract investors.  While there will be some companies that offer that, I suspect there are many more that would be shunned and need to reprice substantially lower to become attractive.  In other words, investors will want much lower entry prices to get involved and that could see a pretty big sell-off in the equity markets.  Just one possible scenario, but one with a decent probability of occurring, I think.

But that is all future prognostication.  In the meantime, let’s look at what the current consensus forecasts are for today:

Nonfarm Payrolls200K
Private Payrolls180K
Manufacturing Payrolls5K
Unemployment Rate3.6%
Average Hourly Earnings0.3% (4.2% Y/Y)
Average Weekly Hours34.4
Participation Rate62.6%

Source: Bloomberg

Wednesday’s ADP number was much higher than expected at 324K although the prior blowout number, 497K in June, was revised lower by 42K.  Still, 455K was much larger than the BLS report so there are many questions as to whether we will see a similar outcome today, a softer NFP number despite a very strong ADP number.  Looking at other indicators, the Initial Claims data continues to improve, hovering around 225K.  The JOLTS data was slightly softer than expected, but still right around 9.6 million and well above levels prior to the pandemic.  And finally, if you look at the employment subsets of the ISM data, they were soft in manufacturing, but solid in services, and services is a much larger part of the economy.

My take is the market is going to behave very clearly based on the actual outcome.  A strong number, anything over 225K, is likely to see the bond market sell off further and I wouldn’t be surprised to see 10-year yields, which have edged up another basis point this morning to 4.19%, trade back above the levels seen last October at 4.25% or more.  That will not be a positive for the stock markets as it will reintroduce the idea the Fed is going to continue to raise rates, something the market has completely priced out at this point.  Similarly, a soft number will open the door to a sharp equity rally and bond rally, with yields likely to even test the 4.0% level if the NFP number is soft enough.  I think we need a 100K or less number for a reaction like that.

Ahead of the data, there seems to be a growing concern over the outcome.  While Asian markets rebounded a bit, European bourses have started to fall across the board from earlier levels and are now all down by between -0.2% and -0.5%.  US futures, too, are now back to unchanged having spent the bulk of the evening higher on the back of a strong earnings report from Amazon.  

Bond markets are under pressure as energy prices around the world are rising, as are food prices, and so inflation prospects seem to be worsening.  This is despite the very earnest efforts of central banks around the world to convince us all that inflation has peaked, and they are near the end of their hiking cycles.  After the BOE raised rates by 25bps yesterday, the market has reduced the expected UK terminal rate down to 5.75%, two more hikes despite CPI running at 7.9% with Core at 6.9%.  In the Eurozone, the ECB has released a new report claiming that inflation has peaked as well, and the market has priced out any further rate hikes.  This all smacks of whistling past the graveyard in my view.

For instance, oil (+0.35%) is higher again, up more than 14% in the past month, and shows no signs of slowing down.  Not only did Saudi Arabia extend their one million bbl/day production cut for another month, but Russia now claims it will cut production by 300K bbl/day in September as well.  I haven’t discussed food prices in a while as they had eased off from the immediate post invasion highs, but the FAO Food price index rebounded last month and despite a sharp decline from its highest levels last year, is still at levels that have caused riots in the streets of African nations in the past.  Metals prices are also under pressure today, but that seems more to do with the strong dollar than anything else.  

Turning to the dollar, it is once again seeing demand as only NOK (+0.2%) has managed to gain on the greenback in the G10 space, although the other currencies’ losses are not large.  The same cannot be said for the EMG space where the APAC bloc is under real pressure led by KRW (-0.8%) and THB (-0.4%) on the dual concern of a slower growing China and broad risk-off sentiment.  One thing that seems likely is the dollar will benefit from a strong NFP print and suffer from a weak one.

And that’s really it for the day.  No Fed speakers are on the docket, but do not be surprised to hear some interviews if the number is very different from the forecasts.  In the end, nothing has changed my view that inflation will remain stickier than forecast and the Fed will hold tight thus supporting the dollar.  Remember, the combination of tight monetary and loose fiscal policy is the recipe for a strong currency.  And the US is running that in spades!

Good luck and good weekend

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Like Goldilocks?

Posted on by 
For assets so safe and secure
It seems bonds have lost their allure
Yields worldwide are rising
And it’s not surprising
Since ‘flation, we all must endure

The question is, what about stocks?
Are they set to soon hit the rocks?
Or will they remain
Resistant to pain
If growth behaves like goldilocks?

Certainly, yesterday was a pretty bad day for risk assets as equity markets in the US sold off aggressively along with commodities.  The thing is it was a pretty bad day for haven assets as well with Treasury yields rising sharply.  And right now, just before 7:00am in NY, those trends remain intact.  In fact, the only thing that seemed to perform well yesterday was the dollar.

So, what gives?  Many will point to the downgrading of the US credit rating by Fitch as the proximate cause of things, and it may well have been an excuse for some selling, but despite the logic I detailed yesterday, the impact on markets should be di minimis.  After all, Treasuries are used for two things largely, either as investments in their own right, or as collateral for other financial transactions.  Regarding the first point, nobody is actually concerned that the US will not repay their debt, so if the yield is attractive, investors will still buy them.  As to the second point, this could have been an issue but since the S&P downgrade in 2011, collateral agreements have been rewritten to accept not only AAA securities, but also US government securities, with no mention of their rating.  So, there is no change in the collateral situation.

If it was not the downgrade, then what has driven the recent upheaval in markets?  Arguably, this has been building for quite some time and was looking for a catalyst to get things started.  I think there are two ways to consider the situation.  For the bears out there, watching equities rally daily despite what appeared to be softening margins along with tightening monetary conditions didn’t make sense.  But the rally has been so relentless that the bears have largely capitulated on their views.  It seems the key lesson is that the timing of monetary policy transmission is much slower than it had been in the past, or at least that’s what it feels like, and so despite the Fed’s aggressiveness, it hasn’t had nearly the impact anticipated.  

To this point, remember, while the Federal government didn’t take advantage of ZIRP to term out its debt, homeowners and corporations did just that.  This has resulted in a lot of borrowers with a long runway before needing to refinance their debt and left them somewhat impervious to the Fed’s recent moves.  We have all heard that > 50% of mortgages outstanding are at rates < 4.0%.  This has resulted in an unwillingness to move and reduced existing home inventories and sales.  But all those people have not been impacted by the rate hikes, at least not on their largest single interest payment.  And the same has been true for many corporations who termed out their debt in 2020-2021 and even the first half of 2022.  While much of that debt will eventually be refinanced, it may be another 5-7 years before we start to see companies feel any stress there.  Consider, too, how this has helped lower rated companies, who, if forced to refinance today would see yields in the 8%-12% range but were able to borrow at 5% or less.  Of course, that debt was likely 5-year tenor, so that comeuppance is likely to arrive in 2025 or 2026.  And maybe that is when we should be looking for the first real problems.

The Fed’s Loan officer survey showed that conditions are continuing to tighten in the bank market, which means that smaller companies are going to be stressed, but the large cap companies that issue debt directly are sitting pretty.

Therefore, if it is not the downgrade, what other reasons could there be?  The first thing to remember is that there doesn’t have to be a specific reason for markets to sell off.  Markets that are overbought (or oversold) can reverse without any particular driver.  Historically, August has been a more volatile and weaker month for equities, often attributed to vacation schedules, with investors and traders both taking their summer trips and leaving skeleton staffs of junior people on the desk.  This will result in reduced liquidity and any outside selling impetus can have an overly large impact.  Remember, though, a rational look at equity markets indicates that on a historic basis they remain quite richly valued with the Shiller Cyclically adjusted P/E ratio at 31.1, well above its long-term median of 15.93.  However, what is typically true is that when an overvalued market starts to correct, it can continue doing so for quite some time until it reaches a more rational valuation.  If the bears have all given up, and the bulls are all on vacation, who is left to buy things?

All this is to say that, while the recent equity market weakness may not make sense specifically, there is nothing to say that it cannot continue for a while yet.  Turning to bonds, though, that is a different story.  Yields around the world are rising and, in many cases, rising sharply.  While the BOE just raised rates 25bps this morning, as largely expected, they are simply catching up to the rest of the G10.  However, 10-year Treasury yields are +6.7bps as I type (7:20) and now trading at 4.14%, their highest level since last October.  My sense is that this move is all about two things, concerns that inflation has seen a local bottom and the dramatic increase in supply just announced by the Treasury.  As discussed yesterday, yields above 4% have led to things breaking, so the question is what is set to break now?  Perhaps, the stock market selling off will be this breakage, or perhaps there will be some other crisis that flares up.  Maybe another large bank going to the wall, or a large corporate bankruptcy in a key sector.

We have discussed rising oil prices and you are all aware of rising gasoline prices every time you go to fill the tank.  Headline CPI, when it is released next week, will be well above last month’s 3.0%.  Too, yesterday’s ADP Employment number was much stronger than expected for a second consecutive month.  If the no landing scenario is correct, then inflation is likely to remain far more stubborn than currently expected and Chairman Powell will not be thinking about thinking about cutting rates any time soon.  In fact, at this point, if the Fed starts to think about cutting rates, that likely means that the economy has reversed course and is clearly headed into a recession.  Be careful what you wish for.

Summing up, I would be wary of reverting to the buy the dip mentality that has prevailed for more than a decade.  The underlying economic and financial situation is changing pretty quickly and that implies previous strategies may not perform that well.  Do not forget last year’s market performance.

I would be remiss if I didn’t mention that the BOJ was back in the market again last night, buying an unlimited amount of JGBs as they try to smooth the rise in JGB yields, which are now up to 0.65%.  This did help the yen a bit, which has rallied slightly on the day, but overall, the dollar remains much stronger.  My take is that we are seeing investors who are uncertain about the medium and long term, buying dollars to buy T-bills, earn a nice piece of interest and reconsider their next move.  One thing to note is that the yield curve’s inversion is lessening quite quickly.  Last Monday, the inversion was -104bps.  This morning it is -75bps.  That is a remarkably fast move in a short time.  It also implies that the demand for 10-year Treasuries is a little soft right now.  As I have written, this inversion could resolve with higher long rates, not lower short rates, and that is not something for which the market is prepared.  I believe that would be a clear equity negative.

There is a lot of data this morning starting with Initial (exp 225K) and Continuing (1708K) Claims, Nonfarm Productivity (2.3%), Unit Labor Costs (2.5%), Factory Orders (2.3%) and then ISM Services (53.0) at 10:00.  But this is all a lead-up to tomorrow’s NFP data.  Fed speakers have been fewer than usual, but we do hear from Richmond’s Thomas Barkin this morning.  I see no reason to believe that there will be any new dovishness upcoming.

To my mind, yields are going to continue to rise, equities are going to remain under pressure and the dollar, overall, is going to remain stronger rather than weaker.  We will need to see big changes in the data to change that view.

Good luck

Adf