Tag Archives: #riskon

Not If But When

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Eight years ago, when Chairman Ben
Suggested t’was not if but when
The Fed would reduce
Its purchase, profuse,
Of bonds, traders sold bonds, bought yen

But these days when taper’s discussed
The bond market doesn’t seem fussed
The reason could be
There’s now nobody
The market invests with its trust

Yesterday’s CPI data printed a tick higher than forecast indicating that, yes, prices are rising relative to last year.  The headline print of 2.6% was the beneficiary of a substantial rise in energy prices compared to last year, but the core price index indicated that both goods and services prices are rising in price.  One data point is not enough to make any claims in either direction, but it will certainly keep the discussion going for a while.  The market response was somewhat counterintuitive as by the end of the day, 10-year Treasury yields had fallen 6 basis points and the dollar was softer amid modestly firmer equity prices.  While the link between the dollar and Treasuries remains intact, the question is why would bonds rally (yields decline) if inflation was rising?

One possible answer is that the market had gotten far ahead of itself with respect to pricing in rising inflation.  Historically, inflation takes time to manifest itself as prices on many things are sticky, meaning they remain stable for a time amid broad pressures and then shift in a relatively large step, rather than a gradual daily or weekly increase.  We are all familiar with the situation when an item regularly purchased suddenly rises in price to catch up to the broad underlying price pressures.  But when taken over the totality of all goods purchased, while any given good or service may see prices rise in discrete steps, the index moves up in a relatively smooth manner.  This fact is why yesterday’s data are interesting, because the headline jump of 0.6% M/M certainly tests the definition of smooth.  Consider that a monthly increase of 0.6% would result in annual inflation of 7.4%, a level that even the Fed would consider too hot.  FYI, yesterday’s core print, which was actually 0.34%, would represent 4.2% core CPI over a year.  So, yes, the base effects were instrumental in the much higher Y/Y data, but the monthly increases were pretty high in any accounting.

And yet, the bond market ultimately rallied all day, having touched 1.7% in early European trading and closing the session at 1.615%.  If this wasn’t a classic case of buy the rumor, sell the news, I don’t know what is.  And, as we have seen consistently all year, the dollar dutifully followed yields lower while equity markets ultimately rallied, although the euphoria over the value trade seems to be waning.

Perhaps of more interest is the fact that we have now had 3 key central bankers, two from the ECB, Knot and Villeroy, and the Fed’s Bullard all start to discuss the idea of tapering bond purchases.  This seems incongruous given the adamant claims on both sides of the pond that current monetary policy is necessary and appropriate to ensure the respective economies return to form.  And yet each of these discussed how tapering of QE could begin before the year is out.  You may recall that Bullard wanted to tie the idea of tapering to the level of vaccinations in the economy, indicating that when 75% of the population is vaccinated, it could be time to start slowing purchases with the implication being the economy would then be able to stand on its own two feet.

This morning, Banque de France Governor Villeroy de Galhau explained that there could be an evolution in monetary policy at the ECB, which while remaining accommodative would shift the burden back to the APP (the original QE plan) from PEPP, which will ostensibly run its course in March 2022.  Last week, Knot, the Dutch Central Bank president expressed his view that the current expectations of robust growth in the second half of the year could be a signal to begin tapering asset purchases.  Now, understand that there were members from both central bank committees pushing back on the idea, but the fact remains that there is some consideration of tapering.  Today, we hear from Chairman Powell again, but we will not hear from Madame Lagarde until her press conference after the ECB meeting next week.

Adding up the disparate facts is quite difficult.  On the one hand, we have the first trial balloons floated regarding tapering of asset purchases as a response to the forecasts for extremely robust growth this year.  On the other hand, the market appears to have indicated that, at least for now, the idea of much faster growth leading to much higher inflation has run its course.  It strikes me that the market is unlikely to worry too much about these trial balloons until they hear from Powell and/or Lagarde.  Until then, it appears that a short period of higher inflation readings is on the cards and unless they really start to spike, that is unlikely to have a big impact on either equities or bonds.

Speaking of equities, yesterday saw the S&P 500 close at yet another new all-time high with the NASDAQ pushing back to within 1% of its February record.  Clearly, there is no inflation scare there.  Rather, all eyes are turning to the first earnings releases due today.  Overnight saw the Nikkei slide (-0.4%) but elsewhere in Asia equities rallied (Hang Seng +1.4%, Shanghai +0.5%).  European markets are mixed with the DAX (-0.1%) lagging while both the CAC (+0.4%) and FTSE 100 (+0.3%) continue to grind higher.  Apparently, Villeroy’s comments about tapering have not been seen as a danger.  US futures are modestly higher at this point, just 0.2% or so as the market bides its time ahead of Powell’s comments at noon.

In the bond market, after a big rally yesterday, the 10-year has seen yields back up slightly, by 1.1 bps, although European bonds are all looking at modest yield declines (Bunds -1.0bps, OATs -1.2bps, Gilts -0.3bps).  It has become pretty clear that the rush higher in yields has stalled for now, with important implications for all the other markets, especially the dollar.

Oil prices are continuing their recent rebound, with WTI +1.6%, although the price action in the metals markets remains confusing.  Precious metals rallied sharply yesterday but are little changed this morning.  Base metals continue to trade both ways with Cu (+1.1%) leading the way higher, but Al (-0.3%) lagging.  It all seems very much like a consolidation period ahead of the next leg higher.

As to the dollar, after sliding all day yesterday alongside Treasury yields, it is continuing lower this morning.  The leading gainer is NZD (+0.8%) which has rallied based on the market’s interpretation that standing pat by the RBNZ last night was actually hawkish, which has helped drag AUD (+0.65%) higher as well.  Oil is supporting NOK (+0.45%) but the rest of the moves are far less significant.  EMG currencies are also performing well this morning, led by KRW (+0.85%) and TRY (+0.5%).  The won was a beneficiary of the generally falling dollar as well as foreign inflows into the KOSPI.  TRY, on the other hand, simply offers yields that are too high to resist for certain investors, despite rising inflation there.

The only data today is the Fed’s Beige Book, to be released at 2:00, but aside from Powell at noon, we hear from four other Fed speakers including vice-chairman Clarida at 3:45 this afternoon.  Come Friday, the Fed will enter their quiet period ahead of the next FOMC meeting, so it seems everyone wants to get their thoughts aired ahead of that.

In the end, the dollar remains beholden to 10-year Treasury yields, so we could be in for a period of very limited movement, if Treasuries have found a new home.  Unless we hear something new from the Chairman today, I expect we are looking at a period of quiet for the next two weeks.  The calm before the storm.

Good luck and stay safe
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Will a New Normal Emerge?

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Recovery this year is set
To be best in decades, and yet
The central bank’s thumb
Will drive the outcome
By buying quadrillions in debt

The question is, after this surge
Will there be a natural urge
For things to go back
To pre-Covid’s track
Or will a new normal emerge?

The Wall Street aphorism, buy the rumor, sell the news, remains as valid today as it ever was.  The idea behind this concept, something to which I regularly point, is that by the time a particular piece of information has been released, the market has already absorbed the information in the price and is looking forward to the next price driver.  The result is that markets rally into good news and fall upon the release, and vice versa.  The most recent evidence that this remains a key to price action was Friday’s payroll report, where the outcome, in an illiquid market, was a much better than expected 916K NFP number with upward revisions of the previous two months.  And yet Treasury yields, which might have been expected to rise further on the news, have done nothing but decline since then.  Including today’s 1 basis point decline, the 10-year yield is lower by 6bps from the release and is now 10bps lower than the peak hit on March 30.  Is this the end of the yield rally?  Almost certainly not, but no market moves in a straight line.

I highlight this idea to discuss the latest forecast by the IMF and how this news may impact markets going forward.  Yesterday the IMF raised its global growth forecasts again, this time up to 6.0% in 2021 and 4.4% in 2022, representing increases of 0.5% and 0.2% respectively from their January analysis. The leadership in this growth is the US, now forecast to grow 6.4% by the IMF, and China, now forecast to grow 8.4% this year.  These are the fastest GDP growth numbers for the US since 1984, and we certainly all hope they are accurate.  After all, life is certainly better for everyone when the economy is growing rapidly.

But we have now seen a wave of higher forecasts for US GDP from official sources, like the Fed and IMF, and from private forecasters like Wall Street firms, with a strong consensus that the US is looking at GDP expansion this year well in excess of 6.0% and possibly as high as 7.0% or more.  And so I ask, isn’t that already in the price of most assets?

The broad bullish argument for risk is that global GDP growth is going to be much stronger in 2021 as the world’s economy rebounds from the Covid inspired recession of 2020.  And we have seen remarkable rallies in risk assets during this time, with the S&P 500 rising just a bit more than 80% in the twelve months following its nadir on March 24 last year.  All that occurred during a period where the virus was rampant but hopes for a vaccine would lead to an end to the government ordered shutdowns and a return to pre-covid type of economic activity.  While I grant that we have not seen all the shutdowns ended, the vaccine rollout has been impressive and is speeding up every day.  In fact, despite a pretty horrendous start to the process for Europe, the European Commission now believes that the continent will achieve herd immunity by the end of June!

So, if we know that all this is going to happen, haven’t risky assets already priced in this good news?  The other question that hangs over the current situation is the fact that this growth is entirely a product of the multiple trillions of dollars of government stimulus led by the US $5 trillion of fiscal injections, but also inclusive of QE, PEPP and QQE from the Fed, ECB and BOJ respectively, which totaled trillions more dollars of support.  Again, it begs the question, how much better can things be expected to get?

For instance, it is not unreasonable to expect that there will be permanent changes in the economy, specifically in the types of jobs that are available, especially for lower skilled workers.  If anything, the pandemic and resulting government lockdowns will have accelerated this process.  Remember, Chairman Powell has been clear that the Fed’s task will not be complete until the 10 million jobs that were lost as a result of government edicts are replaced. But what if that takes 5 years due to the structural changes in the economy?  Can the Fed maintain ZIRP while GDP growth is surging and inflation is rising alongside?  Historically, the answer would be no, but in the post-Covid world, that is no longer clear.  In fact, the one thing that has been truly consistent is that every government and supranational organization has warned every central bank to make sure they do not remove policy ease too soon.  The entire global political leadership is ‘all-in’ on the idea that printing money and spending it has no negative consequences.  In other words, it is no longer appropriate to worry we might wind up in an MMT world, we are already there!

This leads to the final question, will risk acquisition be unstoppable as a result of this new global thesis?  The famous American economist, Herbert Stein (Ben Stein’s father) made the statement, “if something cannot go on forever, it will stop.”  My observation is that printing money and the illusory growth that it brings cannot go on forever.  When this music stops, it will be a devastating fall.  But, as policymakers will do everything they can to prevent the stopping, this can go on for a while longer.  Simply be careful to not fall into the trap of believing stock prices are at “a permanently high plateau,” a comment another famous economist, Irving Fisher, made just weeks before the Wall Street Crash of 1929.

Ok, a super brief recap of markets shows that both Asia (Nikkei +0.1%, Hang Seng -0.9%, Shanghai -0.1%) and Europe (DAX -0.1%, CAC 0.0%, FTSE 100 +0.6%) were mixed with modest movement.  US futures are essentially unchanged at 8:00 as I finish typing.  Sovereign yields in Europe have edged lower by roughly 1 basis point, matching the Treasury market, but really not showing much in the way of activity.  Commodity prices are mixed with oil (+0.9%) rallying while metals (Au -0.6%, Cu -1.0%) are softer.

Finally, the dollar is showing little direction today with G10 currencies showing gains (NOK +0.3%) on oil’s rally and losses (AUD -0.5%) on metals price weakness.  But there is no dollar trend here.  In emerging markets, INR (-1.5%) was the biggest loser after the RBI left policy rates on hold, but not merely increased QE, but put a number on it where they will be buying INR1 trillion over the next quarter, driving Indian bond yields lower along with the rupee.  But away from that story, here, too, there is nothing of note with a mixed picture in the space.

On the data front, we see the Trade Balance (exp -$70.5B) this morning and then the FOMC Minutes are released at 2:00.  Today also brings a great deal of Fedspeak, but I remain highly confident that nothing from that story is going to change.

The dollar is wandering aimlessly today but remains closely tied to Treasury yields.  If yields resume their rally, look for the dollar to rebound.  However, if this correction in yields continues, the dollar has further to fall.

Good luck and stay safe
Adf

Central Bank Dreams

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The story that’s now being told
Is growth worldwide’s now taking hold
So real rates are rising
And it’s not surprising
That havens are now being sold

Thus, this explains why sovereign debt
Is being sold, and is a threat
To central bank dreams
Or really, their schemes
Inflation to truly beget

Treasury yields, or perhaps more accurately, sovereign yields, remain the top story in markets as their movement continues to underpin most other action.  The very sharp rise in yields seen year-to-date had been driven by rising inflation expectations.  This is clear when looking at breakevens where the 5yr-5yr has climbed from 1.93% at the beginning of the year to 2.60% as of yesterday.  This rise makes up the bulk of the rise in the 10-year Treasury yield, which has gone from 0.91% to 1.70% during the same time frame.  And it has been the rise in inflation expectations that has been a key feature in many of the forecasts for rising inflation beyond the next several months, where base effects from the initial pandemic shutdowns will be seen.

Given the run of very strong data that has been recently released, with yesterday’s ISM Services print of 63.7 being the highest in the series’ 25-year history as the latest example, the narrative is starting to adjust slightly. Recently there have been a number of analyst reports discussing the idea that rising yields represent rising growth expectations and not rising inflation expectations.  If this is true, it certainly alters the calculus of future market activity.  It is also likely to alter the reaction functions of central banks.

Consider what we have heard from the major central banks since the GFC; the greatest threat to economic activity is deflation and each and every one of them has gone out of their way to try to stoke inflation.  Of course, the underlying reason for a central bank to stoke inflation is to help debase the value of their government’s outstanding debt.  This concept has grown dramatically in importance as the amount of government debt outstanding has skyrocketed during the past decade while trend growth has slowed.  Thus, the only way to escape this debt trap was to inflate away the real value of that debt.  This logic is part and parcel of the current central bank guidance regarding maintaining ZIRP or NIRP until inflation and employment goals are actually met, rather than acting when they are anticipated to be met.

Understand, monetary policy acts with a lag, generally considered to be in the 6mo-1yr time frame, so if a central bank does not adjust policy until a target is reached, the likelihood is that variable will continue on its recent trend for many months once the central bank acts.  For example, if the Fed waits for inflation to average 2.0% for a period of time before tightening policy, inflation is likely to continue rising beyond that target for upwards of a year or more before beginning to slow down.  It is for this reason that central banks pay such close attention to expectations data as it gives them clues to potential market responses to their actions.  And it is for this reason that a change in the underlying driver of increasing yields will alter so much.

A key feature of the equity market rally has been the fact that real yields have been negative for quite a while driving investors to seek positive real returns.  This is the TINA concept, there is no alternative.  But if real yields start to climb because growth expectations are climbing with less concern over potential inflationary effects, suddenly there is an alternative to owning equities, especially for pension-type investors who generally seek the least risk available for a return.  If there is an alternative, then a rethinking of the current multiples for equity markets is quite reasonable.  In other words, stock prices could easily fall a fair amount.  Now, declining stock prices have been a key signal to central banks that policy ease is in order, at least since October 1987 in the aftermath of Black Monday.  But this begs the question, what if this process unfolds before central banks have begun raising rates?

As you can see, if this change in the narrative is accurate, and real yields begin climbing, central banks will simply find themselves in a different predicament but with the same tools available.  In other words, policy ease may have a different nominal rationale, but that doesn’t help the fixed income investor.  And how will this impact the FX market?  That is probably the easiest short-term answer, the dollar will follow real yields higher, and if the Fed steps in to cap those yields, via YCC or expanded QE, then the dollar will reverse course lower.  So, watch the movement in real yields for clues as to the dollar’s next steps.

Enough of that and on to markets.  Risk is largely in vogue this morning, at least in Europe, although Asian equities had a more mixed session.  Last night saw the Nikkei (-1.30%) soften while Shanghai (0.0%) went nowhere.  The Hang Seng was closed, although we did see the ASX 200 rise 0.8% Down Under.  Europe, however, is all green all the time, with the DAX (+1.2%) and FTSE 100 (+1.1%) leading the way while the CAC (+0.6%) is lagging but still having a good time. Interestingly, after more record highs yesterday in the US, futures markets are all pointing slightly lower, with the three main indices showing declines of -0.1% to -0.2%.

Bond markets, as would be expected in a risk-on session, are mostly declining, with European sovereigns trading with yields higher by about 2.5 basis points in the big three markets.  Treasury yields are little changed at this time but remain right on that 1.70% yield level.  There is much discussion as to whether the next leg higher in yields is coming soon, or if we have exhausted the drive higher.  Arguably, if growth expectations continue to increase, the case for higher Treasury yields will be inexorable.

In the commodity space, oil prices (+1.35%) are rebounding but WTI has had trouble holding the $60/bbl level ever since its sharp decline two weeks ago.  Precious metals are a bit firmer (Au +0.3%, Ag +0.4%), although Cu (-1.5%) has softened a bit on the day.

Finally, the dollar is broadly stronger this morning despite the increased risk appetite in equity markets.  While the euro is little changed, we are seeing sharp declines in NZD (-0.6%), GBP (-0.5%) and NOK (-0.4%) with Kiwi simply retracing gains made in yesterday’s illiquid markets with similar price action seen in both Sterling and Nokkie.  There is little fundamental driving these moves right now.

Emerging market currencies had a more mixed performance with KRW (+0.7%) as the big winner benefitting from an increase in foreign inflows to both the KOSPI and Korean bond markets.  CNY (+0.25%) has responded to word from the PBOC that they are asking the major commercial banks to reduce their lending to prevent bubbles and other possible financial dislocations.  This helped push Chinese interest rates a touch higher supporting the currency.  On the downside, TRY (-0.4%) continues to be the worst performer in the space as inflation worries continue to grow in the country, but elsewhere, movement has been fairly tame.

On the Data front, we only see JOLTs Job Opening (exp 6.9M) which has not gained many market adherents as an important data point despite the Fed’s focus on employment, likely because the data is quite old, with this morning’s release describing February activity.  As to Fed speakers, only Richmond’s Thomas Barkin is on the tape today, but there still seems little chance of a change in Fed expectations.

Many are claiming the dollar has put in a short-term top, although as discussed above, if real US yields continue to rise, I expect the dollar will rise right alongside them.  And in truth, that remains the single key driver in the FX markets for now.  Higher Treasury yields still portend a higher dollar and vice versa.

Good luck and stay safe
Adf

Disinflation’s Deceased

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The plan that the Prez just released
Has taxes and spending increased
As well as what’s planned
There’s pent up demand
As such, disinflation’s deceased

Risk remains in vogue this morning as the details of the $2.3 trillion spending plan released last evening by President Biden were more than enough to keep the risk train rolling.  While there was no mention of ‘shovel ready’ projects, and expectations are that it won’t be until sometime in the summer that any bill will make it to the president’s desk, it is full speed ahead for the investor community.  Certainly, there are no concerns over either financing the new bill nor with the prospect that adding more stimulus demand is likely to drive up prices even more rapidly than currently seen.  In other words, everything is great!

But is it really that great?  It is hard to live in the real world and not have noticed that the cost of living is rising, and seemingly faster than the data indicates.  By now, we have all heard about the shortage of microprocessors causing a reduction in auto production and even iPhones.  I’m pretty sure that less supply in these products will not lead to lower prices.  And if you still drive at all, you are aware of how much the price of gasoline has risen during the past year.  But lately we have heard from a number of companies on more mundane products and how prices are being raised there as well.  Kimberly-Clark, General Mills, J.M. Smucker and Hormel Foods have all announced price hikes in the past week or two, and they all make things we buy in the supermarket each week.  So, while the rising price of a once every 3-6 year purchase of an automobile is not likely to impact any individual regularly, when your toilet paper goes up in price, you notice.  The Fed must be thrilled.

In that vein, I often wonder how the Fed considers its relationship with inflation.  Perhaps Powell rehearses discussions with an anthropomorphized version of inflation.  Maybe it would sound like this:

Inflation: Jay, I have to tell you, I’m feeling pretty strong lately.  I’ve been resting for the past 12 years and have a lot of energy available to jump pretty high.

Chairman Powell: That’s awfully nice, but let me warn you, ‘we have tools.’

Inflation: Tools?  What does that even mean?  Are you going to build a house?  (Nah, too expensive with prices rising 10% annually).  Repair the infrastructure?  (That will certainly drive up raw material prices even further.)

Chairman Powell:  Just what I said, we have tools.  My dear friend Paul Volcker, may he rest in peace, taught us how to deal with you 40 years ago.  We can stop you anytime we want.

Inflation:  Well, 40 years ago, was a different time and place.  The amount of outstanding debt was a fraction of where it is today.  Since you haven’t used those ‘tools’ in 40 years, I suspect they are rusty and ineffective now.  And even if you have them, I’m willing to bet you are either afraid to use them, or don’t know how.  I’m looking forward to our next conversation when I will be bigger, stronger and higher!

Chairman Powell:  Don’t mess with me, I told you, ‘we have tools!’

As Powell awakes shaking from this nightmare, he repeats to himself, we have tools, just like Christine has tools.  It will all be fine.

But seriously, it is very difficult to see the ongoing data releases, especially in the US, where GDP is clearly going to see a very big jump in Q2 and analysts are fighting to forecast the biggest GDP growth number in decades, and not wonder how prices are not going to rise even more rapidly.  In fact, we seem to be approaching a perfect storm, increased demand meets supply shortages.  The Fed is going to get their inflation, as will most central banks, and it is ultimately going to have a big impact on financial markets.  But not today.  Today, investors continue to see only the positives.

After yesterday’s Tech led rally in the US stock markets, Asia performed well (Nikkei +0.7%, Hang Seng +2.0%, Shanghai +0.7%) and Europe is largely green as well (DAX +0.3%, CAC +0.2%, FTSE 100 +0.4%).  As it is the first day of a new month and quarter, we saw PMI and Tankan data overnight, all of which continues to show positive vibes for the near future (although the Japanese data has been lagging that of the US and even Europe on these measures.)  US futures, meanwhile, are also looking good with the NASDAQ (+0.9%) once again leading things higher with lesser gains in the other two main indices.

Bond markets, interestingly, are also in fine fettle this morning, with yields declining in Treasuries (-2.1bps), bunds (-1.2bps), OATs (-1.2bps) and Gilts (-2.1bps).  But 10-year Treasury yields remain firmly above 1.7% and their spread to bunds and JGBs remain right at recent highs.  It appears to me as though bond traders are taking a rest ahead of tomorrow’s payroll report, which will be released on Good Friday, a day of limited liquidity.  If the economic bulls are right, and there is a print above 1 million jobs in NFP, I would expect that we will test 1.8% in the 10-year before the weekend arrives.  However, until then, it looks like the growing short position in bonds is getting adjusted.

Oil prices are firmer this morning with WTI up by 1.1%, alongside gains in gold (+0.25%) and the agricultural space.  Meanwhile, base metals are mixed with Cu (-0.65%) and Zn (-0.2%) softer while Al (+0.65%) and Ni (+0.8%) are firmer.

Lastly, the dollar is mixed today as well, with most of the G10 softer led by AUD (-0.4%) and CHF (-0.3%), although the euro has stopped its freefall, at least temporarily, and is currently 0.1% firmer on the session.  Aussie seems to be slipping on the view that the RBA’s first QE plan, A$100 billion, is complete but that there will be a second one announced next Tuesday.  The Swiss franc, on the other hand, seems to be developing some momentum on a technical view and is responding to market internals rather than fundamentals.

EMG currencies have had a much more mixed picture with both gainers and losers evident.  On the plus side, TRY (+0.8%) and ZAR (+0.5%) lead the way higher, while we are seeing RUB (-0.6%) and CNY (-0.3%) as the key laggards.  The rand seems to be benefitting from seasonal factors as technicians look at recent history when the ZAR has rallied consistently in April.  TRY is simply so volatile these days given the ongoing mess at the central bank, that it is difficult to ascribe any move less than 2% to a specific issue.  As to the negatives, RUB, despite oil’s gains, is suffering from news of a surprising new bond offering of RUB 1 trillion, while CNY seems to have been guided lower by the PBOC as the Chinese government has decided that a weaker currency is clearly going to be necessary to support their economy for now and the current US administration isn’t going to make a big deal about it.

Data this morning brings Initial Claims (exp 675K), Continuing Claims (3.75M) and ISM Manufacturing (61.5) and Prices Paid (85.0).  FYI, that Prices Paid index is back at levels seen during the 50’s, 60’s and 70’s, all times when CPI inflation was far higher than 1.3%!

Frankly, with the payroll data tomorrow, I anticipate a generally quiet session, especially as much of Europe will be taking a long Easter holiday weekend starting quite soon.  The dollar’s trend remains firmly higher, but I don’t expect much movement today.

Good luck
Adf

The Bottom’s Not In

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Attention this morning’s returned
To Treasuries, where we have learned
The bottom’s not in
As yields underpin
The dollar that once had been spurned

Plus ça change, plus ça même chose.

During the past several weeks, there have been a number of stories that seemed designed to shift our attention away from what has been the major market driver in 2021…the Treasury market.  But despite the Ever Given running aground, despite the forced liquidation of Archegos Capital Management and despite Covid’s resurgence throughout Europe and additional mooted lockdowns there, the clear driver of market activity remains US Treasury yields, specifically in the back end of the curve.  As I type this morning, the 10-year has risen 5.7bps on the session with the yield now 1.765%, its highest level since January 22, 2020.  This movement has dragged up yields across the US yield curve, with 5-year yields fast approaching 1.0% while even 2-year yields, which remain anchored by the Fed’s promises to keep the Fed Funds rate at its current level through at least 2023, has edged up by 1.4 basis points.

And this movement is not isolated to the United States, as sovereign yields across the board are higher today with European markets looking at gains of between 5.5bps and 7.5 bps, while overnight saw Australian yields climb 9.2 basis points.  But it is clearly the Treasury market in the lead.  The current story seems to revolve around the ongoing outperformance of the US economy vis-à-vis those of Europe and much of Asia, the success of the US vaccine program and the promise of yet another fiscal stimulus bill coming from the Biden administration.  That trifecta dwarfs all other nations’ activities and so has seen ongoing flows into US equity markets as well as into the dollar.  And the thing is, for now, it is hard to see what can derail this story in the short-term.  In fact, with the latest payroll data due to be released Friday and expected to show a substantial gain in the number of jobs, while more and more states reduce Covid inspired economic restrictions, things seem like they will only get better.

And perhaps things will only get better.  Perhaps we have passed the worst of the pandemic.  Perhaps all Covid inspired restrictions will be relaxed and people will head back out on vacations and to movies and theme parks. Perhaps shopping malls will regain their allure as people look for anyplace to go that is not inside their own home.  In this case, as the service sector reopens along with the jobs attendant to that process, the Fed would likely be able to justify a very gradual reduction in some of their stimulus.  And this could all happen.  But, so could we wake up tomorrow to learn that pigs really can fly.

Instead, while there is no doubt that the US remains the driving force in the economy right now, as it leads other nations out of the pandemic, the imbalances that have developed due to the policies implemented during the pandemic will take a very long time to unwind.  In addition, they pose a very real threat to the stability of markets and economies.  For instance, how will nations around the world address the issue of the massive rise in their debt/GDP ratios.  While servicing costs right now are tenable given the historically low level of interest rates, investors may well start demanding higher yields to compensate for the growing riskiness of those portfolios.  After all, we have seen many nations default on their debt in the past, with Greece and Argentina just the two latest on the list.

But rising yields will force governments to choose between honoring their debt promises, or paying for their activities, a choice no elected politician ever wants to make.  It is not unreasonable to assume that this choice will be forced on countries by the markets (and in fact, is starting to be forced as we watch yield curves steepen) with two potential outcomes; either the central bank caps yields to insure that debt service remains viable, or the debt is restructured by the central bank who will monetize it.  Either situation will almost certainly result in rising inflation, not of the asset kind, but will also result in a situation where those tools that central banks claim they have to fight inflation will not be available.  After all, if they are capping yields, they cannot very well raise rates to fight inflation.

It is this endgame that has some very thoughtful people concerned, as when this situation has arisen in the past, and after all, there is nothing new under the sun, the result has been a combination of much more significant inflation and debt defaults.  Now, in the US, the idea of a debt default seems quite impossible.  However, the idea of higher inflation, especially given the Fed’s stated desire to see inflation rise, is much easier to accept.  And after all, given the newly stated desire to achieve an average inflation rate, with a desire to see higher than 2.0% inflation readings for some indeterminate amount of time, how will the Fed know when they’ve seen enough?  The point is, the Fed, and every central bank, still has a very difficult task ahead of them to maintain stability while supporting the economy.  And there is no guarantee that their actions will work.

With that joyous thought in mind, a quick look at other markets beyond bonds shows that equities remain supported with widespread gains overnight (Nikkei +0.15%, Hang Seng +0.8%, Shanghai +0.6%), while European bourses are all green as well (DAX +0.6%, CAC +0.55%, FTSE 100 +0.25%).  US futures, however, are starting to fade, led by the NASDAQ (-0.8%) although SPX futures (-0.2%) have turned lower as well.  Remember, the NASDAQ, with its predominantly growth-oriented companies, is similar to a long-term bond, as higher yields reduce the current discounted value of its future growth.

Commodity markets are under pressure this morning as well with oil (-1.5%) falling back a bit further, and both base and precious metals all under the gun.  This commodity story is synchronous with the combination of rising yields and…a rising dollar.  And the dollar continues to rise, against all early year supposition.

Versus the G10, it is higher against all comers, with JPY (-0.5%) leading the way lower and breaking above 110 for the first time in a year.  However, this move looks far more sustainable than the price action seen in the immediate wake of the initial Covid panic.  Quite frankly, in the short-term, there is no reason to think USDJPY cannot rise to 115.00.  But the weakness is universal with SEK (-0.4%) and NOK (-0.3%) also continuing lower.  While the latter is undermined by the oil decline, the Swedish krona remains the highest beta G10 currency, and is simply leading the euro (-0.25%) on its downward path.

EMG currencies are not in any better shape with TRY (-2.2%) by far the worst performer as more bets get piled on that the new central bank governor will be cutting interest rates soon at the behest of President Erdogan.  INR (-1.2%) is the next worst performer, suffering as state-run banks were seen actively buying dollars in the market ahead of their fiscal year-end, cleaning up their balance sheets.  But pretty much the entire bloc is lower by between 0.2% and 0.4% on the simple fact that the dollar is growing in demand as US yields lead the way higher.

On the data front, two minor releases today, Case Shiller Home Prices (exp 11.2%) and Consumer Confidence (96.9) are unlikely to have much impact as the market looks forward to the employment situation starting with tomorrow’s ADP Employment report and then Friday’s NFP data.

Adding it all up comes to the idea that the current trends, higher yields and a higher dollar, remain firmly entrenched and I see no reason for them to change in the near future.

Good luck and stay safe
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No Need to be Austere

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From every Fed speaker we hear
That prices might rise some this year
But they all confirm
It will be short-term
So, there’s no need to be austere

I feel like today’s note can be very short as there really has been nothing new of note to discuss.  Risk is on the rise as market participants continue to absorb the Federal Reserve message that monetary stimulus is going to continue, at least at the current pace, for at least the next two years.  That’s a lot of new money, nearly $3 trillion more to add to the Fed balance sheet, and if things hold true to form, at least 60% of it will wind up in the equity market.

This was confirmed by four Fed speakers yesterday, including Powell and Vice Chair Clarida, who made it quite clear that this was no time to start tapering, and that rising bond yields were a vote of confidence in the economy, not a precursor to rising inflation.  What about inflation you may ask?  While they fully expect some higher readings in the short run due to base effects, they will be transitory and present no problem.  And if inflation should ever climb to a more persistent level that makes them uncomfortable, they have the tools to address that too!  I know I feel a lot better now.

Europe?  The big news was the German IFO Expectations index printing at a much better than expected 100.4, despite the fact that Covid continues to run rampant through the country.  While they have managed to avoid the massive Easter lockdown that had been proposed earlier this week, the ongoing failure to vaccinate the population remains a damper on activity, or at least the perception of activity.  Otherwise, we learned that Italy is struggling to pay its bills, as they need to find €15 billion quickly in order to continue the present level of fiscal support, but have a much tougher time borrowing, and have not yet received the money from the Eurozone fiscal support package.  In the end, however long the Fed is going to be expanding its balance sheet, you can be sure the ECB will be doing it longer.

The UK?  Retail Sales were released showing the expected gains relative to last month (+2.
1% M/M. -3.7% Y/Y) and excitement is building that given the rapid pace of vaccinations there, the economy may be able to reopen more fully fairly soon.  Certainly, the pound has been a beneficiary of this versus the euro, with the EURGBP cross having declined more than 5% this year, meaning the pound has appreciated vs. the euro by that much.  Perhaps Brexit is not as big a deal as some thought.

Japan?  The latest $1 trillion budget is being passed, which simply adds to the three supplementary budgets from last year totaling nearly $750 billion, with most observers expecting more supplementary budgets this year.  But hey, the Japanese have perfected the art of borrowing unfathomable sums, having the central bank monetize them and maintaining near zero interest rates.  Perhaps it should be no surprise that USDJPY has been rising, because on a relative basis, the Japanese situation does seem worse than that here in the US.

Other than these stories, things are just not that exciting.  The Suez Canal remains closed and we are starting to see ships reroute around the Cape of Good Hope in Africa, which adds more than a week to transit times and considerable expense.  But I’m sure these price rises are transitory too, just ask the Fed.

So, let’s take a quick tour of markets.  Equities are all green right now and were so overnight.  The three main Asian indices, Nikkei, Hang Seng and Shanghai, all rose 1.6% last night after US markets turned around in the afternoon.  European bourses are looking good, with the DAX (+0.6%), CAC (+0.4%) and FTSE 100 (+0.7%) all solidly higher on the day.  As to US futures, both Dow and S&P futures are a touch higher, 0.2% or so, but NASDAQ futures are under a bit of pressure at this hour, -0.3%.

In the bond market, 10-year Treasury yields are higher by 4.1bps in the wake of yesterday’s really mediocre 7-year auction.  While it wasn’t as bad as the last one of this maturity, it continues to call into question just how able the Treasury will be to sell sufficient bonds to fund all their wish list.  Even at $80 billion per month of purchases, the Fed is falling behind the curve here and may well need to pick up the pace if yields start to climb more.  I know that is not their current story, but oversupply is certainly at least part of the reason that Treasuries have been so weak.  And today, despite ECB support, European sovereign bonds are all lower with yields higher by 4.5bps or more virtually across the board.  Either the ECB has taken today off, or there are bigger worries afoot.  One little known fact is that alongside the ECB, European commercial banks had been huge buyers of their own country’s debt for all of last year.  However, that pace has slowed, so perhaps today’s movement is showing a lack of natural buyers here as well.

Commodity prices are pretty much firmer across the board with the exception of precious metals, which continue to suffer on the back of higher US yields.  But oil (+2.3%) is back at $60/bbl and base metals and agricultural prices are all firmer this morning.

Finally, the dollar is broadly weaker at this hour, with the commodity bloc of the G10 leading that group (NZD +0.5%), NOK (+0.4%), (AUD +0.4%), although the pound (+0.3%) is also doing well after the Retail Sales numbers.  Meanwhile, the havens are under pressure (JPY -0.5%), CHF (-0.15%), as there is no need for a haven when the central bank has your back!

EMG currencies are a bit less interesting, although the APAC bloc was almost uniformly higher by small amounts.  That was simply on the back of the risk-on attitude that was manifest overnight.  The one exception here is TRY (-1.1%) which continues to suffer over the change of central bank leadership and concerns that inflation will run rampant in Turkey.  Two other noteworthy things here were in LATAM, where Banxico left rates on hold at 4.0%  yesterday afternoon and reaffirmed they were entirely focused on data, and that S&P downgrade Chile’s credit rating to A from A+ on the back of the changes in government structure and concerns about the medium term fiscal position.

On the data front we see Personal Income (exp -7.2%), Personal Spending (-0.8%), Core PCE (1.5%) and then at 10:00 Michigan Sentiment (83.6).  To me, the only number that matters is the PCE print, but this is a February number, so not expected to be impacted by the significant base effects from last year’s events.  Of course, given the constant chorus of any rising inflation will be transitory, we will need to see a lot of high prints before the market gets nervous…or will we?  After all, the bond market seems to be getting nervous already.

At any rate, while the dollar is under pressure this morning, my take is that if US yields continue to climb, we are likely to see it retrace its steps.  At this point, I would argue the dollar’s trend is higher and will be until we see much higher inflation readings later this spring and summer.

Good luck, good weekend and stay safe
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Central Banks Fear

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The one thing that’s been crystal clear
Is yields have exploded this year
The question at hand
Since this wasn’t planned
Is what, most, do central banks fear?

For Jay and the FOMC
The joblessness rate is the key
For Christine its growth
And prices, as both
Refuse to respond to her plea

While the bond market has taken a respite from its headlong rush to higher yields, there is no evidence we have seen the top.  Rather, it feels very much like the market has positioned itself for the next leg higher in yields, potentially to kick off after tomorrow’s FOMC meeting.  If you recall, the last Fedspeak on the topic was by Chairman Powell and he was essentially dismissive of the issue as a non-event.  The consistent story has been that higher yields in the back end of the curve is a sign that the economy is picking up and they are doing their job properly, in other words it is a vote of confidence in the Fed.  And he was unambiguous in his discussion regarding the potential to tighten policy; it ain’t gonna happen for at least two to three more years, which is their timeline as to when the employment situation will recover to pre-Covid levels.  Remember, Powell has been explicit that he will not be satisfied until another 10 million jobs have been created and filled.

It has been this intense focus on the employment situation that has driven the Fed narrative that neither inflation or higher yields are of consequence for now or the foreseeable future.  Thus, all the positive US data, both economic and vaccine related, has served to increase expectations of a strong economic rebound consistently supported by front end interest rates remaining at zero.

But the interplay between rising yields and the speed of the recovery remains open to question.  In addition, there is the question of just how high yields can go before the Treasury gets uncomfortable that financing all this deficit spending is going to become problematic.  After all, if yields continue to rise, at some point the cost of carrying all the debt is going to become quite painful for the government.

In fact, it is this issue that has been a key feature of many forecasts of market behavior for the rest of this year and next; at some point, probably sooner rather than later, the Fed is going to step in and cap yields.  But what if the Treasury is looking at this problem from a different perspective, not what actual yields are, but the size of their debt service relative to the economy?  On that measure, despite a more than doubling of Treasury debt outstanding since 2007, interest expense is currently a smaller percentage of GDP than it was back then.  It is important to remember that Treasury debt matures monthly, not just T-bills, but also old notes and bonds, and when those notes and bonds were issued, ZIRP didn’t exist so many carry coupons much higher than the current replacements.  The upshot is that debt service costs have been declining despite the growth in the nominal amount of debt outstanding and are forecast to continue declining for the next 3 years according to the CBO.  So, maybe, Jay is serious that he is unworried about the current level of yields in the 10-year bucket and beyond.

If this thesis is correct, the implications for other markets going forward are significantly different than I believe many are currently considering.  For instance, a further rise in yields will start to have a significant negative impact on equity prices as all of the discounted cash flow models that currently assume zero rates forever to justify the current level of valuations will come crashing back to reality and there will be a realization that price-earnings multiples are unsustainable at current levels.  As well, the dollar bearish theme will likely get destroyed, as it is predicated on the idea that real yields will decline with rising inflation and capped yields.  If yields are not capped, but instead respond to rising inflation expectations by going higher unchecked, the dollar will be a huge beneficiary.  Precious metals?  They will suffer, although base metals should hold their own as growth will support demand and supply continues to be lacking, especially new supply.  And I would be wary of EMG debt as that rising dollar will wreak havoc on emerging market economies.

Perhaps it is the last thing that will cause the Fed to blink, since if the rest of the world slides into another recession amid increased demand for dollars, history has shown the Fed will ease policy to halt that slide.  Of course, for the past thirty years, any significant decline in the US equity market has been sufficient to get the Fed to ease policy, with Q4 2018 the most recent pre-pandemic episode.  But that means those valuations will compress, at least somewhat, before the Fed responds.

Add it all up and we have the opportunity for significantly more volatility in markets going forward, something hedgers need to heed.

As to today, ahead of the Retail Sales release this morning, and of course the FOMC tomorrow, markets are continuing in their quiet consolidation overall, though with a modest risk-on bias.

Equity market screens are all green with gains in Asia (Nikkei +0.5%, Hang Seng +0.7%, Shanghai +0.8%) and Europe (DAX +0.5%, CAC +0.1%, FTSE 100 +0.5%) pretty solid everywhere.  US futures are showing gains in the NASDAQ (+0.5%), but little movement in the other two indices.

Bond markets are also quietly higher, with very modest yield declines in Treasuries (-0.5bps), Bunds (-0.5bps) and Gilts (-1.0bp).  In fact, looking at my screen shows only Italian BTP’s (+1.9bps) and Greek 10-years (+2.8bps) falling as both nations impose stricter lockdowns.  Even JGB’s (-1.0bp) are a bit firmer as market participants await the BOJ’s policy framework Friday.

Commodity prices are under a bit of pressure this morning with oil (-1.3%) leading the way but base metals pretty much all lower as well.  As to the precious metals, they are little changed on the day and are the market with, perhaps, the keenest interest in the Fed meeting tomorrow.  If yields are going to continue to climb unabated, gold and silver will decline.

Finally, the dollar is having a mixed session as well, with a pretty equal split of gainers and losers against the greenback.  In the G10, SEK (+0.3%) and CHF (+0.3%) lead the way higher although both appear to be continuing a consolidation move of the past week.  On the downside, GBP (-0.3%) is the laggard after the EU brought new legal action against the UK on a Brexit related matter.  As to the rest of the space, the movements have been even smaller and essentially irrelevant.

In Emerging Markets, TRY (+0.8%) is the leading gainer as bets grow that the central bank will be raising rates later this week.  Next in line was KRW (+0.6%) which benefitted from large net inflows into the bond market, but after that, things are much less interesting.  On the downside, while there are a number of currencies that have declined this morning, the movements, all 0.2% or less, just don’t need a rationale, they are simply trading activity.

Data wise, we see Retail Sales this morning (exp -0.5%, 0.1% ex autos) a far cry from last month’s stimulus check induced jump of 5.3%.  We also see IP (0.3%) and Capacity Utilization (75.5%) a little later, but the reality is that if Retail Sales is uninteresting, markets are likely to continue to drift until tomorrow’s FOMC meeting.

For today, there seems very little likely to occur, but beware the Fed, if they really are going to allow yields to rise further, we could see some real changes in viewpoint for both equity markets and the dollar.

Good luck and stay safe
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Hubris

Posted on by

Said Janet, the risk remains “small”
Inflation could come to the ball
But if that’s the case
The tools are in place
To stop it with one conference call

hu∙bris
/ (h)yoobrəs/
noun: excessive pride or self-confidence

“Is there a risk of inflation?  I think there’s a small risk and I think it’s manageable.”  So said Treasury Secretary Janet Yellen Sunday morning on the talk show circuit.  “I don’t think it’s a significant risk, and if it materializes, we’ll certainly monitor for it, but we have the tools to address it.”  (Left unasked, and unanswered, do they have the gumption to use those tools if necessary?)

Let me take you back to a time when the world was a simpler place; the economy was booming, house prices were rising, and making money was as easy as buying a home with 100% borrowed money (while lying on your mortgage application to get approved), holding it for a few months and flipping it for a profit. This was before the GFC, before QE, before ZIRP and NIRP and PEPP and every acronym we have grown accustomed to hearing.  In fact, this was before Bitcoin.

In May 2007, Federal Reserve Chairman Ben Bernanke, responding to a reporter’s question regarding the first inklings of a problem in the sector told us,  “Given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the sub-prime sector on the broader housing market will likely be limited.”  Ten months later, as these troubles had not yet disappeared, and in fact appeared to be growing, Bennie the Beard uttered his most infamous words, “At this juncture, however, the impact on the broader economy and financial markets of the problems in the sub-prime market seems likely to be contained.”

Notice anything similar about these situations?  A brewing crisis in the economy was analyzed and seen as insignificant relative to the Fed’s goals and, more importantly, inimical to the Fed’s desired outcomes.  As such, it is easily dismissed by those in charge.  Granted, Janet is no longer Fed chair, but we have heard exactly the same story from Chairman Jay and can look forward to hearing it again on Wednesday.

Of course, Bernanke could not have been more wrong in his assessment of the sub-prime situation, which was allowed to fester until such time as it broke financial markets causing a massive upheaval, tremendous capital losses and economic damage and ultimately resulted in a series of policies that have served to undermine the essence of capital markets; creative destruction.  While hindsight is always 20/20, it does not detract from the reality that, as the proverb goes, an ounce of prevention is worth a pound of cure.

But right now, the message is clear, there is no need to be concerned over transient inflation readings that are likely to appear in the next few months.  Besides, the Fed is targeting average inflation over time, so a few months of above target inflation are actually welcome.  And rising bond yields are a good thing as they demonstrate confidence in the economy.  Maybe Janet and Jay are right, and everything is just ducky, but based on the Fed’s track record, a lot of ‘smart’ money is betting they are not.  Personally, especially based on my observations of what things cost when I buy them, I’m with the smart money, not the Fed.  But for now, inflation has been dismissed as a concern and the combination of fiscal and monetary stimulus are moving full speed ahead.

Will this ultimately result in a substantial correction in risk appetite?  If Yellen’s and Powell’s view on inflation is wrong, and it does return with more staying power than currently anticipated, it will require a major decision; whether to address inflation at the expense of slowing economic growth, or letting the economy and prices run hotter for longer with the likelihood of much longer term damage.  At this stage, it seems pretty clear they will opt for the latter, which is the greatest argument for a weakening dollar, but perhaps not so much vs. other fiat currencies, instead vs. all commodities.  As to general risk appetite, I suspect it would be significantly harmed by high inflation.

However, inflation remains a future concern, not one for today, and so markets remain enamored of the current themes; namely expectations for a significant economic rebound on the back of fiscal stimulus leading to higher equity prices, higher commodity prices and higher bond yields.  That still feels like an unlikely trio of outcomes, but so be it.

This morning, we are seeing risk acquisition with only Shanghai (-1.0%) falling of all major indices overnight as Tencent continues to come under pressure after the government crackdown on its financial services business.  But the Nikkei (+0.2%) and Hang Seng (+0.3%) both managed modest gains and we have seen similar rises throughout Europe (DAX +0.2%, CAC +0.3%, FTSE 100 +0.3%) despite the fact that the ruling CDU party in Germany got clobbered in weekend elections in two states.  US futures are also pointing higher by similar amounts across the board.

Bond markets, interestingly, have actually rallied very modestly with Treasury yields lower by 1.2 basis points, and similar yield declines in both Bunds and OATs.  That said, remember that the 10-year did see yields climb 8 basis points on Friday amid a broad-based bond sell-off around the world.  In other words, this feels more like consolidation than a trend change.

Commodity markets have also generally edged higher, with oil (+0.35%), gold (+0.1%) and Aluminum (+1.0%) showing that the reflation trade is still in play.

Given the modesty of movement across markets, it seems only right that the dollar is mixed this morning, with a variety of gainers and laggards, although only a few with significant movement.  In the G10 this morning, SEK (-0.7%) is the worst performer as CPI was released at a lower than expected 1.5% Y/Y vs 1.8% expected.  This has renewed speculation that the Riksbank may be forced to cut rates back below zero again, something they clearly do not want to do.  But beyond this, price action has been +/- 0.2% basically, which is indicative of no real news.

In EMG currencies, it is also a mixed picture with ZAR (+0.7%) the biggest gainer on what appear to be carry trade inflows, with TRY (+0.6%) next in line as traders anticipate a rate hike by the central bank later this week.  Most of LATAM is not yet open after this weekend’s change in the clocks, but the MXN (+0.3%) is a bit firmer as I type.  On the downside, there is a group led by KRW (-0.3%) and HUF (-0.25%), showing both the breadth and depth (or lack thereof) of movement.  In other words, movement of this nature is generally not a sign of new news.

On the data front, all eyes are on the FOMC meeting on Wednesday, but we do get a few other releases this week as follows:

Today Empire Manufacturing 14.5
Tuesday Retail Sales -0.5%
-ex autos 0.1%
IP 0.4%
Capacity Utilization 75.5%
Wednesday Housing Starts 1555K
Building Permits 1750K
FOMC Decision 0.00% – 0.25%
Thursday Initial Claims 700K
Continuing Claims 4.07M
Philly Fed 24.0
Leading Indicators 0.3%

Source: Bloomberg

While Retail Sales will garner some interest, the reality is that the market is almost entirely focused on the FOMC and how it will respond to, or whether it will even mention, the situation in the bond market.  Certainly, a strong Retail Sales report could encourage an even more significant selloff in bonds, which, while seemingly embraced by the Fed, cannot be seen as good news for the Treasury.  After all, they are the ones who have to pay all that interest. (Arguably, we are the ones who pay it, but that is an entirely different conversation.)

As to the dollar, while it has wandered aimlessly for the past few sessions, I get the sneaking suspicion that it is headed for another test of its recent highs as I believe bond yields remain the key market driver, and that move is not nearly over.

Good luck and stay safe
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On Edge

Posted on by

Two fears have the market on edge
Inflation that many allege
Will drive bond yields higher
Thus, causing a dire
Result, pushing stocks off the ledge

But right now, the bulls rule the roost
As inflation has not been produced
So, Jay and Christine
Have no need to wean
The market from QE’s large boost

Yesterday morning’s CPI release was a touch softer than expected, thus helping to abate fears of the much-mooted inflationary surge arriving soon.  (PS, it is clear that starting next month the CPI data will be much higher, given the year over year comps, with the key question being will that continue through the summer and beyond.)  In the meantime, bond investors, who had clearly been concerned over the rising inflation story, relaxed a bit and bought more Treasuries.  The result was that the early morning rise in yields was unwound.  Of course, the other big news yesterday was the 10-year Treasury auction which was received by the market with general aplomb.  While there was a 1 basis point tail, the bid-to-cover ratio at 2.37 was right in line with recent averages.  One little hiccup, though, was indirect bidders (usually foreign governments) continued their declining participation, falling to 56.8%, with the implication that natural demand for Treasuries is truly sinking.  This latter point is critical because, given the amount of new money the Treasury will need to borrow this year and going forward, it will increase pressure on the Fed to absorb more (i.e. increase QE), or yields will definitely climb.

However, that apparently, is a story for another day.  Equity markets reveled in the low inflation print and modest bond market rally, while the dollar fell pretty much across the board, reversing all of its early gains.

Which brings us to this morning’s ECB meeting, where the question is not about a change in policy, as quite clearly no policy change is in the offing, but rather about the ECB’s utilization and reaction function of its current policy programs.  While sovereign yields have stabilized for the past several sessions, the fact remains that they have not fallen back anywhere near the levels seen at the beginning of the year.  The question market participants have is exactly what will constitute a tightening in financial conditions that might bring a response.

As mentioned yesterday, the ECB has been consistently underutilizing the PEPP compared to recent months, with weekly purchases falling to a net €12 billion despite the rise in yields.  So, it would seem that the ECB does not believe the current yield framework is a hindrance to the economy.  However, you can be sure that Madame Lagarde will field several questions on the topic at this morning’s press conference as market participants try to determine the ECB’s pain threshold.  The last we heard on the topic was that they were carefully watching the market with some of the more dovish members calling for a more active stance to prevent a further climb in yields.

And remember, the ECB is not only focused on sovereign yields, but on the exchange rate as well, which is also officially a key indicator.  With the US inflation story getting beaten back, and US yields slipping, the euro’s concomitant rise will not be welcome.  Now, we remain well below the early January highs in the single currency, but if the euro has bottomed, and more importantly starts that long-term rise that is so widely expected, the ECB will find themselves in yet another sticky situation.  These, however, are stories for a future date, as today the euro is firmly in the middle of recent ranges while sovereign yields are slipping a bit.

With two potential landmines behind us, risk appetite has been reawakened, with asset purchases across virtually all classes.  For instance, overnight saw equity market strength across the board (Nikkei +0.6%, Hang Seng +1.65%, Shanghai +2.4%) although Europe’s early gains have mostly diminished and markets are little changed ahead of the ECB (DAX -0.1%, CAC +0.1%, FTSE 100 -0.35%).  US futures, though, are largely booming, led by the NASDAQ (+1.9%) but seeing solid gains in the other indices as well.

On the bond front, Treasury yields are lower by 1.9 basis points, back to 1.50%, while we are seeing more modest declines in the major European bond markets, on the order of 0.5bps for all of them.

Oil prices are firmly higher (WTI +1.2%) as is the entire energy complex.  Metals prices, too, are rising with both precious and base seeing a resumption of demand.  Meanwhile agricultural prices are generally moving up in sync.  Once again, to the extent that commodity price rises are a harbinger of future inflation, the signs are clearly pointing in that direction.

The dollar, meanwhile, which reversed yesterday’s early gains to close lower across the board, has continued in that direction with further losses this morning.  CHF (+0.5%) leads the way in the G10, which given the fact it had been the biggest loser over the past month, falling more than 5.6%, should be no surprise.  But the rest of the bloc is seeing gains in the commodity focused currencies with AUD (+0.45%), NZD (+0.4%) and CAD (+0.3%) next in line.  Perhaps the biggest surprise is that NOK (0.0%) is not along for the ride.

EMG currencies are also broadly firmer led by BRL (+1.6%) which is following on yesterday’s 2.5% rally as the central bank has been actively intervening to stem the real’s recent weakness.  Concerns remain over rising inflation, and expectations for rising policy rates are growing there, which would likely support the currency even more.  But we are seeing strength in ZAR (+1.0%), CLP (+1.0%) and MXN (+0.65%) as well, clearly all benefitting from the commodity story.  However, virtually the entire bloc is firmer given today’s increasing risk-on attitude.

Aside from the ECB meeting, with the statement published at 7:45 and the press conference at 8:30, we see Initial Claims (exp 725K), Continuing Claims (4.2M) and the JOLTs Job Openings survey (6.7M).  Again, no Fed speakers so look for the dollar to follow risk attitude and the movement in real yields.  Those are both pointing toward a lower dollar as the day progresses, and I see no reason to fight that absent comments from a surprising source.  Unless Madame Lagarde fumbles the press conference, look for this little risk bounce to continue.

Good luck and stay safe
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Right From the Script

Posted on by

While last night, the 10-year yield slipped
It’s still reading right from the script
Of trading much higher
As growth does transpire
And vaccines are rapidly shipped
 
Investors, though, caution, have shown
As high yields have caused a full-blown
Correction in tech
And currency wreck
Just proving the future’s unknown
 
Price action throughout markets overnight has largely been a correction of what has turned out to be a surprising rout in tech stocks and a surprising rally in the dollar.  Quickly recapping the consensus views as the year began, the combination of more fiscal and monetary stimulus and a ramped up vaccination rate would lead to a reopening of the US (and world) economy, much faster growth, higher Treasury yields, rising stock prices and a weaker dollar as increased risk appetite led to dollar selling.  Positioning for those views was both widespread and large as investors looked forward to another banner year.  Oops!
 
As so often happens in markets, even if views are correct in the long run, when a new consensus is reached it means that, pretty much all the investment that is heading in that direction has already arrived, and the result is that those positions tend to lose out as the excitement fades.  And arguably, that is what we have seen in general, although not universally.  Despite last night’s modest bond rally (Treasury yields -5.9bps), the yield curve remains both higher and steeper than at the beginning of the year and appears to have room for further movement in that direction.
 
One of the strongest views that exists is that the Fed will not (cannot) allow Treasury yields to rise beyond a certain, unknown, point, as the cost to the government would be devastating.  That has certainly been my view and informs my belief that when that happens, the dollar will reverse its recent strength and decline sharply alongside real US yields.  But what if the Fed means what they say when describing the rise in long-term yields as a good thing?  How might that play out?
 
The first thing to note is that the yield curve (which I will define as the 2yr-10yr spread) is currently at 137bps, obviously well above the levels seen at the beginning of the year and showing no signs of stopping.  The one thing of which we can be confident right now is that the 2yr yield seems unlikely to move with the Fed maintaining ZIRP up front, so the spread will be entirely dependent on the movement in the 10-year.  But a quick look at the history of the spread shows that the current level is merely in the middle of the range with at least five different times in the past 30 years where this spread rose well over 200 basis points, the most recent being during the Taper Tantrum in 2013 when it reached 260 basis points.  Now, ask yourself what would happen if 10-year Treasury yields rose to 2.75%.  How do you think that would play out in the equity market?  In FX? And for the economy as a whole?
 
Arguably, this type of interest rate movement would be the result of much faster growth and inflation in the US than currently forecast and seen elsewhere in the world.  (As an aside, the OECD today raised their forecast for US GDP growth in 2021 to 6.5%).  If that forecast is accurate, and if inflation simply gets to the Fed’s 2.0% target, that means nominal GDP will be 8.5%!  How can that square with a 10-year yield of 2.75%, let alone today’s 1.55%.  It would seem that something has to give here.  Two potential relief valves are the dollar, which would need to rally much more sharply than we have seen (think EURUSD at 1.05-1.10) or inflation rising more than 2.0%, perhaps as high as 3.5%-4.0%.  History has shown that in situations like that, equity markets tend to underperform.  And maybe that’s the key.  Most of these forecasts for the strong equity, higher interest rate, weaker dollar outcome were based on the idea that central banks and governments could find the perfect mix of policies to achieve these goals.  If there is anything about which we can be sure, other than 2-year yields are not going to rise, it is that neither central banks nor governments have any idea what the proper mix of policies is to achieve those goals.  This is why economic and market activity remain volatile, because the constant tweaks and changes have many unexpected side effects.
 
This is not to imply that the yield curve is going to steepen that much, just that it cannot be ruled out, and if that happens, you need to be ready for a great deal more market volatility.
 
Which takes us to the current session. 
 
In China, the powers that be
Are worried they’re starting to see
A market decline
That could well define
New weakness in President Xi
 
Overnight saw mixed risk appetite with both the Nikkei (+1.0%) and Hang Seng (+0.8%) rising, but Shanghai (-1.8%) having a rough session.  In fact, the decline in stocks on the mainland has been so great that the Chinese government has called in the plunge protection team, which saw action last night to try to prevent a further rout (Shanghai -10% in pat 3 weeks), although obviously they were unable to prevent the process continuing.  As China continues to register concern over bubbles, it is reasonable to expect further declines in this market, as well as many of the other Asian markets that are linked.
 
Europe, on the other hand, is feeling better this morning with gains pretty much across the board (DAX +0.3%, CAC +0.3%, FTE 100 +0.6%), which seem to have ignored modes downward revisions to some Q4 economic data (GDP -0.7%).  And finally, US futures are all firmly higher, notably NASDAQ (+2.2%), which is rebounding from its 11% decline over the past 3 weeks.
 
European bond markets are rallying alongside Treasuries, with Bunds (-5.3bps) and OATs (-5.2bps) a good descriptor of the entire continent’s price action.  Given the type of movement we have seen throughout government bonds worldwide, it would not be a huge surprise to see a further correction before the next leg higher in yields.
 
On the commodity front, oil prices are leading things higher (+0.6%) although the decline in yields has also supported gold (+1.4%) which is coming off a very difficult stretch.  Base metals are mixed as are agriculturals, with the current price action almost certainly a consolidation before the next leg higher for both segments.
 
And finally, the dollar, which is almost universally weaker this morning.  In the G10, AUD (+0.65%) is the leading gainer, but is merely emblematic of the commodity price action as we have seen the other commodity linked currencies in this bloc perform well (NOK +0.6%, CAD +0.45%).  In the EMG space, TRY (+1.5%) is the leading gainer, which during a risk on session is quite normal, with ZAR (+0.9%) and MXN (+0.8%) joining in the fun.  CE4 currencies are also performing well (CZK +0.8%, PLN +0.6%).  However, there are a couple of laggards, notably BRL (-0.7%), KRW (-0.6%) and TWD (-0.5%).  The latter two suffered from ongoing equity outflows from international investors, linked to China’s equity woes, while BRL is suffering from concerns over new political problems President Bolsonaro.
 
On the data front, NFIB Small Business Optimism was released this morning at a worse than expected 95.8, which, while better than expected, demonstrates some still ongoing concerns over the state of the economy.  Clearly, there are no Fed speakers today, so FX is very likely to follow the risk appetite today.  This modest dollar correction lower seems more like a reaction to what had been a surprisingly powerful dollar rally than a reversal.  So my gut tells me that the dollar will rebound along with yields as the week progresses.
 
Good luck and stay safe
Adf