Tag Archives: #riskon

Their Bond Vigilantes

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Down Under, the RBA bought
Four billion in bonds as they fought
Their bond vigilantes
Who came back from Dante’s
Ninth circle with havoc they wrought

Investors responded by buying
More bonds and more stocks fortifying
The view central banks
All still deserve thanks
For making sure markets keep flying

Atop the reading list of every G10 central banker is the book written by Mario Draghi in 2012 and titled, How to Keep Interest Rates Lower for Longer*, and every one of those bankers is glued to page one.  At this point, there is no indication that higher interest rates will be tolerated for any length of time, and while jawboning is always the preferred method of moving markets in the desired direction, sometimes these bankers realize they must act.  And act they did, well at least Phillip Lowe, the RBA Governor, did.  Last night, the RBA bought $4 billion in 3-year ACGB’s, doubling the normal and expected amount of purchases as he fought back against the idea that the RBA would not be able to maintain control of the yield curve as they have announced.  The response must have been quite gratifying as not only did 3-year yields nose back below 0.10%, the target, but 10-year yields tumbled 0.25% as investors regained their confidence and took advantage of the sudden increase in yields available to increase their holdings.

So, last week’s price action is now deemed to have been nothing more than a hiccup, or a bad dream, with market activity today seen as the reality.  At least that is the story all the world’s central banks keep telling themselves, and arguably will continue to do for as long as possible.  It seems that the fact the RBA was willing to be so aggressive was seen by investors as a harbinger of what other central banks are willing and capable of enacting with the result being a massive asset rally worldwide.  Think about that for a moment, the purchase of an extra $1.5 billion of ACGBs has resulted in asset price increases on the order of $1 trillion worldwide.  That, my friends, is bang for your buck!

Of course, the question that remains is, will investors continue to accept this worldview, or will data, and ever-increasing debt supply, return us to last week’s market volatility and force a much bigger response by much bigger players?  My money is on the latter, as there is no sign that deficit spending is being reined in, and the signs of higher inflation remain clear, even in Europe!

But clearly, today is not one for calling out central bankers.  While ongoing conversations in Tokyo highlight the question of whether the BOJ needs to intervene ahead of their mid-month meeting when they are to present their Policy Review, and ECB members continue to warn about unwarranted tightening of financial conditions, thus far, we have not seen any increase in activity by either central bank.  However, at 9:45 this morning we will see the latest data from the ECB regarding their purchases during the last week in the PEPP, and it will be instructive to see if those purchases increased, or if they simply maintained their regular pace of activity.  An increase could be taken positively, shoring up investor belief that the ECB has their back, but given how poorly the European government bond market performed last week, it could also be seen as a sign that the ECB is losing its sway in markets.

The one truism is that market volatility, despite central banks’ fervent desire for it to decrease, remains on a higher trajectory as the possible economic outcomes for the world as a whole, as well as for individual countries, diverge.  And this is, perhaps, the hardest thing for investors to accept and understand; after a forty year period of declining inflation and volatility, if the cycle is turning back higher for both of these characteristics, which have a high correlation, then the future will be more difficult to navigate than the recent past.

So, just how impressive was the RBA’s action?  Pretty impressive.  For instance, equity markets in Asia all rose sharply (Nikkei +2.4%, Hang Sent +1.6%, Shanghai +1.2%) and are all higher in Europe as well (DAX +0.7%, CAC +1.1%, FTSE 100 +1.0%).  US futures, meanwhile, are powering ahead by approximately 1.0% across the board.

As to bonds, while the ACGB move was the most impressive, we did see a halt to the rise in 10-year JGB yields, and in Europe, the rally is powerful with Bunds (-5.0bps), OATs (-5.5bps) and Gilts (-4.1bps) all paring back those yield hikes from last week.  Interestingly, Treasury yields (+2.2bps) are not holding to this analysis, as perhaps the news that the $1.9 trillion stimulus package passed the House this weekend has investors a bit more nervous.  After all, passage implies increased issuance of $1.9 trillion, and it remains an open question as to how much demand there will be for these new bonds, especially after last week’s disastrous 7-year auction.  And that’s really the key question, will there be natural demand for all this additional paper, or will the Fed need to expand QE in order to prevent yields from rising further?

On the commodity front, we are seeing strength across the board with oil (+1.0%) leading energy higher on the reflation idea, both base and precious metals markets rallying and agricultural products seeing their ongoing rallies continue.  Stuff continues to cost more, despite the Fed’s claims of low inflation.

As to the dollar, it is mixed this morning, with commodity currencies performing well (NOK +0.4%, CAD +0.35%, AUD +0.3%) while the European commodity users are all under pressure (SEK -0.5%, CHF -0.5%, EUR -0.25%).  The euro’s weakness seems a bit strange given the manufacturing PMI data released this morning was positive and better than expected.  As well, German CPI, which is released on a state by state basis, is showing a continued gradual increase.

In the emerging markets, TRY (+2.5%) is the runaway leader as the lira offers the highest real yields around and as fear recedes, hot money flows there quickest.  But away from that, RUB (+0.6%) on the back of oil’s rally, and CLP (+0.45%) on the back of copper’s ongoing rally are the best performers.  With the euro softer, the CE4 are all weaker and we saw desultory price action in Asian currencies overnight.

On the data front, this is a big week, culminating in the payroll report.

Today ISM Manufacturing 58.6
ISM Prices Paid 80.0
Wednesday ADP Unemployment 180K
ISM Services 58.6
Fed’s Beige Book
Thursday Initial Claims 755K
Continuing Claims 4.3M
Nonfarm Productivity -4.7%
Unit Labor Costs 6.7%
Factory Orders 1.8%
Friday Nonfarm Payrolls 180K
Private Payrolls 190K
Manufacturing Payrolls 10K
Unemployment Rate 6.4%
Participation Rate 61.4%
Average Hourly Earnings 0.2% (5.3% Y/Y)
Average Weekly Hours 34.9
Trade Balance -$67.4B
Consumer Credit $12.0B

Source: Bloomberg

In addition to all this, we hear from Chairman Powell on Thursday, as well as six other Fed speakers a total of nine times this week.  But we already know what they are going to say, rising long end yields are a positive sign of growth and with unemployment so high, we are a long way from changing our policy.  History shows that the market will test those comments, especially once the Fed goes into its quiet period at the end of the week.

As for today, risk is quite clearly ‘on’ and it seems unlikely that will change without a completely new catalyst.  The RBA has fired the shot across the bow of the pessimists, and for now it is working.  While the euro seems to be under pressure on the assumption the ECB will act as well, as long as commodities continue to rally, that is likely to support the growth story and commodity currencies.

Good luck and stay safe
Adf

*a fictional work conceived by the author

Tempt the Fates

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For everyone, here’s a hot flash
The Treasury’s bagful of cash
May soon start to shrink
And analysts think
That could lead to quite the backlash

The Fed might be forced to raise rates
A prospect that could tempt the fates
How might stocks respond
If the 10-year bond
Sees yields rise as growth now reflates?

You cannot scan the financial headlines these days without seeing a story about either, the extraordinarily low interest rates that non-investment grade credits are paying for money (the average junk bond yield is now below 4.0%, a record low) or about the remarkable bullishness exhibited by investors regarding the future of the stock market given the ongoing reflation story and expected future growth once the pandemic subsides.  In other words, risk is on baby!

But is it really that simple?  There are those, present company included, who believe that the current situation is untenable, and that the future (for markets anyway) may not be as rosy as currently believed.

Consider the following: last summer, as Treasury bond yields were making new all-time lows, we saw a spectacular amount of investment in the stock market, with a particular concentration in companies that were deemed to be beneficiaries of the lockdowns and evolution toward working from home.  These (mostly) tech names have carried the broad indices to record after record and, quite frankly, don’t seem to be slowing down.  Essentially, it could be argued that the tech mega-cap stocks were acting as a substitute for Treasuries, and that the relationship between the stock and bond markets had evolved.  After all, if interest rates were going to remain permanently low, courtesy of the central banks, then it was far better to seek yield in the stock market.  and the situation was that the yield from the S&P 500, at 1.57%, was substantially higher than the yield on 10-year Treasuries, which traded between 0.6%-0.85% for months.  One could define this ‘equity risk premium’ as ~0.80%, give or take, and when combined with the growth prospects it was deemed more than sufficient.

But that was then.  Lately, as the reflation story has really started to pick up, we have seen the Treasury steepener trade come to the fore.  The spread between 2y and 10y Treasuries has risen to 1.13%, its highest level since early 2017 and up from the ~0.50% level seen last summer.  Not only that, but the strong consensus view is that there is further room for 10-yr and longer yields to rise.  After all, expectations are that the Treasury will be issuing another $1.9 trillion of bonds to pay for the mooted stimulus package, and all that supply will simply add pressure to the bond market, driving yields higher.

However, if the bond market story is correct, what does that say about the future of the equity market?  From a positioning perspective, it can be argued that being long the stock market, especially the NASDAQ, is akin to being short a put on the Treasury market (h/t Julian Brigden for the analogy).  In other words, if the premium required to own stocks over bonds is 0.8% of yield, and if the 10-year yield continues to rise to 1.50% (it is higher by 4 more basis points this morning), that means the dividend yield on stocks needs to rise to 2.3% to restore the relationship.  Doing the math shows that stock prices would need to decline by…33% to drive yields that much higher!  I’m pretty sure, that is not in the reflation story playbook, but then I’m just an FX salesman.

Which brings us back to the Treasury and the Fed.  The Treasury, during the pandemic, has maintained an extraordinarily high level of cash balances at the Fed, roughly $1.6 trillion, far above its more normal $500-$600 billion.  It seems that Secretary Yellen is looking to draw down those balances (arguably to spend money), which means that the likely market response will be much lower front-end yields, with the possibility of negative rates in the T-bill market quite realistic.  This outcome is something which the Fed would deeply like to avoid, and so they may find themselves in a situation where they need to raise IOER and the reverse repo rates in order to encourage banks to maintain the cash as reserves, like they currently are, instead of having them flow to the T-Bill market driving rates lower.  But how will the markets respond if the Fed raises rates, even if it is IOER and even though it will surely be described as a technical adjustment?  It could be completely benign.  But given that this is truly ‘inside baseball’ with respect to the markets functioning, it could also easily be misinterpreted as the Fed starting to remove liquidity from the markets.  And that, my friends, would not be taken lightly.

Summing all this up leaves us with the following: Treasury yields continue to rise on the reflation trade and pressure is coming to the front end of the curve which could result in the Fed acting to make technical adjustments to raise rates there.  The combination of these two events could easily result in a repricing of equity markets of some substance.  It would also result in a tightening of financial conditions, something the Fed is very keen to prevent, which means the story would not end here.

And how would this impact the dollar?  Well, the combination of higher rates and risk reduction would likely see a strong, initial bid in the buck.  But this is where the idea of the Fed capping yields comes into play.  A reflating (inflating) economy with rising yields will be quite problematic for the US government and with the justification of tighter financial conditions, the Fed will smoothly pivot to extending QE tenors if not outright YCC.  And that will halt the dollar’s rise, although not inflation’s, and the much-vaunted dollar weakness is likely to be a result.  But as I have said consistently, that is a H2 event for this year.

So, has that impacted markets negatively today?  Not even close.  Risk remains in favor as we saw the Nikkei (+1.3%) and Hang Seng (+1.9%) both rise sharply.  Shanghai remains closed until Thursday.  Europe, however, has been a bit more circumspect with very modest equity gains there (CAC +0.1%, DAX 0.0%, FTSE 100 +0.15%) although US futures are higher by roughly 0.5% across the board.

Bond markets are continuing to sell off, even after yesterday’s sharp declines.  Treasuries, this morning, are higher by 5bps now, while bunds (+2.1bps), OATs (+2.5bps) and Gilts (+3.7bps) are following yesterday’s moves further.  In fact, bund yields are now pushing toward their post-pandemic highs.

On the commodity front, oil continues to perform well, although WTI is benefitting from the ongoing problems in the Midwest where production is being shut in because of the bitter cold and ice thus reducing supply further.  Meanwhile, base metals are modestly higher, but precious metals are unchanged.

Finally, the dollar remains under pressure and for those who thought that the correction had further to run, it is becoming clear that this gradual depreciation is back.  Of course, with risk in demand, the dollar typically suffers.  In the G10, NZD (+0.5%) is the leading gainer although the entire bloc of European currencies is higher by about 0.3%.  The kiwi story seems to be expectations for eased pandemic restrictions to enable further growth, and hence reflation.  But given the dollar’s broad-based weakness, I don’t ascribe too much to any particular story here.

In the EMG bloc, there are more winners than losers, but the gains are not that substantial.  TRY (+0.6%) continues to benefit from the tighter monetary stance of the new central bank governor, while CLP (+0.6%) seems to be the beneficiary of higher copper prices.  On the downside, PHP (-0.6%) is the laggard, falling after both a sharp rise yesterday and news that foreign remittances and foreign reserves both declined in January.  But the rest of the movement here is much smaller in either direction and the main story remains broad dollar weakness

On the data front, this morning we saw that the German ZEW Expectations Survey was much better than expected despite the ongoing lockdowns across the continent.  Here, at home, we get Empire Manufacturing (exp 6.0), which seems unlikely to move things, but then we hear from three Fed speakers, ranging from the erstwhile hawkish Esther George to the unrequited dove Mary Daly.  But any change of message would be shocking.

And that’s it for the day.  With risk continuing to be embraced, the dollar is likely to remain under pressure.

Good luck and stay safe
Adf

A Wonderful Place

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The world is a wonderful place
As evidenced by today’s race
Twixt stock market gains
And bond market strains
While dollars proceed to debase

It seems a bit unusual, but the animal spirits are out in force today as risk is being snapped up everywhere in the world while haven assets are being shunned.  It is unusual because there is no discernible catalyst for this behavior, but the risk impulse is strong.  For instance, a quick scan of the headlines shows that there was a powerful (magnitude 7.3) earthquake in Fukushima, Japan this weekend, although fortunately, while there has been some property damage, there has been no reported loss of life.  Ten years ago, almost to the day, Japan suffered the Tohoku earthquake in the same region, with a much more powerful reading (magnitude 9.3, and remember the Richter Scale is logarithmic, so 9.3 is 100x more powerful than 7.3).  At any rate, it seems hard to believe that was a signal to buy risk.

Other stories are the deep freeze throughout the middle of the US, with Texas suffering greatly, as up to 2 million residents will have lost power today.  Again, hardly a catalyst to buy risk, although it has certainly helped push up energy prices as WTI (+2.1%) is back above $60/bbl for the first time since November 2018.  On the virus front, infection rates seem to be declining and vaccinations are slowly increasing, so that is certainly a positive, but that has been ongoing for the past several weeks, this is not new news, and so doesn’t seem a likely candidate as a risk-on catalyst.  On the political front, former President Trump was acquitted, again, on an impeachment proceeding, but markets have been pretty clear in the fact that they do not respond to purely political memes.  Politics only matters when it impacts policies that will impact markets, like the fight over the current stimulus package.

And yet, risk is clearly in demand today as evidenced by equity market price action around the world, (Nikkei +1.9%, FTSE 100 +1.6%, CAC +1.25%, DAX +0.35%) and bond market price action in Europe (Treasury markets are closed today) with Gilts (+5.4bps), Bunds (+4.0bps), OATs (+3.9bps) all selling off sharply and the rest of the continent following suit.  Even JGBs (+1.3bps) sold off and Australian government bonds had the biggest move (+10.1bps, despite YCC in place in the 3-year space) as not only did the government issue more debt, but there was increased talk of the reflation trade with expectations that economic growth was going to pick up sooner led by the US.

And I guess, this is the story driving markets today, an increasing confidence that we are past the worst impact of the coronavirus and that the continuous fiscal and monetary support that is coming from governments and central banks around the world will feed into risk assets and drive prices ever higher.  So, it is not one catalyst, but a confluence of stories that are doing the job.  In the end, it would seem there are two questions to be answered though; first, have equity markets already priced in all the benefits of the recovery in economies worldwide?  And second, will all of that excess financial support, from both fiscal and monetary policy ease, result in higher, and possibly much higher, measured inflation?

As of today, neither of these seem to be a concern, but many very smart folks, with long experience in markets and economics, are asking those two questions as the answers will have a huge impact on our lives going forward.  We will try to explore these starting tomorrow.

In the meantime, the risk impulse is quite evident in major markets around the world.  In fact, the only one I have not discussed is FX, where the traditional risk-on behavior is in full bloom.  The dollar is weaker vs. essentially all its major counterparts except the yen, which has weakened 0.35%.  But looking at the rest of the G10, we see NOK (+0.5%) leading the way on the oil rally, followed by GBP (+0.4%), which has rallied to its strongest level, above 1.39, since April 2018.  The pound’s strength seems predicated on the ongoing success the UK has had in vaccinating its population, with more than 15 million doses of the vaccine having been given, meaning upwards of a quarter of the population as been given at least the first dose.  That pace is far ahead of anywhere except Israel, and certainly dominates the large nations.  As to the rest of the G10, gains are uniform, but small.

Turning to EMG currencies, TRY (+1.0%) is the leader today followed by ZAR (+0.8%), with the former continuing to benefit from the strong words of the new central bank chief who has been adamant that he will maintain higher rates to fight inflation, which helps to draw investors in a ZIRP world.  ZAR, too, is the beneficiary of its relatively higher interest rates and remains a destination of choice for those seeking yield.  But essentially, the entire bloc is firmer barring two currencies, THB and HUF that have fallen less than 0.1%.  This is a risk-on, dollar selling day, it is that simple.

On the data front, with today’s holiday, nothing is to be released here in the US, but we do get several interesting reports this week:

Tuesday Empire Manufacturing 6.0
Wednesday PPI 0.4% (0.9% Y/Y)
-ex food & energy 0.2% (1.1% Y/Y)
Retail Sales 1.0%
-ex autos 0.9%
IP 0.4%
Capacity Utilization 74.8%
Business Inventories 0.5%
FOMC Minutes
Thursday Initial Claims 773K
Continuing Claims 4.423M
Housing Starts 1658K
Building Permits 1677K
Philly Fed 20.0
Friday Existing Home Sales 6.61M

Source: Bloomberg

Aside from this data, with arguably Retail Sales being the highlight, and the FOMC Minutes, we also hear from 9 different Fed speakers this week, although none of the big guns, and given Chairman Powell is clearly uninterested in even thinking about thinking about tighter policy, I don’t think we will learn too much.  The next big Fed issue will arise when inflation readings start to rise much faster than expected and the yield curve continues to steepen.  At that point, will the Fed watch and wait?  Or will they act?  But that is a summer question, not a Q1, or even Q2 event.

So, on this President’s Day holiday, I see nothing that will stop the risk-on meme, thus, a modestly softer dollar seems quite reasonable.  We are here to help if you need something, although I assure you, come noon, when London goes home, markets will be essentially done.

Good luck and stay safe
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Our Dovish Song

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Said Powell, you all would be wrong,
Til progress moves further along,
On jobs and inflation
To think there’s causation
For us to change our dovish song

I challenge anyone to put forward the name of a central bank board member, from any major central bank, who is anything but dovish.  Once upon a time there was a spectrum of views ranging from neo-Keynesians, who believed it was the central bank’s job to continually support economic activity to the Austrian scholars, who believed that the less central bank activity, the better.  The neo-Keynesians pushed to maintain the lowest interest rates possible to encourage capital investment and by extension further economic growth.  They were far less concerned with price implications and far more concerned with the employment situation.  The Austrians were highly focused on price stability and believed that stable prices allowed people to have the confidence to create products and services demanded by the public, which would drive economic growth.  And there was a great middle with central bankers adhering to some of those views, but willing to be pragmatic.

But that is all ancient history now as there is only one type of central banker left in the world, the uber-dove.  Literally, every comment made by any central banker, whether from the Fed, the ECB, the BOJ, the BOE or anyplace else, describes the need, not only for ongoing easy money, but for massive fiscal stimulus as well.  There isn’t even a lone, voice in the wilderness, arguing the other side anymore.  The financialization of economies, which itself is the result of more than a decade of easy money, has resulted in an evolution of views.  In essence, interest rates, per se, are not the focus, but financial conditions.  And one of the key variables in every central bank measure of financial conditions is the price of the stock market indices.  A higher stock market means easier money, in this model, and so leads to further growth.  I fear they have the causality backwards (easy money leads to a higher stock market), but my views don’t matter.  Even formerly staunch monetary hawks, notably the Bundesbankers, are all-in for more stimulus and see no reason to consider any potential negative consequences of these actions.

This was made clear once again yesterday by comments from Lagarde, Powell and Bailey, all of whom continue to explain that their respective central bank will do whatever is necessary to support the economy, and, oh by the way, more fiscal stimulus is necessary as they can’t do it all by themselves.  While current central bank messaging tells us rates will remain low until at least 2023, look for that terminal date to continue to get pushed back.  We have already seen this play out for the ECB, where in 2018, they tried to explain that rates would begin to normalize by the end of 2020.  We all know that never happened.  Now they claim when the PPE uses up its authorization in 2022, that will be enough.  But it won’t.  They will simply expand and extend the terms again.  Here at home, we have already heard from numerous Fed speakers that if inflation were to rise to 2.5% or 3.0%, they wouldn’t be concerned.  And Powell, yesterday, was clear that more fiscal stimulus was needed to help the economy, and that the Fed would be adding even more liquidity until “substantial further progress” is made toward their goals.

So, what does this mean for markets?  It means that the inflation of asset price bubbles will continue, and that when looking at foreign exchange, the question will be which nation will maintain the easiest (or tightest) relative policy.  The broad view remains the Fed has more firepower than any other central bank, which is a key reason so many (present company included) believe the dollar will eventually decline.  But it will not be without a fight.  No other country believes they can afford for their own currency to appreciate or they won’t be able to achieve their goals.  Perhaps the real question is, what will be the catalyst to stop the flow of easy money?  And truthfully, I cannot see one on the horizon.  Traditionally, it would have been a rise in inflation, but that would be warmly welcomed by the current central bank heads, so there is really nothing left.

But perhaps, we are seeing a bit of fatigue on investors’ parts, as the trend higher in asset prices seems to have stalled for a time.  Certainly, there has been no decline of note, but it is not racing up like it had previously.  Does this mean the end is near?  I doubt it.  But remember this, when the last black swan appeared, Covid, central banks, notably the Fed, had some monetary policy room to adjust rates and try to address the problem.  When that next rare black avian appears, with rates already at zero or negative throughout the G10, what do they do next?

And on that cheery thought, let’s take a quick tour of what has been a pretty dull overnight session, where the Lunar New Year has begun to be celebrated.  In Asia, only the Hang Seng (+0.45%) was open with Japan closed for Coming of Age day, and Shanghai celebrating New Year’s.  PS, the Chinese celebration lasts for a full week.  In Europe, stocks started off mixed, but have edged higher over the past few hours with the DAX (+0.6%) leading the way followed by the FTSE 100 (+0.1%) and finally the CAC essentially unchanged on the day.  US futures markets are all higher, led by the NASDAQ (+0.5%) with the other two key indices up around 0.3%.

Bond markets, despite the growing positivity in stocks, are pretty healthy today as well.  Perhaps the never-ending promises by central bankers to continue to buy bonds is helping.  So, while Treasury yields are essentially unchanged, in Europe, Bunds, OATs and Gilts have all seen yields decline by about 2.3 basis points, and that price action is consistent across the smaller markets as well.

Oil (-0.7%) is lower today for a true change of pace, as it has rallied for the previous eight consecutive sessions.  Arguably, this is simply a trading pause, as there is no news of note that would drive the market.  Meanwhile, gold is unchanged on the day, although there is strength in the base metals space while ags remain mixed.

As to the dollar, it is under very modest pressure this morning, with AUD (+0.35%) the leading gainer in the G10 after mildly positive comments from the Treasury Secretary there.  But away from this, no other currency has moved even 0.2%, indicating there is nothing happening.  In the emerging markets, LATAM currencies are the leaders (CLP +0.8%, BRL +0.6%, MXN +0.5%) although don’t count out ZAR (+0.75%) either.  The ZAR story is a response to much better than expected mining production data while CLP has seen investor inflows into the bond market increase and Brazil is benefitting from a bill just passed granting autonomy to the central bank.  Be careful on MXN, as Banxico meets today and is expected to cut interest rates again, with a 25bp cut priced into the market, but some looking for more.

On the data front, yesterday’s CPI data was a bit softer than forecast, but didn’t seem to have much impact on the markets, although the dollar did edge lower after the release.  This morning, Initial Claims (exp 760K) and Continuing Claims (4.42M) are all we get and there are no Fed speakers slated.  So, on this snowy day in the northeast, I would look for the dollar to remain rangebound as it seeks its next catalyst.  To my eyes, the correction appears to be over, but we will need something else to get the dollar selling bandwagon rolling again.

Good luck and stay safe
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De Minimis Sellin’

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There once was a Fed Chair named Yellen
Whose term saw di minimis sellin’
Of bonds or of stocks
As from her soapbox
She promised a balance sheet swellin’

But now she’s the Treasury Sec
And her goal’s to get a blank check
For spending, not saving
Though that might be paving
The way to a financial wreck

Investors continue to add to their risk portfolios this morning amid the never-ending hopes for yet more fiscal stimulus from the US.  This can be seen most clearly from the combination of rising stock prices and rising bond yields.  In classic risk-on fashion, the ongoing speculative mania continues to drive equity markets higher around the world.  Asia is uniformly green, with the Nikkei (+2.1%) leading the way but strength in Shanghai (+1.0%) and Hong Kong (+0.1%).  The concern for the latter has to do with the upcoming Lunar New Year holiday and the fact that the link between the mainland and Hong Kong stock markets will be turned off during that period, thus reducing inflows. Meanwhile, Europe is also firmer across the board with Italy’s FTSE MIB (+1.4%) the leader as investors gain confidence that Super Mario Draghi will be as “successful” a PM as he was an ECB President.  But the FTSE 100 (+0.95%), CAC (+0.6%) and DAX (+0.3%) are all firmer with the DAX lagging on the back of weaker than expected IP data (0.0%, exp +0.3%) indicating that the ongoing lockdowns in Germany, which are slated to continue for another 6 to 8 weeks, are taking a toll.  And don’t worry, US futures are all green too, higher by roughly 0.4% each.

The second piece of this puzzle is the bond market, which is behaving exactly as expected in a risk-on session by selling off nicely.  In fact, Treasury yields have touched new highs for the move with the 10-year at 1.19% (+2.9bps) while 30-year bonds have just traded to 2.00% for the first time since Feb 19 of last year, right as the Covid crisis was beginning.  But this is not an isolated US feature, we are seeing higher yields throughout Europe, Italy excepted, as Bunds (+2.6bps), OATs (+2.5bps) and Gilts (+3.3bps) are all under pressure today.  Why, you may ask, are European bond markets selling off if the story is US stimulus?  Because it’s one big global trade, and if the $1.9 trillion stimulus package gets passed, the idea is a faster US recovery will support European and Asian companies that sell into the US.

Of course, politics being what it is, even control of the House and Senate doesn’t mean that passing a bill this large is easy.  And this is where Ms Yellen comes in, she needs to forcefully make the case passage is critical for the nation’s economy.  The problem is that the recent data trend, which has been generally better than expected (excluding Friday’s jobs data) points to the fact that perhaps not so much stimulus is needed.  So, on the Sunday morning talk shows she was emphatic in her comments that it is critical, and that erring by spending too much is a significantly better mistake than spending too little.  Interestingly, even some left-leaning economists don’t back that view.  Notably, Larry Summers, former director of the National Economic Council for President Obama, and Olivier Blanchard, former chief economist at the IMF, have highlighted the risks to this package on two fronts; first, it could result in inflation and second, it may prevent the passage of other legislation focused on infrastructure and green investment deemed more important.

Now, the one thing we know about Congress is that virtually none of the members of either the House or Senate have any understanding of economics or finance.  As such, they take their cues from their financial backers staffers and the pronouncements of eminent economists from their side of the aisle.  And this is what makes the Summers and Blanchard comments noteworthy, they are both clearly left of center and both are arguing for less Covid stimulus. Janet has her work cut out for her to get what she wants.  Ironically, the fact that this package may not be passed until March is probably a positive for stocks, after all, that means another 4-6 weeks of stimulus hopes!

A quick look at commodity prices shows that virtually every commodity price is higher this morning led by oil (+1.3%), but with strength in precious metals (gold +0.4%, silver +1.0%) and agriculturals (wheat +0.7%, corn +0.6%).  Again, this is a risk-on market.

The one piece of the relation trade narrative that continues to fail, however, is the weak dollar story.  For now, before inflation data starts to rise sharply and real yields tumble, rising US rates are leading to a rising US dollar.  So, this morning the pound (-0.4%) is the laggard, but the weakness is across the board.  Even NOK (-0.1% and CAD (-0.15%) are softer despite the ongoing oil price rally.  In fact, the entire commodity bloc is suffering despite firmer commodity prices.  This is true in emerging markets as well which is led lower by ZAR (-1.0%) and both BRL (-0.7%) and MXN (-0.7%) today.  The rand story continues to be virus related as the vaccine rollout stalls given the realization that the new strain of virus is not responding well to the AstraZeneca vaccines they have.  In fact, the vaccine story is part of the LATAM problems, but of greater consequence is the fact that as US yields rise, the carry trade is becoming less attractive, and both these currencies are beneficiaries of carry.  On the plus side in EMG, KRW (+0.35%) is the best performing currency around after virus restrictions were eased somewhat amid declining infection statistics.

Speaking of statistics, it is a very quiet week on the data front, with CPI the marquis number on Wednesday.

Tuesday NFIB Small Biz Optimism 97.5
JOLTs Job Openings 6.4M
Wednesday CPI 0.3% (1.5% Y/Y)
-ex food & energy 0.2% (1.5% Y/Y)
Thursday Initial Claims 760K
Continuing Claims 4.41M
Friday Michigan Sentiment 80.9

Source: Bloomberg

Regarding the CPI data, it has printed higher than the survey in all but one month since June and given the ongoing inflationary pressures of higher commodity prices and supply chain issues, my sense is we will see that again.  On the speaking front, just three Fed speakers this week, Mester today, Bullard tomorrow and then Chairman Powell speaks Wednesday afternoon.  This makes Wednesday the day to watch.  Until then, I expect the market will focus on stimulus matters and equity prices.  If US yields continue to rise I suspect the dollar will test resistance again, with the key level in the euro at 1.1910.  Once again, nothing has changed my medium-term view about dollar weakness, and last week did see a halving of the long euro positions in the CFTC data, but for now, I feel like the dollar still has the upper hand.

Good luck and stay safe
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Money’s Still Free

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There once was a time, long ago
When traders all just had to know
If payrolls were strong
So they could go long
If not, they would sell with the flow

But these days, with ZIRP and QE
Attention’s not on NFP
Instead it’s the pace
Of central bank grace
And making sure money’s still free

One of the biggest changes in the market environment since the onset of the global pandemic has been the change in what markets find important.  This is not the first time market focus has changed, nor will it be the last, but a change has definitely occurred.  Consider, for a moment, why the market focuses so intently on certain data points.  Essentially, traders and investors are looking for the information that best describes the policy focus of the time, and therefore, changes in that information are sufficient to change opinions, at least in the short term, about markets.  And remember, that policy focus can come from one of two places, either the Fed or the Administration.

A step back in time shows that in the early 1980’s, when Paul Volcker was Fed Chair, the number that mattered the most was the M2 money supply which was reported on Thursday afternoons.  In fact, the market impact grew so large that they had to change the release time from 3:50 pm to 4:10 pm, after the stock market closed, to reduce market volatility. Trading desks would have betting pools on the number and there were a group of economists, Fed watchers, whose entire job was to observe Fed monetary activity in the markets and make estimates of this number.  At the time, the Fed would not explicitly publish their target Fed Funds rate, they would add and remove liquidity from the money markets in order to achieve it.  And, in fact, you never heard comments from FOMC members which is why Fed Chairs are now compelled to testify to Congress twice a year.

But as time passed and the economy recovered from the recession of 1980-81, the Reagan Administration became highly focused on the US Trade Balance, (especially the deficit with Japan) which became THE number right up through the early 90’s.  Once again, betting pools were common on trading desks and futures markets would move sharply in the wake of the 8:30am release.

At some point there, while Alan Greenspan was still Fed Chair, but there was a new administration, the market turned its attention away from trade and started to focus on domestic indicators, with payrolls claiming the mantle of the best indicator of economic activity.  This suited the Fed, given its mandate included employment, and it suited the Clinton Administration, given they were keen to show how well the economy was doing in order to distract the populace from various scandals.

With the change in Fed Chair from Greenspan to Ben Bernanke, the Fed suddenly became a very different source of market information.  No longer did economists need to read tea leaves, but instead the Fed told us explicitly what they were doing and where rates were set.  Thus, during the GFC, Bernanke was on the tape constantly trying to guide markets to his preferred place.  And that place was full employment, so payrolls still mattered a great deal.  Of course, the market still cared about other things, like the level of interest rates, but still, NFP was seen as the single best indicator available.  Remember, during Bernanke’s leadership, the Fed initiated the QE that began the expansion of its balance sheet and changed the way the Fed worked, seemingly forever.  No longer would the Fed adjust the reserve balances in the system, instead, they would simply post an interest rate and if supply or demand didn’t suffice to achieve that rate, they would step into the markets and smooth things out.

Payrolls were still the focus through Chair Yellen’s term, especially since her background is as a labor economist, so the employment half of the mandate was far more important to her than the inflation half, and so, if anything, NFP took on greater importance.

Jay Powell’s turn at the Fed started amid a period where the economy was getting significant fiscal support and interest rates were trying to be normalized.  In fact, the Unemployment Rate had fallen to its lowest level in more than 50 years and seemed quite stable there, so Powell seemed to have an easy job, just don’t screw things up.  Alas, his efforts to continue normalizing interest rates (aka tightening policy) resulted in a sharp equity market correction in December 2018.  The President was none too pleased with that outcome, as the Trump administration was highly focused on the stock market as a barometer of its performance.  Thus, once again, the Fed stepped in to stabilize markets, and turned from tightening policy to easing in the Powell Pivot.  And perhaps that is the real message here, the most important data point to both the Fed and every administration is not payrolls or unemployment or inflation.  It is the S&P500.

But Covid’s shock to the market was unlike anything seen in a century, at least, and arguably, given the interconnectivity of the global economy compared to the last pandemic in 1918-20, ever.  So, the first NFP data points were shocking, but the market quickly grew accustomed to numbers that would have been unthinkable just months prior.  Instead, the numbers that mattered were the infection count, and the mortality rate.  And arguably, those are still the numbers that matter, along with the vaccination rate and the stimulus size.  All of these have been the market’s primary focus since March last year, and until the idea of the government lockdown fades, are likely to continue to be the keys for market behavior.

Which brings us back to this morning, when the payroll report is to be published.  Does it really have that much impact any longer?  Or has its usefulness as an indicator faded?  Well, it seems apparent that market participants are far more intent on hearing from Fed speakers and trying to discern when monetary accommodation is going to be reduced (never) than on the jobs number.  In fact, given virtually every major central bank has explained that rates will remain at current levels for the next 3 to 4 years, at least, the only thing the data can tell us is if that will last longer than currently expected.

Ok, ahead of payrolls we have seen a general embrasure of risk, with equity markets strong, following yesterday’s US rally.  The Nikkei (+1.5%) and Hang Seng (+0.6%) both performed well although shanghai (-0.2%) slipped slightly.  In Europe, the CAC (+1.1%) leads the way followed by the DAX (+0.3%) after weak Factory order numbers (-1.9%) and the FTSE 100 (+0.1%).  US futures are currently trading higher by about 0.5% to round things out.

Bond markets are behaving as you would expect in a risk on session, with 10-year Treasuries printing at a new high yield for the move, 1.16%, up 2.1bps.  In Europe, the bond selling is greater with Bunds (+2.5bps) and Gilts (+5.3bps) getting tossed in favor of stocks.  Commodities are still in vogue, with oil (+1.0%) and gold (+0.4%) firm alongside all the base metals and agriculturals.

Finally, the dollar, is acting a bit more like expected, softening a bit while risk is being acquired.  The dollar’s recent rally alongside the equity rally seemed unusual compared to recent history, but today, things look more normal.  S,o NOK (+0.4%) and CAD (+0.3%) lead the G10 charge while JPY (-0.15%) is today’s laggard.  Clearly these stories are commodities and risk preference.  In the EMG space, APAC currencies were under a bit of pressure overnight, led by KRW (-0.4%) and MYR (-0.25%), but this morning we are seeing strength in TRY (+1.0%), RUB (+0.8%) and MXN (+0.4%) to lead the way.  The CE4 are also performing relatively well alongside modest strength in the euro (+0.2%).

Now the data:

Nonfarm Payrolls 105K
Private Payrolls 163K
Manufacturing Payrolls 30K
Unemployment Rate 6.7%
Average Hourly Earnings 0.3% (5.0% Y/Y)
Average Weekly Hours 34.7
Participation Rate 61.5%
Trade Balance -$65.7B

Source: Bloomberg

Which brings us back to the question, does it really matter?  And the answer is, not to the stock market, and therefore not really to the Fed.  However, a strong number here could well hit the bond market pretty hard as well as support the dollar more fully.  We shall see.  FWIW, I don’t believe the dollar’s correction is over, and another 1%-2% is entirely viable in the short-run.

Good luck, good weekend and stay safe
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Markets Rejoice

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He once said, “Whatever it takes”
To fix all the prior mistakes
Is what he would do
And Draghi came through
Though that was ere Covid outbreaks

But now Italy’s in a bind
As Conte, the PM, resigned
So, Draghi’s first choice
(And markets rejoice)
To lead a land that’s much maligned

***FLASH***  Mario Draghi accepts mandate to form new Italian government!

Now that GameStop fever is ebbing, far more quickly than Covid-19 I might add, it is time to look elsewhere for market drivers and sentiment.  With this in mind, we turn to the nation that puts the “I” in PIGS, Italy.  My personal experience in Italy is that it is a beautiful country, with extraordinary history and even better food.  The people are warm and welcoming, and it is truly a delightful place.  Alas, it is also, historically, one of the worst run nations on earth.  Attention to detail and a sense of urgency are two things that tend to be missing from the Italian culture, but both are necessary to be able to govern effectively.  Thus, it is not surprising that Italy has had 66 different governments since the end of WWII, with the most recent one falling two weeks ago.  The norm has been for coalitions, often fractious, to come together on short-term issues and then fall apart when longer term questions need to be addressed.

This is an apt description of the current situation, where PM Giuseppe Conte, a law professor with no previous political experience, was tapped to lead a disparate coalition of center-left and radical-left parties in an effort to prevent Matteo Salvini’s Lega Nord, a right-wing party, from taking control.  While this effort stumbled along for nearly two years, it recently foundered when a key supporter of the coalition, Matteo Renzi, withdrew his support and Conte lost a vote of no-confidence in the Italian Senate.  Conte has been unable to piece together another coalition which leaves two choices; the President, Sergio Mattarella, can appoint someone else to try to do so, or elections must be held.

Enter Mario Draghi.  Since his time as ECB President ended in 2019, he has been relatively quiet on most issues, and has not been willing to get involved in the morass of Italian politics at all.  Arguably, because of that, he remains the most popular public figure (non sports or entertainment) in the country.  And so, President Mattarella is meeting with Draghi today to ask him to form a new government with wide latitude to do “whatever it takes” to fix Italy’s many problems.  While the early word from political figures there is mixed, at best, the market thinks this is the best idea since sliced bread.  This is clear from both the equity market, where the FTSE MIB has rallied by a world-beating 2.7% today, as well as from the bond market, where BTPs have rallied sharply with yields falling 9.2 basis points and the spread to bunds has fallen to just over 100 basis points, its tightest level since 2016.

Remember, Italy has been one of the worst hit nations from Covid, as the infections appeared there early and the economy is hugely reliant on tourism and services, exactly the areas Covid destroyed.  Add to that the government’s general incompetence which has slowed the distribution of the vaccines (although in fairness, this seems to be true throughout Europe, Germany included) and you have a situation where the economy, which shrunk 9.0% in 2020, remains on course to shrink again through at least the first half of 2021.  It is not clear, by any means, that Draghi will accept the position, nor if he does, if he will be able to bring together the disparate views in the Italian congress to pass legislation that helps the situation.  But, boy, the markets are all-in on the trade!

The Draghi story has been icing on the market bullish cake this morning with risk continuing to be embraced as US stimulus talks turn away from the bipartisan idea and therefore toward a quicker passage under budget reconciliation terms (where the Senate does not have a chance to filibuster).  As well, in many nations we have seen upticks in data releases, although there are still some, notably China, where the data is falling short of estimates.

Starting with equities, Asia saw strength in the Nikkei (+1.0%) and Hang Seng (+0.2%) but Shanghai (-0.5%) fell after Caixin PMI Services data (52.0) fell short of expectations and pretty significantly from last month’s reading of 56.3.  While still above the key 50.0 level, momentum in China appears to be stalling for now.  Europe is all green, but Italy is truly the outlier.  The DAX (+0.7%) comes next and then the CAC (+0.3%) and FTSE 100 (+0.2%) are both positive, but just barely.  As to US futures, after yesterday’s strong session, with all three indices rising around 1.5%, and after some strong earnings reports yesterday afternoon, futures are higher by modest amounts, led by the NASDAQ’s 0.6% climb.

Bond markets are offering the same message, with yields higher in Treasuries (2.1bps), bunds (1.1bps) and Gilts (1.1bps).  Meanwhile, the bonds of the PIGS are all rallying on the combination of general risk attitude and the hope that good news in Italy will spread.

Oil continues its winning ways, rising another 0.5% this morning which puts WTI above $55/bbl, a level many technicians believe opens the way for a sharper rally from here.  Gold, after a dreadful day yesterday, is still under modest pressure, down 0.15%, but silver, after an even more dreadful day yesterday, having fallen more than 8%, is actually bouncing a bit, and up 0.5% as I type.

Finally, the dollar is generally stronger vs. G10 currencies, with only AUD and NZD (both +0.1%) showing any life.  The kiwi story is based on stronger than expected employment data indicating the economy is rebounding and more monetary support may not be necessary, while Aussie seems to be benefitting from strong PMI data.  But otherwise, the dollar is on top this morning, with broad-based gains although they are not substantial.  SEK (-0.4%) is the worst performer, followed by the pound (-0.25%) and euro (-0.25%), both of which saw underwhelming PMI services data. In the EMG bloc the picture is more mixed, with both gainers and losers, although it is hard to piece together a coherent story.  The CE4 are the laggards, down 0.3% on average as they track the euro.  LATAM is also underperforming, although both MXN and BRL are softer by just 0.2%.  On the plus side, RUB (+0.3%) leads the way, arguably on oil’s uptick, and then some APAC currencies eked out marginal gains as well.  However, given the modest magnitude of movement, this feels an awful lot like position adjustments.

On the data front today we see ADP Employment (exp 50K) and ISM Services (56.7).  The former will attract more attention than the latter, in my view, as the market looks ahead to Friday’s NFP data. It would also be a mistake if I did not mention that Eurozone CPI was released this morning at a much higher than expected 0.9% (1.4% core) which is hard to reconcile with the collapsing economic activity.  Although perhaps, inflation is not dependent on demand as much as supply, and central bankers have it completely wrong.  Nah.

For now, the dollar’s correction continues, and we are right at the 1.2010 level that proved the breakout point in December.  At this stage, a move to 1.1950 seems a good bet, but we will need to see many more positions unwind if we are to overcome the dollar weakness narrative.  The confusing part is the ongoing equity rally alongside the dollar rally, something we have not seen for quite a while.  But that doesn’t mean it can’t continue for a while longer.  I still like the dollar to fall in H2, but right now, momentum is building for further dollar strength.

Good luck and stay safe
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Both Need Downgrading

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Excitement in markets is fading
With GameStop and silver both trading
Much lower today
As sellers convey
The message that both need downgrading

Well, it appears that the GameStop bubble is deflating rapidly this morning, which is only to be expected.  Short interest in the stock has fallen from 140% of market cap to just 39% as of yesterday’s close.  This means that there is precious little reason for it to rally again, as, if you recall, the company’s business model remains a bad fit for the times.  The top tick, last Thursday, was $483 per share.  In the pre-market this morning it is trading at $172, and I anticipate that before the end of the month, it will be trading back to its pre-hype $17-$18 level.  But it was fun while it lasted!

Meanwhile silver, yesterday’s story, has also fallen sharply, -4.7% as I type, as the mania there seems to have been more readily absorbed by a much larger market.  The conspiracy theory that the central banks and JP Morgan have been manipulating the price lower for the past several decades has always been hard to understand but was certainly more widespread than I expected.  The major difference between silver and GME though, is that silver has a real raison d’etre as an industrial metal, as well as a traditional store of wealth and monetary metal.  Last year silver’s price rose 46.5%, leading all precious metals higher.  And, in the event that inflation does begin to show itself again, something I believe is coming soon to a screen near you, there is a strong case to be made for it to rally further.  This is especially so given the ongoing debasement of all fiat currencies by central banks around the world as they print more and more each day.

Down Under the RBA stunned
The market and every hedge fund
Increasing QE
As they want to see
The Aussie increasingly shunned

While other major central banks stood pat in their recent policy meetings, the RBA last night surprised one and all by increasing the amount of QE by A$100 billion, at A$5 billion / month, meaning they will continue the program well into 2022.  As well, they explained that they would not consider raising rates until 2024 at the earliest as they work to push unemployment lower.  This means, the overnight rate will remain at 0.1% and YCC for the 3-year bond will also remain at that level.  Interestingly, the market had tapering on its mind, as ahead of the meeting AUD had rallied nearly 0.6%, with analyst discussions of tapering rampant.  As such, it is no surprise that the currency gave up those gains immediately upon the release of the statement, and has now fallen 0.25% on the day, the worst laggard in the G10.

With the FOMC meeting behind us, Fed speakers are going to be inundating us with their views for the next month, so be prepared for a lot more discussion on this topic.  Remember, before the quiet period ahead of the January meeting, four regional presidents were talking taper, with two seeing the possibility of that occurring late in 2021.  Chairman Powell, however, tried to squelch that theory in the statement and press conference.   Yesterday, uber-dove Neel Kashkari expressed his view that it is “..key for Fed to keep foot on monetary policy gas.”  Meanwhile, Raphael Bostic and Eric Rosengren both harped on the need for additional fiscal stimulus to revive the economy, with Bostic once again explaining that tapering when economic growth picks up will be appropriate, although giving no timeline.  (He was one of the four discussing a taper ahead of the meeting.)  We have seven more speakers this week, some of them multiple times, so there will certainly be headline risk as this debate plays out in public.

But for now, markets are sanguine about the possibility of central bank tightening in any way, shape or form, as once again, risk is being embraced across the board.  Starting in Asia, we saw green results everywhere (Nikkei +1.0%, Hang Seng +1.2%, Shanghai +0.8%), with the same being true in Europe (DAX +1.1%, CAC +1.6%, FTSE 100 +0.5%).  US futures are pointing in the same direction with gains on the order of 0.75% at 7:00am.

Bond markets are also on board the risk train, with yields rising in Treasuries (+2.9 bps) and throughout Europe (Bunds +2.7bps, OATs +2.2bps, Gilts +3.1bps).  Part of this positivity seems to be coming from the release of Eurozone Q4 GDP data, which was not quite as bad, at -0.7% Q/Q (-5.1% Y/Y) as forecast.  That outcome, though, was reasonably well known ahead of time as both Germany and Spain printed Q4 GDP at +0.1% in a surprise last week.  Unfortunately, the ongoing lockdowns throughout Europe, which have been extended into March in some cases, point to another quarter of economic contraction in Q1, thus resulting in a second recession in short order on the continent.  With that in mind, while we have not heard much from ECB speakers lately, it is certainly clear that there is no taper talk in Frankfurt at this time.

Which takes us to the currency markets.  The G10 bloc is split with EUR (-0.25%) matching AUD’s futility, while the rest of the European currencies are all modestly lower.  Commodity currencies, however, are holding their own led by CAD (+0.35%) which is benefitting from oil’s rally (+1.3%), although NOK (+0.1%) has seen less benefit.  EMG currencies, however, lean toward gains this morning, with MXN (+0.8%), BRL (+0.6%) and RUB (+0.6%) leading the way, each benefitting from higher commodity prices.  Even ZAR (+0.5%) is higher despite the lagging in precious metals.  But that story is far more focused on ZAR interest rates, which are an attractive carry play in a risk on scenario.  The laggards in this bloc are basically the CE4, tracking the euro, and even those losses are minimal.

While there is no data this morning in the US, we do have important statistics coming up later in the week as follows:

Wednesday ADP Employment 50K
ISM Services 56.7
Thursday Initial Claims 830K
Continuing Claims 4.7M
Nonfarm Productivity 4.0%
Unit Labor Costs -3.0%
Factory Orders 0.7%
Friday Non Farm Payrolls 60K
Private Payrolls 100K
Manufacturing Payrolls 31K
Unemployment Rate 6.7%
Average Hourly Earnings 0.3% (5.0% Y/Y)
Average Weekly Hours 34.7
Participation Rate 61.5%
Trade Balance -$65.7B
Consumer Credit $12.0B

Source: Bloomberg

So, plenty to see, but will we learn that much?  Obviously, all eyes will be on the payroll data, which given the rise in Initial Claims we have seen during the past month seems unlikely to surprise on the high side.  As such, anticipating sufficient data exuberance to get the Fed doves to talk about tapering seems remote.

Adding it all up leaves the current short dollar squeeze in place, with an opportunity, I think, for the euro to trade back below 1.20 for a time, but nothing we have seen or heard has changed my view that the dollar will fall in the second half of the year.  For those of you with payables, hedging sooner rather than later should be rewarded over time.

Good luck and stay safe
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GameStop

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The company still known as GameStop
Whose model for business, a mall shop
Was heavily shorted
Has seen those shorts thwarted
By buyers whose bubble will not pop

While I recognize GameStop (GME) seems to have absolutely nothing to do with the FX markets, I have been asked by a number of people to explain what happened, so I thought I would offer a relatively short explanation of the events, which were truly remarkable.  And arguably, this is much more about markets in general, and market sentiment in particular.

As always, I think a little perspective is in order.  GME was born in 1984 as Babbage’s in Dallas, Texas.  After a series of mergers, it was acquired by Barnes & Noble in 1999, who merged it with another company, Funco, Inc. and renamed this entity GameStop.  It went public in 2002, was spun off from Barnes & Noble in 2004, and then grew as a business.  Its business model was to be the go-to place for electronic games, and it eventually opened more than 5000 sites throughout malls in the US and around the world.  The problem, of course, is that even before Covid-19, bricks and mortar retail space was suffering.  This was especially so for this business, where games can be downloaded over the internet, and disks and cartridges have lost their appeal.  Covid seemed like the last straw, as malls all over the country were closing and saw extraordinary reductions in foot traffic, thus devastating the company’s business.

Over the course of the past twelve months, short interest in GME stock skyrocketed, as a number of hedge funds expected that the company would file Chapter 11 relatively soon.  After all, revenues had fallen more than 30% on a Q/Q and Y/Y basis, and profitability had disappeared.  In truth, it seemed a pretty logical bet.  However, hedge funds, being hedge funds, and reveling in as much leverage as possible given ZIRP, actually created short positions that grew to 140% of the outstanding float of the stock!  How, you may ask, is that possible?  Well, clearly, there was some naked shorting going on, which means that some of them were selling the stock without having borrowed it to deliver.  Oh, yeah, that is illegal these days.  It is also entirely possible that some brokers holding the stock rehypothecated it, meaning they lent it out more than once, also illegal.

Fast forward to three weeks ago, where a financial analyst, whose Reddit handle is Roaring Kitty, figured out that the short positions in this stock were untenable.  He posted on the Reddit thread WallStreetBets, which picked up traction and encouraged people to buy the stock.  Hence, the stock started to rise after months, if not years, in the doldrums.

The next step came from the options market, where the several million followers of WallStreetBets figured out that the leverage available in buying out of the money call options (also known as low delta call options) was extraordinary, and so they bought millions of them.

As a former option market maker (not in stocks, but FX, bonds and commodities), I can tell you that selling low delta options is a very dangerous trade.  This is because, if the market starts to move toward the strike price, as a hedger, I am forced to buy ever more underlying to hedge my position.  This is called gamma hedging and is the bread and butter of what options traders do all day long.  But the combination of the extraordinary demand for low delta GME calls and the recognition by the hedge funds with extensive short positions fed on itself into a frenzy.  At some point, the prime brokers who were handling those hedge funds’ business had to make margin calls and close out the short positions.  And those type of buyers are completely insensitive to price, because the prime broker doesn’t pay the freight, it is the hedge fund with the short position that is getting stopped out, that takes the losses.

Now, remember, because of the size of the short position, greater than the amount of stock outstanding, this process has taken a while to unfold, and is probably not done yet.  It has, however, busted those hedge funds, who have lost billions of dollars, as well has shown that they were not all that smart after all.  Alas, I fear that all the Robinhooders who were a huge proportion of the buyers are going to find themselves in a bad state as well.  After all, GME is still a dying business with the wrong business model for today.  A $1 billion market cap is probably a lot more appropriate than the current $23 billion market cap, so look for the stock to decline going forward, although probably not as quickly as it rose.

From our perspective, though, I think the lesson of GME is more about what it says about sentiment in the markets these days.  This type of price action and market activity has historically been confined to the last stages of a mania of some sort. In other words, to my eyes, and remember, I have seen market crashes starting in 1987, Tokyo in 1989, 1999-2000, and 2008-2009, this smacks of the true “irrational exuberance” made famous by former Fed Chair Alan Greenspan in 1996.  Whether it is rising rates, disappointment in the slower than expected rollout of the vaccine, or pressure on profit margins and earnings misses, I expect that shedding risk is going to be the norm for the next two quarters at least.  This is not to say we are going to see a collapse in stock markets, just that the gains of the pasts several months and years are unlikely to be repeated.

Which brings us to this morning, where the newest target for a short squeeze by the WSB crowd is silver.  Silver has opened higher by around 8%-10% and is now pressing $30/oz.  The last time silver traded above that level was March 2013, in the wake of the Eurozone debt crisis, and the only other time it did so was in 1980, when the Hunt brothers tried to corner the market.  Understand this, in 1980, the market was smaller, there were more natural buyers of silver for industrial uses, notably Eastman Kodak for film emulsion, and the Hunt’s failed dismally once the COMEX changed the rules.  Today, in a much larger market ($1.5 trillion) with far less industrial demand, this seems destined to fail, at least with respect to achieving the same type of impact as GME.  But that doesn’t mean the price can’t go higher in the short run.

Ok, on to FX, where today is PMI day, with the most noteworthy results coming from China over the weekend.  Noteworthy in the sense that they were all worse than expected (Mfg 51.3, Services 52.4 and Caixin 51.5) and all represented pretty big declines from last month.  In addition, the forward-looking pieces, like New Orders and Employment also fell sharply, so it doesn’t bode well for February.  Recall, China has locked down much of the northern part of the country to prevent the spread of Covid and this is occurring right before the start of the Lunar New Year holiday, the busiest travel time of the year, historically, in the country.  The point is, if expectations are for China’s economy to drive global growth, we could be seeing a longer delay before things pick up.

European PMI’s were generally in line with expectations on the manufacturing side and a number of other emerging market economies saw better than anticipated results.  Again, this simply highlights that the recovery in H1 is likely to be quite uneven.

As to markets, despite early losses in Asia and US futures, equity markets have turned around and were robustly higher overnight (Nikkei +1.55%, Hang Seng +2.15%, Shanghai +0.6%) and are all higher throughout Europe (DAX +1.5%, CAC +1.5%, FTSE 100 +1.2%).  US futures, which had opened the overnight session down as much as 1% are now all higher by more than that.

Bond markets are also demonstrating risk-on characteristics, albeit on a much more subdued basis.  Treasury yields have edged higher by 1.2bps, while bunds are essentially unchanged along with OATs and Gilts.  What we are seeing is PIGS bonds rallying with yields in Italy (-3.2bps) and Greece (-2.7bps) falling the most.

With silver leading the way, gold (+0.7%), too, is higher and so is crude oil (+0.5%).  In other words, risk is in favor here.  Interestingly, the FX market is not as convinced, at least not if we believe that risk-on is synonymous with a weaker dollar.  CHF (-0.6%) is the worst performer, which as a haven makes some sense, but EUR (-0.5%) leads the rest of the European group down, after German Retail Sales fell -9.6%!  The commodity currencies have not been as badly impacted (CAD -0.3%, AUD -0.2%).  Actually, today’s best performing G10 currency, other than the dollar, is the pound, which is basically flat as the success they’ve had with their vaccine program (13% of the population has already been vaccinated, the most by far for a large nation) has investors of the belief that the UK will lead the recovery.

EMG currencies are having a more mixed session with TRY (+1.7%) the leading gainer on further hawkish comments from the new central bank head there helping convince traders that tighter monetary policy will be with us for a while.  MXN (+1.15%) is next in line, on the strength of the commodity rally, along with ZAR (+0.75%) on the same basis.  Remember, Mexico is the largest silver producing country in the world, so the big rally in silver is clearly helping the peso.  On the downside, CNY (-0.6%) suffered on its data, and the CE4 are all falling similar amounts to the euro.  The rest of the bloc is less interesting and mixed as to gainers and losers.

On the data front, ISM Manufacturing (exp 60.0) is the main release today, with Construction Spending (+0.8%) due as well.  It is a payroll week, but I will delve into that more tomorrow as this note is already exceptionally long.  We do hear from three Fed speakers today, with a mix of uber doves and regular doves, so if anything, I expect that we will see more talk of needing more stimulus.  Speaking of which, the political fight over the proposed $1.9 trillion new bill continues but, in the end, you know that they will pass another bill with a lot more money being spent.

For all the conviction as the new year began that the dollar would decline sharply, the price action through January has clearly shaken some people.  However, positioning seems to be remaining steady, and I still believe that as inflation rises, real yields will fall sharply and the dollar along with it.  But for now, the dollar continues to push out the weak shorts, and quite frankly, this move does not feel like it is ending.  At this stage, a move in the euro toward 1.1950 seems quite viable.

Good luck and stay safe
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No Bubble’s Detected

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While Jay and his friends at the Fed
Claim when they are looking ahead
No bubble’s detected
So, they’ve not neglected
Their teachings and won’t be misled

But China views markets and sees
Their policy has too much ease
So, money they drained
As they ascertained
Investors, they need not appease

Perhaps there is no clearer depiction of the current difference between the Fed (and truly all G10 central banks) and the PBOC than the fact that last night, the PBOC drained liquidity from the market.  Not only did they drain liquidity, they explained that they were concerned about bubbles in asset markets like stocks and real estate, inflating because of current conditions.  Think about that, the PBOC did not simply discuss the idea that at some point in the future they may need to drain liquidity, they actually did so.  I challenge anyone to name a G10 central banker who could possibly be so bold.  Certainly not Chairman Powell, who tomorrow will almost certainly reiterate that this is not the time to be considering the removal of policy support.  Neither would ECB President Lagarde venture down such a road given the almost instantaneous damage that would inflict on the PIGS economies.

One cannot be surprised that stock markets fell in Asia after this action, with the Hang Seng (-2.6%) leading the way, while Shanghai (-1.5%) also fared poorly.  By contrast, the Nikkei’s -1.0% performance looked pretty good.  It should also be no surprise that the stock markets of the APAC nations whose trade relations with China define their economies saw weak outcomes.  Thus, Korea’s KOSPI (-2.1%) and Taiwan’s TAIEX (-1.8%) suffered as well.  And finally, it cannot be surprising that the Chinese renminbi traded higher (+0.15%) and is pushing back to levels last seen in June 2018.

Arguably, the key question here is, what does this mean for markets going forward?  Despite constant denials by every G10 central banker, it remains abundantly clear that equity market froth is a direct result of central bank policy.  The constant addition of liquidity to the economic system continues to spill into financial markets and push up equity (and bond and other asset) prices.  If the PBOC action were seen as a harbinger of other central bank activity, I expect that we would see a very severe repricing of risk assets.  However, a quick look at European equity markets shows that no such thing is occurring.  Rather, the powerful rally we are seeing across the board on the continent today (DAX +1.5%, CAC +1.1%, FTSE MIB +0.85%) indicates just the opposite.  Investors are not merely convinced that the ECB will never remove liquidity, but we are likely seeing some of the money that fled Asia finding a new home amid the easy money of Europe.

If the PBOC continues down this road, it is likely to have a far greater impact over time.  In fact, if they are successful in deflating the asset bubbles in China without crushing the economy, something that has never successfully been done by any central bank, it would certainly bode well for China going forward, as global investors would beat a path to their door.  While that is already happening (in 2020, for the first time, China drew more direct investment than the US), the speed with which it would occur could be breathtaking, especially in the current environment when capital moves at a blinding pace.  And that implies that Western equity markets might lose their allure and deflate.  The irony is that a communist nation firmly in the grip of the government would be deemed a better investment opportunity than the erstwhile bastion of free markets.  Ironic indeed!

However, that will only take place over a longer time frame, while we want to focus on today.  So, don’t ignore this occurrence, but don’t overreact either.

In the meantime, a look at today’s activity shows that there is little coherence in markets right now.  As you’ve seen, European equity markets are rallying nicely despite the fact that the Italian government just fell as PM Giuseppe Conte resigned.  A few months ago, this would have been seen as a significant negative for Italian assets, but not anymore.  Not only are Italian stocks higher, but BTP’s have seen yields decline another 3 basis points, taking their rally since Friday to 10 basis points!  As I have often written, BTP’s and the bonds of the other PIGS countries trade more like risk assets than havens, so it should be no surprise they are rallying.  In fact, haven assets all over are declining with Treasuries (+2.2bps), Bunds (+1.4bps) and Gilts (+1.6bps) all being sold today.

Recapping the action so far shows APAC stocks falling sharply, European stocks rallying sharply and haven bonds falling.  Is that risk-on?  Or risk-off?  Beats me!  Commodity prices point to risk-on, with oil rising 0.55% and most agricultural products higher by between 0.4%-1.0%.

Finally, looking at the dollar gives us almost no further information.  While the SEK (-0.25%) is under pressure on a complete lack of news, and the NZD (+0.2%) has moved higher after PM Arcern explained that the country would remain closed to outside travelers until the pandemic ended, the rest of the bloc is +/- 0.1% or less.  In the EMG bloc, the picture is also mixed, with KRW (-0.5%) the worst performer followed by IDR (-0.3%).  Given China’s monetary move last night, this should be no surprise.  On the plus side, TRY (+0.7%) leads the way followed by BRL (+0.4%), with the former benefitting from the IMF raising its GDP growth forecast to 6% in 2021, from a previous estimate of 5%. Meanwhile, the real has benefitted from the news that the BCB meeting last week contained discussions of raising interest rates from their current historically low level of 2.0%.  Concern over inflation picking up has some of the more hawkish members questioning the current policy stance.  Certainly, given that BRL has been one of the worst performing currencies for the past year, having declined 26% since the beginning of 2020, there is plenty of room for it to rise on the back of higher interest rates.

On the data front, this morning brings Case Shiller Home Prices (exp +8.7%) and Consumer Confidence (89.0).  On the former, this reflects historically low mortgage rates and a lack of inventory.  As to the latter, it must be remembered that this reading was above 120 for the entire previous Administration’s tenure until Covid came calling.  Alas, there is no indication that people are feeling ready to head back to the malls and movies yet.

With the FOMC on tap for tomorrow, I expect that the FX market will take its cues from equities.  If the US follows Europe, I would expect to see the dollar give up a little ground, but as I type, futures are little changed with no consistent direction.  While the dollar’s medium-term trend lower has been interrupted, for now, it also appears that the correction has seen its peak.  However, it could take a few more sessions before any downward pressure resumes in earnest, subject, naturally, to what the Fed tells us tomorrow.

Good luck and stay safe
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