Tag Archives: #riskon

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
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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
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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
Adf

Hubris

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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
Adf

On Edge

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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
Adf

Right From the Script

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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

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
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*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
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