Tag Archives: #riskon

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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The Largesse They Bestow

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The status is clearly still quo
For central bank policy so
All rates are on hold
And markets consoled
By all the largesse they bestow

But Covid continues to spread
And Q1 growth seems to be dead
So, Christine and Jay
Will soon have to say
More QE is coming ahead

It has been an active week for central banks so far, at least with respect to the number of meetings being held.  By the end of today we will have heard from six different major central banks from around the world (Canada, Brazil, Japan, Indonesia, Norway and the ECB) although not one of them has changed policy one iota.  The implication is that monetary policy has found an equilibrium for now, with settings properly attuned to the current economic realities.

A summary of current central bank policies basically shows that whatever the absolute level of interest rates being targeted, it is almost universally at historically low levels, with 14 key banks having rates 0.25% or lower.  The point is, a central bank’s main tool is interest rate policy, and while negative nominal rates are clearly viable, after all the SNB, ECB and BOJ currently maintain them, central banks are clearly running out of ammunition.  (PS; the efficacy of negative rates has been widely argued and remains unproven.)  Interestingly, prior to this crisis, reserve requirements were seen as an important central banking tool, with a broad ability to inject more liquidity into the markets or remove it if so desired.  However, in the wake of the GFC, when banks worldwide were shown to be too-highly levered, it seems central banks are a bit more reluctant to open those floodgates.  Even if they did, though, it is unclear if it would make a difference.  Perhaps the lesson we should all learn from the Covid crisis, especially the central banks themselves, is that monetary policy is very good at slowing down economies all by itself, but when it comes to helping them pick up, they need help.

So, with interest rate policy basically at its limit, central banks have been forced to implement new and different tools in their quest to support their respective economies, with QE at the forefront.  Of course, at this point, QE has also become old hat, and has yet to be shown to support the economy.  It has, however, done a bang-up job supporting equity markets around the world, as well as other risk assets like commodities.  And that is exactly what it was designed to do.  QE’s transmission mechanism was to be a trickle-down philosophy, where the ongoing search for yield by investors pushed capital into riskier ventures, helping to support increased investment and more economic growth.  Alas, the only thing QE has really served to do is inflate a number of asset bubbles.  This was never clearer than when the data showed more money was spent by corporations on stock repurchases than on R&D.  Thus, if the stated goal of QE was to support economic growth, it is fair to say it has failed at that task.

At any rate, a recap of the central bank comments shows that economic forecasts and expectations have been tweaked lower for Q1 and higher for Q2 and Q3 with a universal assumption that the widespread inoculation of the population via the new vaccines will help reopen economies all over.  And yet, if anything, we continue to hear of more and more draconian measures being put into place to slow the spread of Covid.  This certainly confirms the idea of a weak Q1 growth pattern, but the leap to a stronger Q2 is harder to make in my mind.

Add it all up and it appears that central banks, globally, are pretty much all in the same position, promulgating extremely easy monetary policy with limited hope that it will, by itself, reignite economic growth.  In effect, until it is shown that the vaccines are really changing people’s behavior, assuming governments allow people back out of the house, central banks can do all they want, and it will not have much impact on the economy.  Markets, however, are a different story, as all that monetary largesse will continue to flow to the riskiest, highest yielding assets around.  Until they don’t!  It will not be pretty when this bubble deflates.

So, is that happening today?  Not even close.  Equity markets continue to rise almost universally, with the Nikkei (+0.8%) and Shanghai (+0.8%) leading the way in Asia.  Europe, meanwhile, is not quite as robust, but still largely in the green led by the DAX (+0.5%) and FTSE 100 (+0.25%) although the CAC (-0.1%) is lagging a bit.  And not surprisingly, US markets continue to power ahead on the ongoing belief that there will be yet more stimulus coming, so futures are all higher by roughly 0.3% or so.

Bond markets are playing their part as well, with 10-year yields higher in all the major markets, with Treasuries, Bunds, OATs and Gilts all seeing yields climb about 1 basis point.  The interesting thing about Treasuries, and truthfully all these markets, is that since the Georgia run-off election, when the market assumption for more stimulus was cemented, the yield has barely moved.  Let me say that the reflation trade seems to be on hold, at least for now.

For a change, oil prices have edged a bit lower this morning, with WTI down 0.6%, as it consolidates its spectacular gains since November.  Gold is little changed, although it had a big day yesterday, rising 1.5% as inflation concerns seem to be percolating.  And finally, as perhaps a harbinger of that deflating bubble, Bitcoin is lower this morning and has been falling pretty steadily, if with still spectacular volatility, for the past 2 weeks, and is now down 24% from its recent highs.

Finally, the dollar is under clear pressure this morning, falling against all its G10 peers and all but one of its EMG peers.  In G10, NOK (+0.8%) leads the way as the Norgesbank did not cut rates which some had expected and were less negative on the economy than expected as well.  But NZD (+0.7%) and SEK (+0.6%) are also putting in fine performances amid stronger commodities and hopes for more stimulus.  In fact, CAD (+0.15%) is the laggard, although it had a strong performance yesterday (+0.7%) after the BOC left rates on hold rather than performing a microcut (10 bps) as some analysts had expected.

In the EMG space, CLP (+1.15%) and BRL (+1.1%) lead the way with the former benefitting from strong investor demand in USD and EUR denominated government bonds, leading to a positive outlook, while the latter seems to be responding to hints that tighter policy may be coming soon given rising inflation forecasts.   But really, the dollar’s weakness is pervasive across all three major blocs.

We finally see some data today as follows: Initial Claims (exp 935K), Continuing Claims (5.3M), Housing Starts (1560K), Building Permits (1608K) and Philly Fed (11.8).  The Claims data has certainly deteriorated during the past several weeks given the renewed lockdowns around the country, which doesn’t bode well for the NFP report in 2 weeks’ time.  The housing market remains on fire given the ongoing exodus to the suburbs from large cities and the historically low mortgage rates.  Meanwhile, Philly Fed should show the strength of the manufacturing sector, which continues to far outperform services.

Still no Fed speakers, so beyond the data, which is all at 8:30, we will also hear from Madame Lagarde in her press conference at the same time.  The risk, to me, is that she comes off more dovish than the market anticipates, thus halting the euro’s modest rebound.  But otherwise, there is no obvious catalyst to stop the risk-on meme and dollar’s renewed decline.

Good luck and stay safe
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Desperate Straits

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When yield curve control was designed
Its goal was a rate be defined
Which can’t be exceeded
With bonds bought as needed
To help governments in a bind

Lagarde, though, when looking ahead
Must work at controlling the spread
So BTP rates
Don’t reach desperate straits
Vs. bunds, an outcome she would dread

Ahead of the inauguration of President Biden, the market has turned its focus to Europe and the ongoing situation in Italy.  Prime Minister Giuseppe Conte has been struggling to lead a fractious coalition from the left and was just subject to no-confidence votes in both houses of the Italian government.  (They have a House and Senate similar to the US.)  This occurred when one of his former allies, Matteo Renzi, split from the coalition triggering the vote.  Renzi leads the Viva Italia party, a center-left group focused on progressive reforms to the Italian government, and it appears Conte has become a little too status quo for his taste.  While Conte was able to cobble together a majority in the lower house, today’s vote in the Senate was less successful, with a majority of votes cast, but no majority in the Senate overall.  This means he has a minority government whose stability has now been called into question.  Estimates are that he has two weeks to develop a majority or the President may call for parliament to be dissolved and new elections held.

As this story has unfolded, investors have been focused on the bond market, specifically the spread between Italian BTP’s and German bunds.  This spread is seen as a key metric, by both the market and the ECB, as to the health of the European economy overall.  The narrower that spread, the healthier the situation.  This is based on the idea that investors are not demanding as great a yield premium to fund Italy’s debt as they are Germany’s.

A quick history shows that for the first eight years of the euro’s existence, that spread hovered between 25 and 45 basis points, with investors not particularly concerned by Italy’s profligate ways.  The GFC awakened many to the potential risks in Italy and the spread ballooned as high as 160 basis points at that time.  But that was nothing compared to the Eurozone bond crisis in 2012, when Greece was on the ropes and the term PIGS was invented.  At that time, Italian yields peaked at 5.525% higher than German yields.  The second time this level was reached, in July 2012, led to Mario Draghi’s famous words, “whatever it takes” regarding the ECB’s will to save the euro.  Since that time, the spread has only ever edged below 1.0% briefly, lately reaching a peak of 2.8% at the beginning of the Covid crisis and currently trading around 1.14%.

The point here is that the ECB watches this spread very carefully.  But now, it appears they are interested in more than merely watching the spread.  Rather, they want to control it.  Yield curve control (YCC) is currently ongoing in both Japan and Australia and has generated a good deal of discussion in the US.  But those three central banks have a single government rate to manage.  The ECB has no such luck, and so they need to find other ways to control things.  Hence, their newest idea is Yield spread control (YSC), where the ECB will buy whatever amount of bonds are necessary to prevent a particular spread from rising above a particular level.  Obviously, this means they will be looking at the bonds of the PIGS, as those are the nations with the biggest outstanding issues.  The problem Lagarde has is the ECB, by law, is not allowed to finance government spending, and QE in Europe was designed to be implemented along the lines of the ECB buying bonds in proportion to national economic size.  But this will require something completely different, as in order to prevent that spread from widening beyond whatever level they choose, the ECB will need to purchase an unlimited number of Italian BTP’s.  As such, this idea is not without controversy, but do not be surprised to hear about it tomorrow when the ECB meeting ends.  While it may not be implemented right away, it does appear they are actively considering the idea.

At this point you are likely asking yourself why you care about this esoteric concept.  And the answer is because it will have an impact on the value of the euro, and therefore the dollar, going forward.  Given the current draconian lockdowns throughout Europe and the significant negative impact they will have on the Eurozone economy, and combine that with a political morass in the 3rd largest economy in the Eurozone, and you have a recipe for a more severe downturn in a double dip recession in Europe.  As the ECB has already used up its basic toolkit of extraordinary measures, it needs to develop new ones if it is to keep the money flowing.  And that is the point.  Especially after yesterday’s testimony by Janet Yellen, where it is clear that the Treasury is not going to slow down spending and the Fed will be right there buying up those new bonds, the ECB is growing concerned that the dollar could fall much further.  They have recently been reminding us that they are paying attention to the exchange rate, and while intervention is not likely in the cards, a new easing policy that results in lower yields and a correspondingly weaker euro just might be.  One has to be impressed with central bank creativity when it comes to spending/printing more money.

But for now, investors remain sanguine to the risk inherent in this strategy and continue to add risk to their portfolios.  This can be seen in the continued rallies in equity markets around the world.  For instance, last night saw strength throughout Asia, except for the Nikkei (-0.4%).  Europe, this morning is showing far more green than red (DAX +0.5%, CC +0.3%. FTSE 100 -0.1%) and US futures, following yesterday’s tech inspired rally, are all higher again this morning.

Bond markets are under pressure generally, with Treasury yields backing up 1.4bps, although still unable to break the recent highs of 1.15%, Gilts are also softer with yields higher by 1.2bps while bunds and OATs are little changed. BTP’s, however, have fallen ¼ point with yields higher by 2.5bps, which means that spread has risen by the same amount.  Keep an eye on this.

Oil (WTI +1.3%) and gold (+0.5%) are both firmer this morning while the dollar is broadly under pressure.  However, the magnitude of that weakness is fairly minimal, with AUD (+0.35%) the biggest gainer in the G10 on the back of firmer commodity prices, while SEK (-0.35%) is the laggard on what appears to be position unwinding.  The euro (-0.15%) is definitely not following a classic risk-on pattern here, with some reason to believe traders are beginning to take the YSC into account.  In the EMG space, the moves are also limited, with TRY (+0.4%) and BRL (+0.25%) the leading gainers while CE4 currencies (CZK and PLN both -0.1%) are the laggards.  But overall, the risk theme does not appear to be having an impact in FX.

Once again there is no data released today and we are still in the quiet period, so no Fedspeak.  And we don’t even have Yellen to testify, so the FX market is going to be paying attention to equity movements and the bond market, probably in that order.  If risk continues to be acquired, I expect the dollar will have difficulty gaining any traction, but if we start to see a reversal, don’t be surprised to see some of the massive dollar short positions unwound.

Good luck and stay safe
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