Though prices are forecast to rise The Treasury market implies That Jay has it right And this is the height Inflation will reach at its highs Instead, once the base effects pass Inflation will run out of gas So there is no need For Powell to heed The calls to halt QE en masse This morning we finally get to learn about two of the three potential market catalysts I outlined on Monday, as the ECB announces their policy decision at 7:45 EDT with Madame Lagarde speaking at a press conference 45 minutes later. And, as it happens, at 8:30 EDT we will also see the May CPI data (exp 0.5% M/M, 4.7% Y/Y headline; 0.5% M/M, 3.5% Y/Y ex food & energy). Obviously, these CPI prints are far higher than the Fed target of an average of 2.0% over time, but as we have been repeatedly assured, these price rises are transitory and due entirely to base effects therefore there is no need for investors, or anybody for that matter, to fret. And yet…one cannot help but notice the rising prices that we encounter on a daily basis and wonder what the Fed, and just as importantly, the bond market, is thinking. Perhaps the most remarkable aspect of the current inflation discussion is that despite an enormous amount of discussion on the topic, and anecdotes galore about rising prices, the one market that would seem to be most likely to respond to these pressures, the Treasury market, has traded in exactly the opposite direction expected. Yesterday, after a very strong 10-year auction, where the coverage ratio was 2.58 and the yield fell below 1.50%, it has become clear that bond investors have completely bought into the Fed’s transitory story. All of the angst over the massive increases in fiscal spending and huge growth in the money supply have not made a dent in the view that inflation is dead. Recall that as Q1 ended, 10-year yields were up to 1.75% and forecasters were falling all over themselves to revise their year-end expectations higher with many deciding on the 2.25%-2.50% area as a likely level for 10-year yields come December. The economy was reopening rapidly and expectations for faster growth were widespread. The funny thing is that those growth expectations remain intact, yet suddenly bond investors no longer seem to believe that growth will increase price pressures. Last week’s mildly disappointing NFP report is a key reason as it was the second consecutive report that indicated there is still a huge amount of labor slack in the economy and as long as that remains the case, wage rises ought to remain capped. The counter to that argument is the heavy hand of government, which is both increasing the minimum wage and paying excessive unemployment benefits thus forcing private companies to raise wages to lure workers back to the job. In effect, the government, with these two policies, has artificially tightened the labor market and historically, tight labor markets have led to higher overall inflation. The last bastion of the inflationists’ views is that the recent rally in Treasuries has been driven by short-covering and that has basically been completed thus opening the way for sellers to reemerge. And while I’m sure that has been part of the process, my take, also anecdotal, is that fixed income investors truly believe the Fed at this time, despite the Fed’s extraordinarily poor track record when it comes to forecasting literally anything. As an example, two weeks ago, I was playing golf with a new member of my golf club who happened to be a portfolio manager for a major insurance company. We spent 18 holes discussing the inflation/deflation issue and he was 100% convinced that inflation is not a problem. More importantly, he indicated his portfolio is positioned for that to be the case and implied that was the house view so his was not the only portfolio so positioned. This helps explain why Treasury yields are at 1.49%, 25 basis points lower than on April 1. However, it also means that while today’s data, whatever it is, will not be conclusive to the argument, as the summer progresses and we get into autumn, any sense that the inflation rate is not heading back toward 2.0% will likely have major market consequences. Stay tuned. As to the ECB, it seems highly unlikely that they will announce any policy changes this morning with the key issue being their discussion of the pace of QE purchases. You may recall that at the April meeting, the key words were, “the Governing Council expects purchases under PEPP over the current quarter to continue to be conducted at a significantly higher pace than during the first months of the year.” In other words, they stepped up the pace of QE to roughly €20 billion per week, from what had been less than €14 billion prior to that meeting. While the data from Europe has improved since then, and reopening from pandemic induced restrictions is expanding, it would be shocking if they were to change their view this quickly. Rather, expectations are for no policy change and no change in the rate of QE purchases for at least another quarter. The inflationary impulse in the Eurozone remains far lower than in the US and even though they finally got headline CPI to touch 2.0% last month, there is no worry it will run away higher. Remember, too, there is no way the ECB can countenance a stronger euro as it would both impair its export competitiveness as well as import deflation. As long as the Fed continues to buy bonds at the current rate you can expect the ECB to do the same. In the end, we can only wait and see what occurs. Until then, a brief recap of markets shows that things have continued to trade in tight ranges as investors worldwide await this morning’s news. Equity markets in Asia were very modestly higher (Nikkei +0.3%, Shanghai +0.5%, Hang Seng 0.0%) and in Europe the movement has been even less pronounced (DAX +0.1%, CAC -0.1%, FTSE 100 +0.3%). US futures are mixed as well with the three major indices within 0.2% of closing levels. Bond markets, after a strong rally yesterday, have seen a bit of profit taking with Treasury yields edging higher by 0.8bps while Europe (Bunds +1.0bps, OATs +1.6bps, Gilts +0.7bps) have moved up a touch more. But this is trader position adjustments ahead of the news, not investors making wholesale portfolio changes. Commodity markets are mixed with crude oil (+0.1%) barely higher while precious metals (Au -0.5%, Ag -0.4%) are under a bit of pressure. Base metals, however, are seeing more selling pressure (Cu -1.5%, Al -0.2%, Sn -0.7%) while foodstuffs are mixed as wheat is lower though corn and soybeans have edged higher. Finally, in the FX market, the G10 is generally mixed with very modest movement except for one currency, NOK (-0.5%) which has fallen sharply after CPI data came out much lower than expected thus relieving pressure on the Norgesbank to tighten policy anytime soon. In the EMG bloc, ZAR (+0.6%) is the leading gainer after its C/A surplus was released at a much stronger than expected 5.0% indicating finances in the country are improving. But away from that, things have been much less exciting as markets await today’s data and ECB statements. In addition to the CPI data this morning, as it is Thursday, we will see Initial Claims (exp 370K) and Continuing Claims (3.65M). Interestingly, those may be more important data points as the Fed is clearly far more focused on employment than on inflation. But they will not be sensational, so will not get the press. FWIW my money is on a higher than expected CPI print, 5.0% or more with nearly 4.0% ex food & energy. However, even if I am correct, it is not clear how big a market impact it will have beyond a very short-term response. In the end, if Treasury yields continue to fall, I believe the dollar will follow. Good luck and stay safe Adf
In Europe, the growth impulse faded
As governments there were persuaded
To lock people down
In city and town
While new strains of Covid invaded
Contrast that with here in the States
Where GDP growth resonates
Tis no real surprise
That stocks made new highs
And bond bulls are in desperate straits
There is no better depiction of the comparative situation in the US and Europe than the GDP data released yesterday and today. In the US, Q1 saw GDP rise 6.4% annualized (about 1.6% Q/Q) after a gain of 4.3% in Q4 2020. This morning, the Eurozone reported that GDP shrank -0.6% in Q1 after declining -0.7% in Q4 2020. In other words, while the US put together a string of substantial economic growth over the past 3 quarters (Q3 was the remarkable 33.4% on this measure), Europe slipped into a double dip recession, with two consecutive quarters of negative growth following a single quarter of rebound. If you consider how markets behaved in Q1, it begins to make a great deal more sense that the dollar rallied sharply along with Treasury yields, as the economic picture in the US was clearly much brighter than that in Europe.
But that is all backward-looking stuff. Our concerns are what lies ahead. In the US, there is no indication that things are slowing down yet, especially with the prospects of more fiscal stimulus on the way to help goose things along. As well, Chairman Powell has been adamant that the Fed will not be reducing monetary accommodation until the economy actually achieves the Fed’s target of maximum employment. Essentially, this has been defined as the reemployment of the 10 million people whose jobs were eliminated during the depths of the Covid induced government lockdowns. (Its stable price target, defined as 2.0% average inflation over time, has been kicked to the curb for the time being, and is unimportant in FOMC discussions…for now.)
At the same time, the fiscal stimulus taps in Europe are only beginning to drip open. While it may be a bit foggy as it was almost a full year ago, in July 2020 the EU agreed to jointly finance fiscal stimulus for its neediest members by borrowing on a collective level rather than at the individual country level. This was a huge step forward from a policy perspective even if the actual amount agreed, €750 billion, was really not that much relative to the size of the economy. Remember, the US has already passed 3 separate bills with price tags of $2.2 trillion, $900 billion and just recently, $1.9 trillion. But even then, despite its relatively small size, those funds are just now starting to be deployed, more than 9 months after the original approval. This is the very definition of a day late and a
dollar euro short.
Now, forecasts for Q2 and beyond in Europe are much better as the third wave lockdowns are slated to end in early to mid-May thus freeing up more economic activity. But the US remains miles ahead on these measures, with even NYC declaring it will be 100% open as of July 1st. Again, on a purely economic basis, it remains difficult to look at the ongoing evolution of the Eurozone and US economies and decide that Europe is the place to be. But we also know that the monetary story is critical to financial markets, so cannot ignore that. On that score, the US continues to pump more money into the system than the ECB, offering more support for the economy, but potentially undermining the dollar. Arguably, that has been one of the key drivers of the weak dollar narrative; at some point, the supply of dollars will overwhelm, and the value of those dollars will decrease. This will be evident in rising inflation as well as in a weakening exchange rate versus its peers.
The thing is, this story has been being told for many years and has yet to be proven true, at least in any significant form. In the current environment, unless the Fed actually does ease policy further, via expanded QE or explicit YCC, the rationale for significant dollar weakness remains sparse. Treasury yields continue to define the market’s moves, thus, that is where we must keep our attention focused.
Turning that attention to market activity overnight, whether it is because it is a Friday and traders wanted to square up before going home, or because of the weak data, risk is definitely on the back foot today. Equity markets in Asia were all red led by the Hang Seng (-2.0%) but with both the Nikkei and Shanghai falling 0.8% on the session. Certainly, Chinese PMI data were weaker than expected (Mfg 51.1, Services 54.9) both representing declines from last month and raising questions about the strength of the recovery there. At the same time, Japanese CPI remains far below target (Tokyo CPI -0.6%) indicating that whatever policies they continue to implement are having no effect on their goals.
European bourses are mixed after the weaker Eurozone data, with the DAX (+0.2%) the star, while the CAC (-0.2%) and FTSE 100 (0.0%) show little positive impetus. Looking at smaller country indices shows lots of red as well. Finally, US futures are slipping at this hour, down between -0.4% and -0.7% despite some strong earnings reports after the close.
Perhaps the US markets are taking their cue from the Treasury market, where yields continue to edge higher (+1.2bps) with the idea that we have seen the top in rates fading quickly. European sovereign bonds, however, have seen demand this morning with yields slipping a bit as follows: Bunds (-1.8bps), OATs (-1.2bps) and Gilts (-1.3bps). Perhaps the weak economic data is playing out as expected here.
Commodities are under pressure this morning led by WTI (-1.9%) but seeing weakness in the Agricultural space (Wheat -0.7%, Soy -0.9%) as well. The one thing that continues to see no end in demand, though, is the base metals with Cu (+0.3%), Al (+0.9%) and Sn (2.2%) continuing their recent rallies. Stuff is in demand!
In the FX markets, the day is shaping up to be a classic risk-off session, with the dollar firmer against all G10 counterparts except the yen (+0.1%) with SEK (-0.55%) and NOK (-0.5%) the leading decliners. We can attribute Nokkie’s decline to oil prices while Stockie seems to be demonstrating its relatively high beta to the euro (-0.3%). EMG currencies have far more losers than gainers led by ZAR (-0.7%), TRY (-0.65%) and RUB (-0.6%). The ruble is readily explained by oil’s decline while TRY is a bit more interesting as the latest central bank governor just promised to keep monetary policy tight in order to combat inflation. Apparently, the market doesn’t believe him, or assumes that if he tries, he will simply be replaced by President Erdogan again. The rand’s weakness appears to be technical in nature as there is a belief that May is a particularly bad month to own rand, it having declined in 8 of the past 10 years during the month of May, and this is especially true given the rand has had a particularly strong performance in April.
On the data front, today brings a bunch more information including Personal Income (exp 20.2%), Personal Spending (+4.1%), Core PCE Deflator (1.8%), Chicago PMI (65.3) and Michigan Sentiment (87.5). Given the Fed’s focus on PCE as their inflation measure, it will be important as a marker, but there is no reason to expect any reaction regardless of the number. That said, every inflation reading we have seen in the past month has been higher than forecast so I would not be surprised to see that here as well.
In the end, though, it is still the Treasury market that continues to drive all others. If yields resume their rise, look for a stronger dollar and pressure on equities and commodities. If they were to head back down, so would the dollar while equities would find support.
Good luck, good weekend and stay safe
Said Jay, markets seem filled with froth
But let me tell you, we are loth
To even discuss
The tapering fuss.
To ZIRP and QE we are troth
Now, ask yourself what markets heard
Jay cooed like his favorite white bird
So, dollars were sold
Investors bought gold
With equity bulls undeterred
The Chairman was very clear yesterday afternoon in his press conference, the Fed is not anywhere near thinking about changing their current policy mix. While paying lip service to the idea that if inflation turns out not to be ‘transitory’ they have the tools to address it, the overwhelming belief in the Mariner Eccles Building appears to be that by autumn, inflation will be a thing of the past and the Fed will still have their foot on the proverbial accelerator.
This does raise the question that, if economic growth is rebounding so smartly, why does the Fed need to buy $120 billion of assets each month and maintain their policy rate at 0.00%? While I am just an FX guy, it seems to me that the current policy stance is more appropriate for an apocalyptic economic crisis, something like we suffered last year or in 2008-9, rather than for an economy that is growing at 7.0% or more. But that’s just me. Clearly, Chairman Powell and his committee are concerned that the economy cannot continue to grow on its own, else they wouldn’t be doing what they are doing.
When it comes to the tapering of asset purchases, Powell was also explicit that it is not nearly time to consider the idea. Yes, we had one good NFP number, but we need a string of them to convince the Fed that we are past the worst of things. Remember, the opening two lines of the Fed statement continue to be about Covid. “The Federal Reserve is committed to using its full range of tools to support the U.S. economy in this challenging time, thereby promoting its maximum employment and price stability goals. The COVID-19 pandemic is causing tremendous human and economic hardship across the United States and around the world.” Until such time as that statement changes, we don’t need to hear the press conference to know that nothing is going to change.
With this in mind, let us consider the potential impact on markets. Starting with Treasuries, it seems reasonable to assume that yields are reflective of investors collective view on inflation going forward. The Fed has been purchasing $120 billion / month since last June and is not about to change. At this stage, it would appear the market has factored those purchases into the current yield. This means, future movements are far more likely to be indicative of the evolving view on inflation. Yesterday, after the press conference, 10-year yields slipped by 4bps, but this morning, they have recouped those losses and we currently sit at 1.65%. With commodity prices clearly still on a massive roll (WTI +1.4%, Cu +0.8%), while the Fed is convinced that any inflation will be transitory, it is not obvious that the rest of the market agrees. Powell said the Fed would need to see a string of strong data. Well, next week the early expectations for NFP are 888K, which would be two very strong months in a row. Is that a string? Certainly, it’s a line. But I doubt it will move the needle at the Fed. Maximum employment is still a long way off, and there will be no changes until then. As inflation readings climb, and they will, Treasury yields will continue to climb as well. There is nothing magical about 1.75%, the level reached at the end of March, and I expect that by the end of Q2, we will be looking at 10-year yields close to, or above 2.0%.
If Treasury yields are at 2.0%, what happens to equity markets? In this case, it is not as clear cut as one might think. First off, this Fed clearly has a different reaction function to data than previous iterations as they have been explicit that pre-emptive tightening to prevent potential future inflation is not going to happen. This implies that any rise in yields is not reflective of expected Fed policy changes, but rather as a response to rising inflationary pressures. History has shown that when inflation rises but stays below 3.0%, equity markets can remain buoyant, but once that threshold has been breached, it is a different story. Remember, especially in the tech sector, but in truth quite generally, the reason low rates boost the stock market is because any discount cash flow model, when discounting at ultra-low rates means current values should be higher. This is why rising yields become a problem for equity prices. In fact, it is reasonable to analogize being long growth stocks to being long bond duration, so when bond prices fall and yields rise accordingly the same thing happens to those stocks. If this relationship holds going forward, and inflationary concerns do continue to percolate in the market, it would appear equity prices could be in for a bumpy ride.
Clearly, that is not yet the case (after all, inflation hasn’t yet reared its ugly head), as evidenced by the overnight price action in the wake of Powell’s comments. Asia was strong (Nikkei +0.2%, Hang Seng +0.8%, Shanghai +0.5%) and most of Europe is as well (CAC +0.55%, FTSE 100 +0.7%) although the German DAX (-0.25%) is a bit of a laggard this morning as concerns over Q1 GDP rise due to the third Covid wave. US futures, though, are all-in with Jay, rising between 0.5% (Dow) and 1.0% (NASDAQ). That makes sense given the assurances that there will be no tapering for
ever the foreseeable future.
As to the dollar, there are two different narratives at odds here. On the one hand, the fundamentalists continue to point to a weaker dollar in the future as rising inflation tends to devalue a currency, and when combined with the massive fiscal deficit policy, a dollar decline becomes the only outlet available for pressure on the economy. On the other hand, rising yields tend to support the dollar, so as Treasury yields continue to rise, if they stay ahead of the inflation statistics, there is reason to believe that the dollar has further to gain from here. Of course, if inflation outstrips the rise in nominal yields such that real yields decline, we could easily have a situation with higher nominal Treasury yields and a much weaker dollar. For now, the inflation data is lagging the Treasury market, but I suspect that by the end of May, that will not be the case, meaning the long-awaited dollar decline has a much better chance to get started then.
In the meantime, the dollar has softened ever so slightly this morning. Versus G10 currencies, only JPY (-0.25%) has declined as the rebound in Treasury yields this morning seems to be garnering interest in the Japanese investment community. But, while the dollar is softer vs. everything else, nothing has even moved 0.2%, which implies there is no news beyond the Fed. In the EMG space, the dollar is also largely softer, led by HUF (+0.5%), THB (+0.45%) and INR (+0.45%). HUF continues to benefit from the relatively hawkish stance of the central bank, while the baht rallied despite a reduction in the 2021 GDP estimate to 2.3% as Covid infections increase in the nation. Meanwhile, INR appears to be the beneficiary of the Fed’s stance as clearly, the ongoing domestic disaster regarding its response to the latest wave of Covid infections cannot be seen as a positive.
On the data front, we start with Initial Claims (exp 540K) and Continuing Claims (3.59M) but also see the first look at Q1 GDP (6.6%), with a range of estimates from 4.5% to 10.0%! With the Fed meeting behind us, we should start to hear from FOMC members again, but today only has Governor Quarles discussing financial regulation, a much drier subject than inflation. Tomorrow, however, we will see the latest Core PCE data, and that has the chance to move things around.
As of now, the dollar remains on its back foot given the Fed’s clear message that tapering is a long way off and easy money is here for now. However, if Treasury yields start to rise further, especially if they get back toward the 1.75% level, I expect the dollar will rebound. On the other hand, if Treasuries remain quiet, the dollar probably has further to fall.
Good luck and stay safe
The Chair and the Vice-Chair both said
Before we raise rates at the Fed
We’ll taper our buying
While we’re verifying
If growth can keep moving ahead
So, don’t look at forecasts ‘cause we
Care only for hard stats we see
Thus, we’ll be behind
The curve, but you’ll find
Inflation we’ll welcome with glee
The Fed has made clear they are driving the bus looking only in the rearview mirror. This is a pretty dramatic change in their modus operandi. Historically, given the widespread understanding that monetary policy works with a lag of anywhere from 6 months to 1 year, the Fed would base policy actions on their forecasts of future activity. This process was designed to prevent inflation from rising too high or allowing growth to lag too far from trend. One of the problems they encountered, though, was that they were terrible forecasters, with their models often significantly understating or overstating expectations of future outcomes.
So, kudos to Chairman Powell for recognizing they have no special insight into the future of the economy. It is always difficult for an institution, especially one as hidebound as the Federal Reserve, to recognize its shortcomings. This does beg the question, though, if they are going to mechanically respond to data with policy moves, why do they even need to be involved at all? Certainly, an algorithm can be programmed to make those decisions without the added risk of making policy errors. Instead, the Fed could concentrate on its role as banking supervisor, an area in which they have clearly fallen behind. But I digress.
Back in the real world, this change, which they have been discussing for some time, is truly important. It seems to be premised on the idea that measured inflation remains far below their target, so running the economy ‘hot’ is a desirable way to achieve that target. And running the economy hot has the added benefit of helping to encourage maximum employment in the economy, their restated goal on that half of the mandate. It also appears to assume that they have both the tools, and the wherewithal to use them, in case inflation gets hotter than currently expected. It is this last assumption that I fear will come back to haunt them. But for now, this week’s CPI data did nothing to scare anybody and they are feeling pretty good.
One other thing they both made clear was that the timing of any rate hike was absolutely going to be after QE purchases are completed. So, the tapering will begin at some point, and only when they stop expanding the balance sheet will they consider raising the Fed Funds rate. Right now, the best guess is late 2023, but clearly, since they are data driven, that is subject to change.
There is a conundrum, though, in the markets. Despite this very clear policy direction, and despite the fact that bond investors are typically quite sensitive to potential inflation, Treasury yields have seemingly peaked for the time being and continue to slide lower. Certainly, the auctions this week, where the Treasury issued $120 billion in new debt were all well received, so concerns over a buyer’s strike were overblown. In fact, overnight data showed that Japanese buyers soaked up nearly $16 billion in bonds, the largest amount since last November. But, depending on how you choose to measure real interest rates, they remain somewhere between 0.0% and -1.0% based on either Core or Headline CPI vs. the 10-year. Traditionally, headline has been the measure since it represents everything, and for a bond investor, they still need to eat and drive so those costs matter.
Summing this all up tells us 1) the Fed is 100% reactive to data now, so overshooting in their targets is a virtual given; 2) interest rates are not going to rise for at least another two years as they made clear they will begin tapering their QE purchases long before they consider raising interest rates; and 3) the opportunity for increased volatility of outcomes has grown significantly with this new policy stance since, by definition, they will always be reactive. To my mind, this situation is one where the current market calm is very likely preceding what will be a very large storm. If central banks handcuff themselves to waiting for data to print (and remember, hard data is, by definition, backwards looking, generally at least one month and frequently two months), trends will be able to establish themselves such that the Fed will need to respond in a MUCH greater manner to regain control. Markets will not take kindly to that situation. But that situation is not yet upon us, so the bulls can continue to run.
And run they have, albeit not as quickly as they have been recently. In Asia overnight, it was actually a mixed performance with the Nikkei (+0.1%) eking out a small gain while the Hang Seng (-0.4%) and Shanghai (-0.5%) both stumbled slightly. Europe, on the other hand, is all green with gains ranging between 0.2% and 0.4% across the major markets. US futures are actually looking even better, with gains of 0.45%-0.6% at this hour. Earnings season started yesterday, and the big banks all killed it in Q1, helping the overall market.
Bond yields, meanwhile, are continuing to slide, with Treasuries (-1.9bps) continuing to show the way to virtually all Western bond markets. Bunds (-1.6bps), OATs (-2.0bps ) and Gilts (-2.7bps) are rallying as well despite the generally upbeat economic news. There was, however, one negative release, where the German economic Institutes have cut their GDP forecast by 1.0%, to 3.7%, after the third wave and concomitant lockdowns.
Oil prices, which have had a huge runup this week, have slipped a bit, down 0.5%, but the metals markets are all in the green with Au (+0.6%), Ag (+0.6%), Cu (+1.5%) and Al (+0.25%) all in fine fettle.
It can be no surprise that with Treasury yields lower and commodity prices generally higher, the dollar is under further pressure this morning. In the G10, the commodity bloc is leading the way with NZD (+0.25%), CAD (+0.2%) and AUD (+0.2%) all performing well. There are a few laggards, but the movement there is so small, it is hardly a sign of anything noteworthy. The euro, for instance, is lower by 0.1%, truly unremarkable. In the EMG bloc, RUB (-1.2%) is the biggest mover, suffering on the news that the Biden Administration is slapping yet more sanctions on Russia for their election meddling efforts. After that, HUF (-0.4%) has suffered as the central bank maintains its rate stance despite quickening inflation readings. On the plus side, ZAR (+0.65%) and MXN (+0.3%) are the leading gainers, both clearly benefitting from the commodity story today.
One thing to watch here is the technical picture as despite the slow-motion decline in the dollar since the beginning of the month, it is starting to approach key technical support levels with many traders looking for a breakout should we breach those levels. We shall see, but certainly if Treasury yields continue to slide, the dollar is likely to slide further.
We have a bunch of data today led by Initial Claims (exp 700K), Continuing Claims (3.7M), Retail Sales (+5.8%, +5.0% ex autos) and then Empire Manufacturing (20.0), Philly Fed (41.5), IP (2.5%) and Capacity Utilization (75.6%). The Retail Sales data is based on the second stimulus check being spent, and the Claims data is assuming strength based on the NFP from last month. We also hear from a bunch more speakers, but Powell and Clarida are done, so it would be surprising to see anything new from this group of three.
All told, nothing has changed my view that as goes the 10-year Treasury yield, so goes the dollar. That will need to be proven wrong consistently before we seek another narrative.
Finally, I will be taking a few, very needed, days off so there will be no poetry until I return on Thursday April 22.
Good luck, good weekend and stay safe
There once was a simple statistic
That people used as a heuristic
Of whether or not
The things that they bought
Cost more as a characteristic
But central banks worldwide decided
That view about costs was misguided
Instead they created
A world that inflated
The price of most all things provided
The market’s (and this author’s) virtual obsession with inflation continues and will receive the latest important data point at 8:30 this morning. At that time, CPI will be released with the following median forecasts according to Bloomberg:
|-ex food & energy MoM||0.2%|
|-ex food & energy YoY||1.5%|
The last time CPI printed as high as 2.5% was January 2020, and prior to that it was October 2018. As I wrote yesterday, the fact that the comparison on a YoY basis is so incredibly low due to the initial government lockdowns last year at this time, mathematically, this number is destined to be high. After all, last month CPI YoY printed at 1.7%, so this is a big jump. We also know that the Fed has made it clear that not only do they understand base effects, so will not get excited by today’s print regardless of its outcome, but that they remain essentially unconcerned about rising inflation anyway as they have interpreted their dual mandate to mean maximum employment at all costs. Oh yeah, they don’t even consider CPI a worthy statistic for their own models, instead preferring Core PCE, which has a somewhat different philosophical background as well as a substantially different makeup as to the weights it assigns to the various items in its basket of goods and services.
Markets, however, do care about CPI as it appears to do a better job of reflecting the state of prices than PCE, and perhaps more importantly, CPI is the actual number used in most inflation adjusted products, notably TIPS and Social Security’s COLA. My good friend Mike Ashton (@inflation_guy) is actually the best source of information on the topic and you should all follow him on Twitter as he produces thoughtful commentary on CPI the day of its release, breaking down the data. What I have gleaned from his recent commentary is that there are many more things pointing to sustainably higher prices than simply the base effects of the calculation. And I can’t help but notice how the price of things that I buy seem to continue to rise as well. While the plural of anecdote is not data, at some point, enough anecdotes about higher prices has to have meaning. Whether it is the cost of plywood, or a meal at your favorite restaurant or that bottle of ketchup at the supermarket, I am hard pressed to find anything that has fallen in price. Certainly not gasoline, and even tech items cost more. If you need a new laptop, while the hedonic adjustments made by the BLS may make theoretical sense, the reality is it still costs more dollars (or euros or yen) to actually walk out of the store with the new computer.
Alas, Chairman Powell and his band of Merry Men (and Women) have made it abundantly clear that rising prices are not of interest now or in the near future. In fact, given the Fed’s current stance, why would they even discuss the idea of tapering QE at all. If rising prices don’t matter, then lower interest rates will be a permanent support for the economy and offer the best insurance that not only will maximum employment be achieved but maintained.
Of course, there is the little matter of the Treasury bond market to contend with, as investors may have qualms over the interest rate at which they will lend to the US government in the face of rising prices. We are all aware of how much Treasury yields have risen this year, especially in the 10-year and 30-year maturities. Those higher yields are a result of both rising inflation concerns as well as significantly greater issuance. Yesterday, for instance, the Treasury issued a total of $96 billion in new debt, $58 billion of 3-year and $38 billion of 10-year. The 10-year auction results were about average, except for the fact that the yield they are paying, 1.68%, is more than 50 basis points higher than the average of the previous 5 auctions. Remember, a key tenet of the Yellen Treasury is that they can afford to borrow much more since the debt service costs are so low. However, if yields continue to rise, those debt service costs are going to rise with them, so this is not a permanent situation.
Tying it all together, despite the Fed’s current obsession with employment and its corresponding indifference to inflation, the inflation debate will not go away anytime soon. This morning will simply be the latest volley in the ongoing ‘war’ between central banks and reality. In the end, I’m confident reality will win, but the central banks have made it clear they will not go down without a fight.
As to markets this morning, after a very dull session yesterday, things remain quiet as this data point continues to be the global market focus. So equity markets have been mixed in Asia (Nikkei +0.7%, Hang Seng +0.1%, Shanghai -0.5%) and Europe (DAX +0.1%, CAC +0.2%, FTSE 100 -0.1%) with US futures actually starting to slide as all three major indices are now lower by 0.4%-0.5% as I type.
Bond markets are modestly softer with Treasury yields higher by 0.5bps, and similar rises in the major European sovereign markets. The PIGS are having a tougher day here, with Italy (+2.9bps) and Greece (+4.3bps) selling off a bit harder. We also saw yields rise in Australia overnight.
Yesterday morning I mentioned oil’s struggle at $60/bbl and it continues as while prices are higher compared to yesterday’s close (WTI +0.75%), the price is right on that big round number, which tells us it fell back in yesterday’s session from early morning gains. Metals markets are similarly mixed (Au -0.2%, Ag +0.6%, Cu +0.2%, Sn -0.3%) and it can be no surprise that grain markets have traded the same way. In other words, pretty much every market is waiting for CPI to take their cues.
FX markets are starting to bias toward dollar strength as NY walks in, with NOK (-0.75%) the laggard in the G10, although on precious little news or data. This is especially odd given oil’s gains in the session. But pretty much the entire G10 is softer, albeit with less emphasis than the krone, as CAD (-0.45%) is the next worst performer and then the rest are simply drifting lower ahead of the number. EMG markets are also biased toward USD strength here, with PLN (-0.8%) and HUF (-0.65%) the two outliers, both on the back of commentary that ongoing easy monetary policy remains appropriate and the central banks are comfortable with the weaker currencies.
The CPI data is the only release, but we will hear from 6 more Fed speakers today as pretty much all members of the FOMC are on the calendar this week. Yesterday’s most notable comments came from St Louis Fed President Bullard as he floated a tapering trial balloon, hinting that when 75% of the population has been vaccinated, that might be an appropriate time to consider that option. While it is clear that is Bullard’s proxy for a return to economic growth, it seems an odd data point on which to base monetary policy decisions, as the relationship between vaccinations and economic activity is not that direct.
At any rate, nothing has changed with respect to markets with 10-year Treasury yields remaining the key driver. If today’s CPI is strong, and yields rise, look for the dollar to continue to rise as well, with a weak print, and lower yields likely softening the buck. These days, it is truly binary.
Good luck and stay safe
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
The positive news keeps arriving
Explaining the ‘conomy’s thriving
Last Friday’s report
Was of such a sort
That showed growth is clearly reviving
The Nonfarm data on Friday was a generally spectacular report that was released into a near vacuum. All of Europe was closed for the Good Friday holiday as were US equity markets. The Treasury market was open for an abbreviated session and there were some futures markets open, but otherwise, it was extremely quiet. And the thing is, this morning is little different, as Europe remains completely closed and in Asia, only Japan, South Korea and India had market activity. Granted, US markets are fully open today, but as yet, we have not seen much activity.
A quick recap of the report showed Nonfarm Payrolls rose by 916K with revisions higher to the past two months of 156K. The Unemployment Rate fell to 6.0%, its lowest post pandemic print and the Participation Rate continues to edge higher, now at 61.5%, although that remains a far cry from the 64% readings that had existed for the previous decade. Arguably, this is one of the biggest concerns for the economy, the fact that the labor force may have permanently shrunk. This is key because, remember, economic growth is simply the product of population growth and productivity gains. In this case, population growth means the labor force population, so if that segment has shrunk, it bodes ill for the future of the economy. But that is a longer-term issue.
Let’s try to put the employment situation into context regarding the Fed and its perceived reaction functions. It was less than two months ago, February 23 to be exact, when Chairman Powell testified to Congress about the 10 million payroll jobs that had been lost and needed to be recovered before the Fed would consider they have achieved their maximum employment mandate. At that time, expectations were this would not be accomplished before a minimum of two more years which was what helped inform the Fed’s broad belief that ZIRP would be appropriate through the end of 2023. And this was the FOMC consensus view, with only a small minority of members expecting even a single rate hike before that time.
But since then, 1.6 million jobs have been created, a remarkable pace and arguably quite a bit faster than anticipated. The bond market has seen this data, along with the other US economic information and determined that the recovery is moving along far faster than previously expected. This is evident in the fact that the 10-year yield continues to climb. Even in Friday’s abbreviated session, yields rose 5 basis points, and as NY is waking up, they have maintained those gains and appear to be edging higher still. Similarly, the Fed Funds futures market is now pricing in its first full rate hike in December 2022, a full year before the Fed’s verbal guidance would have us believe.
The point here is the tension between the Fed and the markets is growing and the eventual outcome, meaning how the Fed responds, will impact every market significantly. So, not only will the bond market have an opportunity to gyrate, but we will see increased volatility in stocks, commodities and the FX markets. The Fed, however, has made it abundantly clear they are uninterested in inflation readings as they strongly believe not only will any inflation be ‘transitory’, but that if it should appear, they have the tools to thwart it quickly (they don’t). More importantly, they have a very specific view of what constitutes maximum employment. And they have been explicit in their verbal guidance that they will give plenty of warning before they start to alter policy in any way. The problem with this thesis is that economic surprises, by their very nature, tend to happen more quickly than expected.
This combination of facts has created the very real possibility of putting the Fed in a position where they need to choose between acting in a timely fashion or giving all that warning before acting. If they choose door number one, they risk impugning their credibility and weakening their toolkit while door number two leaves them even further behind the curve than normal with negative economic consequences for us all. If you wondered why many pundits have used the metaphor of the Fed painting itself into a corner, this is exactly what they are describing.
For now, though, there is precious little chance the Fed is going to change their stance or commentary until forced to do so, which means that we are going to continue to hear that they believe current policy is appropriate and they will give plenty of warning before any changes. I hope they are right, but I fear they are not.
Markets take less time to discuss this morning as most of them are closed. Of the major equity indices, only the Nikkei (+0.7%) was open last night as Commonwealth countries were closed for Easter Monday while China was closed for Tomb Sweeping Day (the Chinese version of Memorial Day). US futures are pointing higher, which given Friday’s data should be no surprise. So right now, we are looking at gains between 0.4% and 0.7%, with both the Dow and S&P sitting at all-time highs.
Bond markets were similarly closed pretty much everywhere, with the US market now edging higher by 0.4bps as traders sit down at their desks. The current 10-year yield of 1.725% is at its highest level since January 2020, but remember, it remains far below the average seen during the past decade and even further below levels seen prior to that. The point is yields are not constrained on the high side in any real way.
Oil prices (-1.7%) are under pressure this morning after OPEC+ indicated they would be increasing production somewhat thus taking pressure off of supplies. However, given the speed of recovery in the US and China, the two largest consumers of oil, I expect that there is more upside here as well.
As to the dollar, it is a pretty dull session overall. That is mostly because so many financial centers have been closed, so trading volumes and activity has been extremely light. In the G10 space, there is a mix of gainers (GBP +0.25%, AUD +0.2%) and losers (SEK -0.25%, NOK -0.15%) but as can be seen by the limited movement, this is really just a bit of position adjustment. In the EMG bloc, TRY (+0.6%) is the leading gainer after a slightly higher than expected inflation print and more hawkish words from the new central bank governor. Otherwise, these currencies are also trading in a range with limited movement in either direction. We will need to wait until tomorrow to see how other markets react to the US data.
Speaking of data, this week sees a mix of indicators as well as the FOMC Minutes.
|Tuesday||JOLTs Job Openings||6.9M|
|Friday||PPI||0.5% (3.8% Y/Y)|
|-ex food & energy||0.2% (2.7% Y/Y)|
Away from this data, we hear from a handful of Fed speakers, including Chair Powell. Powell, however, will be speaking at the virtual IMF/World Bank meetings being held this week. In fact, that should remind us to all be aware of the tape, as we will be hearing from many global financial policymakers this week, and you never know what may come from that.
In the end, the bond market continues to be the key driver of markets, and the US Treasury market remains the driver of global bond markets. I see no reason for US yields to back off given the consistent data story and the increased price pressures. And that, my friends, means the dollar has further room to rise.
Good luck and stay safe
The key for investors today
Is payrolls and how they portray
The jobs situation
Thus, whether inflation
Will rocket, or be kept at bay
It’s Payrolls day, generally a session where there is a great deal of anticipation leading up to the release, often followed by a burst of activity and then a very slow afternoon. However, given today also happens to be Good Friday, with all European markets closed in observation, as well as US equity markets, it is likely the burst activity, assuming one comes, will be compressed into an even shorter timeline than usual. Of course, what makes this potentially unnerving is that market liquidity will be significantly impaired relative to most sessions, and any surprising outcome could result in a much larger move than would normally be the case.
It is not a bank holiday, which means the bond market will be trading, and that is, in truth, the market that continues to drive the action. As evidenced by yesterday’s price action, the bond rally, with 10-year Treasury yields sliding 7 basis points, led to a declining dollar and new record highs in the stock market. We also saw gold and other commodities rally as the combination of strong data (ISM at 64.7) and lower yields was a double-barreled benefit.
With that in mind, here are the latest expectations:
|Average Hourly Earnings||0.1% (4.5% Y/Y)|
|Average Weekly Hours||34.7|
All that seems fine, but it is worth a look at the individual forecasts that make up that NFP number. There is a wide dispersion of views ranging from a gain of just 350K to eight forecasts greater than 900K and three of those at a cool million each.
Let’s consider, for a moment, if the optimists are correct. Harking back to Chairman Powell’s constant refrain regarding the recovery of the 10 million lost jobs, the expected timeline for that to happen remains sometime in late 2023. But if this morning’s release is 1000K or more, that would seem to potentially shorten the timeline for those jobs to return. And following that logic, it seems likely that the Fed may find themselves in a situation where ZIRP is no longer appropriate somewhat earlier in 2023 than currently expected as inflation rises, and unemployment falls back to their new goal of 3.5%-4.0%. The implication here is that the bond market will anticipate this activity and we could see the 10-year yield break through to new highs quite quickly. Based on broad market behavior as seen yesterday, a sharp decline in the bond market would likely result in the dollar rebounding sharply and equity futures, which are trading, retreating. And all this on a day when there is much less liquidity than normal.
Of course, a weak number is likely to have just the opposite effect, with the bond bulls making the case that we have seen the high in yields, and dollar bears back in the saddle making the case the dollar’s run higher has ended.
And that’s really what we have in store for the day. The two markets that were open overnight saw equities rally on the heels of the US equity rally, with the Nikkei (+1.6%) and Shanghai (+0.5%) both performing well. Every European market is closed for the holiday and will be on Monday as well. Meanwhile, US futures are all pointing modestly higher, roughly 0.25%, ahead of the payroll report.
As NY is walking in, we are seeing the first movement in Treasury yields and they have edged higher by 1.1bps at this point. But as I highlight above, this is all about the data today.
In the commodity markets, only precious metals are trading but both gold and silver are essentially unchanged at this hour ahead of the data. This follows yesterday’s strong performance with both rallying more than 1% in the session.
And finally, in the FX market, except for TRY (+0.7%) and KRW (+0.4%) there is no movement more than 0.2%, which is indicative of the fact that some positions are being adjusted but there is no news driving things. In the case of TRY, the new central bank governor, in a speech today, made clear that he was not going to cut rates and that he was likely to raise them again in an effort to combat the rising inflation in the country. This was well received by the market and has helped TRY recover much of its initial losses upon the sacking of the previous central bank chief. As to KRW, they released CPI data last night, 1.5%, which was the highest print since January 2020, indicating that growth was persistent, and the BOK would be more vigilant going forward. This also encouraged equity inflows resulting in the won’s modest appreciation.
So, now we wait for the payroll data. Based on the releases that we have seen during the past couple of weeks, where the economy is clearly pushing ahead, I suspect this number will be somewhere above 800K, although 1000K is clearly not out of the question. As such, my view is we will see the bonds sell off and the dollar retest its recent highs, if not break through them.
Good luck, good weekend and stay safe
Said Madame Lagarde with some jaunt
“They can test us as much as they want”
We’ve exceptional tools
And we still make the rules
These are words that could come back to haunt
If there were any questions as to the key driver in the markets, Madame Lagarde answered them tacitly this morning in a televised interview. The number one driver of all things financial continues to be the yield on the 10-year Treasury bond and its knock-on effects for other markets. Hence, when asked about the rising yields in the European sovereign markets, where similar to the Treasury market, yields are broadly at or near one-year high levels, she uttered what almost seemed like a challenge, “They can test us as much as they want. We have exceptional circumstances to deal with at the moment and we have exceptional tools to use at the moment, and a battery of those. We will use them as and when needed in order to deliver on our mandate and deliver on our pledge to the economy.” While this doesn’t quite rise to Signor Draghi’s famous “whatever it takes” comment, it is certain that Lagarde was trying for the same impact.
Perhaps, however, something is lost in the translation from Italian to French, as the bond market stifled a collective yawn at her comments and yields continue to climb higher this morning, albeit not quite as dramatically as yesterday. So, a quick tour of European bond markets shows yields on the Bunds, OATs and Gilts all about 1 basis point higher, following right along with Treasury yields which are 2.2bps above yesterday’s close as I type. While there is no doubt that this move higher in yields is getting a bit long in the tooth, and it would not be surprising to see a short-term respite, the underlying drivers, which remain a combination of anticipated excess new supply and rising prices, are still very much in place. In fact, later today apparently President Biden is going to introduce his newest spending bill with a $2.25 trillion price tag. This merely adds fuel to that fire of excess supply expectations.
There is one other thing that seems to belie the image of strength put forth by Lagarde, as well as by Chair Powell; the fact that they both go out of their way to explain that
if when the time ever comes that they are actually going to slow down monetary injections, let alone actually reverse them, they will do so only after having given ample warning well in advance of such actions. In other words, they remain terrified that taper tantrums are going to occur if they ever stop expanding their balance sheet, with a resulting decline in asset prices. Now, the one thing that is abundantly clear, especially in the US, is that while there is a great deal of Fedspeak about achieving maximum employment, the Fed’s key indicator is the S&P 500. Thus, a falling stock market will bring about a change in Fed policy faster than anything else. However, it seems to me advance notice of tapering would not change the market reaction, merely its timing, so it is not clear what benefit they see in the idea.
Nonetheless, it remains the working thesis of central banks everywhere, that they must give significant forward guidance in order to be effective. Yet once the market perceives an inflection point in that guidance, it is going to react immediately, even if the promised policy change is not until some future date. My personal belief is that central banks would be far better off simply changing policies as they deem necessary without forward guidance and allow markets to find a new equilibrium after the policy change. But that is a radical idea in today’s world.
In any case, there has been nothing new to change the ongoing narrative which remains the reflationary story is driving yields higher and the dollar along with them. meanwhile, equity prices are beginning to struggle in the face of those rising yields as fixed income has started to become a viable alternative investment to equities, and the discount factor for future growth continues to point to lower current prices. Thus, while markets this morning are taking a pause on their recent trajectory, with the dollar modestly softer along with most equity markets and commodities, much of this can be attributed to the fact that it is month and quarter end (and fiscal year end for many Asian nations), so recent positions may be reduced for balance sheet purposes.
So, let’s take a look at markets today. Equity markets in Asia were mostly under pressure with the Nikkei (-0.9%), Hang Seng (-0.7%) and Shanghai (-0.4%) all weaker on the close. Europe has seen a more mixed picture as the DAX (0.0%) has recovered from mild early losses, but the CAC (-0.2%) and FTSE 100 (-0.3%) are both feeling a bit of pressure. US futures, meanwhile, continue their bipolar activities, this time with the NASDAQ (+0.65%) rising while the DOW (-0.2%) is under the gun. However, remember that much rebalancing is likely to be seen again today given the calendar, so do not be surprised if there are short-term reversals to recent trends.
As to commodities, oil prices (-0.4%) are a touch softer this morning while gold (+0.1%) and silver (+0.25%) seem to have stabilized for the time being. The base metal story is more mixed with Cu (+0.7%) on the day, but the rest of the main trading metals generally softer by a similar amount.
Finally, the dollar is under some pressure today, although given its run over the past week, this appears merely to be a short-term corrective. In the G10, NOK (+0.5%) is the leading gainer, despite oil’s modest decline, as the market continues to look at the Norwegian economy and forecast Norgesbank may be the first G10 bank to raise interest rates. Inflation pressures appear to be building in the country and growth remains on the upswing. Away from the krone, the rest of the bloc is firmer by between 0.2% and 0.3% with modest impact from CPI data across Europe showing prices rising compared to February, but a tick less than forecast in the major countries. The one exception is JPY (-0.25%) which is simply cratering of late and has now declined about 7.5% in 2021. It appears that we are beginning to see an increase in unhedged Treasury buying by Japanese investors, with the 10-year yield spread now above 165 basis points, a level that historically has seen significant interest from the Japanese investment community. In fact, if drawing a long-term trend line from its recent peak in early 2017, USDJPY appears to be breaking higher with a target of 112.00 a very real near-term possibility.
Regarding EMG currencies, there is general strength there as well, led by ZAR (+0.7%) and RUB (+0.6%) which have been two of the overall better performers for the week. But in a broader sense, we are seeing modest reversals of what had been EMG currency weakness for the past week or more.
On the data front, ADP Employment (exp 550K) is the first part of the employment picture this morning with some whisper numbers growing for the NFP on Friday to over 1 million new jobs as the economy reopens. We also see Chicago PMI (61.0), which should show continued growth in the manufacturing sector. Overnight, Chinese PMI data (Composite 55.3) was much better than expected and indicates that the Chinese economy has moved past the Lunar New year lull. There are no Fed speakers, but really, people will be focused on the new spending package, and more importantly, the indications of how it will be funded. The less tax discussion, the likelihood of the bigger negative impact on the bond market.
As to the dollar today, the current trend remains clearly higher, but with month-end rebalancing taking place here as well, a touch of further weakness is quite viable on the day.
Good luck and stay safe
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