Tag Archives: #Treasurys

Central Bank Dreams

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
Adf

Clearly Reviving

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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.

Today ISM Services 59.0
Factory Orders -0.5%
Tuesday JOLTs Job Openings 6.9M
Wednesday Trade Balance -$70.5B
FOMC Minutes
Thursday Initial Claims 690K
Continuing Claims 3638K
Friday PPI 0.5% (3.8% Y/Y)
-ex food & energy 0.2% (2.7% Y/Y)

Source: Bloomberg

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
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Kept at Bay

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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:

Nonfarm Payrolls 660K
Private Payrolls 643K
Manufacturing Payrolls 35K
Unemployment Rate 6.0%
Average Hourly Earnings 0.1% (4.5% Y/Y)
Average Weekly Hours 34.7
Participation Rate 61.5%

Source: Bloomberg

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
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As Much As They Want

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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
Adf

The Bottom’s Not In

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

Plus ça change, plus ça même chose.

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

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

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

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

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

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

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

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

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

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

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

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

Good luck and stay safe
Adf

Flames of Concern

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In Turkey, the president canned
The central bank chief, and has fanned
The flames of concern
As traders now spurn
The lira in lieu of the rand

The top FX story this morning clearly revolves around the abrupt firing of the Turkish central bank’s governor, Naci Agbal, after he had the audacity to raise rates a surprising 2.0% last week in his effort to combat rising inflation.  The market had applauded the rate move and TRY had risen sharply, more than 4%, in the aftermath.  Unfortunately for him, Turkish president Erdogan is strongly of the opinion that rising inflation is caused by higher interest rates and is adamantly against the idea of raising rates.  (It appears that Erdogan is an MMTer at heart).  Arguably this is because it costs his government more to borrow for his spending plans, but whatever the rationale, this is at least the second central bank governor he has fired after a rate hike.  It cannot be a surprise that the lira has fallen dramatically in markets this morning and is down more than 10% as I type.  I highlight this to remind readers that abrupt and very large movements remain quite feasible in the FX markets.

Meanwhile, it’s the Treasury bond
About which most markets respond
Two camps have emerged
Where one side has urged
A cap, while the other side’s yawned

But really, the story that matters the most in markets right now continues to be the future price action in US Treasury markets.  The battle lines have been drawn with the inflationistas convinced that the combination of massive money printing by the Fed (M2 +25.8% Y/Y as of January 31) combined with the recently passed $1.9 trillion Covid bill is going to lead to significant price rises and much higher yields in the bond market.  In this camp, many expect the Fed to be forced to cap yields, either tacitly, by extending the maturity of QE purchases, or explicitly by telling us so, thus driving real yields lower and the dollar down as well.

In the other camp are the deflationists, a shrinking group, who nevertheless believe that the underlying drivers of declining inflation over the past 40 years; namely globalization, technology and demographics, remain firmly in place and will reassert themselves in the medium term.  This camp will also point to the fact that the ratio of interest payments to GDP, a key metric determining the affordability of government debt loads, continues to decline in the US and so a short-term rise in Treasury yields is no cause for concern.   Arguably, Treasury Secretary Yellen lives in this camp as she has consistently expressed her belief that the risks to the economy now are not doing enough to support growth and has been completely unconcerned with the rapid growth of Treasury debt to fund the serial government programs that have been enacted.  In this telling, the current price action in bonds is temporary and will soon be corrected as it becomes clear inflation is not a significant problem.

Ultimately, what this means is that the rest of us are beholden to the outcome of this situation and need to remain vigilant for clues as to how the situation will evolve.  Perhaps this week we will get some clues, if not from the data, then from the twenty-two different Fed speeches that are on the calendar.  Almost every FOMC member will be regaling us with their views following last week’s FOMC meeting.  In fact, the first, Richmond Fed president Barkin, has already spoken overnight and dismissed concerns over rising yields as an issue, rather explaining they were a vote of confidence in the economy and no problem at all.  We shall see!

Ok, on to markets, where the overriding theme is… there is no theme.   Equity markets were mixed overnight (Nikkei -2.1%, Hang Seng -0.4%, Shanghai +1.1%) and European bourses are showing a similar spread (DAX +0.25%, CAC -0.25%, FTSE 100 0.0%). US futures?  Same thing here with NASDAQ up 0.8% while DOW futures are slightly softer, -0.1% and SPUs are +0.1%.

Bond markets, however, are rallying somewhat after last week’s gyrations with the 10-year Treasury yield down 4.6bps and back below 1.70%.  The yield declines in Europe are far more muted (Bunds -1.5bps, OATs -1.0bps, Gilts -1.5bps) although we did see JGB’s (-2.9bps) rally last night.  If pressed, I would say that investors, given the lack of theme are taking advantage of the recent rise in yields to earn a bit more.

In the commodity space, earlier price action saw much deeper declines, but as New York is walking in, oil (-0.2%) is just marginally lower; gold (-0.4%) has retraced some early losses and the base metals are mixed at this time with copper (+0.6%) higher while aluminum (-0.2%) is lagging.

Finally, looking at the dollar, aside from TRY’s collapse, the rest of the EMG space is far less dramatic with MXN (-0.75%) the laggard on a combination of weaker oil and the ongoing border crisis being seen as a negative for the economy there.  On the positive side, the gains are de minimis (PLN +0.3%, KRW +0.25%, PLN +0.2%) with CE4 currencies tracking the euros modest gains and Korea benefitting from comments about a faster than previously expected recovery.

G10 currencies, which had been mixed earlier, have started to gain a bit, led by CHF (+0.3%) and SEK (+0.3%) although the rest of the bunch have seen much smaller movement overall.  The interesting CHF story was that the SNB executed $118 billion of FX intervention last year, which may come under further scrutiny by the US Treasury given the fact that Switzerland was named a currency manipulator last year.  In the end, though, given the remarkably small size of the Swiss economy, it is hard to believe that there has been any real impact on the US economy by their actions.  The SNB meets this week and will almost certainly defend their activities as a requirement to prevent further strength in the currency which could drive a significant deflationary spiral, at least so they believe.

On the data front, there is a good deal coming up as follows:

Today Existing Home Sales 6.49M
Tuesday Current Account Balance -$188.3B
New Home Sales 873K
Wednesday Durable Goods 0.7%
-ex transport 0.6%
PMI Manufacturing (prelim) 59.5
Thursday Initial Claims 730K
Continuing Claims 4.0M
GDP Q4 4.1%
Friday Personal Income -7.2%
Personal Spending -0.8%
Core PCE Deflator 1.5%
Michigan Sentiment 83.6

Source: Bloomberg

In truth, the Friday data seems the most important, as the Personal Spending and PCE are keys being watched most closely.  We all know that the housing market is hot, and that PMI is likely to be strong as the economy reopens.  But what will happen with the Fed’s key measure of inflation?

And then, amidst all the Fed speak, we have Chair Powell in two joint appearances with Treasury Secretary Yellen, first before the House tomorrow and then the Senate on Wednesday, but given the sheer breadth of commentary we are going to hear, it will be important to see if a theme regarding the bond market’s recent declines with ensuing yield increases becomes a key topic.  Certainly, market participants are highly focused on the subject.

So, adding it all up, we have a decent amount of data and a lot of Fed speakers coming our way.  As I strongly believe the dollar’s direction will be driven by the bond market for the near-term, at least, listen carefully to those comments.  Powell actually starts the commentary this morning at 9:00.  The more unconcerned the Fed speakers are with rising yields, the more likely, in my estimation, the dollar is to rise.

Good luck and stay safe
Adf

Right From the Script

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

Covid’s Predations

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There once was a time when reflation
Was cause for widespread celebration
Because it implied
That growth nationwide
Recovered from Covid’s predation

But lately concerns have been rising
That markets are destabilizing
As data that’s good
Does more than it should
To raise yields, thus need tranquilizing

There is an ongoing battle in markets these days, between the G10 central banks, led by the Fed, and the bond market and its investors and traders.  What we know with certainty is that the central banks are keen to maintain their easy money policies for a much longer period of time as they await clear economic recovery and a higher, but steady, inflation level.  In the past week we have heard from a number of different central bank speakers, notably Jay Powell and Christine Lagarde, that current policy settings are appropriate, and that while the sharp move higher in 10-year yields has “caught their eye” there is no indication they will respond.

But the other thing of which we are pretty certain is that markets love to test central banks when they think they have an edge.  And while the equity market mantra for the past decade has been, ‘don’t fight the Fed’, that is not really a bond market sentiment.  Rather, bond investors and traders will frequently make their collective views known via significant selling pressure driving interest rates up to a point where the central bank blinks.  And it certainly feels like that is an apt description of the current market price action.

The problem for the central banks is that they currently find themselves fighting this battle with one hand tied behind their back, and it is their own fault.  Remember, one of the key ‘tools’ that central banks use is forward guidance and verbal intervention to sway market opinion.  But the current timing is such that both the ECB and Fed have meetings upcoming and are in their self-imposed quiet periods, where central bank members are not supposed to make public comments that could impact markets.  And this means that they are unable to make comments implying imminent action if markets continue to misbehave.  Of course, the Fed could simply start buying longer dated debt in the market without announcing that is what they are doing, but while that may have been an acceptable methodology thirty years ago, the Fed’s MO these days is that they feel they must explain everything they do, so seems highly unlikely.

Thus we have a situation where bond investors see news stories like the passage by the Senate of the $1.9 trillion stimulus bill, the increased rate of vaccinations throughout the US population and the rapidly declining pace of infection and have jumped to the conclusion that the recovery in the US is going to be both sooner and more robust than earlier forecasts.  This, in turn, has them believing that inflation is going to pick up and that the Fed will be forced to raise rates to cool the economy.  At the same time, Powell (and Lagarde) could not have been more explicit in their comments that current policy is appropriate, and they have no intention of adjusting it until they achieve their goals.  And, by the way, those goalposts have moved quite a bit since the last tightening cycle, such that headline gains in economic data is not nearly good enough, instead they are focused on subsectors of that data like minority employment and wage growth, historically the last part of the economy to benefit from a recovery.

Add it all up and you have a situation where the bond market is observing much faster growth and raising rates accordingly while the Fed is looking at the pockets of the economy where things move more slowly and trying to boost them.  The Fed’s problem is higher rates are not helping their cause, nor are they helping to maintain easy financial conditions.  And their other current problem is they can’t even talk about it for another 9 days.  Markets can wreak a great deal of havoc in a period that long as evidenced by this morning’s rising 10-year yields and declining stock futures during the first day of that quiet period.

Which is a perfect segue into today’s session, where risk is largely under pressure.  Last night saw weakness throughout Asian equity indices with the Nikkei (-0.4%), Hang Seng (-1.9%) and Shanghai (-2.3%) all lower although there were pockets of strength in the commodity producing countries.  Europe, on the other hand, is broadly higher this morning led by Italy’s FTSE MIB (+2.0%) but seeing strength elsewhere (DAX +1.3%, CAC +0.9%) on news that the European vaccination program is scheduled to pick up the pace.  US futures, though, are continuing to feel the pressure from higher US yields, especially in the tech space as the NASDAQ (-1.5%) leads the decline with the S&P (-0.5%) and DOW (-0.1%) not nearly as badly impacted.

But Treasury yields continue to rise with the 10-year higher by another 2.5 basis point this morning and pressing 1.60% again, a level it touched Friday after the much better than expected payroll report.  However, in Europe, bonds are mixed with Bunds (+0.7bps) a bit softer while OATs and Gilts have both seen yields edge lower by 0.5bps.

Commodity prices continue to perform well in response to the improving data and increasing vaccination rates with oil (+0.3%) modestly higher and maintaining the highest levels seen in more than 2 years.  In the metals markets, base metals are mixed while precious metals continue to suffer from rising US yields.  And finally, agricultural products continue their steady rise higher.

Lastly, the dollar continues to benefit from higher yields as it is higher vs. literally every one of its counterparts in both the G10 and EMG.  There is no need to discuss specific stories here as this is a universal dollar strength situation, where investors are beginning to unwind emerging market positions as well as their short dollar views.  While those positions remain elevated in comparison to historical levels, they have been reduced by about 40% from the peak shorts seen last
August.

On the data front, arguably the most important data point this week is Wednesday’s CPI, but there is a bit more than that coming out.

Tuesday NFIB Small Biz Optimism 96.5
Wednesday CPI 0.4% (1.7% Y/Y)
-ex food & energy 0.2% (1.4% Y/Y)
Thursday ECB meeting -0.5% (unchanged)
Initial Claims 725K
Continuing Claims 4.2M
JOLTs Job Openings 6650K
Friday PPI 0.4% (2.7% Y/Y)
-ex food & energy 0.2% (2.6% Y/Y)
Michigan Sentiment 78.0

Source: Bloomberg

I think it could be instructive to see that PPI data as well, which could be a harbinger of CPI in the coming months.  Now I know that Jay has explained this will be transient, and he may well be right, but history shows the bond market will need to see proof inflation is transient before calming down.

Obviously, there are no Fed speakers scheduled and we don’t hear from the ECB until Thursday, so market participants have free reign to do what they see is correct.  Currently, rising rates has called into question the validity of the tech stock boom and seen a rotation into value stocks.  Meanwhile, rising rates has also seen general pressure on stock indices and the dollar continues to benefit from that scenario.  As I have written many times, historically a steeper US yield curve meant a strong dollar, and as the curve continues to bear steepen, it is hard to call a top for the greenback.

Good luck and stay safe
Adf

Fears to Assuage

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When calendars all turned the page
To ‘Twenty-One, clearly the rage
Was bets on reflation
And more legislation
For stimulus, fears to assuage

The dollar was slated to fall
The yield curve, to grow much more tall
While stocks were to rally
And Covid’s finale
Was forecast, a popular call

But so far, while stocks have edged higher
And bond yields are truly on fire
The dollar remains
Ensconced in its gains
Its meltdown has yet to transpire

One cannot be but impressed with the dollar’s resilience so far this year amid such surety by so many that it was destined to fall sharply.  Consensus views at the beginning of January were that the vaccines would lead to significant reflation in the global economy, equity markets would benefit greatly, bond yields would rise amid trillions of dollars of new issuance, and the dollar would fall.  As I said from the start, higher bond yields and a steeper yield curve did not typically lead to dollar weakness.  And that is what we have begun to see in the past several sessions.

Global bond markets have really started to reprice the current situation.  While the US story is easy to understand; huge new stimulus bill with no tax increases means huge new Treasury issuance to pay for things and supply overwhelms demand, one needs to ask what is driving the price declines throughout Europe and Asia as well. Stimulus efforts elsewhere have been less substantial despite more severe lockdowns by most of Europe and many Asian nations.  So, perhaps it was not merely the supply-demand imbalance that had bond investors concerned, perhaps it was also inflation expectations.

Certainly, these have been rising sharply with US 5yr-5yr breakevens now at 2.40% this morning, the highest level since March 2013, and not merely trending higher, but exploding higher.  (Germany, too, has seen a sharp rise in breakeven inflation, albeit to much lower levels, rising from 0.2% at the lows last March to 1.06% today.)  While last week’s CPI readings were a touch softer than expected on a headline basis, the reality is that higher inflation remains almost assured going forward.  This is partly because of the way the data is calculated, where last year’s pandemic induced lows will fall out of the calculation to be replaced by this year’s much higher readings.  It is also evident in the rising price of commodities, specifically oil (+1.0% this morning) which is higher by 25% this year.  In fact, the entire energy sector has seen prices rise by roughly that amount, and we have seen gains across the board in both base metals and all agricultural products.  In other words, stuff costs more.

Perhaps, of more concern is the insouciance toward inflation shown by the Fed.  For example, just yesterday, SF Fed President Mary Daly, when asked about inflation getting out of hand replied, “I don’t think that’s a risk we should think about right now.  We should be less fearful about inflation around the corner and recognize that fear costs millions of jobs.”  If you think the Fed is going to respond to any inflation data, anytime soon, you are mistaken.  They have made it very clear that the only part of their mandate that currently matters is employment.

So, let’s recap; the price of stuff is going higher while the Fed is adamant that tighter policy is inappropriate at this time.  Bonds are doing their job, or perhaps that is; the bond vigilantes are doing their job.  They are forcing yields higher, and left unabated, probably have much further to go.  But will they be left unabated?  I think the definitive answer is, no, the Fed will not allow Treasury yields to rise very much further.  And this, of course, drives my view that the dollar, while strong now, will eventually reverse course, as the Fed halts the rise in Treasury yields.

But for now, those higher yields are attracting investors into dollar products, and by extension, into dollars.  And this story can play out for a while yet.  It is a mug’s game to try to guess at what point the Fed will become uncomfortable with Treasury yields, with current guesses ranging from 1.50% to 3.0% in the 10-year.  My sense is it will be toward the lower end of that range that will encourage the extension and expansion of QE, perhaps 1.75%-2.0%.  But I remain confident that at some point, they will respond.  And with inflation showing no signs of abating, it will happen sooner than you think.

What about the rest of the world?  Well, the one thing we know is that neither the ECB nor the BOJ can afford for their currencies to strengthen too much.  While Japan has shown more stoicism lately, I can easily envision Madame Lagarde, in the context of alleged lack of inflationary pressures, pushing the ECB to expand their largesse as well, at least enough to try to offset the Fed.  Will it work?  That, of course, is the $64 trillion question.

On to today’s activity.  Risk is under a bit of pressure this morning after what were truly impressive bond market declines yesterday.  but those declines were not so much risk on, as fear starting to spread.  So, a quick tour of equity markets shows that after a mixed US session, the Nikkei shed 0.6% overnight, although the Hang Seng managed a 1.1% gain.  Shanghai reopens tonight.  In Europe, screens are red wit the DAX (-0.55%) leading the way lower, although the CAC (flat) and the FTSE 100 (-0.1%) are not suffering that greatly.  Meanwhile, at this hour, US futures are essentially unchanged.

Bond yields, which rose sharply around the world yesterday (11bps in the US, 5-8bps throughout Europe) are consolidating a bit.  Treasuries are lower by 1.9 basis points, but they have already backed up from earlier levels.  In Europe, we see the same thing, where early yield declines have been virtually erased.  Bunds are flat, OATs are higher by 0.6bps and Gilts, one of the worst performers yesterday, have seen yields fall 1.0bp, but that is well off the levels earlier this morning. The point is, even if equities are under pressure, funds don’t appear to be flowing into bonds.

Rather, commodities are the market of choice, with oil now above $60/bbl (+1.0%) and base metals higher along with almost all agricultural products.  In fact, the only real laggards here are gold (-0.3%) and silver (-0.5%), which are arguably suffering from higher yields as a competitor.

Finally, the dollar is definitely feeling its oats this morning, rising against all its G10 brethren, with the weakest link SEK (-0.45%), although other than CAD (-0.1%) and JPY (-0.05%), the rest of the bloc is lower by at least 0.3%.  This is a broad dollar strength story, with virtually no idiosyncratic national issues to drive things.  In fact, the only data of note was UK inflation, which printed a tick higher than expected.

Emerging market currencies are similarly under pressure across the board, led lower by ZAR (-0.8%) and MXN (-0.8%), although there is broad weakness in APAC and CE4 currencies as well.  Again, one needn’t look too far afield to determine why these currencies are weak, it is simply a dollar strength day.

On the data front, we start the morning with Retail Sales (exp 1.1%, 1.0% ex autos), move on to IP (0.4%) and Capacity Utilization (74.8%) and finish the afternoon with the FOMC Minutes from the January meeting.  It seems hard to believe that the Minutes will have much impact as there were neither policy shifts nor even dissension in the ranks. Perhaps we will learn if YCC or QE extension has been a discussion topic, which would be hugely bond bullish and dollar bearish.  But I doubt it.

Rather, this dollar rebound, much to my surprise, seems to have a little more behind it and could well extend a bit further.  Looking at the euro, the technicians will focus on 1.2000, the 100-day moving average and 1.1950, the low touched in last week’s sell-off.  But if the Treasury curve continues to steepen, the euro could well move back to the 1.1750 level last seen prior to the US election in November.  That is not my base case, but the probability has certainly grown lately.

Good luck and stay safe
Adf

Blue Wave at Last

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Psephologists have now decided
The run-off election provided
A blue wave at last
So laws can be passed
Republicans view as misguided

The market responded by sellin’
The 10-year, with traders foretellin’
Inflation to come
As Powell stays mum
While financing Treasury’s Yellen

While the election results from Georgia are not yet final, the indications at this time are that the Democratic party won one of the seats with the second one still too close to call.  However, the market has already made its decision, that both seats flipped to the Democrats and that the Senate will now be split 50:50, which means that the Vice President will be able to cast the deciding vote.  The clear implication is that, while hardly a mandate, the Democrats will control both the executive and legislative branches and be able to implement a great deal of their agenda.  In other words, the blue wave high tide has finally crested.

The initial reaction to this news has been seen in the sell-off of the 10-year Treasury, where the yield has risen to 1.02% as I type, its first foray above 1.00% since March 19th, during the first days of the Covid-19 market panic.  The reflation trade is back in vogue, with expectations now that the new administration will be aggressively adding fiscal stimulus, thus increasing Treasury issuance significantly and ultimately steepening the yield curve as demand for long-dated Treasuries will not be able to keep pace with the new supply.  However, given the already record levels of debt outstanding, the government simply cannot afford for interest rates to rise too far, as if they do, interest payments will soak up an ever-increasing proportion of available revenues.  It is for this reason that I continue to believe the Fed will increase their current activity, and whether tacitly, by expanding QE and extending the maturity of purchases, or explicitly, by setting a yield target, implement Yield Curve Control (YCC).

At the same time, the Fed has made it abundantly clear that higher inflation is of no concern to the committee.  The latest proof comes from Chicago Fed President Charles Evans, who explained to us yesterday, “Frankly, if we got 3% inflation, that would not be so bad.  It is very difficult to imagine out of control inflation, even with the large debt that fiscal authorities have been running up.”   Perhaps, as a Regional Fed President, he simply lacks imagination.  After all, just yesterday, almost at the same time he was recounting his views, the ISM Prices Paid index printed at 77.6, well above expectations and at a level seen only twice, briefly, in the past decade.  There is a strong correlation between this index and PPI, so the idea that inflation pressures are building is hardly unimaginable.

Which brings us back to the prospects for the dollar, as well as other markets.  While yields have climbed today, the prospect of inflation rising more rapidly and real rates falling further into negative territory still informs my view that the dollar has further to decline.  This will become more obvious when the Fed steps in to prevent the rise in nominal yields, which I am confident will occur sooner rather than later.  Again, while I don’t anticipate a dollar collapse, as other central banks will fight to prevent such an outcome, further dollar weakness is in the cards.

Speaking of other central banks fighting the dollar’s weakness, last night the PBOC started to do just that by establishing the CNY fix at a weaker renminbi rate than anticipated.  Since August 1st, CNY has appreciated by nearly 8% vs. the dollar, which for an economy that remains heavily reliant on exporting for GDP growth, is a growing problem.  As the PBOC makes no bones about directing the value of the currency, you can expect that they will be actively managing the renminbi’s value going forward in an effort to prevent too much further strength.  But, as long as both nominal and real yields remain positive in China, that will attract significant capital flows and continue to pressure the renminbi higher.

So, what has all this news done to other markets?  Well, most of Europe is ecstatic at the election outcome, at least that seems to be the case based on the rallies seen in equity markets there.  The FTSE 100 (+2.3%) is leading the way, but we are seeing strong gains in the DAX (+0.9%) and CAC (+0.8%) as well, despite the fact that the PMI Services data disappointed across the board.  The story in Asia was more mixed with the Nikkei (-0.4%) and Australia (-1.1%) underwhelmed by the outcome, although the Hang Seng (+0.2%) and Shanghai (+0.6%) both wound up in the green.  As to US futures, as I type, they are a mixed bag, with DOW futures higher by 0.2%, SPU’s lower by 0.4% while NASDAQ futures are down 2.0%.  The latter’s decline are a response to the election results as concerns grow that Big Tech will now be in the crosshairs of Congress for more regulation if not outright dismemberment.

While we have already discussed the Treasury market, European government bonds are mostly softer today as well, with yields rising as much as 4bps in the UK, although German bunds are unchanged on the session.

Another inflationary impulse comes from oil, where yesterday the Saudis surprised the market by unilaterally cutting production by 1 million barrels/day helping to take WTI above $50/bbl for the first time since late February.  If this rally continues, look for gasoline prices to creep higher, one of the key sentiment indicators regarding the perception of inflation.

And finally, the dollar remains broadly under pressure this morning, with NOK (+0.75%) the leading gainer in the G10 on the back of the oil rally, although both AUD (+0.6%) and NZD (+0.65%) are also having a good day as both commodity prices gain and they serve as a proxy for Asian growth.  Meanwhile, the euro (+0.35%) is trading at new highs for the move and back to levels not seen since April 2018.

Emerging market currencies are universally higher this morning, led by PLN (+0.85%), MXN (+0.8%) and HUF (+0.8%).  Those stories are easy to see, with oil helping the peso, while the CE4 currencies are tracking the euro’s strength.  Asian currencies, while all firmer, did not show nearly the enthusiasm, with gains between 0.1% and 0.2%, but of course, the election results were not fully known during their session.

On the data front, this morning brings ADP Employment (exp 75K) as well as Factory Orders (0.7%) and the PMI Services index (55.2).  Then, this afternoon, we see the FOMC Minutes of the December meeting, one where they disappointed many folks by not easing further. The first thing to note is that after yesterday’s ISM data, the ADP forecast increased from 50K.  Clearly, the manufacturing sector remains in better shape than expected.  At the same time, the Minutes ought to be interesting as perhaps we will learn more about attitudes regarding any prospects for what could change policy.  Of course, given the world was a different place then, and as Evans explained, inflation is of no concern, the real question from the Minutes will be what will the Fed do next to ease further.

As to the dollar, it is hard to see a short-term path in any direction other than lower, but I continue to expect the decline to be slow and orderly.

Good luck and stay safe
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