Good morning.. I wanted to get this out early as Bond markets are getting smashed. The world’s governments are embracing MMT and massive stimulus packages are being unveiled. I guess they are trying to bridge the economy while we get through this ...
Good Morning.. Having surged last week, we have seen US bond yields give up a lot of the gains seen and I am struggling to see any reason for the sudden change of heart apart from the FOMC meeting looming large. This move down in yields hit USDJPY particularly hard and shows the recent correlation with US yields. But what spooked bonds? I am not sure and so we need to discuss what we could see or hear from the Fed tomorrow. Most see little change to policy but I think markets expect some forward guidance and he will certainly be grilled on YCC. Can the Fed keep tapering with all the supply coming? Quite simply no. This may keep the USD offered and while we may see some profit taking, I see this USD headed lower still. I was fortunate as I moved my stops in USDJPY and AUDJPY up to entry levels, as per yesterday’s note and so saw zero cost there. I will take a look again after the FOMC. EURGBP is struggling again but again my stop is in the right place and we could yet get negative headlines on trade talks this week. That clock is ticking loudly. EU GDP today is for Q1 so not really relevant but JOLTS data from the US may grab the attention later.
Keep the Faith..
Can the Fed afford to continue tapering bond purchases? Are they over-stepping the remit? Bond yields reverse taking USDJPY with them.
There is quite a lot of chatter surrounding this FOMC meeting tomorrow even though many feel it may produce little in the way of policy shifts. But the Fed is facing a problem as the sheer size of the issuance coming down the pipe could swamp bond markets, take yields much higher and create havoc for risk assets. Bond markets seem to think something may be coming as bonds are surging back up in the last two sessions after a serious sell-off which took the 10yr yield close to 1%. 10 now yield 0.845% and 30s dropped to 1.61%. This week the Fed has reduced its bond purchases to “just” $4.5bln a day but with longer dated yields climbing steadily all last week, we are forced to ask if the Fed has shrunk its QE to a point that is unsustainable in light of surging treasury supply, which as a reminder, should amount to trillions more in the near term. I think the Fed must surely be concerned about issuance and the lack of demand, especially at a time when they are tapering bond purchases.
The rise in yields and the subsequent steepening of the curve last week may suggest the answer may be yes (although Monday and last night saw a reversal in global bond yields). Bond markets are sending very mixed signals here. Yesterday, bonds started to trade like YCC was about to become policy! Why yesterday and what sparked this. I am scrambling around to try and find an answer but the Fed meeting tomorrow is all I can see. The 2yr has hardly budged and is within the powers of the Fed already. There is a lot of chat about forward guidance too. The first and most likely policy option will be to announce a lengthy period of forward guidance. Forward guidance is nothing more than the Fed saying it does not expect to raise interest rates for a period of time. Given the current situation, forward guidance will have to be aggressive. With the market already pricing rates staying very close to the zero bound for the next five years, there is not going to be very much shock and awe if the Fed announces that it will keep interest rates at zero for two or three years. Currently the two-year Treasury note is yielding 21 basis points (and got as low as 11 points on May 8), and the five-year note is at 46 basis points. Pegging the overnight rate at zero would have a limited effect on reducing rates at the front end of the yield curve. Again the danger is the spike happens in the 10yr and out, as seen briefly last week.
Swap markets are starting to price in higher rates in 5 years. Does the Fed need to push back on that?
If we have an imbalance between supply (which is simply massive) and demand, then the Fed will be forced to step back in. Did the bond markets realise this and start to front-run a Fed U-turn on bond purchasing this week? Why did bond yields start to rise so aggressively last week? Were bond investors (the large banks especially) forcing Powell to go for more QE in an effort to see equities, which they are heavily invested in, reach new highs? In other words is the Fed being played like a Fiddle. I am not sure what is going on in the repo market but something is not right here either. The Fed is going to have to make sure it can keep a lid on longer dated bond yields and the 10yr was creeping dangerously close to 1% again last week. Is this why we are hearing Fed speakers flying kites about YCC recently? I am sure the Fed is very pleased, as are the banks, that the curve is steeper but the Fed must have concerns about the longer end of the curve getting out of control if it really wants to keep tapering; and yields were undoing all their hard work at the front. The Fed may want address this or at least open the discussion on a more official footing as controlling the long end of the curve is not easy at the best of times but with this issuance due it is almost impossible and I think bonds have sent a clear signal to Powell that the Fed cannot step away for long. The thing about YCC is that, as we have seen in Japan, QE becomes redundant and even the BoJ is desperately trying to taper bond purchases now. Is the Fed planning or at least in deep discussion as it tapers bond purchases, to replace this with YCC? They simply do not need both.
What we do know is that the current pace of Fed purchases is insufficient to absorb the $170 billion in net monthly Treasury coupon issuance forecast for the rest of the year, let alone the hundreds of billions of monthly net T-bill issuance coming. The duration of the next QE program could also be tied to achieving specific dual mandate outcomes, given the high amount of uncertainty around how long the purchases will be needed. If not at this meeting, then at one in the near future, we will surely see the Fed HAVE to step up as buyer of last resort. It will likely take at least $2 trillion in asset purchases per year just to fund the Treasury. The commitment to large-scale asset purchases should allow the Fed to at least take a first step in trying to contain any increase in long-term rates. The trade-off here is that committing to the zero bound for a period of time through forward guidance could raise inflationary expectations, which means that longer-term rates could rise. The rate sensitivity of the mortgage market, and the importance of the housing sector to the overall economy, means the Fed is not going to want to see long-term rates skyrocket. 1% in the 10yr may be a line in the sand.
The Fed’s cash balance has risen a lot recently and as of Friday, stood at something like $1.5bln.
All good so far but there is a problem, as the Treasury’s latest quarterly borrowing needs forecast projected a funding need of $3 trillion for the current quarter, the Treasury also projected that the cash balance at the end of the quarter would be $800 billion. Is the Fed about to release $700bln of liquidity into the market? Maybe this is why equities keep rising. Many opinions are out there as to how quickly we can recover from this virus issue but in my humble opinion, the patient was already sick and becoming immune to the drugs before this virus struck and that whatever broke in 2008, has not yet been fixed but pushed down the calendar.
This “shock” closure of economies will exacerbate what was going on into this and the recovery may yet disappoint, when we eventually look back at this economic phase. Even with sick patients, you can give what becomes a lethal dose of drugs which you thought would be a cure. Painkillers do not fix the problem. Bond yields were surging before the NFP data but what changed this week? The Fed’s macroeconomic projections, which it declined to publish in March because the situation was shifting so rapidly, come after the US jobs report confounded us all after two months of deep job losses, and in the middle of sharp rebound in stock prices. I want to hear what Powell has to say about this crazy speculative rally in stocks, what is going on again in the repo market and how he plans on managing the bond markets at the long end. I am not sure this press conference is a non-event at all. I think the markets are looking for commitments to forward guidance and fully expect a dovish Fed and maybe that is why bonds rallied since Friday. The fall in USD yields hit USDJPY hard and I was pleased I raised my stops in USDJPY and AUDJPY to entry levels at zero cost.
The 4hour chart in USDJPY above took a proper beating and the USD elsewhere continues to fall.
Central bank policies were initially driven by the need to offer cheap loans and mortgages so that the all-important consumer (70% of the economy) will keep spending but as shown here last week, consumers are saving and paying off debt. Consumers do not want cheap loans, they want to shed the debt burden and this is why such policies in Japan did not work and will not work in the US or EU either. QE and cutting rates further from current levels will do nothing for the consumer unless they are heavily leveraged and fully invested in stocks. The Central banks seem wholeheartedly working to stop a market crash; nothing else. So far, they are doing a great job too. There is a strong correlation between stock prices and corporate credit spreads.
If stock prices were to begin to slide, this would mean that corporate credit spreads could widen. If that began to happen in a disorderly manner, the Fed would become more actively involved in purchasing corporate bonds. If the Fed is on a path back to more bond buying, there will likely be another leg higher in equities, as is always the case but the USD may get hammered lower too.
The BoJ discovered they needed to control the whole of the JGB market; I just hope the Fed does not think the same as the bond market is the one instrument that can still take the pulse of the economy, growth and inflation. Take that away and we just have their word for it. That would be a socialised market and while we are at it, there is clear evidence that Fed policies are responsible for breaking down the very structure of capitalism, as nothing is allowed to break and upset asset markets; everything is bailed out, the good and the bad. Is this a policy or a side-effect? But believe it or not, the Fed cannot bail everyone out; but should these unelected officials be allowed to choose who survives and who goes to the wall? In the US, an estimated $7.4 billion in rent for April hasn’t been paid (May numbers have yet to be released), or about 45% of what’s owed, according to a recent analysis by CoStar Group, which also found that just a quarter of expected rent payments have been received by landlords. If landlords pursue this money, then hundreds of bankruptcies could be arriving.
The American Bankruptcy Institute which announced that, as expected, corporate bankruptcies soared during May, pushing the number of filings to levels recorded in the wake of the 2007-09 recession. According to figures from legal-services firm Epiq Global, US bankruptcy courts recorded 722 businesses nationwide filing for chapter 11 protection last month, a yearly increase of 48% from 487 businesses in May of 2019. The surge was also seen on a month-over-month basis, which jumped by 28% from the 562 Chapter 11 filings in April.
According to a separate report from Bloomberg, in May alone, some 27 companies reporting at least $50 million in liabilities sought court protection from creditors – the highest number since the Great Recession and yet, if we look around at risk pricing, due to the Fed alone, there appears to be zero risk premia anywhere and hedges have already been removed. The Cares Act and other swift government measures have been successful in keeping consumers afloat during the crisis but as this relief runs its course (July?) however, mounting financial challenges may result in more households and companies seeking the shelter of bankruptcy. Which ones will the Fed save and based on what?
Long EURGBP @.8978 added @ .8940. Stop at .8825
Long USDJPY @ 108.58.. Stop at entry.. Stopped at zero cost
Long AUDJPY 75.30.. Stop at entry. Stopped at zero cost
Long EUR @ 1.1360.. Stop at 1.1200ish. Added at 1.1285.
Brought to you by Maurice Pomery, Strategic Alpha Limited.
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