Market Insights

What if the FED never hikes again?

In the midst of all the discussions over hiking cycles, we have been pushing for the market to consider some much bigger potential questions: nuclear war, impeachments, powerless governments and the like.

Monetary policy divergence is an old story. It was, like many old stories, a good one. It had a comforting narrative and it worked. The US dollar went up as America indeed was on the path to being great again. Money was made as sense was made.

It’s always much tougher in these periods when various new narratives compete to be the driver. It’s still carry versus the economy versus politics. And as the last of these is still woefully misunderstood and unpriced, we are left with the economy and with carry.

There has now been a shift with regard to the economy. Is reflation running out of steam? We warned that Chinese PPI could be on a downward trajectory, and its last print saw it plateauing, albeit at the racy heights of 5.5%. Then US inflation disappointed. Even Uk inflation came in lower than expected today.

But then on the other hand we have carry. As the Bank of Canada showed last week, the carry rankings don’t stay static. When a central bank wants to shift, it shifts.

The problem with those old stories which made sense and made money, is that they’re very pervasive. They’re comforting. In these periods where the driver is shifting, we like to keep coming back to them. So, we are now back to monetary policy divergence, but at the margins the US Dollar is now the loser as other nations start cranking up the tightening lever. Same story, slightly different actors. (A bit like a female Doctor Who). Who’s hiking next, the RBA? Where is there not enough priced in?

This is all very nice, and will pan out a bit further in the suffusive heat of summer.

We are geared up now for Draghi to signal tapering in his August Jackson Hole speech, and maybe even hint at it at the ECB meeting on Thursday. We wonder how he will deal with the fact the Euro will rise, but we take it higher anyway.

We will ponder whether the US may ever raise rates again. Or if they do in December, is it just a sayonara shot from a departing Janet Yellen? Stories are now circulating that the man responsible for finding her replacement, Trump’s buddy Gary Cohn, might end up being her replacement himself.

Separately, stories circulate that the BOJ are concerned with their own levels of ETF purchases. The point is that QE is over. But we interpret it within our comforting monetary policy divergence story. In that story, there were currency wars as the central banks sought to outdo each other in their easing. Now, they’re seeking to outdo each other with their hiking. At some point we will realise that has much less benign implications for the economy, which will impact politics, which will impact volatility, which will impact the wisdom of the carry trade.

But for now, the shifts in monetary policy are still being seen through the comforting lens of that old story.

Let it lull you to sleep on the beach – for now.

Blame Canada!

Today’s the day for our Canuck friends to take centre stage. The Bank of Canada is expected to deliver a 25bp hike; the market is fully priced for it, and prices an evens chance of another 25bp before the year is out too. Go on Canada! Not usually famed for standing out from the crowd, the Canadians prefer to relish their self deprecating role as the second North American nation, letting big brother over the border bulldoze their way through global news. What about Justin Bieber and Celina Dion you cry? Not to mention Blondemoney’s esoteric favourites, Ryan Stiles and Alanis Morissette (note, the latter provides good loud music for an MRI scan. Except for that bit where she asks, Here can you handle this? And it all goes silent).

 

Well today the Bank of Canada will provide another push for the global reassessment of bond prices. Just two months ago, the chance of 50bp of hikes before the end of this year was just 2%. That’s how stuck we all were in the methadone-fuelled dream of lower for longer forever. But as we pointed out, this has now all changed. Instead of “Hands up if you’re easing, Part Infinity”, we’ve just started “Point at the loser who isn’t normalising”. And the fact that the Bank of Canada did this without destabilising their markets is testament to how we’ve moved on from a taper tantrum. The rise in house prices and stock prices alongside tightening credit spreads has delivered such an easing of financial conditions that the hiking is just easing off the accelerator pedal. It’s not even tightening – it’s making sure the easing doesn’t accelerate.

 

Hence, no tantrum. But it is leading to something potentially much more damaging than the stamped foot and loud crying of a toddler. This won’t be over in a flash, before we put the tired-out child to bed and open the bottle(s?) of wine. No, it’s a realisation that the paring back of stimulus removes the über-bid for bonds. It’s a valuation reassessment in the light of a changing risk scenario. We are finally moving away from “lower forever”, at a time when volatility is low and woefully underprepared.

 

Oh and let’s throw in the word “impeachment” too shall we? Not to mention the UK Prime Minister’s “relaunch”?

 

Folks – sing it loud…. Blame Canada!!:

Taper Car Crash

  • The German 10 year yield makes another new high for the year.
  • The US 10yr is now in the middle of the year’s range, but only 2 weeks ago it was printing a new low for the year at 2.13%.
  • The Japanese 10yr has doubled in the same time period, although that’s only from ~5bps to ~10!

The latter point was enough for the Bank of Japan to pop up this morning and offer to buy unlimited 10yr bonds at 0.11%, and increase their overall JGB purchases from 450bn JPY to 500bn, in an attempt to stem the sell-off.

OMG! Taper Tantrum alert!

Or is it?

The central banks in question have certainly been at great pains to minimise any fear that may come from the anticipated pull back of their epic stimulus programmes:

  • The ECB’s perma-hawk Weidmann today described it as “This is not about a full braking … but taking our foot somewhat off the gas”
  • The BOE’s perma-hawk McCafferty today described it as “a couple of modest rate rises over the next couple of years or so”
  • The BOJ went even further and offered its first fixed-rate purchase operation in 5 months

In a world of ongoing low volatility, this should have been enough to calm things down.
In a world of ongoing low volatility, this should have been the green light for a return to the carry trade.
In a world of ongoing low volatility, the current increase in the geopolitical threat level following North Korea’s missile launch, should have actually seen bond yields go down in a flight to safety.
A bond sell off would usually suggest two things:

  • A “risk on / reflationary” outlook. But we already know, not least from the Fed Minutes this week, that inflation is petering out, and growth numbers in developed nations are stalling (aside from, funnily enough, Japan – where wages just posted their biggest rise in 17 years)
  • A “risk off / get out of everything” panic. Hence the reference to a taper tantrum, which in 2013 knocked risky assets off their perch as the world panicked over whether the global economy really could withstand an exit from unconventionally easy monetary policy

But this isn’t usual.

Remember a few weeks ago we discussed that we are in a period of reassessing what the drivers for financial markets are? We had the cross-cutting currents of Carry, Politics, and the Economy. We concluded in that piece from 6th June:

“What if it’s not? What if, at the exact moment we realise the QE is ending properly, at say, a couple of central bank meetings in the next couple of weeks, we also realise that reflation isn’t quite as robust either? And not just for political reasons?

  • The Carry Trade hasn’t come under any pressure yet as the Central Bank wall of money continues
  • The compression of volatility means that when it does unwind, it will be violent
  • Reflation is under threat, both politically and economically

Firewood? Check.
Tinder? Check.
Matches? Ready.”

Sometimes when the world starts to unwind, it doesn’t come from a specific event. It comes from a dawning realisation about price. At what price are you willing to lend to the German government? At negative rates for 2 years? You’ve been happy to do that for 18 months now:

But as that 2 year yield edged towards -1%, maybe something clicked. Maybe the ECB accidentally revealed the Emperor’s New Clothes when they announced in December that they would allow QE buying to take place at prices through the deposit floor level of -0.40%. This was really a technical change that meant they could continue to buy German bonds. They needed to make this change because otherwise they wouldn’t be able to abide by their capital key proportionality of their QE purchases; in other words, they’d be loaded up with too much Italy and not enough safe Germany. It set off a rational drive down in the German bond yields, because extra demand came into the market. But maybe around -1% all the demand ran out. Fast forward a few months and now the ECB are openly rumoured to be discussing a taper of their programme, even as they’re not explicitly discussing it at meetings. If the mere discussion of a discussion can arrest the bond rally, then what happens when they actually discuss it and then actually do it?

This scenario analysis is now, sensibly, playing out in the market’s mind. Similarly for the UK, which has gone further and had an actual number of dissenting MPC voters for hiking interest rates. Why keep on buying these bonds, particularly at interest rates that ensure a capital loss?

The pennies are starting to drop.

This is much more than a taper tantrum. It’s almost a slow motion taper car crash. A fundamental reassessment of risk-reward will lead to a reassessment of those other drivers we discussed a month ago: why is volatility so low when uncertainty is going up? And why load up on carry when volatility might be about to rise?

We are reaching the realisation that this chart isn’t going to go on forever:

Just as we realise that the risks we face here, now, in 2017, are unquantifiable political ones, and therefore market measures of volatility are woefully mispriced….

Just as we realise that inflation might be petering out….

It’s a hot summer ahead. The tinder is starting to sizzle. A tantrum will be the bare minimum of our reaction.

The most unreliable of boyfriends

With a long history of boyfriend unreliability, Blondemoney considers herseflf somewhat of an expert on the topic. Throw in her knowledge of central bankers and who better placed to be judge, jury and executioner on the serial offender Mark Carney, Governor of the Bank of England. It comes as no surprise that a rollercoaster ride for GBP took place as Carney’s comments suggested a flip-flopping over the outlook for interest rates in a period of just 8 days:

The instinctive response is to bewail that the leopard is showcasing his usual please-everyone spots. This is not the first time the consummate politician has leapt from one side of the argument to the other.

On this occasion, however, we should plead leniency. Look more closely at the two speeches he gave below:

Mark Carney, 20th June:

“Different members of the MPC will understandably have different views about the outlook and therefore on the potential timing of any Bank Rate increase. But all expect that any changes would be limited in scope and gradual in pace.

From my perspective, given the mixed signals on consumer spending and business investment, and given the still subdued domestic inflationary pressures, in particular anaemic wage growth, now is not yet the time to begin that adjustment.

In the coming months, I would like to see the extent to which weaker consumption growth is offset by other components of demand, whether wages begin to firm, and more generally, how the economy reacts to the prospect of tighter financial conditions and the reality of Brexit negotiations.”

Mark Carney, 28th June:

“When the MPC last met earlier this month, my view was that given the mixed signals on consumer spending and business investment, it was too early to judge with confidence how large and persistent the slowdown in growth would prove. Moreover, with domestic inflationary pressures, particularly wages and unit labour costs, still subdued, it was appropriate to leave the policy stance unchanged at that time.

Some removal of monetary stimulus is likely to become necessary if the trade-off facing the MPC continues to lessen and the policy decision accordingly becomes more conventional. The extent to which the trade-off moves in that direction will depend on the extent to which weaker consumption growth is offset by other components of demand, including business investment, whether wages and unit labour costs begin to firm, and more generally, how the economy reacts to both tighter financial conditions and the reality of Brexit negotiations. These are some of the issues that the MPC will debate in the coming months.”

The highlighted sentences are those that the market fell upon, which in isolation suggest he simply flipped from “not raising yet guys”, to “we’ve got to raise rates”.  But the rest of the statements were almost word-for-word identical. He has his understandable doubts about whether the consumer is robust in the face of stagnating wages; whether investment can replace consumption as a driver of growth; and whether any growth momentum can continue with the ongoing Brexit uncertainty. In his defence, both highlighted statements could be true. He could believe now, right now, is not the time to raise rates, while also believing that QE needs to end soon. (Note that he uses the phrase “more conventional”; QE is clearly the apotheosis of unconventional policy.)

A less generous, and often-spurned, commentator might cynically conclude that in fact he has merely noticed the way the wind is blowing. After an unexpected 2 vote dissent in the June MPC meeting, along comes the Bank’s chief economist, former uber-dove Andy Haldane, with the electrifying revelation that he too almost voted for a rate rise. His comments came on 21st June. Carney’s about turn followed 7 days later. With Charlotte Hogg yet to be replaced on the MPC, that leaves only a 5-3 split in favour of leaving rates unchanged. If anyone else were to flip, at 4-4, Carney would have the casting vote. Governors rarely like to be outvoted; it suggests their leadership of the committee is under pressure. And this vote would be a very personal one. The rate cut and increased QE of last August were very much a Carney-driven decision, what with his pre-Brexit vote lamentations about the potential immediate doom in the aftermath of a Leave vote. Now it turns out that the economy not only failed to fall off the preached-about cliff, but in fact rallied back hard as the weaker pound encouraged foreign investment, alongside a global reflationary boost. To take back the cut would be almost an admission that it wasn’t needed in the first place. Arguably it even proved pro-cyclical. No wonder the hawks on the committee have become more vocal about its removal.

Haldane himself made specific reference to the August stimulus when he spoke in the context of a rate hike:

Provided the data are still on track, I do think that beginning the process of withdrawing some of the incremental stimulus provided last August would be prudent moving into the second half of the year

Carney’s 28th June speech was merely giving him the wiggle room to hike / reduce QE but present it as just a removal of extraordinary stimulus. Another one of those “dovish hikes”. Why the flip-flop now? Well, there is a window of political opportunity. Inflation is already well above target, motivating hawkishness. The result of the General Election means that it may be hard to pursue fiscal prudence; equally it may hurt inward investment as the reality of a deadlocked government vacuum becomes clear. In other words, we may be just ahead of the next bout of Sterling weakness – which would get inflation turning even higher. It may be best to remove that extra stimulus before that happens.

The next MPC meeting is on the 3rd August, and will be accompanied as usual by the quarterly Inflation Report. This will provide a plethora of opportunities to explain the decision and try not to frighten the horses.

The ECB have seen recently how skittish the market horse can be: any hint of tapering and the Euro and EU rates are off to the races, with both now at the year’s highs. Hence they’ve flirted with their own unreliable boyfriend status, with a knowing wink this week to Reuters from those always cheeky “sources”, about not going all the way with their stimulus removal. As one source naughtily revealed on Monday, “I was thinking we’d drop the other easing bias in July, but after the market reaction to Draghi’s speech I’m less sure about it“. Ooh, will they, won’t they? If this were an episode of Love Island and not actual life-changing monetary policy decision-making, their unreliable flirtations might actually be engaging.

Instead, they’re just downright frustrating.

Sure, we all understand the issues ahead. We know the taper tantrum of April 2013 and the Bund tantrum of 2015 were destabilising events. But surely with stock markets at record highs, and volatility at record lows, they could take the punt that perhaps the alleged emergency stimulus programmes might now be table to be taken away as the economies no longer require life support? That perhaps, if not now, than never? That perhaps, the persistence of perma-QE has worked only to distort markets and generate a massive asset boom that has driven a widening inequality which is only now manifesting into a burgeoning political rage?

The irony is that the cat is already out of the bag. Pandora is out of her box and may end up out of her tree. There is a madness infecting the market and the electorate that cannot be shaken. Central Bankers may try to flirt with us but they’re purely vapid disposable Love Island bimbos trying desperately to remain relevant.

North Korea has tested an intercontinental ballistic missile that could reach Alaska.
The US is threatening China with trade tariffs while its President conducts foreign policy by tweet.
Oil producers can’t agree on their feelings towards each other, let alone the oil market.
Whether a central bank hikes rates is beyond irrelevant, aside from providing another match to the growing pile of tinder. Where the US Dollar benefited from interest rate divergence, now everyone else is rushing to catch up. There is now convergence. Interest rates tend not to drive currencies when that is the case. Just as well there’s the small matter of war, whether trade, commodity, or nuclear, to drive us instead.

 

May-DUP government

Midsummer is upon us. With it comes the “Day of Rage”, as angry voters protest at the Queen’s Speech. On potentially the hottest day of the year, this really is good reason to avoid central London at any cost and head immediately for the nearest beach. Or air-conditioning. The sadness is that upon your return, there will still be a leaderless krypto-government ‘running’ the country. Today we find that the DUP still haven’t signed up to a deal, which the PM’s Deputy described merely as a “possibility” rather than a done deal. The DUP have said talks “haven’t proceeded in the way we would have expected”, accusing the government of being chaotic, and warning they “can’t be taken for granted”.

This is delightful 11th hour chicanery from erstwhile negotiators, and shows up to the EU27 once again how easy it will be to manipulate the UK’s negotiating position. At least while this headless government persists.

Ah yes, and even if the DUP deal is done, the Conservative Party have themselves to worry about. Sky News reports that 30 Tory MPs have warned “no deal” would be unacceptable. These recalcitrant Remainers are mostly from constituencies that unexpectedly shifted away from the party. The only problem is that with Article 50 triggered, no deal is the only possibility if we don’t agree to a deal. Once again this shows the other side of the negotiating table our fear and our incoherent position. The EU27 really only have to sit back and let the clock tick.

Meanwhile as that clock ticks and uncertainty rises, markets are resolutely unmoved. Here’s GS with an update on low volatility:

GS cross asset vol

This, even as Trump gives up on his China détente, tweeting last night ‘While I greatly appreciate the efforts of President Xi & China to help with North Korea, it has not worked out. At least I know China tried!’. Oh, and as Saudi Arabia’s King surprisingly hands down power to his precocious nephew.

A closer look at the Goldman data shows that it’s “based on the last 10 years”. Well 10 years ago today, a couple of little known Bear Stearns hedge funds prompted panic as lenders seized assets and worried over a fire sale of mortgage securities.

GS go on to show this chart, warning that low vol periods are then followed by high volatility periods:

GS vol period

Get to the beach while you still can.