Darkest Before Dawn

The upcoming economic news is likely to be dreadful, and if it is not dreadful, it will be mostly ignored. This includes the release of the preliminary January PMI figures at the end of the week. Japan is extending its national emergency to another five prefectures, which collectively account for over half of the nation's GDP.  Germany's Merkel, not given to hyperbole, warns that the lockdown may last ten more weeks.  The Dutch do not appear far behind.  England is talking about tightening its restrictions.  Even China appears to be experiencing a flare-up.  The pandemic is out of control in the US, although the curve appears to be flattening in some areas.  

It was widely recognized that the virus and vaccine are going to dictate the economic story in 2021.  The new variant of the virus is more contagious and the roll-out of the vaccine has been frustratingly slow in most countries.  The recovery in Q3 seen among the high-income countries was a dramatic snapback but for many, it was not the beginning of a sustained recovery. That recovery may be several months away.  The point is that the economic risks for the remaining Q4 20 data and for Q1 21, which just began, are on the downside.  

If that is indeed the case, then why have bond yields risen?  Is this another disconnect between Main Street and the House of Finance, like stocks rallying during the pandemic?  It is darkest before dawn and whether it is four months or six months, the investors expect better news in the second half of the year.  At the same time, there will be a new stimulus push in the US.  The UK Chancellor of the Exchequer will have to extend aid as the lockdown is extended and intensified.  It is likely Germany will have to, as well.   Italy's projected debt issuance is a third higher than it was a couple of weeks ago.  

At least four Fed officials have said they could consider tapering before the end of the year.  To be specific, the four are regional presidents, while the governors, including Powell and Clarida, have played this down.  Currently, the Fed is buying $80bn a month of Treasuries (about 55% have been notes of 4.5-years or less before maturing and about 13% in the 20-30 year bucket) and $40 bln a month in Agency mortgage-backed securities. No one is saying that tapering is imminent and a majority of officials that have spoken suggest it does not look particularly likely this year at all. That was also the thinking in last month's primary dealer survey conducted by the Federal Reserve.  

Yet if tapering is not the real culprit for the sharp rise in US yields this year, what is the driver?  Where you begin your narrative points you in the direction of the answer.   In one telling, the US 10-year yield has risen by around 45 bp since the election as investors discounted greater supply and became more committed to the reflation trade, which means higher real rates, and arguably a sensitivity for higher inflation.  At the same time, the price of oil has surged.  The February WTI futures contract closed October near $36.5.  It approached $54 a barrel before profit-taking kicked-in ahead of the weekend. Recall that at the end of last January it was around $50.50.  The deflationary thrust from oil prices has ended. Inflation expectations often track significant moves in oil prices.  

Asian demand, including China's apparent inventory accumulation, drove industrial metal prices higher at the end of last year.  On the other hand, supply concerns following last week's disappointing report on US plantings saw corn and soy prices rise to 6-7 year highs, and cotton traded at a two-year high.  The CRB index has risen by over 22% since the end of October.  

Even the coming Treasury supply may be exaggerated by partisans.  The idea from both sides is that Biden will press ahead with the Democratic control of the legislative branch to push through the rest of the $3.2 trillion bill passed by the House of Representatives last year.   However, we suspect it is more likely that Biden, judging from his disposition and that he learned from his experience with Obama, will avoid antagonizing the opposition and souring the relationship from the get-go.  Instead, he is likely to find a compromise and make it bipartisan even if it results in a small package.  In appointments and temperament, Biden is a moderate. 

Biden will be inaugurated on January 20.  The day before, Yellen will speak at her confirmation hearings.  In addition to broad economic issues, she will likely be asked about the dollar.  As an economist, she recognizes that ideally one wants the currency to move in line with policy, otherwise it blunts or undermines it.  At the Federal Reserve, she recognized that dollar policy is a Treasury remit.  That makes it her call now.    

The "strong dollar" mantra that existed before 2016 cannot simply be returned to now.   A new formulation is needed to confirm that the US will not purposely seek to devalue the dollar to reduce its debt burden or for trade advantage.  To signal a multilateral spirit, Yellen may be best served by reiterating the G7 and G20 stance that markets ought to determine exchange rates, that they should move in line with fundamentals, and avoid excess volatility.  It does not have to be the final word, but as the first word, it would be reassuring.  

Four G10 central banks meet in the coming days.  The gamut of outcomes is likely with the ECB, ironically, being perhaps the least interesting.  Since it met on December 10, the pandemic has gotten worse and social restrictions and lockdowns have intensified and lengthened.  The uncertainty of the US election and UK-EU trade negotiations has been resolved.  Key hurdles to the EU's budget and Recovery Fund were lifted.  

The day before the last ECB meeting, the euro settled near $1.2080.  It settled last week around $1.2150.  March Brent was trading a little below $49 and rallied to almost $57.5 last week before consolidating.  The 10-year German Bund yield has risen around 10 bp (to around minus 50 bp) and Italy's premium has softened from almost 120 bp before the December meeting to almost 100 bp before widening again (115 bp) amid the political challenges in Rome. There is little for the ECB to do now.  

The extension of the emergency in Japan to cover the area which generates more than half of the country's output raises the downside risks.  The central bank is likely to formally recognize this in one or two ways.  It may shave its downgrade on its qualitative assessment.  It could also adjust its forecasts.  In its last forecasts, issued in October, it anticipated the economy to contract 5.5% in the current fiscal year.  Its previous forecast was for a 4.7% slump.  The BOJ could also reduce the projection of growth for the next fiscal year, which was seen at 3.6%, up from 3.3% last July.  

While peak monetary policy may generally be at hand, the Bank of Canada may be an exception.  The overnight target rate sits at 25 bp.  It is clear that officials do not want to adopt a negative rate, but Governor Macklem has suggested the lower bound for Canada maybe a little lower than where it is now but still above zero.   Given the economic consequences of the spreading virus and some disappointing high-frequency data, the market (overnight index swaps) has a few basis points of easing discounted. It may not exactly be clear what a small rate cut achieves, but last year, the Bank of England and the Reserve Bank of Australia delivered small moves of 15 and 10 bp respectively.  

Before this intensification of the virus, the Bank of Canada had seemed to be a candidate for an early exit from emergency policies.  Now Norway's Norges Bank appears at the front of the line.  At its last meeting in the middle of December, the central bank brought forward its anticipated first hike to the first half of 2022.  Since the December meeting, the high-frequency data points suggest that economic activity and prices are more resilient than feared.  The economy contracted by 0.9% in the three months through November.  It was also half as bad as economists projecting.  Underlying CPI, which adjusts for tax changes and excludes energy, rose by 3% year-over-year in December.  The record drawdown from the sovereign wealth fund provided an early and strong fiscal cushion.  

Two emerging market central banks of note meet as well next week. Turkey's new central bank governor Agbal has made several steps that have given notice that there is a new economic regime.  On Christmas Eve he delivered a 200 bp hike outstripping median forecasts for a 150 bp move.  The one-week repo rate now stands at 17%.  Inflation reached 14.6% last month. Since the end of last October, the Turkish lira has been the strongest currency in the world, appreciating by about 13.4% against the US dollar.  It is still off a little more than 19% since the end of 2019.  Over the past three months, the yield on its 10-year dollar bond has fallen by about 105 bp to 5.60%. The market is signaling another rate hike is not needed.  

The South African Reserve Bank can also stand pat, though for different reasons.  SARB cannot afford to cut any further.  Its repo rate is at 3.5% and December CPI stood at 3.2%.  After cutting by 300 bp last year, the central bank held steady at the last two meetings of 2020.  The implied policy path of SARB's projections points to a rate hike in Q3 and Q4 this year, though we are a little skeptical that it can be delivered.  


Darkest Before Dawn Darkest Before Dawn Reviewed by Marc Chandler on January 16, 2021 Rating: 5
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