US equities pushed higher on Friday, the S&P ending up 0.5% to post a fresh record close. Bonds sold off, US10yr yields rising 5bps to 1.21% – the highest since 27 February 2020 – as the reflation trade remains alive and provides the bullish impulse, but is also triggering a real need for inflation hedges across the board. Indeed, investors are beginning to revel again in the USA's fiscal and monetary bazookas that show no abating signs.
With accelerated vaccine rollouts globally and a sharp reduction in Covid-19 infections in the US that seems to have occurred much faster than any prior waves, the most likely scenario is still for a steep economic recovery starting in spring or early summer with heightened overheating risks.
If the Fed wants overheating, there’s an excellent chance those wishes will come true. Chair Powell has done a superbly effective job in communicating an entirely dovish message and successfully shepherding FOMC members around it – at least for now. On the political side, Biden's incentives look fully aligned with getting the US economy and populations as healthy as possible ahead of the 2022 mid-term elections. If both fiscal and monetary policy makes maximum efforts into a post-pandemic recovery, at the very least we’ll get temporary inflation along with plenty of debate about whether it might become more permanent.
Expectations for larger fiscal stimulus closer to USD1.9trn have been moving into the price in recent weeks as Democrats have shifted focus to budget reconciliation. However, rates making a run for the highs in yields without an exact driver likely caught a few by surprise. Although, the soft result in last week’s 30-year auction result implies the recent resurgence of reflation in bond markets may not be misguided.
In the US, fiscal stimulus is likely to come in towards the higher end of expectations and there’s nothing Powell can say now, short of rate cut action itself, that would be a dovish surprise to the market. As we suggested last week, ironically, the very taper tantrum risk the Fed is trying to avoid may now be considerably elevated and now back end yields are moving higher in response that growing market views.
At some point, the surge in US yields will become a temporary problem for stocks. Still, with both monetary and fiscal policy likely going ahead full steam pedal to the metal, it's hard to see a sustained sell-off in that environment.
And for the dollar, even though it looks set to weaken in the post-pandemic world, the growth divergence with Europe should continue to keep EURUSD in a range in the shorter term, if not trending lower.
There’s no accounting for good old Mother Nature when it comes to oil prices, which now sees the bulls frolicking in bone-chilling cold and a barrage of a winter storm raging across the Premium Basin, resulting in crude streaming from those wells to slow or halt completely, according to boots on the ground.
The US oil complex is counter seasonally short inventories due to OPEC production curtailment's objective as the demand for heating oil surges, so supply and demand laws take over.
But US refineries are also throwing their hat in the ring to compete with Asia's insatiable demand for US sweet crude. US refineries started to process large amounts of oil in anticipation of a surge for gasoline at the start of the summer driving season on the expected pent up vaccine-driven gasoline demand boost.
Finally, with the market-based inflation readings snapping back to pre-Covid levels, commodities – particularly oil – provide an exacting breakeven hedge against inflation. The oil futures beta to inflation breakeven is nearly 1:1 and are now significant demand from systematic players.
So, the combination of Mother Nature’s supply disruption fusing with real demand – and in addition to that in cross-asset trades using oil future as a perfect inflation higher – February has surprisingly morphed into a mini oil supercycle.
Russia’s Deputy Prime Minister Alexander Novak was out on the wires over the weekend saying the oil market is balanced, so this could be the start of some Russian production pushback. Still, the market continues to focus on inflation breakevens and good old Mother Nature.
Weather trackers suggest the worst of winter's wrath will miss the significant cities along the East Coast because the storm's track will be too far to the West. So, with most of the North East missing the wrath of the storm, once Texas thaws and oil flows free, prices would then show an inclination to rebalance lower.
Multiple themes have emerged in FX markets; USD weakness has become narrower, the Euro is lagging and EM high yielders are outperforming thanks to a dovish Fed and investors’ insatiable appetite for yield.
There’s a lot of dispersion in the macro outlook, so traders and investors alike are preferring the high-quality commodity currency and risk betas.
The USDJPY remains bid on tip due to UST vs JST widening differentials amid the Bank of Japan’s verbal intervention.
Surging oil prices, negative US real yields, a dovish Fed for as far as the eye can see and a still improving economic backdrop with sectors of the local economy emerging from the MCO should keep the ringgit in good stead – even though Asia FX interest remains low over Chinese Lunar New Year.
Gold came close to breaking back below USD1,800/oz. I believe that a second break below that level this month would have done some psychological damage to the market. It should be clear that rising US yields see investors showing less interest in the yellow metal.
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US equities continue to welcome any high-risk event being put in the rear-view mirror – especially when rates markets look prime to consolidate lower