The Week Ahead
The overly coordinated Fed rhetoric will stop as FOMC members enter black-out mode ahead of the January 27 FOMC meeting, meaning the US data will need to do the talking instead. It will be interesting to see the reaction of the USD to any surprises. If the 2020 dominance of risk-off risk on remains, upside surprises should weaken the USD. If tapering considerations are dominant, the opposite reaction will prevail.
The week ahead is a busy one on the calendar for markets, with the Biden administration taking office in the US this Wednesday; given he’s tabled some ambitious plans, this is shaping up as the main event. And we now have a benchmark to gauge how successful the vaccine rollout will be as he’s already announced a target of 100m vaccinations in his first 100 days in office.
The smoking gun
There isn't a single smoking gun which caused the risk-off move in financial markets on Friday. Still, contributors could be the fact every time the Taper Genie comes out of the bottle risk market always pause. That's just the way things are, hence fixed income markets have probably generated more excitement in the first two weeks of 2021 than they did in the whole of Q4 2020.
President-elect Joe Biden mentioned that everyone would pay their fair share for the stimulus package, bringing the focus back onto taxes when the market has been pretty comfortable assuming they won't come until late 2021 or early 2022. So tin hats are at the ready.
Retail sales were weak, and while weak data in December shouldn't necessarily come as a surprise given the Covid-19 spike, the market rallied on vulnerable non-farm payroll prints as it implied potentially larger fiscal stimulus – now the starting details around fiscal are known, that no longer applies.
But the easy culprit to point out would merely be positioning in consensus reflationary and global reopen trades heading into this year (which I put a spin on below).
President-elect Biden's policy is highly relevant for the Fed and means that the 'no taper in 2021' view is unrealistic. Yes, three speakers this week – Clarida, Brainard and Powell – have pushed back vigorously, suggesting QE will not change for quite some time. However, this was in the context of no additional fiscal stimulus. If Biden launches, say, $1.5trn in March, then the Fed forecasts will change and a taper will come into view for June or September at the latest.
How quickly the term "risk reversal" enters the market lexicon might provide a good panic gauge. And while the technical terms like "overbought" and "oversold" get bandied around, alone these conditions are seldom a catalyst for triggering long-lasting reversals. However, when conditions are at extremes levels, they increase that risk if we get an unexpected economic shock or central bank policy pivot.
And while fear vs greed indexes are well off the extremes of January 2020, market positioning is very stretched, underpinned by a renewed sense of jubilation about the prospects for the US economy later in the year due to vaccine euphoria and the dual policy puts of monetary and fiscal backstops.
Perhaps I seem overcautious, but nothing could be further from the truth as I think another risk-on frenzy is coming by mid-year as a combination of mass vaccination and a return to some normality will synchronise with continued fiscal and monetary support.
Still, we could be entering a very vulnerable situation where 2020 gains have been substantial. However, current prices don't match the level of market enthusiasm. And that disconnect could lead to disappointment – even more so now with the market struggling to come to terms with a 2021 Fed taper, even though rate hikes are likely years off.
In the meantime, the old foes of secular stagnation and structurally weak growth could come to the fore as the challenging winter month coalesce with new and extended lockdowns that push back on the reflation trade.
Since March, there have been three evenly split investor types:
Hence, two-thirds of investors hit the first Monday of 2021 under-positioned and forced to play catch-up. So, those new entrants or "weak hands" are most at risk under my base case scenarios.
Risk appetite can stay at elevated levels for prolonged periods as long as the macro backdrop remains supportive. But when you reach lofty levels and extreme length of positioning, you need to ask yourself what it takes for stocks to move higher. With expectations for 2H economic repricing hitting the stratosphere, investors will need at least a glimmer of hope that, at a minimum, we’re heading in the right direction.
In terms of the S&P, keep an eye on the 3652.5 area in minis, where they were before the Georgia senate elections on January 5.
Sentiment cooled on Friday as the usual suspects provided the toxic combination, with Covid-19 in China and safe-haven demand for the US dollar catching oil traders too far over their skis. But to rub salts in the wounds, the US economic data was even worse than expected. Still, OPEC supply discipline is the linchpin to push prices eventually higher.
But it's just not Covid
Assume we rule out the tail risk – such as vaccines not working against the new viral variants, inhibiting herd immunity and leaving aside Covid uncertainty in China - the wild cards for oil this year are upside to Iranian production (dependent on the potential lifting of US sanctions under incoming President Biden) and the supply response from US producers in a more constructive macro environment.
Dollar up yields down days tend to be 24-48-hour periods (in this cycle) where risk aversion dominates. And it's not a good currency signal unless investors start heading for the equity market door.
Last week was mainly characterised by a sudden shift in EUR sentiment – even though it might be too early to say if this is permanent or temporary. Long the single currency was a consensus view for much of 2020. Still, a few factors have emerged this week that, as a whole rather than individually, have put pressure on EUR and prompted some investors to reconsider; political tension is back in Italy; there are concerns about a slow vaccine rollout in Europe. Some ECB comments on the currency as input in inflation-related considerations were all factors that weighed on the EUR, exacerbated by rising optimism around the US fiscal stimulus effect on US yields.
Treasury yields are far too low. A yield of 1.50% on the US 10y should easily be possible and shouldn't be a big problem for equities. The policy mix for stock markets remains exceptionally supportive as the Fed will continue to be highly accommodating, even after tapering QE and unlikely to hike until 2022.
The one asset that's least clear is the dollar. Longer-term, I think the US policy mix and the humungous deficit will undermine the currency, hence I think EURUSD should remain in a range of 1.18-1.28.
Still, over shorter-term, the US economy will outperform Europe as the global growth "de-synchronisation" again sets in, only this time in the USD’s favour as the "Biden stimulus" and US reopening get repriced where 1.18 looks possible.
Commodity reflation trades still look attractive. Since November, I’ve been highlighting the long CAD view on soaring oil prices but added EURCAD to complement the idea as the EUR becomes a preferred funder Q1. But that too is wilting a touch due to the reemergence of Covid in China which pressured oil prices lower at the end of the week.
On a combination of higher US yields and some macroprudential measure by the PBoC stifling the yuan’s lofty ambitions, USDAsia downward trend seems to have paused for the moment. And yet what’s notable is the absence of new topside interest in the vol space, which suggests local traders are willing to wait out the taper storm – even staring to some decent sized profit-taking last week.
Gold fell on firmer USD, shrugging off a dip in yields and positive monetary and political climate, but an old gold foe, the USD, helps to weaken gold. The US Dollar Index (DXY) closed at 90.77, the highest since Dec. 21 (with gold closing at 1,876/oz that day).
US bond yields getting repriced higher will limit gold’s rise over the short term, so the street has already morphed into a seller on rallies.
Barring the Fed easing into the recovery, it's now unlikely gold will exceed 2020 highs. And with growth returning to trend as vaccines get rolled out, policy expectation will increase, and gold could now close out the year between $1,650 and $1,750, assuming herd immunity is attainable.
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USD regains ground on April inflation figures to outperform low-yielding currencies; EUR/USD meets strong resistance; Gold looks increasingly attractive