The Week Ahead - The economic "Starburst" is brightening the sky
The spotlight will fall squarely on this week's FOMC meeting, which will conclude on March 17 and should set the monetary policy stage for risk markets into Q2.
Although US yields broke new higher ground on Friday, equities and gold held up well, and investors seem to be gradually coming to grips with higher yields in light of the economic starburst that’s becoming much brighter in the sky amid the foreboding gathering of rate hike fevered thunderheads roiling above.
Investors continued to revel in the afterglow of one of the most significant legislative accomplishments ever: Biden’s USD 1.9 trillion stimulus deluge. And with vaccination data suggesting that the US could reach herd immunity from Covid-19 by summer vacation time, all systems are triggered to go for the reopening trades on the Dow and S&P 500.
Since the NASDAQ has already pulled forward a good chunk of the rerating risks on the back of higher rates, "at-risk" positioning should be much cleaner. And with very little selling on the NDX signaling that high-flying mega-cap tech wouldn't put up too much fuss to higher yields in the low 1.60's, it allowed the broader indexes to fly.
So, it's not so much that folks have to keep buying tech for the e-mini to thrive; they have to stop selling them.
Been there done that
In 2013, after the 7.9% drawdown in e-minis following then Chair of the Federal Reserve Ben Bernanke's congressional testimony signaling an eventual taper, rates still moved higher for the following couple of months but equities resumed their climb. In some ways, this is the phase that the market may currently be in, even if it hasn't yet received an actual signal from the Fed around QE tapering.
The big picture here is that despite rising yields, stimulus plus vaccines are still going to trigger a colossal wave of economic growth and, with it, higher corporate earnings; not too bad of a set up for stocks.
No one likes tenterhooks
Still, "The Street" remains on tenterhooks around concerns of further moves higher in US yields, especially if the Fed doesn’t show a brawnier pushback this week. So, sadly, I think broader risk-taking won’t return in earnest until after that.
FOMC, the overhanging SLR and inflation extrapolation still aren't helping. And although virtually everyone on the sell-side expects an SLR extension, it's still not a generous overhang with the April 1 deadline looming large.
In this environment, it feels like whatever Powell says will always result in higher yields, with reopenings driving a nasty near-term spike in inflation. Hence the high volume "clear-out" on bond positions on Friday.
The biggest macro question
The biggest macro question for the United States in 2021 is this: Will the medium-to-large burst of inflation and economic activity baked practically in the cake for the next six months be durable or transitory? Are we in for a quick spurt or a long boom?
I don't think we can know yet, but there seems to be a very palatable gathering for risk markets as some UST bond desks are forecasting UST 10Y yields coalescing around 1.75-1.8 % zone.
It will be difficult for 5y5y OIS to move to the Fed's terminal rate because 5 to 10-year recession expectations will cap Fed rates. Plus, bond traders think most of the USD 1.9 trillion stimulus issuance adjustments will be bills and shorter coupons. So, while the number of dollars that needs to be borrowed will rise sharply, the increase in dollar duration (interest-rate risk) that the market needs to absorb will not increase meaningfully.
I think the market will quickly come to a better understanding of this, which could alleviate some of the supply angst that is getting embedded along the belly of the bond yield curve.
Markets will forever try to turn fantasy into reality
The FOMC's next decision is on March 17, and it's a "dots" and SEP meeting all wrapped up in one.
Towards the end of the week, the markets slightly shifted from trying to challenge the Fed view and are now looking for direction from them, and I think this helped stabilize risk a bit. After the sharp back-up in rates across the whole curve in mid-February, markets looked to Powell's interview with the WSJ for push back on yields. Instead, Powell indicated that the Fed wasn't overly concerned by the lift in longer-tenor yields but was more cautious around Fed funds than perhaps the market was pricing (expressed as a recovery in employment, but structural challenges to inflation).
Chair Powell should use the meeting to clarify "substantial progress" and the policy interconnection between employment, inflation, asset purchases and interest rates. But, as usual, he faces a potential communication challenge. Whilst he and the governors may have a clear view of what they think and want to express, some of the regional Fed presidents might have other ideas.
In December 2020, the dots showed twelve FOMC members thought rates will still be as they are at the end of 2023, one member thought rates take-off would be before the end of 2022, three thought there'd be one hike in 2023, one that there would have been two hikes and one that there would have been four. It takes four of the twelve to move the median for 2023, but it perhaps only takes one or two to shift position to move the markets. Given the repricing of the Fed, there'll be considerable attention on the dots on Wednesday.
Busy week on the Central Bank front
Four central banks are scheduled to meet, which could have impacts on the FX market: FOMC (March 17), Norway (March 18), BOE (March 18) and BOJ (March 19).
OIS markets are pricing 70% and 276% probabilities of 25bps FOMC hikes by the end of 2022 and 2023, respectively.
The BOJ will release their policy review next week and are reportedly looking for ways to enable bond yields to fluctuate more freely, even as Kuroda seemed to rule out a widening of the range of yield target.
The BOE is likely to be a non-event, as the next official forecast update will be published on May 6.
As for Norges Bank, oil prices have rallied about 30% and house prices reached a five year high since their last meeting in December, adding pressures for the bank to change policy ahead of global peers. Some local banks are calling for the first hike as soon as September.
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Today’s key charts focus on oil, where the recent rally has stalled amidst talk of a lift in sanctions and speculation of a production boost.