Putting aside whether or not the Fed is succeeding in convincing investors of its commitment to pin down the yield curve's front end, ‘growth’ equities (weaker) and the USD (stronger) remain highly sensitive to higher yields further along the curve. That's a fact of life in the high flying mega cap fast lane.
And the absence of fundamental news on the energy front hints at broader risk reduction taking place and weighing on the broader energy sector stocks as a 7% move lower overnight is more than just vaccine hic-up which market have easily glided through in the past.
The Inevitable Comparisons
Comparisons are inevitably drawn with the sell-off in risk assets and the USD's appreciation during the 2013 taper tantrum. June 19, 2013, meeting elicited a ~5% sell-off in the S&P 500 within a week and a 2.5% rally in the broad-based USD amid a 40bp rise in 10Y yields, with 2s10s bear steepening 30bp over that period.
The key difference between June 2013 and today is that Fed Chair Bernanke talked about economic recovery and justifying pulling back on asset purchases later in the year. By contrast, the current Fed’s evidence-based approach leaves bond markets in the judgement seat as to whether the Committee’s ‘wait-and-see approach is appropriate into a period of rapidly-improving economic data.
Higher yields will continue to test the Fed's comfort levels, investors long the most rate-sensitive equities and USD shorts. Falling correlations between rates vis-à-vis equities and the USD would hint at greater comfort, but this week’s cross-asset price action suggests that stage isn’t in reach yet.
Forex
The US dollar has been stable and stronger today, anchored by higher US yields as the market awaited news out of Tokyo.
The BoJ will publish the results of its framework review today. Changes to the central bank’s range were floated in January, while a Nikkei ‘sources’ story suggests the BoJ wants a wider band for JGB yields (from +/-0.20% to +/-0.25%) to encourage steeper yield curves. Strong domestic demand has a driven flatter curve in JGBs year-to-date. In an environment of rising global yields outside Japan, a wider band would ostensibly discourage domestic buying. However, yield-curve control hasn’t succeeded in steepening the JGB curve. Without inflation pushing sustainably higher, it’s hard to see JGBs underperforming USTs, suggesting any sell-off in USD/JPY on the BoJ today will be short-lived.
Oil Update
Oil sentiment towards Europe seems to be rock-bottom at the moment, weighed on by news earlier this week of the AstraZeneca (NASDAQ:AZN) vaccine. Still, this could lead to a price u-turn soon after Germany, France, Spain, and Italy, saying it will recommend using the AstraZeneca vaccine after the European Medicines Agency deemed it "safe and effective." Not to mention inventories drew down this week, these should be good results, and when combined, it could be the reason for the soft recovery bid in oil in Asia this morning
However, since there is little in the way of oil specific headlines to support the move lower overnight, the real angst could be the lingering effect from IEA's MOMR suggesting 'no super-cycle I think this is a market turning medium-term sentiment cautious and finding itself quite long in terms of speculative positioning.
The inflation " Wall of Worry" continues to build
There is a palatable fear brewing that the Federal Reserve’s monetary policy will spur on inflation to a level that will ultimately force their hands sooner than later.
And make no mistake, we are very much in a "growth up " and "rates up "world, and at the end of the day, we will always end up with more question than answers in this type of environment.
Indeed this is adding to the high degree of inflation uncertainty which is the biggest tail risk the market is now dealing with
According to the latest BAML fund manager survey, just over 40% of investors think US 10y yields can get back to 2% before causing a drop of 10% or more in equity markets. The other shift in the survey was that since February 2020, COVID is not the number one tail risk for markets for the first time. That honour goes to higher than expected inflation with a bond market tantrum at number two. So indeed, inflation tops the markets new 'Wall of Worry.
Even a strong auction result couldn't hold the market up for very long. The market is getting more and more jittery about the Fed and believes it might get pushed into action faster than expected. In this type of situation, real yields simply don't have many places to go but higher.
Every investor in every market had a vested interest in the FOMC's March gathering. Rather than challenging the Fed, the markets went into the meeting looking for direction. In the main, the outcome shouldn't change any market trends. Bond yields should continue to rise and support the dollar, equities will make the most of the economic recovery, but mega-cap tech will be troubled by yields while credit has been given a lifeline.
As we expected last week, more banks are downgrading their year-end gold forecast. UBS Precious Metals Strategist Joni Teves is the latest to join that trend, revising lower her gold and silver forecasts and reset expectations on what likely comes next amid optimism, stronger growth, and higher rates. Joni now expects gold to average $1780 this year from $2100 previously and sees a further drop to an average of $1675 in 2022.
Indeed these types of forecast downgrades will add to the selling fervour.
The rapid rise in long-end US yields has spooked investors again, but buckle in as the Market vs Fed cat and mouse game is only beginning.
Markets
US equities were lower Thursday, S&P down 1.5%. Losses led by tech, NASDAQ down 3%. The bond selloff has extended further post-Fed, US 10yr yields lifted 7bps to 1.71%, highest since Jan. 23 2020. Oil fell 7.1% on a combination of short term demand and longer-term supply concerns.
The rapid rise in long-end US yields has spooked investors again overnight as there appears to be no lasting respite for the fixed income onslaught. Given the untimely ferocious nature of the selloff, which caught some investors wrong-footed whilst cheering the FOMC "lower for longer" mantra, it caused a real stinger to longer duration growth asset sentiment like mega-cap tech names.
FOMC Experiment Failing
The Fed's experiment isn't working as the market is finding in the aftermath of the latest FOMC meeting. Indeed, this is because of the market's expectations around the forward path of economic data. A dovish stance only increases the inflation risk premium's sensitivity to the economic upgrade in a market state where fundamentals are expected to continue improving.
The two paths as we advance are 1) the Fed eventually gives up on this experiment and has to tighten because they can't talk down realized inflation 2) data fails to meet elevated expectations in the coming months (or a turn in the China credit cycle reins in commodities) which brings inflation breakeven back down to earth and bails out the Fed.
The issue with #2 is that there is still a long runway of catalysts from stimulus and vaccine tailwinds, so it may be a while before the market can confirm or deny its positive outlook on economic data.
But buckle in the Market vs Fed cat and mouse game is only beginning.
The Fear Of Falling Behind The Curve
With the Fed already forecasting a pickup in inflation but assuming it will be transitory, a policy mistake here, if it happens, won't be rectified until it's way too late in the game, which will mean faster hikes and a market meltdown.
The market risk is not that the Fed is not dovish enough in pushing back on the rise in yields. It is instead that the Fed is at risk of falling behind the curve. Bonds reacted to Powell's comment that upcoming inflationary pressures would come from base effects and the potential surge in consumer spending as economies reopened. But even with inflationary pressure coming for improving fundamentals, the Fed would still be biased to question whether it was only transitory. While the Fed could be correct, this always heightens inflation risk premium if they are wrong, and the higher it goes, the higher that risk becomes.
Bonds
US rates and bonds traders took the FED to be much less dovish than headlines initially suggested. With several FOMC members breaking ranks with the central message, seven see higher rates, and the more hawkish are pushing their dots further up. So traders are concluding. It wasn't a "dovish Fed" then, but rather one that was agreeing with the market that there's a rising possibility of rates moving sooner.
Equities are the stickum holding current trends together. As long as risk assets remain resilient, nothing will stop the market from repricing fixed income yield higher.
Oil Markets
What started as a profit-taking correction triggered by a vaccine health scare has now moved into a whole out price level correction. The selloff is getting compounded by risk-off moves in cross-asset correlations. The market continues to price in tighter financial conditions despite the Feds effort to suggest the contrary.
Because of a very patchy reopening narrative with most countries outside the US, the UK and Israel, behind in their vaccination rollout protocols and even some countries in Europe back in lockdown, frothy oil market sentiment is catching down to the short term economic demand reality.
Oil fell 7 % yesterday. There is little in the way of oil specific headlines to support the move, rather a softening in the demand expectations and a strengthening of the dollar spurring some caution in a market that is quite long in terms of speculative positioning.
And despite Germany, France, Spain, and Italy, saying it will recommend using the AstraZeneca vaccine after the European Medicines Agency deemed it "safe and effective.", the oil market shrugged, leaving oil bulls and analyst scratching their head wallowing in a world of hurt.
But at the heart of it all, the rally was mainly on the back of OPEC+ production cuts—or rather, the fact that they agreed to hold production steady in April instead of ramping up production as the market had anticipated. So I suspect the oil market is experiencing a bit of reality check these days as the supercycle bulls might be giving way to the power of spare capacity as the thought of more barrels coming back continues to provide the medium-term supply headwind.
And do watch out if the China credit cycle starts to rein in commodities; that is unlikely to be a pleasing wake up call either.