Last week, rising market interest rates in the U.S. were becoming a concern. But as we discussed on Friday, we ended the week with a big bearish reversal signal in the 10-year yield. This week, the market focus seems to be shifting toward a lower dollar and higher commodities.
Friday’s bearish signal in rates seems to have foreshadowed the news coming into today’s session, that Italy is putting forward an agreement for a coalition government that would break compliance from EU rules (an “Italy first” approach to an economic and social agenda).
That has created some flight to safety in the bond market. You can see in this chart below, money moving out of Italian bonds (yields go up) and into German bonds (yields go down).
And that means money goes into U.S. Treasuries too. So you can see U.S. yields (the purple line in the chart below) backing off of the highs of last week, and with room to move back toward 3% (or below) if this dynamic in Italy continues to elevate the risk environment.
Now, with the rate picture softening, the dollar may be on the path of softening too. That would be a welcome site for emerging market currencies. We discussed last week how the push higher in U.S. yields was putting pressure on emerging market currencies. And the combination of weaker currencies and higher dollar-denominated oil prices was a recipe for economic strain.
Today, Larry Kudlow, the Chief Economic Advisor to the White House, carefully crafted a response on the dollar, as to not say they favored it “stronger.” That’s probably enough, given the rising risks in emerging markets, to get the dollar moving lower (to alleviate some of the pain of buying dollar-denominated oil for some of the EM countries).
And it may be the signal for commodities to start moving again. Because most commodities are priced in dollar, commodities prices tend to be inversely correlated to the dollar.
Today we had a fresh three-year high in the benchmark commodities index (the CRB Index).
Here’s an excerpt from one of my Forbes Billionaire’s Portfolio notes back in June, on the building momentum for commodities: “The technology sector minted billionaires over the past decade. It’s in commodities that I think we’ll see the new billionaires minted over the next decade. The only two times commodities have been this cheap relative to stocks was at the depths of the Great Depression in the early 30s and at the end of the Bretton Woods currency system in the early 70s. Commodities went on a tear both times.”
We’ve talked about the stock market’s discomfort with the 3% mark in rates. People have been concerned about whether the U.S. economy can withstand higher rates–the impact on credit demand and servicing. That fear seems to be subsiding.
But often the risk to global market stability is found where few are looking. That risk, now, seems to be bubbling up in emerging market currencies. We have a major divergence in global monetary policies (i.e. the Fed has been normalizing interest rates while the rest of the world remains anchored in emergency level interest rates). That widening gap in rates, creates capital flight out of low rate environments and in to the U.S.
That puts upward pressure on the dollar and downward pressure on these foreign currencies. And the worst hit in these cases tend to be emerging markets, where foreign direct investment in these countries isn’t very loyal (i.e. it comes in without much commitment and leaves without much deliberation).
You can see in this chart of the Brazilian real, it has been ugly …
Oil has become the potential breaking point here. At $40-oil maybe these countries hang in there until the global economic recovery heats up to the point where they can begin raising rates without crushing growth (and with a closing rate gap, their currencies begin attracting capital again). But at $70-oil, their weak currencies make their dollar-denominated energy requirements very, very expensive. They’ve had nearly a double in oil over the past ten months, and a 15% drop in their currency since January (in the case of Brazil).
Something to watch, as a lynchpin in this EM currency drama, is the Hong Kong dollar. Hong Kong has maintained a trading band on its currency since 2005 that is now sitting on the top of the band, requiring a fight by the central bank to maintain it. If they find that spending their currency reserves on defending their trading band is a losing proposition, and they let the currency float, then we could have another shock event for global markets, as these EM currencies adjust and their foreign-currency-denominated debt becomes a default risk. This all may force the rest of the global economy to start following the Fed’s lead on interest rates earlier then they would like to (to begin closing that rate gap, and avoid a shock event).
The move in the 10-year yield was the story of the day today. Yields broke back above 3% mark, and moved to a new seven-year high.
That fueled a rally in the dollar. And it put pressure on stocks, for the day.
We’re starting to see more economic data roll in, which should continue building the story of a hotter global economy. And it’s often said that the bond market is smarter than the stock market. There’s probably a good signal to be taken from the bond market that has pushed the 10-year yield back to 3% and beyond (today). It’s a story of better growth and growing price pressures, which finally represents confidence and demand in the economy.
From a data standpoint, we’re already seeing early indications that fiscal stimulus may be catapulting the economy out of the rut of the sub-2% growth and deflationary pressures that we dealt with for the decade following the financial crisis. We’ve had a huge Q1 earnings season. We’ve had a positive surprise in the Q1 growth number. The euro zone economy is growing at 2.5% year-over-year, holding toward the highest levels since the financial crisis. And we’ll get Q1 GDP from Japan tonight.
Another key pillar of Trumponomics has been deregulation. On that note, there’s been plenty of carnage across industries since the financial crisis, but no area has been crushed more by regulation than Wall Street. And under the Trump administration, those regulations are getting slashed.
Among the most damaging for big money center banks has been the banning of proprietary trading. That’s a huge driver of bank profitability that has been gone now for the past eight years. But it looks like it’s coming back. Bloomberg reported this morning that the rewrite of the Volcker Rule would drop the language that has kept the banks from short term trading.
That should create better liquidity in markets (less violent swings). And it should drive better profitability in banks. Will it lead to another financial crisis? For my take on that, here’s a link to my piece from last year: The Real Cause Of The Financial Crisis.
At the end of last week, I said “it looks like the all-clear signal has been given to stocks.”
Well, we had some more discomfort to deal with this week, but that statement probably has more validity today than it did last Friday.
With that, let’s review the events and conditions of the past two weeks, that build the case for that all-clear signal.
As of last Friday, more than half of first quarter corporate earnings were in, with record level positive surprises in both earnings and revenues (that has continued). And we got our first look at first quarter GDP, which came in at 2.3%, better than expected, and putting the economy on a 2.875% pace over the past three quarters.
What about interest rates? After all, the hot wage growth number back in February kicked the stock market correction into gear. The move in the 10-year yield above 3% last week started validating the fears that rising interest rates could quicken and maybe choke off the recovery. But last week, we also heard from the ECB and BOJ, both of which committed to QE, which serves as an anchor on global rates (i.e. keeps our rates in check).
Fast forward a few days, and we’ve now heard from the last but most important tech giant: Apple. Like the other FAANG stocks, Apple also beat on earnings and on revenues.
Still, stocks have continued to trade counter to the fundamentals. And we’ve been waiting for the bounce and recovery to pick up the pace. What else can we check off the list on this correction timeline? How about another test of the 200-day moving average, just to shake out the weak hands? We got that yesterday.
Yesterday, in the true form of a market that is bottoming, we had a sharp slide in stocks, through the 200-day moving average, and then a very aggressive bounce to finish in positive territory, and on the highs of the day. That took us to this morning, where we had another jobs report. Perhaps this makes a nice bookend to the February jobs report. This time, no big surprises. The wage growth number was tame. And stocks continued to soar, following through on yesterday’s big reversal off the 200-day moving average.
With all of this, it looks like “the all-clear signal has been given to stocks.”
As we discussed yesterday, the minutes from the most recent Fed meeting (which was still under Yellen) gave us some clues about the tone of a Powell-led Fed. They acknowledged the lift they expected from fiscal policy, which we didn’t hear all of last year, despite the clear telegraphing of it from the Trump administration. Powell was Trump appointed. And it looks like the Fed messaging will now reflect that.
This is from his prepared remarks today:
“The economic outlook remains strong. The robust job market should continue to support growth in household incomes and consumer spending, solid economic growth among our trading partners should lead to further gains in U.S. exports, and upbeat business sentiment and strong sales growth will likely continue to boost business investment. Moreover, fiscal policy is becoming more stimulative. In this environment, we anticipate that inflation on a 12-month basis will move up this year and stabilize around the FOMC’s 2 percent objective over the medium term. Wages should increase at a faster pace as well.”
So he’s bullish on economic output, wage growth and therefore, inflation. That’s bullish for rates. And, for the moment, what’s bullish for rates is bearish for stocks.
Oddly, on the same day Powell had his first testimony to Congress, the two former Fed chairs (Bernanke and Yellen) thought it was acceptable to host a chat about monetary policy this afternoon at the Brookings Institute.
It looked a bit like a partisan counter-punch. The same two former Fed Chairs that were, not long ago, begging Congress for fiscal stimulus to take some of the burden off of monetary policy, continue to (now) criticize the move. In fact, in Powell’s statement, he called the lack of fiscal response from Congress in past years, a headwind: “some of the headwinds the U.S. economy faced in previous years have turned into tailwinds: In particular, fiscal policy has become more stimulative.”
The takeaway from our first look at Powell: He doesn’t sound like a guy that will risk choking off the benefits of fiscal stimulus with overly aggressive “normalization” of monetary policy. That’s good.
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Remember, the Fed met last week and hiked rates for the third time this year, and the fifth time in the post-crisis hiking cycle. But as we discussed, the big event for interest rates wasn’t last week, it’s this week.
The Bank of Japan meets on Wednesday and Thursday. Japan‘s policy on pegging their 10-year yield at zero has been the anchor on global interest rates (weighing on global interest rates). When they signal a change to that policy, that’s when rates will finally move – and maybe very quickly.
With that in mind, we have the stock market continuing to climb north of +20% on the year. Economic growth is going to get very close to 3% for the full year of 2017, and yet the benchmark longer term interest rates determined by the market are unchanged for the year. The yield on the 10 year Treasury is 2.43% this morning (ticking UP today). We came into the year at 2.43%.
Again, this is the flattening yield curve we discussed last week. For a world that is constantly looking for the next potential danger or signal for doom, the flattening of the yield curve has been the latest place they’ve been hanging their hats (as what they believe to be a predictor of recession). But those people seem happy to assume this yield curve indicator is driven by the same behaviors that have led to recessions in past economic periods, ignoring the unprecedented and coordinated global central bank manipulation that has gotten us here and continues to warp the interest rate market.
So now we have the Fed, which has been moving away from emergency policies. The ECB has signaled an end to QE next year. And the Bank of Japan is next in line — it’s a matter of when.
So how do things look going into this week’s meeting? We know the architect of Japan’s economic reform plan, Prime Minister Shinzo Abe, has just followed the American fiscal stimulus movement with a corporate tax cut of his own, but only for companies that will start raising wages for their employees. He said today that Japan is no longer in a state of deflation. The head of the Bank of Japan has said the economy is in “very good shape.” And that they would consider what is the best level of rate targets to align with changes n the economy, prices and financial conditions. The recent Tankan survey showed sentiment in the manufacturing community hitting decade and multi-decade highs.
But inflation continues to undershoot in Japan, as it is in the U.S. Japan is targeting a 2% inflation rate and is running at just 0.8% annualized.
So it’s unlikely that they will give any signal of taking the foot off of the gas this week. But that signal is probably not far off — maybe in January, after U.S. tax cuts are in effect. What does that mean? It means our market rates probably make an aggressive move higher early next year (10s in the mid 3s and rates on consumer loans probably jump 150 to 200 basis points higher).
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We have big central bank meetings this week. Let’s talk about why it matters (or maybe doesn’t).
The Fed, of course, has been leading the way in the move away from global emergency policies.
But they’ve only been able to do so (raising rates and reducing their balance sheet) because major central banks in Europe and Japan have been there to pick up where the Fed left off, subsidizing the global economy (pumping up asset prices and pinning down market interest rates) through massive QE programs.
The QE in Japan and Europe has kept borrowing rates cheap (for consumers, corporates and sovereigns) and kept stocks moving higher (through outright purchases and through backstopping against shock risks, which makes people more confident to take risk).
But now economic conditions are improving in Europe and Japan. And we have fiscal stimulus coming in the U.S., into an economy with solid fundamentals. As we’ve discussed, this sets up for what should be an economic boom period in the U.S. And that will translate into hotter global growth. So the tide has turned.
With that, global interest rates, which have been suppressed by these QE programs, will start moving higher when we get signals from the key players, that an end of QE and zero interest rates is coming. The European Central Bank has already reduced its QE program and set an end date for next September. That makes the Bank of Japan the most important central bank in the world, right now. And that makes the meeting next week at the Bank of Japan the most important central bank event.
Let’s talk a bit more about, why?
Remember, last September, the Bank of Japan revamped it’s massive QE program which gave them the license to do unlimited QE. They announced that they would peg the Japanese 10-year government bond yield at ZERO.
At that time, rates were deeply into negative territory. In that respect, it was actually a removal (a tightening) of monetary stimulus in the near term — the opposite of what the market was hoping for, though few seemed to understand the concept. But the BOJ saw what was coming.
This move gave the BOJ the ability to do unlimited QE, to keep stimulating the economy, even as growth and inflation started moving well in their direction.
Shortly thereafter, the Trump effect sent U.S. yields on a tear higher. That move pulled global interest rates higher too, including Japanese rates. The Japanese 10-year yield above zero, and that triggered the BOJ to become a buyer of as many Japanese Government Bonds as necessary, to push yields back down to zero. As growth and the outlook in Japan and globally have improved, and as the Fed has continued tightening, the upward pressure on rates has continued, which has continued to trigger more and more QE from the BOJ – which only reinforces growth and the outlook.
So we have the BOJ to thank, in a pretty large part, for the sustained improvement in the global economy over the past year.
As for global rates: As long as this policy at the BOJ appears to have no end, we should expect U.S. yields to remain low, despite what the Fed is doing. But when the BOJ signals it may be time to think about the exit doors, global rates will probably take off. We’ll probably see a 10-year yield in the mid three percent area, rather than the low twos. That will likely mean mortgage rates back well above 5%, car loans several percentage points higher, credit card rates higher, etc.
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Over the past two weeks we’ve talked about the two big central bank events. The first was the ECB’s decision last week. As expected, they signaled they will be exiting QE. The second was the anticipated announcement of a new Fed chair. This is a high consequence decision.
I thought early on that the President would show Yellen the door, given that the rate hiking campaign she has been leading at the Fed poses a threat to choke off the impact of the big fiscal stimulus efforts that have been the hallmark of the Trump Presidency.
She stayed longer than I expected. But today we get her replacement: the current voting Fed governor Jerome Powell. Powell has voted with Yellen, along the way. So, it doesn’t appear to be a philosophical change and it doesn’t appear to be a person Trump can influence – but he offers the President party alignment.
I thought Neel Kashkari had postured perfectly to get the job. He has experience at the Treasury overseeing the TARP program through the ugliest period of the financial crisis. And he’s a newbie Fed governor, but one that has dissented on rate hikes and argued to wait for inflation to take hold before moving on rates (to ensure sustainability of the recovery). That view aligns much friendlier with the Trump administrations economic plan.
The Fed chair role was, arguably (unquestionably, to me), the most important role in the world under the Bernanke reign. Bernanke was the right guy, in the right place, at the right time. As a student of the Great Depression he led the Fed through decisions that pulled the world back from the edge of total collapse. At stages through the crisis, the Fed and Bernanke took a lot of heat – and a lot of it came from world leaders, and even global central banks. But had the Fed not swiftly acted to help foreign banks early on (that were frozen from the lack of access of U.S. dollars), the global financial system would have imploded.
Other central banks then underestimated the scale of the crisis and started hiking rates too early, in 2010 and 2011, which ultimately put them back in to recession (most notably, Europe). The Fed stayed put.
Over time, Bernanke’s Fed (and his aggressive QE) proved to be right, and ultimately provided the playbook for major central banks to follow.
Under the Yellen regime, the track record has been spotty, nearly killing the recovery last year, by continually telegraphing a much tighter credit environment ahead. But the policy course was bailed out by the election of a new President and administration that is hell-bent on pumping up the economy.
Now Powell takes over at a more critical juncture. The execution on fiscal stimulus is beginning to materialize, and we’ll get to see how he navigates it. Hopefully, he’ll let the economy run a little hot (chase inflation from behind), and not allow rates (or the perception of tighter credit) to kill the animal spirits that can accompany big tax cuts and government spending programs.
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The Fed decision today was a snoozer, as expected. The market continues to think we get a third rate hike for the year in December (fourth since the election).
Thus far, with three hikes, we’ve had just about the equivalent (just shy of 75 basis points) priced-in to the 10-year Treasury market. Yields popped from about 1.70% on election night (just about a year ago) to a high of 2.64%. We’ve had some swings since, but we sit now at roughly 2.40% (70 basis points higher over the past year).
We revisited yesterday, the prospects for some significant wage growth (and therefore inflation), with the fuel of fiscal stimulus feeding into an already tight (but underemployed) labor market.
The Treasury market isn’t pricing that scenario in, at all.
In fact, the yield curve continues to look more like a world that doesn’t fully believe fiscal stimulus is happening (or will happen), and does believe the Fed is more likely damaging the economy through its rate “normalization.”
That’s a bet that continues to underprice the prospects of fiscal stimulus. And, therefore, that’s a bet that continues to be disconnected from the message other key markets are sending. Over the past six months, we’ve talked the case for stocks to go much higher. We’ve talked about the opportunities in European and Japanese stocks (German stocks hitting new record highs and Japanese stocks nearing new 26-year highs today). We’ve talked a lot about the building bull market in commodities. We’ve talked about the positive signals that copper has been sending, as the leading indicator of a global economic turning point. We’ve talked about the outlook for much higher oil prices – oil hit $55 today. (July 30: Explosive Move Coming For Oil And Commodities Stocks).
And oil prices, whether the central banks like to admit it or not, heavily impact inflation, inflation expectations and policy making decisions.
With that, this next chart suggests that market interest rates are about to make a move (higher).
Source: Billionaire’s Portfolio
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Let’s take a look today at what fiscal stimulus might do to inflation.
The central banks have been able to boost asset prices. They’ve been able to restore stability so that people felt confident enough to hire, spend and invest again. But the scars from over-indebtedness have left demand weak. And because of that, despite the recovery of the unemployment to under 5%, the quality of jobs haven’t returned. And, therefore, the leverage to command higher wages hasn’t been there. That’s been the missing piece of the recovery puzzle.
And with that, we’ve had an ultra-low inflation recovery. That sounds great (low inflation).
But inflation at these low levels has had us (through much of the past decade) teetering on the edge of deflation. That’s bad news.
Among the many threats throughout the crisis period, a deflationary spiral was one of the Fed’s most feared. Central bankers can fight inflation (by raising rates). But they can’t fight deflation when consumer psychology takes over. When people hold on to their money thinking things will be cheaper tomorrowthan they are today, that mindset can bring the economy to a dead halt. It’s a formula that can become irreversible.
And that’s what has kept the Fed (and global central banks) sitting at ultra-low levels of interest rates – to keep the recovery momentum moving so that they don’t have to fight a deflationary spiral (as they have in Japan, unsuccessfully, for two decades).
Now, enter fiscal stimulus. We’re getting fiscal stimulus into an already tight employment market.
Real wages (employee purchasing power) has barely budged for two decades. Introducing big tax cuts and government spending into an economy that has low unemployment and the best consumer credit worthiness on record should pop demand. And that should finally give us some wage growth – maybe bigwage growth.
All of the inflationists that thought QE was going to cause hyper-inflation were wrong – they didn’t understand the severity and breadth of the crisis. Now, after global unlimited QE has barely moved the needle on inflation, the inflation hawks have been lulled to sleep. It may be time to wake them up.
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Over the past two weeks we’ve talked about the two 
The Fed decision today was a snoozer, as expected. The market continues to think we get a third rate hike for the year in December (fourth since the election).
Let’s take a look today at what fiscal stimulus might do to inflation.