One of the most important, but difficult to measure, concepts in macroeconomics is the natural or equilibrium real interest rate. This is the rate of interest consistent with full employment and stable inflation. The last few weeks have seen bond yields tumble and a rising cacophony of market participants questioning both the Fed's central tendency of terminal or natural rates (around 4%) and the market's perception of how fast we get there. SF Fed Williams models see a 1.8% natural rate, BofA also believes it is between 1.5 and 2%; and now Citi admits, "fair value of long-term rates may be lower than we and other market participants judged them to be."
"by July we expect the US economy to be in full recovery from the weather- and inventory-induced slowdown in Q1, and this should push US rates higher and boost the Dollar, including against the Yen." - Goldman Sachs
Despite Mario Draghi and Janet Yellen's (repeat) attempt to steal the show today, the first when the ECB reports its monetary decision (with zero real chance of announcing any change in policy considering all the furious, and failed, attempts to jawbone the Euro lower) as it faces the dilemma of deflationary pressure, record low bond yields and interest rates at record lows coupled with an export crushing Euro just shy of 1.40, and a practical impossibility to conduct QE even as the hawks jawbone a "potential" European QE to death, while Janet Yellen conducts the second part of the congressional testimony this time before the Senate Budget Committee where she will again, say nothing at all, it appears the world will be focused on Russia once again after the latest 24 hour "de-escalation" gambit is now once again dead and buried and on top of it is Putin waving a "come launch a nuclear attack at me, bro" flag.
Prak central bank balance sheets are still ahead. Interest rate increases are still several quarters out. Austerity has peaked. The output gap has peaked. What does this mean in the week ahead ?
For a decade or two, it's been dubbed the widowmaker (though truth be told, the losses are more bleed than massive capital loss like those holding US growth stocks currently), but as Barclays notes the Japanese bond market 'conundrum' (that nothing like a recovery is priced into the JGB curve, which is failing to price even a partial, eventual success of the Abe government's reflationary agenda) may finally be ready to be played..."We are always on the lookout for asset prices that seem inconsistent with the more plausible economic and financial scenarios. Sometimes these discrepancies point toward necessary alterations of our fundamental world view. In other cases, they point toward investment opportunity. At the moment, one of the most glaring discrepancies between macro and markets is the long end of the Japanese curve."
The main overnight event, which we commented on previously, was China's trade data which was a disaster. March numbers turned out to be well below market consensus with exports falling 6.6% YoY (vs +4.8% expected) and imports falling 11.3% YoY (vs +3.9% expected). The underperformance of imports caused the trade balance to spike to $7.7bn (vs -$23bn in Feb). Pricing on the Greek 5-year syndicated bond is due later today, with the final size of the bond boosted to EUR 3bln from EUR 2.5bln as order books exceed EUR 20bln (equating to a rough bid/cover ratio of over 6) as the final yield is set at 4.75% (well below the 5.3% finance ministry target and well above our "the world is a bunch of idiots managing other people's money" 3% target). Ireland sold EUR 1bln in 10y bonds, marking the third successful return to the bond market since the bailout. Also of note, this morning saw the release of lower than expected French CPI data, underpinning fears of potential deflation in the Eurozone.
After Friday's surge fest on weaker than expected news - perhaps expecting a tapering of the taper despite everyone screaming from the rooftops the Fed will never adjust monetary policy based on snowfall levels - overnight the carry trade drifted lower and pulled the correlated US equity markets down with it. Why? Who knows - after Friday's choreographed performance it is once again clear there is no connection between newsflow, fundamentals and what various algos decide to do. So (lack of) reasons aside, following a mainly positive close in Asia which was simply catching up to the US exuberance from Friday, European equities have followed suit and traded higher from the get-go with the consumer goods sector leading the way after being boosted by Nestle and L'Oreal shares who were seen higher after reports that Nestle is looking at ways to reduce its USD 30bln stake in L'Oreal. The tech sector is also seeing outperformance following reports that Nokia and HTC have signed a patent and technology pact; all patent litigation between companies is dismissed. Elsewhere, the utilities sector is being put under pressure after reports that UK Energy Secretary Ed Davey urged industry watchdog Ofgem to examine the profits being made by the big six energy companies through supplying gas, saying that Centrica's British Gas arm is too profitable.
Although there are no policy making meetings, central banks will still dominate the agenda in the week ahead.
While moderate recovery in growth and inflation is BofAML's rates team's base case, there are numerous risks to that forecast. The risk of tapering is already quite well known and they suspect it may not result in the significant market-moving event many expect when it actually happens; however, the following downside and upside risks threaten BofAML's central scenarios for 2014 as well.
The following Top Ten Market Themes, represent the broad list of macro themes from Goldman Sachs' economic outlook that they think will dominate markets in 2014.
- Showtime for the US/DM Recovery
- Forward guidance harder in an above-trend world
- Earn the DM equity risk premium, hedge the risk
- Good carry, bad carry
- The race to the exit kicks off
- Decision time for the ‘high-flyers’
- Still not your older brother’s EM...
- ...but EM differentiation to continue
- Commodity downside risks grow
- Stable China may be good enough
They summarize their positive growth expectations: if and when the period of stability will give way to bigger directional moves largely depends on how re-accelerating growth forces the hands of central banks to move ahead of everybody else. And, in practice, that boils down to the question of whether the Fed will be able to prevent the short end from selling off; i.e. it's all about the Fed.
Somehow, Fed head Bill Dudley has managed to encompass the entire "we must keep the foot to the floor" premise of the Fed in one mind-bending sentence:
- *DUDLEY SEES 'POSSIBILITY OF SOME UNFORESEEN SHOCK'
So - based on an "unforeseen" shock - which he "sees", and while there are "nascent signs the economy may be doing better", the Fed should remain as exceptionally easy just in case... (asteroid? alien invasion? West Coast quake?)
Hunting season is off to a good start this week, and I’m not just talking about deer hunting. It seems that former Fed officials declared open season on their ex-colleagues. First, Andrew Huszar, who once ran the Fed’s mortgage buying operation, let loose in yesterday’s Wall Street Journal. Huszar apologized to all Americans for his role in the toxic QE programs. And then today, the WSJ struck again, this time with an op-ed by former FOMC Governor Kevin Warsh. Warsh is a former Morgan Stanley investment banker whose 2006 to 2011 stint on the FOMC spanned the end of the housing boom and the first few years of “unconventional” policy measures. After such a solid grounding in the ways of the Fed and Wall Street, he recently morphed into a critic of the status quo. His criticisms are welcome and we believe accurate, but they’re also oh so carefully expressed. They’re written with the polite wording and between-the-lines meanings that you might expect from such an establishment figure. He seems to be holding back. So, what does he really want to say?
The latest myth of a European recovery came crashing down two weeks ago when Eurostat reported an inflation print of 0.7% (putting Europe's official inflation below that of Japan's 1.1%), followed promptly by a surprise rate cut by Mario Draghi which achieves nothing but sends a message that the ECB is, impotently, watching the collapse in European inflation and loan creation coupled by an ongoing rise in unemployment to record levels (not to mention the record prints in the amount of peripheral bad debt). Needless to say, all of this is largely aggravated by the EURUSD which until a week ago was trading at a two year high against the dollar, and while helpful for Germany, makes the so-needed external rebelancing of the peripheral Eurozone countries next to impossible. Which means that like it or not, and certainly as long as hawkish Germany says "nein", Draghi is stuck in a corner when it comes to truly decisive inflation-boosting actions. But what is Draghi to do? Well, according to BNP's Paul-Mortimer Lee, it should join the "no holds barred" monetary "policy" of the Fed and the BOJ, and promptly resume a €50 billion per month QE.
As the S&P 500 continues to push to one new high after the next, the bullish arguments of valuation have quietly given way to "it's all about the Fed." The biggest angst that weighs on professional, and retail investors alike, are not deteriorating economic strength, weak revenue growth or concerns over the next political drama - but rather when will the Fed pull its support from the financial markets. For the Federal Reserve, they are now caught in the same "liquidity trap" that has been the history of Japan for the last three decades. Should we have an expectation that the same monetary policies employed by Japan will have a different outcome in the U.S? More importantly, this is no longer a domestic question - but rather a global one since every major central bank is now engaged in a coordinated infusion of liquidity. Will the Federal Reserve "taper" in December or March - it's possible. However, the revulsion by the markets, combined with the deterioration of economic growth, will likely lead to a quick reversal of any such a decision.
The extreme experiment of current US monetary policy has evolved (as we noted yesterday), from explicit end-dates, to unlimited end-dates, to threshold-based end-dates. Of course, this 'threshold' was no problem for the liquidty whores when unemployment rates were extremely high themselves, but as the world awoke to what we have been pointing out - that it's all a mirage of collapsing participation rates - the FOMC (and sell-side strategists) realized that the endgame may be 'too close'. Cue Goldman's Jan Hatzius, who in today's note, citing two influential Fed staff economists, shifts the base case and forecasts that the Fed will lower its threshold for rate hikes to 6.0% (and perhaps as low as 5.5%) as early as December (as a dovish forward-guidance balance to an expected Taper announcement).