“The Fed must be happy”, TD’s Priya Misra said this week. “Well, at least pleased that the market has heard them”.
There’s a sense in which the current state of affairs is the picture of success for Jerome Powell in crisis mode. Credit spreads have compressed dramatically from the March wides, and corporate debt issuance is setting records, both from investment grade and high yield borrowers.
When it comes to what grabs headlines, plenty of digital ink is devoted to the stark juxtaposition between, on one hand, the worst economic downturn in a century and, on the other, very low corporate borrowing costs, a receptive primary market, and persistent inflows into credit funds.
But the dynamics illustrated in the figure (below) deserve just as much attention, as they perhaps speak even louder to the Fed’s early success.
It’s a simple chart, but it says quite a bit. The divergence between real yields and breakevens, and equities’ lockstep rise with the latter, are precisely what the Fed wanted to engineer, even if officials would invariably contend the rebound in stocks is a secondary concern.
The rise in breakevens suggests a deflationary spiral has been averted — or at least in the market’s mind. You’re reminded of the mechanics. “If demand shock is effective, breakevens widen and push real rates further down, which becomes reinforcing as low real rates stimulate more consumption and, in principle, raise price level”, Deutsche Bank’s Aleksandar Kocic wrote back in February. “Conversely, failure to reflate the economy makes the Fed action futile with compression of breakevens pushing real rates higher and inhibiting consumption”.
So, even as the last week (defined as it was by rising coronavirus caseloads, hospitalization rates, and the reimposition of limited lockdown protocols in some affected states) called into question the reopening narrative, thereby catalyzing bouts of bull flattening and a demonstrable stumble for stocks, the recent trend is encouraging.
The dollar’s concurrent weakening is part and parcel of the same dynamics. A weaker dollar is, of course, a welcome development for risk assets and helps underpin the reflation story, in a virtuous loop. Or at least that’s the “plan”.
“In many ways, we are entering the familiar territory of QE where low rates and weaker currency support risk in the same way they did in the first half of the last decade”, Deutsche’s Kocic wrote, in a note dated Thursday.
(Deutsche Bank)
He goes on to say that while the negative correlation between stocks and the dollar is “signature QE mode”, the negative correlation between rates and the greenback “is a function of a particular path of repricing of real rates and breakevens”.
Negative real rates and widening breakevens are a “double whammy” for the currency, Kocic writes, adding that the combination simultaneously serves as a boon for risk assets. You can see the intensification of the dollar’s reaction clearly in the visual.
If breakevens are a referendum on the Fed’s success, they’re having some — success that is. As Kocic wrote in February, this can be self-feeding if it can be sustained, especially to the extent the weaker dollar greases the wheels of global trade and commerce, and buoys commodity prices.
When it comes to inflation, the Fed would be happy to accept some. There are worries in some corners that ultra-loose monetary policy and a historic fiscal response could combine with the inflationary side of the COVID-19 shock to push prices sharply higher down the road. But with inflation still falling in the here and now, that’s a concern for later.
“The destruction of global supply chains, which have in turn exacerbated shocking food shortages, lingering optimism about a V-shaped recovery, and — not least — the Fed’s own strategic review to sharpen up its act on hitting its 2% target” all bolster the reflationary case, Bloomberg’s Emily Barrett wrote Thursday, adding that on the other side, “there are a lot of well-worn counterarguments… from the structural forces of an aging population, advances in technology, or anything Larry Summers has ever written”. (Chuckle)
Reader favorite Kevin Muir (formerly head of equity derivatives at RBC Dominion, and better known for his exploits as “The Macro Tourist”) weighed in on this last week. His take was broadly similar.
“The bond market has been boring lately”, which is probably fine with the Fed, Kevin said.
“Although nominal yields have been flat-lining, the 10-year TIPS yield has fallen [and] the breakeven rate has been steadily increasing”, he added. “The Fed is indicating they’ll keep nominal rates low, and the market is responding by anticipating higher future inflation, which is exactly what the Fed wants”.
The problem is that unless another fiscal stimulus package is passed, Fed buying assets won’t have nearly the bang for the buck. Banks are under pressure for capital- the Fed is limiting share buybacks and capping dividends but that can only go so far. The next step for banks to conserve capital is to limit lending- and that would be game over for economic growth. Risk aversion due to the unpredictable course of the pandemic in the US permeates the economy; only a smart national approach to that will put that genie back in the bottle- until we either get a vaccine or effective treatments. The odds of that happening in the short term (less than 6 months) are pretty remote on all scores. Given this backdrop, smart investors (not traders or dealers) are best served by carefully measuring how much risk they can tolerate- and not going out of their skis.
Reflation trends see less obvious is other asset metrics such as growth / value or the fact that the dollar actually rebounded or that the US outperformance in the equity space vs emerging markets is still continuing and there is more hope than reality when it comes to a bottoming out of global trade