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False Dawns And Summer Doldrums

Market participants sleepily adrift or otherwise mired in the summer doldrums will be compelled to focus in the week ahead as earnings season kicks off in earnest and the data calendar gets more lively.

The big banks are on deck with second quarter results (more on what to expect here) and company guidance will be set against the evolution of reinstated lockdown measures and paused re-opening plans in states representing more than half of the US population.

On the data front stateside, NFIB could provide a window into the impact of the worsening epidemic on the (stalled) engine of America’s labor market, while CPI and retail sales will be watched for evidence that either confirms of disconfirms the “V-shaped” narrative.

While stocks are riding a two-week win streak, the character of the rally (e.g., narrow breadth on some metrics and outperformance from secular growth) betrays palpable concerns about the viability/sustainability of the recovery. In simple terms, it feels like the market is sleepwalking into a summer growth scare.

With that in mind, rates will be at the forefront of the discussion after a week that witnessed bouts of sharp bull flattening as long-end yields moved to the low-end of recent ranges. “The market is finally reacting to the growing infections”, TD’s Priya Misra said. “That’s why rates are falling, led by the long end”.

Healthy demand at last week’s 30-year auction underscored the point and cast considerable doubt on the consensus 5s30s steepener.

While breakevens have drifted higher with consumer inflation expectations, the deflationary side of the pandemic (demand shock) is still expected to dominate the longer-run inflationary effects (e.g., on-shoring, supply constraints, rising protectionism) for the foreseeable future.

“Tuesday’s CPI release will be relevant, if not abundantly market moving as the pickup in the pandemic once again has the undesirable consequence of making the economic data stale”, BMO’s Ian Lyngen and Jon Hill said, in a Friday note. “Even with the backdrop of a clearer view on the progression of the pandemic-stricken domestic economy, our expectations for the data to drive a material repricing in the US rates market are limited”, they went on write. “That honor will fall to the progression of COVID-19 as investors once again favor trading the infection/ mortality stats over any lagged gauges of economic performance”.

On that score, the US continues to log daily record after daily record for infections. It makes no sense to speak of “second waves”. The country never got through the first one.

Of course, if you look at the breakdown of yields (i.e., reals versus breakevens) and take that as a referendum on the success of the Fed in resurrecting the reflation narrative while simultaneously bolstering risk appetite, you’re left to believe they’ve had some success.

After all, reals are negative and breakevens have drifted higher.

But to say there’s rampant skepticism regarding the durability of any trade tethered to the idea that inflation is coming in the middle of what, by many accounts, is the largest demand shock in modern economic history, would be an understatement.

“In this crisis, with supply and demand destruction, the risks are skewed toward disinflation”, says SocGen’s Subadra Rajappa, who predicted a US recession in Q2 2020 last year, albeit obviously not due to a pandemic, which was unforeseeable at the time.

That’s not to say it wasn’t a good idea to get into inflation-linked products during the worst of the panic. It’s just that, like any other trade which relies on a robust recovery, it’s vulnerable to a scenario where those who have warned about a false economic dawn end up being correct.

“Although the sharp rise in inflation expectations can be viewed as a positive, the 10-year real yield at -80bp sends a dire signal of the market’s expectations for real growth over the long run”, Rajappa went on to remark Friday, adding that “the decline in real yields has also coincided with the bid for safe-haven assets, such as gold another troubling signal of uncertainties ahead”.

Needless to say, sticky jobless claims and the prospect of layoffs tied to new lockdowns further cloud the outlook.

Fingers crossed we don’t get another spike in reals comparable to what happened in March, but at -80bps, it’s a bit hard to imagine things running much further.

“If conditions continue to improve, there is a case for a continued rise in inflation expectations, but if conditions deteriorate, we could see a sharp reversal in real yields akin to what happened at the peak of the COVID crisis in March”, Rajappa frets. “Hopefully”, she says, such a reversal “would not be of the same magnitude”.


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