Party Over?

Risk sentiment was clearly impaired by pandemic concerns to kick off the new week, raising questions about whether the party might be over.

Outbreaks in Asia and the many ironies of the UK’s “Freedom Day” dominated headlines. Coco Gauff’s announcement was a high-profile reminder that if the goal is “normal,” we’re not there. Let’s not forget that although highly-effective vaccines and, by now, fortified healthcare systems, have allowed some rich nations to pretend things are generally fine, other countries aren’t so lucky. Some of the pandemic’s early success stories have turned to nightmares in 2021.

Equities responded to a wave of dour pandemic headlines with losses, and bonds extended a monthsold “counterintuitive” rally. 10-year US yields touched 1.18%, the lowest since mid-February (figure below).

“As investors seek justification for the recent bond rally, the underperformance of emerging markets in terms of progress out of the pandemic has been an obvious touchstone,” BMO’s Ian Lyngen and Ben Jeffery wrote Monday, adding that “rising case counts in nations previously assumed to have the virus under control offer the most recent motivation to press yields lower.”

Australia extended a lockdown in Victoria state. Premier Daniel Andrews said that although lifting restrictions now might mean “a few days of sunshine,” chances are “we’d be back in lockdown again.” That, he remarked, is “what I’m trying to avoid.” One has to wonder what this means for the RBA’s normalization schedule.

The dollar, meanwhile, rose to the highest since early April, as the pound touched a three-month low (the paradox there is that the end of restrictions in the UK could mean more cases, which could mean the reimposition of restrictions later). The Aussie hit a seven-month nadir (figure below).

This isn’t particularly palatable for risk assets. The dollar is bid due both to haven demand and the notion that rising inflation will prompt a more hawkish Fed. The same expectations for accelerated Fed tightening are pushing long-end US yields lower, as markets fret over self-defeating rate hikes in a world where growth expectations disappoint.

A dollar that’s buoyant in a risk-off environment and against a rates backdrop that suggests market participants see a policy mistake in the making is a rather inauspicious conjuncture.

On the bright side, Bloomberg’s Cameron Crise noted that although “the squeeze higher in the dollar is maybe another signal that the current bout of risk aversion is ‘real,’ dollar strength, if maintained,” could put a lid on commodity prices and otherwise help tamp down inflation pressures.

Oil was sharply lower Monday following the OPEC+ deal. Goldman did a nice job spinning the resolution as bullish. “The agreement had two distinct points of focus: a moderate increase in production which will keep the market in deficit in the coming months, as well as guidance for higher capacity which will be needed in coming years given growing under-investment,” the bank said, adding that,

While the baselines were raised more than expected, the production path instead implies 1H22 output 0.65 mb/d below our prior expectations (with a threat of a price war now removed). As a result, we view [the] deal as supportive to our constructive oil price view with supply increasingly becoming the source of the bullish impulse and evidence of non-OPEC supply shortfalls likely in the coming months (including shale discipline in the upcoming earnings season).

Still, the bank admitted that oil prices “may continue to gyrate in the coming weeks given growing concerns over the Delta variant.”

As for positioning in rates, BMO’s Lyngen noted Monday that “shorts are still evident in FV, US and ultra-long contracts.” He described the short-covering process as “‘partial’ thus far.” “What’s missing is a wholesale capitulation of the short base and it’s not obvious that such an event is truly in the offing” he and Jeffery added.

Oh, and from a 30,000-foot, three-decade perspective, SocGen’s Kit Juckes reminded folks that “we should never be too surprised by falling yields.”

“10 years ago, 10-year Treasury yields were at 3%. 20 years ago they were at 5% and 30 years ago it was 8%,” Juckes wrote. “This is another reminder that markets are global and while US inflation has surged, the rise elsewhere has been muted, anchoring yields – US ones, too.”