Frayed Nerves, Lit Fuse

Barring some manner of good news on the geopolitical front, it’ll be another challenging week for risk assets. Although the White House said Sunday evening that Vladimir Putin and Joe Biden agreed “in principle” to a summit brokered by Emmanuel Macron, the drums of war will continue to beat loudly in investors’ ears.

Of course, “challenging” doesn’t preclude a rally, nor does it guarantee steep losses. Challenging just means the headwinds bedeviling sentiment haven’t abated, so nerves remain frayed. And fuses remain lit.

Markets don’t like uncertainty (and I don’t like clichés, but there’s one anyway). The only thing more uncertain than the situation on Ukraine’s border is the outlook for US inflation and thereby Fed policy. Complicating matters is the widely-held view that the vaunted “Fed put” is now struck well below 4,000 on the S&P.

Perhaps just as importantly, officials are very wary of a move back towards record highs on US benchmarks. “Any rally back to those levels would see an impulse easing in financial conditions that is outrageously counterproductive for their hawkish efforts,” Nomura’s Charlie McElligott said last week. Goldman’s FCI index still suggests conditions are a bit easier now than they were this time last year, and considerably looser than they were during September 2020’s fleeting tech rout.

The marquee data point in the new week is obviously PCE, due Friday. Needless to say, the price gauges will show inflation remains near four-decade highs. The headline print is expected to come in at 6%, while core is seen at 5.2%. (figure below).

If January’s CPI data was any indication, the scope for an upside surprise is considerable.

The Fed’s in trouble. Lord knows I avoided coming to that conclusion for as long as I could, but reality refused to cooperate. Price pressures haven’t abated. And inflation is broadening out. Those are facts. For most of 2021, the burden of proof rested with those who said inflation would remain elevated. After all, you could cite myriad quantitative and qualitative arguments to support the “transitory” narrative, and besides, some of the structural disinflationary forces we’ve all become accustomed to were made worse by the pandemic (e.g., too much debt). Starting in Q4, though, the burden shifted to the transitory crowd — if “transitory” means anything, this “ain’t it.”

The debate about the likely size of next month’s Fed hike continues to rage. Jim Bullard notwithstanding, it still doesn’t seem like there’s much in the way of support for a 50bps move in March. Some of the rate hike premium came out last week as Ukraine tensions worsened, and the long-end rally (i.e., the flight-to-safety) threatens to further flatten the curve, given the difficulty for short rates to retreat materially in the face of an imminent hiking cycle.

In that context, this week’s two-year sale will be watched closely. “It appears likely to draw a yield of about 1.50%, the highest since December 2019,” Bloomberg’s Liz McCormick wrote, noting that “the January auction drew 0.99%, and an increase of that magnitude hasn’t occurred since 2004.”

Meanwhile, liquidity is a problem. A Bloomberg gauge that measures deviations in yields from modeled fair value suggests a severe deterioration. That, in turn, is conducive to volatility.

BMO’s Ian Lyngen and Ben Jeffrey touched on that. “Volatility and liquidity conditions have emerged as extremely thematic notions in the Treasury market to begin 2022 — especially so after [January’s] CPI read and Bullard’s hawkishness that pushed the curve to its flattest levels since before the pandemic began,” they wrote. The visual (below) illustrates the point.

As Lyngen went on to write, current conditions “are hardly reminiscent of the extremes experienced in early 2020 [but] the combination of monetary policy uncertainty, economic unknowns and geopolitical tensions” is a powder keg.

Again: Thinner liquidity opens the door to higher vol. And higher vol is conducive to thinner liquidity. Not exactly a favorable conjuncture.

Speaking of vol, the obsession with Fed policy has led to a great migration across the surface. Deutsche Bank’s Aleksandar Kocic illustrated the point in the figures (below). The chart on the left shows the percentage performance of different sectors since October, while the visual on the right compares 10-year tenors across expiries.

“We note the outlier rise of the upper left corner: While long-tenor gamma rose about 30% since the beginning of October, 3M1Y went from high teens to above 120bps, a correction in excess of 700%,” Kocic noted.

Friday’s PCE data will also give markets another snapshot of the US consumer. January retail sales surprised markedly to the upside, so any confirmation of consumer resilience might help allay fears of a downturn, even as it stokes concerns of aggressive Fed hikes.

Traders will get two doses of consumer sentiment data this week. The Conference Board gauge is due Tuesday, and the final read on University of Michigan sentiment will hit shortly after Friday’s income and spending report. The preliminary print on the Michigan gauge was “stunningly” dour.

Investors will hear from Barkin, Bostic and Mester this week. Also on the data docket: Home prices, new home sales, the second read on Q4 GDP and, possibly, a war.

In a statement early Monday, the French government said the proposed Biden-Putin summit “can only be held on the condition that Russia does not invade Ukraine.”