By Benjamin Picton, Senior macro strategist at Rabobank
Utopia or Eutopia?
US equities overcame a gloomy lead from Europe to close higher yesterday. That makes for 6 straight trading days of gains after major US indices rose every day of last week. Asian markets posted strong gains too. The Nikkei was up 2.37%, the Hang Seng 1.71% and even the Australian ASX200 managed to squeeze out a gain of 0.27% as it braces for a rate hike from the RBA today.
While equities basked in the afterglow of last week’s soft non-farm payrolls report, 10y treasury bonds unwound almost 8bps of the ~43bps of easing that markets have provided since October 23rd. As our Global Strategist Michael Every observed yesterday, buying bonds in anticipation of the Fed ending its tightening cycle *because* high bond yields have done the tightening for it is a self-defeating strategy. Economists usually claim that markets are rational, but logic has proven no impediment to the market pricing for a Utopia of low rates, rising asset prices, low inflation, no recession and no (major) war.
‘Utopia’ fittingly translates to “no place”, or “the place that cannot be.” Does that suggest that recent falls in yields are a blip, and we will see another run at 5%? The 2s10s spread flattened 2.5 bps yesterday as the market looked ahead to $48 billion of 3-year issuance today. Curve flattening has been the trend since the US Treasury reduced its expected Q4 borrowing from $852 billion to $776 billion (still a record), and concentrated planned issuance in the short end. Perhaps that might revert tomorrow and Thursday when the focus turns to 10-year and 30-year issuance?
The NY Fed’s Crump and Moench (what a name) term premia measure now stands at 19bps vs a 30-year average of 92bps. 14 of those 30 years was the QE era, where central banks were forcibly muscling long yields lower. Not only is that no longer the world we live in, the Fed is now engaged in quantitative tightening to the tune of $60 billion each month. The monetarists among us would tell you that quantitative tightening heralds imminent deflation, leading to rate cuts and bull-steepening of the curve. Huw Pill nodded to this view overnight by suggesting that the BoE could be cutting by the summer of next year.
Huw is an outlier here. Deflation and rate cuts is a niche view among senior central bankers. Most follow our logic that fragmentation means “higher for longer”, implying that any rise in term premia arrives from bear-steepening. Stan Druckenmiller recently observed that “the academics call it term premium. I call it normalization.”
Utopia’s homonym ‘Eutopia’ means “the good place”. The ancient Greeks must have had a sense of humor, because things don’t look too good in the EU at the moment. Final PMI readings for October confirmed yesterday the dire state of industry across the continent. German September factory orders offered a glimmer of optimism by printing at +0.2% m-o-m against the expected -1.5%, but the meager growth only came courtesy of a big downward revision in the previous month’s figures.
Just to emphasize the gloomy outlook, Austria’s Robert Holzmann said that the ECB “must be ready to hike again if needed.” Thus continues the meme whereby central banks attempt to convince us that they’re poised with their finger above the button, even though the market now fully expects that most are finished tightening. They’re talking the talk of higher for longer, but can they walk the walk as their economies slow? Enter the RBA.
Australia’s latest national accounts surprised to the upside, retail sales in September surprised to the upside, Q3 retail sales ex inflation surprised to the upside, Q3 inflation surprised to the upside and the latest labour force report saw the unemployment rate fall to just 3.6%.
Concurrently, the war between Israel and Hamas adds a new supply-side shock, with the attendant risks for inflation expectations. This is especially the case if the situation escalates and draws in other players, as we expect it will. Just yesterday the Pentagon announced that an Ohio class nuclear submarine has been deployed to the Middle East. The Ohio class is not just nuclear propelled, but nuclear armed, and the Pentagon almost never tells us where they are located. This is a message with only one intended recipient, and it isn’t Hamas, Hezbollah or rag-tag Houthi rebels in Yemen.
So, the RBA is ostensibly a ‘data-dependent’ central bank now confronted with loads of data suggesting that they should hike. Despite this, the OIS market today judges the probability of a rate rise at less than 60%. Therein lies a credibility gap where the Eutopian dual mandate of price stability and full employment will prove to be Utopian.
We still expect a 25bps hike from the RBA to 4.35% today, but they’ve had to have their arm twisted to do it (ZH: they did hike 25bps but it was a dovish hike and the AUD tumbled).
