It was a rough week for everyone. Bonds, stocks, commodities – basically everything was down. There wasn’t a ton of economic news to drive the selling. The main report was existing home sales which was a touch soft, but not dramatically so (down -2.7% in March versus February).
Inventories remain exceptionally tight, with the months supply ticking up to just over 2 (red line below).
But of course, this data doesn’t fully reflect the big increase in mortgage rates.
The bigger driver for the markets has been the change in expectations for Fed policy. As we discuss below, investors think the Fed is going to be much more aggressive than originally thought even a few weeks ago. This change in expectations is quickly filtering throughout the financial system.
And it’s moving so quickly that there are hints of panic selling/capitulation starting to emerge. A major sentiment survey is showing the smallest number of bullish investors since the early 1990s.
Another measure is the put/call ratio. This measures the ratio of traded put options (bearish bets) to call options (bullish bets). Simplistically a high number means a lot more bearish bets than bullish bets (a contrarian signal). It can be interesting at extremes, and today’s number is close to the highest level since 1995.
None of this means the market is at a low, only that investors are definitely leaning one way. Too late to sell but too early to buy? But any durable rally will probably require the inflation data coming off the boil.
Fed Expectations and Economist Covers
As we noted above, the big issue weighing on stocks, bonds, and commodities the last couple weeks is the prospect for aggressive central bank action in the months to come. Specifically, the Fed’s rhetoric has morphed from this (Chairman Powell’s comments three weeks ago):
“It is appropriate in my view to be moving a little more quickly..”
To this (Powell a few days ago):
“We’re really going to be raising rates and getting expeditiously to levels that are more neutral and then actually tightening policy if that turns out to be appropriate once we get there.”
Or this comment from Bloomberg:
“James Bullard was quoted this week saying he wouldn’t rule out a 75bps rate hike at some point this cycle, although more than 50bps isn’t more than his base case. He also thought the Fed should get the funds rate to around 3.5% by year-end.”
The bond market started to trip over itself pricing in more and more rate hikes through the end of the year. Just consider the following: At the beginning of 2022 the market was thinking the Fed Funds rate would be just 0.83% after three rate hikes
Implied Fed Funds Rate as of 1/3/2022
Now the market is pricing in a 2.82% rate after 10 rate hikes.
Implied Fed Funds Rate as of 4/22/2022
This is an enormous move in a short period of time and goes a long way towards explaining the weakness in risk assets.
How high can expectations go? Are we nearing peak Fed hawkishness? You have to wonder when Nomura Bank publishes a report calling for two 75bp hikes in May and June followed by 50bps at every meeting thereafter. Then The Economist ran the following cover this week.
As we have noted before, Economist covers don’t come early in a cycle. They are typically a reflection of what everyone is talking about and what is priced into markets. But time will tell. The Fed next meets May 3rd and 4th.
The good news is Chairman Powell and his gang will have to stop talking soon due to their self-imposed communications blackout before meetings!!
Japan Charts Their Own Course
Less than three years ago, as much as 40% of global government debt offered negative yields – basically meaning investors were paying bond issuers for the pleasure of buying their bonds!!. Today that number has fallen to below 10%. But there is still almost $3tn of bonds out there today with negative yields. Yea, that’s pretty nuts
Much of the negative yielding universe is concentrated in very short-term European and Japanese debt. European rates are almost certainly headed higher this year which should solve that problem. But what about Japan?
They appear to be doubling down.
As the chart below shows, the Bank of Japan (BoJ) has been operating a yield curve control policy since September 2016. What this means is that the BoJ explicitly pegs the yield on the 10-year bond at a specific rate. The current iteration is targeting the 10-year JGB yield at 0% with a 25-basis point band/range (gray shade – the blue line is the actual 10-year JGB yield).
In recent weeks the 10-yr JGB yield has been pushing up against the top of this band. As a result, the BoJ has to come into the market and buy huge amounts of government bonds to keep a lid on things. So far it has been working.
But to do this the bank basically prints the money to pay for the bonds. As we learn early on in life, every action has a consequence. And in this case, printing bucket loads of yen to buy bonds isn’t good for your currency. As you can see below, the yen is at a 20-year low (a rising line means a weaker yen).
Ok, so the Yen has declined, so what? Here are the two implications:
1) Their exports have become almost 20% more competitive on the world stage. That’s a big relative price move in a short period of time. This should be good for economic growth, but will really annoy their trading partners. Are retaliatory actions coming? It’s not like we haven’t put tariffs on Japanese exports before!!
2) Everything the Japanese import has just become almost 20% more expensive. Almost overnight. If the Yen keeps falling, eventually they will have an inflation problem. At that point the Bank of Japan will have no choice but to raise interest rates, right?
But as we said earlier – the central bank is doubling down. In a speech on Friday the BoJ’s head said they need to keep on keeping on to get inflation up.
But we have seen this movie before, quite recently actually. The central bank in Australia employed yield curve controls after COVID hit. They pledged to keep the Aussie 3-year under 0.25% at first, then below 0.1%. But this policy wasn’t sustainable as inflation picked up.
They ended the policy on November 2nd, 2021, and yields skyrocketed. So one moment the government is telling you they keep a lid on rates. And then they basically say “nah, just kidding” and you take a portfolio hit. Are similar losses going to hit Japanese bond investors? You have to wonder. But I guess the good news is that the Japanese central bank is the largest owner of Japanese bonds.
Charts We Found Interesting
1. Not sure how credible the numbers are, but the trend is telling.
2. A policy of zero COVID means supply chains are gummed up in a big way.
3. Macron is the favorite to win this weekend’s election in France….
4. ….but if Le Pen pulls off a surprise, the Euro is headed towards parity.
5. First cracks in the housing market. From Bloomberg – “If you’re wondering where the U.S. real estate market might start to show its first cracks, keep an eye on Boise, Idaho. The pandemic work-from-anywhere revolution transformed it into one of the hottest markets in the U.S., but home prices are leveling off there. Typical home values in Boise rose just 0.4% last month, down from a 4.1% monthly pace in June, according to Zillow data. That makes it the first of the country’s top 100 housing markets to flirt with falling prices this year.”
6. It’s not the worst year for the Sierra snowpack, but it’s close to it.
7. Pretty soon the ability to drive a manual transmission will become a lost art. I guess the upside is that if you own one, no one is going to steal it!!
Have a good weekend.
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