It was a broadly lower week for both stocks and bonds, and only commodity prices broke the downward trend. For the week the S&P lost -0.4%, but Friday’s rally of roughly +1% eased the pain greatly. Small-cap equities on the other hand were pummeled, losing -3.1%. Internationally, for the first time in a while it paid to be unhedged. The unhedged European index gained +0.4% while the hedged version was off -2.1%. Only in Japan did it pay to hedge – the yen lost another -1.1% this week.
Bond yields continue to push higher globally. U.S. 10-years moved smoothly through 2% to close the week at 2.12% despite soft economic data. Long-term Treasuries lost -3.9% while intermediate-term bonds were off -1.7%.
Another First Quarter Clunker….
The main report on the U.S. economy this week was the initial estimate on 1st quarter GDP growth. Basically it stunk. Growth came in at just +0.2% year-over-year, far below the roughly +1.0% expected. To be fair, this isn’t a complete shock. It’s not exactly news that the very cold weather at the beginning of the year forced many consumers to stay home. The strong dollar also played a part in pulling exports down. What is surprising is that the fall in oil prices the last few months has done very little to stimulate consumer spending. It is growing pretty clear that consumers are choosing to sit on the gas savings rather than splurge.
But not all the numbers this week were poor. Critically, we continue to see job growth. Initial unemployment claims fell by 34K to 262K, the lowest level since April 2000 (as you can see below)
Next Friday’s payrolls report will be very interesting.
…Means the Fed Won’t Move in the Second Quarter
The soft GDP report came out the same day the Fed concluded their two day meeting. Few thought we’d get much out of the Fed this time, and sure enough, they said very little. There were three keys points:
1) They essentially stuck to their previous position – the weakness in the US economy “during the winter months” was partly a reflection of transitory factors. The statement remains cautiously optimistic that economic growth will return to a moderate pace and that the labor market “will move toward levels the Committee judges consistent with its dual mandate.”
2) Interestingly, the Fed underplayed the inflation risks despite some recent signs of perkiness. The Fed anticipates that inflation will remain near its recent levels in the near-term.
3) Finally, their forward guidance was essentially unchanged. It wants to see further improvement in the labor market and be “reasonably confident” that inflation will move toward its target over the medium term.
So what does it all mean? Our take is that the Fed is keeping all their options open. They’d love to hike rates this fall (September?) and are hoping the data picks up enough between now and then to justify such a move. Time will tell.
European Inflation and Bond Yields
The other interesting economic number came out of Europe. We found out this week that the eurozone’s recent spell of deflation ended last month. The April CPI report showed that prices were flat, up from -0.1% in March (chart below). Inflation hit a low of -0.6% in January following the sharp drop in energy prices.
And energy is playing a key role here. Brent crude was up over +20% in April, and this feeds directly in headline inflation. Core inflation (excluding food and energy) was flat in April at +0.6%.
One immediate consequence of stabilizing inflation in Europe is a relatively large jump in bond yields. As you can see below, the yield on the German 5-year has moved above 0% for the first time since the beginning of the year. Yields aren’t exactly rich, but at least they are positive.
It isn’t just inflation pushing yields higher though. Both Bill Gross and Jeff Gundlach were out this week talking about shorting German bonds at some point in the future. This probably helped push sentiment in the higher yield direction.
Dollar bulls are Burned
Finally, the dollar gave back some of the gains realized over the last few months. As you can see below, the dollar has dipped about 4% over the last couple weeks after a simply massive run.
Almost certainly the selloff in equities, the rise in bond yields, and the dip in the dollar are related. Up until recently long European equities, long European bonds, and long the dollar have been the trade de jour. And even for very liquid markets everyone can’t cut positions without moving prices lower. So that is probably what we’ve seen the last couple weeks. Investors and traders decided to lighten up on the popular trades and prices moved as a reaction. The following quote from JP Morgan on the dollar captures the spirit of things:
“Although in the extreme the dollar could fall another 5% to recouple with rates markets, we’re putting the Q2 drawdown at only another 2% to 3% more due to a sense (or maybe perennial hope) that a growth upturn and a tightening labour market will bring the fed back into play sooner than currently discounted. This rate repricing would keep the dollar above fair value for longer, but there would be no shame in this result. Markets trade well above and well below fair value for months, quarters and years, and only fully realign with fundamentals once monetary policy or the economy is closer to reversing.”
So the major questions for the next three months will be:
1) Will the U.S. economy see the snapback everyone expects?
2) Will employment growth continue to positively surprise?
3) If #1 and #2 are answered in the affirmative, will the Fed start to set the stage for a September hike?
4) The final question concerns China. One bull market that didn’t reverse the last couple weeks of April was the bull run in Chinese equities. Both the on-shore and off-shore markets were up over 15% in April. Markets have rallied because investors are anticipating even more stimulus in China. To quote Gavyn Davies from the FT:
“Until now, the monetary authorities have been disinclined to react aggressively to signs of economic weakening and financial stress, seeing them as part of the solution rather than part of the problem. There has been no precipitous reduction in interest rates, no panic cuts in reserve requirement ratios (RRRs) and, crucially, no apparent desire to weaken the exchange rate. In other words, China has been the only major country to stand aside from the global pattern of unconventional monetary easing. There are now some indications that this may be changing, with the authorities planning measures to ease monetary policy in three different ways:
a. The one percentage point cut in the RRR announced last week…will ‘free’ about RMB 1.3 trn of bank reserves for other uses.
b. It has been reported that the PBOC is contemplating a programme of unconventional monetary easing similar to the LTRO measures undertaken by the ECB in recent years, with elements of the UK’s Funding for Lending Scheme thrown in. This will be aimed at easing the overhang of local government debt, which is being rolled into longer durations via new “municipal” bond issues.
c. The authorities clearly intend to use the policy banks as an avenue for pseudo¬fiscal expansion. Last week, it was reported that they will announce a capital injection of $63 bn into these entities from the foreign exchange reserves, presumably with the intention of enabling them to raise more finance to boost lending on infrastructure, agricultural projects and trade support”.
We will spend the next few weeks flushing out the answers the above questions.
Have a good weekend.