Ascension Day Does Not Stop EUR or Bund Yields

EUR through psychological €1.1400 handle

Inflated EUR to hurt export dominated Europe

Crude prices supported by production, not global growth

Fed Rate hike being pushed into 2016

The speculative investor has being trying to pick a EUR top since the onslaught of the bund rout, and so far they have failed miserably. The single unit is down more than -5.5% against the dollar since the start of the year, but up almost +2% since the start of May. This morning the dollar has managed to tumble to its lowest level in two-months (€1.1423). What we have seen in markets over the past two-weeks has been triggered mostly by fear and not by a change in the outlook for economic fundamentals. Combined with a lack of liquidity problem, has led to some of the most popular trades being stretched (short EUR, long USD’s, short commodity currencies etc.).

Inflation expectations have not changed

Since the middle of April, crude prices are up +45% from their one-year lows, with +60% of that rise due to reduction in production and not growth expectations. Global Q1 growth is projected to be +1.2%, the lowest in 25-years. Currently, the biggest global bond rout in two-years is putting investors in a dangerous place – technically they are challenging the world’s most influential central banks QE and low interest policies (ECB, BoJ, PBoC and the Fed). Sustainable higher energy prices, supported by growth, will lead to higher inflation expectations, but there is little to no change in markets’ inflation expectations in the past two-weeks in either the U.S. or Europe. In fact there are still many in both economies betting inflation will remain below 1%. Worldwide inflation expectations of +0.4% in Q1 will be the lowest in two-decades. The “big” dollar demise is inflating commodity prices.

Bond Yields Continue to Rise

Sovereign debt markets are usually considered relatively stable with intraday yields moving only a few hundredths of a percentage point a day. In less than three-weeks, Germany’s 10-year bund yield has rallied +75 basis points from a record low yield of +0.05% and U.S 10’s have gone from +1.85% to +2.32%. The price move is equivalent to three rate hikes and then some. Receding deflation concerns, upcoming supply issues, and worries about trading liquidity have all been cited as reasons behind the recent bond selloff.

Despite debt markets having lost about $500b+ in value and yields having spiked, monetary policy makers are showing no signs of an imminent increase in the price of money. The ECB and the BoJ are still conducting quantitative easing. The ECB only started in March and Draghi’s monthly +€60b debt demand is expected to cap the upside for yields and QE is slated to continue until September 2016 – there are no reasons to end it sooner. Currently, higher yields are supporting the EUR and a stronger EUR will only weigh on the export driven companies in the eurozone, which does not support growth and does not justify rates being so high. There is an argument for a normalized rate curve, but Euro growth remains uneven and bumpy at best (Germany, the engine of Europe, preliminary GDP Q1 number disappointed yesterday +0.3% vs. +0.7%) and shows no signs of being sustainable.

Fed Looks for Clarity

The Fed has its problems. The want to raise rates, but the timing is crucial, as too soon could unwind all the good that would require them to back peddle. Yellen and her fellow cohorts are trying to justify their next move on the back of Q1 “transitory” blip. Yesterday’s U.S retail sales number was a bust and a big disappointment to those who are banking on a Q2 rebound in consumption. The drop in year-over-year energy prices (tax saving), higher savings and a stronger labor market (+5.4% unemployment rate) has yet to convince the U.S consumer to spend.

The Fed’s normalization rate time line is data dependent, but the latest batch of economic releases are very much mixed and are accompanied with quiet a bit of market noise. This would suggest that recent asset price moves are not wholly fundamentally drive. The stretch positions taken of late are led mostly by fear and liquidity constraints, whether it’s in the fixed income, commodities or forex asset class. The Fed’s data dependency motive gives them little choice but to wait for such clarity. Hence why U.S fixed income is looking further out their curve for the first rate hikes. Some dealers are leaning towards September, but current data would suggest that the Fed has time on their side. This is allowing others to push back Fed rate hike expectations into next year.

Owning USD has been the only true trade of note since the inception of rate divergence talk from the Fed. The problem is that fundamentally the U.S economy is falling short of expectations and is not backing up these trades – the market still needs to pare some of those positions. The highly concentrated “long” dollar trade is taking it on the chin with the change in timing and why the dollar remains vulnerable to the downside in the near term. Its weakness will be exaggerated by position adjustment. So investors should be expecting more blood, more position squeezes and prices moves that do not make any economic or monetary sense. The RBA, RBNZ and BoC for instance do not support stronger commodity currencies, but the dollar’s partial unwind has those currencies trading at multi-month highs.