2017/07/05 Commentary: Bond Bubble Burst?
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Commentary: Wednesday, July 5, 2017
Bond Bubble Burst?
The govvies have been under pressure again since last week Tuesday’s less accommodative noises from both the European Central Bank (ECB) and Bank of England (BoE.) The BoE’s Governor Mark Carney would seem within his rights to discuss a more aggressive interest rate stance after recent combined influences. That was from both higher than expected recent inflation figures and the BoE Monetary Policy Committee vote at their last meeting moving closer to hiking the base rate than many had expected. That was exacerbated by the ECB’s Mario Draghi discussing the elimination of downside economic risks in the Euro-zone and hinting at a reduction of the ECB’s Asset Purchase Program, their designation for Quantitative Easing (QE.)
The net effect has been to create a typical quantum dislocation in bond markets that had become too sanguine about the lack of accelerated growth and inflation. Yet it has also been the case that previous concerns about accelerated economic growth leading to higher inflation and long-term interest rates have been misplaced. Within the broader context going back into 2013 (the reason for the broad opening chart), the initial May 22, 2013 Federal Reserve notice it was going to ‘taper’ its &70 billion per month bond buying program caused a sharp implosion in US 10-year T-note prices (the ‘Taper Tantrum’) into early July. While subsequent influences are too numerous to review here, across the next several years economic indications were weak enough to encourage a T-note rally up to (astoundingly enough) higher levels than prevailed at the ‘taper’ announcement.
The point here is that central bank bond buying (or the lack of it) is rarely more than a short term influence. Bonds are priced on inflation and inflation expectations with some influence from the economic conditions that drive those two aspects. As long as those are subdued there is little chance of a sustained major escalation of bond yields and the attendant drop in bond prices. We presume most of you know that. Yet the other factor at play in the fear of potential ECB QE tapering is… it probably won’t do so. Click through to the extended analysis for interesting considerations of why not.
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NOTE: Given the likelihood the US economy will now get the structural reform that we (along with Mario Draghi and others) have been loudly complaining was not forthcoming since our dual It’s Lack of Reform, Stupid posts in January 2015, we need to adjust our view that a potential economic and equity market failure is coming. We previously referred you back to our December 8, 2015 post for our major Extended Perspective Commentary. That reviewed a broad array of factors to consider Will 2016 be 2007 Redux? While a continued regime of higher taxes and more regulation (i.e. under Clinton) might have fomented a continued weak or even weaker US economy, the tax and regulation changes proposed by the Trump administration will hopefully still be approved by the Republican Congress and diminish the similar fears we had to what transpired in 2007-2008.
[Thanks again to barchart.com www.barchart.com for the graphic.]
▪ Beyond typically incisive views on why central banks do what they do, Praxis Trading’s Yra Harris also discussed some key aspects of the broader issue of central bank balance sheets in a relatively recent (June 9th) Santelli Exchange appearance. That show is some of CNBC’s best content, hosted by irrepressible ex-trader Rick Santelli. And there was another segment revisiting these same issues this Monday that CNBC chose to not post for some reason. Yet the insights and discussions from June 9th remain very relevant for what central banks are actually going to do versus what they say.
Yra is a longtime associate and friend who has always been a keen observer and analyst of central bank pressures and policies, going all the way back to the inception of foreign exchange futures trading in 1972. Anyone interested in further insights from him should consider subscribing to his Notes From Underground blog.
For now the four major points in his June discussion with Santelli are the extensive dovishness of the ECB less than a month ago; the very good reasons why the ECB has no interest whatsoever in shrinking its balance sheet; how distended any Fed balance sheet reduction is likely to be; and the fact that much of the model the Fed (as the leader) and other central banks employ regarding inflation expectations relative to employment are misguided. This gets back to our sustained insights from January 2015 (It’s Lack of Reform, Stupid! parts 1 & 2) onward into much of 2016 on the Fed’s ‘normalcy bias’ based on faulty assumptions related to balance sheet expansion and mistaken employment and economic assumptions.
Based on past form, the pronounced weakness of the govvies over the past week is likely another of the sporadic psychological hiccups due to central bank communications. Or miscommunications, as last Wednesday’s ECB and BoE retractions of the more hawkish implications in Tuesday’s pronouncements would seem to indicate.
The ‘Real’ ECB Mindset
This all relates back to the need for the ECB to continue support for the weaker sisters in Europe over the objections of the stronger sisters. There is no secret that Germany (among others) thinks the ECB’s QE program has gone waaaay too far. Especially with recent German inflation figures pushing above the ECB’s broader Euro-zone target, the inherently inflation paranoiac Germans continue to pressure Draghi to curtail the Asset Purchase Program and raise interest rates. Yet as he almost always reminds them, when they agreed to be part of the euro currency area they agreed to allow monetary policy to strike a mid-range path that would also assist weaker economies.
So what should we make of last week’s discussion of a stronger Euro-zone economy having eliminated downside risks, and the attendant potential to curtail the ECB QE program sooner than planned? Absolutely nothing. That was a great piece of political theater intended to once again placate the more hawkish Teutonic faction with a hope that QE might be curtailed if the Euro-zone economy continues to improve.
Euro-Bonds
Yet that is a fantasy for two good reasons. The first is the needs of those weaker Euro-zone sisters who still need the extensive liquidity to drive investment into their still relatively weak economies. France may prove to be the exception to the Euro-zone weakness outside of Germany after the recent Emmanuel Macron election victory, as implied by the bump seen in June’s OECD Composite Leading Indicators.
Yet whether this is psychology like the Trump bump after last November’s US election or real economic improvement is yet to be seen. On past form any attempt to liberalize the French employment laws will be met by aggressive union opposition. While some might be anticipating better French Gross Domestic Product figures, we suggest preparing for barricades and burning tires in streets of Paris (and elsewhere) before any reforms occur.
So in addition to the necessary assistance for the still very apparent weak sisters like Italy and Greece, the ECB has another reason to keep monetary policy loose. That is to encourage upbeat sentiment in incrementally improving France during what is proposed to be the most major employment and economic reforms ever.
And there is actually a more major, possibly stealth, incentive for the ECB to continue to expand its balance sheet which Yra points out in his June 9th discussion: the desire to establish a Euro-Bond. That’s right, a euro currency area treasury bond that many of the supranationalists feel is the real way to consolidate the Euro-zone into a stronger union.
This is of course an anathema to the Germans and other fiscally conservative Euro-zone members. This blended bond would need to be backed by all Euro-zone countries, combining the borrowings by the less fiscally prudent in with the sound countries’ economies and treasuries. While the Germans had made some noises in the wake of the UK Brexit vote about the need to move to a closer political and economic union for the ‘core’ Euro-zone, the idea that they would be responsible for pan-European debt issuance remains a major negative for them. Yet if the ECB develops a large enough balance sheet, it may become the reality that others will push for over German objections.
US Economy is Still a Key
And what either does or does not transpire on the Trump administration’s proposed US healthcare and tax reforms as well as any stimulus programs remains a key. This might sound far removed from the economic improvement in Europe, yet that is still from a low base. As always, the US performance will undoubtedly still have an impact on the global economy that feeds back into Europe and elsewhere.
Consider the difference for the rest of the global economy if the US continues to muddle along at roughly 2.0% GDP growth versus the Trump promise to encourage growth of 3.0% or higher. While the era of the US leading all economic recoveries and the others suffering when the US catches cold is over, the current situation elsewhere will still be modulated by how much further the moderately improving US economy can accelerate.
The troubling part of that is the degree to which the US Congress can focus on the critical legislative agenda versus being distracted by President Trump’s incessant antagonistic tweeting and other statements. At times the President seems to contradict the attempts by Congress to pass key legislation, like his recent criticism of the House healthcare bill as ‘mean’ just as the Senate is attempting to pass their version. That is the same House bill for which he held a Rose Garden ceremony to celebrate its passage.
As we just covered much of this in our June 21st Commentary: Equities Excess and June 7th Commentary: Self-Inflicted Wounds are Back posts, we will allow those to suffice for now. Of course, there are also the usual media outlets that will bring you the latest Trump tweet travails which have already moved beyond those posts. Last week’s derisive tweets aimed at Mika Brzezinski are particularly interesting as an example of how the President is capable of turning his own party against him… especially female Senate members who he needs to assist with passage of that chamber’s healthcare reform bill.
Trump Trouble
And so it goes in what passes for the Trump reform program that is being significantly deterred by both Democratic Party obstruction (payback for Republican obstruction against the Obama agenda) and the need for Republican Congress people to respond to the President’s frequent and very often outlandish communication on what are less than important matters (other than to his ego) compared to the reform agenda.
And after all those distractions even some Republican legislators are beginning to assert there are just not enough legislative working days left in 2017 to accomplish most of the essential needs (budget and debt ceiling by early-mid October) and Trump reforms and stimulus as well. Some are even calling for the Senate to stay in session during what is typically (also scheduled for this year) a recess during the entire month of August.
As suggested in the June 21st Commentary: Equities Excess, after so many confident pronouncements on the way into the White House, the failure of the Trump reform agenda to produce some real legislative success in 2017 will cast a cloud over its overall fate. And just as that could easily imply lower valuations for US equities that are counting on further economic acceleration, it might also see a return to lower yield assumptions than those encouraged by last week’s somewhat more hawkish ECB and BoE communications.
Bond Market Perspective
All of which has implications for the context of the recent sharp selloff in the govvies, and whether it is the real ‘Bond Bubble’ burst or just another sharp adjustment for now. Especially note that the most recent broad up channel from the mid-December front month T-note future 122-29 low is up to the 125-00 area this week. Any failure below that would represent at least a nominal fresh DOWN Break.
The cautionary word there is that markets which are stabilizing can exhibit short-term failures and still manage to hold lower supports. During the basing activity between September 2013 and September 2014 the front month T-note future exhibited a series of DOWN Breaks that were subsequently Negated (i.e. violated as sustained bearish signals) on the way to the more extensive improvement once again from October 2014 onward.
And as we noted last Fall into this Spring, the far more major Tolerance of the next supports into 124-00 and especially 123-00 is the ultimate price support (inverse of the yield surge on the 2013 Taper Tantrum) is the 122-23 April 2014 trading low. That is now the six-year trading low, any violation of which would represent a major failure.
However, in spite of how far and fast the September T-note future has dropped in the past week, those lower critical levels are still quite a bit lower. More important now to watch the activity into and possibly somewhat below the 125-00 interim congestion that is now also the broadest up channel from that mid-December front month T-note future 122-29 low. It will be especially interesting to see whether any near term failure below it becomes a sustained DOWN Break (i.e. remains mostly below 125-00.) Or after a bit of trading below 125-00 does it regain the bid back above it. The latter would Negate the negative momentum and possibly be pointing to a resumption of the upward trend.
▪ Similarly the September Bund future failing back below 164.50-.00 had slipped below the 162.50-.00 congestion (also a major weekly MA confluence), with next major support reverting back to the 160.50-.00 range (with its typical 159.50 Tolerance.) Yet in this much more buoyant govvie as well there is a weekly up channel from the front month Bund future 158.87 trading low right up into this week’s 161.50 trading low. In that regard the Bund and T-note are very similar, with the same cautionary word on watching the activity around that channel support instead of assuming any DOWN Break should be trusted. That said, it will likely take a recovery back above the 162.00-.50 area to confirm a real return to a more bullish trend.
▪ Similarly for the September Gilt future there is a weekly up channel from the front month Gilt future late January 122.60 trading low right up into this week’s 124.96 trading low. This is also significantly the same as the T-note, with the same cautionary word as on the Bund as well for watching activity around that channel support instead of assuming any DOWN Break should be trusted. In this case as well there are very substantial congestion supports in the Gilt at 124.00 and especially into the 122.90-.60 range. And much as in the Bund, it will take a recovery back above the failed congestion support in the 126.00-.50 range to signal a return to a more bullish trend.
Other Markets
▪ It was obvious US equities had indeed stalled against the higher 2,450-55 area weekly Oscillator resistance, which moves up to 2,460-65 this week. And last Tuesday’s weakness meant the September S&P 500 future violated the 2,430-25 interim support that it has churned broadly above and below since then.
That near term resistance was violated again on Wednesday’s less hawkish central bank communication prior to dropping below it again on Thursday, and it has been pushing modestly back above it again this week with little upside follow through. That is a relatively weak sign. Yet as noted for some time now, the more important support is the old March and May 2,405-00 all-time highs. And that area held very well prior to a strong bounce last Thursday. That reinforces it as key support, as the front month S&P 500 weekly MA-13 has also moved up to 2,400.
▪ The US DOLLAR INDEX backing off from the extended test of the upper .9700 area on the reaction back up from its definitive mid-May failure below the more major .9900-.9850 range finally slipped not only to, but also below the interim .9600 support prior to the current recovery. As noted, .9600 is indeed only interim, with the more major supports into .9400 and .9300.
That fits in with the reinvigorated EUR/USD pushing up more definitively from its recent churn around the 1.1200 area that included swings down near 1.1100. And indeed the higher resistance once it managed to sustain activity above 1.1200 was always the 1.14-1.15 range, which it stalled into the low end of last week. Higher resistances are the old spike highs from 2015 and 2016 in the 1.17 and 1.16 areas (respectively.) Yet it is interesting that this is secular strength in the EURO with not that much strength in other currencies against the US dollar, especially the emerging currencies.
▪ The Extended Trend Assessment with full Market Observations will be updated after today’s US Close. It will include more extensive discussion of the Evolutionary Trend View prior to and after last week’s significant central bank influences and economic data.
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