Doug Noland: Risk On/Risk Off Face-off

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The DJIA rose 11 straight sessions (“longest streak since the Reagan administration”) to end the week at a record 20,822. The S&P500 gained 0.7% this week (up 5.7% y-t-d), its fifth consecutive weekly gain. The Morgan Stanley High Tech Index’s 0.5% rise increased y-t-d gains of 11.5%. Already this year the Nasdaq Composite has gained 8.6%. The Nasdaq100/NDX added 0.3% this week (up 9.9%). Bullish analysts continue to point to strong market momentum.

It’s an unusual backdrop where “Risk On” powers a U.S. equities markets melt-up, while safe haven assets trade as if “Risk Off” is lurking right around the corner. Ten-year Treasury yields declined 10 bps this week (to 2.31%) to the lowest level since November 29th. UK yields sank 14 bps (to 1.08%) to lows since October. Gold added $22 this week to $1,257, trading to the high since the election. Silver jumped 2.0% to $18.41, increasing y-t-d gains to 15%. The yen gained 0.6% this week, increasing y-t-d gains versus the dollar to 4.3% (and near a key technical level).

Elsewhere, it appears some favored trades are performing poorly – with popular longs lagging and popular shorts outperforming. The financials continue to lag, while the out-of-favor Utilities surged 4.1% this week. Defensive stocks outperformed this week, while “Trump reflation” wagers underperformed. Low beta outperformed high beta. The small caps underperformed again this week. Meanwhile, the Treasury bond bears are running for cover. All in all, it would appear Market Dynamics continue to frustrate many hedge fund strategies.

At this point, Europe remains at the epicenter of The “Risk On”/“Risk Off” Faceoff. Major European equities indices reversed lower into this week’s close. After trading to the highest level since 2015, Germany’s DAX index dropped 1.6% during Thursday’s and Friday’s sessions. Italian equities fell 2.2% this week, and Spanish and French equities posted modest declines. The European Bank Stock Index (STOXX 600) dropped 3.2% this week, trading to the lowest level since early-December. Notably, Italian banks sank 5.8% this week, boosting y-t-d losses to 10.4%.

Through the eyes of the global bond market, something just doesn’t look right. And while this week’s Treasury and gilt yield declines were curious developments, the real action continues to unfold in Europe. German bund yields declined a notable 12 bps this week to 0.18%, the low since December 29th. Even more intriguing, German two-year sovereign yields sank 14 bps this week to a record low negative 0.96%.

The French versus German two-year sovereign spread traded as high as 49 bps this week, the widest since the tumultuous summer of 2012. This spread widened 11 bps for the week (to 43bps), and has doubled thus far in February. The Italian to German 10-year spread widened 12 this week, back to a two-year high 201 bps. The Spanish to German 10-year spread surged 18 bps this week to a seven-month high 151 bps. After beginning the year at 37 bps, the French sovereign Credit default swap (CDS) traded Thursday above 70 for the first time since August 2013.

Markets clearly fret approaching French elections (first round April 23, second May 7). National Front candidate Marine Le Pen is widely expected to win the first round but then lose in May’s two candidate runoff. After Brexit and Trump, markets are this time around less willing to take things for granted. Le Pen is running on a far right platform that includes exiting the EU, returning to the French franc and adopting various “France First” measures. Having watched post-Brexit and post-Trump non-turmoil, perhaps French voters will disregard what has become routine fearmongering.

While markets see a Le Pen Presidency as a relatively low-probability (Citigroup says 20%), there is recognition that such an outcome would be highly market disruptive. Many would view a National Front upset as the beginning of the end of the euro monetary experiment.

February 23 – Reuters (Brian Love and Michel Rose): “France’s presidential race took a new turn on Thursday as independent Emmanuel Macron raised the curtain on a partnership with veteran centrist Francois Bayrou to help him beat the far-right’s Marine Le Pen. ‘Political times have changed. We cannot continue as before. The National Front is at the gates of power. It plays on fear,’ Macron said… Opinion polls appeared to show the 39-year-old Macron, a political novice who has never held elected office but who has soared to become a favorite to enter the Elysee, was already benefiting from the new-born alliance announced on Wednesday.”

French (to German) bond spreads narrowed Wednesday on prospects for a Macron/Bayrou alliance to counter Le Pen. This development, however, didn’t slow the melt-up in German bund prices or, for that matter, the rally in Treasuries, gilts and safe haven bonds more generally. And it didn’t stop a sell-off in European bank stocks that seemed behind the late-week underperformance in U.S. and global financial stocks.

A Friday Reuters headline caught my attention: “Global Stocks Fall, Bond Markets Rally as Trump Optimism Pauses.” I have a difficult time with the notion of “Trump optimism” fueling international equities. Rather, it’s too much “money” (liquidity) chasing highly speculative markets in stocks, bunds, Treasuries, gilts, JGBs, corporates and EM debt. This same fuel has been behind gold and silver’s 9% and 15% y-t-d gains.

It’s a Theme 2017 that markets are unprepared for what would be a surprising change in the global monetary backdrop. I expect both the BOJ and ECB to at some point this year begin developing strategies for significantly reducing QE liquidity injections. Clearly, the Germans are contemplating a year-end conclusion to ECB QE operations.

February 23 – Reuters (Francesco Canepa): “Germany’s central bank posted its smallest profit in more than a decade in 2016 as it set aside more money against potential losses on the bonds it is buying as part of the European Central Bank’s stimulus programme… The Bundesbank recorded a net profit of 399 million euros, the lowest since 2004 and a sharp drop from the 3.2 billion euros bagged in 2015… Commenting on the results, Bundesbank president Jens Weidmann said it was right for the ECB to discuss closing the door to a further policy easing in the future.”

February 23 – Bloomberg (Carolynn Look and Manus Cranny): “Investor expectations for an interest-rate increase by the European Central Bank in 2019 aren’t totally unjustified as downside risks to the economic outlook recede, according to Bundesbank President Jens Weidmann… Accelerating inflation and a strengthening economic outlook have fanned a debate in the 19-nation euro area about the appropriate degree of stimulus as central banks prepare for a policy shift. While officials including Weidmann are arguing that the time to talk about an exit is coming closer, ECB President Mario Draghi contends that record low rates and a 2.28 trillion-euro ($2.4 trillion) quantitative-easing plan are still necessary to produce a sustained pickup in inflation… While Weidmann conceded that the ECB is right to keep monetary policy accommodative, he criticized the Governing Council’s decision to extend QE through the end of 2017. ‘I was not very supportive of that step… The monetary-policy stance that I would have been willing to accept is less expansionary than the current one.’ One can certainly ask ‘when we might slow down monetary policy and whether the ECB Governing Council shouldn’t make its communication more symmetrical beforehand, for instance by not only pointing to the fact that monetary policy could be even more expansionary.’”

Angela Merkel appears increasingly vulnerable heading into October elections. Responding to criticism from a Trump advisor, Merkel this week commented: “We have at the moment in the euro zone of course a problem with the value of the euro. The ECB has a monetary policy that is not geared to Germany, rather it is tailored from Portugal to Slovenia or Slovakia. If we still had the D-Mark it would surely have a different value than the euro does at the moment.”

February 23 – Reuters (Francesco Canepa): “Exclusive: ECB seeks to lend out more bonds to avert market freeze – sources: The European Central Bank is looking for ways to lend out more of its huge pile of government debt to avert a freeze in the 5.5 trillion-euro short-term funding market that underpins the financial system, central bank sources told Reuters. The ECB has bought more than a trillion euros ($1.06 trillion) of euro zone government bonds in a bid to shore up economic growth and inflation in the euro zone… By doing so, it has taken away the key ingredient for repurchase agreements, or repos, whereby financial firms lend to each other against collateral, typically high-rated government bonds such as Germany’s… Germany, the only large euro zone country with a top-notch credit rating, is where the problem is at its most severe.”

Will the Merkel government and Weidmann Bundesbank finally craft a more aggressive strategy for reining in Mario Draghi? Securities financing markets are already under heightened strain, as ECB purchases ensure an ever-dwindling supply of German debt in the marketplace. Again this week, there was talk of heightened stress and dislocation in the crucial “repo” marketplace. And while German influence over the ECB has waned throughout Draghi’s term, the Bundesbank holds a commanding position over the (by far) most dominant securities in the euro zone: “AAA” German debt. At this point, there’s a case to be made that German bunds are more critical to global securities funding, leveraged speculation and derivatives markets than even Treasuries.

ECB policymaking is increasingly at odds with German interests. I hold the view that German officials have more power to impose their will than is appreciated in today’s complacent markets. I’m question whether it was coincidence that Mr. Weidmann publically voiced comments critical of ECB policy concurrent with a dislocation in bund trading and associated “repo” market stress. Moreover, I wouldn’t suggest owning risk assets anywhere in the world if European securities financing markets begin to malfunction.

Here at home, perhaps the markets will begin questioning the new Administration’s priorities (along with the ability to get those priorities through Congress). The markets are bullishly positioned in anticipation of a string of tax cuts, deregulation and infrastructure spending. I’m not sure how encouraging markets should find White House chief strategist Steve Bannon’s “three buckets” – “national security and sovereignty,” “economic nationalism” and the “deconstruction of the administrative state,” along with his comment “…one of the most pivotal moments in modern American history was [Trump’s] immediate withdraw from TPP. That got us out of a trade deal and let our sovereignty come back to ourselves.” It’s also worth mentioning that President Trump spent more time at CPAC trumpeting military buildup than offering details for tax reform and deregulation.

February 24 – Reuters (Emily Stephenson and Steve Holland): “President Donald Trump said he would make a massive budget request for one of the ‘greatest military buildups in American history’ on Friday in a feisty, campaign-style speech extolling robust nationalism to eager conservative activists. Trump used remarks to the Conservative Political Action Conference (CPAC)… to defend his unabashed ‘America first’ policies. Ahead of a nationally televised speech to Congress on Tuesday, Trump outlined plans for strengthening the U.S. military… and other initiatives such as tax reform and regulatory rollback. He offered few specifics on any initiatives, including the budget request that is likely to face a harsh reality on Capitol Hill… Trump said he would aim to upgrade the military in both offensive and defensive capabilities, with a massive spending request to Congress that would make the country’s defense ‘bigger and better and stronger than ever before.’ ‘And, hopefully, we’ll never have to use it, but nobody is going to mess with us. Nobody. It will be one of the greatest military buildups in American history…’”

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