Three mighty macro narratives on collision course for markets

See the latest Australian dollar analysis here:

Macro Afternoon

It is fascinating to watch macro analysts diverge into three distinct narratives covering the future of this business cycle. Conveniently for us, the three narratives are represented to three investment banks’ views.

The first we might describe as “good news is bad news”. It’s captured by Bank of America which sees overwhelming US fiscal support leading to major market dislocation and confrontation with Federal Reserve policy which will be forced to implement yield curve control:

  • Scores of the Doors: bitcoin 99.9%, oil 23.3%, global stocks 4.0%, US$ 2.1%, cash0.0%, HY bonds-0.2%, IG bonds-4.8%, government bonds-5.2%, gold-8.9% YTD.
  • Price is Right: tech/FAANG stocks peaking at 33% of global equity market cap in Q1(Chart5)…since Mar’20 lows US regional banks (KRE) have outperformed FAANG stocks.
  • BofA Bull &BearIndicator:rising again, up to 7.3(Chart 1); 10-year [email protected]%, HYinflows >$10bn, EM debt >$5bn among triggers requiredfor 8.0“sell signal”.
  • Catch-21: Fed’s Catch-22 in‘21…vaccine +fiscal excess + bond issuance+inflationary boom = higher yields, which via tighter financial conditions can short-circuit recovery; but YCC (fixing yields to please Wall St) = dollar debasement (to fund>$4tn“twin deficits”– Chart2) and/or asset bubble (worsens inequality); little wonder Bitcoin is ‘21’s “safe haven”(new BofA Research piece on Bitcoin).
  • we say utilities & staples good defensive hedges.

The second we can describe as “bad news is good news”. It is captured by Goldman Sachs which sees endless monetary largesse driving a permanently high plateau for asset prices:

For most of thelast year we have maintained a structurally negative view on the Dollar, informedby three features of the macro backdrop: (i) the Dollar’s high valuation, followinga long stretch of US economic and asset market outperformance before thepandemic, (ii) a recovering global economy, which tends to weigh on thegreenback through “safe haven” channels and other mechanisms, and (iii) thelow interest rate structure at the front end of the US yield curve. Ahead of lastweek’s FOMC meeting we were unsure that the persistently low level ofshort-term rates would continue, in light of large fiscal stimulus and the prospectof higher inflation this year. However,guidance provided at the meeting—especially the mix of inflation and funds rate projections in the SEP—suggeststhe probability of much earlier than expected tightening is relatively low. By2023, the median FOMC participant sees a 3.5% unemployment rate, threeyears with inflation at or above target, and yet no increase in the fed funds rate.This seems a more dovish reaction function than currently discounted bymarkets. For example, the Fed’s projections for PCE inflation in 2022-23 are onlyabout 15-20bp per year below current market pricing, and yet markets see afunds rate of about 0.80% by end-2023, whereas the median FOMC participantexpects no rate increases (seeChart of the Week). In our view, the SEP shouldgive investors reasonably high confidence that temporarily high GDP growth andinflation—as long as they are broadly in line with the committee’s expectations—will not result in early rate increases. This should in turn open space for furtherDollar weakness, helped by strong global growth and rising commodity prices, into the middle of the year.

The third is captured by Deutsche Bank and might be described as “good is good news” as it expects the Fed to do nothing and allow the bond market to reset unmolested:

  • Absolute yields are still low by almost any measure, and extraordinarily low relative to expected nominal GDP growth.
  • It’s not all about the price of money, the quantity of money matters, and M2 growth is near all-time record highs.
  • Don’t shoot the messenger. Market signals are invaluable. Expectations, and real yields are much spoken about and already distorted by QE, don’t add to these distortions.
  • The move in back-end yields is going with the grain of the policy bias towards some desirable tightening in monetary conditions, even if the market may feel like a month or two early.
  • The back-up in yields is rational and part of the objective function. You can’t have a desired rise in growth expectations impacting real yields and a rise in inflation expectations without a rise in nominal yields.
  • The curve is not that steep, 10s-2s have typically peaked near 250bps when the back-end yields head higher after extreme policy easing. Get ready for more steepening.
  • In 2021 the real economy will prove highly interest rate inelastic. Government spending and vaccine-related service sector opening will be insensitive to the back-up in yields.
  • Greater intervention would risk credibility.
  • Most obviously, only long-end rates are heading higher, the remaining components of financial conditions, not least credit and equities remain extremely easy.Very low yields have distorted asset allocation, and normalization is positive for long-term asset prices, and personal savings allocation.

The Deutsche analysis is closest to my base case. I see tearaway growth and inflation into mid-year before yields peak into H2. The spike in US 30-year yields is already beginning to slow as markets are still pricing structural deflation. If the Fed does nothing as yields rise then it can deflate a dangerous Nasdaq bubble without being blamed for it because contagion into a ripping real economy will be minor. This enables a higher growth and inflation outlook for the US than the last cycle without blowing it up.

The winners in this scenario are DM workers as the economy and wage growth are stronger for longer. The US dollar and value stocks remain strong. With an eventual rotation back into growth as inflation worries subside into a strong but not overheated economic cycle. The losers are EMs, commodities and the Australian dollar.

The BofA scenario is the primary risk case to defeat this outcome. But it has a couple of mitigating factors. The yield spike will need to dramatically widen junk spreads and combine with falling EM stocks and commodities to create a contagion feedback loop large enough to impact US growth. But how can that happen if the dislocations are contained to tech, EMs and commodities, while the wider value rotation triggered by higher yields supports the overall equity market? Runaway US yields might combine with a slowing China in H2, to hit EMs struggling to get vaccine traction, but all EMs will be enjoying booming exports as DMs open up. As well, so long as the US runs large fiscal deficits, with a hint of MMT, why would markets demand EMs address current account deficits? The US dollar can only get so high in such an environment and spreads should remain narrow enough.

On the other hand, the Goldman analysis underestimates the pace of the bond back-up, which enables it to defend scandalously high equity valuations. That looks like a typical vampire squid bubble-blowing exercise.

To summarise, the base is “good new is good news” as the strong American vaccine response and fiscal tailwind enables the Fed to shift its focus to managing the real economy from markets. That is not without its risks that will need to be tracked closely as areas of the latter deflate.

David Llewellyn-Smith
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