Why We Look at 5-Year 5-Year Forward Inflation: JPM

Inflation Expectations: How the Market Speaks
The Federal Reserve wants to know what people think—specifically, the Fed wants to know what people think the future path of inflation is. One reason is that people’s expectations about inflation influence their behavior in the marketplace, and that, in turn, has consequences for future inflation. Being able to forecast future inflation plays a critical role in the Fed’s efforts to meet its mandate of promoting price stability in the U.S. economy.
Estimates of longer-term inflation expectations have been available from various surveys for quite some time. While useful, these survey estimates suffer a bit from the “talk is cheap” problem. What one would like, instead, is evidence that reflects people’s “putting their money where their mouth is.” And, indeed, in recent years, such a source of evidence has emerged, with the introduction of new financial instruments. These market-based estimates represent a bet by market participants on the future course of the economy, usually in terms of certain economic indicators or asset prices, and they have been shown to be better predictors than survey-based estimates.
One of these new financial instruments is the Treasury Inflation-Protected Security, or TIPS, which was introduced by the U.S. Department of Treasury in 1997 as a new class of government debt obligation. The key feature of TIPS is that the payments to investors adjust automatically to compensate for the actual change in the Consumer Price Index (CPI). Conventional Treasury securities, in contrast, do not provide such protection, so investors in those securities protect themselves by demanding nominal interest rates that compensate them for expected inflation as well as for bearing the risk that actual inflation could turn out to differ from their expectations. In principle, having information from both types of Treasury securities allows researchers to separate out the inflation compensation component embedded in nominal interest rates.
This Economic Letter discusses the structure of TIPS contracts, the development of the market in recent years, and the measure of inflation compensation derived from comparing TIPS yields to nominal yields.
How TIPS work
TIPS are one of two types of inflation-protected securities sold by the U.S. Treasury (the other type is Series I savings bonds for small investors). In 1997, the Treasury Department started issuing TIPS that are structured along the lines of the Real Return Bonds issued by the government of Canada. Like conventional Treasury notes and bonds, TIPS make interest payments every six months and a payment of principal when the securities mature. However, unlike conventional Treasury notes and bonds, both the semiannual interest payments and the final redemption payments of TIPS are tied to inflation.
All TIPS are issued by the Treasury using the single-price auction—the same auction used for all of Treasury’s marketable securities. The interest rate on TIPS, which is set at auction, remains fixed throughout the term of the security. To protect against inflation, the Treasury adjusts the principal value of the TIPS using the CPI, published by the Bureau of Labor Statistics. Thus, TIPS are redeemed at maturity at their inflation-adjusted principal or their original par value, whichever is greater. While TIPS pay a fixed rate of interest that is determined at the initial auction, this rate is applied not to the par value of the security but to the inflation-adjusted principal. So, if inflation rises throughout the term of the security, every interest payment will be greater than the previous one. To the extent that both the semiannual interest payments and the final redemption value of TIPS rise and fall with the CPI, the nominal return on TIPS hedges perfectly against inflation.
The market for TIPS has grown steadily and now includes three terms to maturity: 5 years, 10 years, and 20 years. The Treasury auctions 5-year and 20-year TIPS semiannually and 10-year TIPS quarterly. As of 2005, there are about $200 billion TIPS outstanding, as part of the total $4 trillion Treasury marketable securities outstanding. The trading volume of TIPS also has increased gradually but still remains small compared to other Treasury securities; hence, TIPS generally are not as liquid as comparable Treasuries.
Extracting implied inflation expectations from TIPS
In principle, comparing the yields between conventional Treasury securities and TIPS can provide a useful measure of the market’s expectation of future CPI inflation. At a basic level, the yield-to-maturity on a conventional Treasury bond that pays its holder a fixed nominal coupon and principal must compensate the investor for future inflation. Thus, this nominal yield includes two components: the real rate of interest and the inflation compensation over the maturity horizon of the bond. For TIPS, the coupons and principal rise and fall with the CPI, so the yield includes only the real rate of interest. Therefore, the difference, roughly speaking, between the two yields reflects the inflation compensation over that maturity horizon.
This inflation compensation is sometimes referred to as the breakeven inflation rate because, if future inflation were at this rate, the realized returns of holding a conventional Treasury bond and TIPS would be exactly the same. Figure 1 charts the breakeven inflation rate over the next five years by comparing the yield on the 5-year Treasury note to the yield on 5-year TIPS, and the breakeven inflation rate over the next ten years by using the 10-year Treasury note and 10-year TIPS, from 1998 to present.

There are two important caveats in using the breakeven inflation rate to measure inflation expectations. First, the breakeven inflation rate actually measures the compensation that conventional Treasury bondholders receive for expected inflation and for bearing the risk that realized inflation may deviate from expected inflation. The breakeven inflation rate hence has two components: expected inflation and the inflation risk premium. Ideally, one would like to subtract the inflation risk premium from the breakeven inflation rate to obtain a pure measure of inflation expectations. Nevertheless, assuming the inflation risk premium to be fairly stable over a short period of time, the changes in the breakeven inflation rate capture the changes in inflation expectations.
Second, TIPS yields contain a liquidity premium. While the market for TIPS is growing, it is still relatively small compared to the market for conventional Treasuries. Therefore, to the extent that TIPS are less liquid than Treasuries, investors would demand a liquidity premium for holding TIPS over conventional Treasuries. Because the breakeven inflation rate is obtained by comparing the yields on TIPS and similar maturity conventional Treasury bonds, the breakeven rate captures not only the inflation compensation but also the liquidity premium demanded by TIPS investors. In Figure 1, it is quite clear that the breakeven inflation rates exhibit an upward trend. This probably reflects artificially low breakeven rates when TIPS were introduced. At that time, the amount of TIPS outstanding was small and the investor base for TIPS was narrow, so TIPS were not very liquid and their yields likely contained a relatively large liquidity premium to compensate investors for holding TIPS in their portfolio. As the TIPS market has grown, the liquidity premium in TIPS has shrunk, resulting in higher breakeven inflation rates.
The breakeven inflation rate overstates inflation expectations because of the inflation risk premium in Treasury yields, but it understates inflation compensation because of the liquidity premium in TIPS yields. With a more mature TIPS market, and over relatively short time periods, both the inflation risk premium and the liquidity premium are likely to be fairly constant. Thus, the changes in breakeven inflation rates can be interpreted as the market measure of changes in inflation expectations. Estimates of intermediate-term inflation expectations can be extracted using 5-year TIPS and conventional Treasury securities. To focus on a relatively short recent time period,
Figure 2 shows the 5-year breakeven inflation rate since July 2004. Note that this measure of inflation expectations over the next five years has fluctuated between 2% and 3% over the past 12 months. In part, the swings reflect temporary factors, such as movements in energy prices, cyclical factors, and the influences of monetary policy.

Estimates of longer-term inflation expectations can be derived using the forward nominal yields and forward real bond yields. For example, suppose one is interested in inflation expectations for the period from 2010-2015, that is a five-year period beginning five years from now. The forward nominal yield for that period is implied by the 5-year and 10-year nominal yield. The forward real yield is, likewise, implied by the 5-year and 10-year TIPS yield. And comparing the forward nominal yield to the forward TIPS yield implies a forward breakeven inflation rate.
Figure 2 plots the 5-year forward 5-year breakeven inflation rate. It suggests that longer-term inflation expectations have been trending down from about 3% to about 2.5% since the beginning of the current monetary policy tightening cycle. Compared to the spot 5-year forward breakeven rate, it is noteworthy that the forward breakeven inflation rate is more stable. This is because longer-term inflation expectations tend to be less affected by cyclical factors.
One interpretation of this measure of longer-term inflation expectations is that it captures the market’s assessment of how well the Federal Reserve promotes price stability in the long run. From that perspective, the decline in this measure—by more than one-half a percentage point over the last 12 months, despite rapidly rising energy prices—suggests that the market views the run-up in energy prices as transitory and that it is confident in the Fed’s commitment to promoting longer-term price stability.
Given the Federal Reserve’s dual mandates, promoting maximum sustainable output and employment and promoting price stability, having credibility in fighting inflation gives the central bank more room to promote economic growth. For example, with longer-term inflation expectations currently seemingly well anchored, the recent run-up in energy prices has not led to widespread fears about future inflation; therefore, the Fed has not had to tighten more aggressively. Nonetheless, the Fed cannot be complacent—the credibility of its commitment to price stability was earned through years of consistent performance, and to maintain that credibility, the Fed will need to continue to earn it. And to gauge its success, the Fed will also continue to pay close attention to longer-term inflation expectations.

Via – Federal Reserve Bank of San Francisco


Markets Mark Time

The economic data stream is picking up, but there is an uneasy calm in the markets

Sterling has been weakened by two developments, one political and one economic

Markit reported softer eurozone flash February PMI

The focus in North America will be on the performance of US equities

Korea reported trade data for the first 20 days of February; South Africa January CPI rose 4.4% y/y, as expected

The dollar is broadly firmer against the majors as markets await fresh drivers.

Stockie and Kiwi are outperforming, while sterling and Aussie are underperforming.

EM currencies are mostly softer. TWD and PHP are outperforming, while KRW and ZAR are underperforming.

MSCI Asia Pacific was up 0.4%, with the Nikkei rising 0.2%.

MSCI EM is up 1% on the day, with Chinese markets closed until Thursday.

Euro Stoxx 600 is down 0.6% near midday, while futures are pointing to a lower open for US markets.

The 10-year US yield is flat at 2.89% ahead of another day of heavy debt issuance.

Commodity prices are mostly lower, with WTI oil down nearly 1%, copper down 0.5%, and gold flat.

The economic data stream is picking up, but there is an uneasy calm in the markets. It is almost as if the dramatic drop in stocks has left many with a sense of incompleteness, like waiting for another shoe to drop. The price action has not clarified the situation very much. The equity markets are stalling in front of important chart points as are yields and the dollar.

The MSCI Emerging Market Index is up nearly one percent, rebounding from yesterday’s 0.55% loss. However, it is struggling to get a toehold above the 50% retracement of the drop earlier this month. MSCI Asia Pacific Index rose a milder 0.4% but is stalled at a similar retracement objective. Of note, foreign investors continue to sell South Korean and Philippines, while buying Taiwan shares as local markets re-opened, and small in buying in Indonesia. Taiwan’s Taiex jumped 2.8%, while Hong Kong bounced back 1.8%, and the A-shares index rose 2.3%.

Europe’s Dow Jones Stoxx 600 is off 0.5% in late morning turnover, and telecom is the only sector that is resisting the selling pressure. The index is generally moving sideways for the fourth session, after stalling at the 38.2% retracement last week. Yesterday the S&P 500 snapped a six-day advance and US shares are a little heavy now.

Bond yields are mixed. Asia-Pacific yields eased and European core rates have slipped, but the peripheral yield are flat to slightly higher. Australia’s 10-year yields fell four basis points and is back through the similar US rate. The drop in yields comes despite news that wages growth was a little stronger than expected in Q4, rising 0.6% q/q for a 2.1% y/y pace. The Australian dollar is wrestling with sterling for the weakest of the major currencies today, off nearly 0.4%. The Aussie has been sold to a new five-day low and appears to be finding a bid near $0.7840.

Sterling has been weakened by two developments. First, some 62 Conservatives have pressed Prime Minister May for a quick and clean break from the EU (hard line). May is expected to clarify the response to the EU’s negotiating position. Second, the UK’s unemployment rate unexpectedly ticked up (4.4% from 4.3%) in the three-months through December for the first time in a couple of years, though the jobless claims fell in January. Employment growth in the last quarter of 2017 was half (88k vs 165k) expected.

Sterling has also slipped to a new five-day low. It is currently testing support near $1.3930. A clean break may spur a move toward $1.3800 in the coming days. The euro, which was turned back from the GBP0.8900 area last week found demand near GBP0.8800.

The euro extended this week’s losses to $1.2300. The $1.2340 area, which was breached yesterday and seemed to cap it today, represents a 61.8% retracement since $1.22 was seen on February 11. A move below $1.2280 would send it back to the month’s low. There is a 744 mln euro option struck at $1.23 that expires today.

Markit reported softer eurozone flash February PMI. The manufacturing PMI fell to 58.5 from 59.6 and the service PMI fell to 56.7 from 58.0. The composite reading of 57.5 (from 58.8) returns the much-watched indicators to November levels, and has begun the whispers that the growth momentum has peaked. New orders, output, and employment eased, though factory gate prices rose at their fastest pace since early 2011. Only country details are available in the flash reading from Germany and France, and the readings for both countries fell.

The dollar is rising against the yen for the fourth session. It approached JPY108 in Asia. Last week, it seemed that the Asian session was likely to sell dollar-yen, but this week, it has come back with an apparent bias toward buying dollars. Japan also reported a softer preliminary manufacturing PMI (54.0 vs. 54.8), which could be linked to the appreciation of the yen.

The focus in North America will be on the performance of US equities. In terms of data, the preliminary Markit PMIs may draw some interest, and existing home sales for January may surprise on the upside (0.5% expected). The FOMC minutes from the January meeting, Yellen’s last, will be released. Although some have tried playing up their significance, we are skeptical. It is clear that the FOMC statement teed up the Fed to hike rates “further” this year. Many suspect the next dot plot will anticipate four hikes this year rather than three.

Perhaps the most important part of the minutes will be references to how the members are thinking about fiscal policy. It also seems clear that official confidence in the strength of the economy and that inflation will move toward its target has grown. Operationally, we remain concerned that only changing policy at FOMC meetings with press conferences, and only having press conferences every other meeting unnecessarily denies the central bank degrees of freedom. We argue that a press conference after every meeting, like the BOJ and ECB hold, makes sense from a communication, transparency, and operational point of view.

The US Treasury will continue raising money this week. It raised $179 bln yesterday and will raise another $50 bln today (five-year notes, and two-year floating rate notes). The Treasury Department has indicated it will sell $441 bln of marketable securities this quarter. It is getting a big chunk out of the way this week.

Korea reported trade data for the first 20 days of February. After slowing in Q4 to single digits, export growth rebounded to 22% y/y in January. So far in February, exports contracted -3.9% y/y but the readings for both months are distorted by the timing of the Lunar New Year holiday. One by-product of the yen’s recent strength against the majors is the rise in JPY/KRW. Korean exporters like this cross above 10 and that’s where it’s been hovering this past week. A sustained move above 10 would boost exports.

South Africa January CPI rose 4.4% y/y, as expected and down from 4.7% in December. This was the lowest rate since March 2015 and puts inflation in the bottom half of the 3-6% target range. This supports the case for lower rates. The central bank started the easing cycle last July with a 25 bp cut to 6.75%, but has been on hold since. If the rand remains relatively firm, we think another 25 bp cut to 6.5% is likely at the next policy meeting March 28.

Source: Trading Economics

Mind on the Markets

Markit Economics Japan Flash PMI

Markit Economics Eurozone Flash PMI


From the Securities Lending Trading Desk:​ BBH



I find these reports from Brown Brothers Harrium’s Lending Desk an interesting insight into a seldom-discussed side of the markets.

Below please find this week’s edition of From the Trading Desk, which provides timely commentary about top security earners, revenue drivers and other factors influencing the securities lending market from the BBH Securities Lending Trading Team.

Last week, shares tumbled in one of Australia’s top electronics retailers after reporting poor profit guidance for 2018.  Dutch Auctions were in focus in the US last week as both Amgen Inc (AMGN) and Greenhill & Co., Inc (GHL) recently announced plans to repurchase shares.  Fallout from Carillion has spread across UK companies and given rise to increased securities lending demand.


Dutch Auctions were in focus last week as both Amgen Inc (AMGN) and Greenhill & Co., Inc (GHL) recently announced plans to repurchase shares. For corporate repurchases, a range of prices is set by a company within which shareholders are invited to tender their shares. The tender offer is open for a specific period of time and the amount of stock to be purchased is stated as well (subject to proration). When there is a difference between the tender price and the market price, there is a lending opportunity. AMGN is offering to purchase its common stock for cash for an aggregate purchase price up to $10 billion, at a single per-share purchase price not greater than $200.00 and not less than $175.00. AMGN closed on 2/15 at $183.60 per share.


GHL is offering to purchase its common stock for cash for an aggregate purchase price up to $110 million, at a single per share purchase price not greater than $20.50 and not less than $18.50. The stock closed at $20.40 on 2/15. We anticipate continued demand for both of these stocks as we approach critical dates.


Sears Holdings (SHLD) remains a long term focus of demand as the share price fell to a 5-year low of $2.07 on 2/12. According to CNBC, SHLD is expecting to “record an impairment charge tied to its trade name of between $50 million and $100 million for fiscal 2017.” This is in addition to charges of $381 million for 2016 and $180 million in 2015. The retailer also recently said they expect Q4 2017 sales of $4.4 billion, compared with revenue of $6.1 billion a year ago.

SHLDScreenshot 2018-02-20 15.00.55

The retail sector as a whole continues to draw attention. Earlier this week, the U.S. Commerce Department reported “retail sales dipped 0.3 percent in January, the worst decline in 11 months.” This was below analyst expectations of an increase of 0.2 percent. Other names in the sector continue to garner attention, including JC Penney Co Inc (JCP), Under Armour Inc (UAA), and GNC Holdings, Inc. (GNC), as bearish sentiment remains strong.


Asia Pacific

Shares tumbled in one of Australia’s top electronics retailers after reporting poor profit guidance for 2018. JB Hi-Fi Limited, the operator of a chain of electronics retail stores, reported record first half net profits of A$151.7 million ($120 million), but warned that it will face pressure on revenue in 2018. The company cited increased competition and a focus on sales of lower-margin goods as factors in projecting lower than expected guidance for the remainder of the year. Although the launch of Amazon’s product offering three months ago has yet to have a direct effect on the retailer, it still remains a threat for the company in the long-term. We have seen strong securities lending demand for JB Hi-Fi’s shares in recent weeks, which fell by 8% after the release of its results before recovering later in the week.

Domino’s Pizza’s shares plunged after reporting poor profit growth. The pizza operator reported last week that underlying net profit for the first half of its accounting year rose to A$62.9 million ($50 million), falling short of various forecasts of around A$67 million. The pizza chain downgraded its forecasts as it battles increased competition, declining overseas revenue in markets such as Japan and a scandal that its franchisees were deliberately underpaying and exploiting workers. The company also reduced its expectations for local sales growth and analysts remain skeptical of Domino’s international expansion plans. We have seen strong securities lending demand for Domino’s in recent weeks, which has been one of the worst performers in the Australian Stock Exchange in the past year.

Screenshot 2018-02-20 15.07.21


The securities lending market is feeling the liquidity squeeze in German stocks due to new regulation. Liquidity traps have appeared following the recent change in German tax regulation. In-scope clients now have to make a tax return to the German tax officials if stocks are held over record date. While the clients and market digest these requirements, a lot of the liquidity has been withdrawn. Those clients that are either willing to file a tax return, or are out of scope, are able to achieve a premium on stocks such as Metro, K+S, ElringKlinger, Suedzucker, Evonik Industries, Hellofresh, etc.

Fallout from Carillion has spread across UK companies and given rise to increased securities lending demand. This week Galliford announced plans to raise £150m to cover additional financial obligations arising from contracts related to Carillion for Aberdeen Western Peripheral contract. Other UK companies which have seen volatile price movements in their stock price are Interserve, Van Elle Holdings, Balfour Beatty, and Morgan Sindall.


Source: Mind on the Markets


Dominoes Pizza Investor Relations

Sears Holdings Investor Relations


Dollar Higher, Stocks Challenged

• Nearly all the major currencies have risen at least two percent against the US dollar this week

• Headline UK retail sales rose 0.1%

• The US has a several economic reports on tap today, but none have the heft to change market sentiment

• Czech Q4 GDP grew 5.1% y/y vs. 5.2% expected

The dollar is mixed against the majors as the week winds down.  The Antipodeans are outperforming, while sterling and euro are underperforming.  EM currencies are broadly softer.  TRY and THB are outperforming, while INR and ZAR are underperforming. 

MSCI Asia Pacific was up 0.6%, with the Nikkei declining 1.2%. 

MSCI EM is up 0.2% on the day, with Chinese markets closed until next Thursday.  Euro Stoxx 600 is up 0.7% near midday, while futures are pointing to a higher open for US markets. 

The 10-year US yield is down 2 bp at 2.89%. 

Commodity prices are mostly higher, with oil up 0.2%, copper up 0.2%, and gold up 0.3%.

Nearly all the major currencies have risen at least two percent against the US dollar this week.  The Canadian dollar is an exception.  It has risen one percent this week ahead of today’s local session.  Sterling is becoming another exception after disappointing retail sales.  It is up just shy of two percent.

The Dollar Index is off 2.3% on the week, which would be the biggest weekly loss since 2015.  The dollar has firmed a bit on the European morning, but look for North American operators to see the upticks as a selling opportunity.

The greenback slumped to nearly JPY105.50 in Tokyo, which appears to have led this week’s decline.  It is the biggest weekly loss since July 2016.

Japanese officials are becoming more concerned.  Reports suggest a high-level meeting was held today between the BOJ, MOF and FSA on the yen’s strength.  Although Finance Minister had said earlier this week that the yen’s movement did not require intervention, the MOF’s point man on FX, Asakawa, expressed greater concern for “one-sided” move that was “not in line with fundamentals.”

This still seems to be low level concerns.  Reiterating the G7/G20 boilerplate line about “excessive volatility” needs to be avoided, and hints that there are talks among G7 officials about the recent foreign exchange market developments, would be additional rungs on the escalation ladder.  Still, we suspect that the Japan’s cabinet submission to the Diet of Kuroda’s nomination for a second term (leaked in the media for the past several days) and the appointment of two deputies (Amamiya, a key Kuroda ally within the BOJ, and a dovish academic Wakatabe), is not really much of a yen protest.  It underscores the continuity of monetary policy.  Still, nearly half of a Bloomberg survey expect the BOJ to tighten policy late this year.

The euro reached near three-year highs today near $1.2555.  It is the sixth consecutive advancing session.  The euro has appreciated 2.2% this week.

The dollar was sold through CHF0.92 to see its lowest level since June 2015.  Sterling has been dragged off its high near $1.4145 by the soft retail sales report.  It has advanced every day this week and is straddling the unchanged level today.

Headline UK retail sales rose 0.1%.  The median forecast was for a 0.5% gain after a revised 1.4% decline (initially -1.5%).  The 1.6% year-over-year pace makes it the weakest January since 2013.

But sterling has not been trading higher because the economy is booming.  Recall that the January PMIs were all weaker than expected.

Sterling may find support ahead of $1.4050.

The RBA’s Lowe was equally circumspect on Australian dollar, which is up 2% this week.  The Australian dollar has appreciated in 8 of the past ten weeks, and those two losing weeks were here in February.  The Aussie has approached the $0.7990 area that houses the 61.8% retracement of recent decline.  Lowe said that the trade-weighted index was manageable, and that although he would prefer a lower rather than higher exchange rate, “we are where we are.”

The US has a several economic reports on tap today, but none have the heft to change market sentiment.  January import prices were likely lifted by oil’s appreciation.  Excluding oil, import prices may have edged 0.1% higher.  January housing starts are expected to have bounced back from the weather-induced 8.2% drop in December.  University of Michigan’s consumer sentiment is expected to have edged fractionally lower.  The long-term inflation expectations may draw more interest given the sensitivities now.  In January, it stood at 2.5%, up from 2.4% in November and December, matching the 2017 low prints.

What a difference a week makes for equities.  After last week’s drop, this week has seen equities rally.  In fact, coming into today’s session, the S&P 500 is up 5.8%, leading the major markets higher, and is poised to record its best week since 2011.  A weekly close above 2743 would be seen as a constructive technical development.  The MSCI Asia Pacific Index advanced every day this week for a 3.8% weekly gain.  The MSCI Emerging Markets Index is up 5.9%.  The Dow Jones Stoxx 600 is up 3%.  This week’s price action lends credence to our hypothesis that last week’s meltdown was more like the 1987 crash than the 2000 end of the tech bubble or the 2008 financial crisis.

While US Treasury yields edged higher this week, there is a sense of consolidation ahead of the psychologically important 3.0%-handle.  On the week, the yield has risen three basis points, while the two-year yield is up eleven.  This likely reflects the shift in Fed views that is illustrated by the 10 bp increase in the implied yield of the December 2018 Fed funds futures contract this week.

The two-basis point decline in the US 10-year yield today is sufficient to encourage a decline in European yields, which are now slightly lower on the week.  The UK gilts are the notable exception, and the yield is a single basis point higher on the week, even with today’s 3.5 bp decline.

Czech Q4 GDP grew 5.1% y/y vs. 5.2% expected and 5.0% in Q3.  Earlier this week, January CPI came in at 2.2% y/y vs. 2.4% in December.  Inflation remains in the top half of the 1-3% target range.  The central bank has been hiking rates once every quarter, but recently has taken a more dovish tone.  After hiking February 1, no change is expected at the next policy meeting March 29.  After that, the next meeting is May 3 and that will be of more interest to the markets.

Source: Trading Economics

Mind on the Markets


Drivers for the Week in IV


  • 2743 in the S&P 500
  • 3% on 10-year US yield
  • $1.26 in the Euro
  • Final January EMU CPI

The US dollar is narrowly mixed in uneventful turnover.  Of note, the dollar selling seen in Asia last week slacken today and the greenback moved above the pre-weekend highs seen in the US.  It is the first time in eight sessions, the dollar has risen above the previous days high against the yen.  Europe seems to be losing interest though, with the dollar near JPY106.60.


The euro dipped below the pre-weekend low and buyers emerged near $.1.2390.   For a third session, sterling demand appeared just below $1.40.  The dollar-bloc currencies are firm, but largely confined to the previous session’s range.


Among emerging markets, the South Korean won is the strongest, gaining about 0.9%, perhaps encouraged by the return of foreign investors into the equity market.  Central and Eastern European currencies are firm, while the Philippine peso and Thai baht are the laggards.  The Turkish lira and South African rand  are off about 0.33%

Asian equities advanced, with the MSCI Asia Pacific Index up 0.9%; extending its recovery for a sixth consecutive session.  It has retraced nearly 50% of the recent slide.  European markets are struggling and nursing a small loss through the morning.  Two sectors are advancing today, energy and financials.

Screenshot 2018-02-19 12.47.43Screenshot 2018-02-19 12.48.12

Bond markets are under pressure in Europe with Italy and Spain’s 10-year yields rising 4-5 bp, while the core is a little less.


Greek 10-year bond yields are off nearly 5 bp following Fitch’s credit upgrade ahead of the weekend to B from B- (positive outlook).


The US markets are closed on Monday, and many parts of Asia will continue to celebrate the Lunar New Year.  The economic schedule is fairly light, and market psychology appears fragile after the dramatic activity in equities and what appears to be shifting macro-relationships.  To help navigate the challenging investment climate, we identify four “numbers” that can illuminate the path ahead.

1.  The equity market is center stage.  The key number here is 2743.  It is the 61.8% retracement of the S&P 500’s recent sell-off from record highs on January 26 near 2873. If last week’s impressive recovery, the largest weekly advance in six years, is “dead cat bounce” from the sudden drop, then this area should hold.  It was teased before the weekend, but the S&P 500 closed below it (~2732).



In the starkest terms, the issue is whether the drop in equities was the beginning of the end of the bull market in equities.  Many observers and analysts seem to think it is and welcome the increase in volatility ss chiefly a beneficial development.  The argument is that the capital markets have entered a new era, and many seem to attribute it to the end of the extraordinary monetary policies of central banks.

We have offered an alternative hypothesis. Yes, the equities were stretched, with a substantial rally in the first several weeks of the year.  The correction was overdue, which again underscores the hazards of market timing.  However, that is all it was, and even that may have been exaggerated, we suggest, by the new products that profited from the continuation of low volatility.   An echo-chamber was created that amplified the drop but the underlying drivers are still in place.



Rather than seeing the historical precedent for the stock market action in 2000 or 2008, we suggest it is 1987.  US equities lost a quarter of their value in a single day.   Coincidentally, a new Fed chief (Greenspan) had just taken his post.  There was no recession, and the stock market did not see those October 1987 lows again.  Then it took two years for the S&P 500 to make new highs, but if our hypothesis is correct, new highs will be seen much sooner.

Conversely, Goldman Sachs believes this is the wrong comparison to make. As explained by Mr. Heisenberg, in a post called Goldman: Relax, This Isn’t 1987.

Generally speaking, Goldman thinks that might be a bullshit comparison.

For one thing, the bank notes that “unlike in 1987, the equity market’s YTD rise has been driven primarily by accelerating earnings growth.” Upward revisions are of course tied to the tax plan. Notably, the bank says all of the S&P’s YTD returns are attributable to optimism on earnings, “whereas P/E expansion drove the entire index rise in January 1987.”

Besides that, Goldman says everyone seems to be ignoring the fact that there have been a dozen other instances since 1950 when returns in January were greater than 5% and if you look at those years, “1987 is the only one in which the February-December return was negative.” In fact, the median 11-month return is a whopping 17%:


Finally, the bank notes that given the global growth outlook, the prospect of higher oil prices and a weaker dollar, there’s as much as $8 in upside to their EPS forecast which, if you slap an 18X multiple on it, could put the S&P at 3,000 by year-end, notably higher than the bank’s “rational exuberance” target of 2,850.


More broadly, the consensus narrative puts the central banks at the center of its explanation for low-interest rate environment and the elevated valuations in the equity market and low volatility.  We respectfully demur.  While recognizing an important role for central banks, the huge pools of capital that do not find a sufficiently profitable outlet in production remain in circulation and park in financial assets.  Financialization is one of the key developments in the past generation, and the source of it is not central banks per se, but surplus capital.

2.  That leads us to the second key number:  3.0%.  That is in reference to the US 10-year yield.  Its importance, unlike the S&P 500, is more directly a function of psychology than technical factors.  At the end of 2017, many expected the US 10-year yield to rise to 2.90% by the end of this year.  That target has been met this month.  Already, many investors recognize that the 30-year downtrend in long-term US yields has been broken, but a move above 3.0% could spur another wave of adjusting and hedging.


‘Boiling Frogs, Rising Yield’: 10-Year Yield Hits Highest Level SInce April 2014

The 10-year TIPS yield may be used a practical measure of the real rate.  The yield had risen from about 42.5 bp at the end of last year to 79.5 bp last week.  That 37 bp increase explains two-thirds of the increase in the nominal 10-year yield (from 2.40% to 2.94%). The rise in real rates has been impacted by the shifting expectations of Fed policy.  The implied yield of the December Fed funds futures contract, which settles at the effective average Fed funds rate for the month, has risen 16 bp this year.  The December FOMC meeting concludes on the 19th, so the 16 bp increase reflects actually a greater increase in overnight rate expectation.


Screenshot 2018-02-19 12.50.37

By nearly any measure, real interest rates remain very low.  The average over the past 20 years is closer to 1.75% rather than the prevailing rate a little below 80 bp.  This is remarkable given what appears to be an unprecedented amount of fiscal stimulus directed at an economy that is growing above trend. At the same time, the Federal Reserve has been quite transparent about its intention to buy $420 bln fewer Treasuries this year, just as the supply is increasing.  Moreover, the tax changes may reduce corporate treasurers’ demand, while demographics will likely see Social Security buy fewer (non-marketable securities) as well.

Market-based measures of inflation expectations have risen, but remain modest, given the fiscal consideration and now the new tariffs (solar panels, washing machines, and soon, likely aluminum and steel) that raise prices for consumers of those items.  The recent string of reports, including average hourly earnings, CPI, PPI, and import prices was above expectations.

The shift in expectations of Fed policy has not been dramatic.  Several bank economists now forecast four hikes this year.  There is much discussion that the updated forecasts by the Fed will see the median forecast increase from three to four hikes.  What is the problem?  The market has not even discounted three.

Here is a way to conceptualize the issue.  The Fed funds futures settle at the average effective rate over the course of a given month.  Since the December hike, the effective average has been 1.42%.  Three hikes would lift the effective average to 2.17%, while a fourth hike would generate an effective average of 2.42%.  The January 2019 contract may give the best read of the end of 2018 rate.   It finished last week with an implied yield of 2.09%.

Our hypothesis in the equity market is that we have not entered a new investment paradigm that is a bizarro (or opposite) version of the current one. We do not believe that investors have been awoken from the Soma-like narcotic effect of central bank aggressive policy stance that blurred the distinction between monetary and fiscal policies, as the consensus narrative would have it.


Nor in their awakened state will rationality will return, and equity prices will return to valuations closer to their long-term cyclically-adjusted price-earning ratio averages.   Our hypothesis in the bond market is that the ample capital available, and the fact that the ECB and BOJ are buying the net new supply by their respective governments, will serve to keep US rates lower than what many macro models may suggest, given supply and demand considerations and rising inflation expectations.

3.  The third number is to be found in the foreign exchange market.  It is $1.26 and represents a key area for the euro.  There are two important technical levels.  First, it is the last major retracement objective of the euro’s down move that began in mid-2014.  Second, it is where a downtrend from the record high (2008 ~$1.60) is to be found.

A convincing move above there would likely spur action by some of the structural long dollar positions.  Technically, a move to $1.32-$1.35 would seem likely, if not a bit higher.  The OECD’s PPP model puts fair value near $1.33.

Speculators in the futures market have already begun taking liquidating long euro positions.  The week ending February 13 was the third in a row that the gross long position was trimmed.  The gross shorts eased 7k to about 103.5k, they have been fairly steady in a narrow around 100k.

With the US debt ceiling lifted, the Treasury Department will dramatically increase it T-bill issuance.  Next week, nearly $200 bln bills will be sold.  This includes $50 bln four-week bills and the same about of 55-day cash management bills.  This raises $70 bln in new cash.  Then the Treasury will auction a record amount of three-month ($51 bln) and six-month ($45 bln) bills.  The anticipation of such supply is already begun lifting short-term rates.

The hypothesis is as the Treasury replenishes its T-bills it will drain some of the high dollar liquidity.  In turn, this will push up the premium for dollars in the liquidity markets, like cross-currency swaps. This is also part of a broader explanation of last year’s dollar decline–namely the running down US T-bills due to debt ceiling maneuvering–flooded liquidity markets with dollars, driving down the price.

4.  The fourth number to watch is the final read of the January eurozone CPI.  The preliminary report is usually reliable.  It said that the headline rate fell 0.9% on the month for a 1.4% year-over-year rate.  Prices in Europe often fall in January.  The 0.9% decline is at the smaller end of the -0.8% to -1.5% range over the past five years.

Recall that the headline pace peaked at 2.0% last February, an inflation scare that did not lead to much of a euro rally, ahead of the Dutch and French elections. A Bloomberg survey shows a median expectation that the headline rate may be revised to 1.3%, which would match last year’s lows.  After holding steady at 0.9% through Q4 17, the core rate edged to 1.0% in the initial estimate.

The impulses coming from the exchange rate and oil prices suggest upward pressure on the headline rate and less pressure on the core rate going forward.  The euro has appreciated around 5% against the dollar since the staff’s last forecast, while oil prices have risen around 2%.   Good for German metal workers and engineers who fought for better pay increases and some flexibility in hours, but there are serious questions about how representative the settlement is going to be in Germany and Europe.

The initial estimate for February CPI is due February 28, and that will be the last input ahead of the ECB meeting on March 8. That is a few days after the Italian election and the result of the SPD decision whether to accept the deal with Merkel’s CDU/CSU and enter a coalition government again.

Investors are likely to be sensitive to eurozone inflation data.  It is seen as important for the current differences between hawks and doves.  That said, there appears to be a consensus currently that accepts a reduction of asset purchases after September, but to conclude at the end of the year.  Since the first rate hike (from minus 40 bp deposit rate) will start sometime after the end of purchases, the implication is that pushing the QE to the end of the year means a rate hike likely no sooner than mid-2019.