Short-covering in Treasuries and a third wave in Europe

I expect to see more of the bear market in bonds in due course. Eventually, I think it’s the sell off in Treasuries that will force the Fed’s hand. But right now, that is a crowded trade. We’ve got some negative Covid-19 data out of Europe and some negative retail sales data out of the US this morning that could cause the backup in yields to take a breather. Let’s see. But let me outline how I am thinking about the real economy and markets right now.

Looking through the re-opening

I think the narrative of markets being forward-looking is overplayed. But, there is some truth to it. And what I see now is a market that has priced in the reflation of the global economy and is looking to understand what happens after the full post-vaccine re-opening.

For example, Bloomberg’s Jonathan Ferro noted this morning that a BofA survey showed that Covid-19 lost its spot as the primary tail risk driver in investors’ minds for the first time since February 2020. That tells you that investors are looking through the vaccination period to what happens afterward. And they see the risk of inflation and asset purchase tapering as the two risks to watch now. That’s why yields have backed up and speculative short positions in Treasuries have piled up.

On Wednesday, we get a view into what the Fed plans to do to deal with the latest information on the US economy. And there is a lot of speculation on this front. Bear Traps Report author Larry McDonald told me yesterday he believes the Fed needs to and will eventually offer more calendar guidance regarding tapering and what the parameters around yield curve control would look like. His view is that the Fed needs to move away from an open-ended commitment to quantitative easing because it’s no longer credible. And he believes calendar-based guidance would be more credible and help prevent further steepening of the yield curve.

I am not so sure there. I do know that the Reserve Bank of Australia is moving against steepening with actual bond purchases and that the ECB has talked down yields. But the Bank of England is taking the same line as the Fed now, which gives the Fed cover to continue its open-ended language. I don’t expect the Fed to announce anything major tomorrow. And even if they did, the -3.0% m-o-m print in retail sales that just came out is enough to give support to the Treasury market. As an aside, let me say that the Q1 2021 Atlanta Fed GDPNow tracker is running at 8.4%, with the consensus estimates now up to near the 5% range.

Stimulus

The increase in Q1 is only based upon what Congress did before Biden became President. The recent $1.9 trillion package will come on top of that while the US economy is re-opening and vaccination accelerates. The upside risk is inflation there. And I agree with the markets that there is more risk there than tail risk from Covid-19.

Having said that, I still believe coronavirus is a tail risk. At this point, it represents a greater risk to Europe than to the US. For example, Italy has imposed a lockdown because of spiking case counts. And Germany is seeing infection rates rise as the B117 UK mutation takes over in spreading the virus there (link in German). The lack of vaccination progress in Europe is the primary reason to think of Europe as more vulnerable to a mutated-virus induced wave than the US. Right now, the US is winning the foot race with the mutants. I am hopeful this continues but still believe we will see another wave in the US as well.

So, by mid-Spring, we will have maximum stimulus, and, depending on circumstances, we may have a closer to full re-opening just as the base effect from last year’s shutdown makes inflation look its worst. That is what has driven the inflation narrative. But, I don’t think we see anymore stimulus until the Fall. And so, the risk after April or May is that the economy and inflation disappoint, both in Europe and the US.

My View

I am looking at mid-Spring as an inflection point where market dynamics might change to a “sell in May and go away” theme. All of the reflation trade thinking will have been priced in and we will begin to see whether the tail risks materialize. Inflation, which is negative for large cap technology shares, is the dominant tail risk people are thinking about now. But, I believe that by May doubts about the durability of economic reflation will creep in enough to also be a tail risk.

In the meantime, I expect equity markets to churn higher and, after consolidating at present levels, yields as well.