No major catalysts in either direction
Right now, there are no major stories that I think will have any meaningful near-term impact on asset markets. We’re definitely still in a risk-on market phase. And ostensibly, this is largely because we are poised for a growth re-acceleration rather than simply a reaction to Fed easing. I have my doubts about that narrative and think risk assets are vulnerable to a sharp pullback, when a catalyst presents itself.
In the first instance, I think a lot of this rally is simply a rebound due to the Fed’s about face from its hawkish pre-Christmas rhetoric. But I also have major questions about the real economy. And I think bond markets share my concerns. Treasury yields are depressed, indicating concern about economic weakness forcing the Fed to cut. Fed funds futures are showing a 32% probability of a cut this year. And the middle of the curve is still inverted, with the 1-year yield more than 11-basis points north of the 5-year and higher than the 7-year.
The same goes for Europe, by the way. There, the ECB is adding liquidity. And that’s not bullish. It’s a sign of distress and economic under-performance, not a catalyst for a risk-on rally. But the Euro Stoxx 50 is up 16% from its 2908 low in the week just before New Year’s.
So the bond market and the equity market are singing from different hymn books. And eventually one of those markets will realize they have been singing the wrong verses. Which market will it be? Let’s look at five events in today’s news to think about it.
Deutsche Bank
The news out of Germany is that Deutsche Bank and Commerzbank, Germany’s largest private lenders, are in merger talks. This is not a merger of opportunity from a position of strength, but of necessity from a position of weakness. And these are two gargantuan companies, with a combined enterprise value of about $450 billion.
The problem is that the equity portion of that value is only $46 billion – or just over 10% of the combined entity. In an economic downturn, that equity would dwindle rapidly. Hence the government’s urgency in coercing these banks into merger discussions – against the will of the bank employee trade union, which correctly fears tens of thousands of job losses.
This smacks of Japan’s desperation as it fought its post-bubble depression. See the FT’s blurb on one of the latest forced mergers in Japan from last year – and notice the link to zero and negative interest rate policy:
Japan has approved the first ever deal between two dominant regional banks, paving the way for a potential wave of mergers.
[…]
The decision to allow the deal sets a precedent that could lead to widespread consolidation in a Japanese banking sector plagued by ultra-low interest rates and declining regional economies.
[…]
Fukuoka Financial and Eighteenth Bank are the two dominant players in Nagasaki prefecture, on the western island of Kyushu, with a combined market share of 70-75 per cent in business lending.
Historically, that meant a merger was considered off limits. But the growing weakness of Japan’s regional banks in an environment with few lending opportunities and huge excess deposits has prompted a rethink.
And remember, although the Germans have the de facto safe asset in the euro area, they are still currency users who are not sovereign. So, that means Japan-style fiscal loosening is off the table. And that practically guarantees a shortfall in domestic demand growth as these job losses hit the streets. That’s not bullish.
Quantitative Tightening
In the US, a lot of people are running with the market liquidity scenario regarding the Fed’s balance sheet roll off. I think that displays a lack of understanding of the fundamentals of the bond market. Since the US is a sovereign currency issuer, the bond yields across the curve mostly reflect anticipated future overnight rates, with a term premium tacked on. ‘Liquidity’ is not a fundamental factor.
In fact, when the Federal Reserve was engaged in quantitative easing by buying bonds, bond yields went up, contrary to the liquidity thesis. And now that the Fed is withdrawing liquidity by rolling off its balance sheet, Treasury yields are depressed, with the middle of the curve inverted.
The yield curve, therefore, reflects the concern bond markets have about future growth. When those concerns are low – in part because of Fed easing as signalled by QE – yields rise. When concerns about growth are higher – as they are now, then rates are depressed, even if the Fed is selling into the market.
QE and QT are signals of Fed policy, not determinants of yields. And the signal that QT gives is of over-tightening by the Fed.
The Fed’s rate decision
So, what the market wants to see is that the Fed has fully removed the possibility that monetary policy will add downward pressure to growth. Even though equity markets are convinced by Chair Powell’s dovish messaging, bond markets are less sanguine about the prospects of future growth. And the fact that the Fed continues to engage in QT is part of why.
What the markets want to hear later this week is that the Fed has completely rolled over and moved to the dovish side, both on rate policy and on the signal that its balance sheet represents about the Fed’s monetary policy stance. If the Fed does not signal that QT is coming to an end, expect yields to stay depressed or even go lower, as the bond market rallies in anticipation of economic weakness and future Fed cuts due to that weakness.
The only other large central bank with a rate decision this week is the SNB. And since the Swiss Franc is a major funding currency for the carry trade, it will be interesting to see what the Swiss National Bank says about the global economy and what kind of forward guidance it provides.
The PMIs are weak
I have been looking at a lot of the data coming out in the last couple of weeks and it is mostly weak. Still, I think we should consider that the global economy is in a rebound mode.
I know that Torsten Slok, chief international economist at Deutsche Bank, has been saying that global trade – and, ostensibly, global growth – is rebounding. Both the Harpex and Dry Baltic shipping indices suggest a bottoming around the beginning of the year. Oil and commodity prices are rebounding as well. All of this suggests a pick-up in demand.
Yet when you look at the PMIs, they are weak – and weakening further still. Here’s what IHS Markit said two weeks ago about February data:
- Global PMI Output hits 33-month low in February.
- Output and orders near stagnation as global exports fall for sixth month
- Input price inflation lowest since September 2016 as supplier pricing power wanes
- Thirteen out of 30 countries now in manufacturing downturns, up from just two this time last year
My view: If the data for March do not show a rebound, this is a false recovery and risk-on rally that will fade. However, if there is a rebound in the March data, the global growth re-acceleration story could have legs.
Basically, we are in a holding pattern to see how this breaks. And either the bond market will stumble or the equity market will as a result of the data trend. Early April will be the moment of truth.
Lyft and Uber
Until then, I will watch the Lyft and Uber IPOs with fascination. They represent the best look at how well late cycle ultra risk-on plays can do in the public markets. Lyft disclosed today that it wants to raise over $2 billion in its IPO, with shares selling between $62 and $68 per share. This would put its initial public market cap over $19 billion. The roadshow starts today.
Back in the summer f 2018, Lyft’s last private funding round was raised at a $15 billion market cap. So, this is materially better than that in an equity market that is essentially unchanged in that time frame. That’s a n aggressive move. And it will interesting to see what kind of reception the loss-making company gets as well as how well shares trade in the open market afterwards.
Just this weekend, I was talking to someone who was telling me he is indifferent between Lyft and Uber, deciding on when one has a better deal on which service to use. That reinforced for me my recent point about the lack of switching costs. This gentleman said he took Lyft a lot when they opened for business in Austin because Lyft offered $5 rides for every ride regardless of distance as a promo in building out adoption in Austin. Clearly, that’s a predatory pricing model, where Lyft is pricing below cost to gain market share. But given this gentleman’s behavior, it’s questionable whether such high cost customer acquisition is beneficial in terms of getting users sold into the platform.
My view: The cost advantage of Lyft and Uber over traditional taxi service is illusory. It’s supported by a flood of VC money. And when they go public, the gravy train will be over. The companies will be forced to move to profitability quickly or their stock price will tumble. In a worst case scenario, they could even run out of money.
My prediction is that this is THE stock market event we have been waiting for as the quintessential signpost on the mobile Internet bubble. Either these companies flourish and we move into overdrive, the hyperbolic phase of the bubble. Or they crash down to earth, are forced to husband cash and raise prices, ruining the valuations and IPOs for all the remaining Unicorns running through buckets of VC money. It will be exciting to watch.
Happy Monday!