Rabobank: There Are Only Three Ways That This All Ends
By Michael Every of Rabobank
Our problem, in a Canute shell
As posited yesterday morning, Monday indeed proved that Friday’s market price-action had been about end-of-month short covering in bonds, rather than a sudden market recognition that major central banks are ahead of the curve in controlling longer bond yields. Monday was a new day, a new week, a new month, and a new way to show us that inflation is still something bonds are unhappy about.
The US ISM manufacturing survey, for example, saw the number of firms reporting that they were paying higher prices stay at 100% for a third month in a row: there isn’t much room for misinterpretation when everyone is paying more for their inputs. Then we also saw the US House pass the USD1.9 trillion stimulus bill, which now moves on to the Senate: apparently this can continue to be priced in over and over again.
As such, at time of writing, long bond yields are going up; and so are stocks; and so are commodities. Yet the first and the third trend on that short list risk hitting the second, as we have already seen graphically displayed of late.
To repeat the analogy from yesterday, central banks are going to have to do something other than just expect markets to retreat at their verbal command like King Canute, whom popular British legend says believed the tides would obey him as he sat on his throne on the seashore.
They will certainly need to do more than the ECB did yesterday in sending the signal, genuine or not, that it may be scaling back its QE bond purchases just as at least one governing council member jawboned that it may need to increase it. (Markets, unlike tides, can count.)
They will arguably need to act more like the RBA, which smashed bond bears yesterday with a doubling of its QE purchase at the longer end to AUD4bn. However, it is vitally important that central banks in general, and the RBA in particular, understand that the huge intra-day drop in 10-year bond yields seen in the Aussie market yesterday was the product of follow-through short-covering from the US on Friday (i.e., the tide decided that it wanted to go out) rather than a reflection of shock and awe at the figure of AUD4bn.
The tactical risk for markets is that the conservative RBA, which meets today, sits on its throne with its crown at a jaunty angle, strokes its beard, and proudly announces that it is in full control of the curve. If so it, and then others by extension, are going to get pretty wet, pretty fast.
Yet our good King Canute and the central banks differ: the latter *do* have the ability to control the curve if they really want to; they *can* peg yields wherever they want them to be. Indeed, one can expect the market to start calling for exactly that both in word –and they are, with calls for the Fed to shift to a new Operation Twist focusing QE at the long end of the curve– and in deed, through both higher yields and bear steepening, with every inflation anecdote and data release.
As has been underlined here for years, and many times recently, the only problem with central banks displaying such awesome powers at a time when input prices are soaring is that there is no going back to normal market tides afterwards: no ripples; no waves; and certainly no surfing. The sea will be artificially becalmed – but lots of important things will still drown.
Tactically, let’s see what the Fed’s Brainard and Daly have to say today as they get their latest chance to dip their toes in the water on this key topic. Strategically, however, and given King Canute is NOT applying his powers to the labor market *directly*, where the waters still remain full of sharks and dangerous undercurrents (and no USD15 minimum wage), one has to recognize that there are only three ways that this all ends up: the tide is either coming in or going out, so to speak. Either:
Central banks refuse to step in; longer yields rise sharply, and probably overshoot; stocks are dragged down; the US Dollar is pushed up; commodities are dragged down; markets start to panic; governments start to panic; corporations start to panic; and everyone ends up in rags crammed onto the tiny desert island of the short-end of the yield curve under a solitary coconut tree; or
Central banks step in; longer yields are crushed, as we saw Monday in Australia; stocks rally further; the US Dollar is pushed down (assuming the Fed is doing this); commodities are pushed up; markets are on fire; governments are free to spend – if they can bothered, which still looks unlikely; corporations are free to build lots of ‘useful’ projects like The World islands in Dubai; and those long assets get to sit on man-made islands drinking cocktails under coconut trees, while those long labour get to swim with the sharks in wave-free seas to serve the drinks to them; or
Central banks and governments step in; and they focus on the labour market *directly*, which will have to involve building a whole series of dykes to keep liquidity in and other fishers out, in a proletarian version of The World islands in Dubai where everyone has rolled up trousers and wears a white hankie on their head; and only the rich end up on a desert island, one way or another.
So which of the above is really nautical, and which is nice? That’s our problem in a Canute shell.