The Big Conversation
Episode 106: A rising risk for 2022
This week we look at bond yields and the US dollar. Rising yields are being interpreted as a positive repricing of growth, but this close to the beginning of a new year, they could be nothing more than rebalancing trades. A tighter Fed is also expected to boost the US dollar and yields, but price action over the last 18 months suggests that the opposite may be the outcome. And last year’s Q1 flows were themselves a head fake caused by asset allocation trades. Could this year’s early moves also be a false signal?
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Roger [00:00:00] Welcome to 2022. At end of last year, we highlighted a few charts that investors should keep on their radar for the next 12 months. U.S. government yields are one of the most important determinants for financial markets. The US 10 year yield is now pushing against critical resistance levels. But is this a response to the policy path that the Federal Reserve outlined in the last FOMC? Or is this a potential head fake, caused by the first of year flows? Well, that's The Big Conversation.
Roger [00:00:32] Now, it's always very dangerous to extrapolate for the full year, the price action that's been seen in the first few days of trading. These year-end and year beginning flows are often driven by rebalancing and window dressing. And it can take a few weeks before a true pattern begins to emerge. Over the turn of this new year, it's clear that asset allocators are positioning for a continuation of last year's risk-on environment. U.S. equities closed near a record high, and the first of month flows have also been broadly positive. The weakness in bonds and the surge in yields implies a shift out of safe-haven assets and into riskier opportunities. U.S. dollar vs. the Yen has made a five year high. There are a couple of factors which often put the Yen on the back foot. Firstly, if Japan's retail investors perceive that a risk-on environment will continue, they will often sell Yen to buy riskier foreign assets, putting downward pressure on the Yen. Also, overseas investors such as hedge funds will often borrow in Yen where interest rates are low, and use that to fund positions in assets that are denominated in other currencies and where the potential yields are higher, often called carry trades. The Yen is one of a number of funding currencies such as the euro and Swiss franc, but these other currencies have not performed as poorly as the Yen in recent weeks, suggesting that domestic Japanese investors, rather than foreign currency, carry trades are behind this move. Dollar / Yen is now testing a 30-year downtrend and there's significant potential to exceed most strategists targets for dollar / Yen this year, if current levels are convincingly broken. The global risk environment could quickly become unstable however, if we have a sudden move higher in U.S. yields. Low and stable yields have so far helped keep US financial conditions, which are a proxy for global financial conditions, near their all-time lows. Furthermore, during this recent bout of slightly higher yields, we've seen both the front end and the back end of the curve rise. The U.S. 2-year yield has just reached its highest level since the midst of the pandemic. The yield curve has also steepend slightly, because longer dated yields have risen by more than those at the front end in the last few days. And this brings into focus one of the big potential risks for 2022, and that's a breakout in yields that reflects a change in positioning, rather than a re-evaluation of growth itself. A steady rise in yields that's more than offset by a rising growth is one that financial markets can absorb. But a rise in yields that's in excess of growth, will be much harder to digest. We've shown in previous episodes that global growth remains on a very uneven footing, and that even US growth has been mainly a beneficiary of fiscal stimulus that's now running into a few roadblocks. And additionally, there's been that supercharged performance of tech stocks, but tech stocks have tended to underperform when yields rise too quickly. So if growth picks up, cyclical stocks should benefit from a rotation out of tech. But that probably won't be the case, if yields are marching higher without growth. And the current consensus is that growth will prevail. The market expects higher growth, higher inflation, higher yields and also rate hikes in 2022. This therefore increases the chance that we get a negative growth surprise. Growth projections nearly always exceed reality, and we may already be receiving similar mixed signals that we experienced at the beginning of 2021. Now, whilst last year was obviously a good year for risk assets in general, there was significant divergence in performance. Many of the usual beneficiaries of growth and reflation, such as emerging markets, failed to gain momentum. The rise in yields in Q1 2021 was seen as confirmation that the reflation trade was in full swing, even though emerging markets were struggling to make significant gains. In the end, yields peaked out at the end of Q1. That Peak in yields coincided with the end of Japan's financial year on the 31st of March. High yields were not a confirmation of true reflation, but instead reflected an asset allocation by the world's largest pension fund, out of bonds and into equities. And could a similar pattern be emerging today? While it's rare to get a repetition on that scale, but it's certainly worth bearing in mind before we take the current move in bond yields as our cue for growth in 2022. A rapid rise in yields today could be very destabilising, and therefore very fleeting in nature. And obviously, the action of policymakers will also be key. And it could be argued that U.S. yields are rising because the Fed will quickly taper its bond purchases in the first half of 2022. But many investors have been using the 2013 taper tantrum playbook to determine the likely path of yields today, but that comparison already looks obsolete. Yields today have edged higher, but they've not surged like they did in 2013, since the taper announcements. If inflation expectations in 2020 and 2021 had risen on the back of loose monetary policy, then it seems more likely that inflation expectations should begin to fall, if the Fed is ending its bond buying programme and planning to hike rates two or three times over the coming year. Obviously, U.S. monetary policy should also impact the US dollar, but again, probably not in the way most people imagine. There's now a consensus for a stronger US dollar in 2022, and the main driver of this view is the policy divergence between the Fed and other central banks, such as the ECB and the Bank of Japan. Now we've already seen that the Japanese Yen has weakened, but the Yen has weakened against the euro and the Swiss franc, too. So it's unlikely that this policy divergence is at the heart of this current move. In fact, policy divergence over the last 18 months has worked in reverse when it's come to the performance of currencies. Coming into 2021, there was a near unanimous belief that the dollar would weaken because the Fed would be most aggressive of all the central banks. If the Fed expanded its balance sheet at the fastest pace, then the dollar should fall, or so the thinking went. Initially, the Fed was the most aggressive, but the ECB soon caught up and overtook the Fed. However, over this period, the balance sheet has worked in reverse. Whichever central bank has expanded its balance sheet at the fastest pace, has been rewarded by strength in its own currency. During the second half of 2020, the ECB overtook the Fed, and the DXY fell whilst the euro rallied. In the first quarter of 2021, the ECB took its foot off the pedal and the dollar rose. For the second half of 2021, the Fed's balance sheet has again expanded at a faster pace than that of the ECB, and the dollar has rallied during this period. Therefore, if the Fed is now about to slow down its pace of purchases, whilst the ECB maintains its own, well that suggests that the tighter policy from the Fed, may actually put downward pressure on the US dollar, contrary to common thinking. Furthermore, we've also shown that positioning against the euro has now turned neutral, from an extremely long position at the beginning of 2021. Both policy and positioning could work against the dollar in 2022. Clearly, there are many other factors at work, including the relative attractiveness of the US equity market compared to many others. But if yields start to rise, then the tech sector could lose some of its lustre, and so could the US equity market. Though it's not really been a winning strategy to bet against U.S. stocks over the last decade. But if the dollar does lose some of its momentum, then it can only be a good thing for financial markets. The last thing we want to see, is both surging yields and a surging dollar. A weaker dollar would at least offset some of the tightening in financial conditions, that would come with higher yields. And a weaker dollar would also be beneficial to emerging markets. Though as we argued through much of 2021, China will be the key determinant in that performance. So whilst many of last year's themes are continuing in 2022, we must be careful not to extrapolate current trends out too far into the future. First of the month and first quarter flows are tricky enough, but first of the year flows can be very choppy and have a habit of performing a round trip in the first quarter of each year, with many investors getting dragged in, just as momentum is about to turn. So rising yields therefore remain the biggest threat for the market. A reverse head and shoulders of the US 10 year yield implies a move back above three percent, if key resistance is broken. Now that seems unlikely, it was already destabilising when yields got back above three percent in 2018. And that was at a time when economies were at least showing some signs of life, and were not reliant on government handouts to bolster growth. Significantly, higher yields are not a base case because if they rise too quickly, and destabilise markets, they become a self-correcting mechanism. And again, this is what we saw after the equity swoon in 2018, which led to 10-year yields falling through the first nine months of 2019. But for those holding cash in reserve, higher yields could well provide a buying opportunity within the tech sector, though so far these opportunities have been relatively short lived. Institutional investors have been looking at hedging risks via long volatility, in both the bond market and the equity market. But again, any long volatility positions that have worked, have tended to be difficult to monetise because the periods of high volatility, have been brief in nature. But it's always best to buy volatility when you can, rather than when assets have already had an outsize move. Now that's easier said than done, but there's a clear and present danger in the fixed income market that could create a painful VAR shock if these current key levels are significantly exceeded over the short term. And if you have any questions about this episode, financial markets or the economy, please put them in the comments section or send them to TBC@Refinitiv.com