Great Commentary …again from IFR

BOSTON, July 16 (IFR)-

• Correction Seen as Over for Now as Europe Resumes Bull Trend
• Calibrating Central Bank Reaction Functions on Global Economy
• Earful of Fed Speak and Corporate Earnings and Fiscal Noise
• Retail Sales, Import Prices, Inventories, IP, NAHB and T-bills

There is much going on with market shifts and policy pivots left and right, but it’s important to keep it all in the context of light volume and relatively illiquid summer market conditions. With the compromised market liquidities, take nothing for granted. Appreciate that markets can turn on a dime and for reasons unknown.

Last week’s technical reversal lower in the European bond complex and the under-subscribed 30-year UST auction were examples that markets can and do get out of step with the prevailing narrative. They were also reminders that market narratives mature and change.

The current narrative is one of a crippled global economy with a heavily damaged manufacturing sector. The root cause is a breakdown in global trade that is essentially ongoing even though there are behind-the-scenes attempts to remedy it.

As this is occurring global central bankers feel compelled to support their respective economies and have signaled that various forms of additional stimulus are likely on the way. Seen as most capturing the market’s attention in this regard is the ECB and what they have planned. ECB President Draghi has essentially signaled a multi-pronged version of shock and awe of lower for longer interest rates, a fusillade of large-scale asset purchases along with clear and resolute forward guidance.

The large-scale asset purchases (QE) are what the market is most trying to get out in front of. There is already a significant “scarcity” factor in the European sovereign debt complex that another round of QE would exacerbate exponentially. Indeed, according to Street modeling there is talk that European sovereign yields could plunge by 100 bps or more (with a sharply flatter curve) under the current supply regime.

Complicating matters, there is increasing talk that fiscal stimulus either will be or at least should be rolled out in Europe. This week saw the presumptive EU President Ursula von der Leyen propose a $1 tn “green” spending plan to help address climate change and other social issues. As well, Laurence Boone, the chief economist for the Organization for Economic Cooperation (OECD), opined that Europe is ill-prepared for an economic shock and that it is “crying out” for fiscal stimulus. As well, the presumptive new president for the ECB, Christine Lagarde, is also a big proponent of the need for fiscal stimulus in Europe.

The markets could see such an enterprise as a major game changer (in the direction of interest rates) and even if the ECB took to shock and awe. Conclusions could be drawn that a surge in fiscal spending would be the elixir for the European economy to find the elusive escape velocity and vault inflation up along with it.

And then there is the Fed. The markets appear of the notion that the Fed has capitulated to a new paradigm, basically concluding that the natural rate of unemployment (or full employment) is far lower than previously thought, that the current economy has ample labor slack so as not to be a danger in promoting higher inflation, and that to help sustain the current expansion they will “act as appropriate” and lower their funding rate by at least 50 bps.

Such an approach is a double-edged sword. An easier Fed should be supportive for the markets, but a “hotter” economy carries greater inflation potential. The treasuries market has been more sensitive to where it believes the economy (and inflation) is heading and not so much to what the Fed’s view is. Of course the two are inextricably intertwined but if the markets see the Fed as abandoning prudence for a preemptive strike on disappointing inflation it could well be viewed as bond bearish and produce a sharply steeper curve.

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