US equities were lower overnight with NASDAQ down 3%. The bond sell-off has extended further post-Fed, US 10-year yields lifted 7bps to 1.71%, highest since 23 January 2020.
The rapid rise in long-end US yields has spooked investors again overnight as there appears to be no lasting respite for the fixed income onslaught. Given the untimely ferocious nature of the sell-off, which caught some investors wrong-footed whilst cheering the FOMC “lower for longer” mantra, it caused a real stinger to longer duration growth asset sentiment like mega-cap tech names.
FOMC experiment failing
The Fed’s experiment isn’t working as the market is finding in the aftermath of the latest FOMC meeting. Indeed, this is because of the market’s expectations around the forward path of economic data. A dovish stance only increases the inflation risk premium’s sensitivity to the economic upgrade in a market state where fundamentals are expected to continue improving.
The two paths as we advance are:
1) the Fed eventually gives up on this experiment and has to tighten because they can’t talk down realized inflation
2) data fails to meet elevated expectations in the coming months (or a turn in the China credit cycle reins in commodities) which brings inflation breakeven back down to earth and bails out the Fed.
The issue with #2 is that there is still a long runway of catalysts from stimulus and vaccine tailwinds, so it may be a while before the market can confirm or deny its positive outlook on economic data.
But buckle in as the market vs Fed cat and mouse game is only beginning.
The fear of falling behind the curve
With the Fed already forecasting a pickup in inflation but assuming it will be transitory, a policy mistake here, if it happens, won’t be rectified until it’s way too late in the game, which will mean faster hikes and a market meltdown.
The market risk is not that the Fed is not dovish enough in pushing back on the rise in yields. Instead, it’s that the Fed is at risk of falling behind the curve.
Bonds reacted to Powell’s comment that upcoming inflationary pressures would come from base effects and the potential surge in consumer spending as economies reopened. But even with inflationary pressure coming for improving fundamentals, the Fed would still be biased to question whether it was only transitory.
While the Fed could be correct, this always heightens inflation risk premium if they are wrong, and the higher it goes, the higher that risk becomes.
What started as a profit-taking correction triggered by a vaccine health scare has now moved into a whole out price level correction. The sell-off in oil is getting compounding by risk-off moves in cross-asset correlations as the market continues to price in tighter financial conditions despite the Feds effort to suggest the contrary.
Because of a very patchy re-opening narrative with most countries outside the US, the UK and Israel behind in their vaccination rollout protocols and even some countries in Europe back in lockdown, frothy oil market sentiment is catching down to the short-term economic demand reality.
Oil is down 7% overnight. There is little in the way of oil specific headlines to support the move, rather a softening in the demand expectations and a strengthening of the dollar spurring some caution in a market that is quite long in terms of speculative positioning.
And despite Germany, France, Spain, and Italy saying they will recommend using the AstraZeneca vaccine after the European Medicines Agency deemed it “safe and effective”, the oil market shrugged, leaving oil bulls and analyst scratching their head wallowing in a world of hurt.
But at the heart of it all, the rally was mainly on the back of OPEC+ production cuts—or rather, the fact that they agreed to hold production steady in April instead of ramping up production as the market had anticipated.
So, I suspect the oil market is experiencing a bit of reality check these days as the supercycle bulls might be giving way to the power of spare capacity as the thought of more barrels coming back continues to provide the medium-term supply headwind.
And watch out if the China credit cycle starts to rein in commodities; that is unlikely to be a pleasing wake-up call either.
Market analysis from Stephen Innes, Chief Global Market Strategist at Axi