Draghi's Animal House Moment Shocks Bond Traders
(Bloomberg Opinion) -- In the classic 1978 movie “Animal House,” Dean Vernon Wormer of Faber College shocks the deplorable Delta Tau Chi fraternity, which is already on academic probation, by putting it on “double secret probation.” It turns out that European Central Bank President Mario Draghi has also been keeping a secret file of sorts, and bond investors are just as shocked.
Although the ECB is projecting inflation to average 1.7 percent through 2020, below the target of just under 2 percent, Draghi told the European Parliament in Brussels on Monday that those forecasts conceal an improvement in fundamental price pressures. In Draghi’s words, there’s a “relatively vigorous” pickup in underlying euro-area inflation. I guess that’s possible, especially with Brent crude — the benchmark for Europe — rising above $80 a barrel for the first time since late 2014, but the the latest data show the euro zone’s economy is anything but vigorous, which usually tamps down inflation. Just a couple of weeks ago, the ECB reduced its forecast for how much gross domestic product will expand this year and next by 0.1 percentage point to 2 percent and 1.8 percent, respectively. It was disclosed on Friday that the seasonally adjusted IHS Markit U.S. Composite Purchasing Managers’ Index fell to 53.4 in September — a 17-month low. In that context, it’s easy to see why European bonds fell out of bed Monday, with yields on 10-year German bunds rising the most since July 11, or almost 5 basis points to 0.51 percent. The weakness even spilled over into the U.S. bond market, with demand at the Treasury Department’s auction of $37 billion in two-year notes matching the lowest since 2008.
The ECB is desperate to join the Federal Reserve and start boosting policy rates up from the zero bound while pulling back on bond purchases, and is looking for any excuse to do so, just as Dean Wormer was looking for any excuse to kick the Deltas off campus. Bond investors are slowly realizing that, having pushed up the yield on the Bloomberg Barclays Global Aggregate Treasuries Index of sovereign debt to 1.51 percent. That may not sound like much, but it’s the highest since early 2014.
THE WRONG LEADERS
The S&P 500 Index has risen in five of the past six weeks, reaching a new intraday record high on Friday. Even so, the mood feels rather gloomy and more in line with Monday’s decline than anything like animal spirits. One reason for that might be the way the S&P 500 has rallied of late, led more by defensive stocks such as utilities and consumer staples than those that tend to benefit from a strengthening economy. After lagging behind for most of the year, those two sectors, along with S&P 500 Dividend Aristocrats and the S&P 500 Low Volatility indexes, have recently caught up and matched the S&P 500’s total return since mid-February, according to Leuthold Group Chief Investment Strategist Jim Paulsen. “It might be worth paying attention to this oddity,” Paulsen wrote in a research note Monday. “During the post-war era, when the unemployment rate was low and defensive stocks outperformed, it often signaled a pending recession. And, from unemployment rates of 4 (percent) or less — where it is today — defensive stocks have outperformed.” In other words, stock investors believe this might be is as good as it gets. All this dovetails with what we pointed out in this space last week, which is that despite the records, U.S. stocks were trailing their global peers in recent weeks. “Post-war history suggests this is precisely the time to lean defensive — when the economy is great, and most importantly, when the unemployment rate is 4 (percent) or less,” Paulsen wrote.
OIL IS POPPING
The oil markets are receiving a lot of attention, with many market watchers staring to predict a sustained rise in prices. If true, that could pinch corporate profits and consumer spending, threatening the global economy when analysts such as those at the Organization for Economic Cooperation and Development are already trimming their forecasts amid turmoil in emerging markets and an escalating trade war. After cratering below $28 a barrel in early 2016, prices of global benchmark Brent have rallied, recently popping back above $80 as fresh sanctions on Iranian crude loom and members of OPEC hesitate to increase output, according to Bloomberg News’s Dan Murtaugh. Large oil-trading houses are predicting the return of $100 crude for the first time since 2014. U.S. President Donald Trump has been seeking to pressure OPEC to raise production, but the cartel and its allies gave mixed signals at a meeting in Algiers on Sunday, ultimately showing little sign they would heed U.S. demands to rapidly push down crude prices, Bloomberg News reports. “The market does not have the supply response for a potential disappearance of 2 million barrels a day in the fourth quarter,” Mercuria Energy Group Ltd. co-founder Daniel Jaeggi said in a speech at the S&P Global Platts Asia Pacific Petroleum Conference, known as APPEC. “In my view, that makes it conceivable to see a price spike north of $100 a barrel.”
LONG AND WRONG
The latest Commodity Futures Trading Commission data released late Friday showed that currency traders boosted their aggregate bets on dollar strength to a net 249,375 contracts in the week ended Sept. 19, the most since early 2017. That’s understandable given the Fed is expected to raise rates this week for the eighth time since December 2015 and reiterate its plan to boost them again come December. But the thing is, dollar bullish positioning has been elevated at above 200,000 contracts for the past two months, and the Bloomberg Dollar Spot Index has done nothing in that period after a big jump between mid-April and late June. Absent any strong signs that the greenback is due for another leg higher, such as an overly hawkish Fed, it wouldn’t be too hard to see some of those bulls turn into bears. That could, in turn, put a lot of downward pressure on the dollar. Morgan Stanley is one firm forecasting a weaker dollar. Its foreign exchange strategist noted in a Thursday report that not even relatively high interest rates in the U.S. compared with the rest of the developed world have been enough to push the dollar higher in recent weeks. “We believe the current yield compensation offered by the (U.S.) is no longer adequate to attract sufficient foreign funds to cover (U.S.) capital-import needs,” the Morgan Stanley strategist wrote in the report. “Hence, we posit that (the dollar) has to decline to attract international funds” to the U.S.
Will India be the next emerging market to come under attack by speculators? It’s sure looking as if that’s a possibility following a Monday when the benchmark Sensex index of stocks tumbled 1.46 percent in its biggest decline since March. It’s a stunning turnabout of India's stock market, which is down 2.66 percent since late August after rallying 19 percent in the previous five months. At the same time, the rupee has fallen to its weakest on record. Investors are increasingly concerned about the health of India’s financial system amid a recent default by Infrastructure Leasing & Financial Services Ltd. The situation has created the worst liquidity crunch in India’s banking system in more than two years, according to Bloomberg News’s Saloni Shukla and Ameya Karve. Liquidity in the financial system is currently at a deficit of around 1.4 trillion rupees ($20 billion), according to the Bloomberg Economics India Banking Liquidity Index, having moved from a surplus of 580 billion rupees earlier this month. At $2.60 trillion, India’s economy is worth being concerned about and dwarfs that of some emerging markets that have run into trouble in recent months, such as Turkey at $851 billion and Argentina at $638 billion. The government will provide adequate liquidity to mutual funds and nonbank financial companies, Finance Minister Arun Jaitley said on Monday, but sometimes when it gets to that point it’s already too late.
Something has to give, right? I’m referring to the Grand Canyon-sized gulf between how consumers perceive current conditions and what they expect to happen in the future. The Conference Board’s consumer confidence present situation index has risen steadily this year, reaching 172.2 for August, which is the highest since December 2000. The expectations index, however, has done a lot of nothing this year, settling in at a reading of 107.6 last month. The gap is the widest since 2001, just as the economy was heading into recession. The Conference Board on Tuesday will release its index for September. The forecast is for little change in the headline number that combines the current and future conditions indexes, but if consumers continue to think that things down the road will be nowhere near as good as they are now, then it’s not hard to imagine them becoming more cautious in their spending habits. That would be a significant drag on the economy.
What to Expect From the Fed This Week: Mohamed A. El-Erian
OPEC Is the Oil Producer of an Unlikely Future: Liam Denning
A Bull Market Quandary: Your Clients or Convictions: Nir Kaissar
Fed Misses the $13 Billion Buyer in the Room: Brian Chappatta
Why U.K. Stocks Are Exiled to the Brexit Doghouse: Mark Gilbert
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Robert Burgess is an editor for Bloomberg Opinion. He is the former global executive editor in charge of financial markets for Bloomberg News. As managing editor, he led the company’s news coverage of credit markets during the global financial crisis.
©2018 Bloomberg L.P.